As I stated in my previous post, there are those who interpret the recent expansion of the monetary base as a sign of rising future inflation. In addition, there are those who interpret the failure of that surge in the monetary base to have real effects as evidence of a liquidity trap.
With the Fed paying interest on reserves, open market operations literally entails the Fed exchanging debt for debt — specifically, Federal Reserve debt for Treasury debt. Commenter ‘The Money Demand Blog’ points out that this distinction is irrelevant as without interest on reserves the T-bill rate would fall to zero would therefore remain perfect substitutes for reserves. This might be so, but it is not necessarily the case that it would go all the way to zero and there is a difference between near-zero rates and a zero rate (see this post by Tyler Cowen). Nonetheless, by paying interest on reserves, the Fed has rendered any such distinction moot.
Regardless, when thinking about monetary policy in terms of open market operations, it should be clear that the Fed is not being expansionary when it exchanges debt for debt. Nonetheless, this is not the same thing as saying that the Fed cannot be expansionary.
Brunner and Meltzer (1968) demonstrated some time ago that the existence of a liquidity trap is not possible when the model consists of a spectrum of interest rates rather than “the” interest rate — as is typical in the majority of macroeconomic models. To understand why, one needs a grasp of the monetarist transmission mechanism.
Monetarists emphasize the role of monetary policy on relative prices and a variety of asset substitutions. For example, an open market purchase is likely raises the price of bonds and reduces the yield. Following the open market purchase, the seller(s) will seek to re-balance their portfolio(s), most likely by trying to buy other financial assets. This process bids up the price of financial assets relative to non-financial assets, like capital, which increases the demand for the latter. Initially, the lower relative price leads to an increase in the demand for existing non-financial assets. However, as the price of existing non-financial assets gets bid up, this increases the demand for newly produced non-financial assets and leads to increased capital accumulation. In addition, these higher asset prices boost wealth, which increases the demand for consumption. These asset substitutions generate real effects and ultimately the price level will rise to bring real money balances in line with desired money balances.
It follows that the central bank’s ability to affect the price and corresponding yield of financial assets through open market operations is essential to understanding the effects of monetary policy. This is where quantitative easing comes in. Some commentators have assumed that the sole effect of quantitative easing is to reduce long-term interest rates and stimulate investment. This is wrong-headed and demonstrates — or at least after reading this post, I hope will demonstrate — why obsessions with the interest rate effect are misguided. The point of quantitative easing is not to reduce the long-term interest rate, but rather to resolve monetary disequilibrium.
Suppose that there is an excess demand for money. Since money is the medium of exchange and is traded on all markets, this necessarily causes an excess supply of goods and services. The central bank can eliminate the excess demand for money by increasing the money supply. However, as has been discussed above, if the central bank is exchanging interest-bearing reserves for interest-bearing debt, it is essentially exchanging perfect substitutes. If this is the case, traditional open market operations will not resolve the excess demand for money. Rather, the central bank needs to exchange the interest-bearing reserves for something that is not a perfect substitute. Potential assets that satisfy this criteria could be anything from long-term bonds to a portfolio of stocks. The central bank purchases these assets in order to increase the money supply and resolved monetary disequilibrium.
In addition, these asset purchases will have real effects as well. As the monetarist transmission mechanism highlights, open market purchases can resolve monetary disequilibrium, but also lead to real effects through capital accumulation and wealth effects. As Nick Rowe recently highlighted, rising stock and bond prices that result, directly or indirectly, from open market purchases can lead to increased investment due to the effect on Tobin’s Q.
So what is the point of all of this? The point is that much of the focus on quantitative easing is misguided. The purpose of QE is to resolve monetary disequilibrium. Given that the Fed is paying interest on reserves, traditional open market operations will not suffice. An exchange of interest-bearing reserves for interest-bearing government debt is unlikely to lead to portfolio re-balancing and therefore the increase in the monetary base is unlikely to resolve the excess demand for money. A shift toward other types of asset purchases is much more likely get the increase in the monetary base circulating the resolve monetary disequilibrium.