The Monetary Base and the Channels of Monetary Transmission in the Age of ZIRP: Conclusion

A Mark Sadowski post

1. The Object of This Exercise

One point of this series of posts (see list at the end) was to show that during the US age of zero interest rate policy (ZIRP) from December 2008 through May 2015, using nothing more complicated than a simple conventional Vector Auto-Regression (VAR) model with a minimum of structure, the monetary base has had statistically significant effects on the goods and services markets through broad spectrum of financial market variables. The other is that we now have a baseline VAR model that can be used for further policy analysis, and which can be improved in the future through the use of different impulse response identification structures, or perhaps more advanced estimation methods.

2. Why the Monetary Base?

The monetary base is unique among monetary aggregates in that the central bank has the ability to decide precisely how large it will be at any given moment. Even the amount of bank reserves, which along with currency in circulation is a component of the monetary base, cannot be determined with any precision by the central bank, since it is a residual of the amount of currency in circulation, which is itself determined by the depositors’ desire to hold currency. The only other variable which the central bank can arguably target with such precision is the overnight interbank lending rate, which is itself largely determined by the size of the monetary base through the conduct of open market operations.

Thus, if one is interested in studying the effects of monetary policy at the zero lower bound in short term interest rates, the monetary base is the logical variable to represent the instrument of monetary policy. The fact that, away from the zero lower bound, the usual instrument of monetary policy, namely the overnight interbank lending rate, is itself essentially determined by the size of the monetary base, means that this change in instrument during the age of zero interest rate policy (ZIRP) is less meaningful than many may realize.

And, it is worth noting, any monetary economics model that uses as its primary monetary variable one which cannot be easily controlled by the central bank is, quite simply, useless for studying the effects of monetary policy.

3. The Importance of Proper Model Specification

In each of these posts I have discussed in detail the types of diagnostics that I have conducted in fitting the model to the data. The reason for this is two-fold.

One is that I wanted these posts, as technical as they may at times seem to be, to be highly accessible. That is, I want these results to be easily reproducible by anyone who has the time series econometric background and access to commonly used econometric software packages such as EViews, Stata, SAS, R, Gretl, etc. If I am doing anything at all novel here, it is to as much as possible enable others to verify these results for themselves.

Second, without proper model specification, the obtained results almost certainly will be statistically biased, meaning that the reported statistical significance of the results, if any, will be highly questionable.

And if a time series model’s results are reported without routine references their statistical significance, then they should always be viewed with deep skepticism.

4. Other Channels of Monetary Transmission

The three most important channels of money transmission that I didn’t directly address in this series of posts are 1) the Traditional Real Interest Rate Effects Channel, 2) the excess bank reserve channel of the Bank Lending Channel, and 3) the Cash Flow Channel.

According to the Traditional Real Interest Rate Effects Channel, reductions in the expected long-term real interest rate lead to increased expenditures on physical investment and durable goods. My own estimates indicate that during the age of zero interest rate policy (ZIRP) there is no correlation between expected long-term real interest rates (as measured by the 10-Year Treasury Inflation-Indexed Security) and industrial production or the price level. Moreover there’s no correlation between the monetary base and expected long-term real interest rates.

According to the excess bank reserves channel of the Bank Lending Channel, a rise in excess reserves leads to an increase in bank lending. My own estimates indicate that there is in fact a correlation between excess bank reserves and bank credit, but that this correlation is hard to disentangle from the other channels through which changes in the monetary basis appear to be influence bank credit, namely the balance sheet channel and the household liquidity effects channel. Moreover, I am skeptical that an increase in bank reserves would have much of a marginal effect on the amount of bank credit. In any case, regardless of how changes to the monetary base are influencing the amount of bank credit, the effect is statistically significant. The more important problem is of course that the level of bank credit does not have a statistically significant effect on output or prices.

According to the Cash Flow Channel, reductions in nominal interest rates lead to increase the liquidity of debtor households and firms at the expense of creditor households and firms. The interest rate that is most representative of this effect is the 10-Year Treasury Security yield. As we saw in the post on the Bond Yield Channel, positive shocks to the monetary base lead to increases in the 10-Year Treasury Security yield, the opposite of what the effect of expansionary monetary policy is theorized to be under the Cash Flow Channel. Furthermore, increases in the 10-Year Treasury Security yield lead to increases in industrial production, the opposite effect of what is implicitly theorized under the Cash Flow Channel.

Is there reason to believe that these three channels of monetary transmission work away from the zero lower bound in short term interest rates? The short answer is no.

Many researchers, including Bernanke and Gertler (1995), believe that empirical evidence does not support strong interest rate effects operating through the cost of physical capital, as is theorized under the Traditional Real Interest Rate Effects Channel. My own estimates from during times when the US economy has been away from the zero lower bound in short-term interest rates show that while there is a correlation between the ex-post real (i.e. adjusted by the year on year PCEPI) 10-Year Treasury Security yield and private nonresidential investment and private residential investment, there is no correlation with durable goods spending. More importantly, I find that higher real interest rates lead to higher physical investment spending, not lower. That only really makes sense in a model that acknowledges the role of money in determining interest rates.

As for the excess bank reserves channel, several studies have shown that during times when the central bank is targeting the overnight interbank interest rate as its instrument of monetary policy, bank credit usually Granger causes the monetary base. This is often misinterpreted by endogenous money enthusiasts as meaning that the actions of the central bank are constrained by the demand for bank credit. The reality is that when the central bank targets an interest rate, the level of bank credit and the monetary base (and practically everything in the economy for that matter) are endogenous to the central bank’s interest rate target. The reason why I bring this up however is that away from the zero lower bound in short term interest rates there is little reason to believe that it is the level of excess bank reserves that is determining the level of bank credit. Rather, it is the central bank’s interest rate target that is ultimately determining the level of bank credit.

And finally, as weak as the empirical evidence is for the theorized workings of the Cash Flow Channel during the age of ZIRP, it is even weaker during the times when the US economy has been away from the zero lower bound in short-term interest rates. Anyone who has taken note of the yield curve’s obvious predictive power for business cycles knows that the correlation between nominal long term-rates and aggregate nominal spending must be the opposite of what is theorized under the Cash Flow Channel.

5. Whither the Role of Interest Rates?

In most of these posts I was able to generate statistically significant monetary policy effects without any reference at all to an interest rate as the instrument of monetary policy. The only exception was in the posts on the Exchange Rate Channel where I found it necessary to include the overnight interbank interest rate owing to the fact that most major US trading partners have been targeting that rate as the instrument of monetary policy during the age of US ZIRP, and the real exchange rate is determined not only by the monetary policy of the domestic country, but also by the foreign trade partner.

However, as we have just discussed, the empirical evidence does not support the Traditional Real Interest Rate Channel, and the empirical evidence flatly contradicts the supposed workings of the Cash Flow Channel, and these two are the only other monetary transmission channels that rely at all on interest rates. Thus we are left with the realization that interest rates are only important to the extent that they are targeted by the central bank, and even then their importance seems to be primarily stemming from what it indicates about what is happening to the monetary base.

6. Does the Liquidity Trap Exist?

Modern applied macroeconomic models of the liquidity trap usually rely on some version of the David Romer’s ISLM/ISMP model.

If expected short-term real interest rates cannot be lowered to a level prescribed by some version of a Taylor Rule, the only way to increase real output is by increasing inflation expectations. This is because the central bank can only determine the level of real output through changes in the expected short-term real interest rate.

But as we have seen here there is really is no monetary transmission channel that works primarily, much less exclusively, through expected short-term interest rates. Thus any model that relies on the supposed inability of the central bank to lower expected short-term interest rates to demonstrate the ineffectiveness of monetary policy is guilty of assuming its conclusion.

Central banks usually target short term interest rates as an instrument of monetary policy not because there is any credible mechanism by which they directly and significantly impact the economy, but because 1) they are quickly and accurately measurable, 2) the central bank can exercise a great deal of control over them, and 3) because changes in them usually lead to reasonably predictable outcomes in terms of policy goals. These qualities may make short term interest rates convenient as an instrument of monetary policy away from the zero lower bound, but they should in no way cause us to confuse short-term interest rates for the actual mechanisms by which monetary policy is transmitted.

7. Are There Other Reasons to Believe in the Liquidity Trap?

The most popular way to “prove” the existence of the liquidity trap is to simply point at a graph of the monetary base of a country in ZIRP (and/or the velocity of the monetary base) and then profoundly intone, “see?” But all this really shows is that the velocity of the monetary base is a variable, something which every applied macroeconomist already knows.

And an argument consisting of little more than a line graph depicting the time series of values of a quantity should never be accepted as a proof of anything, except that the person who is arguing that it proves something is not familiar with what constitutes acceptable empirical evidence, is incapable of understanding what constitutes acceptable empirical evidence, or is simply willfully ignoring what constitutes acceptable empirical evidence because it contradicts their preferred model.

The series of posts:1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11,