An interesting new NBER working paper by Vasco Curdia of the New York Fed and Michael Woodford of Columbia University will likely feature on Ben Bernanke’s reading list as he ponders both the options for further Fed easing (should it be necessary) and the Fed’s eventual exit strategy from easy policy. Mr Woodford is one of the world’s top monetary economists and a former colleague of Mr Bernanke at Princeton.
Here is part of the abstract:
We distinguish between “quantitative easing” in the strict sense and targeted asset purchases by a central bank, and argue that while the former is likely be ineffective at all times, the latter dimension of policy can be effective when financial markets are sufficiently disrupted. Neither is a perfect substitute for conventional interest-rate policy, but purchases of illiquid assets are particularly likely to improve welfare when the zero lower bound on the policy rate is reached. We also consider optimal policy with regard to the payment of interest on reserves; in our model, this requires that the interest rate on reserves be kept near the target for the policy rate at all times.
To attempt to paraphrase these conclusions:
- Quantitative easing – e.g. buying Treasuries to increase bank reserves with no commitment to keep them high in the future – doesn’t work. “Our reading of the Bank of Japan’s experience with quantitative easing leads us to suspect that our theoretical irrelevance result is likely close to the truth.”
- Credit easing – e.g. buying asset-backed securities – can work when private financial markets are highly disrupted. “We are inclined to suspect that it is only at times of unusual financial distress that active credit policy will have substantial benefits,” say the authors.
- Interest should be paid on reserves at the central bank’s target for the policy rate.
What might this mean for Fed policy? First, when you hear Mr Bernanke say that the Fed’s policy options depend on the state of financial markets, listen carefully. It reflects the view that asset purchases work best when financial markets are in turmoil and less well when they are not.
Second, while some economists think that asset purchases are effective in easing policy with rates are at zero, others are doubtful. There is an active debate about the results of asset purchases within the Fed. It would be unwise to assume that further Fed easing automatically means ‘QE2′.
One more point from the paper about Fed exit strategy:
In considering an appropriate strategy for “exit” from the current unconventional posture of the Federal Reserve, it is important to recognize that, according to our model, there is no reason that the timing of the Fed’s reduction in its holdings of assets other than short-term Treasuries must be tied in some mechanical way to the timing of a decision to raise the federal funds rate above its current historically low level. These are independent dimensions of policy, not only in the sense that they can be varied independently in practice, but in that they have different effects as well, and are appropriately adjusted on the basis of considerations that are fairly different. Just as the primary justification for undertaking non-traditional asset purchases should relate to conditions specific to the markets for those assets, rather than to the central bank’s assessment about whether the level of the policy rate is correct, so should decisions about the proper time at which to unwind such purchases.
Mr Curdia and Mr Woodford, in other words, think that the Fed could raise rates before it sells assets or vice versa.