By Stephen Grenville

With the US official interest rate now in effect zero, there is much talk of monetary policy “running out of ammunition” and “pushing on a string”. Has monetary policy become impotent in the US and Japan? Does a similar fate await the rest of us?

The idea that a zero interest policy (ZIP) has no impact is absurd. A zero rate isn’t like putting the motor into neutral: it’s more like having the accelerator flat to the floor. Of course it can’t do any more, but it’s the level of interest rates (not the rate of change) which matters. This is “cheap money” and, considered in isolation, should provide a strong incentive to borrow and to spend. The zero “time value” of money should also raise discounted-cash-flow calculations of asset values.

Why does this obvious truth seem so incongruent with current circumstances?

First, there is an imperfect linkage between the official reference rate and the range of borrowing rates. Some borrowers are further out on the yield curve and this hasn’t fallen as far (the Fed Funds rate is down 500 bp but the 10-year bond is down less than 200).

More important in explaining high borrowing rates is the huge change in perceptions of risk and hence in default risk margins. Related to this, there has been a fundamental breakdown in the formal risk assessment process: the rating agencies have gone from sprinkling their top endorsements on almost everyone, to almost no-one.

Secondly, lending institutions may not be in a position to carry out their normal intermediation. Some have gone broke, and the most active area of intermediation - the shadow banking sector - no longer exists. The commercial credit market has evaporated. Other intermediaries are short of capital (or now feel that they are) and can’t raise equity easily. The flight-to-quality by investors has narrowed the range of institutions which can borrow. Illiquid financial markets hinder intermediaries from managing their balance sheets. The monolines and others which supplied insurance have contracted. For all these reasons, funding may not be available at the quoted interest rates

Can monetary policy help here?

While the zero bound leaves no room for further shift in interest rates, at the same time it removes a constraint on central bank operations. Normally they have to balance the money market each day through open market operations, supplying the public with the currency it wants to hold and giving the banks a comfortable level of reserves. This is usually a fairly routine process, supporting the official interest rate setting. But with interest rates at zero, the authorities can push out as much base money as they want to - quantitative easing (QE) is the name of the game.

In itself, more base money may not do much: it just accumulates in bank balance sheets (as happened in Japan in 2001-2005 and is happening now in the US). But the central bank can use base money to buy longer-dated government paper, pushing down the yield curve, partially addressing the first problem mentioned above. More powerfully, it can buy private sector assets. Buying undervalued assets not only helps to unclog illiquid markets, it also adds capital to the balance sheets of those who hold these undervalued assets, as the price is bid up. All this addresses the second problem, above.

Beyond monetary policy proper, base money can fund expansionary fiscal policy (”printing money”), so if the government can identify good Keynesian policies, these can be funded without pushing up the interest rate on government securities, lessening the possibility of “crowding out” (although it may crowd out bank lending by stuffing the banks’ balance sheets with base money).

Then, there is a range of insurance or guarantees which could be provided by either the central bank or the government. The Australian government, for example, has guaranteed new overseas borrowing of banks. Insurance could be offered on the systemic component of debt, as suggested by Milne, Kotlikoff and Mehrling.

So there are still policy options, even when interest rates hit zero. Why, then, does it seem so difficult to fix the situation (in the US now, or in Japan during the “lost decade” of the 1990s)?

The US economy faces headwinds that monetary policy, even running flat-to-the-floor, can’t offset. Keynes’ animal spirits are lying low, so the best businesses don’t want to borrow, even at low interest rates. Wafer-thin credit margins and reckless lending have left a legacy of assets whose values cannot be sustained in normal markets, and it will take time to absorb these mistakes. To underpin these asset values would just shift the problem forward in time, as was done when the post-Tech-Wreck economy was boosted by lending to ninja (no income, no ob, (and) no assets) borrowers.

Certainly, let’s use the opportunity to fix infrastructure through fiscal expansion. But how do you shrink the house-of-cards which is the financial sector, without bringing the whole lot down? While this necessary contraction is happening, how to maintain the flow of essential funding to good enterprise? How to distinguish between good and toxic assets, when the “lemons” problem is ubiquitous? All this requires micro-level banking analytical skills, which seem to have atrophied.

At the macro level, using ZIP to signal that money has no time value might be appropriate, but it doesn’t do much to address these micro-issues. A zero interest rate (or even one with a risk premium on top of this) is a low hurdle-rate for new investment proposals to jump. Whatever is holding back demand now, it isn’t the level of interest rates: we shouldn’t waste too much energy regretting America’s inability to lower interest rates further.

Stephen Grenville is a visiting fellow at the Lowy Institute for International Policy, and former deputy-governor at the Reserve Bank of Australia

Tags: Quantitative easing

January 13, 2009 1:46pm in Credit squeeze, Federal Reserve, Fiscal policy, Monetary policy | Comment