Rethinking Monetary Policy in a
Very Low Inflation Environment
Alan S. Blinder
Princeton University
Burt Malkiel Conference
April 8, 2011
References
 “Quantitative Easing: Entrance and Exit Strategies,” Federal
Reserve Bank of St. Louis Review, November/December
2010, pp. 465-479 (the 2010 Homer Jones lecture).
 “Revisiting Monetary Policy in a Low Inflation and Low
Utilization Environment,” Journal of Money, Credit and
Banking, forthcoming in a special issue.
2
Things our intellectual fathers…
a) taught us
b) didn’t tell us
3
Things our intellectual fathers…
a) taught us
b) didn’t tell us
↑
one of mine
4
And while we’re on the subject…
5
Bagehot and recent history
 “Lend freely, at a penalty rate, against good collateral.”

Most CBs did


Well, not much.



Well, it varied.
• For the ECB, Bagehot+ was just about enough (until Greece).
• But the Fed, BoE, and BoJ felt compelled to do more.
• Why? The zero lower bound (ZLB) on nominal interest rates led
to a perceived need for unconventional monetary policy.
 ECB never hit the ZLB; neither did the BoE, but it came close.
6
Friedman and recent history
 “Don’t peg the nominal interest rate.”
 Why not? r = i - π
 Friedman was thinking mainly about upward instability when
π is rising and r is falling.
 But the argument is symmetric: When i is stuck at zero, and
π is falling, r is rising.
 Again, the ZLB leads to unconventional monetary policy.
 And, BTW, can also lead to huge fiscal multipliers.
7
Keynes and recent history
 The liquidity trap idea: In a very depressed economy, the
central bank might push the short rate all the way down to
zero--and still not stimulate the economy.
 Then monetary policy becomes useless.
 But fiscal policy becomes powerful.
 But what if fiscal policy is paralyzed by large deficits and/or
public debt?
8
Four quick conclusions
1.
2.
9
(obvious) In an environment of very low inflation, we need to
worry much more about the ZLB.
(less obvious, but should be) If that environment also has low
utilization, we may need large doses of expansionary policy.

If fiscal policy is paralyzed, that must be monetary policy.
3.
(deduction) Given our starting point today, unconventional
monetary policy will be more important than in the past.

So the “crazy aunt” may not be stuffed back in the closet so easily.
4.
Maybe we should think more about unconventional monetary
policy options.
Types of unconventional monetary policy
1. Commitment via words (“extended period”)
2. A higher π* (because r = i – π)
3. Lower the interest rate on reserves (no ZLB here)
4. Quantitative easing (← will focus on this one)
a) Treasury bonds (work on term premia)
b) Private-sector assets (work on risk premia)
5. Pegging one or more bond prices
 Exactly what our forefathers told us not to do!
6. Supervisory forbearance (if CB is a supervisor)
10
The underlying idea
 Idea: Demand curves for financial assets are not horizontal,
so changing relative supplies can change term and/or risk
premiums.
Rj = r + ρj
• Requires imperfect substitutes or “frictions”
11
A taxonomy of QE
 Alter the composition of the central bank’s balance sheet.
 Increase the size of the central bank’s balance sheet.
Longer-dated government securities
b) Private-sector securities
a)
12
Simplified Fed balance sheet
ASSETS
LIABILITIES AND
NET WORTH
Treasury bills
Currency
Less liquid assets
Bank Reserves
Loans
Treasury deposits
Capital
13
Specific strategies
To shrink term premiums
 Buy long-term government bonds...
-- and sell T-bills
-- by creating new bank reserves
 Relies on imperfect arbitrage across yield curve
(“preferred habitat” theory)
 Related option: commit to keeping the overnight rate low
for a long time
 Note: This strategy relies on the expectations theory.
14
Specific strategies
To shrink term premiums
 Buy long-term government bonds...
-- and sell T-bills
-- by creating new bank reserves
 Relies on imperfect arbitrage across yield curve
(“preferred habitat” theory)
 Related option: commit to keeping the overnight rate low
for a long time
 Note: This strategy relies on the expectations theory.
This man taught me those theories. →
15
Specific strategies
To shrink term premiums
 Buy long-term government bonds...
-- and sell T-bills
-- by creating new bank reserves
 Relies on imperfect arbitrage across yield curve (“preferred
habitat” theory)
 Related option: commit to keeping the overnight rate low for a
long time
 Note: This strategy relies on the expectations theory.
To shrink risk premiums
 Buy some risky asset…
-- and sell the safe asset
-- by creating new bank reserves
 Relies on imperfect substitutability (e.g., preferred habitat)
16
Swapping assets (QE 0)
ASSETS
LIABILITIES AND
NET WORTH
Treasury bills 
Currency
Less liquid assets 
Bank Reserves
Loans ↑
Treasury deposits
Capital
17
Early QE did not blow up the Fed’s
balance sheet…
18
…nor increase bank reserves much
1,400
1,300
1,200
1,100
Billions of dollars
1,000
900
800
700
600
500
400
300
200
100
0
19
Lehman changed everything
20
Lehman changed everything
1,400
1,300
1,200
1,100
Billions of dollars
1,000
900
800
700
600
500
400
300
200
100
0
21
Blowing up the balance sheet (QE I)
ASSETS
Treasury securities
LIABILITIES AND
NET WORTH
Currency
Less liquid assets↑ Bank Reserves ↑
Loans ↑
Treasury deposits
Capital
22
CP and MBS purchases:
Working on risk premiums
Ri = r + ρi

riskless rate
23
Did QE I work?
CP vs. T-Bill risk spread
Corporate bond vs. T-note risk spread
1.8
6
1.4
1.2
1
0.8
0.6
0.4
0.2
Percentage points
Percentage points
1.6
5
4
3
2
1
0
Econometric evidence suggests: yes
24
Blowing up the balance sheet (QE II)
ASSETS
Treasury securities
• Bills
LIABILITIES AND
NET WORTH
Currency
• Bonds ↑
25
Less liquid assets
Bank Reserves ↑
Loans
Treasury deposits
Capital
Did QE II work?
 It was supposed to work on term premiums.
 They have widened. (see next slide)
26
Three yield curves
August 2010, November 2010, March 2011
4
3.5
3
2.5
8/24/2010
2
11/4/2010
3/30/2011
1.5
1
0.5
0
0
27
2
4
6
8
10
12
Did QE II work?
 It was supposed to work on term premiums.
 They have widened. (see next slide)
 But perhaps for other reasons:
 brighter outlook for the economy
 higher expected inflation
 worsening outlook for national debt
• Too early for econometric evidence. (But you can guess!)
28
Questions for research/thinking
• Which of the six unconventional monetary
policies works best, under what circumstances?
• If it’s going to be QE, which kind?
29
There is a strong a priori case
for using private assets:
• Treasury market is the broadest, deepest in the
world → hardest to move.
• Any other market is thinner → easier to move.
• The substitutability between T-bills and T-bonds
must be higher than the substitutability between,
say, T-bills and MBS.
30
Thank you
31