Pumping Liquidity to Fight Deflation

By L. Randall Wray [via CFEPS]

In recent years there have been numerous calls on the central banks to “pump” liquidity into the system to fight deflationary pressures, first in Japan and more recently in the US. (Bernanke 2003) Years ago, Friedman (1969) had joked about helicopters dropping bags of money as a way to increase the money supply. If this practice were adopted, it probably would be an effective means of reversing deflationary pressures—if a sufficient number of bags were dropped. There are two problems with suc h a policy recommendation, however. First, of course, no central bank would even consider such a policy. Second, and more importantly, this would not really be a monetary policy operation, but rather a fiscal policy operation akin to welfare spending. In practice, central banks are more-or- less limited to providing reserves at the discount window or in open market operations. In both cases, the central bank increases its liabilities (reserves)and gains an asset (mostly sovereign debt or private bank liabilities, although the central bank could also buy gold, foreign currencies, and other private assets). Helicopter money drops are quite different because they increase private sector wealth; in contrast central bank operations do not (except to the extent that adoption of a lower interest rate target increases prices of financial assets).

From the previous section, it should be clear that the central bank cannot choose to increase reserves beyond the level desired/required by the banking system if it wishes to maintain positive overnight rates. If private banks have all the reserves they need/want,then they will not borrow more from the central bank. Open market purchases would simply result in excess reserve holdings; banks with excessive reserves would offer them in the overnight market, causing the interbank interest rate to decline. Once the overnight rate reached the bottom of the central bank’s target range, an open market sale would be triggered to drain excess reserves. This would return the overnight rate to the target, and the central bank would find that it had drained an amount of reserves more-or-less equivalent to the reserves it had “pumped” into the system to fight deflation. Fortunately,no central bank with a positive overnight interest rate target would be so foolish as to follow the advice that they ought to “pump liquidity” to fight deflation.

Japan presents a somewhat different case, because it operates with a zero overnight rate target. This is maintained by keeping some excess reserves in the banking system. The Bank of Japan can always add more excess reserves to the system since it is satisfied with a zero rate. However, from the perspective of banks, all that “pumping liquidity” into the system means is that they hold more non-earning reserves and fewer low-earning sovereign bills and bonds. There is no reason to believe that this helps to fight deflation, and Japan’s long experience with zero overnight rates even in the presence of deflation provides empirical evidence that even where “pumping liquidity” is possible, it has no discernible positive impact. (The US had a similar experience with discount rates at 1% during the Great Depression.) And, to repeat, “pumping liquidity” is not even a policy option for any nation that operates with positive overnight rates.

Can the central bank do anything about deflation? As the overnight interest rate is a policy variable, the central bank is free to adjust the target to fight deflation. However, both theory and empirical evidence provide ambiguous advice, at best. It is commonly believed that a lower interest rate target will stimulate private borrowing and spending—although many years of zero rates in Japan with chronic deflation provide counter evidence. There is little empirical evidence in support of the common belief that low rates stimulate investment. This could be for a variety of reasons: the central bank can lower the overnight rate, but the relevant longer-term rates are more difficult to reduce; most evidence suggests that investment is interest- inelastic; and in a downturn, the expected returns to investment fall farther and faster than market interest rates can be brought down.

Evidence is more conclusive regarding effects of low rates on housing and consumer durables; indeed, recent lower mortgage rates in the US have undoubtedly spurred a refinancing boom that fueled spending on home remodeling and consumer purchases.

Still, this effect must run its course once all the potentially refinanceable mortgages are turned-over. Further, it must be remembered that for every payment of interest there is an interest receipt. Lower rates reduce interest income. It is generally assumed that debtors have higher spending propensities than creditors, hence, the net effect is presumed to be positive. As populations age, it is probable that a greater proportion of the “rentier” class is retired and at least somewhat dependent upon interest income. This could reverse those marginal propensities.

More importantly, if national government debt is a large proportion of outstanding debt, and if the government debt to GDP ratio is sufficiently high, the net effect of interest rate reductions could well be deflationary. This is because the reduction of interest income provided by government could reduce private spending more than lower rates stimulated private sector borrowing. In sum, the central bank can lower overnight rate targets to fight deflation, but it is not clear that this will have a significant effect.

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