Inverted Monetary Policy — A partial solution to stagflation, inequality and high debt levels.

By Dianyi Yang

Abstract

The existing literature has shown that current monetary tools are insufficient to address the current issue of stagflation and have contributed to the pre-existing problems of wealth inequality and high debt levels. Therefore, I propose a new set of monetary tools, namely the “Inverted Monetary Policy” (IMP), as part of the solution to these mentioned problems. I argue that this new set of tools has a disinflationary impact in the short term and redistributive effects in the medium to long term. In a nutshell, this policy “borrows from the future” to suppress current prices, and the cost is paid mostly by the high-income class. Extra fiscal revenue might come as a side effect of this policy. Nevertheless, the policy would involve reforms of the monetary institutions and the fiscal-monetary relationship, and policy-makers need to face trade-offs between different policy objectives.

1. Introduction

As of 2022, central banks in the West have generally reversed their previous position that inflation was “transitory” (BoE, 2021; ECB, 2021; Powell, 2021) and admitted the persistence of inflation as evident in their hawkish turn. Despite the late acknowledgements of the problem, they are far from solving it.

Existing monetary policy tools (including the 10-year-old “unconventional” monetary policies) have only one dimension of “easing” and “tightening”, therefore leaving central banks with a trade-off between economic activities, such as unemployment, growth and inflation. However, due to the supply-side shocks, the current wave of inflation is unusually compounded by the current economic stagnation (World Bank, 2022) and a likely recession in both Europe (Look & Ichikura, 2022) and the United States (Wingrove, 2022) next year. This limits the margin of manoeuvre of monetary policy. The capacity of the central bank to raise interest rates is limited in fear of a severe recession and collapsing markets (IMF). With existing tools, inflation and recession will not be an “either-or” question but rather “both-and”.

Problems associated with previous monetary policy tools:

Past monetary policy tools have contributed to some of today’s economic problems.

The Austrian School has been blaming recessions and economic crises on artificially low interest rates long before the recent crises (Polleit, 2011); excessive borrowing eventually becomes unsustainable when interest rates rise. Later tools, such as the Quantitative easing (QE) have also added to the unsustainable expansion of credit as it functions through lowering the long-term interest rates, which equally encourages borrowing and discourages savings (BoE, 2023). Woodford’s (2016) model suggests that “a combination of the expansion of the central bank’s balance sheet with a suitable tightening of macroprudential policy can have a net expansionary effect on aggregate demand with no increased risk to financial stability”. However, his assumption of a perfectly met inflation target does not rule out more financial instability at a time when inflation is out of control. The mismatch between expectations and the reality in uncontrolled circumstances could induce fear and irrationality in the markets, which could lead to financial instability.

Another problem associated with expansionary monetary policies is increased wealth inequality. İmrohoroğlu & Zhao (2022) find that lower interest rates increase wealth inequality as entrepreneurs benefit from lower financing costs while workers face lower returns on their assets, especially bank deposits. Similarly, Montecino and Epstein (2015) suggest that quantitative easing (QE) is, at best, modestly dis-equalising as equity price appreciations outweigh the positive impacts on employment and mortgage refinancing. Bonifacio et al. (2022) suggests that the effects of interest rates and QE on wealth distribution are ambiguous and depend on the composition of assets and liabilities of households’ balance sheet, whereby wealth inequality rises in societies with lower levels of home ownership. Moreover, Pereira da Silva et al. (2022) found that inequality limits the stabilisation effect of monetary policy. Although there is a negative correlation between wealth inequality and economic growth (Madsen, et al., 2020; Milanovic, 2021), the causal link is to be proven. Conversely, Colciago et al. (2018) suggests the impact of unconventional monetary policies on inequality is also not clear-cut. Nevertheless, the negative impact of wealth inequality on political instability and polarisation is demonstrated, which is a rising concern (Stewart, 2020; Pabst, 2022).

Moreover, significant losses made by central banks are a new feature associated with contractionary monetary policy after massive quantitative easing. Such losses add a burden to public finance. Significant losses to the central banks arise when they raise the interest rates and sell the assets at lower prices, which they previously bought at high prices with lower interest rates; higher interest rates also mean more interests are paid on the reserves held with the central bank. As both asset purchases/sales and interest rates are decided by central banks conducting monetary policy, this is a “self-inflicted harm”. Nevertheless, the losses made by monetary authorities are paid directly or indirectly by the taxpayers. The burden is heavier in places where the “negative dividend rule” applies (i.e. Treasury pays a “negative dividend” to the central bank when it runs a negative net income), such as the UK. On 22 Nov 2022, the Treasury of the UK bailed out the Bank of England for the first losses of £828mn from rate hikes after quantitative easing; the OBR estimated that the Treasury would need to pay the BoE £133bn over the next five years, which outweighs the cumulative profits of £122bn remitted to the Treasury (Giles, 2022). The impact is lower in places where the loss is paid by the central bank itself with future profits, such as the US, Australia, Switzerland, Czech Republic (Reis, 2015; Chaboud & Leahy, 2013). Many economies, such as the Eurozone and South Korea, take a middle approach whereby governments are only required to recapitalise the central banks to when the losses are large enough to deplete the central banks’ reserves (Chaboud & Leahy, 2013). Therefore, public finances are ultimately burdened by the losses made by central banks in terms of direct payment from the treasury to the central bank or reduced remittances from the central bank to the government. Many media (including The Economist and Financial Times) portray this loss for a public authority as harmless, invoking the duty of a central bank being maintaining price stability and minimising unemployment instead of profits, and losses do not impair their ability to conduct monetary policy. But if this loss could be avoided by changing the sequence of the policy tools without affecting the policy outcome (as demonstrated later) — why not?

2. The Four-Period Cycle and Inverted Monetary Policy

This paper proposes a Four-Period monetary policy cycle in response to the business cycle (See Table 1). Among the four periods, two of them (easing and tightening) are considered “traditional”, i.e. existing combinations of policy instruments. For example, the easing period entails the central bank cutting interest rates, purchasing treasury bonds/bills of various maturities through Open Market Operations such as QE or reverse repurchase agreements (reverse repos) and buying domestic equities (e.g. Bank of Japan), not to mention less common tools such as lowering the reserve ratio or currency devaluation through purchasing foreign currencies. The tightening period, on the other hand, is the opposite of the easing period mentioned above.

Table 1 Four-period Policy Cycle

Note: the numbers denote the sequence of policy actions in the period.

The novelty is centred around the periods of deleveraging and leveraging, which involve the combination of seemingly contradictory monetary policy tools. These periods exist primarily for addressing uncommon issues such as stagflation and high debt levels and are, therefore, not commonly used for prolonged periods of time in normal business cycles.

2.1 The Deleveraging Period

Suppose we are in a situation where a tighter monetary policy is inevitable, but the side effects of such hikes are unpalatable (e.g. during stagflation or when private debt levels are too high). Under these circumstances, the economy is not “overheated” with higher-than-trend growth or unsustainably low unemployment. Therefore the central bank would be in a dilemma between leaving high inflation and debt levels unresolved or creating an artificial recession by raising the interest rates.

Nevertheless, this dilemma could be alleviated by the central bank doing the following steps:

1. Selling Treasury bonds/bills (as in a normal tightening period)
2. Raising interest rates (as in a normal tightening period)
3. Buying equities or other non-debt assets.

When buying equities, private placements and debt-for-equity swaps are preferable to buying outstanding stocks from existing shareholders since the former two ways help to improve the firms’ financial situation directly, whereas the latter mainly benefit the shareholders and only indirectly help the firms (when they issue new stocks).

During this process, the tightening steps (bond sales and rate hikes) and equity purchases seem contradictory (we are both reducing and increasing the money supply). Nevertheless, they are reciprocal in achieving lower corporate debt levels (deleveraging): higher interest rates pressurise firms to deleverage through issuing new shares; the central bank’s purchases of newly issued stocks provide injections of new funds into the firms, which mitigates some of the negative effects of rate hikes. Namely, firms no longer need to reduce their balance sheets to service the debt, as they can simply adjust the composition of the liabilities side of their balance sheets (See Figure 1).

Figure 1 Deleveraging of a firm with the help of central bank equity purchase scheme.

To address the two concerns about the central bank exercising voting rights as a major shareholder and being exposed to higher risks as they engage in equity purchases, the preferred stock could be a viable solution to both concerns. Preferred stocks do not bear voting rights; the dividends paid on preferred stocks are more stable and safer than common stocks. Moreover, preferred stocks can be converted to common stocks if the central bank favours this decision over later exiting (selling). To help the commercial banks in a crisis, the central bank could consider buying Basel III compliant bonds, which also count as additional capital for the commercial bank.

For the central bank, rate hikes imply that higher interest rates are paid on bank reserves and the assets it holds are losing value, both of which contribute to a lower net income if not a loss for the central bank. This could affect public finance directly or indirectly as illustrated in the Introduction.

Therefore, the central bank could consider quantitative tightening (QT) before raising the policy interest rate to avoid losses. Wei (2022) from the Atlanta Fed estimates with a simple “preferred habit” model that the impact of active sales of 2.2 trillion USD in 3 years is equivalent to an immediate increase of 22 basis points in the current federal funds rate. The impact is lower in normal crisis conditions than in crisis market conditions. This means that QT before rate hikes minimises central bank losses in two ways — the bond prices are higher before rate hikes, and they could sell more bonds than in a post-rate hike environment for the same policy effect. If central banks would like to exit their quantitative easing programmes, the preferred timing of exit should be before the increase in interest rates. The case for QT as a primary substitute for higher policy interest rates is discussed more in the 2.4 Tightening Period section.

Nevertheless, buying equities in a tightening period would lower the net income of the central bank, if not contributing to a negative net income for a period of time. As illustrated in Figure 2, helping the firms deleverage by buying equities from them entails issuing more interest-bearing bank reserves (same as under normal quantitative easing). However, the dividends that the central bank receives during this period might not cover the interest paid on the newly created reserves, hence lower net income or even a loss. There is a trade-off between profits for the central bank (hence public finance) and economic growth at this stage — buying shares from firms at an earlier stage at higher prices could mean more losses to the central bank now and less profits later, but the severity of the recession would be less (fewer bankruptcies); buying shares at a later stage when prices are lower would result in higher profits for the central bank (and the government) overall but add to the burden of the private sector, which intensifies risks in the next recession. In case of stagflation, the central bank should willingly accept a loss that is financially bearable to the central bank and could be recovered in the deleveraging period, as discussed later.

Figure 2 Central Bank’s Balance Sheet

Over this course, inflation should be curbed by higher interest rates. The larger-than-usual balance sheet due to equity purchases alone does not affect the inflation-curbing impact of higher interest rates as long as interests are paid on reserves (Cúrdia & Woodford, 2011). With the use of non-traditional policy tools such as quantitative easing, the traditional theory of multiplier is unlikely to hold in economies such as the US — changes in reserves are unrelated to changes in lending; the lower level of interest rates is the culprit of higher demands (Carpenter & Demiralp, 2012).

However, structurally this combination of policy tools avoids clusters of bankruptcies of some firms, which can potentially be profitable and competitive in the future once the debt burdens are relieved, which underpins future recovery — an improvement compared with tackling stagflation with tightening only.

As a result, the corporate debt levels are reduced and inflation is curbed, paid for by reduced profits if not losses to the central bank. Nevertheless, the economy would be in a mild recession, but the severity of the recession should be less significant than if the central bank tightened monetary policy without the equity purchase scheme, as there would be fewer bankruptcies.

2.2 The Easing Period

Now we should be in a situation where stagflation has ended — we are now in a mild recession with low inflation, and the economy needs to be reignited. As illustrated at the beginning of Section 2, the central banks should engage in easing policies as in conventional practice.

Nevertheless, it would be beneficial for central banks to purchase long-term treasury bonds before they lower their interest rates to avoid losses and maximise profits — the prices of bonds with longer maturities are more sensitive to interest rate changes. The sequence of buying short-term bills and lowering the interest rates does not matter — the formal is a tool to achieve the latter as under normal Open-Market Operations.

2.3 The Leveraging Period

Now the economy should be in a robust recovery, and it is time for the central bank to realise its profit by reversing what it did in the deleveraging period.

The central bank could achieve this goal by doing the following steps:

1. Buying Treasury bonds/bills (as in a normal tightening period)
2. Lowering interest rates (as in a normal tightening period)
3. Selling equities or other non-debt assets it previously bought.

In a way mirroring the deleveraging period, buying treasury bonds before extensively lowering the interest rates helps maximise the profits for the central bank while achieving the same policy goals.

At this point the stock prices should be high, fuelled both by the low-interest rates and by the recovery of the economy. The central bank should now be selling its holding equities back to the firms or the market.

As shown in Figure 3, the higher stock prices are reflected in the inflated Assets side of the balance sheet of the central bank. By selling the equities now, the central bank could realise a gain from a higher market value of its holdings than when it purchased them. After compensating for previous losses (offsetting the deferred assets) and self-recapitalisation, the rest of the profits could be transferred to the government according to the local central bank laws.

Figure 3 Change in Central Bank’s Balance Sheet After Rate Cuts

Note that there would be trade-offs between the objectives, for instance, economic growth/stability on the one hand and public finances; on the other hand, that a central bank could achieve with IMP. Spreading the share sales more evenly across the leveraging period would entail selling a significant portion of the portfolio at an early stage for lower prices — less profits for the central bank and the government, but the business cycle would be more stable and the risks in the private sector would be less. Conversely, choosing to sell shares primarily in the later stages for higher prices would mean more profits for the government but a more volatile business cycle and more risks in the private sector.

2.4 The Tightening Period

Now we should be in an economic expansion where the economy is overheated — unemployment is low and inflation is above target. This would mean monetary tightening is needed.

As discussed above, existing tightening monetary tools (e.g. higher interest rates, quantitative tightening) as well as equity sales need to be implemented, but in a different order to avoid losses and ensure stability:

1. (Selling equities or other non-debt assets it previously bought).
2. Selling Treasury bonds/bills (as in a normal tightening period)
3. Raising interest rates (as in a normal tightening period)

The continuation of the equity sales is a legacy tool from the previous leveraging period. It could be used as a device to “cool down” an overheated financial market and “prick” a financial bubble without using more harmful methods, such as higher interest rates.

Selling treasury bonds/bills could be a substitute for rate hikes as discussed before (Wei, 2022). The cases against using quantitative easing as a substitute for higher interest rates, as The Economist (2022) suggests, are that empirically the first round of QT in the US starting in 2017 did not show much impact on long-term interest rates and that more QT would signal reduced rate rises, not more, so could cause bond yields to fall — both are disputable. Firstly, the QT round starting in 2017 was passive, i.e. the Fed only stopped reinvesting the proceeds from maturing bonds; it did not involve actively selling bonds held by the Fed. Secondly, the scale of the QT between 2017 and 2020 was too small — it was only $710bn; in contrast, Wei (2022) suggests $2.2 trillion dollars over three years for an impact equivalent to a 22 basis points rate hike. Thirdly, The Economist’s (2022) argument that yields might instead rise as a result of QT due to market expectation of reduced rate hikes is an evidence that the scale of the QT is not big enough, and the central bank fails to provide convincing forward guidance — had the central bank communicated to the market about its goal in terms of bond yields (e.g. “we aim to push up the 10-year yield to 5%”), rather than a “quantitative” commitment in terms of the size of the balance sheet reduction, the impact might have been much bigger.

Once the central bank has depleted its short-term treasury bond/bills and considers its balance sheet to be at a level below which there could be significant systemic risks in the economy, and if the inflation goal has still not been achieved, it could use interest rate hikes as the last resort of tightening device. At this stage, the central bank should just continue its normal interest rate decisions and open-market operations (OMO) until the inflation target is met.

2.5 The Overall Picture

The overall picture of a full 4-period monetary policy cycle involving the IMP is as follows:

Figure 4 The full picture of a 4-period monetary policy cycle, including IMP

Note: Red = selling/tightening, Green = buying/easing.

The deleveraging period matches the peak and early recession in a normal business cycle and could be used whenever stagflation is present or the private sector needs deleveraging. When the economy is strong or the goal is deleveraging, the central bank could start its equity-purchasing scheme in the later stages for a higher profit. However, when dealing with stagnation, the central bank might need to subsidise the economy with its potential profits by starting its equity-purchasing scheme early — but a potential caveat is that the central bank should avoid bailing out inefficient firms and rent-seeking during this process. Details are discussed in the practicality section. Overall, the central bank should be able and is expected to suffer a loss in this period, as long as it could be recovered in the leveraging period.

The leveraging period is when the losses of the central bank are recovered, and trade-offs need to be made. After boosting the share prices by buying bonds and lowering interest rates, the central bank could sell its shares in possession to cover its previous losses and build a capital buffer (recapitalise) itself for the next period. There would practically be no point transferring all of the profits to the government in this period as government revenue would also be increasing and borrowing costs would be low.

A trade-off needs to be made between financial/economic stability and fiscal health. The central bank extracting more profits by buying/selling shares later in the leveraging/tightening periods and more extreme tightening/easing policies would exacerbate the business cycle rather than smoothen it. This trade-off is reflected in Figure 5.

Figure 5 The trade-off between business cycle stability and fiscal health under IMP

However, I propose a hypothesis that this frontier would have a concave shape (i.e. the marginal rate of transformation increases in absolute size as one moves from the top left of the PPF to the bottom right of the PPF), which needs to be tested with empirical evidence or well-designed models in the future. One way of understanding this is that the marginal cost (in terms of lost profits) of smoothing the business cycle is increasing. — the intuition behind this is that to smooth the business cycle, the central bank must advance the starting times of its equity transactions (purchases and sales), rather than by increasing the scale of its operations. Although the transactions per se have a stabilising effect on the business cycle as the central bank is buying in downturns and selling in booms, there is a limit to the volumes of such transactions — buying/selling too much would result in the markets soaring/plunging. However, as the central bank advances the starting times of the transactions, the loss in profits increase exponentially — early equity purchases imply higher prices for all later purchases and more interests paid on reserves; early equity sales imply lower prices for all later sales and forgiving more dividends. Another way of interpreting this is the effects of interest rate and government bond operations. Assuming fixed effects of these operations on business cycle, the marginal benefit of increasing the scales of these operations in terms of profits decreases. Larger scales of rate hikes/government bond sales increases the profits for the central bank by pushing the purchasing prices of equities lower, but the marginal benefit of doing so decreases as the interests paid on reserves are higher, the sale prices of bonds are lower, and the economy is more damaged, which reduces future share prices. Conversely, larger scales of rate cuts/government bond purchases increases the profits by raising the sale prices of equities higher, but the marginal benefit of doing so decreases as inflation dilutes the return and the purchasing prices of government bonds become higher.

The actual shape and position of this frontier, in reality, depends on the third dimension, which is different when the economy is in a normal business cycle or in a recession. In such cases, the action of the government needs to be taken into account; the definition of fiscal health is defined as extra government revenue provided by IMP less the extra government spending in either providing welfare for the poor (under a normal business cycle) or subsidising energy (under stagflation).

2.5.1 3-dimensional trade-offs under a normal business cycle

Under a normal business cycle, the third dimension is redistribution, in addition to the previous dimensions of business cycle stability and fiscal health. Inflation instability is not a concern here as it would be pro-cyclical — under a normal business cycle there are no negative supply-side shocks and inflation is determined by aggregate demand.

A three-dimensional trade-off frontier under a normal business cycle with IMP conceived by me would look like this:

Figure 6 The three-dimensional trade-off frontier in a normal business cycle with IMP

The rationale is that the third axis, representing both income and wealth equality, has a concave shape with the two other axes when the third is held constant. The concave shape between equality and fiscal health arises from the fact that profits are primarily extracted from the rich and this inherently has a redistributive effect. The concave shape between equality and business cycle stability is supported by the fact that ceteris paribus, a stronger fiscal intervention could also help smooth the business cycle through the fiscal stabiliser, and as discussed above, lower inequality improves the effectiveness of monetary policy in maintaining a smooth business cycle (Pereira da Silva, et al., 2022).

Given the “dome-shape” of the frontier, it is, therefore, possible for the monetary policy maker to find a “sweet spot” of the Inverted Monetary Policy.

2.5.2 3-dimensional trade-offs under stagflation

Under stagflation, the emphasis of government fiscal intervention (spending) is on curbing inflation (subsidising energy, etc.).

The new trade-offs are as follows:

Figure 7 The three-dimensional trade-off frontier under stagflation with IMP

There would be a trade-off between fiscal health and price stability: the government could spend more on subsidising energy imports (which is usually the cause of stagflation). This is already being implemented in countries such as the UK (Atkinson & Landberg, 2022). I argue that this trade-off also has a concave shape as long as we assume the diminishing marginal benefits of disinflationary subsidies — when the subsidies are limited to the provision of energy, the reduction in the (currently high) inflation would be significant; nevertheless, if subsidies exist on a large scale across the whole economy, it will boost aggregate demand and devalue the currency which would offset the disinflationary effort.

The concave trade-off frontier between business cycle stability and price stability is understood as a flipped short-run Philips curve.

Figure 8 The trade-off between Business Cycle Stability and Price Stability is just a flipped Philips Curve.

3. Preconditions of IMP

3.1 High degree of financialisation

This is defined by me as high values of non-debt financial markets compared to the size of the economy (market-value-to-GDP ratio). The non-debt financial markets must be large enough to withstand the IMP operations, which will be huge in terms of value to become a reliable source of revenue.

Also, since the private placement scheme involved in the IMP only helps the public listed firms and disadvantages non-listed firms, it is therefore crucial that the former constitutes a relatively high share of the economy.

3.2 High degree of institutionalisation and well-established regulation of the financial system

A high degree of institutionalisation includes but is not limited to, the independence of the central bank. This condition is to prevent rent-seeking during IMP operations.

3.3 Strong anti-corruption institutions and the rule of law.

To prevent rent-seeking during IMP operations.

3.4. A need for a rate hike, whether that be high inflation (most preferable) or a deleveraging strategy

Since the rate hike is inevitably damaging to the economy in terms of growth and unemployment, despite the alleviation by the IMP, since our policy relies on a temporary financial market dip/crash, which in itself is an undesirable outcome, it is best to do it when it is necessary so that the benefits outweigh the costs.

Otherwise, there could be a watered-down version of the IMP whereby the size of the asset purchases is much smaller, and the operation cycles can be shorter (see 2.5 for trade-offs between business cycle stability and other objectives).

4. Practicality

4.1 Avoiding bailouts of inefficient firms

The question of avoiding bailing out inefficient firms is extremely crucial as Acharya et al. (2017) show that conventional quantitative easing by the European Central Bank to lower the cost of capital through excess government bond purchases without a targeted recapitalisation programme and/or forced bank closures have exacerbated the prevalence of Zombie firms, which could lead to economic stagnation. With the IMP, direct equity financing from the central bank might cause more moral hazard problems than indirect financing through the conventional QE.

The central bank could delegate the asset purchase scheme to existing investment banks — for two reasons: Firstly, this could reduce (but not necessarily avoid) rent-seeking behaviour, which is a source of inefficiency — e.g. central bank officials may offer preferential conditions to those with personal connections, etc. Secondly, the central bank might not be capable of implementing this massive scheme on its own — outsourcing to existing investment banks, which are professionals in this job, could be more efficient.

4.2 Central Bank Insolvency

Reis (2015) distinguishes among three types of central bank insolvency when the central bank does not have the full fiscal support from the government: intertemporal insolvency, when the present value of dividends is negative; rule insolvency, when the central bank cannot stay committed to the rule for dividends in its charter without reserves exploding; and period insolvency when there is one period of negative net income.

The full fiscal support should be precluded firstly as it is in itself undesirable (explained in the introduction) as the government would have to make remittances back to the central bank when the government itself is in the worst possible financial situation — when the interest rate is high, and government spending is politically forced to be high (to support poorest families and subsidise energy during stagflation). Secondly, the IMP requires the combination of an expected loss to the central bank during the deleveraging period and a simultaneous remittance to the government at the same time, which is contradictory to full fiscal support.

Therefore, the rule of the central bank should be changed in such a way that allows the central bank to suffer a significant loss in the deleveraging period, given that it could be recovered in the leveraging period. In this way, the rule insolvency and intertemporal insolvency are protected, but the period insolvency is inevitable.

4.3 Government indebtedness

As discussed above, under stagnation, the government would be in the direst fiscal situation. It is therefore plausible for the central bank to transfer funds to the government during this period to avoid government over-indebtedness, despite the guaranteed loss to the central bank during this period. It is crucial that the central bank is independent when deciding the size of the transfer to the government.

In such a case, it would be akin to the helicopter money, which is defined by Reis and Tenreyro (2022) as an increase in the monetary base (when neglecting the simultaneous sales of bonds) and a direct increase in the nominal after-tax income of some private agents. The first criterion is satisfied as on the central banks’ balance sheet. It is a conversion of the bank’s equity to one of its liabilities (government deposits). The second criterion is satisfied as it is used to subsidise the energy sector (increasing the income of energy providers). The difference would be that in this case the extra money is created to lower, not raise inflation to the target.

4.4 Transparency and perfect knowledge

Transparency of the central bank’s operations is not at odds with the IMP. Nevertheless, misunderstandings of the central bank’s intentions or wrong expectations of the reality by private agents would cause a movement along the dome-shaped trade-off frontiers: underestimating the scale of the central bank’s policies or overestimating the volatility of the business cycle could shift the point close to the red axis (more profits and better fiscal health, at the cost of macroeconomic stability); conversely, overestimating the scale of the central bank’s policies or underestimating the volatility of the business cycle could shift the point close to the blue axis (more stable business cycles but with less profits for the central bank).

After all, bad knowledge should not cause a loss in Pareto efficiency (defined by an outcome point inside rather than on the frontier) if it only leads to a movement on the frontier as argued above. Again, this is an untested hypothesis.

5. Defying the theory — the case against the Wallace’s Neutrality

Neil Wallace (1979) famously applies the Midigliani-Miller theorem to government finance, claiming that open-market operations do not have an impact on asset prices, real allocations in the economy or even inflation under certain conditions. Cúrdia and Woodford (2011) summarises these conditions into two assumptions: assets in question are valued only for their pecuniary returns; all investors can purchase arbitrary quantities of the same assets at the same market prices. This is known as the Wallace Neutrality.

Under the assumptions of Wallace Neutrality, any market price of any asset should be determined by the present value of the random returns, calculated using an asset pricing kernel with stochastic discount factors derived from the representative household’s marginal utility of income in different future states of the world (Cohen-Setton, 2016).

A simplified illustration of this which overlooks the stochasticity and the marginal utility of income is as follows:

The core of the pricing kernel is the Discount Cash Flow method (DCF) proposed by Fisher (1930) and Williams (1938). Nevertheless, the Discounted Cash Flow method only evaluates the present value of cash flows for a certain period of time, that is, the Net Present Value (NPV); this has to be combined with a calculation of the Terminal Value when the investor exits. The Terminal Value could be calculated using the Gordon Growth Model.

For the original model using Free Cash Flow to Equity and the Gordon Growth Model:S

Where FCFEt denotes the Free Cash Flow to Equity in the tth time period (year), n denotes the time of the number of time periods to “maturity” or exit, g is the long-term average of growth rate, r is the discount rate, for which I will use the required rate of return.

I would introduce variable discount rates instead of fixed discount rates, and the formula would become

Where ra denotes the discount rate for the time period a and r denotes the long-term average of the required rate of return.

The Discounted Cash Flow is normally combined with the CAPM or WACC techniques in calculating the required rate of return/cost of capital. Nevertheless, the CAPM and WACC require the knowledge of market return/premium, which are unknown variables in the setting of my model. Therefore, the Arbitrage Pricing theory, proposed by Ross (1976), which directly accounts for the change in risk-free rate of return, is adopted. Jagannathan and Wang (2006) have empirically demonstrated with data for the period 1954–2003 that the Arbitrage Pricing Theory is superior to the traditional Capital Asset Pricing Model (CAPM).

According to the APT,

Where ERp denotes the expected return or the required rate of return (r) in the adjusted model; n denotes the sensitivity to the factor of n; Fn denotes the nth factor price, and Rf denotes the risk-free rate of return, which is directly influenced by the interest rates set by central banks.

Therefore, this implies a perfectly elastic supply of this asset at price P0 (evaluated price), assuming perfect knowledge of the future economic conditions and future central bank decisions. As Figure 9 shows, even if the central bank buys an asset, it will not affect the price of that asset. However, empirically, the success of quantitative easing has invalidated this claim as it exactly relies on changing the price of bonds to affect the yield and hence the interest rates. Charoenwong et al. (2021) also review the massive equity purchase scheme of the Bank of Japan since 2011. They have found that BOJ purchases lift valuations, increase share issuances and increase total assets.

Figure 9 The price of the asset is unaffected by the central bank’s purchases/sales.

If the prices of assets do not change, the returns on assets and interest rates will not change, and the real allocations of the economy would be unaffected by the central bank’s balance sheet policies.

Moreover, the value of the asset at the start of the next period will be:

Therefore, the return of the first period is (P1- P0)/P0+(FCFE1)P0= r1, and the return of any period is, accordingly, the required return of that period (ra). In this case, the central bank is unable to generate supernormal returns (i.e. higher than the market return rm).

Also, the Wallace Neutrality argues that the central bank cannot make the risk disappear from the economy (Cohen-Setton, 2016). This is because the losses borne by the central bank will translate into less income for the government (see the last paragraph of Introduction for explanation), which will then raise taxes and transfer the risk back to the private sector, given the fiscal constraint.

So, what could invalidate the Wallace Neutrality in favour of the IMP in practice?

Firstly, the market might misevaluate the central bank’s determination and future economic outlooks — this may cause a movement along the trade-off frontier, as explained in section 4.4.

Secondly, the animal spirits might lead to overvaluation during an economic boom and undervaluation during an economic downturn — this generates more profits for the central bank.

Thirdly, the cost of “borrowing” to the central bank is no higher than the interest it pays on bank reserves — this is always lower than the cost that normal investors bear when investing — implying more profits for the central bank.

Fourthly, the assumption that all investors can purchase arbitrary quantities of the same assets is not upheld in reality — smaller investors are restricted by the availability of cash and loans and face higher borrowing costs than big investors, especially during recessions. This again benefits the central bank, whose borrowing is virtually unlimited.

Fifthly, the private placement scheme dilutes the value of existing shares — this impact is difficult to take into account in reality.

Sixthly, a model by Roger Farmer (2016) shows that assumptions of finite lives with overlapping generations, multiple equilibria and a belief function that is heuristic in forecasting based on data could make unconventional monetary policy work “in theory”.

Lastly, assets are not held only for pecuniary returns in reality. This is especially important for equities as transactions by major shareholders may have implications for market confidence, the control of the firm and so on.

6. Concluding remarks

The IMP policy framework incorporates previous monetary policy tools and introduces new tools (private placement); these tools are reorganised in a four-period policy cycle to achieve objectives such as tackling stagflation, cooling/heating the economy, increasing government revenue, deleveraging the economy, etc. Adjusting the timing and the scale of these tools allows policy-makers to choose an optimal policy outcome between three objectives under normal business cycles or stagflation. One caveat is that some preconditions are required before implementing the IMP to achieve the optimal outcome, which is usually met in developed economies. However, this framework defies the conventional baseline model of the Wallace Neutrality. Instead, it relies on the deviation of reality from this model to function. Future research could centre on mathematically modelling this framework and prove/disprove it with an improved model based on the Wallace Neutrality while considering the factors I mentioned. Moreover, I did not take into account the international dimension — the effects of capital flight and exchange rate policies could have huge implications on the IMP. The international factors are unlikely to completely invalidate this framework, though. After all, other major economies might just follow suit. It would be an interesting field to investigate what would happen if this is not the case. My intuition is that the exchange rate fluctuations will work toward the inflation and (normal) business cycle objectives of IMP, not against them. The capital flows of equity and hot money will offset each other to an extent. Finally, if this framework gets to be implemented in reality one day, empirical research on its effects could follow.

This article was written by Dianyi Yang, an economic research analyst within the Central Banking Society’s Economic Research Division. This article was reviewed by Yating Zhang, the present Head of Economic Research.

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