I’ve made it clear that I very much approve of Japan’s new monetary aggressiveness. But I gather that some readers are confused – haven’t I been arguing that monetary policy is ineffective in a liquidity trap? The brief answer is that current policy is ineffective, but that you can still get traction if you can change investors’ beliefs about expected future monetary policy – which was the moral of my original Japan paper, lo these 15 years ago. But I thought it might be worthwhile to go over this again.
So, at this point America and Japan (and core Europe) are all in liquidity traps: private demand is so weak that even at a zero short-term interest rate spending falls far short of what would be needed for full employment. And interest rates can’t go below zero (except trivially for very short periods), because investors always have the option of simply holding cash. Incidentally, this isn’t just a hypothetical: there has been a surge in currency holding….
Under these circumstances, normal monetary… open-market operations in which the central bank buys short-term debt with money it creates out of thin air, have no effect. Why? Well, the reason open-market operations usually work is that people are making a tradeoff between yield and liquidity – they hold money, which offers no interest, for the liquidity but limit their holdings because they pay a price in lost earnings. So if the central bank puts more money out there, people are holding more than they want, try to offload it, and drive rates down in the process. But if rates are zero, there is no cost to liquidity, and people are basically saturated with it; at the margin, they’re holding money simply as a store of value… short-term debt. And a central bank operation that swaps money for debt… changes nothing…. The flip side of this, by the way, is that all those fears about how “printing money” in this slump would lead to runaway inflation were predictably wrong….
Here’s the thing, however: the economy won’t always be in a liquidity trap, or at least it might not always be there. And while investors shouldn’t care about what the central bank does now, they should care about what it will do in the future. If investors believe that the central bank will keep the pedal to the metal even as the economy begins to recover, this will imply higher inflation than if it hikes rates at the first hint of good news – and higher expected inflation means a lower real interest rate, and therefore a stronger economy.
So the central bank can still get traction if it can change expectations about future policy.
The trouble is that central bankers have a credibility problem… the concern is that at the first sign of good news they’ll revert to type, snatching away the punch bowl… [as] the Bank of Japan did just that in the 2000s. The hope now is that things have changed enough at the Bank of Japan…. And that’s why I’m bullish on the Japanese experiment, even though current monetary policy has little effect.
I am more skeptical.
I would rather that they announced--and hit--an exchange rate target today.
This is Deep Magic. This succeeds only if it succeeds in summoning the Inflation Expectations Imp from the Vasty Deep.
Now if only I knew the Latin for "Inflation Expectations Imp", we could start up the Gregorian chant: "Veni Propudie… "