No Monster At The ZLB, Just Supply

Before Chuck Yeager broke the sound barrier in his experimental Bell X-1 aircraft, it was long thought by many to be an extremely difficult challenge if not impossible altogether. Many test pilots spoke of a monster that lay beyond the speed of sound, one ready to destroy any human machine attempting to go faster. In fact, a year before Captain Yeager’s triumph, Geoffrey DeHavilland was killed when his DH-108 disintegrated near the barrier, with many witnesses on the ground reporting a sonic boom.

In economics, there remains today a similar constraint though one not nearly as useful in fact as well as in theory. Economists loathe the Zero Lower Bound (ZLB) mostly because it is a limitation on what they might do. Nominal interest rates can’t be negative (yet), so getting monetary policy into the Twilight Zone of the ZLB is an experiment in fantasy.

Not for lack of trying, of course. The Japanese have been struggling with nominality for decades now. Western central bankers have been well aware of the Bank of Japan’s inability to make much of it, but instead of reworking their theories they blamed the Japanese for poor execution. Now a decade after the global monetary panic, nobody wants to talk much about QE at all anymore.

The theory was relatively simple and plausible. To generate “stimulus” at the ZLB meant emphasizing real interest rates rather than nominals. Economics had moved already in that direction as a result of the 1970’s, where it was realized that there was often a large difference between them. Economic behavior was dictated by real interest rate experience.

To achieve negative real interest rates a central bank needs only to create positive inflation expectations. That’s it. Since, in the words of Ben Bernanke, it possesses the printing press it merely has to threaten to use it in order to push inflation expectations upward. People who believe that money printing is going to happen will act today in anticipation of that happening. Expectations for prices rise, real nominal rates fall, even at the ZLB, and the world benefits by “stimulus.”