Forward guidance and unconventional monetary policy
I recently noticed that swap rates purchases were discussed as an unconventional monetary policy tool are discussed in Reserve Bank’s bulletin “Aspects of implementing unconventional monetary policy in New Zealand”.
Namely, they state:
“Purchasing interest rate swaps could be a way to signal that the Reserve
Bank expects to keep the OCR low for a prolonged period. Swap rates
comprise the expectations of future policy rates, the term risk premium,
and margin for bank credit risk.”
So why would we want to keep OCR persistently low in long-term? Let’s have a closer look at this.
The reduction of long-term rates is actually a pretty contentious issue. The goal is to move expenditure forward. So if we have a view that there is some “long-run interest rate” and we are lowering the current interest rate relative to that to get people to shift expenditure forward.
Now lower long-rates appear to violate this – as suddenly the incentive to shift expenditure forward is lower! But how exactly are we “lowering long rates”. There are two ways to think about this that can make it expansionary:
- We are doing so by purchasing illiquid assets with a long maturity and replacing them with liquid assets (cash), bidding up the price of these long held assets are reducing their yield (the interest rate). The increase in liquidity allows credit constrained agents spend.
- People may be unwilling to invest now as they expect interest rates to increase in the future, or the relevant interest rate for them is a longer term rate. By “committing” to keep this rate lower, or just reducing the fixed rate of investing in the long term, people will be incentivised to invest.
The commitment models provided the main explanation of the idea of “forward guidance at the zero lower bound” – which is what Woodford wrote about here.
Essentially, the central bank has some rule where it will respond to inflation, but the optimal policy SHOULD let inflation go above its target in the future. To credibly commit to breaking the inflation target, the bank needs to make it costly to change their future interest rate and they do this with forward guidance and asset purchases! A previous TVHE post explained this with respect to QEIII here.
However, concerns about this logic is valid – it is dangerous to argue from a price change alone. Why?
- After all r = i – inflation (the real interest rate is equal to the nominal interest rate minus inflation, approximately), so if we push down long-run i and r is determined by the economy then aren’t we just saying that inflation will be low?
- Furthermore, in so far as monetary policy is working through substitution and NOT income effects a flatter path of interest rates certainly does not imply an increase in aggregate expenditure.
These are both arguments that have been made (although they are both different), hence why we need an income effect reason (eg credit constraints for borrowers) and we need to have a model of how r can differ for a persistent period of time (co-ordination games, the potential for “instability” in inflation to drag us between multiple equilibrium).
I prefer the idea that long-rates are set by the market, and that we focus on shifting demand now by direct asset purchases rather than trying to “flatten the curve”. A healthy economy will generate a certain long-run interest rate, so trying to hold that down seems perverse. However, the mainstream is definitely about forward guidance with interest rates above asset purchases.