Tuesday, April 20, 2021

Sunday, August 30, 2020

Sorry You're Let Down By the Fed's Monetary Policy Review

On Thursday, the FOMC released a revised Statement of Longer Run Goals and Monetary Policy Strategy, and Jay Powell made a speech at the virtual Jackson Hole conference, explaining the changes in the FOMC's approach. The new statement is rather murky, though that's of course nothing new in the world of fedspeak. Why did the FOMC think these changes were needed, and what will they imply for monetary policy going forward?

We'll start with the statement itself. This document originated in 2012, and at the time was a venue for Ben Bernanke to set down an inflation-targeting goal consistent with the Fed's Congressional dual mandate. Subsequently, the FOMC revisited the Statement annually (more or less), and published revised versions every January. Those previous changes were fairly minor tweaks to the document. Revisions tend to be produced after rounds of haggling among FOMC members, which end when consensus is reached. As a result the document reads like what it is - the work of a committee. Individual words and sentences have been put in to appease one or another faction of the committee, and the result tends to be something that no one likes much. But they will hold their noses and agree to it.You might find it useful to read the annotated version, as it shows you all the changes from the last published Statement.

In the second paragraph of the new Statement, an important new element is a recognition of the role played by low real interest rates (low r*, in fedspeak) in monetary policymaking. You might wonder why that's in there, as it's not apparent what that has to do with stating the FOMC's objectives. First, the Statement says

The Committee judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average.

That's just recognition that, over the long run, if the real interest rate is lower, and the inflation target stays at a fixed 2%, this implies a lower average fed funds rate, by the logic of Irving Fisher. The fed funds rate will then more frequently encounter the zero lower bound (ZLB), under the assumption that nominal interest rate variability is about what it was in the past. The conclusion? 

 ...the Committee judges that downward risks to employment and inflation have increased.

I've seen that idea frequently, both in research done at the Board, and public statements by Fed officials. The reasoning comes from Keynesian economics. In a Keynesian world, the zero lower bound is a constraint on policy, and there's a Phillips curve. Nominal interest rate reductions make output and inflation go up, according to Keynesian logic, so if the nominal rate hits the ZLB, the central bank can't increase output and inflation as appropriate. So, if the Fed is encountering the ZLB more frequently, it's running into that problem more frequently, by Keynesian logic. So average inflation and output could on average be too low. But, you might wonder how that's consistent with the previous quote, which says that low r* implies a low average fed funds rate. If inflation and output are on average too low, it seems we could raise the average fed funds rate, have inflation closer to target on average, and have higher average output as we're encountering the ZLB less often.

But, again, what is the discussion about low r* doing in the Statement? Is this just providing cover for the possibility that the Fed chronically undershoots the 2% inflation target and gets stuck at the ZLB indefinitely?

The third paragraph addresses issues related to the second part of the Fed's dual mandate - "maximum employment." The old Statement made reference to "normal" levels of growth in output and employment, the idea being that the economy could be above or below what might be considered normal. The Committee now appears to think that the relevant metric is the shortfall relative to maximum employment, with maximum employment being some sort of optimal state that we never achieve. In any case, the FOMC does not want, for good reasons I think, to define maximum employment, or to provide measures of it. But then why go to the bother of changing the language? We'll be able to answer that when we get to Powell's speech.

A key change that might, in principle, amount to something substantive is in the paragraph on inflation:

In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.

So, that doesn't appear to commit to anything. If the FOMC were committing to an inflation averaging procedure, it would have to specify at least three things - and maybe more, depending on how complicated they wanted to get. Specifically, first we would need to know over what period the FOMC was averaging over past inflation rates to determine what needs to be made up. Second, the Statement would need to specify the length of the future period over which the FOMC intended to make up the missing inflation. And third, the FOMC would need to specify what the average inflation target would be. They've given us the third number, 2%, but not the other two. To see how actual inflation targeting would work, suppose the FOMC specifies a rolling window relative to the current month, over which it is going to average. For example, if the FOMC chooses a window that goes 2 years into the past, and 2 years into the future, then at each point in time, it would calculate average inflation over the past two years, and then plan to make it up over the next two years, in such a way that average inflation from two years ago to two years hence is anticipated to be 2%. This implies that the target inflation rate will change month-to-month. That's pretty complicated, and hard to explain - which is an argument against inflation averaging - but if you're going to do it, you might as well do it properly.

So, what we have in the above quote is some half-assed inflation targeting, which one could argue is worse than what was in the statement before. Someone even added the word "likely," so they're telling us they might do it, but maybe not. Great. Finally, the averaging isn't really averaging, as it's not symmetric. Nothing is said about what happens when inflation has been running above target. You might think this is a way of slipping a higher inflation target past you, without saying so. Maybe so, but not to worry, for reasons I'll give you in what follows.

There is some more language in the Statement about how the FOMC's inflation and maximum employment goals fit together. And the Statement finishes off with a commitment to do a thorough policy review every five years, which seems like a good idea - though if this sort of thing is the result, maybe we would be better off without the review.

But, on to Powell's speech. Powell says there are four things that are driving the change in the FOMC's Statement (using my words here):

1. Low productivity growth and demographic factors have lowered the average growth rate of real GDP.

2. r* is expected to remain persistently low.

3. As of February 2020, the labor market had become unusually and unexpectedly tight, with a very low unemployment rate and a very high vacancy rate.

4. The Phillips curve is flat.

And, as further motivation for why the Fed needs to reconsider what it's doing, Powell addresses inflation undershooting, and why that's a bad thing. According to him, here's what can go wrong:

Inflation that runs below its desired level can lead to an unwelcome fall in longer-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations.

So, that's an instability story, which crops up from time to time. Basically, the narrative goes, we can get into a deflationary black hole, with inflation falling forever. What causes the deflationary black hole to materialize? According to Powell, it's inflation below the "desired level." So, what central bankers wish for seems to matter for deflationary black holes. Whichever staff members helped write this speech weren't quite doing their jobs in this section. 

The deflationary black hole narrative has been around for a long time. I think I saw it for the first time when nominal interest rates were low in the early 2000s. For example, in 2002, Ben Bernanke gave a speech about deflation, which didn't quite go full deflationary-black-hole, but warned of the dangers of deflation that could arise at the zero lower bound. People worried about deflation again in 2008-2009, because of zero lower bound issues, but given that the sustained deflation never materialized, I thought the concern had gone away. Problem is that the deflationary black hole is something we've never seen. Nominal interest rates at or near zero in Japan for 25 years have produced inflation that has averaged about zero. And mainstream theory won't give you a deflationary black hole, though I've seen it in some examples with very sticky prices and very sticky expectations.

So, what concerns does low inflation raise for Powell?

...if inflation expectations fall below our 2 percent objective, interest rates would decline in tandem. In turn, we would have less scope to cut interest rates to boost employment during an economic downturn, further diminishing our capacity to stabilize the economy through cutting interest rates.

When I first read this, I thought that "interest rates would decline in tandem" meant long bond yields. That is, anticipated inflation falls, which reduces the inflation premium on long-term bonds. But I think it's clear he means that a drop in anticipated inflation causes the FOMC to drop its fed funds rate target. So that's a strange argument - the problem has to do with our policy response, he's saying. That may actually sense to you, if you've read Benhabib/Schmitt-Grohe/Uribe (2001) on "Perils of the Taylor Rule."  The idea is that an aggressive Taylor-rule central banker, who cuts the nominal interest rate target more than one-for-one when he or she sees a shortfall in inflation relative to target, can get on a path that leads to perpetually low nominal interest rates and inflation. That is, if the central banker sees inflation below target, he or she drops the nominal interest rate rate target. But, the central banker doesn't understand the Fisher effect. The drop in the nominal interest rate results in a decrease in inflation, the decrease in inflation results in lower interest rates, etc., and the rest point is the effective lower bound on the nominal interest rate. Inflation stays below target until the central banker figures out how inflation dynamics work. To me, that seems a nice description of what's been happening in many countries since the financial crisis, and in Japan since about 1995. In practice, I don't think you necessarily need aggressive Taylor rule behavior to get chronic inflation-target undershooting. Probably it's enough that central bankers find few supporters for interest rate increases, and plenty of supporters for cuts. In fact, as I'll discuss later in this piece, the policy trap - perpetually low inflation and low nominal interest rates - could arise if the central bank only cuts and hikes interest rates in response to the unemployment rate, so long as the response is asymmetric.

This is one of the few cases in economics I know of where a basic, well-entrenched misconception can actually lead to tolerably good results. Low inflation, in contrast to what Powell seems to think, is generally fine. The only cost is to the reputations of central bankers who consistently promise 2% inflation and deliver less.

The rest of Powell's speech deals with the new statement, and how it reflects these new issues, as Powell sees it. First, Powell thinks it's important that the new Statement says that the FOMC will use its "full range of tools," which it will need, he says, because low r* implies a frequently binding ZLB. It's not clear why this needs to be in the revised Statement, as the previous Statement gave essentially no information about how the Fed intended to realize its goals. Best guess is that the language on tools is in the Statement to allow the unconventional monetary policy enthusiasts on the committee to commit their colleagues to future actions.

This is more interesting, I think:

...our revised statement says that our policy decision will be informed by our "assessments of the shortfalls of employment from its maximum level" rather than by "deviations from its maximum level" as in our previous statement. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.

So, Powell's view is that the Phillips curve is flat, thus low unemployment will not increase inflation. So, is the Fed abandoning its Phillips curve model of inflation, which appears to have been driving its decisions ever since I can remember? Apparently not. But if the Phillips curve is flat, so that unemployment is irrelevant for inflation, in the FOMC's view, then what determines inflation, and what does that tell us about how the Fed should control it? Seems part of the answer is in Powell's description of the costs of disinflation. That is, inflation expectations drive inflation. But how do changes in a nominal interest rate target affect inflation expectations, in the minds of FOMC participants? Inquiring minds want to know.

But, let's see if we can predict the implications of the last quote above for FOMC actions in the future. In the past, most of the short run variation in the FOMC's fed funds rate target has been due to short run variation in the unemployment rate. The FOMC typically finds it easy to cut interest rates in the face of increases in the unemployment rate - they get few arguments about that. It's difficult, however, to justify interest rate hikes. Particularly during the last tightening cycle, running from late 2015 to late 2018, inflation was mostly below target, and the interest rate hikes were justified as preemptive actions. Apparently, Powell is now judging 2015-2018 to be a mistake.

But it's hard to see what was wrong with the FOMC's performance in 2015-2018, given the observed outcomes and the previous Statement. At the end of the tightening cycle in December 2018, the unemployment rate had fallen to 3.9%, the lowest it had been since the 1950s, and the inflation rate was 1.9%, just shy of the 2% target. I'm having a hard time seeing a mistake.

Earlier in Powell's speech he tells us the current FOMC consensus on the "neutral interest rate" is that it's about 2.5%. That is, if the Fed is hitting its 2% inflation target consistently, and the economy is humming along at maximum employment consistently, then the fed funds rate should be about 2.5%, according to the FOMC. That is, the FOMC thinks r*, the long-run real rate of interest, is about 0.5%. The FOMC also thinks the Phillips curve is flat so, roughly, the FOMC thinks that, to achieve 2% inflation on average, the fed funds rate should average about 2.5%. The FOMC might also think that keeping the fed funds rate at zero will eventually make inflation go up, but that's not consistent with what we observe. The central banks that undershoot their inflation targets tend to be the ones that can't seem to get off the effective lower bound, the Bank of Japan being the prime example.

So it seems that, to sustain 2% inflation, the FOMC will sometimes have to find an excuse to increase its fed funds rate target. The usual excuse was the one they used last time, which is that a low unemployment rate tells us inflation is about to blow through the roof. That's actually baloney, as Powell recognizes, but it's a piece of fiction that served the purpose. It's hard to convince people that interest rate hikes are a good idea, but for some reason the specter of incipient inflation does the trick. The truth is that, to sustain higher inflation, you need a commitment to a higher nominal interest rate target. Like it or not, that's how it works.

In any case, the FOMC just denied itself license to use the standard excuse to hike interest rates. If we ever see another increase in the fed funds target range, I'll be amazed.

The last issue discussed in the speech is what most people have focused on, which is the quasi-inflation-averaging approach. As Powell points out,

...we are not tying ourselves to a particular mathematical formula that defines the average.

This means that the promise is empty, essentially. If it's not written down, the FOMC can't be held to anything.

But, the key problem Powell seems concerned with, and which is reflected in the statement, is below-target inflation, which needs to be matched by periods of above-target inflation. So how do we get above-target inflation?

...following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.

Well, that clears it up. Seriously, I'm pretty sure I know what "appropriate" means. Given the new Statement and Powell's speech, it seems the FOMC thinks lower for longer will do the trick. As far as I can tell, though, this is just dooming the approach to failure. Lower for longer is just going to produce extended periods with below-target inflation. If no one believes the Fed is committed to increasing nominal interest rates sometime in the future, everyone believes inflation will stay low.

This is all somewhat depressing. I don't get the sense that the FOMC is learning and improving. This looks like a step backward. But probably they're not going to do any great harm. Low nominal interest rates and low inflation forever is fine. The only cost is that we're in for a long period of excuses for poor performance relative to the stated 2% inflation goal. Not to mention much unconventional (and ineffective, I think) monetary policy, and a large balance sheet that will never shrink. 

 

Monday, July 27, 2020

The Bank of Canada Dives Into Unconventional Policy

The Bank of Canada has been doing things that, for it, are unprecedented. And, since our new Bank fo Canada Governor, Tiff Macklem, has made his first policy decision on July 15, now would be a good time to figure out what the Bank of Canada is up to. Since late March, the Bank's target for the overnight policy rate has been at 0.25%, which Macklem referred to in his press conference last week as the "effective lower bound." That's not an effective lower bound in the usual sense, as it's clear that the Bank could go negative if it chose to. By saying "effective lower bound," I think the idea is to impress on you that the Bank won't go lower. The Bank has also engaged in a large balance sheet expansion, again since late March. Recall that this is a first for the Bank of Canada, which went through a short period from Spring 2009 to Spring 2010, where it ran a floor system. But during that floor-system period, the Bank only put enough overnight reserves (about $3 billion) in the system to peg the overnight rate at 0.25%. This time is different, in that the Bank now has assets of about 23.5% of annual GDP, as compared for example to a Fed balance sheet in the US of about 32.5% of GDP. In domestic GDP units, the Bank's balance sheet is growing at about twice the rate of the Fed's.

Let's look at some of the details. Here are the main items on the asset side of the Bank's balance sheet that have shown big increases.


There are some other asset purchases, including provincial bonds, corporate bonds, and commercial paper, but those are small potatoes, I think. The Bank has certainly not entered into the realm of credit allocation in a big way, as the Fed has, for example. The chart shows weekly data from the beginning of the year. A big difference here from typical central bank balance sheet expansions is that a large portion of the expansion consists of lending in the repo market, both term and overnight. Presumably that's intended as a crisis lending program that reaches into all the nooks and crannies of the financial system. The bank also lends at the "bank rate" (like discount window loans) only to Payments Canada large-value transfer system participants - there are 17 of those, including the chartered banks. Lending at the bank rate is minimal right now. As well, as Carolyn Wilkins (senior deputy governor) outlined July 15  in the press conference, purchases of government of Canada securities, which comprise most of the balance sheet increase, other than repos, have been conducted across the maturity spectrum and are not confined, as would be usual in these policy moves, to long-maturity government securities. Note in particular that the Bank has increased substantially its holdings of t-bills, which the Fed has not bought (on net) since March.
 
Early in the COVID-19 crisis, when Stephen Poloz was Governor, the justification for the balance sheet expansion - the purchases of federal government securities in particular - was to improve market function. As the July Monetary Policy Report states, markets in government debt, and financial markets more broadly, seem to be functioning well now, more or less. So, the Report lays out a fairly conventional rationale for unconventional asset purchases, as follows:

Large-scale secondary market purchases of Government of Canada bonds provide monetary stimulus through several channels and can be described as quantitative easing (QE). When markets are not functioning well, QE improves liquidity in the government bond market (liquidity channel). QE can also lower borrowing costs for businesses and households by putting downward pressure on government yields (interest-rate channel).8 Through the purchase of a large quantity of government bonds held by the private sector, QE reduces the relative supply of bonds and thus lowers their relative yields, leading investors to reallocate their portfolio to riskier assets (portfolio balance channel). In addition, some investors will adjust their portfolios to include more assets priced in other currencies, placing downward pressure on the Canadian dollar (foreign exchange channel). Markets generally interpret QE as a signal that rates will likely be at the lower bound for an extended period (signalling channel).

The "liquidity channel," is no longer an issue, as the Bank sees it, so what we're left with, from their point of view, is the "interest rate channel," the "exchange rate channel," and the "signalling channel." The interest rate channel basically involves a segmented markets or portfolio balance story. This was the main justification given by Ben Bernanke for the several rounds of QE in the US, post-financial crisis. According to this view, we can think of the demand for government debt as being segmented by maturity. So, if you buy that idea, the central bank can purchase long-maturity bonds, sell short maturity bonds, and thus increase the prices of long maturity bonds and lower the prices of short maturity bonds - flatten the yield curve. Or, in a floor system with short rates tied down to zero (or 0.25% in this case), the sale of short maturity assets is irrelevant, long bond yields fall, and the yield curve flattens, according to the story. The exchange rate channel is just part of the same phenomenon. If the central bank thinks it can play with the yield curve, it can also move other asset prices in the process, including the exchange rate. The signalling channel, from the Bank's point of view, seems to depend on inferences people make about future policy based on the current state of the balance sheet. I guess we're supposed to view growth in the balance sheet as a commitment to accommodative policy for the indefinite future.

On the balance sheet, the Bank has committed to purchasing government of Canada securities at a rate of $5 billion per week until the recovery is well underway. For context, QE3 in the US, which ran from 2012-2014, involved asset purchases of $85 billion (US) per month. So, adjusting for exchange rates and size of the economy, the current Canadian program is roughly twice the size of QE3, so in principle it's a big deal - though more about this below.

So, what questions might we want to ask about this?

1) What's the exit strategy?  To date, central banks that have dived into quantitative easing (QE) in a big way have never exited. The Fed outlined exit strategies from its large balance sheet state as early as 2011, but never did it, other than to allow a bit of runoff. Basically, the more the Fed lives with its large balance sheet, the more it likes it, for no good reasons as far as I can tell. In the Bank of Canada's case, the structure of the balance sheet increase seems designed for somewhat easy exit. Repos can disappear quickly, and t-bills will also mature quickly or could be sold, presumably without capital losses, if the balance sheet exit occurs before liftoff in the policy interest rate. But, given the accounting standards the Bank has adopted, it seems that government bonds are classed as "held to maturity," are carried at book value, and can't be sold. If asset purchases proceed at the current rate, then by the end of 2020 government bonds held by the Bank will be about 12% of GDP. That's compared to Bank of Canada assets which are normally around 5% of GDP. So, if interest rates go up, say 2 years from now, the Bank will have quite low interest earnings on an asset portfolio that is being financed by maybe 50% currency (at 0%), and 50% reserves (at the policy rate). So that would put a dent in the transfer the Bank makes to the federal government. Under some scenarios, that transfer could hit zero, which would be problematic.

2) If the "interest rate channel" is so important to the Bank, why is it purchasing t-bills? Basically, there's an exchange of reserves for t-bills going on, which doesn't accomplish anything, and could actually be harmful (more below). If the Bank really buys the segmented markets story, it should be purchasing long-maturity government bonds, and lengthening the average maturity of the assets in its portfolio. But maybe it's up to something else. If so, someone should let us know.

3)What's going on with the government of Canada's account balance with the Bank? Here's what's happening on the liabilities side of the Bank's balance sheet:


There's been unusual growth in currency outstanding, but that's not a big deal relative to what you see in the chart, which is growth in reserve balances - overnight balances of LVTS participants with the Bank of Canada earning 0.25%. What's really weird here - and you see this in the US now as well - is that the federal government is holding a very large and growing balance with the Bank. So, in an environment in which it's claimed that the market in government debt isn't working properly (at least through some of the period in the chart), the federal government is issuing so much debt that it's not spending all the proceeds from its issuance, and instead parking the cash at the Bank of Canada. In addition, in the first chart, since April 1, t-bills and bonds held by the Bank have increased by about $216 billion - that's a swap of reserves for $216 billion in government securities - while the federal government has proceeded to swap $154 billion in government securities for reserves. So, this isn't much of a QE program, if that's the intention, as the federal government and the Bank seem to be working at cross purposes. But we know that the Bank and the Department of Finance are on good terms, and there's a regular conversation going on. So what have they agreed to? Inquiring minds want to know.

4) Who says QE works anyway? QE is essentially debt management - the central bank making choices about how much interest-bearing overnight reserves are in the market, relative to government securities or other assets of various other maturities. A move by the central bank to engage in protracted QE is then a move by the central bank to take on the debt management role normally assigned to the central government. In Canada, the line between the Bank of Canada and the Department of Finance is blurry. Debt management policy seems to be something that is worked out jointly between the Bank and the Department Finance - for example I have talked to economists at the Bank who think about nothing but debt management. Once debt management policy is decided, the Bank implements it. As well, management by the Bank of the government of Canada's cash balances is an integral part of day-to-day monetary policy intervention, at least in normal times. In the past, there has been some worry that QE would be inflationary. You heard that a lot in the US post-financial crisis - from what remains of the monetarist contingent. The alleged inflationary effects of QE have also been put forward as justification for the use of QE, particularly by the Bank of Japan, beginning in 2013. The BOJ tried to use QE as a means for getting inflation up to its 2% target, which was a failure. Typically, low-nominal-interest rate environments just produce low inflation - that's Japanese experience since the mid-90s, and what we've seen in Europe and elsewhere since 2008. So, with the policy rate at zero or below, currency outstanding is driven by the demand for it at a zero nominal interest rate, inflation is low, and QE simply changes the composition of the outstanding consolidated government (central government plus central bank) debt. More overnight reserves, and less of whatever the central bank is buying. So why should we think that having more interest-bearing reserves in the banking system, and less government debt in financial markets should stimulate anything? To help get at that, let's look at money market interest rates in Canada.


Day 60 is late March, when the interest rate on reserves (balances of LVTS participants held with the Bank) went to 0.25%. Early in the year, you can see a normal configuration of interest rates in Canada - typically t-bill rates (1 month and 3 month) are lower than the overnight repo rate. You can see the period of market turmoil after day 60, when t-bill rates are typically at or above the repo rate, and the repo rate is below the interest rate on reserves. Then, things eventually settle down, getting into July. The repo rate is now at the interest rate on reserves, as it should be in a well-operating floor system, and t-bill rates are lower than the overnight rate, though the margin is not as large as pre-COVID-19. The current configuration of interest rates might make you wonder why swapping reserves for t-bills is a good idea. Apparently the Bank has to give the chartered banks a premium to hold reserves rather than t-bills, implying that reserves are inferior to t-bills. Now think about long-maturity government bonds. Essentially, the Bank is swapping reserves for long-maturity government debt, and the chartered banks are taking reserves and turning them into bank deposits. Of course, chartered banks can hold long-maturity government bonds directly and turn them into bank deposits, so why isn't the Bank of Canada just a redundant middleman in this operation? You might argue that the Bank is unloading risk from the chartered banks, but what risk? Given the Bank's forward guidance, we're expecting short rates to stay low for a long period of time, and so we should expect little variability in long bond prices. Further, these are large Canadian banks, and their ability to bear a small amount of risk on government debt is pretty good, I think. Here's what's happening with the chartered banks:


In this chart, I've shown only bank deposits, which have increased substantially since March (sorry the hash marks on the horizontal axis divide a year into fifths), and illiquid assets, which have not. As you might imagine, on the asset side, banks are holding much more liquid assets:


Chartered banks are holding much more reserves, but also much more t-bills, and somewhat more government bonds (less than and more than 3 years to maturity). So, the question would be: What difference would it make to these chartered banks if they had less reserves and more government debt on the asset side of the balance sheet? Basically, QE involves stuffing the banking sector with overnight assets, while taking safe assets widely used as collateral out of the market, so it's hard to see why we would think of QE as accommodative.

5) Aren't bond yields pretty low anyway? With the overnight rate at 0.25%, the current 2-year government bond yield is 0.268%, the 5-year is at 0.342%, the 10-year is 0.50%, and the 30-year is 0.975%. The Bank thinks it can squeeze a few more basis points out of the 10-year bond yield for example? And what would that accomplish?

So, you can tell that I'm not too excited about the Bank's QE program. On the positive side, the interest rate policy looks OK. It's hard to see what else the Bank should do other than keep the policy rate at zero, or close to it, for the foreseeable future. Forward guidance is perhaps overemphasized as a policy tool I think - it's best for a central banker to take an action, make it well understood why the action was taken, and then trust people to understand how the state of the world maps into policy actions - but the Bank's interest rate guidance is fairly innocuous, as these things go. The July policy statement says:
The Governing Council will hold the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved.
There are things I don't like about that, but it's a piece of fiction that allows the Bank to justify interest rate hikes when the time comes. The Bank is telling you that there's a Phillips curve (that's the fiction), and that the way to control inflation is to control an output gap, say as measured by the unemployment rate. As I argued in this paper, what the Bank has typically done in the past is to raise and lower its interest rate target in response mainly to the unemployment rate. As long as the Bank gets the average level of the policy rate about right, in the process they can successfully hit a 2% inflation target, as they've done since 1991. Best guess is that the right average policy rate is where it was before COVID-19, at 1.75% or thereabouts. To sustain 2% inflation, the Bank has to get back up to that level sometime in the future. But, inflation targeting is off the table right now, for good reasons, though Tiff Macklem wants to reassure us, in line with the Bank's agreement with the federal government, that he has the 2% target on his mind. Problem is, as the Bank recognizes in its report, that the CPI measure used by the Bank as their inflation measure was designed to be useful only if expenditure shares don't vary much. That's not the case now, so standard inflation measures won't have much meaning for a while. In any case, we should expect inflation to be fairly low and stable, though below target for some time. Take my word for it, that's just a feature of low-nominal-interest-rate environments, large central bank balance sheet or small.

Monday, March 16, 2020

What Sort of Financial Panic Is This?

Well, as you know, things are changing by the day in financial markets, and central banks are moving quickly to keep up. Most central banks have taken aggressive action recently. After a between-meetings policy rate cut of 50 basis points on March 3, the Fed yesterday reduced its target range for the fed funds rate to 0-0.25%. More to the point, the interest rate on the Fed's overnight reverse repo facility is set at 0%, the interest rate on reserves is 0.10%, and the interest rate on primary credit at the discount window has been reduced to 0.25%. The interest rate target moves, in timing and magnitude, are very aggressive. This was done on a Sunday, before financial markets opened on Monday, and amounted to a 100 basis-point drop in the target range. The discount window rate (the rate at which the Fed lends to Fed member financial institutions) was cut even more, as this rate moved from 50 basis points above the top of the fed funds rate range to the top of the range.

There's more. The Fed lists actions that are intended to enhance the functioning of credit markets, though some of these "actions" are simply encouragement to banks to use the Fed's credit facilities - the discount window and intraday central bank credit - and to lend in instances where the bank has liquidity and capital in excess of regulatory mandates.

One item that stands out is the discontinuation of reserve requirements in the United States. Reserve requirements were dropped long ago in some countries, and currently Canada, the UK, New Zealand, Australia, Sweden, and Hong Kong, are without reserve requirements. In the US, reducing required reserve ratios to zero is essentially a formality. US financial institutions have figured out workarounds, including sweep accounts, that allow them to skirt the effects of reserve requirements, and the Fed's large balance sheet has made reserve requirements non-binding for most banks. The elimination of reserve requirements in the US is long overdue, but why now? Possibly what's going on is that liquidity requirements (the liquidity coverage ratio requirement, for example) exclude required reserves, so eliminating the reserve requirement does in fact relax a constraint on banks, and could encourage them to acquire other assets - loans or asset-backed securities, for example.

Closer to (my) home, the Bank of Canada has reduced its policy rate by 100 basis points, to 0.75%, in two steps, and has announced some moves to enhance market liquidity, as outlined here. But I'll focus on the US, where most of the action is.

What is the Fed responding to? Most people are aware of the downward slide in the stock market, which continues today. But there are various other signs of distress in financial markets. This has little in common with traditional banking panics, such as what the US banking system encountered in the Great Depression, or prior to the founding of the Fed, between the Civil War and 1914. The primary feature of such panic episodes as the 1907 panic was runs on retail bank deposits, and disruption of retail payments. In principle, such panics could be mitigated, or stopped entirely, through central bank lender-of-last-resort lending, for example through the discount window in the United States. Indeed, a principle function of the Fed, as the authors of the Federal Reserve Act intended, was to lend to banks during financial crises. The Fed could lend to banks, replacing the outflow of deposits, and could finance this lending by issuing more currency, thus giving consumers a safe means of payment to flee to. But what we're seeing now is certainly not a flight from bank deposits to currency.

The current panic does have something in common with the financial crisis of 2008, though there are important differences. During the 2008 financial crisis, the origin of the crisis was in the financial sector. Incentive problems in the mortgage market ultimately led to a loss in confidence in the value of a class of asset-backed securities, which fed through to drops in asset prices, a flight to safety in financial markets, and chains of defaults and potential defaults. The current crisis is rooted in the non-financial sector, but some of the same elements are in play. The reduction, or anticipated reduction, in income flows for businesses and individuals, has caused those businesses and individuals to re-evaluate their portfolios, generating a desire to trade in asset markets. But at the same time, everyone is very uncertain about outcomes, and where the risks are. So perceived risk is high, in general, market participants are fleeing to safe assets, and people also want to sell liquid assets to adjust their portfolios in ways they perceive as optimal. What's happening? First, as in the financial crisis, there's been an increase in interest rate spreads. Here's the difference between the 3 month commercial paper rate and the T-bill rate:
You can see that this spread has increased substantially, but it's nowhere near as large as at times during the 2008 financial crisis. Similarly, if we look at a risky corporate bond spread, we get the same story, more or less:
Though note that the data in the last 2 charts only runs to late last week, so things could have changed for the worse.

As well, markets in US government Treasury securities are not functioning normally. Apparently the bid-ask spread in markets for Treasury securities has widened, and volume has declined, making it more difficult to buy and sell Treasuries. The liquidity of this market is important. There has to be some asset that is easy to buy and sell, at a predictable price, and if government debt is not filling that role, then nothing is.

Which brings us to a key part of the Fed's announced intervention plan, which is the resumption of quantitative easing (QE), after a sort-of hiatus of five years or so. Over the next several months, the Fed plans to purchase at least $500 billion in Treasury securities, across maturities, and $200 billion in agency mortgage-backed securities. That's a program about the size of QE2, which ran from 2010-2011, but not as large as QE1 (2009-10) or QE3 (2012-14). This program would amount to a nominal increase of about 18% in the Fed's asset portfolio, or about 3.2% of annual GDP. Not small potatoes, but the Fed has done this on a larger scale before. What's the rationale? The Fed has already expanded its repo program. The Fed is currently lending in excess of $100 billion in the overnight repo market every day, and is also lending substantially in term repo markets. So, if you want to unload some Treasuries and are having trouble doing it, the Fed will lend you the cash. Similarly, the Fed's reverse repo facility is still in place, so if you want to buy Treasuries, but are having a hard time doing it, you can lend the cash to the Fed through the reverse repo facility, say if you're a money market mutual fund, or you can just hold interest-bearing reserves if you have a reserve account.

But, possibly there's a role for QE in purchasing on-the-run Treasury securities that financial markets are having a hard time absorbing. In this case, the purchases of Treasuries potentially make life easier for the Treasury. The Fed purchases the Treasury securities, increasing the balance in the Treasury's general account (TGA) with the Fed, and as the Treasury spends the balance, these funds end up in bank reserves. But the Treasury is currently holding a balance (as of last week) of about $380 billion in the TGA account, which is enough to fund Treasury outlays for a typical month. So, the Treasury has a substantial buffer if it has trouble selling its debt, and such difficulties aren't likely to last long.

So, why are we into another QE episode? Principally, the FOMC thinks this is an accommodative policy - it's supposed to increase real GDP and inflation. Of course there's no evidence for that - from experience in the US or elsewhere. And QE could actually be harmful, in that it's fundamentally a swap of less useful assets - reserves - for more useful assets - Treasuries and MBS. It's possible that more reserves and less Treasuries and MBS in the market right now would be a good idea. But why commit to this asset purchase program over the next several months? The Fed could at least hold off decisions about continuation of the program until we have more information.

Here's what I'm afraid of. The Fed's actions may be appropriate in the moment, but I'm worried about how we get back to some semblance of normal again. The Fed had a set of normalization plans as early as 2011, to undo policies that were put in place during the financial crisis. But the FOMC never followed through on that normalization plan, and ultimately chose to stick with its large balance sheet. Interest rates were never normalized, in the sense of attaining a level that would sustain inflation at 2% indefinitely. Now we're back at the zero lower bound, with plans for a substantial Fed balance sheet increase, no solid science telling us why this is a good idea, and no plans for getting out of this once this virus gets out of town.