Debt monetization, inflation, and the “neutral” interest rate

byAlfonso Palacio-Vera

Universidad Complutense de Madrid, Spain

Conference “Economic Policies of the New Thinking in Economics”

St. Catharine´s College, Cambridge, UKThursday 14 April 2011

Introduction (I)

• A number of central banks (ECB, US Fed, Bank of Japan, and Bank of England) have resorted, mainly from 2008 onwards, to large-scale purchases of sovereign debt in an attempt to:

– Provide liquidity to the financial sector and help compress term and risk premiums

– By-pass malfunctioning financial markets like the inter-bank market

– Alleviate the financial burden to the Treasuries of the massive fiscal expansions that were engineered to counteract the collapse of private expenditure in the wake of the financial crisis of 2007-9

• The US Fed has also purchased large quantities of mortgage-backed securities.

Introduction (II)

• The empirical evidence suggests that these “unconventional” monetary policy measures succeeded, to some extent, in:

– Flattening the money market yield curve

– Containing risk/liquidity premiums in dysfunctional money markets

– Preventing the collapse of the inter-bank market

• Some examples are: – US Fed: Gagnon et al. (2010), D´Amico and King (2010), Hamilton and

Wu (2011), Del Negro et al. (2010).

– Bank of England: Joyce et al. (2010)

– Bank of Japan: Ueda (2010)

– ECB: Lenza et al. (2010)

Introduction (III)

• Nevertheless, the effectiveness in stimulating aggregate demand of debt monetization or “quantitative easing” remains unclear.

– Baumeister and Benati (2010) find that the compression in the long-term bond yield spread during the period 2007-2009 in the US, the Euro area, Japan, and the UK exerted a “powerful” effect on output growth.

– Fullwiler and Wray (2010) question the efficacy of debt monetization:

‘If we consider the possible negative impact on income and spending resulting from lower interest income received on savings, a plausible case can be made that QE2 [Quantitative Easing] will actually be deflationary if the policy is successful in lowering rates’ (Fullwiler and Wray, 2010, p. 10)

Introduction (IV)

• As shown in Auerbach and Obstfeld (2005), there still remains an argument for large-scale open market purchases of public debt as a “fiscal” policy tool when short-term nominal interest rates are zero.

• This is because, provided long-term interest rates are positive, trading money for interest-bearing public debt reduces future debt-service requirements thus allowing fiscal policy to become more expansionary.

The ‘decoupling’ principle (I)

• Several authors emphasize that CBs are able to fully control the supply of reserve balances and this, in turn, allows them to set the price at which they are supplied by simply announcing the target short-term interest rate (Friedman and Kuttner, 2010).

• Consequently, there arises a strong disconnection between the level of short-term nominal interest rates and the quantity of liquidity actually supplied.

The ‘decoupling’ principle (II)

• Such disconnection is most evident when the CB adopts a ‘floor system’ whereby the former can target independently both the amount of bank reserves and the overnight interest rate in the inter-bank market.

• In a ‘floor-system’ the CB manipulates short-term interest rates by varying the interest rate it pays on reserves instead of varying the quantity of reserves it supplies.

• Under this system, the interest rate paid on reserves effectively becomes a floor below which the market rate cannot fall.

The ‘decoupling’ principle (III)

• By adopting a ‘floor-system’, a CB actually divorces the quantity of reserves from the interest rate target and in the process it gains one degree of freedom insofar as it can now employ interest on reserves together with open market purchases of assets to target independently short-term nominal interest rates and the quantity of reserves.

• Borio and Disyatat (2009) have labelled this feature of a ‘floor system’ the ‘decoupling’ principle (see Figure 1).

The ‘decoupling’ principle (IV) Figure 1: A ‘floor system’ of monetary implementation

The ‘decoupling’ principle (V)

• The main aim of the study is to explore the potential for macro- stabilization purposes of the utilization by the CB of its ability to manipulate both the short-term interest rate and the size of the money base.

• For that purpose, we construct a closed-economy macro model with Keynesian features that is made up of three sectors:

– Debtor and creditor households

– Businesses

– Public sector: Treasury and the Central Bank

The model (I)• Assumptions:

– Financial intermediaries channel saving flows among the three sectors. – Creditor households purchase all the securities issued by the other sectors

except those ones that are “monetized”. – Securities issued by different sectors (e.g. debtor households, businesses,

Treasury) exhibit different risk premiums. – Debtor households, businesses, and the Treasury adjust spending so as to

hit a “target” debt-to-capital ratio in the long run. – All securities are perpetuities, i.e. they pay coupons forever and issuers

do not have to redeem them.– Treasury revenue comes from both taxes and CB transfers. – Interest income accruing to creditor households is paid in arrears so that

the debt service depends on last period´s debt and nominal interest rate.– The CB adopts a ‘floor’ system.

The model (II)

• Supply-side:

– Potential output in real terms:

– Capacity utilization:

– CIER:

– “Natural” growth rate:

– Change in the inflation rate:

kvNy ttt

1

kv

yu

t

tt

1

K

Le

vp

K

Nv

pKv

ypu

t

ttt

t

ttt

t

t tt

angn

uu ttt 11

The model (III)• Consumption:

– Debtor households´ consumption in money terms:

– Creditor households´ consumption in money terms:

where CHII = creditor households´ nominal interest income and

RII = interest on CB reserves accruing to creditor households.

ddd

Y

YKDh tHHtHH

t

tttHtH 1,1,

11,, )ˆ(/

DDiYtzcC tHtHtHtwtD D ,1,11, )()1)(1(

CHIIYttYtzcC ttpcttwctc 11, )1)(1()1()1)(1)(1(

)1)()1)(()1)(()(( 1,11,11,1 tRIIDiDiDiCHII ctGMGtGtF

MFtFtHtHt t

DiDiRII tGtMGtFt

MFt 1,11,1

The model (IV)

• Investment and businesses´ indebtedness in money terms:

where RP = retained profits

= firms´ average retention rate

))((/ *11 uuffgKI tuttt

gf n *

)ˆ( 1,*

dd FtFdt 0,* d

)1)()(( 1,11 tDiYRP ptFtFttt

)1)()1(())((/ 1,11*

11,, tdiuvuuffKDh ptFtFtttuttFtF

The model (V)• Public sector:

where CBRII = flow of interest payments to reserve holders,

and b0 captures the stance of discretionary fiscal policy.

RCBDTDiG ttGttGtGt ,1,1)1(

HCBRIIDiDiRCBDD ttM

tFtFM

tGtGtM

tFM

tG 1,11,1,, )1()1(

DDiCBRII tFMFtG

MGtt 1,1,1

DGH tFMFtG

MGt ,,

didibK

Dh tFt

MFFtGt

MGGGt

t

tGtG 1,11,1

1

,, )1(

KTGb tttt 1/)(

))(1()ˆ( 111,0 uuddbb ttGtGt

The model (VI)

• Goods market equilibrium:

• Monetary policy rule:

where is the steady-growth “neutral” interest rate and

where

)( *11

* ttt ari

r* 0a

TGIS tttt

bgditK

Cuvt

Y

YtttFtFpt

t

ttpt

t

t

1,11

11

))(1()1(1

The model (VII)

• A liquidity trap (LT) is typically defined as a situation in which the real interest rate (in a closed economy without a government sector) at which aggregate saving at the level of output consistent with constant inflation and investment would be equal is negative (Krugman 1998).

• If we denote by the minimum (ex-ante) actual real interest rate that a CB can set for a given expected rate of inflation, we may define a LT as a situation where:

• If we express as the difference between the risk/term premium and the expected rate of inflation

then we say an economy is mired in a LT if:

rn

e

enr

Steady-growth equilibrium • Steady-growth equilibrium:

where

ggYYDD nttttt *11 //

dd HtH ˆ,

dd GtG ˆ,

ri ***

)(* uuu

0 ddduu GFH

dd FF ˆ

dddrgb FMFFGG

MGGn

ˆˆ)1(ˆ)( **0

))(ˆ1(ˆ)1)(()1(

1 ****

* gddtruvt

nFFpFp

Steady-growth analysis (I)• The steady-growth “neutral” interest rate is given by:

where the sign of all the operators is a priori ambiguous and:

where

gAAAA

r ngr

*0

* 1

dtdtccdtctA GccFccpr cHccDˆ)]1(1[ˆ)]1([ˆ)1(

)ˆ1)](1(1[

ˆ)]1(1)[1(ˆ)1(ˆ))]1((1[))(1( *

dt

dttdtdtcuvA

Fcc

FpcccGccHcc

c

ccccD

Steady-growth analysis (II)

• The ambiguity of obeys to the fact that an increase in the debt service of businesses (brought about by an increase in the real interest rate) causes both an increase and a decrease in creditor households´ interest and profit income respectively thus having an uncertain impact on their consumption.

• Yet, under normal circumstances, we may assume .

• The sign of is also ambiguous, albeit the higher the debt-to-capital ratios are, the more likely it is that it will be positive.

• However, the former may irrelevant when the economy is mired in a LT since the increase in the inflation target may simply not be credible.

Ar

A

0Ar

Steady-growth analysis (III)

• The comparative dynamics results are:

where

Table 1: Impact on r* of changes in the parameters

MG M

F z d Hˆ d G

ˆ d Fˆ H G F cD cc gn *

r* + + + ? ? ? ? - - + ? ? ? ?

Note: (+) and (-) mean that an increase in the variable listed on the upper row gives rise to an increase and a decrease respectively in the value of r* whereas (?) means that the effect is ambiguous

Steady-growth analysis (IV)

• In particular, we have that:

• Debt monetization entails a redistribution of income away from creditor households and towards the Treasury so that aggregate demand will increase insofar as the public sector sets the level of the budget deficit so as to hit its target debt-to-GDP ratio.

where

0ˆ))1(1(*

A

dtr

r

FFcc

MF

c

iff 0F

0ˆ))1(1(*

A

dtr

r

GGcc

MG

c

iff 0G

Steady-growth analysis (V)

• And

• The fall in leads to an increase and a decrease in creditor households´ profit and interest income respectively but it also leads to a decrease in the transfers of income from the CB to the Treasury and, hence, in the public budget balance.

where

0ˆ))1((*

A

dtcr

r

Hcc

H

cD

0ˆ)]1())1(1([*

A

dtcttcr

r

FccpMFc

F

c

0ˆ)1)](1(1[*

A

dtcr

r

GMFc

G

c

F

Conclusion (I)• The monetization of public and private debt operates primarily through its impact on the transfer of CB revenue to the Treasury and, hence, it constitutes an important fiscal policy tool.

• Its effectiveness will be directly proportional to the size of the risk/term premiums on different types of securities and on the proportion of these securities that are purchased by the CB.

• If debt monetization is to be effective as a fiscal policy tool, there is a need for a high degree of coordination between the CB and the fiscal policy authorities.

where

• Debt

Conclusion (II)

• The effectiveness of debt monetization when it brings about the compression of risk and term premiums on different types of securities is unambiguous in the case of public debt.

• However, the net impact on aggregate demand stemming from the compression of risk/term premiums on securities issued by businesses may be negative due to:– The ambiguous impact on consumption by creditor households and– The adverse impact on transfers from the CB to the Treasury

• Finally, an increase in the inflation target may have (provided it is credible) an expansionary effect when the aggregate debt-to-capital ratio in the economy is relatively high.