Monday, August 5, 2019

Is the Fed Doing Anything Right?

I'm not sure the Fed has many friends these days. Donald Trump is unhappy with it, and the financial media seems puzzled by what the Fed is doing. Can we make sense of the Fed's behavior, particularly its change in policy last week, or is the Fed simply incoherent?

It might help to start with first principles. What would good central bank policy look like, were we ever to have the good fortune to observe such a thing? A central bank should have clearly-stated goals. Those goals could be stated in the legal structure that constrains the central bank, or they could be in the central bank's interpretation of the law. For example, in the US the Fed's structure is defined in the Federal Reserve Act, and the Fed's dual mandate is in the Employment Act of 1946 and the Full Employment and Balanced Growth Act of 1978. The Fed's interpretation of what Congress stipulated is in the "Statement on Longer-Run Goals and Monetary Policy Strategy," which says, basically, that the Fed has a symmetric 2% inflation target, and that it seeks to achieve a "maximum level of employment," without being precise about what that might mean. A central bank's goals should be such that they can be stated in an easily understandable way. That means that the public should be able to understand what the Fed thinks it's doing, and the Fed should be able to understand what it's supposed to be doing. So, the 2% inflation target seems OK in that sense. It's simple, and we'll be able to tell if the Fed is succeeding or not, with respect to that specific goal. However, "maximum level of employment" is a poor goal. Fed officials are free to define it however they like, and it's impossible to evaluate performance in terms of something that's not precisely defined.

Once the central bank has dealt with what its goals should be, it has to decide on how to achieve those goals. For 40 years or more, it's been well understood among macroeconomists that achieving policy goals is about choosing a policy rule. That policy rule takes all available current information and generates a setting for some targeted variable the central bank can control. In typical modern central banking practice, that targeted variable is an overnight nominal interest rate - the fed funds rate in the Fed's case. The Fed need not write down its policy rule. In fact, writing it down would be a bad idea, in spite of what John Taylor thinks. What the central bank needs to do is to explain carefully what it is doing, and why, every time it takes an action. Over time, if central bankers make those decisions in a consistent way, and explain them well, then their actions become predictable. As it's generally understood by macroeconomists, that predictability is a wonderful thing. Eventually, central bank pressers should become so routine that they're boring as hell. In fact, boring as hell is the nirvana of central banking. Of course, the policy rule should be the best available rule for achieving the central bank's goals. There should be a theory that says it's the best thing around, and we should be able to evaluate the rule's performance in practice.

Finally, once the central bankers have figured out their policy rule, they have to have an operating strategy for achieving their short term target. For example, the Fed needs an operating strategy for targeting the fed funds rate. Currently, that operating strategy is to simply fix an interest rate on reserves, in the context of a large central bank balance sheet with a very large quantity of reserves outstanding - a floor system. Basically, the operating strategy should successfully achieve the target. Not much more to it than that.

So, what happened last week at the FOMC meeting? They decided (with a couple of dissents) to reduce the target range for the fed funds rate by 0.25% to 2.00-2.25%. That seems to represent a change of plan, since in September 2018, the median FOMC member was thinking that the fed funds rate by the end of 2019 would be 3%. So, something important must have changed since last September. What was it? From the FOMC statement and Powell's presser after the meeting, it seems there were 5 things bothering the committee:

1. Weak global growth.
2. Trade policy uncertainty.
3. Muted inflation.
4. The neutral rate of interest is down.
5. The natural rate of unemployment is down.

Let's deal with the second part of the Fed's mandate first - the maximum level of employment. On the real side of the economy, things seem to be going quite well. Real GDP has been growing smoothly for the last 10 years:
That's an average growth rate of 2.3% vs. 3.3% for the 1947-2009 period, but if we calculate per capita real GDP growth rates, it's not as large a difference, i.e. 1.6% for 2009-2019, and 2.1% for 1947-2009. Of course, there's also a level drop in real GDP from peak to trough in the last recession of about 5%. But in terms of GDP growth, we're not looking worse than last September. In the labor market, a standard measure of labor market tightness is the ratio of job openings to the number of unemployed:
So, it looks like the labor market is no less tight than it was in September, when it was tighter than it had ever been since the JOLTS data has been collected by the BLS. There was some talk by Powell in the presser about weak investment, but I don't see that either:
No significant weakening in year-over-year real investment growth since September, as far as I can tell.

So, things must be really bad in the rest of the world, and maybe we should be worried about that affecting us? Here are real GDP growth paths for the Euro area, Japan, UK, Canada, and the US:
So, I don't know about you, but I don't see "weak global growth" there, relative to September, when everyone was so optimistic. Maybe this is showing up in labor markets? Certainly not in Japan:
Or the Euro area:
Or the UK:
But, I can certainly understand that there's "trade policy uncertainty." More like "Trump uncertainty," I think. But that's been with us since January 2017. And for North America, which we could argue is more relevant for the US, the trade uncertainty is actually lower than it was in September. The USMCA was signed by Mexico, Canada, and the US on November 30, 2018, though it is as yet not ratified. Brexit anxiety is with us of course, but again that's nothing new. So, I think you have to be more specific if you want to make a general case about policy uncertainty. And what's the hurry? You can't wait for resolution?

If you're like me, you're now more puzzled than when you started reading this. Typically central banks lower interest rates in the face of observed decreases in aggregate economic activity - somewhere. But we haven't seen any such thing. Must be some very weird policy rule at work here.

But what's the story with inflation?
So, I guess "muted" is as a good a word as any for that, relative to the 2% inflation target. The Fed's chosen measure - headline PCE - is at 1.4%, and stripping out food and energy gives us 1.6%. Not low, certainly, and well within what you might think is reasonable tolerance, but definitely below target. So, that's clearly a change from September, when inflation was roughly on target, though a deviation of 0.6% below target, possibly pushed down temporarily by energy prices, doesn't seem like a big deal.

But, suppose we thought that the only problem here is a slightly-below-target inflation rate. What would the corrective action be? Well, we need to go back to the policy rule stage to answer that question. What's the relevant theory to bring to bear on the problem, and what does the theory tell us the Fed should do? A below-target inflation rate says the target fed funds rate moves in what direction? Standard central bank practice says the answer is down. Why? Inflation-targeting central bankers argue that they have built up credibility with the public, who believe that the inflation rate will be 2% indefinitely. That's what a central banker means by "anchored expectations." Then, if inflation expectations are anchored, and assuming there is a stable Phillips curve, everyone knows that lower nominal interest rates imply lower real interest rates in the short run. And lower real interest rates, as everyone knows, makes "aggregate demand" go up. Further, as everyone knows, output is demand-determined, so output therefore goes up. Then, by Phillips curve logic, inflation goes up.

But, as everyone knows, I think, there are issues with the Phillips curve. AOC knows it, and Jay Powell knows it, as we can see in this exchange. Powell seems to be telling AOC what his staff told him, which is that the Phillips curve is currently very flat. The Phillips curve is still there though, or so Powell seems to think, though he seems a little confused about how the whole thing works. But, if you're a Phillips curve person, as Powell seems to be, how do you think you're going to get any action in the current environment from an interest rate reduction? You're convinced the Phillips curve is flat, and it's hard to see how the labor market could get any tighter, so where is this Phillips curve inflation going to come from. Expectations? It certainly doesn't look like financial market participants, who had been primed for this interest rate reduction, think so.
That is, the current breakeven inflation rate, at a 10-year horizon, is 1.6%, so market participants don't appear to anticipate a return to 2% inflation.

So, this rate decrease seems very hard to justify, even in terms of how the typical FOMC participant looks at the world. And you can see that in the presser with Powell. The reporters are trying hard to understand what the Fed is up to, Powell is struggling to explain it, and everything is coming out muddled. For example, this exchange:
MICHAEL MCKEE. [inaudible] question is how does it do that? How does cutting interest rates lower, or how does cutting interest rates keep that going since the cost of capital doesn’t seem to the issue here.
CHAIR POWELL. You know, I really think it does, and I think the evidence of my eyes tells me that our policy does support, it supports confidence, it supports economic activity, household and business confidence, and through channels that we understand. So, it will lower borrowing costs. It will, and it will work. And I think you see it. Since, you know, since we noted our vigilance about the situation in June, you saw financial conditions move up, and you saw, I won’t take credit for the whole recovery, but you saw financial conditions move up. You see confidence, which had troughed in June. You saw it move back up. You see economic activity on a healthy basis. It just, it seems to work through confidence channels as well as the mechanical channels that you are talking about.
Well, there's no confidence channel running from Powell to me, that's for sure. The rest of the presser is more of the same. Powell started off well when he was appointed. He opted for press conferences after every FOMC meeting, reduced the wordiness of FOMC statements, and generally seemed to be communicating well. But this decision makes clear what his limitations are. Powell is an attorney whose experience with monetary policy comes from sitting on the FOMC since 2011. You may think that puts you at the center of things. Sorry, it doesn't. There's a lot Powell doesn't know, and it shows.

The other piece of FOMC decision making at this last meeting was to move up the date when the Fed would resume asset purchases. That is, for the time being the Fed intends to maintain the size of its balance sheet, in nominal terms, at its current size. To do this, the Fed will purchase assets (mainly Treasury securities) each month to replace the assets that mature. Earlier this year, the Fed decided it would retain its current floor system operating procedure. Why exactly is unclear. As far as I can make out, the justification seems to be that this makes interest rate control easier. But the Fed claims to be committed to running a floor system with the least possible amount of reserves outstanding that permits the system to work efficiently. Here's some quantities on the Fed's balance sheet.
In nominal terms, the "normalization" in the balance sheet that was promised years ago by the Fed never materialized. The reduction in securities held outright was modest, to about $3.6 trillion. This asset quantity is much more than enough to back the current stock of currency outstanding, which is about $1.7 trillion, and there is still $1.5 trillion in reserves outstanding. That anyone thinks this could be anything close to the minimum amount required to run a floor system is bizarre. Even if $1.5 trillion in reserves were considered about right, there is about $500 billion in other liabilities that the Fed has outstanding for no good reason. This $500 billion includes what is in the Treasury's general account with the Fed, and what are effectively reserve accounts (these are called "reverse repos") of foreign entities, including foreign central banks. All of that $500 billion could go to the private sector, in various forms, which would increase reserves outstanding by $500 billion. That is, it would make no difference if $500 billion in securities were allowed to run off, and the $500 billion in foreign-held reverse repos and Treasury balances went to the private sector.

Another issue is that the floor system does not appear to be working as advertised. So, in contrast to what the Fed seems to want to tell us, interest rate control is not easier with a floor system. The fed funds rate, which previously was below the interest rate on reserves, is now somewhat above it, and interest rates on overnight repos are misbehaving. A potential solution to this, discussed at the June FOMC meeting, is a standing repo facility. Effectively, this would be a lending facility, possibly for banks and/or primary dealers, with the rate set above the interest rate on reserves. Maybe you're wondering why we need this, given that we have a discount window. But, the claim is that this would somehow make Treasury securities more liquid and reduce the demand for reserves, while also eliminating some upside volatility in overnight repo rates. So, that puzzles me. Why?
In the chart, you can see month-end spikes in the overnight repo rate. But you can also see that the 3-month T-bill rate, and the 1-month T-bill rate, are typically lower than the interest rate on reserves through this period. If Treasuries were so illiquid, relative to reserves, then banks would be asking for a premium to hold Treasuries. But that's not what we see. But maybe banks aren't holding much in the way of Treasuries? No, that's not the case.
So, this idea makes no sense. I could see someone making an argument for a standing repo facility on the grounds that, for some well-articulated reason, the discount window isn't working well. But that's not the argument.

So what's going on here? The Fed announced a normalization plan, which started at the end of 2015. Under the plan, interest rates would normalize. What's that mean? Normal means that short-term nominal interest rates are high enough to be consistent with 2% inflation over the long term. Under current conditions, the real short-term interest rate is persistently low, so a "normal" short-term interest rate would be lower than in the past. That's just the logic of Irving Fisher, which we all learned as undergrads. But, if the nominal interest rate is too low on average, then inflation will be too low, on average. That's abundantly obvious given the post-1995 Japanese experiment. Late last year, the FOMC was thinking that a normal fed funds rate is about 2.5-3.0%. I think that's about right. Basically, they aborted normalization. And, if the FOMC thinks an important goal is hitting 2% inflation, it should have kept its target fed funds rate range constant, or moved it up.

Balance sheet reduction was also to be a part of normalization, but obviously that's not happening, and the FOMC is not providing us with good reasons for retaining its floor system, which has never behaved according to what the people at the Fed predicted. The recent surprises in the overnight interest rate structure are just another example of that.

Where does all that leave us? Not in a really bad place. The central banks of the world are going to model themselves on the Bank of Japan. Barring a Trump recession, things will be OK. We'll have inflation below 2%, a large central bank balance sheet in perpetuity, odd behavior in overnight markets, and puzzled central bankers who can't explain what's going on. Oh well.

Friday, June 21, 2019

Libra: Financial Inclusion for the World's Poor, or Scam?

In case you haven't heard, Facebook has recently set up a financial subsidiary, Calibra, and has issued a so-called "white paper" which is a proposal to issue a cryptocurrency, Libra. As stated in the white paper, "Libra's mission is to enable a simple global currency and financial infrastructure that empowers billions of people." Sounds rather lofty, don't you think? Financial innovation that's going to make a significant fraction of human beings, particularly the world's poor, significantly better off. Makes me want to give Mark Zuckerberg a big hug.

But hold on. What is Facebook actually proposing? The "white paper," which is obviously, in part, a public relations document, is long on vague descriptions of inclusion, working together, integrity, blah, blah, blah - and short on some critical details. So what is Libra exactly? It's a bank. Let's just call it the Facebook Bank. This bank will have assets, liabilities, capital, and shareholders. And, what makes it a bank is that its liabilities - Libra - are intended to function as means of payment. So what's the problem the Facebook Bank is trying to solve? Given the available technology, our payments systems are remarkably slow and costly to use, particularly the ones that involve international transactions. God knows that domestic payments in the United States are particularly slow and costly, but try to move money between countries and you'll have spend some time and energy in figuring out how to do it at the lowest cost. And you probably won't be happy with the best thing you can find.

Some of the people who want to move money between countries are poor people, for example immigrants come to Canada from poor countries and want to send transfers to their relatives. But most of the money moving around the world is moved by rich people, so they would certainly benefit in principle from what the Facebook Bank claims to offer. And of course, plenty of shady people move money between countries. For example, people in the US who import street drugs from wherever need to get money to the suppliers of those drugs, and it would be a lot cheaper to send it electronically than running currency across the border. Or Don Jr. needs a vehicle for getting his money from the Russian oligarch, the Saudi Prince, or whoever. If regulation of the Facebook Bank is lax, plenty of shady people will be using it for sure.

So, just in case this isn't totally obvious, Mark Zuckerberg cares about making a profit. If this enterprise flies, it's not because it's just helping poor people, though some of them might benefit. Mark Zuckerberg makes big money by serving rich people and, maybe, crooks.

Next, to the details of what's in the "white paper." First, note that "white paper" is a term first used by the British government for proposals it was floating prior to writing legislation. Callting the Facebook Bank proposal a "white paper" of course lends an air of authority to this marketing effort, which has also included consultation by Facebook with some financial regulators - the Fed included (Powell mentioned this in his last press conference). Zuckerberg understands that regulation is a potential obstacle to big profits, so he wants to stay on the good side of people like Jay Powell.

We need to look at the proposed financial structure of the Facebook Bank. In contrast to typical cryptocurrencies, the Facebook Bank will have assets backing Libra. Bitcoin for example is more like a commodity money. It's fundamentally costless to create Bitcoin, but the Bitcoin mechanism is set up to make Bitcoin scarce - there's an upper bound on supply, and creating more Bitcoin currently requires competing as a miner to update the blockchain, and this competition burns phenomenal quantities of electricity. New Libra will be created by someone exchanging balances denominated in some standard currency, Canadian dollars for example, for Libra. Then, those balances would be used to buy assets. No mystery there, as that's what banks do. But what are the assets? The section in the "white paper" on the "The Reserve" tells us that these assets will be "stable and liquid," more particularly the short term debt of countries not deemed to be likely to default or inflate, and "bank deposits."

So this is starting to sound a bit like a narrow bank. An example of a narrow bank would be a bank that issues demand deposits, subject to withdrawal, one-for-one, in U.S. currency, backed by a portfolio of 3-month US Treasury bills. But the Facebook Bank is not a standard narrow bank. First, its assets will have payoffs denominated in different currencies. In principle, the asset portfolio could be diversified, but the riskiness of the whole enterprise will depend on the nature of the liabilities.

Facebook Bank liabilities - Libra - is where the action is in this proposed operation. Ultimate users of the means of payment will not actually interact directly with the Facebook Bank. There will be "authorized resellers" who transact with the Facebook Bank. If you and I want to acquire Libra, or sell Libra in exchange for Pound Sterling or Mexican Pesos, we have to interact with an authorized reseller. Though this is vague in the "white paper," it appears that resellers can exchange Libra for various currencies, and vice versa, with the Facebook Bank. So, as the "white paper" says, the Facebook Bank "mints and burns coins." The key question is, at what prices can a reseller "mint and burn?" It seems that Libra is a demand liability. This is what makes every successful banking system work. Bank liabilities are convertible into something at a fixed rate. In the very old days, there was convertibility into precious metals, and in modern times banks convert deposits one-for-one into domestic currency. If the convenience of the Facebook Bank comes from having demand liabilities that are convertible at fixed rates into a set of currencies, then the Facebook Bank is potentially unstable, in the same sense any bank is. We know how we overcome that. We have regulation, deposit insurance, central bank lender-of-last-resort facilities, capital requirements. If there aren't fixed rates of conversion of the liabilities, then the Facebook Bank is more like a mutual fund, which makes the liabilities less convenient as a means of payment. An interesting feature of the Facebook Bank is that the liabilities won't pay interest. How come? There's inflation in the world, so one might think it would be in the interest of an profit-seeking financial institution to offer liabilities that are going to compensate for inflation - by paying interest.

Don't be fooled by the use of the word "cryptocurrency" in the "white paper" to describe the Facebook Bank's liabilities. This is similar to how some security issuers use the word "coin" to mask what they're doing. For example, an "initial coin offering" or ICO is just the issue of a security that typically has features that look like simple debt or equity. What makes these securities different is that they're traded using a decentralized ledger. A complete record of ownership and trades is in the blockchain. Similarly, the Facebook Bank's liabilities - Libra - are just bank deposits traded on a distributed ledger instead of through the conventional system of bank recordkeeping, supported by interbank transfers on the central bank's books. What we should be wary of is the possibility that, by issuing a cryptocurrency, Facebook is just evading regulation, in the same way that "coin offerings" evade securities regulation. It's well-known that ICOs are a cesspool of fraud.

And why trade the Facebook Bank's deposit liabilities using blockchain? From what I can tell, all the experiments with blockchain have been a bust. It's very exciting to sort out how blockchains work, and to talk about it at dinner parties, but decentralized ledgers have thus far been a failure. Basically, providing the incentives that prevent manipulation of the blockchain for individual gain is too costly. Unless Facebook has some technological breakthrough they're hiding from us, what we know about blockchain makes the "white paper's" claims of low-cost financial services seem like wishful thinking.

Is there anything regulators should be doing about the Facebook Bank, or should we just let Facebook take its chances and let them worry about the consequences? Well, in banking we have a long history of regulation. Sometimes regulators, and the people setting up the regulatory structure, make mistakes. But there's never been a successful banking system that didn't have a strong regulatory hand behind it. Laissez faire banking is only an idea, not demonstrated best practice. So, regulators should be paying attention to this, asking questions, and figuring out what to do about it.

Thursday, May 2, 2019

Can the Fed Control Overnight Rates?

The mechanism under which central banks peg overnight nominal interest rates typically relies on having a sufficiently large buffer of some asset or liability, then supplying that asset or liability inelastically at the desired overnight rate. Financial market arbitrage then looks after the rest - the pegged nominal interest rate effectively sets all short-term interest rates. Before the financial crisis, the buffer for the Fed was a stock of overnight repos, supplied at a rate that would peg overnight repo rates. But, that was a tricky game, as the Fed's ultimate interest rate target was the unsecured fed funds rate. The New York Fed had to make daily adjustments in its repo market trading strategy to account for the factors that might cause differences between market repo rates and the fed funds rate. So, with the advent of interest payments on reserves in October 2008, and the large Fed balance sheet, some may have thought that controlling overnight interest rates would be comparatively easy.

Under the floor system the Fed now operates under, the buffer is a large stock of reserve balances held by commercial banks. The Fed sets the interest rate on reserves, IOER, and in theory this should determine all overnight rates. That is, the Fed now pegs an interest rate on one of its liabilities, rather than one of its assets. But, as it turns out, arbitrage in US financial markets does not work like arbitrage in theory. In spite of the very large stock of reserves outstanding, setting IOER does not always do a good job of pegging overnight rates of interest.

When the Fed began "normalization," by raising its interest rate target, in December 2015, it established a "leaky floor" system, under which IOER would be viewed as an upper bound on the fed funds rate, and the lower bound would be the ON-RRP rate, an interest rate on reverse repurchase agreements, which the Fed would supply elastically in a daily auction. Initially, the margin between the IOER and the ON-RRP rate was 25 basis points. Until early in 2018, the fed funds rate fell between the ON-RRP rate and IOER. Overnight repo rates, along with short-term T-bill rates, tended to fall around the ON-RRP rate.

But, by early 2018, things changed. All short-term interest rates moved up to the vicinity of IOER, and the Fed's ON-RRP facility became effectively dormant. I discussed these developments in this post, in this one, and in this one. My interpretation of events is that, from 2009 to early 2018, collateral was scarce in overnight markets, making repo rates low relative to the fed funds rate and IOER. This scarcity was primarily due to the Fed's asset purchases (quantitative easing), and when the Fed phased out its reinvestment policy (replacing maturing assets on its balance sheet), the scarcity went away. The Fed blamed the Treasury, citing increased Treasury issues. It's possible that contributed to the easing of the collateral scarcity, but I'm not sure.

Recently, something unexpected has happened. These are daily observations on the fed funds rate and a Treasury repo rate:
This shows daily data from December 20, 2018, just after the last FOMC interest rate hike, through April 29. IOER is set at 2.4% through the whole period. You can see that, until recently, IOER was pegging the fed funds rate at 2.4%, but in recent weeks the fed funds rate has eased up to, to at most 5 basis points above IOER. The repo rate I've shown exhibits a similar pattern, though there's more volatility in the repo rate. As well, the repo rate exhibits spikes at month end - particularly pronounced at year-end 2018. The other two Treasury repo rates the New York Fed reports show essentially identical behavior.

For good measure, the next chart shows 1-month and 3-month T-bill secondary market yields.
So, T-bills are actually trading lower than fed funds recently - for the most part.

So, what could be going on here? It cannot be the case that reserves are somehow becoming "scarce." There's still about $1.5 trillion in reserves outstanding, and even extreme floor-system enthusiasts don't seem to think that $1.5 trillion isn't a lot. Why would banks forego a five-basis-point profit opportunity to lending on the fed funds market rather than holding reserves? What's changed in the last few weeks? Whatever is going on, the Fed is not controlling overnight rates as it anticipated, or the way it should.

There's an easy fix, however, and that's Andolfatto and Ihrig's standing repo facility (see also this post) - though Andolfatto and Ihrig (A/I) are offering the wrong reasons for the right action. The A/I argument is that a standing repo facility is necessary to make the Treasury holdings of large banks more liquid in the event of financial stress and wholesale funding outflows. Large banks hold liquid assets in line with their Dodd-Frank resolution plans, as well as to fulfill liquidity coverage requirements. One might think that Treasury securities are just as good as reserves for these purposes, but A/I argue to the contrary. The idea is that a stressed large bank might have trouble unloading a large quantity of Treasuries, or borrowing against them on the repo market. This argument might seem odd as: (i) A time of heavy stress for a large bank would typically be associated with aggregate stress. And - again typically - what happens in such episodes is that market participants are fleeing to safety, and safe assets include Treasury securities. So, there's not likely to be a problem in unloading Treasuries or in borrowing against them during a period of stress. (ii) It's the Fed's job to smooth fluctuations in short safe rates of interest. So, is there something wrong with the Fed's ability to control short rates?

Well, it appears there is something wrong with the Fed's ability to control short rates. I'm actually less concerned with the fed funds rate, and more concerned with repo rates, as the Fed should be. Those end-of-month spikes in repo rates shouldn't be happening. Here's what would fix overnight markets. The Fed should go back to the sort of repo intervention they did before the financial crisis - fine if they want to call this a standing repo facility, or whatever. Use the same counterparties as for the Fed's reverse repo facility - a broad-based approach is ideal. A/I are suggesting that the targeted repo rate be above IOER, but why not set it equal to IOER?

This then raises two questions: (i) Why the focus on the fed funds rate? Most central banks target a repo rate. (ii) Why the large balance sheet? The floor system isn't working.

Thursday, February 21, 2019

Balance Sheet News

The FOMC minutes for the January 29-30 meeting, released yesterday, contain some important information about the Fed's balance sheet, and plans for the FOMC's future operating strategy. Let's unpack this, to try to understand what they're up to.

The key information is in the section in the minutes on "Long Run Monetary Policy Implementation Frameworks." This section deals with presentations from staff economists (in part from the previous FOMC meeting), and discussion of that material. The minutes say:
The staff briefing also included a discussion of factors relevant in judging the level of reserves that would support the efficient implementation of monetary policy.
The key word is "efficient." It's not clear why we would just look at the level of an item on the liabilities side of the Fed's balance sheet to determine what would permit "efficient" monetary policy. It's also not clear what "efficient" means. But whatever it is, some people seem convinced that the Fed has almost attained it:
Some recent survey information and other evidence suggested that reserves might begin to approach an efficient level later this year.
So, what to do?
Against this backdrop, the staff presented options for substantially slowing the decline in reserves by ending the reduction in asset holdings at some point over the latter half of this year and thereafter holding the size of the SOMA portfolio roughly constant for a time so that the average level of reserves would fall at a very gradual pace reflecting the trend growth in other Federal Reserve liabilities.
Note that, at that point in the meeting, this is all coming from staff economists. There's a statement about the objective, which is efficiency, a conclusion that we're close to efficiency, and a recommendation as to what to do once efficiency is achieved. That is, later in the year, the Fed should start buying securities again, so as to maintain the size of the balance sheet at a constant nominal level, until further notice. Ultimately, the minutes indicate that the FOMC agreed to that.

What's going on? Total securities held outright by the Fed look like this:
So, in terms of the nominal quantity of securities held, there hasn't really been much "normalization" of the asset portfolio. And it's not like we would arrive at a different conclusion if we were to look at total Fed assets as a percentage of GDP:
That is, 20% of GDP is lower than the peak of 25% of GDP, but it's a lot higher than the pre-crisis 6%. If 6% was OK before the financial crisis, why is something a little less than 20% "efficient" now?

It might help to look at what is happening on the liabilities side of the balance sheet. Two key Fed liabilities are currency and reserves, of course, but there are also a couple of weird items that we wouldn't normally be concerned about, which are reverse repos of foreign institutions (including foreign central banks), and the Treasury's general account with the Fed. First, currency:
The stock of currency in circulation has more than doubled in nominal terms since before the last recession. Even more impressive is what we see if we look at the currency/GDP ratio:
U.S. currency held in the world has increased from about 5.5% of U.S. GDP before the financial crisis, to over 8% of GDP today. Thus, the Fed now needs an asset portfolio of 8% of GDP just to support the demand for U.S. currency. Still, that's far short of 20%.

With respect to those weird Fed liabilities, look at this:
First, what are those reverse repos, "foreign and international accounts?" Details on this are on the New York Fed's website. These are "accounts" held by "250 central banks, governments and international official institutions." The accounts are reserve accounts. The accounts are reserves during the day, and then become Fed reverse repos overnight, secured by securities in the Fed's portfolio. Thus, like the Fed's domestic reverse repo (ON-RRP) facility, this basically permits the Fed to pay interest on a reserve account to an entity which is not permitted to receive interest on reserves given the rules set up by Congress. Calling this "reverse repurchase agreements" is just a convenient fiction to get around the law. The key point is that these reverse repos have grown from about $50 billion before the financial crisis to about $250 billion today. What's driving that? The New York Fed says:
Like other factors affecting the level of reserves in the U.S. banking system, an increase in investment in the foreign repo pool results in a corresponding decrease in reserves. Given that a change in the size of the foreign repo pool alters the availability of reserves in the U.S. financial system, the New York Fed can manage the overall size of the foreign repo pool or individual account participation in the foreign repo pool in order to maintain orderly market or reserve management conditions. In addition, the New York Fed may choose to limit the overall size of, or individual account participation in, the foreign repo pool based on other factors, such as the amount of available securities held at any time in the SOMA.
This recognizes that more reserves held by these foreign entities means less reserves held by domestic entities, and that this could mess with the Fed's monetary policy actions. But, the quote tells us that the quantity of outstanding reverse repos of this type is purely discretionary. So, for some unspecified reason the Fed decided to increase the "foreign repo pool," and presumably there is no reason outstanding reverse repos could not be reduced to their pre-crisis levels or lower.

Next, consider the balance in the Treasury's General Account, in the last chart (in blue). It's become large, and it's highly variable. For any central bank, managing reserve balances of the fiscal authority at the central bank is an issue. Whenever tax revenue flows into the fiscal authority's reserve account, that reduces reserves held by the private sector. And, when the fiscal authority issues more debt, that also reduces reserves in private hands. So, if the central bank is running a conventional corridor system, as for example in Canada, with zero reserves held overnight, inflows and outflows in the fiscal authority's reserve account can thwart monetary policy, unless these inflows and outflows are offset. For example, the Bank of Canada conducts a twice-daily auction of government of Canada reserve balances. Some of these auctions involve secured funds, some are unsecured, and the funds are lent out at various maturities.

In the US, before the financial crisis, the Fed implemented monetary policy in a corridor system, where the lower bound on overnight interest rates was zero. In that system, part of the mechanism in place to deal with fiscal effects on reserve balances was the Treasury Tax and Loan Program, which parked tax revenues in private financial institutions rather than in the Treasury's reserve account. That solved part of the problem, and presumably the New York Fed was actively engaged in offsetting the effects of Treasury auctions and maturing government debt, which would be predictable on a daily basis. All of that is out the window, apparently, as part of the Fed's current floor system. Treasury balances are large - close to $400 billion currently - and highly volatile, with swings of up to $100-$300 billion over short periods of time. Apparently this amount of volatility is of no concern to the Fed currently.

In total, the weird Fed liabilities comprise roughly 3% of GDP, so this is significant.

What's left, in terms of Fed liabilities? Reserves, of course:
So, at the current rate of decline, reserves could be down to the vicinity of $1 trillion toward the end of the year. It appears that this is the number that the Fed people think is "efficient."

So, it appears the FOMC has decided: (i) that a floor system is better than a corridor system; (ii) that it might take $1 trillion in reserves to support a floor system. What are their arguments?

1. Transitioning back to a corridor system would be difficult. From the FOMC minutes, the argument seems to be that, given uncertainty about the level of reserves required to support the floor system, we would have to go through a period of volatile short-term interest rates in the transition period. Nonsense. The problem here follows from a poor choice of the Fed's interest rate target. If the Fed were to target a repo rate, rather than the fed funds rate, the problem goes away. Here's how to do it. For now, set the target repo rate equal to IOER (interest rate on reserves). Then, auction either repos or reverse repos at that rate - fixed rate full allotment.
2. Survey evidence indicates that the demand for reserves is large. The survey evidence comes from the Senior Financial Officer Survey. Basically, people in the banking industry respond to survey questions in a way that appears to indicate that their institutions would continue to hold large quantities of reserves, even if they were giving up 25 to 50 basis points by foregoing lending in the repo market, for example. If this were true, this indicates significant friction in overnight markets, and we should see that in market interest rates. Currently, IOER is at 2.4%, and the fed funds rate is 2.4%. The last date on which the fed funds rate was less than IOER was December 14, 2018. The repo rates measured by the NY Fed are currently 2.39%, 2.37%, and 2.37%, so right now financial arbitrage in overnight markets seems pretty good. So, I think the interpretation of the survey evidence is nonsense too.
3. Regulation has increased the demand for reserves. On this one, a speech by Randy Quarles is helpful. Quarles explains how Basel III regulatory changes regarding liquidity coverage ratios (LCR) were implemented in the United States. Basically, commercial banks need to hold sufficient liquid assets to buffer potential outflows of wholesale deposits. This is essentially a type of reserve requirement. But what's a liquid asset for regulatory purposes? It turns out that Treasury securities and reserves are equivalent, and some other assets are deemed less liquid, and get a haircut when the LCR is calculated. As Quarles says:
One could envision that as the Fed reduces its securities holdings, a large share of which consists of Treasury securities, banks would easily replace any reduction in reserve balances with Treasury holdings, thereby keeping their LCRs roughly unchanged.
It's not clear in Quarles's speech whether he buys that argument or not - he's just laying out the arguments. But I think that argument is powerful. A reduction in the Fed's balance sheet is essentially a swap of Treasury securities for reserves. In fulfilling the LCR, Treasuries and reserves are equivalent, and should be. Given a deposit outflow, a bank can reduce reserves, it could sell Treasuries, or it could borrow in the repo market with Treasuries as collateral. A financial system with a lot of Treasuries and not so much reserves is just as liquid as a financial system with not so much Treasuries and a lot of reserves. In fact, we could argue that the the first system is more liquid, since Treasuries can be traded widely while reserves are confined to those financial institutions with reserve accounts. I'd say this argument is nonsense too.
4. Short-term interest rates are more volatile in a corridor system than in a floor system.Again, this depends on what interest rate the Fed targets. Using the fed funds rate as a target has its problems, for two reasons. First, under its corridor system, the Fed did not intervene in the fed funds market - it was typically intervening in the overnight repo market. Essentially, the Fed varied the quantity of repos in order to hit a fed funds target, without being able to see the actual fed funds rate while it was intervening. You can see why that might not work so well. Further, fed funds lending is unsecured, so in times of financial market turmoil, the fed funds market is contaminated with risk. The Fed may be pegging the fed funds rate in such situations, but volatility in risk will then cause volatility in safe rates of interest. Again, these problems can be solved easily if the Fed were to target an overnight repo rate, as is done in many other countries. Here in Canada, the Bank of Canada has no problem with volatility of short-term interest rates, in running its corridor system.

Overall, the Fed is overly-focused on reserves, as if monetary policy implementation could be represented satisfactorily in terms of some static demand and supply analysis of the "market for reserves." That's very misleading. Any central bank has a lot of options in implementing monetary policy, but basically there are two broad approaches. Market interest rates can be targeted through variation in the central bank's lending, or in its borrowing. When the Fed was founded, the founders envisioned that the intervention would happen through lending, and that the key instrument would be the discount rate - with potentially different discount rates for different Fed districts. Roughly, the ECB intervenes by lending to banks in the Euro zone - it's key policy rate is its refinancing rate (at least when it's running a corridor and not a floor). Before the financial crisis, the Fed intervened day-to-day by lending on the repo market. Here's what that looked like:
So, repos outstanding fluctuated between $20 billion and $40 billion, for the most part. The Fed could have chosen to intervene by varying the quantity of reverse repos outstanding (on the borrowing side), and that would not have made much difference. In the current floor system, the Fed intervenes on the borrowing side, fixing the interest rate on reserves, and letting the private sector determine the quantity of reserves and currency to hold, given that currency can be converted to reserves one-for-one.

However the Fed intervenes, this involves varying the quantity of some Fed asset or liability, so as to peg the market interest rate on that asset or liability. This intervention is most effective if the Fed can essentially set that market interest rate, and then let the market determine the quantity. For that to work, the relevant market should be sufficiently liquid, and the Fed needs to have an adequate buffer stock of that asset or liability. Apparently, before the financial crisis, the Fed was successful in intervening with a stock of repos of from $20 billion to $40 billion. So why does the Fed think it needs $1 trillion in reserves outstanding to allow it to peg short-term interest rates by setting IOER?

As David Beckworth points out, between spring 2009 and spring 2010, the Bank of Canada ran a floor system with about $3 billion in reserves held overnight. As is well known, translating between Canada and the US involves multiplying by a factor of 10, so accounting for the exchange rate, that's about $40 billion in US reserves - in the ballpark of outstanding repos prior to the financial crisis. Canada has a very different institutional setup, but one would have to make the case that the US financial system has huge financial market frictions relative to Canada to justify a threshold of $1 trillion to make a floor system work.

But what's the harm in a large Fed balance sheet? The larger the balance sheet, the lower is the quantity of Treasury securities in financial markets, and the higher is reserves. Treasuries are highly liquid, widely-traded securities that play a key role in overnight repo markets. Reserves are highly liquid - for the institutions that hold them - but they are held only by a subset of financial institutions. Thus, a large Fed balance sheet could harm the operation of financial markets. As I pointed out here and here, there's evidence that such harm was being done. That is, if there's harm, it would be reflected in a scarcity of collateral in overnight financial markets - in market interest rates. Before early 2018, T-bill rates and repo rates tended to be lower than the fed funds rate, and the fed funds rate was lower than IOER. Now, all those rates are about the same. The Fed thinks the difference is more Treasury debt, but I think the end of the Fed's reinvestment program mattered, in that it increased the stock of on-the-run Treasuries. Whichever it was, apparently the quantity of Treasuries outstanding matters for the smooth - indeed, efficient - operation of financial markets, and the Fed should not mess with that. My prediction would be that, if we get to the end of the year and the Fed is again buying Treasuries, that we'll see repo rates and T-bill rates dropping below IOER. Watch for that.

Tuesday, January 1, 2019

The Fed and the New Year

Much of the first two years of the Trump administration was unexpectedly good for the Fed. Appointees to the Board of Governors - Quarles, Bowman, Clarida - are actually qualified to do their jobs, in contrast to most of the folks now inhabiting the executive branch. Trump may have been willing to ditch Janet Yellen (for no obvious reason other than that she was appointed by Obama), but he replaced her with a Fed insider, Jay Powell, who has more or less maintained the status quo. On some dimensions, Powell is an improvement on Yellen, particularly in the communications department. The FOMC's post-meeting statements are less wordy and belabored, the press conferences are more fluid, and the pressers will now take place after all 8 FOMC meetings in the coming year, which officially makes all meetings "live." The previous fiction had been that important Fed moves could happen at any meeting, but everyone knew this was not the case. Indeed, of the 9 interest rate hikes that occurred from December 2015 through December 2018, none came after a non-presser FOMC meeting.

The quiet central banking life ended for the Fed late last year, when Trump needed a scapegoat for a tanking stock market. The Fed is now a regular Presidential tweet subject, and Powell's job is on the line. Welcome to the club, Fed, you're now on Trump's radar screen. Perhaps Powell can take solace in the belief that, even if Trump could fire him, he won't, as a scapegoat can no longer serve his or her purpose if removed from the scene.

But is the Fed doing the right thing? And what's in store for 2019? In terms of achieving its Congressional mandate, as it interprets that mandate, the Fed is doing a great job. Inflation is on target:
The labor market is tighter than it's been since the BLS began collecting JOLTS data:
And real GDP is growing at a good clip, relative to the post-recession history:
Of course, we could have said the same thing a year ago, when the Fed was achieving its inflation target, the labor market was very tight, and real GDP was growing at a good clip. Yet, the FOMC raised the target range for the fed funds rate four times during the year, and seems set to do the same thing two more times in 2019 before it stops, providing the economy stays roughly in the same place. What is the Fed trying to fix, exactly?

One place we could look for enlightenment is in the public statements of John Williams, President of the New York Fed, and Vice Chair of the FOMC. Williams has been with the Fed for essentially his whole career. He's also an economist, and accustomed to explaining technical stuff to people who don't normally think about it. Two of Williams's recent speeches deal with low real interest rates and monetary policy normalization. The bottom line from those is that the Fed is normalizing, normalization is good, and the new normal will feature a long-run nominal interest rate that is lower than in the past, as the real interest rate has fallen, and is expected to stay low. So, Williams's views about the long-run real rate of interest inform how he thinks about "normal." Those views seem to be in line with the "dot plot" from the FOMC's December 2018 projections:
Recall that each dot is associated with an FOMC participant (no names attached), and represents that member's projection for the year-end fed funds rate. The median projection for the long run is 2.8% so, given the inflation target of 2%, the committee thinks the long run real interest rate is about 0.8%.

Estimates of the long-run real interest rate differ considerably, as coming up with such estimates requires a model, and there are many of those to choose from. Alternatively, a proxy for the overnight real interest rate is the three-month T-bill rate minus the core inflation rate:
As well, we could look at TIPS yields:
So, by those measures real interest rates on safe assets have been increasing. One reason for that is what the Fed has been doing. Conventional macro models tell us that, in response to a nominal interest rate increase, the real rate increases in the short run, and then falls, with inflation ultimately increasing one-for-one with the nominal interest rate as the long-run Fisher effect sets in. This might give the Fed cause for concern, as it tells us that inflation (absent the effects of changes in the relative price of crude oil) could overshoot the 2% inflation target, even if the FOMC does not hike the fed funds target range this year. In other words, 0.8% may be too high an estimate for the long run real rate - maybe zero is more accurate.

However, we may have good reasons to think that the real interest rate is rising for reasons independent of the Fed's interest rate policy. As I noted in a previous blog post, recent developments in the overnight financial markets suggest that the Fed itself may have been responsible for some downward pressure on the real interest rate. That is, the Fed's large scale asset purchases, typically thought to work by lowering long-term bond yields, may have contributed in an important way to a safe asset shortage, noted by John Williams as an important cause of low real interest rates (though Williams didn't mentioned the Fed's role in contributing to the shortage). Treasury securities and mortgage-backed securities are an important source of collateral in secured overnight credit markets, so by purchasing these securities and replacing them with inferior reserves, the Fed contributed to a collateral shortage. The phasing out of the Fed's reinvestment program, from October 2017 to October 2018, helped to relieve this collateral shortage, moving overnight repo rates and T-bill rates up to the vicinity of the interest rate on reserves. Fed officials typically attribute these developments to an increased supply of Treasury bills, but the timing relative to the phasing out of reinvestment is difficult to ignore. In any case, we could make a case that mitigation of the safe asset shortage is putting upward pressure on the real interest rate.

So, maybe a long-run real interest rate of 0.8% isn't far-fetched. The Fed appears to be getting skittish about further interest rate increases, and language about "accommodation" has been removed from the FOMC statements. The FOMC appears to be planning at most an increase of 50 basis points in the fed funds rate range over the next year, which is not likely to be a big deal in terms of real effects, and the FOMC is very likely to back off in response to negative data. Given what we know, I'm finding it harder to quarrel with what the Fed's doing.

Things to look out for in 2019:

1. The Fed's balance sheet: In the November 2018 meeting, the FOMC discussed issues concerning the long-run implementation of policy. Will the Fed conduct policy with a small balance sheet in a corridor system, as is done in other countries (Canada, for example), or continue with the current large-balance-sheet floor system? This will involve a decision about when to resume asset purchases. The Fed will be making this decision in consultation with the public - a new approach for them. It will be interesting to see how the public consultation works, but the Fed could look to the Bank of Canada for guidance on that. Every 5 years the Bank of Canada renews its agreement with the federal government (currently an inflation-targeting agreement), and precedes the renewal with extensive consultation with the general public, academics, and think tanks. That works well I think - it's a different institutional environment, but the approach could be adapted.

2. Appointments: There are currently two vacancies on the Board of Governors. Marvin Goodfriend was nominated, and approved by the Senate Banking Committee, but his appointment may be dead. Is Trump going to weigh in on the next nominations - Sean Hannity on the Board, or some such? Among the Presidents of the regional Feds, most have not been in office long, and there are no anticipated departures, so far as I know, so probably not much going on there.

3. Voting FOMC Members: Presidents of regional Feds who vote this year are: Williams (NY), Evans (Chicago), Rosengren (Boston), Bullard (St. Louis), and George (Kansas City). All of these, except Bullard, are currently hawkish. No reason to expect any changes in policy soon, but Rosengren and Evans will likely turn dovish at the first sign of weakness in the real economy.