Unconventional monetary policy
Central banks worldwide have gone into `unconventional monetary policy' owing to policy rates having hit the zero interest rate bound, and owing to the difficulties in finance which have impeded the monetary policy transmission. This has involved dramatic increases in money supply, purchases by central banks of government bonds and corporate bonds, and other unconventional things.
Unusual expansion of debt
A critical part of the global fiscal response to the downturn has been massive fiscal stimuli, particularly in the OECD. Governments worldwide have seen a sharp escalation of debt/GDP ratios in recent years, through a combination of automatic stabilisers (reduced tax revenues, and more spending on welfare programs, in a downturn) and discretionary expenditures (fiscal stimuli and financial sector problems).
The UK DMO, which issued roughly 8 billion pounds of bonds in the year it was created, moved up to issuing 225 billion pounds this year. An IMF projection suggests that by 2014, G-20 advanced countries will have added 36 percentage points of GDP to their debt compared with end-2007 levels.
This new mountain of debt, and the dramatic enlargement of money supply, is making some people nervous. A host of questions are now back to prominence:
- Will there be an upsurge of inflation?
- Do these recent actions amount to an abandonment of inflation targeting?
- How safe is it to buy a US or a UK long bond?
The graph superposes the three-month and ten-year interest rates in the US. While the short rate has gone to zero and roughly stayed there, the long rate has risen substantially through calendar 2009, going up from 2% to 4%. Can this be interpreted as a resurgence of fears about inflation?
Direct observation of inflationary expectations by comparing the prices of inflation-indexed and nominal bonds would have given a direct reading of how the bond market feels. Unfortunately, market efficiency on the market for inflation indexed bonds in the US has broken down and this information source has been snuffed out.
There is a distinct question that engages many people, which is an evaluation of the recent developments in macro policy. Should fiscal stimuli and unconventional monetary policy have been adopted? In the present discussion, we treat these as given, and ask about what comes next. Now that we are here, how might things unfold?
Outright default vs. inflation
The ratings agencies focus on default in the technical sense of the word. Default takes place when a government reneges on the cashflows promised on its bonds.
An equally important notion of default is unanticipated inflation. A person who bought a bond that pays $100 at a future date is short changed if, owing to unanticipated inflation, this nominal cashflow has reduced purchasing power. Unanticipated inflation is a soft option for governments faced with fiscal distress. Here is an example of an opinion piece by John Taylor in Financial Times which envisions an inflation scenario.
Fiscal prudence vs. inflation
Debt dynamics are benign in times of high GDP growth; but troublesome with low GDP growth. There is a benign scenario: Monetary and fiscal stimuli will do the trick, and GDP growth will quickly come back. Fairly large debt issuance is paid for by the increased tax revenues in a recovery. If there was confidence that (a) not doing a fiscal stimulus would yield a deep downturn and (b) doing a fiscal stimulus would considerably reduce the severity of this downturn, then a good chunk of the fiscal stimulus pays for itself.
But what about a gloomy scenario? What if this is a long, shallow recession, with only an anaemic recovery? What if a fresh wave of poorly thought out over-regulation of the economy in general and finance in particular makes it hard for world GDP growth to get back to the above-4% range? Higher tax rates, required for fiscal adjustment, will increase deadweight cost and thus lower GDP growth. In this case, it's a scenario with the burden of a big debt/GDP ratio but a slow growth environment. The existing empirical evidence encourages us to expect this kind of scenario in the aftermath of a financial crisis.
In that scenario, debt stability will require reduced government expenditure and higher taxation. Substantial fiscal corrections in the US and the UK will be required from 2010 onwards, assuming that the recovery commences by the end of 2009. The IMF estimates that the UK primary balance needs to improve by six percentage points of GDP, and for the US the estimate is roughly half as big. These are very large fiscal adjustments and they will be politically unpopular. Will governments bite the bullet and go down this route, or will they try to default in some fashion?
In short: Will inflation in the US and the UK in 2011-2014 shape up to a scenario of 1981-84? How big is the risk to buyers of bonds in these difficult times?
Does democracy induce an adequate check against inflation?
In democracies, voters are averse to high inflation and that exerts a good check to rule out high inflation. In India, it often appears that inflation is a bigger priority for politicians than it is for the central bank, and politicians have exerted a healthy pressure in favour of lower inflation.
However, from the viewpoint of the trust that a bondholder places in a long bond, even small changes in inflation - that might not bother voters so much - are material. A zero coupon bond that pays $100 at a horizon of 30 years has a price drop from $55 to $41 (i.e. a drop in the bond price of 25%) if the interest rate goes up from 2% to 3%.
The most that inflation-averse voters can do is to create the enabling environment for legislation that holds central banks accountable for delivering on an inflation target. Short of this, public opinion and the processes of democracy do not, by themselves, give an adequate safeguard against `small' movements in inflation from 2% to 3% that the public might not mind so much.
Has the UK inflated away debt in the past?
It is useful to look back at the history of the UK for guidance on how things might work out. UK debt surged in the Napoleanic wars and in the first world war. The gold standard was in operation, so the inflation option was absent. Over the years, this debt was (largely) paid down.
Then came the debt associated with the second world war. Their debt/GDP ratio went from something like 40% to 140% of GDP. This was a period with fiat money, so inflation was a feasible option.
At the time, they did not have a clean separation of debt management, monetary policy and public finance. All three functions spilled over into each other. These conflicts of interest may have induced an inflationary bias. Unprecedented inflation came about. Large public debt was not the sole causal factor behind that outburst of inflation. But it was one factor influencing the minds of economic policy makers, encouraging them to view a little inflation benignly.
To summarise, while the UK has had three great episodes of building up debt when faced with a calamity (the Napoleanic wars and the two world wars) and while it brought down debt in the decades of peace which followed each of these, in one of these three episodes (where fiat money existed) it did use inflation to a significant extent.
The inflation option in the current institutional setting in the UK
In the current institutional setting, the UK Bank of England is mandated by legislation to deliver on an inflation target. The UK Debt Management Office (DMO) does the work of investment banking for the government, that of selling bonds. The Bank of England does not share the goals of the DMO and does not worry about the task of selling bonds. It only focuses on the inflation target.
There are two ways to get an upsurge of inflation that would help reduce the burden of debt: the Treasury could instruct the Bank of England to target a higher inflation rate, or Parliament could modify the legislation so as to abandon inflation targeting.
To put this differently, a person who is shorting the long bond issued by the UK government with an expectation of a substantial upsurge in the long rate is, to some extent, a person who has the view that the Treasury will instruct the Bank of England to target a higher inflation rate, or that Parliament will modify the legislation so as to shift away from inflation targeting. Neither of these scenarios so far appears particularly likely. Hence, it seems that this institutional structure will deliver on the inflation target.
Can unconventional operating procedures of monetary policy be consistent with inflation targeting? If unconventional things (i.e. directly influencing corporate bond prices since the monetary policy transmission had broken down) had not been done, inflation would have dropped below target. The strategy remains getting to inflation of 2%; the tactical details about how this is achieved have changed. Similarly, the immense expansion of money supply is consistent with the fact that the money multiplier collapses in a financial panic. If reserve money had not been dramatically expanded, we'd have been in an environment like the Great Depression, with strong deflationary pressures, which is not consistent with achieving the inflation target. So the people who are worried about the framework of inflation targeting having broken down are perhaps worrying too much. The strategy has not changed; the tactics have.
Inflation targeting has been the key element of the institutional apparatus
Unconventional monetary policy and unusual debt enlargement are raising concerns about inflation. Inflation targeting is particularly important in assuaging these fears.
With de jure inflation targeting as the overall framework, the central bank is able to go into unconventional terrain, while simultaneously reassuring the bond market that there is no risk of an explosion in inflation in the offing. If de jure inflation targeting were absent, the central bank would have to be more concerned about unhinging inflation expectations when it adopted unconventional tactics.
The same applies with unusual fiscal policy. When governments set forth to borrow on a large scale, if the bond market was uncomfortable about the possibility of inflation, the prices at which governments were able to borrow would have rapidly escalated. This would have limited the extent to which fiscal stimulus was possible and choked off the recovery. In other words, the cheap financing that governments have got, which has enabled fiscal stimuli, has been made possible in part by inflation targeting.
De jure inflation targeting gives the central bank credibility to temporarily do dramatic things that a central bank without this overall framework would stop short of doing. This reasoning is the opposite of what the critics of inflation targeting worry about -- that inflation targeting is too rigid and reduces the flexibility for coping with unusual events. Instead, inflation targeting as the medium term framework is precisely what gives the central bank credibility to do unusual things - i.e. obtain more flexibility on tactics - in the short term.
The immense enlargement of central bank balance sheets would be worrisome were it not for the fact that these are taking place under the overall strategy of inflation targeting. As the financial system comes back to life, as the money multiplier comes back to normal values, the intellectual framework of inflation targeting will shape the responses of the central banks. There will obviously be some mistakes in forecasting inflation, given that the parameter estimates in our models are driven by normal times. But one can expect an average error of zero in the sequencing through which unconventional monetary policy is withdrawn. And when mistakes are made, when de jure inflation targeting is in place, the bond market will know that these are mistakes of execution and not a change in strategy.
In summary, the fact that almost all OECD countries and many emerging markets have tied down monetary policy with either de jure or de facto inflation targeting is a critical difference of the institutional environment today, when compared with earlier business cycle downturns. It is the critical glue which has enabled unconventional monetary policy and unusual fiscal responses. The hard work done in preceding decades, of putting monetary policy on a sound footing and separating out the bond issuance of the government from monetary policy, has helped the world economy come out relatively lightly in this downturn.
The perspective of a credit analyst who thinks inflation targeting will work
De jure inflation targeting in the UK is comforting to bond holders who might otherwise worry about being defrauded. But it is interesting to see that as a consequence, the present situation is more like the UK of 1815 or 1918: a government has built up debt; it faces a hard budget constraint; it does not have the choice of having an upsurge of inflation. The Treasury will be forced to make ends meet by spending less and taxing more - the alternative is that of reneging on the inflation target in the public eye -- something like going off the gold standard in the olden days -- and enduring the wrath of the bond market when that is done.
Hence, if you were narrowly focused on technical default on a bond, this is a more difficult environment for the government because a lever (inflation) that was used in the 1970s to stave off default is now unavailable. This is a scenario more like 1815 or 1918, where there was an upsurge of debt and the monetary regime gave no space to inflate it away (barring a drastic measure, that of going off the gold standard).
For a credit analyst narrowly focused on technical default of a bond and not concerned with defrauding bondholders through inflation, holding other things constant, a country with fiat money which lacks inflation targeting is safer than a country with fiat money and inflation targeting. A Zimbabwe can be counted on to pay on local currency bonds by printing money since its fiat money lacks the intricate institutional dance of inflation targeting.
The inflation option in the US
The situation is a bit different in the US. There also, the central bank does not do investment banking for the government: this function is placed in the Treasury. But the central bank has not been tied down by law to deliver on an inflation target. As with the UK, a substantial fraction of bondholders are not US citizens; this raises a fear that decisions by the US government might inflict losses on them.
The lack of de jure inflation targeting raises greater uncertainty about what the central bank might do in the future. I can't see why the US Fed might like to help out the Treasury shed some debt by having an upsurge of inflation, and I do believe this is an unlikely scenario. But until the legal foundations of the central bank clearly require achieving an inflation target, there is some uncertainty about what might happen.
Reducing the US debt/GDP ratio using inflation to any significant extent would be a drastic option. Foreign bondholders would feel defrauded, and dump US government bonds and the dollar. The US long rate would skyrocket and the US dollar would crash. The crash in the dollar could possibly induce tightening of the short rate to cope with the inflationary consequences. The severity of this punishment helps stave off this scenario even if a successor to Ben Bernanke is not as clear-headed about inflation targeting as he is. Similar considerations apply to the time when (if) the UK government envisages a bigger inflation target or an abandonment of inflation targeting.
Will interest rates go up because governments are issuing so much debt?
Suppose a government issues a lot of 10 year paper. Can this induce price pressure, giving lowered prices (i.e. higher interest rates for 10-year bonds)?
Suppose we live in a world where the bond market is working properly. In this case, the various points on the yield curve are linked up by arbitrage. Ultimately, all points on the yield curve are about expectations about movements of the short rate (i.e. the policy rate) in the future.
So given enough arbitrage capital, price pressure at the 10 year rate will result in a flurry of arbitrage opportunities and an arbitrage-free yield curve will be restored. Since policy rates are low and are likely to stay low for a while, an arbitrage-free curve will be one where rates further out on the yield curve would be pushed down.
In many places in the world, the financial system has broken down (or had broken down in the last few months) into a `limits of arbitrage' trap. There is often not enough arbitrage capital chasing down these arbitrage opportunities. As an example, as mentioned above, liquidity in the bond market no longer supports accurate estimates of expected inflation based on bond market data. Hence, in these stressed times, excessive issuance by the government of (say) 10-year paper could possibly result in price pressure at the 10 year rate and create a kink in the yield curve.
So it seems that there are some question marks about the traditional reasoning about an arbitrage-free yield curve, with the long rate being tied down by expectations of the trajectory which the short rate is likely to trace out in coming years and by yield curve arbitrage. The one factor which is perhaps holding down the long rate is the simple flight to quality. A great deal of capital that had walked into risky assets during the great moderation has been spooked and portfolio managers have rediscovered the joys of government bond holdings. For a while, we're probably going to see bigger weightages on government bonds. I think this factor will significantly help provide the other side of the trade when governments are selling a lot of bonds. See Martin Wolf on this. The rise in the long rate should not necessarily be interpreted as signalling a sharp rise in inflation expectations.
The two paths through which monetary policy gets distorted
Monetary policy today wants to drive down interest rates so as to push up aggregate demand and achieve the inflation target. Since yield curve arbitrage has broken down, this requires central banks to buy government bonds so as to drive up their price and drive down the interest rate. This is tantamount to monetisation of government debt.
Monetisation is often seen as something Truly Dangerous; it's the start of the slippery slope to the Weimar Republic. But it's important to be clear on means and ends.
With a well structured monetary policy regime that is targeting inflation, the central bank will periodically buy and sell government bonds. When it is buying government bonds, this will be tantamount to monetisation, and vice versa. As long as monetisation happens as a pure side effect of achieving the goals of monetary policy, this is not dangerous. When monetisation is done in order to achieve the goals of the Debt Management Office, this is where the slippery slide to Zimbabwe commences.
In similar fashion, a central bank can trade on the currency market in order to help achieve an inflation target. This is perfectly safe. This will lead to periodic increases or reductions in the net foreign assets of the central bank. As long as these are merely the side effects of a well structured monetary policy framework, this is safe.
In short, reserve money is the sum of net domestic assets (NDA) and net foreign assets (NFA). As long as NDA and NFA fluctuate as a side effect of a well structured monetary policy framework, this is safe. It is when NDA and NFA are distorted owing to the pursuit of other goals, that this becomes troublesome. The danger to NDA comes from the goals of the Debt Management Office which might influence the central bank to do monetisation, and the danger to NFA comes from exchange rate policy. This symmetry between NDA and NFA as sources of change in reserve money is not widely appreciated: people generally see that deficit financing by purchase of government bonds is bad because it distorts NDA, but fail to see that this is no different from a distorted NFA caused by purchase of foreign assets.
Institution building in monetary policy is essentially about getting these extraneous influences (selling bonds for the government and the pursuit of exchange rate policy) out of the objectives of the central bank. These risks are not present in the US or the UK, which have a pretty sound inflation targeting framework, where neither central bank cares about the goals of bond issuance of the government or about the exchange rate. These risks are present in places like India, where the pursuit of these extraneous goals has repeatedly distorted monetary policy, where fiscal/financial/monetary institution building has not yet taken place.
A one-time increase in the targeted inflation rate?
The operating procedures of monetary policy that work fine with ordinary interest rates have run into trouble once interest rates hit the zero lower bound. These are admittedly rare scenarios; ordinary operating procedures might work for many decades before hitting a scenario like this. At the same time, we are all keenly aware of the problems that have arisen once interest rates went to zero.
What is wrong with unconventional monetary policy? First, we do not have the foundations of economic knowledge required to guide us on what to do when placed in unconventional territory. E.g. the DSGE models used by central banks are lost when the policy tools become `quantitative easing' (whatever that means). Second, it is very hard for financial markets to comprehend what is being done, which undermines the effectiveness of monetary policy. Central banks must `say what you do, and do what you say'. This clarity is unavoidably hampered when in unconventional zone. Thirdly, there is the risk of loss of independence owing to these unconventional actions. Individual firms/industries are gainers or losers of these operating procedures, and politicians will demand oversight.
In this crisis, it looks like there have been situations where achieving an inflation target of 2% required a policy rate of -5%, which is impossible. One way to reduce the extent to which the zero lower bound is hit is: to raise the level of the inflation target. Roughly speaking, if 7% inflation had been targeted, then in a crisis like this one, the policy rate would have gone to zero but negative rates would not have been desired by the central bank.
We might not need to go as far as 7%, but this crisis has certainly changed my mind on the desirable inflation target; instead of 2-3% maybe something like 4% is better.
If a country with an existing inflation target (e.g. the UK) announces that the target inflation will go up from (say) 2% to 3%, this would induce massive losses for the bondholders. The only fair way to do this would be to simultaneously compensate bondholders for this loss that they suffered.
Willem Buiter Fiscal Implications of the Global Economic and Financial Crisis, released by the fiscal affairs department of the IMF on 9 June.
My thinking on this was improved through conversations with Joydeep Mukherji, Charlie Bean, Anand Pai, Josh Felman, Percy Mistry, Roberto Zagha, Russell Green, Ila Patnaik, Paul Levine and Econlogic.