Massive Liquidity Preference Test the Potency of US Monetary Policy

Global Economic Slowdown: Blame Fiscal Consolidation, Not Monetary Policy

In the wake of the most serious global economic slowdown since the end of the Great Recession, central banks in advanced economies have seemingly run out of ammunition in terms of being able to use interest rates to fine tune aggregate demand. The fact that short-term interest rates have nearly hit their zero lower bound limits has prompted some economists to say the actions of central banks now have little or no impact on real economic activity. The only beneficiaries of further monetary easing are financial markets. Abundant liquidity is seemingly not finding its way into the real economy.

The underlying growth rate of the global economy has, without question, slowed over the past eighteen months. This slowdown follows, however, a period where growth was above-trend in the early stages of recovery after the Great Recession, courtesy of a massive simultaneous easing of both fiscal and monetary policies. This shows that, working in tandem, these policy tools can have a powerful impact in terms of affecting aggregate demand.

The International Monetary Fund (IMF) recently concluded that the size of the so-called fiscal multiplier may have been under-estimated in developed economies: changes in the stance of fiscal policy will now have a bigger impact on headline GDP than previously estimated. If the IMF is correct, then much of the deceleration in the global economy over the past eighteen months can be attributed to the tightening of fiscal policy in developed countries. Continued easing of monetary policy has arguably prevented a more profound deceleration. In this sense, monetary policy has continued to display its efficacy. It is unfair, therefore, to conclude that monetary policy has been ineffective.

US Monetary Policy under Quantitative Easing Part 3

The Fed has announced that it will purchase up to $40bn in mortgage backed securities (MBS) per month as part of its third tranche of quantitative easing. Since the inception of quantitative easing, it has now become the third largest holder of agency MBS. The decision to concentrate on MBS was driven by the desire to ensure that the recovery in housing does not falter. Softness in housing has hitherto presented a significant headwind to both headline GDP and employment growth. Ensuring that housing does not relapse will increase the chances of underlying economic and employment growth improving in the US.

The Fed has effectively given an extension to the mortgage carry trade for US banks until 2015. Banks are being encouraged to engage in more mortgage lending of a standard that can be securitised by the agencies and also to retain some credit risks on their balance sheet. This should be a win-win situation for US banks. Future developments in US house prices will, however, be critical if this way of injecting liquidity into the real economy will prove to be successful. One reason why the level of liquid or cash assets at US banks remains so high is continued caution about real estate collateral quality in the post-Great Recession era.

Abundant US Liquidity Still Being Hoarded By Private Sector

Financial Armageddon was avoided in 2009 by massive injections of liquidity from central banks, particularly the Fed. This huge pool of liquidity still largely remains in the global financial system. Some commentators worry about the inflationary implications of global monetary easing over the past eighteen months. Inflation in the developed world has, however, remained subdued, particularly in the US, for one simple reason: the velocity of circulation of money continues to fall, consistent with continued hoarding of cash or so-called liquidity preference by the private sector.

An unstable velocity of circulation of money will play havoc in terms of predicting just how much liquidity filters into the real economy following any given monetary policy stance change. Monetarists have always asserted that the velocity of circulation is stable and, by implication, predictable. The demand for money is primarily driven by the level of transactions in the economy, according to monetarists. If there is too much money in the system, inflation will rise because the economy’s capacity to produce goods and services remains unchanged. This has clearly not been the case in the recovery after the Great Recession: other factors are affecting the demand for money, thereby suppressing the velocity of circulation.

The demand for money is also affected by precautionary and speculative motives. These can be heavily influenced by volatile expectations, particularly when a high degree of uncertainty about the global economy prevails. For example, high cash levels at US corporations probably incorporate a precautionary element. Companies may have felt the need to provide for possible contingencies requiring sudden expenditure against an uncertain political and economic backdrop by keeping liquid assets high.

The main reason behind the decline in the velocity of circulation for money has, however, been a massive rise in the speculative demand for money. The speculative demand for money is inversely related to the level of interest rates. Not surprisingly, the decline in US interest rates to abnormally low levels engineered by the Fed has produced this outcome.

When Does US Monetary Policy Become Impotent?

The speculative demand for money will determine that point when monetary policy loses potency. The Fed will continue to purchase assets insofar as it believes that the private sector does not yet believe that cash and bonds are perfect substitutes. Once the private sector believes that cash and bonds have become perfect substitutes, then further Fed asset purchases will no longer be able to lower interest rates. This would signify the arrival of a full-blown liquidity trap. At this point, monetary policy becomes impotent. Expansive fiscal policy will then be needed to support aggregate demand. Fed Chairman Bernanke clearly does not believe that we have reached this juncture as yet by announcing a potentially very aggressive round of future asset purchases. The sheer potential size of future asset purchases would, however, indicate that the easy days of reducing long-term US interest rates are probably behind us.

Future Fed Asset Purchases, Risky Assets and Economic Activity

The Fed has decided not to be shy about its commitment to engage in potentially very aggressive purchases under the third tranche of quantitative easing. The size of additional asset purchases could easily total $1.5 trillion. How would this affect economic activity and risky assets?

Prior announcements by the Fed of new tranches of quantitative easing have coincided with strong performance from risky assets, as well as a re-acceleration in economic growth. More importantly, these announcements have followed periods where US economic data releases have been abnormally soft. It is therefore difficult to prove that the re-acceleration in growth was directly attributable to further monetary easing, as opposed to the return of “normal” economic data via less statistical noise. Given that the third tranche of quantitative easing will probably be at least as large as the first tranche; we probably need to see the onset of better-than-expected US economic data to sustain the rise in risky assets that has been in place since late-June.

Will the Fed Adopt a New Policy Goal in 2013?

We are all aware of the Fed’s dual mandate: maximum sustainable employment and price stability. Under the auspices of the third tranche of quantitative easing, reducing elevated unemployment has been given a greater weighting. It has led some commentators to believe that the Fed is prepared to tolerate a higher level of inflation. The Fed is cognisant of the long-term damage to its reputation if financial markets accepted this viewpoint. It is unlikely that the Fed would tolerate any unhinging of longer-term inflationary expectations. Such an outcome could raise nominal bond yields, thereby completely undermining the intended outcome of additional asset purchases.

It has been argued that one of the positive by-products of higher inflation would be lower real interest rates. This would create a situation completely opposite to that of Japan, where deflation has raised real interest rates. Could the Fed attempt to disguise tolerance of higher inflation via targeting another variable? The most obvious variable to target would be nominal GDP: the Fed would not need to specify the intended split between its real and inflation components. Currently, US nominal GDP is well below its trend level as dictated by its 1990-2008 growth path. The Fed could announce that it is committed to returning nominal GDP back to trend at all costs. Such an announcement would raise inflationary expectations and reduce real interest rates. The rise in inflationary expectations could, however, be significant and volatile, because the main reason for sub-par nominal GDP is the weak real component vis-à-vis inflation. Under these circumstances, it becomes highly contentious if risky assets would perform well.

It is unlikely that the Fed under Chairman Bernanke would embrace targeting nominal GDP due to the impact that unhinged inflationary expectations could have on nominal bond yields and the real economy. Furthermore, the Fed would be wary of the damage to its long-term reputation.

Summary and Conclusions

Monetary policy has not totally lost its effectiveness, particularly when used in conjunction with fiscal policy. The bulk of the global economic slowdown over the past eighteen months is attributable to the tightening of fiscal policy in developed economies.

The third tranche of US quantitative easing intends to channel banks’ liquidity into the real economy by further encouraging mortgage lending. Future movements of house prices will be crucial in determining its success.

Abundant amounts of liquidity are still not flowing into the real economy due to high levels of cash hoarding by the private sector. The elevated demand for money is being driven by precautionary and speculative motives, thereby producing a significant decline in the velocity of circulation of money.

The Fed does not yet believe that the US is in a full-blown liquidity trap or that monetary policy has become impotent, because it plans to undertake further aggressive asset purchases. Previous announcements of quantitative easing have been followed by rising risky asset prices and improved economic data.

There are rumours that the Fed may decide to target nominal GDP growth and tolerate a higher level of inflationary expectations in order reduce real interest rates. It is doubtful that the Fed would embrace targeting nominal GDP due to the risks that rising and volatile inflationary expectations would pose to nominal bond yields and the real economy, along with possibly considerable damage to its own long-term credibility.

About Said Desaque

I'm a professional economist in financial services, with a keen interest in international relations, along with their implications for economic development.

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