Wednesday, April 16, 2014

Interest Rate Targeting and Finanical Instability

David Beckworth linked to slide program by Michael Darda.   I agree with Darda's analysis in general.   I would emphasize that it is like 1936.   Spending on output is far too low, but at least some at  the Fed are worried that "loose" money is causing excessive speculation.   We can only hope that we don't end up with the same result--a steep recession in an economy that is already below potential.

Still, I am more and more concerned that Federal Reserve policy tends to cause problems with financial instability.   The problem, however, isn't maintaining the nominal anchor, but rather targeting interest rates.   More generally, the problem is interest rate smoothing.   However, in the current situation, the problem is an attempt to generate a recovery by promising to keep interest rates low.

Interest rate smoothing is a policy by a central bank to keep money market interest rates stable.   Of course, there is probably no central bank today that tries to keep interest rates fixed beyond a very short time horizon.   Typically, they adjust interest rates periodically in order to keep inflation on a target, though in the U.S. they also most promote full employment.   What interest rate smoothing amounts to is a commitment to keep interest rates unchanged as long as inflation remains on target and real output at potential, and if deviations occur, adjust interest rates in a series of modest steps.   Mainstream macro usually works on the assumption that the changes in interest rates occur once and for all based upon the size of the deviation of inflation or real output from target, and interest rate smoothing then is a modification of the Taylor rule so that the current interest rate is adjusted to the target through a series of modest steps.  This should have little adverse effect because everyone is assumed to understand the underlying rule.  Knowing that the policy rate will adjust soon, longer term rates adjust promptly to their expected long term level.   And it is these longer term interest rates that impact spending decisions.   And expectations about these spending decisions are what determine production and pricing decisions, and so real output and inflation.

So, why interest rate smoothing?   In my view, it is one of those situations where mainstream macro is simply following the lead of central bankers.   They like to smooth interest rates, and mainstream macro shows that it is consistent with macro stability.   Rationalizing what central bankers want to do somehow ends up playing a key role in mainstream macro.  

But why do central bankers want to smooth interest rates?   Surely, the underlying reason is that money center financial institutions borrow on money markets.   A key role of financial intermediation is to borrow short and lend long.  Even traditional investment banking has involved borrowing short to underwrite stocks or bonds.    If short term interest rates spike, this is costly to financial institutions.   Keeping short term rates fixed avoids those problems.   Of course, keeping short term interest rates fixed is a recipe for inflationary disaster, and impossible.   Still, it is possible to manage the short term rates so that the adjustments are slow and steady.   And this allows the financial intermediaries to make needed adjustments.   While mainstream macro makes all of this very mechanical--rule driven--central banks have never implemented such a policy.   And so, needed adjustments in interest rates can be implemented in a way that allows money center banks to make needed adjustments in their balance sheets in a smooth way.  

From a monetary disequilibrium perspective, there are two different sources of interest rate fluctuations.    Focusing on increases, one possibility is an excess demand for money.   By money, I mean the financial instruments used as media of exchange.    An excess demand occurs when the existing quantity of money is less than the demand to hold it.   Those short on money may sell off short term assets they hold for his very purpose or perhaps borrow--effectively issuing and selling new money market instruments.   This will tend to cause money market rates to rise.   From a monetary disequilibrium approach, the solution is to increase the quantity of money to accommodate the demand.   It is also important to consider the possibility of lowing the interest rate paid on financial instruments used as money to reduced the quantity demanded.

The other reason interest rates might spike is because of an excess demand for credit.   This could occur because of an increase in desired borrowing to fund purchases of capital goods or consumer goods.   Or it could occur due to a decrease in desired lending.   It could be that firms choose to lend less and instead internally fund purchases of capital goods.   Or it could be that households are saving less.   From a monetary disequilibrium perspective, the interest rate should rise to bring the credit supplies and demands into balance.   More fundamentally, the interest rates should rise to coordinate saving and investment.   If the monetary regime is such that the quantity of money rises or the demand to hold money falls, creating an excess supply of money, this is a failure.   The result is that interest rates fail to adjust enough to keep saving and investment equal, and instead total expenditure fluctuates.  A central bank with a policy of interest rate smoothing is purposefully causing monetary disequilibrium to keep the interest rate from adjusting enough to clear the supply and demand for credit.   Avoiding an interest rate spike due to an increase in the demand for or decrease in the supply of money is generating an undesirable excessive increase in spending on output.

From the point of view of individual money center banks, it hardly matters whether an increase in interest rates is due to an increase in credit demand--more investment or less saving--or a shortage of money.   Their borrowing costs increase either way.   But from the point of view of maintaining monetary equilibrium and so, overall macroeconomic equilibrium, it makes a difference.

A policy of interest rate smoothing then, keeps interest rates too stable.   This means that financial intermediaries have less risk and can operate with more leverage.    This makes financial institutions more likely to fail due to those increases in interest rates that the central bank finally approves to avoid inflation.   However, as explained above, slowing any needed interest rate increase can give financial institutions time to adjust. 

However, interest rate spikes are hardly the only thing that might go wrong for financial intermediaries.  Bad investments, such as investing into a speculative real estate bubble, can also generate losses.   

Of course, a monetary regime that allows monetary disequilibrium to generate fluctuations in money market interest rates will create even more risk to financial intermediaries from interest rate spikes.   And so, they would tend to have more capital and less leverage than an ideal regime that always adjusts the quantity of money to the demand to hold it.   Further, if the monetary regime allows that disequilibrium to fester, so that spending on output, production, and prices all decrease due to a shortage of money, the solvency issues that creates for financial intermediaries will greatly increase their motivation to limit leverage, have ample capital, and even hold higher reserves.  

But surely, creating fear for financial intermediaries is hardly a sufficient reason to have a monetary regime that periodically results in recessions and deflation.    Still, a monetary regime that seeks to protect financial intermediaries from all short term increases in interest rates to the degree possible, is creating extra financial risk as well as tending to generate booms in output and inflation.

Wednesday, February 12, 2014

More on Negative Interest Rates

Miles Kimball wrote a kind response to my previous post.  However, it was quite critical.   One small advantage that I have over Kimball is that I regularly read his blog, and so am familiar with his arguments.   In fact, I have written posts in response to a number of the points he brought up.

Most of his points amount to criticism of nominal GDP level targeting.   While I favor that  regime, I grant that it falls short of perfection.   However, I have not yet been convinced by Kimball that price level targeting is better.

My approach to supply shocks is fundamentally microeconomic.   It roughly follows the analysis in Selgin's monograph, "Less Than Zero."    I suppose that an "oil price shock" is the sort of supply shock that concerns me, though a shift in supply for any single good or service creates the same issue.

If there is a shift in supply for a single good in a multi-good economy, the least bad option is for the price and quantity of that particular good to change without any response by the macroeconomic regime.   In particular, generating monetary disequilibrium to force all of the other prices in the economy, including nominal wages, to change in the opposite direction to stabilize some price index is an undesirable policy.  

Now, Kimball has that problem solved.  First, he proposes to only stabilize the price level within a broad band.   Make the band broad enough, and then, sure enough, any change in the price level due to a shift in supply of some particular good can be ignored.   Second, he proposes to stabilize "core" inflation, and ignore volatile prices.   Any shift in supply of any of the goods whose prices are counted as volatile will be ignored.    And finally, he proposes that a new price index be stabilized, one that focuses on sticky prices.   Any shift in supply of any good with a sufficiently flexible price will be ignored.

I think a target growth path for spending on output is superior to all of these fixes for price level targeting.   I am very open to the use of bands in monetary rules.   These rules are best understood as constraints on the monetary regime.   However, making the band so broad that changes in the price level due to shifts in the supply of particular goods are likely to stay within the band is not constraining enough.

Since I favor targeting the growth path of spending on output, I naturally would consider some shift in spending away from trend under Kimball's approach to price level targeting.   For example, suppose spending on output falls.   Some prices fall as well.   Almost by definition, these would be the flexible ones.   Some of them might be volatile as well.   The low relative prices of those goods discourages production, even though markets clear.   And firms with sticky prices reduce production to prevent an excessive build up of inventories.   The central bank can congratulate itself on keeping the price level within its wide band, and really it was only the volatile and flexible prices that shifted.   It sounds like 2008 to 2014 all over again.

Of course, if we require that the central bank also manage the output gap, then there would still be a problem with the scenario above.  But we know that there are central bankers that will consider a job half done (price level target achieved, at least) as good enough.  And further, there are plenty of economists who can cast quite plausible doubts on any measure of the output gap.

Keep nominal GDP on a target growth path, or within a narrow band, is a simple rule.   For those of us who believe that the discretion of central bankers should be limited, that is an important criterion.  That it is the same thing as keeping the quantity of money on a stable growth path in the special case where velocity is constant is also important.  The central bank is not using monetary policy to manipulate the economy--it is just accommodating shifts in velocity.

Kimball cites a paper that argues that the price level should be stabilized in the face of  a positive productivity shock  That was in response to my statement, "Negative interest rates to prevent unusually rapid growth in productivity from causing deflation seems like a very bad idea."    

Here I had in mind the arguments made by David Beckworth.   Productivity rises, pushing inflation below trend. But the natural interest rate rises due to the additional productivity growth.  The Fed keeps interest rates low to get inflation back up to its two percent target.   If, like Kimball and I, you favor a trend inflation rate of zero and an ability to have short and safe interest rates less than zero, then this sort of scenario could play out with deflation and negative short and safe interest rates aimed returning the price level to target.

However, I am really more concerned with the following scenario.   Peace breaks out in the Persian Gulf.   Oil prices drop significantly.   The CPI in the U.S. falls significantly.   The natural real interest rate is little impacted, but the deflation is greater than the real interest rate.   To keep the CPI stable, it is necessary to generate increases in the prices of other goods and services, including nominal wages.   The nominal interest rate is pushed below zero to cause the real interest rate to fall below the natural rate, generate a boom, increase the prices of goods and services other than oil, and create a sufficient shortage of labor to raise the growth path of nominal wages.   What a bad idea.

My understanding of Kimball's argument is that the scenario is quite different.    Labor productivity rises.   During the adjustment period, there is a decrease in labor's share of income and an increase in capital's share of income.   In the long run, continued saving and capital accumulation returns the income shares to the initial values, consistent with steady state growth.   If nominal income shifts up to a higher growth path, total nominal wage income can continue on an unchanged growth path and capital income can rise to a higher growth path.   Nominal wage rates can continue on an unchanged growth path.  As the economy adjusts to the long run steady state and the share of labor income recovers, nominal wage income shifts to a higher growth path as do the nominal wage rates.   Capital income shifts down to a lower growth path.

While I wouldn't describe this as a reason why the price level should be kept stable, I might see this as a reason why stabilizing the growth path of wage income is better than stabilizing total nominal income.   Glasner and Sumner both have argued for stabilizing the growth path of a wage index for much the same reason.    These are the sorts of reasons why most of us understand that nominal GDP level targeting is not perfect, just better than inflation or price level targeting.

How important is this problem in the real world?   Was employment stabilized by the Fed's efforts to keep inflation stable in the face of more rapid growth in productivity?   I am doubtful of any overall boom in 2002, but I do think there was a boom in late nineties.  A cursory look at the time series shows a bump in nominal GDP, real output and employment above their long run growth paths.  

As for free banking, I think Kimball has not fully internalized the idea of a monetary regime where hand-to-hand currency is not base money.   If base money solely takes the form of deposit liabilities of the central bank, then currency just isn't that important.   Sure, it has some advantages for some transactions.   Some of those transactions are even legal.   But there is no need to worry about financial collapse if there is a temporary suspension of hand-to-hand currency payouts when the currency is not base money--when the deposits are not defined as promises to pay currency.  

I have been interested in such systems for a long time.   While the term "free banking" is sometimes identified with a system with no central bank, full privatization of hand-to-hand currency is consistent with all sorts of monetary policies directed by a central bank.      In my view, having the central bank provide deposit accounts directly to the public or manage a currency at a varying exchange rate is just a bit too rube goldberg.    Of course, I admit that any government dominated scheme, no matter how convoluted, is more politically feasible than complete privatization of hand-to-hand currency.

Friday, February 7, 2014

Kimball on Ending Recession and Inflation

Kimball has an interview on Wonkblog about electronic money and interest rates.    I am not sure where the "ending recessions forever" actually came from, but that seems a bit oversold.   I don't think all recessions are associated with the zero nominal bound.   Surely, there are some supply side recessions.    Allowing short and safe interest rates to fall below zero would at best make potentially deep recessions that drive the nominal interest rate to zero a bit milder.

However, since central banks can expand the quantity of money enough to avoid a deep recession, negative interest rates really allow the central banks to continue with "business as usual."   A central bank can focus on a short and safe interest rate.  Further, the needed increase in the quantity of money would be smaller.  A negative interest rate on reserves will reduce the demand for reserves.   It should be possible to have a "bills only" monetary policy.

Kimball also says that electronic money will end inflation.   Here he depends heavily on the notion that the reason for having trend inflation is to keep nominal interest rates higher on average and reducing the chance of hitting the zero nominal bound.    In other words, again, the "problem" with zero trend inflation is that it interferes with central banks' "business as usual."  That is, focusing on periodic changes in a short and safe interest rate. 

I favor a stable price level on average, but I think that the price level should rise with adverse supply shocks and fall with favorable supply shocks.   Trying to keep the price level fixed would result in deeper recessions with adverse supply shocks and tend to cause booms with favorable supply shocks, even with electronic money.   Negative interest rates to prevent unusually rapid growth in productivity from causing deflation seems like a very bad idea.   

Kimball is very skeptical of suspending currency payments as a solution to the zero nominal bound.   Perhaps the reason I find it less troubling is that I know that free banks in the 18th century had an option clause to allow the suspension of currency payments.   Governments interfered with freedom of contract, and the option clause disappeared.   But in practice, suspensions occurred regularly in the 19th century.   They were just illegal.  

On the other hand, I favor the private issue of hand-to-hand currency.   As long as private currency isn't government insured, the interest rate on central bank reserves and Treasury-bills might be quite negative before anyone decides that bank-issued currency is a better store of wealth.  



Tuesday, February 4, 2014

Robert Murphy on the Minimum Wage

Robert Murphy reviewed some of the literature regarding the minimum wage on Econlib.  I found the article helpful and interesting.

Simple supply and demand economics suggests that any price floor, including the minimum wage, will create a surplus.   The quantity demanded will decrease and quantity supplied increase relative to the equilibrium levels.  

However, the conventional wisdom on the quantitative magnitudes is that the demand for labor is highly inelastic.   That means that while a higher wage reduces the amount of labor firms will hire, it doesn't reduce it much.   Inelastic means that the reduction in quantity demanded is less than in proportion to the increase in the wage.    "Highly" inelastic means much less than in proportion.    Only "perfectly inelastic" demand would mean that there is no decrease in employment.

Murphy argues that even if the demand for labor is highly inelastic, a surplus of labor will be generated due to the increase in the quantity of labor supplied.    He emphasizes that this surplus of labor will still make it difficult for some to find work.    Say, for example, youths from impoverished backgrounds.   

For example, Bobby middle class sits at home playing computer games.   While he could get a job, the money isn't worth that sacrifice of leisure.    Dave from the inner city, works at a low minimum wage for Pizza Inc.   The minimum wage is increased.   Bobby now finds it worthwhile to work.   Pizza Inc. thinks Bobby is well spoken and clean cut.   They never really liked Dave's gold tooth.   So, Bobby replaces Dave.   Dave needs a job still, and is especially interested in getting one now that the pay is better.  

This story fits in well with the evidence that most minimum wage workers live in households with total income well above the minimum wage.   However, there is another story that I find interesting as well.    Suppose the D- students drop out of school and get minimum wage jobs.   The minimum wage rises, and so now, the C- students drop out of school and get minimum wage jobs.   What happens to the D- students?   Do they stay in school?   Or do they hangout on the street corner unemployed?   Employment is not impacted, but the most disadvantaged employees get nothing.

Murphy mentions also that many studies suggesting that the demand for unskilled labor is perfectly inelastic or is even positively related to wages, focus on how higher wages reduce turnover.    I think that point deserves more emphasis.

As before, Dave works for Pizza Inc. at a low minimum wage.   After a year or two, he finds a better job that pays better than the minimum wage.   Pizza Inc. replaces him by hiring Dave Jr.   Dave Jr. works for a year or two, and then moves on to a job that pays better than the minimum age.

Now,  suppose the minimum wage is increased.   Pizza Inc. doesn't fire Dave.   Rather Dave stays on with Pizza Inc. for five years.   Eventually he moves on, but in the meantime, Dave Jr. is unemployed.       Of course, Dave Jr. does eventually get hired when Dave goes on to a better job.   But Dave III isn't being hired.  

Instead of having low skilled workers pass through low wage employment in a way that provides training for more skilled work, all work is paid like the more skilled work and workers capable of doing the more skilled work do less skilled work.   For those patronizing unionized grocery stores, we see the middle aged man supporting his family by bagging groceries.   In Charleston, South Carolina, for the most part, teenagers bag groceries.   

The story about Bobby and Dave suggests that "jobs" are being misallocated.   They aren't going to the workers who need them most.   But the story of Dave and Dave Jr. implies that labor is being misallocated.   It isn't going to the most productive uses, and poor Dave Jr. is left unemployed.

Saturday, January 11, 2014

Testing Market Monetarism

Krugman claimed that 2013 would be a test of Market Monetarism.   Market Monetarists rejected that claim, because the Fed didn't target the level of nominal GDP.   The Fed didn't give up on interest rate targeting.   The Fed continued to pay interest on reserves.    It is also true that the Fed didn't start trading index futures contracts on nominal GDP.   (Even I count that last one as asking a lot.)

Kling has accused Sumner of making Market Monetarism irrefutable.    Kling said that suppose the Fed said that it was targeting the level of nominal GDP, but the business cycle continued as before.   Market Monetarists would either accept that targeting the level of nominal GDP did no good, or they would say that the Fed was not really targeting the level of nominal GDP.   He said that he anticipated that we would do the second thing.

I think this is due to Sumner's claim that nominal GDP expectations are the stance of monetary policy.   Sumner argues that actual nominal GDP varies little from expected future nominal GDP, and so that when nominal GDP changes, especially if the change is significant, it was due to changes in expected future nominal GDP.   And that means it changed due to a change in the Fed's monetary policy stance.

How could this be refuted?   I think Kling has in mind a situation where actual nominal GDP deviates from the target, and fluctuates as before.   If shifts in nominal GDP are defined to be loose or tight monetary policy, then nominal GDP level targeting hasn't failed.  The Fed has failed to implement the proper monetary policy by definition.

But that isn't all there is to Market Monetarism.

In my view, the most obvious test would be a situation where nominal GDP does remain close to the target growth path, but the business cycle, understood to be fluctuations in real output and employment, continues as before.   Obviously, inflation would be strongly countercyclical.  

Now, Market Monetarists believe that booms and busts would continue to exist even with perfectly successful nominal GDP level targeting due to supply-side factors.   So, the test would be whether there really are any "demand-side" business cycles.   Or, whether an alternative regime, like inflation targeting exacerbates supply-side recessions.   I think the test would need to compare the fluctuations of real output and employment under a period of nominal GDP level targeting to some other monetary regime.  

Of course, it might be possible to actually identify supply side factors directly.   Are the business cycles under nominal GDP level targeting more closely related to various supply side factors?

Now it would be really interesting to see how nominal GDP level targeting performs with a financial crisis.   If nominal GDP remained on target, but real output fell and inflation rose, presumably because of the inability of the financial sector to efficiently allocate credit, then that would count against nominal GDP level targeting.  

But Kling isn't worried about that sort of test.   It is rather the central bank adopts nominal GDP level target but fails to hit the target.  

One possibility is that nominal GDP fluctuates exactly as before, but around the target.    That would be the most challenging scenario.   How hard are they trying keep nominal GDP on target?     Of course, if they say, we can't do it because short term interest rates would change too much, or the quantity of base money would change too much, then we would say they aren't really trying.   They are targeting the level of nominal GDP subject to the constraint that something else, such as money market interest rates, remain within reasonable bounds.

On the other hand, if nominal GDP was below target despite interest rates on reserves being negative, a significant currency drain, and the Fed owning every asset it can legally own, then that would count against Market Monetarism.    Sure, we could say that they could still do more, but Market Monetarists generally argue that with a nominal GDP level target, they should be able to raise nominal GDP.

On the other side, if nominal GDP was above target even after the central bank has sold off all of its assets, then maybe they are doing the best they can.

Of course, if nominal GDP is fluctuating around the  target, it is possible that the changes in base money are excessive and causing overshooting.

But what about a different scenario.   Suppose nominal GDP shifts to a new trend, and the Fed is committed to return to the target growth path, but nothing it does shifts nominal GDP.    If the problem is not excessive fluctuations around the target, but rather stabilizing below target, then the test of whether they have bought all the assets they can or sold off all of their assets would be telling.

If they were really trying and nominal GDP would not move to target, that would count against Market Monetarism.

Interestingly, Market Monetarists argue that a nominal GDP level target would generally require more modest changes in base money or interest rates than inflation targeting.   This is because of automatic stabilizing features of the regime.   This could be tested by looking at the variation of base money or interest rates controlled for deviations of the goal for target.

Finally, there is the test of whether the market expectation of future nominal GDP strongly impacts current nominal GDP.   If the expectation of future nominal GDP can be measured, and it stays on target, but nominal GDP fluctuates as before, then this would be a test of that view.

However, the better test would be if nominal GDP were expected to deviate from target, and it really stayed the same.  

Suppose nominal GDP level targeting is implemented, and the market shorts nominal GDP contracts.   The Fed takes the opposite long position.   Nominal GDP remains on target.   This would count against Sumner (and my) view that index futures convertibility is desirable.

Secular Stagnation and Asset Prices

One of Summers' arguments for fiscal policy is that the low interest rates generated by monetary policy results in excessively high asset prices.

While it is true that given the expected return on an asset, a lower interest rate raises the asset's present value, the problem is supposed to be "secular stagnation."   There is an excessively high supply of saving and excessively low demand for investment.

But the low demand for investment is being generated by low expected returns on real investment.   Given the interest rate, that results in a lower present value of an asset.   And to the degree that excessive saving is driving down the marginal return on investment, the result is the same.

And so, secular stagnation should lower asset prices at a given interest rate. The lower interest rate, then, simply dampens the decrease in asset prices.

To the degree there is a decrease in the quantity of saving supplied and increase in consumption due to the lower interest rates, the fundamental value of the assets falls.  

If the supply of saving were perfectly inelastic with respect to the interest rate, then the interest rate must fall enough so that despite the lower expected return on investment, asset prices remain the same, and so it remains profitable to maintain real investment expenditure.

Now, it is also true that if there are fewer low risk, high yield projects available, the rational approach to investment is not simply to exploit equally low risk, lower yield projects.   It is also sensible to exploit higher risk, equally high yield projects as well.   There is nothing wrong with "a reach for yield."  It is perfectly rational.

Of course, it would probably be more sensible for households to purchase equity to avoid lower yields rather than keep their money in banks that claim to promise the same safety without a reducing yield.   In other words, to the degree a bank wants to promise depositors the same safety, it should lower the interest rate it pays enough to make it possible to fund a lower yield, equally safe asset portfolio.   Those depositors who want a higher yield should buy stocks.    

But if depositors want to earn a higher return and take a higher risk on deposits, should it be forbidden?   I don't think so.   But I don't think they should have government deposit insurance or even a lender of last resort.  

What should be done instead?   Option clauses and rapid resolution of insolvent institutions.   

And most importantly, nominal GDP level targeting so that financial problems don't cause persistent shifts in the growth path of spending on output.

Finally, if the central bank is using a policy interest rate to target inflation, and the growth path of spending falls, and the lower spending results in depressed real output, and it is that depressed real output that reduces expected future returns and so equity prices, then if the central bank shows a willingness to shift to a more sensible policy, stock prices will rise because of the higher expected returns.  

Now, suppose that to keep stock prices from rising, a foolish monetary policy is maintained.   Instead, the national debt is increased enough so that national saving is low enough, that the interest rate that keeps saving and private investment equal prevents any increase in expected returns so that stock prices remain depressed.   Further aiding this policy is the possibility that business profits will be taxed in the future to pay the interest on the national debt.   By reducing expected future after tax profits, that will also keep stock prices depressed.

I think this would be a really bad policy.



Rowe on the Liquidity Trap


Nick Rowe argued that the zero nominal bound is an illusion and that the real issue is the desired size of the central bank's balance sheet.

I agree that the zero nominal bound is largely self-inflicted by central banks, but I don't agree with Rowe's argument.   He argues that there is a spectrum of assets that are more or less liquid.   The more liquid, the lower the yield.   This creates a continuum of assets with progressively higher nominal yields.   Rowe's point is that there is always some asset that is close to the zero bound.    An expansionary monetary policy generates a perfectly liquid asset by purchasing a somewhat less liquid asset.   If the central bank buys up the most liquid nonmonetary assets first, and then goes to progressively less liquid ones, then it will always be pressing against a zero nominal bound.   The only question is how far it must go to keep inflation (or the level of nominal GDP) on target.  

I think there is an element of truth in this argument, but I am pretty sure that with competitive issuers, a highly liquid asset can have a substantially higher nominal yield than currency.    Checkable deposits are extremely liquid, but their yield depends on the return that banks can earn on their asset portfolios and the cost of providing intermediation services.

But this high yield creates an incentive to deposit currency.   Doesn't that result in banks lending more, driving down the returns on their portfolios, and so the yield on deposits?    Not if there a nominal anchor, like a growth path for nominal GDP.   The quantity of currency is reduced to match the lower demand for it.   The implicit yield on the services provided by currency rises to match the yield on deposits.  

Now, suppose rather than conventional banking, the only option is to either hold currency or else competitively-issued bonds.   The issuers fund real investment projects.   There are costs to underwriting the bonds.   Further, there are transactions costs to managing "cash."     But does the nominal yield on these bonds have to approach zero?   That is, will people buy the bonds, driving down their yields, and I suppose fund more real investment projects until those yields are driven down?   No.  With a nominal anchor, the quantity of currency is reduced to meet the demand.  

As Rowe surely knows, the whole point of Friedman's optimum quantity of money is to generate a deflation rate so that these competitive nominal interest rates are driven to zero, raising the demand for currency.   The implicit nominal yield is driven to zero.   And, of course, the high real demand for currency in this situation implies a larger real balance sheet for the central bank.  

Still, I agree with Rowe that the zero nominal bound is largely self imposed.    Suppose the central bank issues currency.   However, it is prohibited from buying government bonds.   It solely buys corporate bonds.   The corporate bond market it entirely made up of 10 year notes.   The corporations fund risky investment projects, but they are mostly diversifiable.   The central bank's asset portfolio isn't very risky.   Even so, if the central bank were to become insolvent, the government promises to bail it out.    The interest rate on these corporate bonds is 8 percent.   The quantity of currency is $6,000 billion, and nominal GDP is $15,000 billion.

There is a national debt.   It is very small, only $1 billion.   It is funded entirely by T-bills.   The government runs a slight budget surplus, so the outstanding national debt is generally decreasing.   The T-bills are very liquid.    Some people manage their cash positions using the T-bills.   The yields are only 2 percent and have been dropping over time.

The central bank has noticed that when it expands the quantity of money by purchasing corporate bonds, the yield on T-bills falls.   And further, when people are short on money, they reduce expenditures on a variety of things.   Those who have fewer receipts are also short on cash, so they reduce expenditures.   However, those who hold T-bills to manage their cash balances sell them when they are short on money, raising the yield.

The central bank decides to target the T-bill rate.   It is pretty effective.   New Keynesian economists develop complicated models where consumption depends solely on the T-bill rate.   They even have models explaining the relationship between the yield on T-bills and the yield on corporate bonds.   The corporate bond rate is equal to the expected future T-bill rate plus a risk premium.

Now, suppose the government pays off the entire national debt.   There are no more T-bills.   There is no yield on T-bills.   Does monetary policy become ineffective?     If the only short and safe asset is currency, does monetary policy become impossible?  

Well, the demand for currency will rise because T-bills can no longer serve as money substitutes, but given the numbers I described, this is just a drop in the bucket.   Those who were managing their cash positions no longer earn a return.   Like everyone else, they just use zero nominal interest currency.

Clearly, all that changes is that the central bank's previous target can no longer be used   The central bank can still purchase and sell the corporate bonds as always.

While I can imagine New Keynesian economists insisting that the government run a budget deficit and issue some T-bills so that all of their models still work.   I can imagine central bankers taking the same position so that they can get back to business as usual.    But I can't imagine any economist thinking that monetary policy is ineffective.

Now, suppose the national debt isn't paid off, but private investors worry more about losses on corporate bonds.   Those most worried sell the bonds and buy T-bills.    The yield on T-bills is driven to zero.   That is, the $1 billion of T-bills that are outstanding now have a zero yield.    If people worried about the risk of corporate bonds still want more safety, there is no benefit to buying T-bills rather than just holding currency.   Perhaps the demand for currency rises substantially.

Is monetary policy impossible?   No, the central bank can continue to buy corporate bonds as usual.  Presumably, the sale of corporate bonds and purchase of T-bills and accumulation of currency would tend to raise the yield on corporate bonds.   The central bank can buy the corporate bonds, accommodate any increase in the demand for currency, and even reverse the increase in the yield on corporate bonds.

Of course, if there is a different story, where the supply of corporate bonds falls substantially, and the demand for them rises substantially as well, either directly by private investors or indirectly through a demand for currency.  Then, perhaps, corporate bonds would reach the zero nominal bond.   

But this account shows, much as Rowe was arguing, that monetary policy does not break down just because the shortest, safest, and most liquid security has a nominal yield of zero.