Unconventional monetary policy challenges the Wicksellian approach
In a “conventional” monetary policy environment [1], open market operations largely focused on government bond purchases and sales at the short end of the yield curve. Given its generally upward-sloping nature, fluctuations in the central-bank policy rate [2] can be expected to shift the entire yield curve. The longer-end of the maturity structure for government liabilities was largely an afterthought. Now, under a ZLB environment, to generate further stimulus, purchases must be geared towards bonds of longer maturities (i.e. QE). The maturity structure of government debt is now a direct tool of monetary policy. In fact, raising/lowering rates further along the yield curve probably yields a greater expansionary/contractionary effect than movements on the overnight end. People make investment, borrowing, mortgage, credit, or purchasing decisions for the longer-term after all. This is more relevant to the real economy. Overnight purchases and borrowing on the other hand are financial plumbing issues enacted to meet financial sector liquidity needs, with a smaller direct effect [3] for the real economy absent large shocks to liquidity.
This is of imperative consideration when liftoff occurs in the US. The FFR per se is perhaps less salient an issue than the entire yield curve, hence tapering decisions will matter a lot. This also poses a flaw for neofisherianism (there is only one i, the short-term rate on nominal bonds, in the Fisher equation after all), or any model that considers just one uniform nominal policy rate, as opposed to the entire curve. Whilst these matters were trivial under conventional monetary policy, our models need to reflect the revolution in monetary policy since the last decade.
In any case, r* is essentially a lagged moving average of many interest rates across different maturities. Due to QE, it follows that r* is heavily influenced via monetary policy (a point I have emphasised multiple times across numerous blogs). Indeed, a forthcoming paper by Bianchi, Lettau, and Ludvigson (2022) finds that secular declines in real rates are driven via monetary policy.
As such, perhaps r* is not that useful a concept? This is a point much emphasised by heterodox economists in the infamous Cambridge capital controversies. Capital should not be aggregated via a homogenous production function according to the post-Keynesians or Straffians, as rates of return influence capital accumulation, yet the size of the capital stock influences rates of return. The reasoning of the ‘neoclassical’ side is circular. R* matters in ‘neoclassical’ models insofar that monetary policy is conducted in reference to a ‘neutral’ rate of interest (the Wicksellian approach).
I have often argued that economists should pay greater attention to heterodox schools of thought (listening and debate, or an easier process for publication in mainstream journals, does not indicate endorsement). Yet, as in this post, one does not even need to invoke heterodox thought to criticise the Wicksellian approach. Ironically, the ‘neoclassical’ side was represented by Samuelson, who is integral in the development of OLG models. OLG models overcome the flaws presented in this blog regarding the Wicksellian framework, as they directly model heterogeneity in maturities. Under an “unconventional” monetary policy environment, perhaps macroeconomics can be improved with less DSGE, and more OLG?
As in open market operations under a “scarce reserve” regime to set interest rates, in contrast to “unconventional” monetary policy that operates on a “floor” system at the ZLB/ELB, with large QE operations under an “ample reserve” regime. Albeit this framing is flawed; “unconventional” operations have persisted for the majority of my lifetime!
For Brits, the Federal Reserve sets the federal funds rate (the rate for overnight interbank borrowing, think LIBOR) under conventional monetary policy. For Americans, the U.K. base rate (or based rate) is our IOR.
With the transmission of monetary policy via overnight transactions to the real economy largely via indirect channels (wealth effects, liquidity conditions themselves, exchange rates, the housing market for mortgages with rates directly linked to policy rates, and so on).