WHAT HAVE WE LEARNED ABOUT CENTRAL BANK BALANCE SHEETS AND MONETARY POLICY?

• Author: Gagnon, Joseph E.

In the aftermath of the Great Recession of 2008-09, central banks conducted large-scale purchases of long-term bonds and other unconventional financial assets to stimulate economic recoveries and raise inflation toward its targeted level. Dire predictions of runaway inflation and financial distortions did not come to pass. But recovery proved much slower than had been expected. This article argues that the main lesson is that central banks need to use their powers more aggressively if confronted with a similar situation in the future. Planning now can help central banks to be more prepared later. It is also a good time to make sure central banks have all the tools they need to confront the zero bound on nominal interest rates.

A Deeper Understanding of Monetary Policy

For decades monetary policy has been focused on the manipulation of short-term risk-free interest rates to guide economic growth and inflation. John Taylor (1993) characterized desirable interest rate policy in his famous rule. Lower interest rates stimulate growth and inflation, whereas higher interest rates are contractionary. Michael Woodford (2003) wrote an authoritative textbook summarizing the principles of monetary policy in terms of a short-term rate of interest. (1) However, it was long understood that the existence of paper currency with a fixed interest rate of zero would make it difficult (or impossible) for central banks to push short-term interest rates substantially below zero (Hicks 1937). Any attempt to do so would cause lenders to hold their wealth in risk-free paper currency rather than accept a lower rate of return in any other form. (2)

The zero bound on short-term interest rates led Paul Krugman (1998) to conclude that the only monetary route out of deflation in Japan required a commitment by the Bank of Japan to create far more inflation in the future than anyone expected at the time. (3) He referred to this policy as a "credible promise to be irresponsible," but he questioned how easy it would be to put into practice.

This focus on the short-term risk-free interest rate grew naturally out of standard texts on monetary policy in which the central bank issues money to buy bonds (Patinkin 1965). However, the textbooks typically are silent on the maturity of the bonds held by the central bank. John Maynard Keynes (1930) was an early proponent of the possibility of central banks buying long-term bonds to influence long-term interest rates. (4) James Tobin (1969) went further and considered the implications of conducting monetary policy over a range of assets, including productive capital (equity).

The power of monetary policy derives from the unique ability of central banks to create liabilities with an exogenous rate of return (typically zero) that must be accepted as payment for any other asset or commodity. To ease policy, a central bank creates paper currency or bank reserves to buy financial assets and push their prices upward. If a central bank limits its purchases to short-term risk-free bonds, it may indeed reach an upper bound on asset prices that corresponds to the lower bound on interest rates. (5) However, there is no fundamental reason to restrict central bank balance sheets to shortterm risk-free assets. The central bank can push up the price of any bond with a yield above zero and can always push up the prices of real assets such as equity and real estate. (6) It can also push up the prices of assets in foreign currencies by depreciating the exchange rate. (7) All of these actions raise nominal wealth, stimulate growth, and support inflation.

Milton Friedman (1969) famously proposed another form of monetary policy, distributing currency to the general public by dropping it from a helicopter. No central bank has ever conducted policy in this way (even by means other than a helicopter). Indeed, it is not clear that central banks have the legal authority to do so. Transfers to the public are generally considered to be the domain of fiscal policy. Consider the following definitions of expansionary monetary and fiscal policy:

* A monetary expansion is the creation of money to buy assets with the goal of raising their prices and reducing their rates of return.

* A fiscal expansion is the sale of assets (bonds) to fund government spending, tax cuts, and transfers to the public.

Monetary and fiscal contractions are defined as the reverse of the above operations. From these definitions, it follows that Friedman's helicopter money drop is a combination of monetary and fiscal expansion. The focus of this article is on monetary policy, but the final section revisits the possibility of Friedman's monetary-fiscal helicopter drop.

The Experience of Quantitative Easing (QE)

When their short-term policy interest rates hit zero during and after the Great Recession of 2008-09, (8) several central banks began to buy longer-term bonds in large quantities and the Bank of Japan also stepped up its purchases of equity and real estate investment trusts. Dozens of studies confirm that QE bond buying is effective at lowering long-term interest rates (Gagnon 2016). Studies also show that QE bond purchases tend to boost stock prices and depreciate the exchange rate (Rogers, Scotti, and Wright 2014). The experience of Hong Kong in 1998 suggests that...