Category Archives: Monetary Economics

The Fed as a Bank

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A commenter asks,

1) Suppose the Fed increased interest on reserves from 0.25% to 8% tomorrow and simultaneously began a program to sell few trillion of the assets on it’s balance sheet and announced a new inflation target of 0%. What does the Book of Arnold predict will happen to inflation over the next two years?

2) Suppose the Fed cut the interest rate on reserves to -2%, announced a plan to buy an unlimited amount of financial assets until a market based forecast of NGDP 5 years from now reached $22.5T (5% year over year growth). What does the Book of Arnold predict will happen to NGDP over the next two years?

I think of the Fed as a bank. It makes profits in a weird way. It requires banks to hold reserves, and then it imposes a tax on those reserves by paying a below-market interest rate. Funded this way, it buys assets that earn a market rate of interest. (The Fed also profits from assets obtained with zero-interest-rate currency.)

So in the first exercise, the Fed’s cost of funds would rise from 0.25 percent to 8 percent. If this were to happen to any bank, it would soon be insolvent. For the Fed, this would mean having to go to Congress and beg for a large appropriation to cover its losses. That is such a weird and unlikely scenario that I do not think that any prediction can be made about NGDP.

In the second exercise, the higher tax on bank reserves would make their business less competitive, perhaps even unprofitable. We could see a big decline in bank balance sheets and an increase in shadow banking, or maybe just an increase in reserve-minimization tactics, like sweep accounts. Because reserves would plummet, the Fed’s liabilities would shrink, not rise. The only way that the Fed could expand its balance sheet would be by using currency to pay for its increase in assets.

I am not sure what the net effect would be on nominal GDP. Perhaps in the short run, you get bank failures and other forms of financial disruption, causing actual and forecast nominal GDP to decline.

The phrase “buy an unlimited amount of financial assets until…” makes me want to draw a cartoon with Janet Yellen telling investors “we will administer an unlimited amount of beatings until morale improves.” Again, I wonder how much the Fed could actually buy before running afoul of Congress.

Look, if you get rid of any constraints on the size and maneuverability of the Fed, then sure, they can do something to nominal GDP. And if you get rid of any constraints on the size and maneuverability of my body, then I could play in the NBA.

Did Scott Sumner Stumble?

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He wrote,

Unfortunately, the Fed doesn’t get to decide the path of interest rates. It looks like they do, but that’s a cognitive illusion. The bond market determines the path of interest rates, reflecting factors such as global credit markets, as well as NGDP growth and the level of NGDP in the US.

I am fond of Winston Churchill’s remark about someone who “stumbles across the truth, but then picks himself up as if nothing happened.”

That is what I feel took place here. I think that the implication of the quoted sentences is that it is the bond market, not the Fed, that is in control. As I write in the Book of Arnold, the Fed is just another bank. It has no more ability to “target” macroeconomic variables than does Citibank. Of course, Citibank is free to set a ridiculous interest rate for its on loans and deposits, and so is the Fed. And if the Fed set a ridiculous rate on reserves (right now negative 1 percent would be ridiculous, as would positive 5 percent) lots of crazy things would happen. With a negative rate on reserves, cash would dominate reserves as an asset. With a rate of 5 percent, reserves would dominate pretty much any loan as an asset.

But leave aside such hypotheticals. The Fed is not the macroeconomic driver it is made out to be.

The Fed and Long-Term Rates

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A commenter writes,

you can just look at a graph of the effective federal funds rate and see that (especially in recent years) it’s moved closely — in artificial-looking steps that are surely not the recent of some fundamental market rate process — with the FOMC’s target rate. You can then see that this rate and its near-term trajectory is transmitted almost one-for-one to short-term Treasuries, CD rates, etc., and that there is a heavy influence on mortgage rates, corporate bond rates, and so on as well. The extreme market segmentation needed for B clearly doesn’t seem to be there.

The fact that interest rates generally move together can be consistent with a number of hypotheses. One hypothesis is that the Fed influences all of these interest rates. Another hypothesis is that the views of the Fed are usually not much different from the views of markets. The question to ask is what happens when the long-term interest rate is X and the Fed thinks that it ought to be Y. Can the Fed move the long-term rate from X to Y? My impression is that the answer is in the negative.

Eugene Fama on Fed Impotence

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He writes,

Section II uses autoregressions with error correction terms to document that the day-to-day
variation in rates for maturities of a month or more has little or nothing to do with the Fed’s target rate.
This is consistent with a Fed that has little control of rates, but we shall see that it is also consistent with a
powerful Fed whose predictable actions with respect to TF are built in advance into interest rates.

Thanks to John Cochrane for the pointer. Note that TF is the Fed funds rate. My remarks:

1. I do not trust any time series regressions.

2. I think it is interesting that a framework in which the Fed has no influence is observationally close to a framework in which the Fed controls interest rates but market participants anticipate the Fed’s actions very well.

3. We may be in an environment today in which long-term rates over-react to short-term changes in the Fed funds rate.

4. Still, I take the view that the Fed is not big enough in the financial markets to have much durable influence on market interest rates.

Defining Money Like a State

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Kathleen McNamara writes,

single currencies are never the product of debates about optimal economic solutions. Instead, currencies like the U.S. dollar itself are the result of political battles, where motivated actors try to centralize power. This has most often occurred “through iron and blood,” as Otto van Bismarck, the unifier of Germany put it, as a result of catastrophic wars. Smaller geographic units were brought together to build the modern nation state, with a unified fiscal system, a common national language that was often imposed by force, a unified legal system, and, a single currency. Put differently (with apologies to sociologist Charles Tilly), war makes the state, and the state makes the currency.

The U.S. case is instructive. America used to have a chaotic multitude of state currencies and privately issued bank notes, with complex exchange rates between them. This only changed thanks to the Civil War. The American greenback was created in 1863 when Abraham Lincoln’s Republican Party muscled through legislation giving the federal government exclusive currency rights. It was only able to do this because Southern legislators, who opposed more centralization of power, had seceded from the American union.

Pointer from Mark Thoma, who comments, “whether the euro was politically motivated for the most part, or not, economics matters for the sustainability of a political union.”

A Gentleman’s Bet on the Fed

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I would bet that five years from now the size of the Fed balance sheet will be at least 85 percent of what it is now. I would make the same bet for ten years from now, but it is easier to hold me accountable in five years. Unlike Bryan Caplan, I prefer non-money bets.

My view is that “monetary policy” is just a ruse. If you want to understand government’s role in financial markets, focus on credit allocation. From that perspective, I do not think that the Fed will want to reallocate credit away from government debt and mortgage securities any time soon. . .or, in fact, any time.

Steven Pinker on Money as a Consensual Hallucination

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He writes,

Life in complex societies is built on social realities, the most obvious examples being money and the rule of law. But a social fact depends entirely on the willingness of people to treat it as a fact. It is specific to a community, as we see when people refuse to honor a foreign currency or fail to recognize the sovereignty of a self-proclaimed leader. And it can dissolve with changes in the collective psychology, as when a currency becomes worthless through hyperinflation or a regime collapses because people defy the policy and army en masse.

That is from p. 65 of The Blank Slate, which I am re-reading.

I would quibble that you do not get hyperinflation from a sudden loss of confidence in the currency. You get it when the government spends more than it taxes and loses the ability to borrow, so its only choice is to print money–and then people lose confidence in the currency.

The important social reality is that people are willing to lend to the government at affordable interest rates. That is what has the potential to suddenly change (see Greece) and that is why large deficits create potential instability.

Larry White on Free Banking History

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His final sentence:

Central banks primarily arose, directly or indirectly, from legislation that created privileges to promote the fiscal interests of the state or the rent-seeking interests of privileged bankers, not from market forces.

Pointer from Mark Thoma (!).

I think that one could write essentially the same sentence to explain quantitative easing.

The Fed as Shadow Bank

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What would you call an institution that holds a portfolio of mortgage-backed securities and government bonds, funded mostly by overnight borrowing at an annual interest rate of 0.25 percent?

If Goldman Sachs or Citadel (a hedge fund) did that, we would call it “shadow banking.” That is, the institution is engaging in maturity transformation without being regulated as a bank.

And that is the Fed as it operates today. It pays 0.25 percent interest on “reserves,” which is just a way of saying that the Fed is borrowing at 0.25 percent to fund its portfolio.

It may be worth spending some time thinking about the Fed as just another shadow bank. When other shadow banks do what the Fed does, we call it portfolio management or carry trading or riding the yield curve. We don’t use mumbo-jumbo like “monetary policy” or “inflation targeting” or “quantitative easing.”

The Fed’s role as a shadow bank was less obvious back in the days of textbook central banking, with the Fed’s liabilities consisting of non-interest-bearing reserves and currency, and its assets consisting of short-term T-bills. (Actually, the textbooks had it wrong. The assets were repo loans. The Fed has always been a big player in the Gary Gorton shadow-banking poster child known as the repo market.) Still, I think that if we had always thought about the Fed in terms of shadow banking we would have been on the right track.

Some people call the classic Fed liabilities “money” or “high-powered money.” But I do not find that so exciting. In my view, the market decides what to use as money.

I tend to think that shadow banking affects the economy. As with other forms of banking, when there is more of it, credit conditions are looser, and this makes it easier for businesses to keep experiments going. This can be a good thing–if enough experiments turn out well. It can be a bad thing–if the experiments include too many ideas that are not really sustainable.

However, banking and shadow banking that is centered around portfolios of government securities does nothing to help credit conditions for businesses. It just facilitates crowding out.

So what could be wrong with holding the view that the Fed has never been and never will be something other than just another shadow bank? Most economists would argue that the Fed did important things in the 1970s and 1980s. In the 1970s, it was too loose and we got inflation. In the early 1980s it tightened and inflation went away.

I would say that we could just as easily blame the rest of the shadow banks. Who was it that kept long-term interest rates below inflation in the 1970s? Who was it that made long-term rates shoot up in the early 1980s? I think that one can defend the notion that it was the rest of the shadow banks that did that, and the Fed just kind of followed along.

Does More Government Debt Reduce Interest Rates?

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This is a random idea that is almost surely wrong. And if it is wrong, it will be wrong in a way that seems obviously stupid. So don’t expect me to stick with it.

Without blaming Nick Rowe, I started thinking about this when he wrote,

By “secular stagnation” I mean “declining equilibrium real interest rates”.

Most explanations of secular stagnation say it is caused by a rising desire to save and/or a falling investment demand. Call this the “Saving/Investment Hypothesis”.

But there are lots of different real interest rates. For example, the real interest rate on Bank of Canada currency is around minus 2%. (That currency pays 0% nominal interest, and the Bank of Canada targets 2% inflation). But people are willing to hold currency, despite that, because it is very liquid. But all assets differ in their liquidity. More liquid assets will have a lower real yield than less liquid assets. And if an asset becomes more liquid over time, its real yield will fall over time.

What if there is a sharp rise in the supply of government debt? The standard view is that this tends to raise interest rates, as debt absorbs more savings.

The alternative view I am putting out there is that government debt offers liquidity (in the limiting case, think of it as a very close substitute for money). If the supply of liquidity goes up, then there is less demand for banks to manufacture liquidity out of risky assets. The public wants fewer deposits backed by loans on fruit trees and instead is happy to hold mutual funds containing government bonds.

The result is fewer fruit trees planted. We would observe a decline in interest rates on low-risk assets and an increase in interest rates (or a loss of credit availability altogether) for risky investment projects.

Think of this as government debt crowding out private investment, even though the interest rate on safe assets, particularly government debt itself, can remain low and perhaps even fall as the crowding out gets larger. Again, this is probably wrong.