Ben Bernanke’s Jackson Hole speech was overshadowed by a new research paper from Michael Woodford titled Accommodation at the Zero Lower Bound (image via flickr/ travelswithkim)
Last week, investors were excited about Fed Chair, Ben Bernanke’s speech at the Jackson Hole summit. Those who were hoping that Bernanke would hint at if/when QE3 would be announced, were happy to the hear the parts of his speech that implied that QE3 was in the works. But what has everyone buzzing about this morning is the research paper that was presented by Michael Woodford, a Columbia economist who is considered to be one of the world’s foremost experts on monetary policy and interest rates.
The title of the paper was Accommodation at the Zero Lower Bound and provides an overview of which monetary stimulus techniques really work when the Fed’s official interest rates have hit ~0%. The main highlight of the paper was that the actual actions of Federal Reserve Banks is not as important as verbal commitments to future actions. What this means is that investors react less to the immediate actions (i.e. dropping rates) and are more interested in future policy. Which, of course, makes sense as the stock market is forward looking.
Couple of interesting points from Woodford:
Standard New Keynesian models imply that a higher level of expected real income or inflation in the future creates incentives for greater real expenditure and larger price increases now; but in the case of a conventional interest-rate reaction function for the central bank, short-term interest rates should increase, and the disincentive that this provides to current expenditure will attenuate (without completely eliminating) the sensitivity of current conditions to expectations. If nominal interest rates instead remain unchanged, the degree to which higher expected real income and inflation later produce higher real income and inﬂation now is ampliﬁed. If the situation is expected to persist for a period of time, the degree of ampliﬁcation should increase exponentially. Hence it is precisely when the interest-rate lower bound is expected to be a binding constraint for some time to come that expectations about the conduct of policy after the constraint ceases to bind should have a particularly large eﬀect on current economic conditions — to the extent, that is, that it is possible to shift expectations about conditions that far in the future.
In layman terms – the Fed should be saying that the red line is where the economy should be, the blue line is where we are now – until the blue line gets to the red line, rates will stay low:
I find this paper to be very interesting, as in the past I have mentioned that I think the Fed needs to do more “cheerleading” to get consumers and investors excited.
To read Mr. Woodford’s paper click here: Accommodation at the Zero Lower Bound