Tag: Monetary Policy

Is monetary policy less effective when interest rates are persistently low?

Interesting BIS working paper which says that at low interest rates,  monetary policy transmission becomes less effective.

Interest rates in the core advanced economies have been persistently low for about eight years now. Short-term nominal rates have on average remained near zero since early 2009 and have been even negative in the euro area and Japan, respectively, since 2014 and 2016. The drop in short-term nominal rates has gone along with a fall in real (inflation-adjusted) rates to persistently negative levels. Long-term rates have also trended down, albeit more gradually, over this period: in nominal terms, they fell from between 3–4% in 2009 to below 1% in 2016.

From a historical perspective, this persistently low level of short- and long-term nominal rates is unprecedented. Since 1870, nominal interest rates in the core advanced economies have never been so low for so long, not even in the wake of the Great Depression of the 1930s (Graph 2, top panels). Elsewhere, too, including in Australia, short- and long-term interest rates have fallen to new troughs, reflecting in part global interest rate spillovers especially at the long end.

The persistently low rates of the recent past have reflected central banks’ unprecedented monetary easing to cushion the fallout of the Great Financial Crisis (GFC), spur economic recovery and push inflation back up towards objectives. However, despite such efforts, the recovery has been lacklustre. In the core economies, for instance, output has not returned to its pre-recession path, evolving along a lower, if anything flatter, trajectory, as growth has disappointed. At the same time, in many countries inflation has remained persistently below target over the past three years or so.

Against this background, there have been questions about the effectiveness of monetary policy in boosting the economy in a low interest rate environment. This paper assesses this issue by taking stock of the existing literature. Specifically, the focus is on whether the positive effect of lower interest rates on aggregate demand diminishes when policy rates are in the proximity of what used to be called the zero lower bound. Moreover, to keep the paper’s scope manageable, we take as given the first link in the transmission mechanism: from the central bank’s instruments, including the policy rate, to other rates.

The review suggests that both conceptually and empirically there is support for the notion that monetary transmission is less effective when interest rates are persistently low. Reduced effectiveness can arise for two main reasons: (i) headwinds that typically blow in the wake of balance sheet recessions, when interest rates are low (eg debt overhang, an impaired banking system, high uncertainty, resource misallocation); and (ii) inherent nonlinearities linked to the level of interest rates (eg impact of low rates on banks’ profits and credit supply, on consumption and saving behaviour – including through possible adverse confidence effects – and on resource misallocation). Our review of the existing empirical literature suggests that the headwinds experienced during the recovery from balance-sheet recessions can significantly reduce monetary policy effectiveness. There is also evidence that lower rates have a diminishing impact on consumption and the supply of credit. Importantly, these results point to an independent role for nominal rates, regardless of the level of real (inflation-adjusted) rates.

The review reveals that the relevant theoretical and empirical literature is much scanter than one would have hoped for, in particular given that periods of persistently low interest rates have become more frequent and longer-lasting. While there are appealing conceptual arguments suggesting that monetary transmission may be impaired when rates are low, many of these have not been formalised by means of rigorous theoretical modelling. And the extant empirical work is limited, both geographically and in scope. For instance, most studies assessing changes in monetary transmission in low rate environments focus on the United States. Similarly, there is hardly any work assessing specific mechanisms. The field is wide open and deserves further exploration, not least given the first-order policy implications.

Note: BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.

Fed Minutes From March Meeting – Financial Market Impact

The minutes of the US Federal Open Market Committee March 14–15, 2017 have been released. They provide context for the rate decision. All but
one member agreed to raise the target range for the federal funds rate to ¾ to 1 percent. We also got some impressions on how the FED will manage the billions of dollars in assets it purchased in an attempt to reflate the economy after the financial crisis. This is a big deal, with global consequences for financial markets.  Not least, think about how expected future rate rises may interact with reducing asset purchases.  Bond prices may be impacted. The US T10 was down a little.

In the U.S. economic projection prepared by the staff for the March FOMC meeting, the near-term forecast for real GDP growth was a little weaker, on net, than in the previous projection. Real GDP was expected to expand at a slower rate in the first quarter than in the fourth quarter, reflecting some data for January that were judged to be transitorily weak, but growth was projected to move back up in the second quarter.

Recent information on housing activity suggested that residential investment increased at a solid pace early in the year. Starts for both new single-family homes and multifamily units strengthened in the fourth quarter and remained near those levels in January. Issuance of building permits for new single-family homes—which tends to be a reliable indicator of the underlying trend in construction—also moved up in the fourth quarter and remained near that level in January. Sales of existing homes rose in January, while new home sales maintained their fourth-quarter pace.

The open market reinvestment operations, are currently supporting the financial markets in the US, and are having global impact on interest rate and bond benchmarks. When the time comes to implement a change to reinvestment policy, participants generally preferred to phase out or cease reinvestments of both Treasury securities and agency MBS.

The staff provided several briefings that summarized issues related to potential changes to the Committee’s policy of reinvesting principal payments from securities held in the System Open Market Account (SOMA). These briefings discussed the macroeconomic implications of alternative strategies the Committee could employ with respect to reinvestments, including making the timing of an end to reinvestments either date dependent or dependent on economic conditions.

The briefings also considered the advantages and disadvantages of phasing out reinvestments or ending them all at once as well as whether using the same approach would be appropriate for both Treasury securities and agency mortgage-backed securities (MBS). In their discussion, policymakers reaffirmed the approach to balance sheet normalization articulated in the Committee’s Policy Normalization Principles and Plans announced in September 2014. In particular, participants agreed that reductions in the Federal Reserve’s securities holdings should be gradual and predictable, and accomplished primarily by phasing out reinvestments of principal received from those holdings. Most participants expressed the view that changes in the target range for the federal funds rate should be the primary means for adjusting the stance of monetary policy when the federal funds rate was above its effective lower bound. A number of participants indicated that the Committee should resume asset purchases only if substantially adverse economic circumstances warranted greater monetary policy accommodation than could be provided by lowering the federal funds rate to the effective lower bound. Moreover, it was noted that the Committee’s policy of maintaining reinvestments until normalization of the level of the federal funds rate was well under way had supported the smooth and effective conduct of monetary policy and had helped maintain accommodative financial conditions.

To Solve One Problem, Did The RBA Rate Cut Last Year Just Make Another One Worse?

From Business Insider.

When it’s all said and done, May 3, 2016, may well go down as the day when an attempt to solve a problem ended up creating an even greater one in Australia.

Six days after the release of Australia’s March quarter consumer price inflation (CPI) report — something that revealed headline CPI fell with underlying inflation also tumbling to fresh lows — the Reserve Bank of Australia (RBA) resumed a rate cutting cycle that began in late 2011, lowering the cash rate to a then record low of just 1.75%.

That reduction was followed three months later by another cut taking the cash rate to 1.5%, the level it remains at today.

Though there were other considerations, both were largely done in the name of helping to boost inflation — both near-term and in the future.

While the RBA’s response was not all that unusual — it is, after all, an inflation-targeting central bank — the twin rate cuts appear, in hindsight, may have actually created an even larger problem for the RBA.

Those cuts, along with other factors such as the Turnbull government’s reelection ending in political uncertainty over the tax treatment of housing, put a rocket under property prices in Sydney and Melbourne, already the most expensive in the country.

While there’s debate over just how much they’ve increased given varying readings from individual market providers, in simple terms the answer is a lot, in particular driven by resurgent investor activity in these markets.

It’s created a conundrum for the RBA perhaps even greater than just one year ago.

Bill Evans, chief economist at Westpac, summed up the problem perfectly earlier today.

“Even though income growth and inflation are too low and there remains ample spare capacity in the labour market the (RBA) has no flexibility to cut rates,” said Evans.

“The evidence is clear that the rate cuts the Bank embraced last year in the face of low inflation fuelled house prices and household leverage. The Bank is concerned about possible excesses in the housing market.”

Now, like then, inflation remains stubbornly low and unemployment (and especially underemployment) high, creating conditions that are leading to record-low wage growth which are then feeding back into a lack of inflationary pressures.

It’s easy to understand why some believe that the only inflation the RBA succeeded in creating was in housing prices in just two Australian cities, rather than delivering appropriate policy settings for the remainder of the country.

To be fair to the new RBA governor Philip Lowe, a man who took over that title the month after the RBA last cut rates, he’s well aware of the problem, telling parliamentarians last month that he’d like to see unemployment a bit lower and inflation a bit higher.

His reluctance to use monetary policy to speed up this trend, however, was that further rate cuts “would probably push up house prices a bit more, because most of the borrowing would be borrowing for housing.”

He’s hamstrung, in other words, as Evans suggested earlier today.

Other parts of the economy would no doubt benefit from lower borrowing costs, and potentially a lower Australian dollar, but that can’t be delivered by the RBA because of financial stability risks in Australia’s largest, most expensive and economically most important housing markets.

Though no one knows whether the RBA’s conundrum will self-correct, allowing the bank increased policy flexibility to benefit the broader Australian economy, the question that needs to be asked is whether we should wait to find out the answer.

That answer is undoubtedly no.

What is required is a coordinated response to reduce risks in the Australian housing market that will free up monetary policy to do its one and only job — to bring forward or pull back demand within the economy when necessary.

That task will fall to Australia’s banking regulator, APRA, in consultation with the RBA, along with state and federal politicians.

There’s noises being made that suggest this is already occurring, but the longer house prices in Sydney and Melbourne are allowed to run away unfettered, the greater the likelihood that the RBA will be unable to make a difference for the broader economy if and when its required.

That’s a scenario that no one wants to see tested in reality.

Are Small Business Bearing Some Of The Bank’s Interest Rate Risk?

An interesting working paper from the IMF was released today. Why Do Bank-Dependent Firms Bear Interest-Rate Risk? looks at the link between bank funding, floating rates and how this is transmitted to firms who borrow on variable rate terms. The paper concludes that banks do indeed transfer interest rate risks to firms, and this is especially so when banking regulation tightens.

Here is the summary:

I document that floating-rate loans from banks (particularly important for bank-dependent firms) drive most variation in firms’ exposure to interest rates. I argue that banks lend to firms at floating rates because they themselves have floating-rate liabilities, supporting this with three key findings. Banks with more floating-rate liabilities, first, make more floating-rate loans, second, hold more floating-rate securities, and third, quote lower prices for floating-rate loans. My results establish an important link between intermediaries’ funding structure and the types of contracts used by non-financial firms. They also highlight a role for banks in the balance-sheet channel of monetary policy.

Here is the full conclusion from the report:

Bank lending is in large part funded with floating-rate deposits. As hedging is costly, banks avoid mismatch with the interest-rate exposure of their liabilities, in part, by making floating-rate loans to firms. To establish this link between the structure of bank liabilities and the floating-rate nature of bank lending, I examine the cross section of banks. Banks with greater interest rate pass-through on their deposits hold more floating-rate assets: both loans and securities. In the cross section, these floating fractions are positively correlated with each other. I show that if banks were responding to demand for floating-rate debt from firms instead of their own liabilities, this correlation would be negative.

Moreover, while banks with more deposit pass-through hold more floating-rate loans, they quote lower interest rates for ARMs relative to FRMs. The combination of higher quantities and lower prices points to variation in supply rather than demand. I also present time series and historical evidence supporting the supply-driven view of floating-rate bank lending to firms.

This paper therefore highlights an important consequence of banks’ short-term funding: the potential for interest-rate mismatch. While standard models do analyze maturity mismatch created by short-term funding, they typically do not consider uncertainty in interest rates and interest-rate mismatch.

This paper shows that the structure of banks’ funding has important implications for the choices banks make about interest-rate risk on the asset side of their balance sheets. More broadly, my results establish an important link between intermediaries’ funding structure and the types of contracts used by non-financial firms. My results suggest that tighter regulation of banks’ exposure to interest rates might lead banks to pass on more risk to firms, which is particularly relevant given renewed regulatory focus on banks’ exposure to rates.

Bank-dependent firms, i.e. poorly rated firms and smaller firms, are more exposed to interest rates than firms with better access to capital markets. While these firms do use interest-rate derivatives to hedge this exposure, they do so only partially. I show that this exposure is a component of the Bernanke & Gertler (1995) balance-sheet channel of transmission of monetary policy. Banks therefore play a role in the transmission of monetary policy to firms beyond the usual bank lending channel; here the effect is based on existing rather than new bank lending.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

QE Is Likely To End Badly

From Zero Hedge

As the WSJ reports, prominent hedge fund managers have joined an increasingly bigger and louder chorus which says central bank bond buying programs that are pumping trillions of dollars into global markets will end badly.

In yesterday’s main event, the ECB said it would extend its asset purchase program to the end of next year, buying bonds at a reduced rate. As the following chart from BBG projects, at the ECB’s revised rate of bond purchases, its balance sheet will soon surpass that of the Fed.

So what happens next? Prominent managers have told The Wall Street Journal in recent interviews of their doubts about the endgame for quantitative easing around the world.

“There’s no non-messy way out of this,” said Luke Ellis, chief executive of Man Group, one of the world’s biggest hedge-fund firms with $80.7 billion in assets. “There’s two versions” of how this ends, he added. Either central banks could move to so-called ‘helicopter money,’ where they buy debt from the government, which then spends the proceeds or gives it to the population to spend. This “for a few years looks golden then leads to hyperinflation,” he said. Or the speed at which money circulates within the economy could grind to a halt. “Then you effectively have a barter economy,” he said.

In a series of exclusive interviews with the Journal, hedge-fund executives overseeing around $280 billion in total highlighted a range of problems created by quantitative easing. The problems they highlight are precisely those that QE was designed to solve, and are exactly the same problems we warned about since the 2009, for which we have been repeatedly branded some variation of “fake news.” Now the skepticism has become mainstream. This is what, according to the hedge fund managers interviewed by the WSJ, will happen:

Damage to economic growth

Rather than kick-starting growth, quantitative easing may do the reverse. Some managers fear it distorts financial markets and undermines capitalism. That system relies on profit-hungry investors to differentiate between strong and weak companies—funding the strong while letting the weak die. QE, say some managers, doesn’t differentiate.

For instance, the Bank of England is buying the debt of firms it deems make “a material contribution” to the U.K. economy. That has led some investment banks and companies to create new debt especially for it to buy. The ECB has bought €48.2 billion ($51.2 billion) of corporate debt since June, but the hoped-for private-sector investment hasn’t materialized.

“What does a market do? It’s a voting mechanism,” said Michael Hintze, billionaire founder of hedge fund CQS, which runs around $12 billion in assets. “Instead you’ve got this 800-pound gorilla out there who’s hoovering up assets. “There’s a misallocation of capital and an opportunity cost to the real economy,” added Mr. Hintze, whose portfolio is up 30% this year, ranking it one of the world’s top-performing hedge funds. “It means GDP is not growing as much as it might.”

Some put it even more strongly. “It’s definitely destructive of economic growth,” said Crispin Odey, founder of Odey Asset Management, which runs $8.2 billion in assets.

“Capitalism dies a death,” said Mr. Odey, who sees government policy as the main factor influencing markets. His fund, a top performer after the credit crisis, is down sharply this year because of being too bearish. “It’s all policy. It’s the Kremlin. And I’m in the gulags.”

Damage to society

In her speech to the governing Conservative Party conference in October, U.K. Prime Minister Theresa May spoke of “some bad side effects” from quantitative easing as people with assets got richer while those without them suffered. U.S. President-elect Donald Trump has said low rates have robbed savers. Those side effects include “envy and distress” within society, “as people think ‘I can’t get out of where I am,’” said Andrew McCaffery, group head of solutions at Aberdeen Asset Management, who looks after $170 billion in assets.

Ultralow interest rates mean the large part of the population with few financial assets begins to despair of how to generate income to fund retirement, he said.

“People see a developing black hole,” he said. This “increases the sense of there being little to lose for many” people.

Andrew Law, chief executive of New York-based Caxton Associates LP, which runs around $7.8 billion, said quantitative easing averted economic depression after the financial crisis.

But he added: “The losers of QE are society, and democracy is also a loser, because central banks are not publicly elected officials.”

Deflation

Quantitative easing was also introduced as a way of increasing private-sector spending and raising inflation. Some investors even worried it would spark hyperinflation and rushed to buy gold. Instead, say some managers, it has led to deflation.

“It took me a long time to work it out,” said CQS’s Mr. Hintze. “It’s a very complex issue.” He said that massive amounts of liquidity mean that “liquidity’s not worth much anymore,” which leads to negative interest rates. “I do think it [QE] is a massive deflationary force. The reason is because money is worth less but the price of real assets goes up.”

Mr. Odey said quantitative easing leads to deflation because weaker competitors are kept alive by cheap debt as “zombie” companies.

Hard stop

Finally, hedge-fund managers see difficulty in ending quantitative easing.

“Central banks are sadly helping to create the ‘black hole,’ and the sucking noise and pull is getting bigger,” said Aberdeen’s Mr. McCaffery, “but you just have to keep going as your alternative options as a central banker are just too unpalatable to consider.

Using an analogy we first came up with in 2009, McCaffrey slammed the use of a drug placebo to keep the system intact: “More methadone is not going to help, a form of cold turkey [is] needed, but no central bank is going to do that,” he added. He warns governments’ debt-to-GDP levels have risen.

The punchline:

“In the long term, it implies rates can never go up, as the damage will be extraordinary in nature,” he said, as they struggle with their debt loads. For now, however, the market which moments ago hit new all time highs, is blissfully ignoring all of the above.

Statement on the Conduct of Monetary Policy

The Treasurer and Governor of the Reserve Bank have reaffirmed the statement on the Conduct of Monetary Policy.  Both the Reserve Bank and the Government agree that a flexible medium-term inflation target is the appropriate framework for achieving medium-term price stability. They agree that an appropriate goal is to keep consumer price inflation between 2 and 3 per cent, on average, over time.

RBA-Pic2

The Statement on the Conduct of Monetary Policy (the Statement) has recorded the common understanding of the Governor, as Chair of the Reserve Bank Board, and the Government on key aspects of Australia’s monetary and central banking policy framework since 1996.

The Statement seeks to foster a sound understanding of the nature of the relationship between the Reserve Bank and the Government, the objectives of monetary policy, the mechanisms for ensuring transparency and accountability in the way policy is conducted, and the independence of the Reserve Bank.

The centrepiece of the Statement is the inflation targeting framework, which has formed the basis of Australia’s monetary policy framework since the early 1990s.

The Statement has also been updated over time to reflect enhanced transparency of the Reserve Bank’s policy decisions and to record the Bank’s longstanding responsibility for financial system stability.

Building on this foundation, the current Statement reiterates the core understandings that allow the Bank to best discharge its duty to direct monetary policy and protect financial system stability for the betterment of the people of Australia.

Relationship between the Reserve Bank and the Government

The Reserve Bank Governor, its Board and its employees have a duty to serve the people of Australia to the best of their ability. In the carrying out of their statutory obligations, through public discourse and in domestic and international forums, representatives of the Bank will continue to serve the best interests of the people of Australia with honesty and integrity.

The Governor and the members of the Reserve Bank Board are appointed by the Government of the day, but are afforded substantial independence under the Reserve Bank Act 1959 (the Act) to conduct the monetary and banking policies of the Bank, so as to best achieve the objectives of the Bank as set out in the Act.

The Government recognises and will continue to respect the Reserve Bank’s independence, as provided by the Act.

The Government also recognises the importance of the Reserve Bank having a strong balance sheet and the Treasurer will pay due regard to that when deciding each year on the distribution of the Reserve Bank’s earnings under the Act.

New appointments to the Reserve Bank Board will be made by the Treasurer from a register of eminent candidates of the highest integrity maintained by the Secretary to the Treasury and the Governor. This procedure ensures only the best qualified candidates are appointed to the Reserve Bank Board.

Objectives of Monetary Policy

The goals of monetary policy are set out in the Act, which requires the Reserve Bank Board to conduct monetary policy in a way that, in the Reserve Bank Board’s opinion, will best contribute to:

  1. the stability of the currency of Australia;
  2. the maintenance of full employment in Australia; and
  3. the economic prosperity and welfare of the people of Australia.

These objectives allow the Reserve Bank Board to focus on price (currency) stability, which is a crucial precondition for long-term economic growth and employment, while taking account of the implications of monetary policy for activity and levels of employment in the short term.

Both the Reserve Bank and the Government agree on the importance of low and stable inflation.

Effective management of inflation to provide greater certainty and to guide expectations assists businesses and households in making sound investment decisions. Low and stable inflation underpins the creation of jobs, protects the savings of Australians and preserves the value of the currency.

Both the Reserve Bank and the Government agree that a flexible medium-term inflation target is the appropriate framework for achieving medium-term price stability. They agree that an appropriate goal is to keep consumer price inflation between 2 and 3 per cent, on average, over time. This formulation allows for the natural short-run variation in inflation over the economic cycle and the medium-term focus provides the flexibility for the Reserve Bank to set its policy so as best to achieve its broad objectives, including financial stability. The 2-3 per cent medium-term goal provides a clearly identifiable performance benchmark over time.

The Governor expresses his continuing commitment to the inflation objective, consistent with his duties under the Act. For its part the Government endorses the inflation objective and emphasises the role that disciplined fiscal policy must play in achieving medium-term price stability.

Consistent with its responsibilities for economic policy as a whole, the Government reserves the right to comment on monetary policy from time to time.

Transparency and Accountability

Transparency in the Reserve Bank’s views on economic developments and their implications for policy are crucial to shaping inflation expectations.

The Reserve Bank takes a number of steps to ensure the conduct of monetary policy is transparent. These steps include statements announcing and explaining each monetary policy decision, the release of minutes providing background to the Board’s policy deliberations, and commentary and analysis on the economic outlook provided through public addresses and regular publications such as its quarterly Statement on Monetary Policy and Bulletin. The Reserve Bank will continue to promote public understanding in this way.

In addition, the Governor will continue to be available to report twice a year to the House of Representatives Standing Committee on Economics, and to other Parliamentary committees as appropriate.

The Treasurer expresses support for the continuation of these arrangements, which reflect international best practice and enhance the public’s confidence in the independence and integrity of the monetary policy process.

Financial Stability

Financial stability, which is critical to a stable macroeconomic environment, is a longstanding responsibility of the Reserve Bank and its Board.

The Reserve Bank promotes the stability of the Australian financial system through managing and providing liquidity to the system, and chairing the Council of Financial Regulators (comprising the Reserve Bank, Australian Prudential Regulation Authority, the Australian Securities and Investments Commission and the Treasury).

The Payments System Board has explicit regulatory authority for payments system stability. In fulfilling these obligations, the Reserve Bank will continue to publish its analysis of financial stability matters through its half-yearly Financial Stability Review.

In addition, the Governor and the Reserve Bank will continue to participate, where appropriate, in the development of financial system policy, including any substantial Government reviews, or international reviews, of the financial system itself.

The Reserve Bank’s mandate to uphold financial stability does not equate to a guarantee of solvency for financial institutions, and the Bank does not see its balance sheet as being available to support insolvent institutions. However, the Reserve Bank’s central position in the financial system, and its position as the ultimate provider of liquidity to the system, gives it a key role in financial crisis management. In fulfilling this role, the Reserve Bank will continue to coordinate closely with the Government and with the other Council agencies.

The Treasurer and the Governor express their support for these longstanding arrangements continuing.

“Helicopter money” – reality bites

Unconventional monetary policies are being used by many central banks across the world to try and address insipid growth and restart economic activity. As a result, central banks’ balance sheets have expanded.  Now there are calls for them to go further, and distribute “helicopter money”. But is this wise?

Based on commentary by Claudio Borio, Head of the Monetary and Economic Department of the Bank for International Settlements, and Piti Disyatat, Executive Director of the Puey Ungphakorn Institute for Economic Research, Bank of Thailand and featured in the Nikkei Asian Review; the answer is no!

Since the Great Financial Crisis, central banks in the major economies have adopted a whole range of new measures to influence monetary and financial conditions. The measures have gone far beyond the typical pre-crisis mode of operation – controlling a short-term policy rate and moving it within a positive range – and have therefore come to be known as “unconventional monetary policies.” To be sure, some of these measures had already been pioneered by the Bank of Japan roughly a decade earlier in the wake of that country’s banking crisis and uncomfortably low inflation. But no one had anticipated that they would spread to the rest of the world so quickly and become so daring, testing the boundaries of the unthinkable.

As growth has remained disappointing and inflation stubbornly below targets, the range and size of these measures have increased. Hence the growing use of long-term liquidity support, large-scale asset purchases, sizable increases in bank reserves (so-called QE) and, of late, even the introduction of negative policy rates. In the wake of these measures, the central banks’ monetary base (cash and bank reserves) has ballooned in step with the overall size of their balance sheets (see graph).

Central bank liabilities: the monetary baseWith central banks delving further down into their box of unconventional tools, calls for them to take a deep breath and pull out “helicopter money” have intensified. What was just a thought experiment designed to shed light on how money affects the economy is now threatening to become a reality. Proponents of this tool – more soberly described as “overt money financing” of government deficits – see it as a sure-fire way to boost nominal spending by harnessing central banks’ most primitive power: their unique ability to create money at will. But can helicopter money work in the way its proponents claim? And is the balance of benefits and costs worth it? Our answer to both of these questions is no.

Proponents argue that helicopter money is special because it amounts to a permanent increase in non-interest bearing central bank liabilities (“money”) as the counterpart of the deficit. This form of financing is most effective because money is free and debt is not. Permanent monetary financing means less government debt and thus lower interest payments forever. All else equal, this saving should boost nominal demand, as there would be no need to raise additional taxes. Moreover, the argument continues, the central bank is then free to increase interest rates again whenever it wishes while the lower amount of debt outstanding will still yield savings. This is the best of all possible worlds: Demand is boosted without the collateral damage of prolonged exceptionally low interest rates.

Devil in the details

Or so it seems. But the devil is in the details.

As we have argued elsewhere, the reasoning may be correct in the stripped-down models people have in mind, but not in reality. In fact, the central bank faces a stark choice: Either helicopter money results in interest rates permanently at zero, so that control over monetary policy is lost forever, or else it is equivalent to either debt or to tax-financed government deficits, in which case it would not yield the additional boost. Since losing monetary policy control forever is not a feasible option, helicopter money is just fiscal policy dressed up.

The reason is hidden in an obscure but critical corner of the financial market. Contrary to what the stylized models suggest, it is not the amount of cash that determines interest rates but what the central bank does with bank reserves (commercial banks’ deposits at the central bank), over which it has a monopoly. Monetary deficit financing will, in effect, amount to an equivalent increase in bank reserves. If the central bank issued more cash than people demanded, the amount in excess of desired balances would inevitably be converted into bank deposits and then switched by banks into reserves (see in the graph how steadily and slowly cash grows, reflecting the demand for it). If the government issued checks, the same would happen. If the reserves are non-interest bearing – as they must be for helicopter money – the increase will inevitably also drive the short-term (overnight) rate to zero. This is because when the system as a whole has an excess of reserves, no one wants to be left holding it but someone must.

The problem arises once the central bank decides to raise interest rates again, as this, alas, would not be consistent with helicopter money. To do so, the central bank has only two options. Either it pays interest on those reserves at the policy rate, in which case this is equivalent to debt financing from the perspective of the consolidated public sector balance sheet – there are no interest savings. Or else it imposes a non-interest bearing compulsory reserve requirement to absorb the reserves, but this is equivalent to tax financing – someone in the private sector must bear the cost. While the tax would in the first instance fall directly on banks, they could decide to pass it on to their customers — for example, in the form of higher intermediation spreads.

Thus, either helicopter money comes at a prohibitive price – giving up control over monetary policy forever – or else, choreography and size aside, in its watered-down version it is not very different from what some central banks have already been doing: engineering temporary increases in reserves which may happen to coincide with increases in government deficits (a form of QE). Views about QE’s effectiveness differ, but we would be talking about “more of the same.” Such a policy already exploits the synergies between ultra-low interest rates and fiscal policy so as to enhance any expansionary impact that fiscal policy may have.

That said, choreography and size do matter. And they don’t speak in favor of the tool. Imagine policymakers went down this route, announcing that they were embarking on a “new” policy and explicitly linking the increase in reserves with higher public sector deficits. They could hide the inconvenient truth and renege on their promise not to raise rates. But this would hardly be an example of good policy, and in any case its effectiveness would at best be doubtful – the private sector would surely anticipate this possibility to some extent, thereby tempering the impact of the signal. Alternatively, policymakers could hope that the fanfare surrounding the tool would induce people to spend more. This is a possible but by no means obvious outcome. And in any case, unless the exercise is repeated over and over again on a large scale, its impact is likely to be only temporary.

And therein lies the danger. It is hard to imagine helicopter money not ending up in fiscal dominance, the outcome that would obviously be inevitable in its purest form, where interest rates are kept at zero forever. Sooner or later this could indeed erode the value of money, but at the cost of losing the public’s confidence in our monetary institutions – a trust so painfully gained over the years – and with unpredictable consequences. It would be a Pyrrhic victory.