More On: Economics
The dollar's depreciation will not avert future recessions.
In a thought‐provoking article published by the IMF in April, Ruchir Agarwal and Miles Kimball suggest that the "paper money standard" should be replaced by a "electronic money standard." Shorter recessions and lower average inflation are among the anticipated benefits. The elimination of the "zero lower bound" on nominal interest rates is claimed to have resulted in these benefits, enabling the Federal Reserve the freedom to drop nominal interest rates as far as it needs to go—even into negative territory—to encourage recovery from a recession. Even if nominal interest rates are just 2% when the recession begins, the Fed could decrease rates by 5 percentage points (say), to 3%, if they believe a quick recovery is required. Agarwal and Kimball (hereinafter AK) claim that the ability to execute a negative interest rate policy eliminates the necessity for an inflation objective substantially above zero in order to keep nominal interest rates high enough to allow for a 5 percentage point rate decrease. As a result, the Fed is encouraged to cut its inflation target from 2% to 0%.
Nobody will tolerate severely negative returns when they can always earn a zero return (or, more correctly, zero minus a minor storage expense) by keeping Federal Reserve Notes. Think of the scene in Breaking Bad where Walter and Skyler White survey a room‐sized storage locker where they are keeping millions of dollars in stacks of $100 bills. A back‐of‐the‐envelope estimate indicates that their storage costs were less than one‐tenth of one percent per year. Under such conditions, the public will not accept bond returns more than one‐tenth of one percent per year below zero.
The authors propose a "electronic money standard" in which Federal Reserve Notes (the circulating paper part of the Fed's monetary liabilities) do not always provide a zero return because they do not always trade 1:1 against bank reserves (the account balance electronic part of the Fed's monetary liabilities). To prevent it from being a zero nominal return asset that establishes a zero lower bound on nominal interest rates, AK point out that it isn't essential to destroy high denominations of paper currency (as some other proposals to enable a negative interest rate, like as Kenneth Rogoff's, would). When the Fed pays a negative interest rate on bank reserves, it is only necessary to assure that keeping currency pays a negative rate as well. When a negative interest rate on bank reserves is deemed necessary to combat recession, AK proposes a comparable devaluation of paper dollars against electronic dollars. If bank reserves, for example, pay 3% per year, paper dollars will lose 3% per year against electronic dollars maintained on the Fed's (bank reserves) and banking system's records (deposit balances).
In their 2022 publication, AK does not specify a precise mechanism for enforcing a negative return on cash, but instead refers to a 2019 work that considers numerous options. There, they rank "taking paper currency off par" as the "first best" policy. The Fed would essentially announce and maintain a sliding peg between Federal Reserve Notes and bank deposits. When the policy rate is 3% each year, a "$100 bill" at the beginning of the year will be convertible into (and purchaseable with) just $97 in electronic dollars by the end of the year. Conversions on intermediate dates will result in intermediate rates, ensuring that "the paper currency depreciates steadily over the course of the year." Because it can print or buy back Federal Reserve Notes in unlimited quantities, the Fed has no limit on its power to enforce its preferred exchange rate. Businesses and individuals in the private sector will discount paper money at the rate that their banks discount it for deposits, and their banks will discount it at the rate that the Fed discounts it for bank reserves.
The AK proposal explains how removing the zero lower bound can be done without removing high denomination paper currency and the financial privacy it affords. It also demonstrates that a positive secular inflation rate is not required to allow for anti-recession policy.
Would enacting the AK proposal, assuming we keep our fiat currency, make the people better off? Would allowing the Fed to impose negative returns on all kinds of currency assist the average dollar holder? Obviously, the answer is no. It's worth noting that a 2% average dollar inflation rate (the Fed's current aim) already imposes a 2% average real return on dollar currency holders. If enabling negative interest rate policy in this way actually leads the Fed to lower its non-recession inflation target to zero percent from two percent, and a negative nominal rate on currency is imposed less than half of the time, the program could actually raise the average expected real return on holding US currency, as AK hopes.
If such an option were available, a program of lowering the inflation target to zero and combating recessions in an equally effective fashion that does not require negative nominal rates would dominate such a program. (Another viable option will be described shortly.) In comparison to currency that retains its value in the unit of account, devaluation of paper currency is a welfare-reducing tax on currency. I have written before about the dubious wisdom of punishing money‐holders in order to escape the zero lower bound.
As a result, AK's proposal promises to improve money holders' welfare only if (1) it actually results in a lower average combination of (inflation + negative nominal own return on money) or, failing that, (2) negative interest rate policy is so much more effective at recession fighting than the alternative that its benefits outweigh its cost to money holders. The second has not been demonstrated and is therefore suspect. It's worth noting that the US economy has recently recovered quickly from a severe recession without dropping interest rates below zero or by more than 1.5 percentage points. On the eve of the pandemic recession in 2020, the Fed's policy instrument of interest on reserve balances was 1.6 percent on 1 February 2020, then fell to 0.1 percentage points over the next six weeks and stayed there for the next 15 months. For the first two quarters of 2020, actual output fell, but over the next four quarters, it recovered and even bridged the gap to 99.5 percent of the full employment or "real potential GDP" growth path (see Figure 1).
Figure 1: Real GDP and Real Potential GDP, 2014–2022.
Granted, this was an atypical recession and recovery. The point I seek to make in citing it is only that prompt recovery is at least sometimes possible without a deep cut in the Fed’s interest‐rate instrument. The broader point I want to make is that, under alternative policy procedures, counter‐cyclical monetary policy does not require the Fed to use an interest rate instrument at all. The class of Taylor Rules, which specify the proper value of an interest rate target or instrument as a function of current macro data, does not exhaust the set of viable monetary policy rules with recovery‐supporting feedback from current macro data.
The macro economist Bennett McCallum (2000) long ago formulated a feedback rule for using the monetary base—the degree of quantitative easing—as an instrument to target the path of nominal income. The Fed uses the McCallum Rule to adjust the rate of growth of the monetary base in response to the moving average rates of increase of base velocity and real income, without taking interest rates into account. Until 2015, the monthly Monetary Trends publication from the St. Louis Fed recorded whether monetary base growth was above or below a range of McCallum Rule prescriptions, as well as whether the Fed Funds rate was above or below a range of Taylor Rule prescriptions. A McCallum Rule, unlike a Taylor Rule, does not require the use of an interest rate objective or instrument. It does not necessitate an estimate of the true natural rate of interest, which is a well-known issue in Taylor Rule implementation. It is unconcerned about the effect of interest rate changes in the transmission of monetary policy.
The argument underlying the success of using the monetary base as a policy instrument is simple, albeit it is sadly less well known today than IS-LM and the Taylor Rule. It starts with the idea that avoiding or prolonging a monetary disequilibrium, defined as an excess supply or demand for money balances by the public at the current price level, is an appropriate goal for fiat monetary policy. (This theme was central to the work of Leland B. Yeager and the late Axel Leijonhufvud, who emphasized that recessions characterized by an aggregate excess supply of non‐money goods are logically equivalently characterized by an excess demand for money balances.) To minimize monetary disequilibrium, the system should expand the supply of fiat money in response to signs of an unsatisfied excess demand for money balances, and contract it in response to signs of excess supply.
The central bank controls the supply of base money in a closed economy. Quantitative easing or tightening—open market purchases that expand the monetary base or sales that contract it—expands or contracts broader money in the hands of the public, assuming the "money multiplier" remains constant (under the Federal Reserve's current operating system, this means that the interest rate on reserves that the Fed pays banks tracks the risk-free rate that banks could earn on Treasuries). In 2020, the Fed did the right thing by expanding M2 in reaction to a surge in demand for M2 balances, or, to put it another way, in response to a drop in M2 velocity. Although the expansion did not arrive in time to prevent nominal GDP from declining in 2020, it was more than enough to return nominal GDP to its pre-pandemic level by the end of 2021 and to push it well above that level in 2022. (see figure 2).
Figure 2: Nominal GDP and Nominal Potential GDP.
The McCallum Rule (McCallum 2000, p. 52), for readers who are unfamiliar with it, specifies the appropriate quarterly growth rate for the monetary base as
where (all variables in logs) Δbt is the quarter‐over‐quarter change in the adjusted monetary base, Δνta is the moving‐average change in base velocity over the previous 16 quarters, Δxt* is the target level of nominal GDP, Δxt–1 is lagged actual nominal GDP, and the parameter λ= 0.5. The rule (the first equation) prescribes that base money growth should offset base velocity growth shocks. And, if nominal GDP is undershooting its reference path, the Fed should loosen monetary policy by increasing the expansion of base money by half the discrepancy. The second equation says that the nominal income target Δxt* is the sum of the desired price level π* plus the 40‐quarter moving average of real GDP Δyt*. In sum, the rule stabilizes nominal GDP along a pre‐determined path using a monetary instrument. McCallum calibrated the λ parameter and the moving‐average lengths using various simulations, and found that the calibrated rule’s counterfactual performance across a variety of macro models was better than the Federal Reserve’s actual performance even during the Great Moderation.
Anti-recession monetary policy, according to AK, must work by lowering an interest rate target or instrument. "Before zero lower bounds became a concern," they write, "postwar central banks generally slashed nominal rates by 5 to 6 percentage points to restore the economy to its full capacity." However, the structure of a fiat-based monetary economy does not imply such a manner of functioning. It is the result of a policy framework that was imposed on oneself. The Federal Funds rate was employed as an intermediate target by the Fed before to 2008, and it may be viewed as a guideline for supplying enough money to meet the quantity of money demand at the targeted price level. If you switch from an interest rate targeting technique to a monetary aggregate instrument, the "need" for decreasing nominal rates by 5 or 6 percentage points to alleviate an excess demand for money should vanish as well. To put it another way, zero lower bounds are only "major hurdles to monetary policy" if monetary policy is undertaken with an interest rate as its instrument or intermediate aim, as AK phrased it. Where AK says the zero lower limit "is not a rule of nature, but a policy choice," I believe the same may be said of the need to combat an excess demand for money by lowering an interest rate instrument or objective.
McCallum (1989) provided some evidence that a Taylor Rule (during a period in which the zero lower bound is not binding) is no more effective at mitigating recession than a McCallum Rule. If this finding is persuasive empirically (an update would be welcome) or theoretically, then it is hard to justify imposing the burden of negative interest rates on depositors and the burden of currency devaluation on currency‐holders. For this reason, devaluing currency would rightly be highly controversial among members of the public—nearly as much as abolishing currency altogether.