IMPROVING THE MONETARY REGIME: THE CASE FOR U.S. DIGITAL CASH.

• Author: Bordo, Michael D.

A fundamental purpose of the monetary system is to provide a stable unit of account that facilitates the economic and financial decisions of households and businesses. Thus, as of a few decades ago, monetary economists were primarily concerned about how to prevent a recurrence of the "Great Inflation"--that is, how to design a systematic and transparent monetary policy framework that would ensure low and stable inflation.

More recently, however, a number of advanced economies have experienced protracted periods of relatively weak aggregate demand, with inflation falling persistently short of its stated objective and conventional monetary policy constrained by the effective lower bound (ELB) on nominal interest rates that arises from the zero interest rate on paper cash. Consequently, a number of major central banks--including the Bank of Japan, the European Central Bank, and the Federal Reserve--have deployed unconventional policies such as quantitative easing that have proven to be complex, opaque, discretionary, and ineffectual.

Thus, a crucial task now is to strengthen the U.S. monetary system to ensure that the Federal Reserve can provide sufficient monetary stimulus to preserve price stability and foster economic recovery even in the face of severe adverse shocks. One potential option would be to raise the inflation target by several percentage points, essentially allowing inflation to return to the levels last experienced a half-century ago. By raising the normal level of nominal interest rates, the Federal Reserve would have more room to cut rates sharply without being constrained by the ELB; see Blanchard, Dell'Aricca, and Mauro (2010), Ball (2014), and Ball et al. (2016). However, such an approach would complicate the decisions and plans of ordinary families and businesses, and the inflation target would most likely become a political football rather than a credible anchor.

Therefore, our analysis indicates that the Federal Reserve should take active steps to establish digital cash as the fulcrum of the U.S. monetary system. (1) Digital cash--often referred to as "central bank digital currency"--can serve as a practically costless medium of exchange and as a secure store of value that yields essentially the same rate of return as U.S. Treasury bills. Individuals and businesses would remain free to use paper cash if desired, but its obsolescence would be accelerated by the convenience, security, and ubiquity of digital cash. Arbitrage between paper cash and digital would be mitigated by a graduated system of transfer fees, thereby eliminating the ELB. Thus, the Fed would be able to follow a systematic and transparent strategy in adjusting the interest rate on digital cash, without the need to rely on unconventional policy tools, and would be able to foster true price stability.

The remainder of this article is organized as follows. We begin by documenting the muted effectiveness of unconventional monetary policy tools. We then set forth basic principles for the design of digital cash, discuss the characteristics of the monetary policy framework, consider some near-term practical steps that the Federal Reserve can take in the process of establishing U.S. digital cash, reflect on financial stability issues, and offer some concluding remarks.

Assessing Unconventional Monetary Policies

Paper cash pays zero interest and hence limits the extent to which a central bank can provide conventional monetary accommodation by reducing nominal interest rates in the face of weak aggregate demand and persistently low inflation. In the wake of the global financial crisis, the Federal Reserve and other major central banks became constrained by this ELB and deployed two basic forms of unconventional monetary policy: quantitative easing (QE) in the form of large-scale asset purchases, and forward guidance about the likely trajectory of short-term nominal interest rates. Each of these policy tools is intended to provide monetary stimulus, thereby fostering the pace of economic recovery and bringing inflation back upwards to its stated objective; thus, these tools are intrinsically different from the emergency liquidity measures that a central bank may implement in serving as a lender of last resort during a financial crisis.

In deploying these unconventional policies, central bankers and other analysts were quite optimistic that implementing QE and forward guidance could substantially mitigate the severity of the ELB. However, those projections relied heavily on extrapolations from statistical patterns over preceding decades and on event studies of policy actions taken in the midst of the financial crisis. Consequently, such assessments were necessarily subject to a high degree of uncertainty. (2) With the passing of time, however, it has become increasingly evident that QE and forward guidance are subject to intrinsic limitations and hence have relatively muted benefits in providing monetary stimulus; see Borio (2018), Greenlaw et al. (2018), and Hamilton (2018). This suggests that the Fed may be hampered in offsetting the next recession more than it believes. unchanged "at least until mid-2013." That announcement was associated with a decline of about 10 basis points in the 2-year Treasury yield--roughly similar to a small surprise in conventional monetary policy during the precrisis period; see Williams (2013). By contrast, subsequent revisions in the Federal Open Market Committee's forward guidance in January 2012 ("at least through mid-2014") and in September 2012 ("at least through mid-2015") were associated with very small reductions in the 2-year Treasury yield of about 4 basis points and 1 basis point, respectively. Finally, in December 2012, the FOMC reframed its forward guidance in terms of specific quantitative thresholds for unemployment and inflation. According to the Federal Reserve Bank of New York's survey of primary dealers, that reframing came as a surprise to financial market participants but had negligible effects on their expectations regarding the likely timing of liftoff from the ELB.

The Federal Reserve initiated its first round of large-scale asset purchases (QE1) during the most intense phase of the financial crisis. In particular, at the tail end of 2008 and the first half of 2009, the Fed purchased $1.35 trillion of agency debt and mortgage-backed securities, predominantly issued by Fannie Mae and Freddie Mac, with the specific aim of "providing support to the mortgage and housing markets" by reducing risk spreads on those securities. (3) QE1 also included $300 billion in purchases of Treasury securities. In 2010-11, the FOMC initiated purchases of an additional $600 billion in Treasuries (QE2) and a program to expand the average maturity of its Treasury holdings (often referred to as "Operation Twist"). Nonetheless, the recovery remained sluggish and inflation remained well below target.

The FOMC's third major round of asset purchases, commonly known as QE3, was launched in autumn 2012 and concluded about two years later. The Federal Reserve concluded all of its emergency lending programs during 2009-10, and measures of U.S. financial stress remained at low levels thereafter. Thus, the QE3 program was clearly aimed at providing additional monetary stimulus. Indeed, the FOMC specifically stated that QE3 was intended to push down longer-term bond yields, thereby fostering a more rapid economic recovery and pushing inflation upwards to the FOMC's 2 percent goal.

In explaining the rationale for launching QE3, Federal Reserve officials extensively cited the analysis of Chung et al. (2011), who conducted simulations of the FRB/US model to assess the benefits of QE; see Bernanke (2012, 2014) and Yellen (2012, 2015). That Federal Reserve study indicated that a $600 billion asset purchase program would reduce the term premium by 20 basis points, expand nonfarm payrolls by about 700,000 new jobs, raise real GDP by nearly 1 percent, and push up core inflation by about 0.3 percent. Given that the FRB/US model is essentially linear, the predicted macroeconomic effects of QE3 (which comprised $1.9 trillion in purchases) would be roughly three times larger--reducing the term premium by 60-70 basis points, expanding nonfarm payrolls by 2 million jobs, raising real GDP by about 3 percent, and raising core inflation by nearly a percentage point. (4) Indeed, internal staff memos that were sent to the FOMC in 2012 (and which have been subsequently released to the public after a five-year time lag) used this methodology to quantify the likely benefits of the QE3 program. (5)

Nonetheless, as shown in Figure 1, the term premium on 10-year U.S. Treasury securities was broadly stable during the second half of 2012 and the first quarter of 2013, even as the FOMC initiated QE3. The surveys of primary dealers conducted by the Federal Reserve Bank of New York indicate that the launch of QE3 was largely unanticipated prior to September 2012 and that over subsequent months financial market participants made large upward revisions to their assessments of its likely duration and cumulative size.

Any near-term effects from launching QE3 were subsequently swamped by the so-called taper tantrum in spring 2013. At that time, Fed officials suggested that the tantrum was a transitory phenomenon and that bond yields would quickly subside. However, the New York Fed's June 2013 survey indicated that most primary dealers attributed the tantrum to market confusion about the FOMC's policy strategy. And the term premium remained elevated over the subsequent year, even as investors made further upward revisions about the likely size of the Fed's balance sheet, and did not fall significantly until after the end of QE3 in late 2014.

As shown in Figure 2, the launching of QE3 and the initiation of explicit forward guidance appear to have had only muted...