Raghuram Rajan recently offered some advice on monetary policy regimes:
[T]he balance of risks suggests that central banks should reemphasize their mandate to combat high inflation, using standard tools such as interest rate policy. What if inflation is too low? Perhaps, as with COVID-19, we should learn to live with it and avoid tools like quantitative easing that have questionably positive effects on real activity; distort credit, asset prices, and liquidity; and are hard to exit. Arguably, so long as low inflation does not collapse into a deflationary spiral, central banks should not fret excessively about it. Decades of low inflation are not what slowed Japan’s growth and labor productivity. Aging and a shrinking labor force are more to blame.
I think it’s a mistake to adopt asymmetrical policy targeting, where you combat above target inflation and tolerate below target inflation. Better to set a target path (preferably NGDP) and eliminate deviations in either direction.
But here I’d like to focus on a different issue. While Rajan doesn’t say this explicitly, his comment implies that tolerating low inflation is an alternative to quantitative easing (QE). In my view, toleration of very low inflation is a cause of QE. To see why, let’s review a few concepts in monetary economics:
1. The demand for base money (as a share of GDP) is negatively related to the trend rate of inflation/NGDP growth. Prior to 2008, most developed countries had monetary bases of roughly 5% to 10% of GDP. In extreme cases of very high inflation, base demand can fall to 1% or 2% of GDP. At the opposite extreme, countries with very low inflation (such as Japan and Switzerland) have base/GDP ratios exceeding 100% of GDP.
2. In a technical sense, central banks do not have to accommodate high base demand with QE policies. But if they fail to do so, a country can fall into severe deflation, as we saw in the early 1930s in the US. Thus in a political sense, a high base demand as a share of GDP almost forces central banks to engage in lots of QE. The central banks of Switzerland and Japan are not left wing organizations. They are (small c) conservative. They have accumulated large balance sheets as a way of meeting a high demand for base money, and thus preventing outright deflation.
Rajan is correct that Japan has adapted to a regime of low inflation (although the initial adjustment process during the 1990s was somewhat painful.) But I don’t think the example of Japan shows what Rajan seems to think it shows. In the long run, Japanese success in maintaining a very low inflation environment has required much more extensive QE policies than those adopted by either the Fed or the ECB.
Toleration of very low inflation is not an alternative to QE; in the long run it’s the primary cause of QE. There is a close analogy with monetary policy and interest rates. On any given day, a cut in the central bank’s interest rate target is expansionary (for any given natural rate of interest). But over the longer run, a central bank with a contractionary policy regime that leads to low inflation will end up with lower nominal interest rates than a central bank that tolerates a high trend rate of inflation.
In the long run, there are three regimes that central bankers can choose from:
Regime A: Very low trend inflation. Very low nominal interest rates. Lots of QE and a large central bank balance sheet. (Japan and Switzerland are examples.)
Regime B: Moderate trend inflation. Moderate nominal interest rates. Very little QE and a moderate size balance sheet. (The US prior to 2008.)
Regime C: High trend inflation. High nominal interest rates. Substantial QE (financing budget deficits), but small central bank balance sheets as a share of GDP. (Argentina and Turkey.)
PS. Yes, the payment of interest on reserves complicates this picture somewhat, leading to larger CB balance sheets for any given trend rate of inflation. But IOR is a policy choice. (Unwise, in my view.)
READER COMMENTS
Andrew_FL
Mar 6 2023 at 9:32am
A, B, and C all seem premised on the assumption the long run growth potential is terrible
ssumner
Mar 7 2023 at 8:24am
That’s my view.
Thomas Lee Hutcheson
Mar 6 2023 at 10:18am
Missing from Rajan’s analysis is and analysis of what the inflation target ought to be (based on expected shocks, aysmetric price flexibility etc.)
Jeff
Mar 8 2023 at 10:08am
Does Rajan think there should there even be an inflation target at all? I read this article as suggesting that there are fundamental deficiencies with that framework. “Arguably, so long as low inflation does not collapse into a deflationary spiral, central banks should not fret excessively about it.”
Mark Barbieri
Mar 6 2023 at 11:29am
I don’t understand Japan. Are they trying to keep inflation down near zero? When I read the news, it often seems they are struggling with the “zero lower bound” problem. But they have a massive national debt. Why can’t they just start monetizing their debts and adjust the pace of monetization to get the level of inflation that they want?
Richard W Fulmer
Mar 6 2023 at 11:51am
Why is the government better equipped to determine the price of money than it is to determine the price of anything else?
vince
Mar 6 2023 at 8:54pm
Excellent question!
Scott Sumner
Mar 6 2023 at 9:17pm
Because they produce money, and private firms produce other stuff.
vince
Mar 6 2023 at 9:48pm
There’s the problem. They produce it and then they borrow it.
Richard W Fulmer
Mar 7 2023 at 10:34am
And produce, and produce, and produce …
True, but it’s the market that really controls their prices.
ssumner
Mar 7 2023 at 1:52pm
“True, but it’s the market that really controls their prices.”
Not if it’s a monopoly. And the Fed has a monopoly on the monetary base.
I think people are asking the wrong question. It’s not a question of why the Fed sets a price of money, it’s whether the government should be involved in any way in the monetary system.
vince
Mar 7 2023 at 2:29pm
By price of money, I assume you mean the interest rate. I believe Richard is saying the market is more qualified than the government to set the correct rate of interest.
Richard W Fulmer
Mar 7 2023 at 5:51pm
Even a monopoly is controlled by the market. Alcoa had a monopoly on ingot aluminum but not on all building materials. Also, Alcoa could not prevent market entry except by keeping its prices low.
Jeff
Mar 7 2023 at 3:18am
Maybe this is just a matter of definitions? I thought QE referred to the expansion (i.e. positive first derivative) of the size of the central bank balance sheet relative to GDP. So I don’t see why you wouldn’t just expect to reach a steady state balance sheet size given the demand for base money associated with any particular inflation rate. Doesn’t QE rather result from an undershoot of trend inflation relative to the desired inflation rate of the central bank?
I don’t read Rajan’s argument as having anything against accommodating an increased demand for base money, but rather against an over-accomodation of the demand in an effort to push up inflation expectations.
ssumner
Mar 7 2023 at 8:27am
In my view, real world QE programs in developed economies have mostly served to accommodate increased base money demand—they have not done much to push inflation higher (merely prevented it from falling into deflation.)
Jeff
Mar 7 2023 at 10:32am
Ok, but it still seems there could be a lot of daylight between “we’ve halted the flow in the wrong direction” and “we did so much we reversed the flow”.
Thomas Lee Hutcheson
Mar 7 2023 at 10:40am
But is that not just a refection of not “doing whatever it takes” to reach the inflation target?
ssumner
Mar 7 2023 at 1:54pm
That’s right. In 2009-16 the Fed didn’t even do enough to hit their inflation target. After 2020, they did too much.
The BOJ has almost never done enough (time will tell if the recent Japanese inflation is transitory–I suspect it is.)