Monetary policy

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Should Emerging Economies Embrace Quantitative Easing during the Pandemic?

Published by Anonymous (not verified) on Fri, 02/10/2020 - 9:00pm in

Gianluca Benigno, Jonathan Hartley, Alicia Garcia Herrero, Alessandro Rebucci, and Elina Ribakova


Emerging economies are fighting COVID-19 and the economic sudden stop imposed by lockdown policies. Even before COVID-19 took root in emerging economies, however, investors had already started to flee these markets–to a much greater extent than they had at the onset of the 2008 global financial crisis (IMF, 2020; World Bank, 2020). Such sudden stops in capital flows can cause significant drops in economic activity, with recoveries that can take several years to complete (Benigno et al., 2020). Unfortunately, austerity and currency depreciations as enacted during the global financial crisis will not mitigate this double whammy of capital outflows and policies to cope with the pandemic. We argue that purchases of local currency government bonds could be a viable option for credible emerging market central banks to support macroeconomic policy goals in these circumstances.

Vulnerable Emerging Economies

The pandemic is causing a devastating impact on emerging economies, which are experiencing even more dramatic drops in employment and growth compared to more advanced economies. Commodity-producing emerging economies have seen sharp declines in their export prices (Hevia and Neumeyer, 2020), while others have been hit by the collapse of remittances and tourism. Overall demand for goods and services produced in these countries have collapsed.

Emerging economies face unprecedented challenges stemming not only from the pandemic-induced economic shock but also from their more limited ability to borrow during a crisis. To complicate matters, IMF resources are stretched as several economies face sizeable financial needs (García-Herrero and Ribakova, 2020). There have been efforts at international cooperation and coordination aimed at boosting IMF resources or supporting the debt rescheduling or restructuring proposed by Bolton et al. (2020), but such initiatives might come to fruition too late.

The conventional view is that economies should enact fiscal stimulus to the extent to which their level of government debt allows. However, as seen in the chart below, emerging markets have limited fiscal space, with an average government debt-to-GDP ratio of more than 50 percent at the end of 2019—close to historically burdensome levels for emerging economies. (Note, though, that the high levels seen in Hong Kong and Singapore are a byproduct of their role as financial centers.)


Experimenting with QE

Emerging economies have responded to the pandemic and the resulting sharp global economic downturn by allowing their currencies to depreciate and easing monetary policy, as they did during the global financial crisis. Several central banks have gone further and, for the first time, even before reaching the zero-lower-bound on policy rates, have started to engage in long-term government asset purchases, commonly referred to as quantitative easing (QE)—one of the “unconventional” monetary policy tools employed by advanced economy central banks during the global financial crisis.

Quite surprisingly, government bond markets and foreign investors have responded quite favorably to these announcements, with long-term interest rates falling significantly in all but three cases (see table below), and exchange rates either appreciating or slowing their depreciation (see table and Arslan et al., 2020).


The Argument for QE

Many emerging economies operate under a flexible inflation-targeting regime, letting their exchange rate float to different degrees, and have long been able to issue sovereign debt in their local currency. This latter critical strength was acquired over the past several years in an attempt to eliminate foreign exchange risk in the government balance sheet. Indeed, local currency bonds now represent the lion’s share of the stock of government debt in these countries, with an average share of local currency debt in total government debt of 79 percent as at the end of 2019 as seen in the top table above.

Government bond purchase programs by central banks can restore liquidity in the local bond market during times of crisis, thereby lowering the cost of borrowing for the rest of the economy. This is particularly relevant for economies in which foreign investors hold a significant share of the local currency sovereign debt outstanding as seen in the chart below. These investors’ liabilities tend to be in U.S. dollars, giving rise to currency mismatches in their balance sheets (Carstens and Shin, 2019). As a consequence, a rise in risk aversion can trigger fire sales of local bonds that put pressure on emerging market government bond yields and exchange rates. Emerging market central banks can counter these forces by being purchasers of last resort and preserve liquidity and stability in the local government bond market. Stepping into the market in this manner makes it less likely that foreign investors sell bonds, reducing downward pressure on local asset prices.


We argue that emerging economies with a flexible exchange rate regime and well-anchored inflation expectations should consider the benefits of QE to stabilize financial conditions and help finance the government budget deficit caused by the pandemic. This way, QE programs would help reduce the risk of prolonged stagnation.

The Downside Risks

QE, like any aggressive monetary expansion, poses the risks that the exchange rate depreciates and inflation expectations de-anchor. However, as long as there is abundant slack in the economy, monetary-financed fiscal expansions are unlikely to be inflationary. Inflation is low and stable in many emerging markets, as seen below. In addition, expectations are well anchored, with many more countries with inflation rates within or below target bounds rather than above them. Moreover, large depreciations led only to moderate and temporary bursts of inflation during the global financial crisis, as the exchange rate pass-through had already fallen to levels close to those in advanced economies, as documented, for instance, by Jašová, Moessner, and Takáts (2016).


Economies that have a poorly diversified production base and are heavily dependent on imports for consumption or production purposes will face stronger price pressures from a weaker currency. Hence, the argument for embracing QE for fiscal purposes does need to be qualified, as not all countries will be in a position to use QE without exposing themselves to significant inflation risks.

Finally, another risk associated with QE is related to the extent to which the private sector is exposed to foreign exchange risk (see, for example, Avdjiev, McGuire, and von Peter, 2020). In this case, a sharp depreciation would put pressure on private sector balance sheets, raising the risk of adverse consequence if the asset purchase program causes a significant currency depreciation. Central banks can counter by providing foreign currency to the corporate sector by drawing on their war chest of reserves.

In sum, we argue that QE is a viable macroeconomic policy response to the pandemic for countries with a credible central bank, a floating exchange rate regime, and sovereign debt that is largely denominated in its own local currency. By undertaking such a policy, these central banks could stabilize domestic financial markets and help finance the government spending needed to flatten both the pandemic and recession curves.

Benigno_gianlucaGianluca Benigno is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Jonathan Hartley is a visiting fellow at the Foundation for Research on Equal Opportunity.

Alicia Garcia Herrero is the chief economist for Asia Pacific at Natixis. 

Alessandro Rebucci is an associate professor at the Johns Hopkins Carey Business School.

Elina Ribakova is deputy chief economist at the Institute of International Finance.

How to cite this post:

Gianluca Benigno, Jonathan Hartley, Alicia Garcia Herrero, Alessandro Rebucci, and Elina Ribakova, “Should Emerging Economies Embrace Quantitative Easing during the Pandemic?,” Federal Reserve Bank of New York Liberty Street Economics, October 2, 2020,


The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

The Paradox of Yield Curve: Why is the Fed Willing to Flatten the Curve but Not Control It?

Published by Anonymous (not verified) on Thu, 01/10/2020 - 10:44pm in

From long experience, Fed technicians knew that the Fed could not control money supply with the precision envisioned in textbooks.” Marcy Stigum

By Elham Saeidinezhad – In the last decade, monetary policy wrestled with the problem of low inflation and has become a tale of three cities: interest rate, asset purchasing, and the yield curve. The fight to reach the Fed’s inflation target started by lowering the overnight federal funds rate to a historically low level. The so-called “zero-lower bound restriction” pushed the Fed to alternative policy tools, including large-scale purchases of financial assets (“quantitative and qualitative easing”). This policy had several elements: first, a commitment to massive asset purchases that would increase the monetary base; second, a promise to lengthen the maturity of the central banks’ holdings and flatten the yield curve. However, in combination with low inflation (actual and expected), such actions have translated into persistently low real interest rates at both the yield curve’s long and short ends, and at times, the inversion of the yield curve. The “whatever it takes” large-scale asset purchasing programs of central banks were pushing the long-term yields into clear negative territory. Outside the U.S., and especially in Japan, central banks stepped up their fight against deflation by adopting a new policy called Yield Curve Control, which explicitly puts a cap on long-term rates. Even though the Fed so far resisted following the Bank of Japan’s footsteps, the yield curve control is the first move towards building a world that “Money View” re-imagines for central banking. Yield curve control enables the Fed to assume its “dealer of last resort role” role to increase its leverage over the yield curve, a private dealer territory, without creating repeated dislocations in the private credit market. 

To understand this point, let’s start by translating monetary policy’s evolution into the language of Money View. In the traditional monetary policy, the Fed uses its control of reserve (at the top of the hierarchy of money) to affect credit expansion (at the bottom of the hierarchy). It also controls the fed funds rate (at the short end of the term structure) in an attempt to influence the bond rate of interest (at the long end). When credit is growing too rapidly, the Fed raises the federal fund’s target to impose discipline in the financial market. In standard times, this would immediately lower the money market dealers’ profit. This kind of dealer borrows at an overnight funding market to lend in the lend in term (i.e., three-month) market. The goal is to earn the liquidity spread.

After the Fed’s implementation of contractionary monetary policy, to compensate for the higher financing cost, money market dealers raise the term interest rate by the full amount (and perhaps a bit more to compensate for anticipated future tightening as well). This term-rate is the funding cost for another kind of dealer, called security dealers. Security dealers borrow from the term-market (repo market) to lend to the long-term capital market. Such operations involve the purchase of securities that requires financing. Higher funding cost implies that security dealers are willing to hold existing security inventories only at a lower price, and increasing long-term yield. This chain of events sketches a monetary policy transmission that happens through the yield curve. The point to emphasize here is that in determining the yield curve, the private credit market, not the Fed, sets rates and prices. The Fed has only some leverage over the system.

After the GFC, as the rates hit zero-lower bound, the Fed started to lose its leverage. In a very low-interest-rate condition, preferences shift in favor of money and against securities. One way to put it is that the surplus agents become reluctant to” delay settlement” and lower their credit market investment. They don’t want promises to pay (i.e., holding securities), and want money instead. In this environment, to keep making the market and providing liquidity, money market, and security dealers, who borrow to finance their short and long-term inventories, respectively, should be able to buy time. During this extended-time period, prices are pushed away from equilibrium. Often, the market makers face this kind of trouble and turn to the banks for refinancing. After GFC, however, the very low-interest rates mean that banks themselves run into trouble.

In a normal crisis, as the dealer system absorbs the imbalances due to the shift in preferences into its balance sheet, the Fed tried to do the same thing and take the problem off the balance sheet of the banking system. The Fed usually does so by expanding its balance sheet. The Fed’s willingness to lend to the banks at a rate lower than they would lend to each other makes it possible for the banks to lend to the dealers at a rate lower than they would otherwise charge. Putting a ceiling on the money rate of interest thus indirectly puts a floor on asset prices. In a severe crisis, however, this transmission usually breaks down. That is why after the GFC, the Fed used its leverage to put a floor on asset prices directly by buying them, rather than indirectly by helping the banks to finance dealers’ purchases.

The fundamental question to be answered is whether the Fed has any leverage over the private dealing system when interest rates are historically low. The Fed’s advantage is that it creates reserves, so there can be no short squeeze on the Fed. When the Fed helps the banks, it expands reserves. Hence the money supply grows. We have seen that the market makers are long securities and short cash. What the Fed does is to backstop those short positions by shorting cash itself. However, the Fed’s leverage over the private dealer system is asymmetric. The Fed’s magic mostly works when the Fed decides to increase elasticity in the credit market. The Fed has lost its alchemy to create discipline in the market when needed. When the rates are already very low, credit contraction happens neither quickly nor easily if the Fed increases the rates by a few basis points. Indeed, only if the Fed raises the rates high enough, it can get some leverage over this system, causing credit contraction. Short of an aggressive rate hike, the dealer system increases the spread slightly but not enough to not change the quantity of supplied credit. In other words, the Fed’s actions do not translate automatically into a chain of credit contraction, and the Fed does not have control over the yield curve. The Fed knows that, and that is why it has entered large-scale asset purchasing programs. But it is the tactful yet minimal purchases of long-term assets, rather than massive ones, that can restore the Fed’s control over the yield curve. Otherwise, the Fed’s actions could push the long-term rates into negative territory and lead to a constant inversion of the yield curve.

The yield curve control aims at controlling interest rates along some portion of the yield curve. This policy’s design has some elements of the interest rate policy and asset purchasing program. Similar to interest rate policy, it targets short-term interest rates. Comparable with the asset purchasing program, yield curve control aim at controlling the long-term interest rate. However, it mainly incorporates essential elements of a “channel” or “corridor” system. This policy targets longer-term rates directly by imposing interest rate caps on particular maturities. Like a “corridor system,” the long-term yield’s target would typically be set within a bound created by a target price that establishes a floor for the long-term assets. Because bond prices and yields are inversely related, this also implies a ceiling for targeted maturities. If bond prices (yields) of targeted maturities remain above (below) the floor, the central bank does nothing. However, if prices fall (rise) below (above) the floor, the central bank buys targeted-maturity bonds, increasing the demand and the bonds’ price. This approach requires the central bank to use this powerful tool tactfully rather than massively. The central bank only intervenes to purchase certain assets when the interest rates on different maturities are higher than target rates. Such a strategy reduces central banks’ footprint in the capital market and prevents yield curve inversion- that has become a typical episode after the GFC.

The “paradox of the yield curve” argues that the Fed’s hesitation to adopt the yield curve control to regulate the longer-term rates contradicts its own reasoning behind the introduction of a corridor framework to control the overnight rate. Once the FOMC determines a target interest rate, the Fed already sets the discount rate above the target interest rate and the interest-on-reserve rate below. These two rates form a “corridor” that will contain the market interest rate; the target rate is often (but not always) set in the middle of this corridor. Open market operations are then used as needed to change the supply of reserve balances so that the market interest rate is as close as possible to the target. A corridor operating framework can help a central bank achieve a target policy rate in an environment in which reserves are anything but scarce, and the central bank has used its balance sheet as a policy instrument independent of the policy interest rate.

In the world of Money View, the corridor system has the advantage of enabling the Fed to act as a value-based dealer, or as Mehrling put it, “dealer of last resort,” without massively purchasing assets and constantly distorting asset prices. The value-based dealer’s primary role is to put a ceiling and floor on the price of assets when the dealer system has already reached their finance limits. Such a system can effectively stabilize the rate near its target. Stigum made clear that standard economic theory has no perfect answer to how the Fed gets leverage over the real economy. The question is why the Fed is willing to embrace the frameworks that flatten the yield curve but is hesitant to adopt the “yield curve control,” which explicitly puts a cap on long-term rates.

Elham Saeidinezhad is Term Assistant Professor of Economics  at Barnard College, Columbia University. Previously, Elham taught at UCLA, and served as a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”.  Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

The post The Paradox of Yield Curve: Why is the Fed Willing to Flatten the Curve but Not Control It? appeared first on Economic Questions.

Expanding the Toolkit: Facilities Established to Respond to the COVID-19 Pandemic

Published by Anonymous (not verified) on Tue, 22/09/2020 - 9:00pm in

Anna Kovner and Antoine Martin


First of three posts

The Federal Reserve’s response to the coronavirus pandemic has been unprecedented in its size and scope. In a matter of months, the Fed has, among other things, cut the federal funds rate to the zero lower bound, purchased a large amount of Treasury securities and agency mortgage‑backed securities (MBS) and, together with the U.S. Treasury, introduced several lending facilities. Some of these facilities are very similar to ones introduced during the 2007-09 financial crisis while others are completely new. In this post, we argue that the new facilities, while unprecedented, are a natural extension of the Fed’s toolkit, as they operate through similar economic mechanisms to prevent self-reinforcing bad outcomes. We also explain why these new facilities are particularly useful as part of the response to the pandemic, which is an economic shock very different from a financial crisis.

An Overview of the Facilities

The distinction between new and old facilities loosely maps to a commonly used description of facilities as “liquidity” or “credit” facilities. Liquidity facilities include the Primary Dealer Credit Facility (PDCF), the Commercial Paper Funding Facility (CPFF), and the Money Market Mutual Fund Liquidity Facility (MMLF). These facilities support financial intermediaries, such as primary dealers and money market funds, or money markets, such as the commercial paper market. In addition, they provide short-term support, generally less than one year. "Credit" facilities include the Municipal Liquidity Facility, the Main Street Lending Program, the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF), the Term Asset‐Backed Securities Loan Facility (TALF) (introduced during the 2007-09 crisis) and the Paycheck Protection Program Liquidity Facility (PPPLF). They support corporations, states, and municipalities more directly and the terms of the loans are longer. All these facilities were established under Section 13(3) of the Federal Reserve Act, with approval of the Treasury Secretary.

Regardless of the label used to describe these facilities, they all serve a similar purpose, to ensure that American businesses and households have access to credit. Moreover, we argue that they do so through a similar economic mechanism; stepping in to ensure that, when there are multiple possible economic outcomes, the U.S. financial system is positioned to facilitate the best possible outcome for the U.S. economy.

How do Federal Reserve facilities help the financial system?

Liquidity provision by the central bank can break the vicious cycle that makes panics self-fulfilling. For example, in a bank run, if a bank can borrow from the central bank to repay its depositors, it will not have to sell its assets at a loss. This means that the bank will have enough resources to repay the depositors that are not withdrawing immediately, which reduces or eliminates the incentive to do so. This is an example of multiple equilibria—a situation with multiple outcomes. By acting according to Walter Bagehot’s advice to the Bank of England to lend freely and vigorously against good collateral, the Fed can prevent or mitigate run dynamics.

In the 2007-09 financial crisis, the liquidity facilities were established to help prevent run dynamics in financial markets, just as the Fed has done through the discount window for banks since its founding, thus avoiding the bad equilibrium that could follow from inefficient fire sales of assets. Many of these facilities have been reinstated to respond to the severe market dislocations and run risks that emerged in response to the coronavirus pandemic.

Are "credit" facilities a new role?

At first glance, the "credit" facilities appear new to the central bank’s tool kit, targeting businesses and localities directly rather than providing liquidity to banks and financial markets. When the cause of lack of access to credit is fundamental uncertainty about the real economy, we argue that, just as the Fed steps in to lend to solve the multiple equilibria facing banks in a run, the "credit" facilities help solve a multiple equilibria problem facing the real economy. In this way, the facilities are a natural evolution of the toolkit adapted to the current circumstances.

A growing literature in economics theorizes about the possibility of multiple equilibria in the real economy. For example, if households and firms have pessimistic views about the future, they are likely to be reluctant to consume and invest. This will in turn depress economic activity. Conversely, if households and firms have optimistic views about the future, they will be willing to consume and invest and this will in turn stimulate economic activity (see, for example, this Liberty Street Economics post). This literature also suggests that in models with multiple steady-states, a self-reinforcing negative outcome is likely to happen only in unusual circumstances, for example, following an unusually large shock (as in Benigno and Fornaro). This possibility of multiple equilibria is also explored empirically in Adrian, Boyarchenko, and Giannone. They estimate forecasts in a framework that allows for negative feedback between ever-tighter financial conditions and slowing growth. The authors apply this estimation in a recent blog post and show the prospect of two possible outcomes, a more benign outcome and a very negative one in 2020. The possibility of multiple equilibria is rare in their framework but was also evident in 2008.

Why now?

It is important to recognize that the coronavirus pandemic is of a different nature than the 2007-09 financial crisis. That crisis was primarily a financial shock that amplified what may have otherwise been a reasonably small macroeconomic shock. By contrast, the pandemic is primarily a large macroeconomic shock arising from measures taken to contain it. The shock to the economy created by the pandemic has created unusually high uncertainty about the possible macroeconomic outcomes, affecting companies and localities that rely on capital markets. This can arise when financial markets assign too much weight to negative outcomes that good policy can avoid. As a result, market prices will diverge from what they would be under the better equilibrium. Since the multiple possible economic outcomes affect mainly the real economy, and are driven by uncertainty about the prospects for the post-shutdown economy rather than financial institutions, the Fed had to adapt its tools to address this new problem.

The multiple equilibria argument does not mean that these facilities are a free lunch—costlessly leading the U.S. economy to the better outcomes. Interventions could raise concerns, particularly about moral hazard, as we discuss in a later post.

A Joint Effort

As noted by Fed Chair Jerome Powell during a Brookings webinar, the Fed is providing “credit to households, businesses, state and local governments as we are directed by the Congress.” In theory, if the Fed knew with perfect certainty the length of the COVID-19-related disruptions and the state of the better equilibria for the economy, no capital would be required to extend these facilities. However, in practice, given their unconventional natures, and the scale of the required intervention, the facilities have been established in partnership with the U.S. Treasury. To provide a large-enough backstop at reasonable prices, the Fed in particular relies on the equity that the U.S. Treasury provides to protect it from losses on the "credit" facilities as mandated in the CARES Act and in Section 13(3) of the Federal Reserve Act. In addition, Section 13(3) requires that the Secretary of the Treasury approve any Section 13(3) facility established by the Fed.

The Fed plays two important roles in this partnership. First, it leverages the capital that Treasury is putting toward helping the real economy. This means that the amount of support available to households, businesses, state and local governments is larger than it otherwise would be. Second, the Fed provides technical and operational expertise to help set up these programs as fast as possible so that relief is available quickly to those who need it.

To Sum Up

A central bank’s toolkit must adapt to the circumstances it faces. The Fed has established a number of facilities, in partnership with the Treasury and at the direction of the Congress. These facilities play a similar role to that played by the facilities introduced during the 2007-09 financial crisis, helping to prevent self-reinforcing bad outcomes. The "credit" facilities are particularly helpful to respond to the macroeconomic shock created by the uncertainty associated with the coronavirus pandemic. Of course, the facilities are only one aspect of the official sector’s response to the pandemic. In tomorrow’s post, we consider interventions by the official sector more broadly, including institutions like the Treasury and Congress, asking whether, during the pandemic, they should extend support to insolvent businesses.

Anna Kovner

Anna Kovner is a policy leader for financial stability in the Federal Reserve Bank of New York’s Research and Statistics Group.

Antoine Martin

Antoine Martin is a senior vice president in the Bank’s Research and Statistics Group.

How to cite this post:

Anna Kovner and Antoine Martin, “Expanding the Toolkit: Facilities Established to Respond to the COVID-19 Pandemic,” Federal Reserve Bank of New York Liberty Street Economics, September 22, 2020,

Related Liberty Street Economics reading

Market Failures and Official Sector Interventions

The Official Sector’s Response to the Coronavirus Pandemic and Moral Hazard


The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Jump-starting an international currency

Published by Anonymous (not verified) on Mon, 21/09/2020 - 6:00pm in

Saleem Bahaj and Ricardo Reis Only a handful of currencies are regularly used for cross-border payments: the euro, the yen, the pound, the yuan and, of course, the US dollar, which dominates almost any measure of international use. But how does a currency achieve an international status in the first place? And which government policies … Continue reading Jump-starting an international currency →

What’s Up with the Phillips Curve?

Published by Anonymous (not verified) on Fri, 18/09/2020 - 9:00pm in

William Chen, Marco Del Negro, Michele Lenza, Giorgio Primiceri, and Andrea Tambalotti

U.S. inflation used to rise during economic booms, as businesses charged higher prices to cope with increases in wages and other costs. When the economy cooled and joblessness rose, inflation declined. This pattern changed around 1990. Since then, U.S. inflation has been remarkably stable, even though economic activity and unemployment have continued to fluctuate. For example, during the Great Recession unemployment reached 10 percent, but inflation barely dipped below 1 percent. More recently, even with unemployment as low as 3.5 percent, inflation remained stuck under 2 percent. What explains the emergence of this disconnect between inflation and unemployment? This is the question we address in “What’s Up with the Phillips Curve?,” published recently in Brookings Papers on Economic Activity.

Inflation Has Been Less Responsive to Unemployment since 1990

To illustrate this phenomenon, the chart below shows the dynamic responses of core PCE inflation and the unemployment rate to a surprise increase in the latter, based on a vector autoregressive (VAR) model. When these responses are computed using data before 1990 (in blue), core inflation drops significantly. When they are computed using data after 1990 (in red), core inflation barely moves. The behavior of unemployment, in contrast, is pretty similar across the two samples.


What Explains the Inflation–Unemployment Disconnect?

Economists have explored three main possible explanations for the emergence of this disconnect between inflation and unemployment: (1) Labor markets have changed in the past three decades, making unemployment a poorer indicator of both resource utilization in the economy (“slack”) and the cost pressures faced by firms. (2) Firms’ pricing decisions have become less sensitive to these cost pressures, leading to a flattening of the so-called Phillips curve. (3) Policy has become more successful in stabilizing inflation, as argued most recently by McLeay and Tenreyro (2019).

It Is Not the Labor Market

The chart below suggests that the first hypothesis is unlikely to be the main story. It shows the response of various measures of economic slack and cost pressures—such as GDP, the unemployment rate, hours worked, and unit labor costs—to the unemployment shock mentioned above. The responses of all these variables are very similar before and after 1990. This suggests that the stability of inflation over the past thirty years is not due to a break in the cyclical behavior of any specific measure of slack or cost pressures, which arguably rules out changes in the functioning of labor markets as a leading explanation for the inflation–business cycle disconnect.

What’s Up with the Phillips Curve?

Distinguishing Demand and Supply

This leaves us with two possible explanations: a flatter Phillips curve or improved monetary policy. We distinguish the two by studying the dynamic effects of aggregate demand shocks. Monetary policy can limit their impact on inflation by “leaning against the wind” to counteract their effects on economic activity, as well as on inflation. Therefore, if improved monetary policy is behind inflation stability, these demand shocks should have minor effects on both inflation and unemployment after 1990. But if inflation stability is due to limited sensitivity of prices to cost pressures and a flatter Phillips curve, demand shocks should continue to have a large impact on unemployment, although not on inflation.

In the paper, we associate demand shocks to financial disturbances. More specifically, we follow Gilchrist and Zakrajšek (2012) and identify the latter with shocks to the so-called excess bond premium, which measures changes in credit spreads driven by credit market sentiment, as opposed to default risk. As vividly illustrated by the macroeconomic disruptions brought about by the financial crisis of the last decade, financial shocks hit both firms and households, leading them to reduce their demand for investment and consumption. The left panel in the chart below shows the response of the excess bond premium to its own shock, which is basically identical across samples. The middle panel shows the response of unemployment. In the post-1990 sample, this response is attenuated in the first few quarters, but it is also more persistent than in the pre-1990 sample, leading to a larger cumulative effect. On balance, unemployment reacts strongly to demand shocks both before and after 1990, indicating that monetary policy is not entirely successful in leaning against the wind. In contrast, the response of core inflation is muted since 1990, consistent with a flatter Phillips curve.

What’s Up with the Phillips Curve?

These empirical results are consistent with the common narrative behind the Great Recession, which most observers would associate with a collapse in demand: economic activity fell precipitously, but inflation barely budged, suggesting that the Phillips curve is flat. This flattening of the Phillips curve is also what we find by estimating the New York Fed DSGE model before and after 1990.

What Does a Flat Phillips Curve Imply for Monetary Policy?

Does monetary policy lose its traction on inflation when the Phillips curve is as flat as we find it to be after 1990? Our DSGE model suggests that this is not necessarily the case. The reason is that the other side of the “flat Phillips curve” coin is that the economy is more “Keynesian,” meaning that economic activity reacts more persistently to changes in monetary policy, as discussed in this 2014 Liberty Street Economics post. Therefore, even if the reaction of inflation to changes in economic activity is smaller, monetary policy has more traction on the latter, evening things out. To illustrate this principle, we show that policies that react forcefully to deviations of inflation from the central bank’s target, such as flexible average inflation targeting, can deliver stable inflation even with a flat Phillips curve. In fact, the flatness of the Phillips curve was one of the main motivations for the new monetary policy strategy recently unveiled by the Federal Reserve, as discussed by Chair Powell in his Jackson Hole speech as well as in this recent interview with NPR.

William Chen
William Chen is a senior research analyst in the Federal Reserve Bank of New York’s Research and Statistics Group.

Marco Del Negro
Marco Del Negro is a vice president in the Bank’s Research and Statistics Group.

Michele Lenza is an economist at the European Central Bank.

Giorgio Primiceri is a professor at Northwestern University.

Andrea Tambalotti
Andrea Tambalotti is a vice president in the Bank’s Research and Statistics Group.

How to cite this post:

William Chen, Marco Del Negro, Michele Lenza, Giorgio Primiceri, and Andrea Tambalotti, “What’s Up with the Phillips Curve?,” Federal Reserve Bank of New York Liberty Street Economics, September 18, 2020,


The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

“Monetary Policy in a Changing World”

Published by Anonymous (not verified) on Fri, 18/09/2020 - 6:52am in

While looking for something else, I came across this 1956 article on monetary policy by Erwin Miller. It’s a fascinating read, especially in light of current discussions about, well, monetary policy in a changing world. Reading the article was yet another reminder that, in many ways, debates about central banking were more sophisticated and far-reaching in the 1950s than they are today.

The recent discussions have been focused mainly on what the goals or targets of monetary policy should be. While the rethinking there is welcome — higher wages are not a reliable sign of rising inflation; there are good reasons to accept above-target inflation, if it developed — the tool the Fed is supposed to be using to hit these targets is the overnight interest rate faced by banks, just as it’s been for decades. The mechanism by which this tool works is basically taken for granted — economy-wide interest rates move with the rate set by the Fed, and economic activity reliably responds to changes in these interest rates. If this tool has been ineffective recently, that’s just about the special conditions of the zero lower bound. Still largely off limits are the ideas that, when effective, monetary policy affects income distribution and the composition of output and not just its level, and that, to be effective, monetary policy must actively direct the flow of credit within the economy and not just control the overall level of liquidity.

Miller is asking a more fundamental question: What are the institutional requirements for monetary policy to be effective at all? His answer is that conventional monetary policy makes sense in a world of competitive small businesses and small government, but that different tools are called for in a world of large corporations and where the public sector accounts for a substantial part of economic activity. It’s striking that the assumptions he already thought were outmoded in the 1950s still guide most discussions of macroeconomic policy today.1

From his point of view, relying on the interest rate as the main tool of macroeconomic management is just an unthinking holdover from the past — the “normal” world of the 1920s — without regard for the changed environment that would favor other approaches. It’s just the same today — with the one difference that you’ll no longer find these arguments in the Quarterly Journal of Economics.2

Rather than resort unimaginatively to traditional devices whose heyday was one with a far different institutional environment, authorities should seek newer solutions better in harmony with the current economic ‘facts of life.’ These newer solutions include, among others, real estate credit control, consumer credit control, and security reserve requirements…, all of which … restrain the volume of credit available in the private sector of the economy.

Miller has several criticisms of conventional monetary policy, or as he calls it, “flexible interest rate policies” — the implicit alternative being the wartime policy of holding key rates fixed. One straightforward criticism is that changing interest rates is itself a form of macroeconomic instability. Indeed, insofar as both interest rates and inflation describe the terms on which present goods trade for future goods, it’s not obvious why stable inflation should be a higher priority than stable interest rates.

A second, more practical problem is that to the extent that a large part of outstanding debt is owed by the public sector, the income effects of interest rate changes will become more important than the price effects. In a world of large public debts, conventional monetary policy will affect mainly the flow of interest payments on existing debt rather than new borrowing. Or as Miller puts it,

If government is compelled to borrow on a large scale for such reasons of social policy — i.e., if the expenditure programs are regarded as of such compelling social importance that they cannot be postponed merely for monetary considerations — then it would appear illogical to raise interest rates against government, the preponderant borrower, in order to restrict credit in the private sphere.

Arguably, this consideration applied more strongly in the 1950s, when government accounted for the majority of all debt outstanding; but even today governments (federal plus state and local) accounts for over a third of total US debt. And the same argument goes for many forms of private debt as well.

As a corollary to this argument — and my MMT friends will like this — Miller notes that a large fraction of federal debt is held by commercial banks, whose liabilities in turn serve as money. This two-step process is, in some sense, equivalent to simply having the government issue the money — except that the private banks get paid interest along the way. Why would inflation call for an increase in this subsidy?


The continued existence of a large amount of that bank-held debt may be viewed as a sop to convention, a sophisticated device to issue needed money without appearing to do so. However, it is a device which requires that a subsidy (i.e., interest) be paid the banks to issue this money. It may therefore be argued that the government should redeem these bonds by an issue of paper money (or by an issue of debt to the central bank in exchange for deposit credit). … The upshot would be the removal of the governmental subsidy to banks for performing a function (i.e., creation of money) which constitutionally is the responsibility of the federal government.

Finance franchise, anyone?

This argument, I’m sorry to say, does not really work today — only a small fraction of federal debt is now owned by commercial banks, and there’s no longer a link, if there ever was, between their holdings of federal debt and the amount of money they create by lending. There are still good arguments for a public payments system, but they have to be made on other grounds.

The biggest argument against using a single interest rate as the main tool of macroeconomic management is that it doesn’t work very well. The interesting thing about this article is that Miller doesn’t spend much time on this point. He assumes his readers will already be skeptical:

There remains the question of the effectiveness of interest rates as a deterrent to potential private borrowing. The major arguments for each side of this issue are thoroughly familiar and surely demonstrate most serious doubt concerning that effectiveness.

Among other reasons, interest is a small part of overall cost for most business activity. And in any situation where macroeconomic stabilization is needed, it’s likely that expected returns will be moving for other reasons much faster than a change in interest rates can compensate for. Keynes says the same thing in the General Theory, though Miller doesn’t mention it.3 (Maybe in 1956 there wasn’t any need to.)

Because the direct link between interest rates and activity is so weak, Miller notes, more sophisticated defenders of the central bank’s stabilization role argue that it’s not so much a direct link between interest rates and activity as the effect of changes in the policy rate on banks’ lending decisions. These arguments “skillfully shift the points of emphasis … to show how even modest changes in interest rates can bring about significant credit control effects.”

Here Miller is responding to arguments made by a line of Fed-associated economists from his contemporary Robert Roosa through Ben Bernanke. The essence of these arguments is that the main effect of interest rate changes is not on the demand for credit but on the supply. Banks famously lend long and borrow short, so a bank’s lending decisions today must take into account financing conditions in the future. 4 A key piece of this argument — which makes it an improvement on orthodoxy, even if Miller is ultimately right to reject it — is that the effect of monetary policy can’t be reduced to a regular mathematical relationship, like the interest-output semi-elasticity of around 1 found in contemporary forecasting models. Rather, the effect of policy changes today depend on their effects on beliefs about policy tomorrow.

There’s a family resemblance here to modern ideas about forward guidance — though people like Roosa understood that managing market expectations was a trickier thing than just announcing a future policy. But even if one granted the effectiveness of this approach, an instrument that depends on changing beliefs about the long-term future is obviously unsuitable for managing transitory booms and busts.

A related point is that insofar as rising rates make it harder for banks to finance their existing positions, there is a chance this will create enough distress that the Fed will have to intervene — which will, of course, have the effect of making credit more available again. Once the focus shifts from the interest rate to credit conditions, there is no sharp line between the Fed’s monetary policy and lender of last resort roles.

A further criticism of conventional monetary policy is that it disproportionately impacts more interest-sensitive or liquidity-constrained sectors and units. Defenders of conventional monetary policy claim (or more often tacitly assume) that it affects all economic activity equally. The supposedly uniform effect of monetary policy is both supposed to make it an effective tool for macroeconomic management, and helps resolve the ideological tension between the need for such management and the belief in a self-regulating market economy. But of course the effect is not uniform. This is both because debtors and creditors are different, and because interest makes up a different share of the cost of different goods and services.

In particular, investment, especially investment in housing and other structures, is mo sensitive to interest and liquidity conditions than current production. Or as Miller puts it, “Interest rate flexibility uses instability of one variety to fight instability of a presumably more serious variety: the instability of the loanable funds price-level and of capital values is employed in an attempt to check commodity price-level and employment instability.” (emphasis added)

The point that interest rate changes, and monetary conditions generally, change the relative price of capital goods and consumption goods is important. Like much of Miller’s argument, it’s an unacknowledged borrowing from Keynes; more strikingly, it’s an anticipation of Minsky’s famous “two price” model, where the relative price of capital goods and current output is given a central role in explaining macroeconomic dynamics.

If we take a step back, of course, it’s obvious that some goods are more illiquid than others, and that liquidity conditions, or the availability of financing, will matter more for production of these goods than for the more immediately saleable ones. Which is one reason that it makes no sense to think that money is ever “neutral.”5

Miller continues:

In inflation, e.g., employment of interest rate flexibility would have as a consequence the spreading of windfall capital losses on security transactions, the impairment of capital values generally, the raising of interest costs of governmental units at all levels, the reduction in the liquidity of individuals and institutions in random fashion without regard for their underlying characteristics, the jeopardizing of the orderly completion of financing plans of nonfederal governmental units, and the spreading of fear and uncertainty generally.

Some businesses have large debts; when interest rates rise, their earnings fall relative to businesses that happen to have less debt. Some businesses depend on external finance for investment; when interest rates rise, their costs rise relative to businesses that are able to finance investment internally. In some industries, like residential construction, interest is a big part of overall costs; when interest rates rise, these industries will shrink relative to ones that don’t finance their current operations.

In all these ways, monetary policy is a form of central planning, redirecting activity from some units and sectors to other units and sectors. It’s just a concealed, and in large part for that reason crude and clumsy, form of planning.

Or as Miller puts it, conventional monetary policy

discriminates between those who have equity funds for purchases and those who must borrow to make similar purchases. … In so far as general restrictive action successfully reduces the volume of credit in use, some of those businesses and individuals dependent on bank credit are excluded from purchase marts, while no direct restraint is placed on those capable of financing themselves.

In an earlier era, Miller suggests, most borrowing was for business investment; most investment was externally financed; and business cycles were driven by fluctuations in investment. So there was a certain logic to focusing on interest rates as a tool of stabilization. Honestly, I’m not sure if that was ever true.But I certainly agree that by the 1950s — let alone today — it was not.

In a footnote, Miller offers a more compelling version of this story, attributing to the British economist R. S. Sayers the idea of

sensitive points in an economy. [Sayers] suggests that in the English economy mercantile credit in the middle decades of the nineteenth century and foreign lending in the later decades of that century were very sensitive spots and that the bank rate technique was particularly effective owing to its impact upon them. He then suggests that perhaps these sensitive points have given way to newer ones, namely, stock exchange speculation and consumer credit. Hence he concludes that central bank instruments should be employed which are designed to control these newer sensitive areas.

This, to me, is a remarkably sophisticated view of how we should think about monetary policy and credit conditions. It’s not an economywide increase or decrease in activity, which can be imagined as a representative household shifting their consumption over time; it’s a response of whatever specific sectors or activities are most dependent on credit markets, which will be different in different times and places. Which suggests that a useful education on monetary policy requires less calculus and more history and sociology.

Finally, we get to Miller’s own proposals. In part, these are for selective credit controls — direct limits on the volume of specific kinds of lending are likely to be more effective at reining in inflationary pressures, with less collateral damage. Yes, these kinds of direct controls pick winners and losers — no more than conventional policy does, just more visibly. As Miller notes, credit controls imposed for macroeconomic stabilization wouldn’t be qualitatively different from the various regulations on credit that are already imposed for other purposes — tho admittedly that argument probably went further in a time when private credit was tightly regulated than in the permanent financial Purge we live in today.

His other proposal is for comprehensive security reserve requirements — in effect generalizing the limits on bank lending to financial positions of all kinds. The logic of this idea is clear, but I’m not convinced — certainly I wouldn’t propose it today. I think when you have the kind of massive, complex financial system we have today, rules that have to be applied in detail, at the transaction level, are very hard to make effective. It’s better to focus regulation on the strategic high ground — but please don’t ask me where that is!

More fundamentally, I think the best route to limiting the power of finance is for the public sector itself to take over functions private finance currently provides, as with a public payments system, a public investment banks, etc. This also has the important advantage of supporting broader steps toward an economy built around human needs rather than private profit. And it’s the direction that, grudgingly but steadily, the response to various crises is already pushing us, with the Fed and other authorities reluctantly stepping in to perform various functions that the private financial system fails to. But this is a topic for another time.

Miller himself is rather tentative in his positive proposals. And he forthrightly admits that they are “like all credit control instruments, likely to be far more effective in controlling inflationary situations than in stimulating revival from a depressed condition.” This should be obvious — even Ronald Reagan knew you can’t push on a string. This basic asymmetry is one of the many everyday insights that was lost somewhere in the development of modern macro.

The conversation around monetary policy and macroeconomics is certainly broader and more realistic today than it was 15 or 20 years ago, when I started studying this stuff. And Jerome Powell — and even more the activists and advocates who’ve been shouting at him — deserves credit for the Fed;s tentative moves away from the reflexive fear of full employment that has governed monetary policy for so long. But when you take a longer look and compare today’s debates to earlier decades, it’s hard not to feel that we’re still living in the Dark Ages of macroeconomics

Is the New Chapter for the Monetary Policy Framework Too Old to Succeed?

Published by Anonymous (not verified) on Tue, 15/09/2020 - 5:34am in

Bagehot, “Money does not manage itself.”

By Elham Saeidinezhad – In this year’s Jackson Hole meeting, the Fed announced a formal shift away from previously articulated longer-run inflation objective of 2 percent towards achieving inflation that averages 2 percent over time. The new accord aims at addressing the shortfalls of the low “natural rate” and persistently low inflation. More or less, all academic debates in that meeting were organized as arguments about the appropriate quantitative settings for a Taylor rule. The rule’s underlying idea is that the market tends to set the nominal interest rate equal to the natural rate plus expected inflation. The Fed’s role is to stabilize the long-run inflation by changing the short-term federal funds rate whenever the inflation deviates from the target. The Fed believes that the recent secular decline in natural rates relative to the historical average has constrained the federal funds rate. The expectation is that the Fed’s decision to tolerate a temporary overshooting of the longer-run inflation to keep inflation and inflation expectations centered on 2 percent following periods when inflation has been persistently below 2 percent will address the framework’s constant failure and restore the magic of central banking. However, the enduring problem with the Taylor rule-based monetary policy frameworks, including the recent one, is that they want the Fed to overlook the lasting trends in the credit market, and only focus on the developments in the real economy, such as inflation or past inflation deviations, when setting the short-term interest rates. Rectifying such blind spots is what money view scholars were hoping for when the Fed announced its intention to review the monetary policy framework.

The logic behind the new framework, known as average inflation targeting strategy, is that inflation undershooting makes achieving the target unlikely in the future as it pushes the inflation expectations below the target. This being the case, when there is a long period of inflation undershooting the target, the Fed should act to undo the undershooting by overshooting the target for some time. The Fed sold forecast (or average) targeting to the public as a better way of accomplishing its mandate compared to the alternative strategies as the new framework makes the Fed more “history-dependent.” Translated into the money view language, however, the new inflation-targeting approach only delays the process of imposing excessive discipline in the money market when the consumer price index rises faster than the inflation target and providing excessive elasticity when prices are growing slower than the inflation target.

From the money view perspective, the idea that the interest rate should not consider private credit market trends will undermine central banking’s power in the future, as it has done in the past. The problem we face is not that the Fed failed to follow an appropriate version of Taylor rule. Rather, and most critically, these policies tend to abstract from the plumbing behind the wall, namely the payment system, by disregarding the credit market. Such a bias may have not been significant in the old days when the payment system was mostly a reserve-based system. In the old world, even though it was mostly involuntarily, the Fed used to manage the payment system through its daily interventions in the market for reserves. In the modern financial system, however, the payment system is a credit system, and its quality depends on the level of elasticity and discipline in the private credit market.

The long dominance of economics and finance views imply that modern policymakers have lost sight of the Fed’s historical mission to manage the balance between discipline and elasticity in the payment system. Instead of monitoring the balance between discipline and elasticity in the credit market, the modern Fed attempts to keep the bank rate of interest in line with an ideal “natural rate” of interest, introduced by Knut Wicksell. In Wicksellians’ world, in contrast to the money view, securing the continuous flow of credit in the economy through the payment system is not part of the Fed’s mandate. Instead, the Fed’s primary function is to ensure it does not choose a “money rate” of interest different from the “natural rate” of interest (profit rate capital). If lower, then the differential creates an incentive for new capital investment, and the new spending tends to cause inflation. If prices are rising, then the money rate is too low and should be increased; if prices are falling, then the money rate is too high and should be decreased. To sum up, Wicksellians do not consider private credit to be intrinsically unstable. Inflation, on the other hand, is viewed as the source of inherent instability. Further, they see no systemic relation between the payment system and the credit market as the payment system simply reflects the level of transactions in the real economy.

The clash between the standard economic view and money view is a battle between two different world views. Wicksell’s academic way of looking at the world had clear implications for monetary policy: set the money rate equal to the natural rate and then stand back and let markets work. Unfortunately, the natural rate is not observable, but the missed payments and higher costs of borrowing are. In the money view perspective, the Fed should use its alchemy to strike a balance between elasticity and discipline in the credit market to ensure a continuous payment system. The money view barometer to understand the credit market cycle is asset prices, another observable variable. Since the crash can occur in commodities, financial assets, and even real assets, the money view does not tell us which assets to watch. However, it emphasizes that the assets that are not supported by a dealer system (such as residential housing) are more vulnerable to changes in credit conditions. These assets are most likely to become overvalued on the upside and suffer the most extensive correction on the downside. A central bank that understands its role as setting interest rates to meet inflation targets tends to exacerbate this natural tendency toward instability. These policymakers could create unnaturally excessive discipline when credit condition is already tight or vice versa while looking for a natural rate of interest.

Elham Saeidinezhad is Term Assistant Professor of Economics  at Barnard College, Columbia University. Previously, Elham taught at UCLA, and served as a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”.  Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

The post Is the New Chapter for the Monetary Policy Framework Too Old to Succeed? appeared first on Economic Questions.

Monetary policy and happiness

Published by Anonymous (not verified) on Thu, 20/08/2020 - 6:00pm in

Philip Bunn and Alice Pugh It has been well established that macroeconomic outcomes, such as recessions and unemployment, can have important impacts on households’ well-being. So it follows that monetary policy decisions can affect happiness too. In a recent working paper we use a novel approach to assess how the unprecedented loosening in monetary policy in … Continue reading Monetary policy and happiness →

Bitesize: The age evolution of first-time buyers

Published by Anonymous (not verified) on Tue, 11/08/2020 - 6:00pm in

Fergus Cumming and John Lewis Over the last 15 years house prices have increased and home-ownership rates have fallen. But while the *number* of first-time buyers (FTBs) has fallen – what happened to the average *age* of FTBs? Not very much… Using data on every UK mortgage from the FCA’s Product Sales Database, we pick … Continue reading Bitesize: The age evolution of first-time buyers →

Covid-19 briefing: post-lockdown macro

Published by Anonymous (not verified) on Wed, 29/07/2020 - 6:00pm in

Michael Kumhof In the wake of Covid-19 lockdown, macroeconomic policymakers have to deal not only with the immediate contraction in the economy, but also with the medium and longer term macro-consequences. Over the past four months, the macroeconomic literature on these topics has expanded rapidly. This post reviews the literature that considers the channels via … Continue reading Covid-19 briefing: post-lockdown macro →