Tuesday, March 18, 2014

Draghi is guiding interest rates, Yellen is tapering the quantity of reserves (Guest Post by Vaidas Urba)

Readers of this blog will notice that while I write about monetary policy quite often, I usually approach this from an investor's point of view, given its importance for all asset prices in the economy. That said, I rarely delve into the technical specifics of monetary policy, which are often beyond my level of understanding. One frequent commenter in the blogosphere with no such technical limitations is Vaidas Urba, who will be familiar to many of you from his comments on The Money Illusion and Twitter, where you can follow him @VaidasUrba. Vaidas has written a (relatively non-wonkish!) guest post on the nature of monetary policy. I criticised the ECB's belief in forward guidance in a recent post, and Vaidas takes up the issue in this post. So with that, here's Vaidas:

Draghi is guiding interest rates, Yellen is tapering the quantity of reserves

What is monetary policy? Is it concerned with setting interest rates, or is concerned with setting the quantity of reserves? This question makes no sense. We might as well be asking "Is it colder in Celsius or in Fahrenheit?”. Monetary policy is all about central bank reaction functions. We may describe a central bank reaction function in interest rate coordinate space, but we could express the same reaction function in terms of quantity of reserves - both ways are equivalent mathematically.

At the zero lower bound, interest rate coordinate space has a disadvantage - the current interest rate does not help us in distinguishing between different central bank reaction functions, and we absolutely need forward guidance for this purpose. On the other hand, if we use the quantity of reserves, we get a simple albeit simplistic form of forward guidance already built in. The Fed has used this property of quantity of reserves to a great effect. With QE Infinity, every passing month had brought us stronger and stronger forward guidance. This powerful effect has disappeared when Bernanke hinted at tapering last year, and after a period of market turbulence the Fed started the process of divorcing the credibility of reaction function from QE.

Interestingly, the ECB is trying to get away with not using QE to bolster the forward guidance. Instead of a blunt message delivered by the rising line in the quantity of reserves chart, we are getting subtle signals about the ECB reaction function every month. "Firmly reiterate the forward guidance“ has replaced "confirmed its forward guidance". A bit later "a presence of slack" has joined in. Now we are getting "euro exchange rate increasingly relevant in our assessment of price stability" and "real rates are set to fall over the projection horizon". Unfortunately, marginal market players are still looking at that old-fashioned quantity of reserves chart.

For the sake of science, I hope the ECB will succeed in avoiding QE, as in this case we would get a clean test of Woodfordian theory. For the sake of the European economy, I hope the ECB will start QE soon. Let's use the QE language everybody understands, or the ECB reaction function might get lost in translation


  1. In his Jackson Hole paper, Woodford advocated targeted fiscal stimulus measures to support forward guidance. And he also suggested NGDP targeting. But everyone seems to have conveniently forgotten that he said either of these.

  2. Frances Coppola,

    Yes, NGDP LT is the best form of forward guidance.

    Regarding fiscal stimulus, Woodford has a point when the optimal policy rate is sharply negative, as it probably was in early 2009. On the other hand, fiscal bang for the buck is very low when the optimal rate is close to zero. And the optimal rate would likely be above zero now if we switched to NGDPLT.