A deviation from the textbook to a complex world of shadow banking and collateral chains
In the traditional Econ 101 explanation of monetary policy, the federal reserve expands the money supply by buying treasuries, thereby expanding the monetary base. Banks use that cash by lending it to businesses that subsequently invest the money. This spending makes its way back to the banks via deposits, thereby adding to the stock of demand deposits and the money supply. A fraction of the deposits, as determined by the reserve ratio, is held in reserve by the banks; the rest is lent out again. This is one of the marvels of fractional reserve banking:The "money" that the fed creates in its open market purchases multiplies itself throughout the money supply through this lending/re-lending process.
Singh and Stella emphasize a different channel of money multiplication: collateral chains. Their fundamental argument is that, in a world of shadow banking, repos, and financial derivatives, a lot of credit creation takes place by pledging the same collateral over and over again, a process otherwise known as rehypothecation. High quality collateral, "safe assets", serves the role deposits serve in the textbook explanation of monetary policy. Safe assets, instead of being deposited like cash, are used over and over again by different firms to obtain financing, thereby expanding the "shadow money supply". Banks who were burned in the past want to limit their loans and try to deleverage. But in this process, banks shorten the collateral chains, make credit less available, and contract the shadow money supply. Central banks can compound the problem by reducing the supply of safe collateral by purchasing the assets in open market operations. As a result, traditional purchases of US treasuries become contractionary. While they may increase the base, they prevent collateral chains from forming and facilitating more credit creation. The cash that financial institutions get from open market operations can't be rehypothecated, and therefore fails to expand credit supplies. Instead, collateral chains contract and this "shadowy" money supply grows more limited. So yes, the Fed can raise prices to any level by printing money. But no, rehypothecation and collateral chains prevent quantitative easing from being fully effective.
Collateralization also brings up the possibility that the Fed could ease not by Quantitative Easing, but rather by Qualitative Easing. Instead of buying up collateral and replacing it with uncollateralizable cash, the Fed could buy up risker assets (mortgage backed securities again?) and replace them with safer treasuries. While it may not expand the size of the Fed's balance sheet, it would help with the collateral chains and expand credit. Fiscal policy then gains new traction, as increases in government debt can
1) Increase available collateral, thereby directly expanding credit
2) Limit the contractionary effect of the Fed's buying of collateral
An interesting corollary of this is that if fiscal policy becomes more effective, the Federal Reserves interest rate forward guidance becomes more powerful. As I've written before, the interest rate guidance would lose its indeterminancy, and change from Delphian to Odyssean. Low interest rates no longer represent low expectations for NGDP, rather they represent a committment to a temporary period of faster than trend NGDP growth. Interest rates aren't low because of low NGDP, but rather in spite of it.
Meanwhile, David Beckworth's NGDP targeting - safe assets story becomes murkier. David argues that, in a world of stable NGDP growth, private sector safe asset creation goes up significantly. So if the Fed commits to a stable NGDP growth path, the collateral chain problem goes away as there's enough private sector safe assets for rehypothecation. But if the NGDP growth path is uncertain, Quantitative Easing won't help. While the initial treasury purchases may marginally increase lending, the credit contraction from collateral chains may cause the policy to be net contractionary. However, the story is still not that simple. Much like currency depreciation in a small economy, there exists a sufficiently large change that would boost growth. Quantitative Easing would only have an effect once it has collapsed collateral chains to their minimum. After that point "printing money and buying assets" would undoubtedly raise NGDP. This leads to a peculiar result when we take Nick Rowe's concepts of nonlinear causality and expectations into account. If the scale of the initial asset purchases is perceived as credible enough to shape future NGDP expectations, even though initial purchases would shorten collateral chains, the supply of collateral would expand as the private sector created more safe assets.
Another lesson we can learn from the debt rehypothecation/shadow money supply story is that nominal GDP targeting has a critical role to play in limiting the negative growth effects of financial regulation. If debt chains serve a function to expand the shadow money supply, then banning debt in a move to a more Black Swan free society can have severe monetary effects, significantly hampering growth. But if the central bank targets nominal GDP (ideally through a mechanism not as bank or debt-centric as treasury purchases), this would help ease in the structural adjustments to build macroeconomic resilience.
Monetary policy is muddled, adjustments are painful, but stable expectations can help. While Singh and Stella's story may not be perfectly applicable now, it is an interesting example of the peculiar nexus of modern finance and modern monetary policy. These uncertainties will only get worse in the future, so it's even more important to find a credible, robust, stable regime now.