Category Archives: Monetary Economics

Money, Finance, and Nominal GDP

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Scott Sumner writes, among other things,

there is utterly no reason to presume that “the financial markets will evolve ways to insulate the economy from what the Fed does.” Indeed so far as I know no economist has ever even proposed a model where this is true. And that’s because it would have to be a very strange model.

This puts me in an awkward position. Either I say that this is my own model, in which case I think I am taking more credit than I should. Or I say that it is implicit in the writings of some other economists, in which case Scott is going to argue that I am misinterpreting them. When in doubt, I will commit the first error.

However, I am not totally daft. Jeffrey Rogers Hummel has just posted an excellent tour of monetary theory. It serves as a very useful reference. Read the whole thing. He concludes,

As I conceded at the outset, central banks can affect interest rates somewhat. What is incorrect is the now-common but simplistic belief that the liquidity effect is so powerful that it allows the Fed to put interest rates wherever it wants, irrespective of underlying real demands and supplies in the economy. Nor do I deny that central banks have other far-reaching economic repercussions, often detrimental. But in a globalized world of open economies, the tight control of central banks over interest rates is a mirage. Central banks remain important enough players in the loan market that they can push short-term rates up or down a little. But in the final analysis, the market, not central banks, determines real interest rates.

If you take Hummel’s tour, pay attention to the McCloskey-Fama challenge. Also, pay attention to this point:

As the Fed increased bank reserves and currency in circulation by $2.5 trillion over the five years since, it also was, for the first time, paying banks interest on their reserves deposited at the Fed. Although the 0.25 percent rate it pays is quite low, it has consistently exceeded the yield on Treasury bills, one of the primary securities in the Fed’s balance sheet. Thus, at least $2 trillion of the base explosion represents interest-bearing money that, in substance, is government or private debt merely intermediated by the Fed…The Fed can have no more impact on market rates through pure intermediation—borrowing with interest-earning deposits in order to purchase other financial assets—than can Fannie Mae or Freddie Mac. The remaining $500 billion increase in non-interest-bearing money (what economists call “outside money”) represents only a slightly more rapid increase than in the decade before the crisis, and nearly all of that has been in the form of currency in the hands of the public.

In some sense, quantitative easing consists of the Fed borrowing at 0.25 percent to buy Treasury securities. It is engaged in debt management, converting the long-term obligations of the Treasury into short-term obligations of the Fed/Treasury. As other economists have pointed out, the Treasury could cut out the middle man by buying back long-term obligations and borrowing more at the short end of the market.

Hummel does not depart from the standard theoretical assumption that there is an equilibrium “real” money supply, which ultimately ties the price level to the supply of money. That means that when the Fed raises the money supply, eventually the economy must adjust with higher prices. If you take that view, then the question of whether or not the Fed can affect interest rates may not matter. If the Fed can force prices higher, then it can raise nominal GDP, and we have something.

However, I take the view that the McCloskey-Fama challenge means that in fact that the Fed cannot force prices higher, because there is little adjustment needed in the economy when the Fed does something. The Fed is dipping its little cup in and out of a sea of financial assets. Right near the cup, you can observe water move, but viewed from overhead, the sea seems to have its own tides and storms.* As Fischer Black wrote in “Noise,” this leads to the upsetting and heretical conclusion that there is no equilibrium “real” money supply that ties down the price level. Instead, prices evolve higgledy-piggledy, based on habits and expectations.

*If the Fed used a really huge pitcher, big enough to raise the sea level by several meters, then I think we would see an effect. I only think that will happen if we run into a government debt crisis and the option of sudden monetization is adopted.

Contemporary Money and Banking

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In a comment on this post, the DeLong who is still attached to his hinges left me with quite a reading list.

1. Barkley Rosser writes,

Prior to 1984, there was a clear correlation between reserves, loans, and M2. After then, while loans and M2 continued to go along in a pretty close lockstep, reserves simply have flopped around all over the place.

Rosser cites Seth Carpenter and Selva Demilrap, who write

For better or worse, most economists think of M2 as the measure of money. M2 is defined as the sum of currency, checking deposits, savings deposits, retail money market mutual funds, and small time deposits. Since 1992, the only deposits on depository institutions’ balance sheets that had reserve requirements have been transaction deposits, which are essentially checking deposits. As noted above, the majority of M2 is not reservable and money market mutual funds are not liabilities of depository institutions. Nevertheless, it is the link between money and reserves that drives the theoretical money multiplier relationship. As a result, the standard multiplier cannot be an important part of the transmission mechanism because reserves are not linked to most of M2.

After reading these and other papers on his list, Mr. DeLong writes,

All this leaves me befuddled as to what the FRB and the econ profession are using as a model of the money machine.

I think that the popular saying among monetary economists these days is that attention has shifted from the Fed’s liabilities to the Fed’s assets. The old story was that the Fed’s liabilities were currency and bank reserves, and the banks lent out a predictable multiple of their reserves. The new story is that banks hold a ton of excess reserves. Also, if you include retail money market mutual funds in M2 (when did that happen? I’m so out of it, I thought that M2 was still, you know M2), then Carpenter and Demilrap are right that the money multiplier was never so reliable, anyway.

Anyway, back to the Fed’s assets. When the Fed buys long-term Treasuries, this takes them out of the hands of private investors, who then have to find something else to buy. They bid up the prices of other bonds and drive down interest rates, or so the theory goes.

My own view is that in an enormous world capital market, the Fed is not driving long-term interest rates. I am willing to be wrong. But my null hypothesis is that the Fed is always in an asset substitutability trap. Financial markets work to create substitutability. As a result, you have Goodhart’s Law: if the Fed can control the supply of an asset class (or definition of money), then that asset class will not have much effect on the economy; if an asset class correlates strongly with economic activity, the Fed will not be able to control it.

Another way to put this is that monetary and financial arrangements are endogenous with respect to Fed procedures. The financial markets will evolve ways to insulate the economy from what the Fed does.

Risk Premiums and Short-term Rates

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Jeremy Stein sees a connection.

over a sample period from 1999 to 2012, a 100 basis point increase in the 2-year nominal yield on FOMC announcement day–which we take as a proxy for a change in the expected path of the federal funds rate over the following several quarters–is associated with a 42 basis point increase in the 10-year forward overnight real rate, extracted from the yield curve for Treasury inflation-protected securities (TIPS).

…These changes in term premiums then appear to reverse themselves over the following 6 to 12 months.

…Banks fit with our conception of yield-oriented
investors to the extent that they care about their reported earnings–which, given bank accounting rules for available-for-sale securities, are based on current income from securities holdings and not mark-to-market changes in value. And, indeed, we find that when the yield curve steepens, banks increase the maturity of their securities holdings.

Thanks to Tyler Cowen for the pointer.

If this is correct, then monetary policy affects long-term real rates, although having the effect reverse itself within 6 to 12 months makes me wonder. In fact, this whole thing makes me wonder….

Sentence to Ponder

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From Peter Stella.

What many are calling central bank “money creation” “helicopter money” or “rolling the printing presses” may – in combination with tighter leverage ratios – lead to a tightening of bank credit and deflationary pressures.

Pointer from John Cochrane.

Read (and re-read) the whole thing. Stella’s interesting argument is that highly-rated securities are more liquid than bank reserves. Therefore, when the Fed supplies bank reserves in exchange for highly-rated securities, it is draining liquidity from the system.

My initial reaction is that this is just too cute. It makes it sound as though investment bankers make loans, using securities as reserves. I think of investment bankers as holding inventories of securities, financed by short-term debt. The larger the inventories they have to finance, the lower their demand for securities, and the higher the interest rates on those securities. So I still think that the Fed’s purchases go in the direction of pulling down rates on securities. Of course, I count myself as a skeptic that these effects are significant.

Underbussed by Stanley Fischer

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The WSJ blog reports,

“You can’t expect the Fed to spell out what it’s going to do,” Mr. Fischer said. “Why? Because it doesn’t know.”

He added: “We don’t know what we’ll be doing a year from now. It’s a mistake to try and get too precise.”

It seems to me that this throws both Scott Sumner and John Taylor under the bus. Instead, Fischer seems to be implying that the Fed needs to engage in fine tuning, using indicators that are too arcane to describe to the public.

By the way, Sylvester Eijffinger and Edin Mugajic think that the “new tools” of monetary policy will be used as far as the eye can see.

Given that other central banks will also proceed cautiously, “textbook” monetary policy will probably not be the norm again until at least 2020. Even then, central bankers would continue to view expansionary monetary policy as a viable strategy to cope with deteriorating economic conditions in the future. Against this background, the term “unconventional” does not apply to ZIRP and QE.

Fischer Black on PSST

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Comments on this post reminded me that I need to re-read Fischer Black’s famous address, Noise. He writes,

The costs of shifting real resources are clearly large, so it is plausible that these costs might play a role in business cycles. The costs of putting inflation adjustments in contracts or of publicizing changes in the money stock or the price level seem low, so it is not plausible that these costs play a significant role in business cycles.

Tyler Cowen and I both credit Fischer Black with influencing our views on macro. More from Black:

I cannot think of any conventional econometric tests that would shed light on the question of whether my business cycle theory is correct or not. One of its predictions, though, is that real wages will fluctuate with other measures of economic activity. When there is a match between tastes and technology in many sectors, income will be high, wags will be high, output will be high, and unemployment will be low. Thus real wages will be procyclical.

I am pretty sure that the ratio of wages to nominal GDP has been falling as the labor market has weakened over the past dozen years. So procyclical real wages are still with us.

And then:

I believe that monetary policy is almost completely passive in a country like the U.S. Money goes up when prices go up or when incomes goes up because demand for money goes up at those times. I have been unable to construct an equilibrium model in which changes in money cause changes in prices or income, but I have not trouble constructing an equilibrium model in which changes in prices or income cause changes in money.

Similarly, I also think that it is at least as plausible that causality runs from the long-term bond market to the Fed funds market as the reverse.

Finally:

I think that the price level and the rate of inflation are literally indeterminate. They are whatever people think they will be. They are determined by expectations, but expectations follow no rational rules.

Keep in mind that he is talking about a country without an insane fiscal/monetary nexus. I am sure he would grant that you can have hyperinflation by running ridiculously large deficits and printing money to fund them.

Monetary Offset

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See Scott Sumner’s short paper.

estimates of fiscal multipliers become little more than forecasts of central bank incompetence. If the Fed is doing its job, then it will offset fiscal policy shocks and keep nominal spending growing at the desired level. Ben Bernanke would deny engaging in explicit monetary offset, as the term seems to imply something close to sabotage. But what if he were asked, “Mr. Bernanke, will the Fed do what it can to prevent fiscal austerity from leading to mass unemployment?” Would he answer “no”?

The Keynesian point of view is that the Fed “ran out of ammunition” when the Fed Funds rate went to zero. At this point, I do not know what to say to people who take that view. If it were true, then the fiscal multiplier should be bigger than one would otherwise expect. Yet it seems to have turned out smaller–the stimulus did less than predicted, and the austerity did less damage than predicted. And to me, it seems obvious that as long as there is stuff that the Fed can buy, including long-term bonds and foreign currency, it has “ammunition.” But the Keynesians routinely dismiss as incompetent anyone who who claims that the Fed cannot run out of ammunition. Perhaps Scott’s paper will force them to actually defend their position, although chances are that they will just continue to ignore or insult those with whom they disagree.

My own views do not align with either Sumner or the Keynesians. PSST is an alternative to the AS-AD story.

Booms, Busts, and Money

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George Selgin writes,

it seems to me that there is a good reasons for not buying into Friedman’s view that there is no such thing as a business cycle, or Sumner’s equivalent claim that there is no such thing as a monetary-policy-induced boom. The reason is that there is too much anecdotal evidence suggesting that doing so would be imprudent. The terms “business cycle” and “boom,” together with “bubble” and “mania,” came into widespread use because they were, and still are, convenient if inaccurate names for actual economic phenomena. The expression “business cycle,” in particular, owes its popularity to the impression many persons have formed that booms and busts are frequently connected to one another, with the former proceeding the latter; and it was that impression that inspired Mises and Hayek do develop their “cycle” or boom-bust theory rather than a mere theory of busts, and that has inspired Minsky, Kindleberger, and many others to describe and to theorize about recurring episodes of “Mania, Panic, and Crash.” Nor is the connection intuitively hard to grasp: the most severe downturns do indeed, as monetarists rightly emphasis, involve severe monetary shortages. But such severe shortages are themselves connected to financial crashes, which connect, or at least appear to connect, to prior booms, if not to “manias.” That the nature of the connections in question, and the role monetary policy plays in them, remains poorly understood is undoubtedly true. But our ignorance of these details hardly justifies proceeding as if booms never happened, or as if monetary policymakers should never take steps to avoid fueling them.

Read the whole thing. The conventional wisdom, as of 2007, was that no matter what happens in financial markets, the Fed can keep employment high if it avoids disappointing people’s inflation expectations. That conventional wisdom disappeared during the crisis of 2008. At that time, Chairman Bernanke decided that ordinary monetary policy was not going to work. Instead, bailouts were needed in order to prevent a catastrophic recession. In the event, we had a bad recession. Now, the conventional wisdom is that he was right and that he made the recession less catastrophic. My alternative hypothesis is that we got more or less the same recession we would have had without bailouts (and without the stimulus, for that matter). It is impossible to go back and run the relevant experiment to determine who is right. I am willing to admit I may be wrong, but I think that those who espouse the conventional wisdom ought to be equally modest.

Scott Sumner became a notorious radical by sticking with the pre-crisis conventional wisdom rather than adopting the post-crisis conventional wisdom. Meanwhile, as Selgin points out, the Austrian alternative that there is such a thing as an unsustainable boom has been picked up by everyone from erstwhile descendants of Milton Friedman to President Obama (in the latter case, it fits in with the narrative that everything bad that takes place during his Administration is the fault of George Bush and/or Congressional Republicans).

My instincts are:

1. Downplay the role of the financial crisis, as opposed to ongoing structural adjustment.

2. Having said that, rapid expansion and contraction of the banking sector is bound to require a lot of short-term structural adjustment elsewhere, particularly in the contraction phase.

3. I am finding myself more and more reverting to what I call the MIT view (before Dornbusch and Fischer) that asset shuffling by the Fed (including all the conventional tools of monetary policy as well as the unconventional ones) does not have much impact.

Miles Kimball on Currency Reform to Resolve the ZLB

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I missed this the first time Kimball posted it.

The bottom line is that all we have to do to give the Fed (and other central banks) unlimited power to lower short-term interest rates is to demote paper currency from its role as a yardstick for prices and other economic values—what economists call the “unit of account” function of money. Paper currency could still continue to exist, but prices would be set in terms of electronic dollars (or abroad, electronic euros or yen), with paper dollars potentially being exchanged at a discount compared to electronic dollars. More and more, people use some form of electronic payment already, with debit cards and credit cards, so this wouldn’t be such a big change. It would be a little less convenient for those who insisted on continuing to use currency, but even there, it would just be a matter of figuring out with a pocket calculator how many extra paper dollars it would take to make up for the fact that each one was worth less than an electronic dollar. That’s it, and we wouldn’t have to worry about the Fed or any other central bank ever again seeming relatively powerless in the face of a long slump.

…for paper dollars, the interest rate would be made at least another 1% per year lower by having the discount for paper dollars gradually change over time.

I got to that piece from this post. Thanks to Tyler Cowen for the pointer.

A country that is ready to stop hyperinflating will often go for a currency reform. We cut the budget deficit so that we have to stop printing so much money. And we issue a new shekel, which is worth 100 of the old shekels. We phase out the old shekels.

Kimball’s proposal made me think of a currency reform for when inflation is too low. Imagine issuing a new dollar that eventually will trade at parity with old dollars. However, in the first month, for currency exchanges only, the government offers 10 new dollars for 9 old dollars. The next month, it offers 9.99 in new dollars for 9 old dollars. The following month, the exchange rate is 9.98 to 9. And so on, until the parity value is reached.

With this exchange policy, the interest rate on old currency will effectively be negative. Thus, you avoid the zero lower bound on interest rates.

I am not advocating this. I am suggesting that it is perhaps related, or even equivalent, to Kimball’s proposal.

Loosening the Monetary Dial

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Hasan Comert’s Central Banks and Financial Markets is strong reinforcement for my tendency to be skeptical of the effectiveness of monetary policy. What Comert says is that the evolution of the financial system has tended to decouple monetary aggregates from bank reserves and long-term interest rates from the Fed Funds rate. For example, consider sweep accounts. On p. 33, Comert writes,

Depository institutions developed computer programs to analyze customers’ checkable accounts, which are subject to reserve ratios, and automatically sweep them into savings deposits which were not subject to required reserve ratios.

On p. 47, Comert presents a striking chart showing that the ratio of required reserves to total deposits at depository institutions has declined from about 3.25 percent in 1959 to about 0.25 percent in 2007. At this point, it is perhaps a misnomer to call these “required” reserves. Instead, today there is essentially no connection between the level of reserves that the Fed supplies and the size of the financial sector.

Another way to see the decline in the influence in monetary policy is to track the correlation between the Fed Funds rate and mortgage rates. On p. 145, Comert writes,

the correlation between a one-year mortgage rate and the Fed rate was about 0.700 in the 1990s. It delined to about 0.250 in the period from 2002q1 and 2007q3. On the other hand, whereas the correlations between the 30-year fixed mortgage rate and the Fed rate was about 0.500 in the first period, it is 0.172 for the levels and 0.063 but insignificant for the differences in the second period.

I do not say that the Fed’s monetary dials are completely disconnected. I think that if they were really determined to cause rampant inflation, they could do so. But I do not think that their dials allow for fine tuning. I am not sure that if they were really determined to get an inflation rate of 4 percent, as opposed to 1 percent or 10 percent, that they could do that.