Andrew Haldane: How Low Can You Go?

Andrew Haldane’s latest speech discussed what could be done to tackle the ZLB problem and offered a few alternatives. Rather than addressing the feasibilities of the alternatives, I would like to quote some other points I find interesting:

Reputation, in all walks of life, is hard-earned and easily lost.  Inflationary reputation is unlikely to be any different.  So consciously de-anchoring the boat, with a promise to re-anchor some distance north, runs the risk of a voyage into the monetary unknown. Once un-moored and de-anchored, the course of inflation expectations is much harder to fathom. That navigational uncertainty is likely to be damaging to macro-economic stability.

Moreover, there is a deeper point to bear in mind here about society’s preferences, as distinct from economists’ utterances. The costs of inflation as calculated by economists may not be the same as the costs of inflation as perceived by normal people. International survey evidence suggests stronger concerns among the general public about inflation than the academic literature would imply (Shiller (1997)).

I think post the Fed’s decision, credibility should not be a huge concern for the BoE. The linkage between the Fed and BoE policies mean expectations for the BoE to raise rates when Fed has not are now lower. There was an interesting question during the Yellen Q&A yesterday where she quoted numerous studies that showed how the most vulnerable in society are helped by accommodative monetary policy. This may be a desirable outcome even though it’s not in the mandate.

Market frictions are not all created equally.  Frictions in goods and labour markets arise from contractual arrangements, or rules of thumb, between employers and employees of labour or buyers and sellers of goods (Blanchard and Fisher (1989)).  Because there are costs – menu and behavioural – from changing these arrangements, they tend to be fairly static.  Goods and labour market frictions are thus relatively fixed, or at least state-invariant, over time.

The same is not true of frictions in asset markets.  These are shaped, for example, by constraints on investors’ portfolios and by their risk preferences (Vayanos and Vila (2009)).  Both are likely to be time-varying and highly state contingent (Baker and Wurgler (2007) and Guiso, Sapienza and Zingales (2013)).  Portfolios themselves are altered at high speed and frequency.  So too are risk appetites.  So shifts in asset risk premia are sharp and unpredictable (Bollerslev and Todorov (2011)).  And assets prices tend to exhibit excess-sensitivity.  Asset market returns are thus likely to be volatile, fat-tailed and highly state-contingent (Haldane and Nelson (2012)).

All of which has direct implications for the transmission mechanism for QE.  If asset frictions are highly state-dependent and volatile, so too will be the efficacy of QE.  Estimates of the impact of QE during periods of high risk premia and disturbed financial conditions may be very different than when asset markets are tranquil and risk premia low.

The occurrence of market corrections, like an avalanche, can be sudden. Although the event may be short-lived, the ripple effect on actual businesses may last for far longer as it could raise the risk premium. The last two lines concerning the difference between efficacy of QE during high and low risk premia above are also interesting to note, which may explain the diminishing returns we have seen from successive rounds of QE.

And lastly,

One of the channels through which QE operates is the exchange rate. Conventional interest rate policy works through the exchange rate channel too. But because QE acts directly on stocks of assets held by the private sector, the potential for asset market – including foreign exchange market – spillovers is prospectively greater.

Evidence from QE interventions is consistent with significant exchange rate responses in many cases. Domestic currencies have tended to depreciate in response to domestic QE policy announcements.  But, particularly for small open economies, there are also spillovers from international QE that might be as important.  …  US QE appears to have had, if anything, a larger impact on the UK economy than UK QE.

Given the close alignment of UK and US business cycles, this cross-border spillover is potentially positive for both countries. But that may not be the case if business cycles are misaligned. International spillovers from QE could then complicate the setting of national monetary policies.Indeed, the cross-border impact of QE could then be seen as imposing a potential externality on the international monetary system.

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