tag:blogger.com,1999:blog-24997159099567742292024-03-09T02:22:57.448-08:00Stephen Williamson: New Monetarist EconomicsWhat's happening in monetary policy and macroeconomics.Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.comBlogger605125tag:blogger.com,1999:blog-2499715909956774229.post-72970533401309146202021-11-18T12:51:00.003-08:002021-11-18T12:51:40.763-08:00Bank of Canada at a Crossroads<p> Post available <a href="https://stevewilliamson.substack.com/p/bank-of-canada-at-a-crossroads">here</a>.</p>Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com0tag:blogger.com,1999:blog-2499715909956774229.post-46756701184818365032021-11-18T12:50:00.003-08:002021-11-18T12:50:46.636-08:00Fed Monetary Policy Needs an Overhaul<p> Post available <a href="https://stevewilliamson.substack.com/p/fed-monetary-policy-needs-an-overhaul">here</a>.</p>Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com0tag:blogger.com,1999:blog-2499715909956774229.post-15189065139308225472021-07-03T07:52:00.001-07:002021-07-03T07:52:14.836-07:00The Fed's Policy Implementation Framework Does Not Work As Advertised. How Come?<p> <a href="https://stevewilliamson.substack.com/p/the-feds-policy-implementation-framework">Part I here.</a></p><p><a href="https://stevewilliamson.substack.com/p/the-feds-policy-implementation-framework-11c">Part II here.</a></p>Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com0tag:blogger.com,1999:blog-2499715909956774229.post-20285574792984121222021-06-21T18:19:00.001-07:002021-06-21T18:19:20.893-07:00Whatever Happened to Milton Friedman's Ideas?<p> <a href="https://stevewilliamson.substack.com/p/whatever-happened-to-milton-friedmans">Find the article here.</a></p>Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com0tag:blogger.com,1999:blog-2499715909956774229.post-36559270672216989162021-06-15T11:31:00.003-07:002021-06-15T11:31:21.400-07:00Jay Powell's April 28 Press Conference<p> <a href="https://stevewilliamson.substack.com/p/jay-powells-april-28-press-conference">Find the post here.</a></p>Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com0tag:blogger.com,1999:blog-2499715909956774229.post-51427336454162904022021-06-15T11:30:00.001-07:002021-06-15T11:30:07.239-07:00Should We Be Happy with the Bank of Canada?<p> <a href="https://stevewilliamson.substack.com/p/should-we-be-happy-with-the-bank">Find the post here.</a></p>Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com0tag:blogger.com,1999:blog-2499715909956774229.post-10640704793191246662021-06-15T11:29:00.000-07:002021-06-15T11:29:02.173-07:00The Mysteries of Inflation<p><a href="https://stevewilliamson.substack.com/p/the-mysteries-of-inflation">Find the post here.</a></p>Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com0tag:blogger.com,1999:blog-2499715909956774229.post-30754316134989148062021-04-20T15:09:00.000-07:002021-04-20T15:09:06.113-07:00Move to Substack<p> You can now find my posts at on Substack at <a href="https://stevewilliamson.substack.com/">https://stevewilliamson.substack.com/</a></p>Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com0tag:blogger.com,1999:blog-2499715909956774229.post-71342984617304154492020-08-30T12:31:00.000-07:002020-08-30T12:31:08.293-07:00Sorry You're Let Down By the Fed's Monetary Policy Review<p>On Thursday, the FOMC released a revised <a href="https://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf">Statement of Longer Run Goals and Monetary Policy Strategy</a>, and Jay Powell <a href="https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm">made a speech</a> 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?</p><p>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 <a href="https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm">annotated version</a>, as it shows you all the changes from the last published Statement.</p><p>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</p><blockquote><p>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.</p></blockquote><p>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? </p><blockquote><p> ...the Committee judges that downward
risks to employment and inflation have increased.</p></blockquote><p>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.</p><p>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?</p><p>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.</p><p>A key change that might, in principle, amount to something substantive is in the paragraph on inflation:</p><blockquote><p>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.</p></blockquote><p>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.</p><p>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.</p><p>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.</p><p>But, on to <a href="https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm">Powell's speech</a>. Powell says there are four things that are driving the change in the FOMC's Statement (using my words here):</p><p>1. Low productivity growth and demographic factors have lowered the average growth rate of real GDP.</p><p>2. r* is expected to remain persistently low.</p><p>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.</p><p>4. The Phillips curve is flat.</p><p>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:</p><blockquote><p><span face="" style="background-color: white; color: #333333; font-size: 14px;">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.</span></p></blockquote><p>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. </p><p>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, <a href="https://www.federalreserve.gov/boarddocs/speeches/2002/20021121/">Ben Bernanke gave a speech about deflation</a>, 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.</p><p>So, what concerns does low inflation raise for Powell?</p><blockquote><span face="" style="background-color: white; color: #333333; font-size: 14px;">...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.</span><p></p></blockquote><p>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 <a href="http://www.columbia.edu/~mu2166/perils.pdf">Benhabib/Schmitt-Grohe/Uribe (2001) on "Perils of the Taylor Rule."</a> 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.</p><p>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.</p><p>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.</p><p>This is more interesting, I think:</p><blockquote><p><span face="" style="background-color: white; color: #333333; font-size: 14px;">...our revised statement says that our policy decision will be informed by our "assessments of the </span><em style="background-color: white; box-sizing: border-box; color: #333333; font-family: arial, helvetica, sans-serif; font-size: 14px;">shortfalls</em><span face="" style="background-color: white; color: #333333; font-size: 14px;"> of employment from its maximum level" rather than by "</span><em style="background-color: white; box-sizing: border-box; color: #333333; font-family: arial, helvetica, sans-serif; font-size: 14px;">deviations</em><span face="" style="background-color: white; color: #333333; font-size: 14px;"> from its maximum level" as in our previous statement.</span><span face="" style="background-color: white; color: #333333; font-size: 14px;"> This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.</span></p></blockquote><p>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.</p><p>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.</p><p>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.</p><p>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.</p><p>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.</p><p>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.</p><p>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,</p><blockquote><p>...<span face="" style="background-color: white; color: #333333; font-size: 14px;">we are not tying ourselves to a particular mathematical formula that defines the average.</span></p></blockquote><p>This means that the promise is empty, essentially. If it's not written down, the FOMC can't be held to anything.</p><p>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?</p><blockquote><span face="" style="background-color: white; color: #333333; font-size: 14px;">...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.</span></blockquote><p>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.</p><p>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. </p><blockquote><p> </p></blockquote>Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com0tag:blogger.com,1999:blog-2499715909956774229.post-61614545248469553652020-07-27T08:09:00.000-07:002020-07-27T08:09:55.405-07:00The Bank of Canada Dives Into Unconventional PolicyThe 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 <a href="https://www.bankofcanada.ca/multimedia/mpr-press-conference-webcasts-july-2020/">press conference last week</a> 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.<br />
<br />
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.<div><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiaJyKPbxC3hJm4N5XbgWEhmTnZMtHZIaPInvmiID-jK_SeWEXoBUCSURLMTG1kClbOCJmsk4DLPPTNeZOalDXktJ3PRgW-GEwx63ws5J4CbMRZcOVtdQWa7ERhkGShGvJgw9E_F9Qci1km/s1600/assets.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="842" data-original-width="948" height="568" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiaJyKPbxC3hJm4N5XbgWEhmTnZMtHZIaPInvmiID-jK_SeWEXoBUCSURLMTG1kClbOCJmsk4DLPPTNeZOalDXktJ3PRgW-GEwx63ws5J4CbMRZcOVtdQWa7ERhkGShGvJgw9E_F9Qci1km/s640/assets.png" width="640" /></a></div><div><br /></div>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.<div>
<div>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 <a href="https://www.bankofcanada.ca/wp-content/uploads/2020/07/mpr-2020-07-15.pdf">July Monetary Policy Report</a> 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:</div><div><br /></div><div><blockquote>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).</blockquote></div></div><div><br /></div><div>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.</div><div><br /></div><div>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.<br /></div><div><br /></div><div>So, what questions might we want to ask about this?</div><div><br /></div><div>1) <i>What's the exit strategy? </i>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 <a href="https://www.bankofcanada.ca/wp-content/uploads/2010/01/dp07-2-e.pdf">accounting standards the Bank has adopted</a>, 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.</div><div><br /></div><div>2) <i>If the "interest rate channel" is so important to the Bank, why is it purchasing t-bills?</i> 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.</div><div><br /></div><div>3)<i>What's going on with the government of Canada's account balance with the Bank? </i>Here's what's happening on the liabilities side of the Bank's balance sheet:</div><div><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj2HEgmanMCYufq4Qqo_G1wQ6mZqoE6PuTquA4c2Kdsr_jJXU_4YvyzoDrOVidHInOC5q9xpnIg9CtQLFYKdxuTo9eots5IWGoRsBvtSjNnuqwwYtzviPmOEDTo3JkJrFq3bau-hst9Ud1j/s970/liab.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="798" data-original-width="970" height="514" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj2HEgmanMCYufq4Qqo_G1wQ6mZqoE6PuTquA4c2Kdsr_jJXU_4YvyzoDrOVidHInOC5q9xpnIg9CtQLFYKdxuTo9eots5IWGoRsBvtSjNnuqwwYtzviPmOEDTo3JkJrFq3bau-hst9Ud1j/w625-h514/liab.png" width="625" /></a></div></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">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.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">4) <i>Who says QE works anyway? </i>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.</div><div class="separator" style="clear: both; text-align: left;"><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgX5QOKqO0bvvflVe2-bDKcJeaWH4-4ju-t1OqqHk8Ivj284urxpL3hel0tyomyryUor07wV9D3u5TE56jtkZzQtTCA5TtNi1l4Z5v8KTQJZU2XLVBaNNNKaMEpeYzw_tsfU-dyDOoGk1fz/s978/rrates.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="842" data-original-width="978" height="539" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgX5QOKqO0bvvflVe2-bDKcJeaWH4-4ju-t1OqqHk8Ivj284urxpL3hel0tyomyryUor07wV9D3u5TE56jtkZzQtTCA5TtNi1l4Z5v8KTQJZU2XLVBaNNNKaMEpeYzw_tsfU-dyDOoGk1fz/w625-h539/rrates.png" width="625" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">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:</div><div class="separator" style="clear: both; text-align: left;"><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiMNtX-QEqqfd1If-ka1TK4s2C3a6bE8XXs7dNLNsXwY9YOc1JgJd1v4q6A3V8m4YBiapxHGdujAJSZNtW9uEgEQ4YUxKzP_zziLeS1enxLCYnaS00EMgyXakq_IaMM1KhpqiRYLx14wq4-/s995/totalbank.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="798" data-original-width="995" height="501" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiMNtX-QEqqfd1If-ka1TK4s2C3a6bE8XXs7dNLNsXwY9YOc1JgJd1v4q6A3V8m4YBiapxHGdujAJSZNtW9uEgEQ4YUxKzP_zziLeS1enxLCYnaS00EMgyXakq_IaMM1KhpqiRYLx14wq4-/w625-h501/totalbank.png" width="625" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div>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:</div><div class="separator" style="clear: both; text-align: left;"><br /><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhiFF6hAn_esNjcAGnMHvxZPKowXkxhec68t6hBU9576HO5wZELyhX7K_kwWLEG5MlKpC557dYm0FF-XjRRv3RDujw5TIvyNSRIjvU2ZQRzuRRNBVdRbLWzGG4nS2Pm1E6vvWova8p-0TEy/s1003/liquid.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="798" data-original-width="1003" height="499" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhiFF6hAn_esNjcAGnMHvxZPKowXkxhec68t6hBU9576HO5wZELyhX7K_kwWLEG5MlKpC557dYm0FF-XjRRv3RDujw5TIvyNSRIjvU2ZQRzuRRNBVdRbLWzGG4nS2Pm1E6vvWova8p-0TEy/w625-h499/liquid.png" width="625" /></a></div><div class="separator" style="clear: both; text-align: left;"><br /></div>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.</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">5) <i>Aren't bond yields pretty low anyway? </i>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?</div><div class="separator" style="clear: both; text-align: left;"><br /></div><div class="separator" style="clear: both; text-align: left;">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:</div><blockquote><div class="separator" style="clear: both; text-align: left;"><span style="background-color: white; color: #676984; font-family: "open sans", "helvetica neue", helvetica, arial, sans-serif; font-size: 14px; font-variant-ligatures: none;">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.</span></div></blockquote><div>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 <a href="https://www.utpjournals.press/doi/full/10.3138/cpp.2019-058">in this paper</a>, 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.</div><div class="separator" style="clear: both; text-align: left;"><br /></div></div></div>Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com7tag:blogger.com,1999:blog-2499715909956774229.post-67497019394799959972020-03-16T13:49:00.001-07:002020-03-16T13:49:48.825-07:00What 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.<br />
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There's more. The Fed <a href="https://www.federalreserve.gov/newsevents/pressreleases/monetary20200315b.htm">lists actions</a> 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.<br />
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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.<br />
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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 <a href="https://www.bankofcanada.ca/2020/03/market-notice-2020-03-16/">outlined here.</a> But I'll focus on the US, where most of the action is.<br />
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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.<br />
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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:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhgMxSGdCs8LDGgUnWAhIwRhAHq_y7FPFILM_hRi4Em0LtntVvt6_L0YWSlo15hHAxvkEvfb5fY3AFDQoQGqhhxQOmis1q5iz-918-zAQYNTEKDTCSKXKabuaTwKfxeDMjEctHc6oHeeld8/s1600/commpaper2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhgMxSGdCs8LDGgUnWAhIwRhAHq_y7FPFILM_hRi4Em0LtntVvt6_L0YWSlo15hHAxvkEvfb5fY3AFDQoQGqhhxQOmis1q5iz-918-zAQYNTEKDTCSKXKabuaTwKfxeDMjEctHc6oHeeld8/s640/commpaper2.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>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:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJgfFFCGz63-ox626MnIE4Rl-td8YwPBMo6SRzKnq25lKaMb9wF07-X7LHOJlRAivK5lu4ClAlgST4RZHOyzKkqtATz2EIEMQefGq_oaYsw5IF9YxMu90SonoFViPHcWlrZAAaqqELj3Dv/s1600/spread.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJgfFFCGz63-ox626MnIE4Rl-td8YwPBMo6SRzKnq25lKaMb9wF07-X7LHOJlRAivK5lu4ClAlgST4RZHOyzKkqtATz2EIEMQefGq_oaYsw5IF9YxMu90SonoFViPHcWlrZAAaqqELj3Dv/s640/spread.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>Though note that the data in the last 2 charts only runs to late last week, so things could have changed for the worse.<br />
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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.<br />
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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.<br />
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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.<br />
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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.<br />
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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.<br />
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Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com4tag:blogger.com,1999:blog-2499715909956774229.post-10005662622781534082020-03-05T14:41:00.003-08:002020-03-05T14:41:37.833-08:00Coronavirus and Monetary PolicyOn Tuesday, the FOMC voted to reduce the Fed's range for the fed funds rate by 50 basis points, to 1.00-1.25%, and on Wednesday, the Bank of Canada followed suit with a 50 basis point cut in its overnight interest rate target, from 1.75% to 1.25%. As you know, 50 basis point cuts by central banks are aggressive, particularly in the Fed's case where the cut occurred outside a regularly scheduled FOMC meeting. Other central banks might be doing the same - if their policy rates were not already at or close to zero, if not negative.<br />
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What's going on? Well, Jay Powell and Steve Poloz have told us why they're doing what they're doing. What do they have to say? First, in the <a href="https://www.federalreserve.gov/newsevents/pressreleases/monetary20200303a.htm">FOMC statement</a> that Powell and his colleagues issued, it says that the "fundamentals of the US economy remain strong," but the coronavirus "poses evolving risks." The FOMC is cutting 50 basis points "in support" of the Fed's dual mandate. There's no information beyond that. In <a href="https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20200303.pdf">his short press conference,</a> Powell didn't really add to that. Basically, the cut is to lend "support," apparently, and there are no promises about where the Fed goes from here. And, by the way, this has nothing to do with what Donald Trump wants, according to Powell.<br />
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So, that doesn't enlighten me much. An extreme action has been taken, but it's not based on anything that's actually showing up in the data yet. This is based solely on speculation about the effects on economic activity of a contagious virus that is going around. About which we know more than we did a couple of months ago, but much less than we would like to know. So, from all evidence, the Fed is taking a shot in the dark.<br />
<br />
But maybe Steve Poloz knows something that Powell doesn't know? The <a href="https://www.bankofcanada.ca/2020/03/fad-press-release-2020-03-04/">Bank of Canada statement</a> certainly has more information in it than does the FOMC statement, in part because the Bank of Canada made its decision in a regularly-scheduled policy meeting. There's a review of current conditions, which basically looks like more of the same. Current inflation (headline CPI) is above target at 2.4%, the labor market looks good, but there is some weakness in 4th quarter 2019 real GDP growth. Otherwise, like the US, the fundamentals are strong, but the statement seems to go out of its way to suggest that there's some weakness, presumably to justify the big reduction in the target rate. With regard to the coronavirus, the statement says: <blockquote>...business activity in some regions [of the world] has fallen sharply and supply chains have been disrupted. This has pulled down commodity prices and the Canadian dollar has depreciated. Global markets are reacting to the spread of the virus by repricing risk across a broad set of assets, making financial conditions less accommodative. It is likely that as the virus spreads, business and consumer confidence will deteriorate, further depressing activity.</blockquote>So, I think that's really the guts of the information that's supporting the policy decision. We know there's something going on with respect to the real side of the economy. Anecdotal evidence tells us that supply chain disruptions, originating mainly in China, could be a serious problem for domestic economic activity. We're also seeing large asset price movements. Stock prices are down, and prices of government debt are up. We're expecting to see some negative information in soft data - business and consumer confidence - but we're not measuring that as yet.<br />
<br />
But, we still don't have so much to go on. No hard data, really. Asset prices have been known to move by large amounts in the past, without any central bank response. But what's this about financial conditions becoming "less accommodative." I've heard that comment elsewhere, and I'm not sure what it means. The idea seems to be that financial markets get "tight" on their own, and then it's the job of the central bank to loosen things up. Maybe I can see some sign of "tightening" financial conditions in stress indices, or financial conditions indices. Here's the St. Louis Fed's financial stress index:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhGM2KzDiXxHtjy1v8cm3PcKfcADdH0VlgltjBf1Td_QclOl4xSg-e50U6tz2RUMrBbZxkyCDHq-n9_P5vHE265yS5cY_aQXx0tWCej3fkYe1bmKoQ9ux8Nc_979vbPbdYa25S0gIVRx0Xh/s1600/stlstress.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhGM2KzDiXxHtjy1v8cm3PcKfcADdH0VlgltjBf1Td_QclOl4xSg-e50U6tz2RUMrBbZxkyCDHq-n9_P5vHE265yS5cY_aQXx0tWCej3fkYe1bmKoQ9ux8Nc_979vbPbdYa25S0gIVRx0Xh/s640/stlstress.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>And here's the Chicago Fed's financial conditions index:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgyPjXFGZhVmprcw3HT7-JUNf0jc5MevRovtBG4f1QN4oBFbt_xv2DgBeXsMIxV10GDtCD0FDCJpeMEcBq3ObQUy30u2wCyWtVv-p4Odq05GZeKLoJlgvsYrS4nAoinrKfowaob6GymfX4X/s1600/chicagostress.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgyPjXFGZhVmprcw3HT7-JUNf0jc5MevRovtBG4f1QN4oBFbt_xv2DgBeXsMIxV10GDtCD0FDCJpeMEcBq3ObQUy30u2wCyWtVv-p4Odq05GZeKLoJlgvsYrS4nAoinrKfowaob6GymfX4X/s640/chicagostress.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>Those two charts show basically the same thing. Not much going on. Maybe people have something else in mind? There certainly have been large movements in the prices of Treasury securities in the US:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEidKa7KPQMh5bc0jlZoGRlIuMAZQe76HbUIpN9WoIppyTX600UMW2F3LgPfATFGLn4vX6kfx6WrCeLB9DWbkc6_plfTXAppgUna0NkfrdQ1AWUfC9l59TZ53ZjpWfIz0RlrYuEwYB8C8dEG/s1600/interest2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEidKa7KPQMh5bc0jlZoGRlIuMAZQe76HbUIpN9WoIppyTX600UMW2F3LgPfATFGLn4vX6kfx6WrCeLB9DWbkc6_plfTXAppgUna0NkfrdQ1AWUfC9l59TZ53ZjpWfIz0RlrYuEwYB8C8dEG/s640/interest2.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>The chart shows the 3-month T-bill rate, and the 10-year bond yield, both of which have dropped even more than the drop in the Fed's policy rate. The Fed moved down 50 basis points, but the whole Treasury yield curve has shifted down by much more than that. But why would I call that financial tightening? Looks like easing, don't you think?<br />
<br />
Another interesting phenomenon in US financial markets is what's going on in overnight markets. Since last fall, the Fed has been purchasing Treasury bills, and now has a <a href="https://www.federalreserve.gov/releases/h41/current/">stock of about $280 billion in T-bills.</a> As well, to maintain its overnight fed funds target, the Fed has been intervening in the overnight repo market, on the lending side. On February 27, there was about $140 billion in repos outstanding (overnight and term). However, on Tuesday and Wednesday of this week, the Fed's lending on the repo market expanded substantially. In fact, demand for overnight repos apparently exceeded the Fed's $100 billion cap. So, overnight Fed repos on Tuesday and Wednesday were $100 billion, where last week overnight repos were running roughly $30-$50 billion per day. So, something is causing high demand for overnight credit, and upward pressure on the overnight repo rates, while Treasury yields at all maturities are dropping like rocks. So, two issues here. First, why is the Fed capping its overnight repo lending? If it's so important to hold down short rates, the Fed should lift the cap. Second, the drop in Treasury yields in part reflects a high demand for safe assets. Why is the Fed continuing to buy T-bills? The market wants them, so the Fed should be selling T-bills or, short of that, stopping its purchases.<br />
<br />
What does history, and theory, tell us about what central banks should be doing now, in response to the coronavirus? History doesn't give us a lot to go on. In modern times, we haven't had to deal with a global pandemic of this type, with this level of potential widespread economic disruption. But, is this like dealing with other types of large shocks? First, is this like a financial crisis? No. The financial crisis originated as disruption in the financial sector. As such, it had historical precedents, and there is a wealth of experience concerning how a central bank should deal with a financial panic. In a financial crisis, the standard responses involve central bank lending, and bailouts. There is of course plenty of judgement that comes into play concerning who to lend to and how, who to bail out and how, and what the costs and benefits are. But, in general, this is all relatively well-understood. I know policymakers got plenty of flack in the last recession, but in general they were following a time-worn script. Not so much after the recession was over, but that's another story.<br />
<br />
Second, for policy purposes, is the coronavirus anything like a war? No. Wars involve a reallocation of labor and capital across sectors, as human beings go into the armed forces, peacetime production goes away, and wartime production ramps up. There are important questions concerning how the expenditure on the war machine is financed. Little of that is going on here, as what policymakers are dealing with is a general cutback in across-the-board economic activity, and a reduction in time devoted to market activities. Public spending comes into play, but it's not of the magnitude that we observe in a war. So, I don't think we can learn anything from wars in this case.<br />
<br />
Finally, what about natural disasters? Is that similar? Maybe. Floods and hurricanes, for example, can destroy aggregate economic activity temporarily, so that looks similar. And public spending is required to deal with the disaster. But if we take that seriously, this might tell us that monetary policy should do nothing and central bankers should sit on the sidelines. You may remember some monetary policy response to a hurricane or flood, but I don't.<br />
<br />
But what would theory tell us? There are of course plenty of Keynesian models - both new and old - in which output is demand-determined, and therefore output contractions occur because "demand" falls. I guess what people mean when they say the coronavirus is a "supply" shock and not a "demand" shock is that Keynesian models are not equipped to help us understand what is going on in this instance, so let's forget about that stuff. Some people -Roger Farmer for example - like to think about multiple equilibrium models. In a multiple equilibrium world, what policymakers say, or what they commit to, can make a difference. So, perhaps the large moves by the Fed and the Bank of Canada this week could be seen as bolstering confidence. But, those aggressive moves could also cause people to think that a disaster is looming. Maybe the central bankers know something we don't, and we should panic. Go buy toilet paper, instead of that new car.<br />
<br />
But, there are regular declines in economic activity that we deal with on a regular basis, apparently without any discretionary response from the central bank. Those regular declines are due to weekends, and seasonals. Every weekend a lot of people produce no market output. Every winter, some types of economic activity become more costly to undertake. Every summer a lot of people go on vacation. But, we've all become so accustomed to staring at seasonally adjusted data, that we forget a lot of that. There's a substantial amount of seasonal variation in a many macroeconomic time series. For example, here's US employment, unadjusted:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh0jrqEjP6KSxfqpaTUnTqi1XcQ9NKY0vCrV9e3hmCViDKj7CiQThZQexYlfp6rgc3LM-cvgXy9rI7D9MvkVtX_1BjfjXIXmiABYyFq_0rIyqwFYsGxDfzcBOSDh3YQ5jPRc79guIoDN1ho/s1600/employment.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh0jrqEjP6KSxfqpaTUnTqi1XcQ9NKY0vCrV9e3hmCViDKj7CiQThZQexYlfp6rgc3LM-cvgXy9rI7D9MvkVtX_1BjfjXIXmiABYyFq_0rIyqwFYsGxDfzcBOSDh3YQ5jPRc79guIoDN1ho/s640/employment.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>Typically, there's a big dip in employment in January, and a smaller one in August. The drop in employment from the busiest month to the least busy month isn't as large as the drop in employment during the last recession, but it's about 25% of that drop, typically, and it happens every year. And, importantly, the central bank is responding to that. Part of what the central bank does is to smooth out seasonal variation in interest rates, and also to smooth out bumps in the payments system, that is predictable disturbances that have to do with the month, the day of the week, or the season. An important part of central bank activity (though increasingly less important) is to supply currency elastically on weekends, in the holiday season, etc., to accommodate demand.<br />
<br />
So, that's all just happening automatically, as a result of standard central banking procedure - pegging an overnight nominal interest rate. And that will happen while the coronavirus is making us sick. The key question is whether the central bank should be doing more. Should the central bankers have done what they did - aggressively cut interest rate targets as if they were dealing with a financial crisis, or a large drop in (seasonally adjusted) employment at the onset of a recession?<br />
<br />
Jay Powell says that the interest rate cut will "support" the economy. Steve Poloz says that the interest rate cut will help consumer and business confidence. But how? Central bankers are always telling us about Friedman's "long and variable lags." The usual claim is that it takes a long time - maybe up to a couple of years - for monetary policy to have its effects. I don't know whether that's true or not, but it's a standard part of central banking lore. But, if the effects of the coronavirus are going to be temporary - a few months - why do anything if it's not going to matter within the relevant time frame? Maybe the interest rate cuts are supposed to inspire confidence. Typically, we think that interest rate cuts are going to tip the balance for consumers thinking about buying consumer durables and houses, or for firms making investment decisions. But, if the message I'm getting from the central bank is that things could get really bad, I'm going to be inclined to hunker down and postpone big spending decisions. So, it's hard to see what got accomplished this week on the monetary policy front.<br />
<br />
Finally, there's the issue of leaving policy space to deal with whatever future shocks might be thrown at us. Central bankers find it very easy to cut interest rate targets, and very hard to increase them. It's clear that, now these rate cuts are in place, central bankers will be slow to move up again, after the coronavirus passes. Non-neutralities of money are temporary - we don't get permanently lower output by having low nominal interest rates forever. So, once we cut rates now, we can't cut them later, and the real effects, such as they are, will dissipate.<br />
<br />
So, I'm inclined to think that the Fed, and the Bank of Canada, did the wrong things this week. The potential benefits are too small, and the potential costs too large. At the minimum, central bankers could have waited for more information, or cut less aggressively.<br />
<br />
Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com0tag:blogger.com,1999:blog-2499715909956774229.post-48779112451498684162020-02-18T09:12:00.000-08:002020-02-18T09:12:41.363-08:00Is Inflation Targeting the Best We Can Do?In the U.S., the Fed is considering modifications to its <a href="https://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf">longer-run goals and monetary policy strategy</a>, and last year Fed officials went on a <a href="https://www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-and-communications-fed-listens-events.htm">listening tour</a> to hear public views on its approach to monetary policy. This is new territory for the Fed, but the Bank of Canada does this sort of public outreach on a regular basis, in between renewals of its <a href="https://www.bankofcanada.ca/2016/10/renewal-of-the-inflation-control-target-2016/">policy agreement with the government of Canada.</a> The Bank <a href="https://www.bankofcanada.ca/toward-2021-renewing-the-monetary-policy-framework/">conducts in-house research, runs conferences, and interacts with the public in various ways,</a> to get a fix on whether the Bank's approach needs to be changed. Since 1991, the BoC has had a 2% inflation target, specified in its agreement with the federal government, and changes to that agreement since 1991 have been minor. In <a href="https://docs.google.com/viewer?a=v&pid=sites&srcid=ZGVmYXVsdGRvbWFpbnwxOTU0c3RlcGhlbndpbGxpYW1zb258Z3g6NTJmNWI3Yjc4Y2FjOWYwZA">"The Role of Central Banks,"</a> I discuss the BoC's inflation-targeting history, and evaluate potential modifications to the Bank's approach. My conclusion is that the BoC's performance has been excellent over the last 29 years, and that it is difficult to make the case that any changes to their approach are necessary.<br />
<br />
But what about the Fed, which operates under a different mandate, and potentially faces different issues than do other central banks? Since 2012, the FOMC has articulated its approach to fulfilling its Congressional dual mandate in its statement on <a href="https://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf">longer-run goals and monetary policy strategy,</a> which is typically updated each January (with the exception of January 2020). The Fed now has an explicit 2% inflation target, but one could argue that, implicitly, the 2% target was in effect long before 2012. For example, if we plot the path for the PCE deflator from 1995 through the end of 2019, relative to a 2% trend, here's what it looks like:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgC3NbbwYHGLQQ5oMA8XiF6XVnFfyaxOqiuf8C-YyIYHR7BHuqwFFS6poYSCHo-57Ymg5s8KrgOZMZgn8jYLd9Jcp07028bE53oyzIyC7RN5Hoeu_dhhu9z4W2ag7hLB2mX_g4kCsAH_mJy/s1600/pricelevel.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgC3NbbwYHGLQQ5oMA8XiF6XVnFfyaxOqiuf8C-YyIYHR7BHuqwFFS6poYSCHo-57Ymg5s8KrgOZMZgn8jYLd9Jcp07028bE53oyzIyC7RN5Hoeu_dhhu9z4W2ag7hLB2mX_g4kCsAH_mJy/s640/pricelevel.png" width="640" height="520" data-original-width="1031" data-original-height="837" /></a></div>This is perhaps surprising. The Fed actually does quite well relative to a 2% price <i>level</i> target, but starts to miss on the low side in 2012 - just when it makes the 2% inflation target explicit. Since 2012, average inflation has been 1.4%. Not great, but not bad either, relative to the sated goal.<br />
<br />
So, could the Fed do better? The Fed's dual mandate is a constraint of course, but Congress wrote the law in a sufficiently vague fashion that the constraint shouldn't bind if the Fed plays its cards correctly. Indeed, the FOMC's "Statement of Longer-Run..." skirts around the the second part of the mandate, which Fed officials typically state as "achieving maximum employment," without quantifying the concept. The Fed could change its <i>goals,</i> that is it could specify a different objective rather than 2% inflation - an NGDP (nominal GDP) target for example. It could change its <i>policy rule</i>, that is the mapping from observables to a target for something the Fed can control. For example, the policy rule could be a Taylor rule, which dictates a target for the fed funds rate as a function of current inflation and aggregate output. The Fed could also change its <i>implementation strategy,</i> for example the specific actions or mechanism for achieving a specific fed funds rate target.<br />
<br />
Potential changes that appear to be taken seriously inside the Fed system are relatively minor tweaks to the Fed's goals, principally makeup-strategy modifications of inflation targeting. These could be categorized as price level targeting and inflation averaging. Under conventional inflation targeting, history is irrelevant. For example, if <i>P(t)</i> is the price level, and <i>i*</i> is the inflation target, then in an period <i>t</i> the target for next period's price level is<br />
<br />
(1) <i>P*(t+1) = (1+i*)P(t)</i><br />
<br />
Or, in logs (approximately),<br />
<br />
(2) <i>p*(t+1) = i* + p(t)</i>.<br />
<br />
An advantage of this conventional approach is that there is only one number that describes it, <i>i*</i>. That's easy for a central banker to understand, and it's easy for the central banker to communicate what policy is about to the public. Given <i>i*</i>, it's easy to evaluate the central bank's performance. If <i>p(t)-p(t-1)</i> deviates from <i>i*</i>, the central banker needs to explain why, and specify what corrective action is to be taken, if any. Maybe there's some transitory reason for the deviation, and the central banker can provide that reason to justify doing nothing.<br />
<br />
But, it's possible that there could be some advantage to makeup inflation-targeting strategies, under which history matters. For example, price level targeting can be specified in terms of a base year <i>b</i>, a rate of adjustment <i>a</i>, and an inflation rate <i>i*</i>, which implies (see <a href="https://docs.google.com/viewer?a=v&pid=sites&srcid=ZGVmYXVsdGRvbWFpbnwxOTU0c3RlcGhlbndpbGxpYW1zb258Z3g6NTJmNWI3Yjc4Y2FjOWYwZA">my paper</a>) that next period's price level target is (in logs),<br />
<br />
(3) <i>p*(t+1) = (1-a)p(t) + ap(b) + [1+a(t-b)]i*</i>.<br />
<br />
In theory, we can find good reasons why price level targeting, embodied in (3), would be preferable to standard inflation targeting, as in (2). In principle, people care about inflation at all horizons. That is, if we think that the most important nominal contracts are intertemporal contracts - debt contracts of different maturities - then price level targeting has nice properties. Over any future horizon, if the price level target is well-understood, people know what inflation rate to expect, provided the central bank knows how to control the price level relative to the target. But, with standard inflation targeting, given that the central bank does not make up for past misses, the deviation from <i>i*</i> over a long horizon could be substantial, as was the case over the last 6 or so years.<br />
<br />
Two problems with price level targeting, though. First, it takes three parameters to describe the price level target - one needs to specify a base period, a rate of adjustment to the desired price level path, and a target rate of inflation. But, for conventional inflation targeting, I need to know only one number. With price level targeting, the target rate of inflation over the upcoming period is constantly changing, and that has to be understood by the central banker and communicated to the public.<br />
<br />
The second problem with inflation targeting lies not with the goal itself, but with the policy rule that goes along with it. People who think that price level targeting would be a good idea typically are not arguing that this will make credit markets more efficient by making inflation predictable over any future horizon. More typical is a type of forward guidance argument, for example <a href="https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-level-targeting-an-alternative-framework-for-monetary-policy/">Ben Bernanke's argument for temporary price level targeting.</a> Roughly the argument is that, in a recession, if inflation is below target, and the central bank has driven nominal interest rates to the zero lower bound, price level targeting implies a commitment to making up for misses on low side, and this will cause the central bank to take appropriate actions - staying lower for longer, or QE, for example. Such polices are supported by New Keynesian forward guidance arguments, but ignore Taylor-rule-perils problems. That is, in contrast to what central bankers and most macroeconomists want to believe, in theory and practice, following a Taylor rule prescription for monetary policy can lead to a policy trap in which central banks keep nominal interests rates low in the face of persistently low inflation. Basically, this is due to the force of the Fisher effect. If the central bank cuts the nominal interest rate more than one-for-one in the face of below-target inflation, this tends to reduce inflation even further, leading to further rate cuts, etc., stopping only when the central bank reaches the zero lower bound, or effective lower bound on nominal interest rates. In the limit, every country looks like Japan. The problem with price level targeting, motivated in the way that Bernanke motivates it, is that this just compounds the Taylor-rule-perils problem. Rather than producing higher inflation in a recession than might be the case with standard inflation targeting, the policy just increases the chances the central bank gets stuck in the low-inflation policy trap. The central banker will not be achieving his or her goals, and a frustrated central banker doesn't behave well.<br />
<br />
But, if Taylor-rule-perils are a problem, why didn't the Fed get stuck at zero after the last recession, or long before that? Does this mean that <a href="http://www.columbia.edu/~mu2166/perils.pdf">Benhabib et al. (2001</a>) were wrong? No. The Fed doesn't follow a Taylor rule. Suppose we look at HP-filtered monthly data for 1995-2019 on the fed funds rate, <i>R(t)</i>, the inflation rate, <i>i(t)</i>, as measured by the year-over-year percentage increase in the pce deflator, and the unemployment rate, <i>u(t)</i>, so as to capture short run policy responses to inflation and unemployment. The next chart shows deviations from trend in the fed funds rate vs. deviations from trend in the inflation rate:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiUHzUzTNfpLBbvFMM3cb9VeEqC03JWmRQAmpCVl8LxHK7ozziALe-mgZAyjs_Z_SR4roFQ4ZhnwQ_zzHdNKEZiYUu1JiILhGZtqalxGLfaH1rVKetjAzPbRYhbwEf6qWQ_LQjKzVlawzbX/s1600/iresponse.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiUHzUzTNfpLBbvFMM3cb9VeEqC03JWmRQAmpCVl8LxHK7ozziALe-mgZAyjs_Z_SR4roFQ4ZhnwQ_zzHdNKEZiYUu1JiILhGZtqalxGLfaH1rVKetjAzPbRYhbwEf6qWQ_LQjKzVlawzbX/s640/iresponse.png" width="640" height="529" data-original-width="1012" data-original-height="837" /></a></div>The correlation coefficient is positive, but small, at 0.3, and the chart does't show evidence of a large response of the fed funds rate to deviations of inflation from trend. If we look at deviations of the fed funds rate from trend vs. deviations of the unemployment rate from trend, we get:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhSgncH6oOxZAG87v6AIg1aoE0rVbSJwsYDnAGgfSL5HHvkam92Kve-O0Ha0tDR5GE4IYXTSdUWn-lzEvisLEIZZBZ2Far2TrFUsfX6IS_Z4MjE7T67STluST-NAwZjbaLBKzjJpw3opfPv/s1600/uresponse.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhSgncH6oOxZAG87v6AIg1aoE0rVbSJwsYDnAGgfSL5HHvkam92Kve-O0Ha0tDR5GE4IYXTSdUWn-lzEvisLEIZZBZ2Far2TrFUsfX6IS_Z4MjE7T67STluST-NAwZjbaLBKzjJpw3opfPv/s640/uresponse.png" width="640" height="522" data-original-width="1023" data-original-height="834" /></a></div>In this case, the correlation coefficient is -0.5. The most striking thing about this last chart is the absence of observations in the northeast quadrant - the Fed doesn't raise its fed funds target rate when the unemployment rate is above trend. If we run a Taylor-rule regression, we get<br />
<br />
(4) <i>R(t) = 0.06i(t) - 0.71u(t)<br />
</i><br />
So, we could interpret the regression as telling us that the fed funds rate target responds mainly to short-run movements in the unemployment rate. Why does this work? To come close to its inflation target, the average level of the nominal interest rate has to be consistent with the target inflation rate. By Fisherian logic, if the average real interest rate is lower, the average nominal interest rate should be lower. If the target inflation rate is higher, the average nominal interest rate has to be higher. But, given the inertia in inflation, the Fed can engage in countercyclical policy without causing untoward variability in inflation. And countercyclical policy gives the Fed an excuse to, on occasion, hike interest rates. In general, a monetary policy rule has to dictate that the nominal interest rate target increase in <i>some</i> states of the world, otherwise the central bank is doomed to perpetually undershooting its inflation target.<br />
<br />
What about inflation averaging? How does that differ from price level targeting? Inflation averaging is a makeup strategy, but with a moving base year. One way to specify this is to say that the central bank makes up for inflation targeting misses over the last <i>s</i> periods by compensating for these misses over the next <i>s</i> periods. This yields a target for next period's price level,<br />
<br />
(5) <i>p*(t+1) = (1-1/s)p(t) + (1/s)p(t-s) + 2i*</i><br />
<br />
Note that (5) is just (3) with <i>a = 1/s</i> and <i>b = t - s</i>. That is, the size of the window, 2s, determines both the speed of adjustment to the desired inflation path, and the base year. Though defining the makeup strategy in this way economizes on parameters - there are two instead of three - inflation averaging has basically the same drawbacks as price level targeting. Inflation averaging is hard for central bankers to understand, and it would confuse communication with the public. And, given the arguments of the promoters of such approaches, it seems clear that inflation averaging would make low-inflation policy traps more likely.<br />
<br />
Finally, let's deal with NGDP (nominal GDP) targeting. If nothing else, a change in the current regime to either NGDP growth or level targeting attracts the most passionate supporters, who include George Selgin (Cato Institute), David Beckworth and Scott Sumner (both George Mason University, Mercatus Center). That these people are all associated with right-wing think tanks is helpful in understanding what motivates NGDP targeters, though adherents of the approach are certainly not confined to the right. But, roughly, an NGDP targeter appears to be a modern-day monetarist. Monetarism, as practiced by the Volcker Fed, was successful in bringing down inflation, but central banks found that monetarist approaches failed in achieving low and stable inflation on an ongoing basis. Post-1980, changes in regulation and technology created a weak relationship between money growth and inflation, causing central bankers to abandon money growth targeting in favor of direct inflation targeting. A monetarist interpretation of the history might start with the equation that defines the income velocity of money,<br />
<br />
<i>MV = PY</i>,<br />
<br />
where <i>M</i> is some measure of money, <i>V</i> is the income velocity of money, <i>P</i> is the price level, and <i>Y</i> is real GDP, so <i>PY</i> is nominal income. One could say that Friedman's argument was that <i>V</i> is predictable, implying a predictable relationship between the money stock and nominal income, but Friedman went further. Friedman's writings indicate that he thought that instability in <i>M</i> caused instability in both <i>P</i> and <i>Y</i>. In practice, <i>V</i> proved to be unstable, which presented a problem for monetarists. But then people sympathetic to monetarism, for example Ben McCallum in the 1980s, argued that, in face of <i>V</i> instability, the central bank might just as well target <i>PY</i>, which would solve the problem.<br />
<br />
What does NGDP targeting have going for it? It's certainly simple, in the same way a money growth target is simple. We measure nominal income on a quarterly basis, it's easy to describe what the goal is, and it's easy for the public to evaluate performance. It's also connected to the Fed's dual mandate, in that nominal income could be a summary statistic that tells us all we need to know about price stability and the real performance of the economy. But, the key questions are:<br />
<br />
1. What's the connection between nominal income and the things the Fed should actually care about?<br />
2. Is it even feasible for the Fed to achieve an NGDP target, with some reasonable degree of accuracy?<br />
<br />
In an NGDP targeting regime the central bank would first have to choose a trend growth rate. Then, either this is a simple NGDP growth rate strategy, much like current inflation targeting schemes where history does not matter, or it's a makeup scheme, similar to price level targeting or inflation averaging. As such, any NGDP makeup strategy suffers from the some of the same problems as inflation targeting makeup strategies. First, such strategies are hard to understand, and hard for central bankers to explain. Second, part of the motivation for NGDP targeting comes from an assessment that monetary policy has been too tight in downturns, particularly during the last recession. Actually, Fed intervention, beginning in late 2007, and continuing through late 2015 and beyond, was massive in this episode, and to claim that more should have, or could have, been done seems silly. The Fed cut the target fed funds rate by 325 basis points from July 2007 to May 2008, set up the Term Auction Facility and lent substantially in early 2008 through that facility, and through the discount window. Overnight rates were essentially at zero for seven years, from fall 2008 to December 2015, and there was an unprecedented and large increase in the Fed's balance sheet.<br />
<br />
It's useful to consider the following experiment. At the beginning of 1995, suppose that the Fed had chosen an NGDP level target, and had conducted policy in the same way as they actually did. How would we be evaluating their performance, and what might they have done differently to achieve the NGDP target? From 1947 to 1995, real GDP grew at about 3.5% per year, so suppose that in 1995 the Fed had set a target path of 5.5% for nominal GDP. The next chart shows actual nominal GDP and the 5.5% target path from 1995-2019.<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjfObNiunl4UcwvcjcZPmqlrP1J4oFBe9diGb3B98r3hkZFBnBYMZBUNIbBzLy1HbzCGTs2qQwHbGxKHny1rmSTjFu9hmHFQ1DoG7VxfvbgSfoDTVygBYOrYP-GAf5BfHbYbPAFp-1z9oMw/s1600/ngdp.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjfObNiunl4UcwvcjcZPmqlrP1J4oFBe9diGb3B98r3hkZFBnBYMZBUNIbBzLy1HbzCGTs2qQwHbGxKHny1rmSTjFu9hmHFQ1DoG7VxfvbgSfoDTVygBYOrYP-GAf5BfHbYbPAFp-1z9oMw/s640/ngdp.png" width="640" height="517" data-original-width="1037" data-original-height="837" /></a></div>Until the 2008-09 recession, the Fed would have been doing quite well according to this criterion, but then things would have gone awry. But surely the Fed could, and would, have changed policy to achieve the target, right? I don't think so. Given conventional policy thinking, and what appears to be the mindset of anyone advocating NGDP targeting, to achieve the target path in the last chart, the Fed should have been more accommodative - more interest rate cuts and more unconventional easing. But short rates were at zero, and it's not clear that QE was doing much of anything at the time - more QE would likely have meant more nothing. So, having adopted the 5.5% NGDP target, the Fed's failures would be worse in terms of the alternative target, and the Fed would be suffering even more complaints than they are now.<br />
<br />
A key problem with NGDP targeting is that it requires that the policymaker take a stand on the the future trend growth rate in real GDP, which macroeconomists have no ability to predict. As well, problems can ensue due to short run fluctuations in real GDP. In the worst-case scenario in which monetary policy has no real effects, a nominal GDP target, if achievable, involves forsaking price stability. Thus, to the extent that price stability is desirable, economic welfare declines. The likely outcome, however, is related to what we see in the last chart. It is unlikely that the Fed would actually behave differently in a recession with an NDGP target than with an inflation target. If a recession happened next month, the Fed would cut its policy rate, and then start buying assets when the policy rate hit the zero lower bound, under the current regime, or under NGDP targeting. But, as in the last recession, the Fed would be missing on the low side much more substantially with an NGDP target than with a price level target, which would create pressure to stay lower for longer. Just as with inflation targeting, the result is to increase the chances the Fed gets stuck in a low-inflation policy trap.<br />
<br />
Advocates of NGDP targeting make three claims:<br />
<br />
1. The costs of variable inflation are negligible.<br />
2. Inflation-targeting central banks - the Fed in particular - are singularly focused on inflation control.<br />
3. There are large untapped welfare gains from output stabilization.<br />
<br />
It seems to me the weight of theory and evidence tells us all three claims are wrong. First, it's no accident that legislation constraining central bank behavior typically mandates that the central bank concern itself with price stability. That extremely high and variable inflation is destructive is self evident. And moderately high inflation in North America in the 1970s produced a consensus in favor of taking action to bring inflation down. The success of inflation targeting is reflected in the lack of attention paid to inflation currently by most individuals. But perhaps macroeconomists have paid insufficient attention to examining why low and stable inflation are beneficial. For example, New Keynesian theory tells us that unpredictable inflation is costly because it creates relative price distortions. But, it seems more likely that inflation variability reduces performance in credit markets. High variability in inflation, combined with nominal debt contracts with various maturities, creates uncertainty for borrowers and lenders in credit markets - uncertainty that is costly, and can be mitigated by the central bank.<br />
<br />
Second, most inflation-targeting central banks have other important concerns than controlling inflation - they worry in particular about GDP growth, the state of the labor market, and financial stability. The Fed takes its dual mandate seriously, and I showed above that short run movements in the Fed's policy rate are primarily explained by deviations of unemployment from trend.<br />
<br />
Third, that the Fed could be doing more to stabilize output seems a difficult case to make, particularly as regards the financial crisis and the ensuing recession. In general, the ability of the Fed to affect real outcomes in a good way is limited. Some macroeconomic shocks are not amenable to mitigation by the central bank. Our knowledge of how the economy works is rudimentary. Macroeconomic measurement is not all it could be. Data is not available on as timely a basis as we might like. Decision-making is cumbersome and takes time.<br />
<br />
Conclusion: The FOMC's <a href="https://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf">"Statement of Longer-run Goals and Monetary Policy Strategy"</a> is fine for now. No need for changes.<br />
<br />
<br />
<br />
<br />
Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com3tag:blogger.com,1999:blog-2499715909956774229.post-19008319525807443872020-01-10T13:00:00.000-08:002020-01-10T13:00:52.910-08:00The FOMC: Where It's Come From, and Where It's GoingAfter three reductions of 25 basis points each in its fed funds rate target range since the middle of last year, the Fed seems to be on pause. What is the FOMC concerned about, and why, and what's in store for the rest of the year?<br />
<br />
What does the data look like? First, the labor market has become increasingly tight:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiQrQ7P70r5dqZzH3SymWsud65JADJgq8-oWl0XYbQjp5h_P3-DZBohJXV-UfeoX4Rl8WapHqVabboEFf7TE1nl2nbUHaQ49NibAeZU6fOQ1A9hBKc6deFqvgFskldQGLXr-ptchmo9gEgI/s1600/labor+market.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiQrQ7P70r5dqZzH3SymWsud65JADJgq8-oWl0XYbQjp5h_P3-DZBohJXV-UfeoX4Rl8WapHqVabboEFf7TE1nl2nbUHaQ49NibAeZU6fOQ1A9hBKc6deFqvgFskldQGLXr-ptchmo9gEgI/s640/labor+market.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>The unemployment rate is lower than it's been for a very long time, and the job openings rate is higher than at any time since the BLS started collecting the vacancy data. Most people, me included, have been surprised by how low the unemployment rate has fallen, but possibly that's because our experience with expansions of this length is limited to non-existent. Real GDP growth has been consistently strong, if we adjust for the moderate average growth we have been seeing since the 2008-2009 recession:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEeIz5HxvsxFIaNHQpPBS2JD8XctCIEOXUgqkTwhpJobGC37OkyjirzSLmR4PjkAiUM4R7xI1WJb4N0V7t0a9KB6P4j2WudPtR46IPAnJnO9Rdk7GFd2OoAEwXJTwR6YqmkrUJ5ves5siU/s1600/gdp+growth.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEeIz5HxvsxFIaNHQpPBS2JD8XctCIEOXUgqkTwhpJobGC37OkyjirzSLmR4PjkAiUM4R7xI1WJb4N0V7t0a9KB6P4j2WudPtR46IPAnJnO9Rdk7GFd2OoAEwXJTwR6YqmkrUJ5ves5siU/s640/gdp+growth.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>In particular, recent observations in the chart are close to the 2.3% year-over-year average since 2010. Finally, according to standard measures, inflation is close to, though slightly below, the FOMC's 2% inflation target.<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjOkYrrIGY-o8K39wGiQZKRe5I3DnsAYrVKq0Too_Sd8wnbqelvQW29btDBwdMATeSk3fYg5eKq5JhOiv9PfChxuYKmj0X-B5p4nyg2lR0mFENiViuokIQS7GLvU-hqETLHJO-YDBu4bH_X/s1600/inflation.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjOkYrrIGY-o8K39wGiQZKRe5I3DnsAYrVKq0Too_Sd8wnbqelvQW29btDBwdMATeSk3fYg5eKq5JhOiv9PfChxuYKmj0X-B5p4nyg2lR0mFENiViuokIQS7GLvU-hqETLHJO-YDBu4bH_X/s640/inflation.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>In the last three years, inflation has been close to 2%, and the most recent observations for headline PCE, core PCE, headline CPI, and core CPI, are 1.4%, 1.8%, 2.4%, and 1.8%, respectively.<br />
<br />
So, relative to the objectives the FOMC laid out for itself in the <a href="https://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf">Statement of Longer-Run Goals and Monetary Policy Strategy</a>, it is doing well. This is an economy that has not experienced a large shock for a long time, and is growing smoothly with no apparent unemployed resources - at least, unemployed resources of the sort that monetary policy could put back to work. In terms of what monetary policy can hope to accomplish, there's nothing to do, which should be a wonderful state of affairs for American central bankers. Of course, people being what they are, you can find complainers, both inside and outside the Federal Reserve System.<br />
<br />
The only fault we could find here is that inflation is below the 2% target. According to the inflation measure the FOMC chose for itself - the raw PCE deflator - inflation is at 1.4%, year-over-year. We can temper our criticism with the fact that a miss of 0.6 percentage points isn't so bad in inflation-targeting circles and also, as I showed in the last chart, by other measures inflation is closer to target. But there's more going on here. Concern with below-target inflation was part of the motivation for the three interest rate reductions that occurred last year, in three consecutive FOMC meetings. And part of the concern about inflation is focused on anticipated inflation measures, for example the 10-year breakeven rate:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgTYCa4I6M8BOp-e05XFD4nCGlhldwme_lnUxKd28tlG0XY36R_1ydIGHMQdcUpGIdGxSwp-EmFIEJf39szIASb3M4KK8k5R3SAsvZnbtAjodiDUlVNjcOjuMiXfg4IzciEQAgcM3sZVSwP/s1600/breakeven.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgTYCa4I6M8BOp-e05XFD4nCGlhldwme_lnUxKd28tlG0XY36R_1ydIGHMQdcUpGIdGxSwp-EmFIEJf39szIASb3M4KK8k5R3SAsvZnbtAjodiDUlVNjcOjuMiXfg4IzciEQAgcM3sZVSwP/s640/breakeven.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>At 1.8%, that's not so low, but it's lower than seems consistent with 2% inflation over a 10-year horizon.<br />
<br />
The troubling part is that the typical FOMC member seems willing to admit that he or she does not understand the connection between FOMC actions and inflation. For example, Mary Daly, President of the San Francisco Fed, is quoted in the <a href="https://www.nytimes.com/reuters/2020/01/04/business/04reuters-usa-fed-daly.html">January 4 New York Times</a> as saying, at the ASSA meetings, that: <blockquote>We don't have a really good understanding of why it's been so difficult to get inflation back up...</blockquote>And, this makes here want to predict that: <blockquote>...this new 'fighting inflation from below' is going to be with us, I would argue, for a longer period of time than just a few years.</blockquote>She also concludes that: <blockquote>...a new policy framework will likely be required...</blockquote>So, that seems correct - if the FOMC feels its chronically failing on some dimension, it should change what it's doing. Of course, it will help if the Fed understands the problem first.<br />
<br />
I've been saying this for a long time (e.g. <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3194984">this paper in the St. Louis Fed Review,</a> <a href="https://onlinelibrary.wiley.com/doi/full/10.1111/caje.12403">this one in the CJE,</a> and numerous blog posts), but it bears repeating. For some reason, central bankers have a hard time understanding Fisher effects. There's ample empirical evidence that low (high) nominal interest rates induce low (high) inflation, and that's what essentially all of our mainstream dynamic macroeconomic models tell us. For about 20 years we've known about the <a href="https://www.sciencedirect.com/science/article/pii/S0022053199925851">perils of Taylor rules.</a> The idea is that a Taylor-rule central banker, observing inflation below target, will cut the nominal interest rate target, which reduces inflation, which produces further rate cuts, until the central banker hits the zero lower bound (ZLB), or possibly a lower effective lower bound. This behavior fits some recent central bank experience - the Bank of Japan in particular.<br />
<br />
We can think of the long-run problem of an inflation-targeting central bank as one of finding the average nominal interest rate target that is consistent with hitting the inflation target, on average. The problem for the FOMC, post-financial crisis, is that it is hard to know what that average nominal interest rate is. It's certainly lower than in the past - worldwide, we have observed falling real interest rates on safe debt since about 1980. But, the post-financial crisis period was not such a bad one for sorting this out, for the FOMC. Basically, "normalization" was proposed by the FOMC as a sorting-out - let's increase the policy rate until we find the sweet spot that sustains 2% inflation. The FOMC engaged in a somewhat leisurely tightening phase, with an ultimate target of about 3% for what the Fed thought was a "neutral" rate - roughly, the rate that would be consistent with 2% inflation, provided the economy never saw another large shock again. This approach seemed OK, as the FOMC could take its time to see the effects of tightening policy work themselves out, and decide when to stop (possibly before reaching 3%) based on observed inflation.<br />
<br />
The FOMC developed a case of the heebie jeebies in mid-2019, however, brought on in part by Donald Trump - his criticisms of the Fed and his trade "policy" - and by inflation falling below the 2% target. In hindsight, I think the interest rate cuts were wrong. I'd argue that nominal interest rates at the current level are too low to be consistent with 2% inflation over the long run, and nothing was achieved on the real side of the economy. If the fed funds rate target were still at 2.25%-2.5%, the real economy would be performing about the same, inflation might be on target, and the FOMC would have another 75 basis points that they could cut in the event that something bad actually coming to pass.<br />
<br />
Since the July 2019 FOMC meeting, the Committee has had a running discussion which you'll find under "Review of Monetary Policy Strategy, Tools, and Communication" in the published FOMC minutes. To summarize, the Board staff and the Committee appear to recognize that low real interest rates are a persistent phenomenon, and that this implies that nominal interest rates have to be low in order for the Fed to be achieving 2% inflation. This then implies that, if the Fed engages in countercyclical policy to the same extent as in the past, then the FOMC will more frequently encounter the ZLB. What then to do at the ZLB? Should the Fed engage in unconventional monetary policies? If the answer is yes, then what? Also, should this state of affairs imply some change in the Fed's inflation-targeting approach?<br />
<br />
The FOMC seems to like unconventional policies - at least the ones it's experimented with. It doesn't like negative interest rate policy, though, which is fine with me. The FOMC seems very confident that quantitative easing (QE) and forward guidance are effective policies. However, in several meetings worth of discussion, as reported in the FOMC minutes, it's hard to see how the Fed learned anything from its experience with QE and forward guidance after the financial crisis. The theory has not advanced, and the evidence to support the use of such policies to further the Fed's goals is lacking. With respect to QE, it seems hard to argue that replacing US Treasury securities with bank reserves is a useful thing to do - this amounts to swapping a crappy asset for a good one, basically. And there's no evidence that QE helps in terms of achieving the Fed's ultimate goals. Ask the Bank of Japan, which has tried in vain, through a massive increase in its balance sheet, to get inflation up to 2% in the last 7 years. Forward guidance, while in principle unobjectionable if it serves only to clarify the nature of the FOMC's policy rule, was a bust in the post-financial crisis period. If someone characterizes the Fed's forward guidance over that period as anything but confusing, they need to explain - carefully.<br />
<br />
A significant portion of the discussion of new approaches to policy in the FOMC minutes relates to possible modifications of the FOMC's inflation targeting approach. Standard inflation targeting has an important defect, which is that past inflation is a bygone - under inflation targeting, the central bank cares only about how its policy rule allows it to control future inflation. In principle, depending of course on why we think inflation is costly, it's possible that "makeup strategies" might be superior. The FOMC considers a couple of these, which are price level targeting and inflation averaging. I discuss both of these in more detail in <a href="https://docs.google.com/viewer?a=v&pid=sites&srcid=ZGVmYXVsdGRvbWFpbnwxOTU0c3RlcGhlbndpbGxpYW1zb258Z3g6NTJmNWI3Yjc4Y2FjOWYwZA">this paper.</a> Price level targeting essentially involves the choice of three parameters: a base year, an inflation rate, and a rate of adjustment. The idea is to calculate, given the base year, and the inflation rate, a target inflation path, and to then conduct policy so that the price level adjusts to the target path at the required adjustment rate. Inflation averaging is related, but uses a rolling base year. In this case, policy is conducted so that inflation misses over some past period of time are made up over some future period of time.<br />
<br />
Both of these approaches have something going for them in theory, but in practice there are problems. Both makeup strategies are difficult to explain to the public, as they imply that the target inflation rate needs to change over time. This creates internal decision-making problems as well, since a more complicated rule permits slippage between stated and unstated goals in policy discussions, and can only bog down a committee. The most important problem, though, is that support for makeup policies tends to come from people who believe strongly (as I think they should not) in Phillips curve theories of inflation. These proponents typically think that price level targeting or inflation averaging would lead to more stimulative policy in a recession. Also typically, I think, what people have in mind is that price level targeting or inflation averaging will imply lower rates for longer during a recession. What this would lead to is actually worse performance relative to the target - more undershooting of inflation targets, however specified. This is just part of the "Taylor rule perils" problem - policy rules that produce permanently low nominal interest rates and low inflation. It's not the goal that's the issue here, but the policy rule that people have in mind to achieve the goal.<br />
<br />
An interesting exercise is to look at the time path of the price level (as measured by the PCE deflator) in the United States for a long period of time, and see how the Fed did relative to a 2% path for inflation. We'll take a "long time" to be the last 25 years:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi0q5uCfgJhCJA-fw5TbvOmt-71uItAgggKinNQdpjV5dDQY02wJLTc-AYv2np5rlXrxU8bB5LGW1FRJ7cJNLDe0jhJb6tUjJ3e4j1KQ8r4mZT4V-zEdP6fmpEkRJeryd87k27pqCwE3Wjx/s1600/two+percent+goal.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi0q5uCfgJhCJA-fw5TbvOmt-71uItAgggKinNQdpjV5dDQY02wJLTc-AYv2np5rlXrxU8bB5LGW1FRJ7cJNLDe0jhJb6tUjJ3e4j1KQ8r4mZT4V-zEdP6fmpEkRJeryd87k27pqCwE3Wjx/s640/two+percent+goal.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>Up until the last recession, performance was pretty good, and you can see the undershooting since 2009. Even so, the current deviation from the 25-year 2% inflation path is only about 5%, which seems pretty good. What does this say? Clearly, the Fed hasn't been following a Taylor rule as this would have turned the US into low-inflation low-nominal-interest-rate Japan long ago. What's going on? I ran the following regression on monthly data for the US:<br />
<br />
<i>r(t)=a + bu(t) + di(t)</i>,<br />
<br />
where <i>a</i> is a is a constant, <i>b < 0,</i> <i>d > 0</i>, and <i>r(t)</i>, <i>u(t)</i>, and <i>i(t)</i> are, respectively, the nominal fed funds rate, the unemployment rate, and the pce inflation rate, all hp-filtered. That is, we're estimating the response (in a crude way, of course) of the deviation in trend from the Fed's policy rate to the deviation from trend in the unemployment rate, and the deviation from trend in the inflation rate. The OLS estimates are <i>b</i> = -0.95, <i>d</i> = 0.13, and <i>a</i> = 0 by construction. This says that, indeed, the Fed has not been a Taylor-rule central banker, which would imply <i>d > 1</i>. The Fed responds strongly to deviations of the unemployment rate from trend, and in a minor way to deviations of inflation from trend. So, that approach seems to have been successful in achieving a 2% inflation target - supposing that the implicit target was 2% even in the Greenspan era. Maybe getting too bothered by inflation isn't such a great idea (in the short run), even if you're an inflation-targeting central bank. Though of course long-run policy is important for hitting the inflation target.<br />
<br />
What's the upshot? If central banks want to hit inflation targets, they have to find reasons to increase nominal interest rate targets in the face of below-target inflation. The Fed, and other central banks have used an incipient-inflation argument in the past - basically, inflation is just around the corner unless we increase interest rates now. Unfortunately, that argument seems to lose steam if the central bank tries to do the interest rate hikes in a leisurely fashion. But, if central banks undershoot inflation perpetually, who cares? Probably only the central bankers, as no one outside of direct financial market participants is paying attention. That the central bankers care can be a problem, as they seem to like QE and forward guidance which, it seems to me, can be harmful policies. I could go on to complain about the Fed's floor system, but we'll leave that for another time. Have a good 2020.<br />
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Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com0tag:blogger.com,1999:blog-2499715909956774229.post-31012951866239117652019-10-27T17:54:00.002-07:002019-10-27T17:56:23.282-07:00An Attempt to Sort out the Fed's Overnight Market IssuesFirst, we'll get up to speed on the state of monetary policy implementation in the United States of America, in case you haven't been paying attention. After the financial crisis, the Fed substantially increased the size of its balance sheet, primarily through the purchase of long-maturity Treasury securities and mortgage-backed securities. On the liabilities side of the balance sheet, the Fed has seen a steady increase over the last 10 years in the quantity of Federal Reserve notes (currency) outstanding, but the primary source of funding for the increase in securities-held-outright by the Fed is an increase in the reserve balances held by financial institutions. This increase in reserves outstanding necessitated a floor-system approach to targeting overnight interest rates. That is, once there is a sufficiently large quantity of reserves outstanding, the interest rate on reserves (IOER) should, in theory, peg all overnight interest rates, through financial arbitrage. Basically, financial institutions should be indifferent in a floor system between lending to the Fed overnight and lending to other financial institutions overnight. Whether this approach to day-to-day overnight credit market intervention is better or worse than the approach taken before the financial crisis was not a matter of concern for the Fed when it embarked on its balance sheet expansion. The floor system simply came with the large-scale asset purchases (QE) that were part of the Fed's post-financial crisis approach. The initial understanding, going back at least to 2011, was that the Fed would eventually revert to "normal," that is the Fed's policy rate would rise, and the quantity of reserves outstanding would revert to the neighborhood of, say, $10-$15 billion, as before the crisis.<br />
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Well, normalization never happened, either with respect to interest rate policy or balance sheet policy. The Fed backed off its interest rate hikes, reversed direction, and certainly does not seem on the road to pegging short term interest rates in the ballpark of what would be commensurate with sustaining 2% inflation. Remember, sustained low nominal interest rates just creates sustained low inflation. Just ask the Bank of Japan. On balance sheet policy, there was a modest reduction in the Fed's total assets between late 2017 and this August, of about $600 billion:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjXvvBPsD7GfuaJI3V6b5D9N1xYO7YBsFzVu5X7DOIBXckE_-RQ7inljWWjziutK9qgIfX6IUPMdqakTXcUa9pSfng97RJ3SL9Pi66peDguSh6XGh0WH5_9lOavEHVVhKdG8evez9n6kHJq/s1600/fedassets.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjXvvBPsD7GfuaJI3V6b5D9N1xYO7YBsFzVu5X7DOIBXckE_-RQ7inljWWjziutK9qgIfX6IUPMdqakTXcUa9pSfng97RJ3SL9Pi66peDguSh6XGh0WH5_9lOavEHVVhKdG8evez9n6kHJq/s640/fedassets.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>Better still, we can look at Fed assets minus currency outstanding, which is the quantity of non-currency Fed liabilities, along with reserves:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjFOkzdP7If8wO4kiXmM4363XQoC_-V4DyLsn5BJhraoWGuBZB7PrSiUgFqv2dx3hvBm3cZk2FzPQYGA4qI2i54E9U6-MNdqmUqHwflmYLAm80875uW1LHn5lEASeX3j9wFXiFECfwV5Y30/s1600/reservesetc.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjFOkzdP7If8wO4kiXmM4363XQoC_-V4DyLsn5BJhraoWGuBZB7PrSiUgFqv2dx3hvBm3cZk2FzPQYGA4qI2i54E9U6-MNdqmUqHwflmYLAm80875uW1LHn5lEASeX3j9wFXiFECfwV5Y30/s640/reservesetc.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>What this shows is that, while reserves outstanding have declined substantially to less than $1.5 trillion, the quantity of Fed liabilities other then currency and reserves has grown substantially. In the last <a href="https://www.federalreserve.gov/releases/h41/current/h41.htm">Fed balance sheet snapshot,</a> those liabilities included $293 billion in the foreign repo pool - that's effectively reserves held at the Fed by foreign central banks and other foreign institutions - and $378 billion in the Treasury's general account held with the Fed. More about that later.<br />
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How does the FOMC think about overnight interest rate determination in a floor system? Typically, they're relying on this:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjO_mZhrmJd-hkToGzG2U8sUsxjToNPdQ_4MFLHLUB71y2cBjoVLm6oN49qF6BKGUcbmKCNIsNiTtqH3wpdjfEpQlSmgYj3mnerKl2l2H8phvNyYEShuZBepd28_ZxdohsVuEvhCWUkI45d/s1600/figure1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjO_mZhrmJd-hkToGzG2U8sUsxjToNPdQ_4MFLHLUB71y2cBjoVLm6oN49qF6BKGUcbmKCNIsNiTtqH3wpdjfEpQlSmgYj3mnerKl2l2H8phvNyYEShuZBepd28_ZxdohsVuEvhCWUkI45d/s640/figure1.png" width="640" height="360" data-original-width="1280" data-original-height="720" /></a></div>In the figure, <i>R</i> is the fed funds rate, and <i>Q*</i> is the quantity of reserves that is the threshold between "abundant" reserves and "scarce" reserves. So long as the supply of reserves is larger than <i>Q*</i>, according to this story, if the Fed wants to target the fed funds rate at <i>R*</i>, it simply pegs the interest rate on reserves (IOER) at <i>R*</i> and then the market clears at <i>R*</i>.<br />
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You can see how, if this is your view of how overnight markets work, then the mid-September episode when the overnight repo rate spiked well above IOER would be interpreted as a symptom of reserves being less than <i>Q*</i>. As a reminder of what has happened to overnight interest rates in the US since interest rate hikes began in December 2015:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgS8QSoab48TlV4v_hmVCUDx1LRP-AzElnFk2rTPnChfMGgYVOwa9qUHtZx-jbMCW2u6M5xrOP39TCPIidZ9AA_6V1YOMCdo5kuYg2eMJwzi2Z5P8hJs2DSU0PfYmcnUeyPCcS4JQiULQis/s1600/figure4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgS8QSoab48TlV4v_hmVCUDx1LRP-AzElnFk2rTPnChfMGgYVOwa9qUHtZx-jbMCW2u6M5xrOP39TCPIidZ9AA_6V1YOMCdo5kuYg2eMJwzi2Z5P8hJs2DSU0PfYmcnUeyPCcS4JQiULQis/s640/figure4.png" width="640" height="476" data-original-width="1075" data-original-height="800" /></a></div>The chart shows IOER, the effective fed funds rate and, later in the sample (when the Fed started collecting the data for the repo rate series), the secured overnight financing rate (SOFR), i.e. a measure of the overnight repo rate. The data in the chart certainly doesn't conform to the simple model in the figure above. Note in particular that, early in the sample, the fed funds rate was lower than IOER, and exhibited downward spikes at the end of each month. Then, later in the sample, when we can see what is going on in the repo market, as measured by SOFR, the repo rate is for a while close to to IOER and the fed funds rate, then starts to exhibit more volatility, with spikes at month-end occurring even prior to the large spike in mid-September. So, if we judge the performance of an interest-rate-targeting regime by success in pegging all overnight rates to the FOMC's target, then this floor system worked well for only a few months in late 2018. And, recall that, in the pre-2018 period, the floor system had substantial support from the Fed's overnight reverse repo (ON-RRP) facility, under which the Fed was a borrower (and sometimes a large borrower, to the tune of several hundred billion dollars overnight) in the overnight repo market, at a rate 25 basis points below IOER. So I wouldn't call this floor system a well-oiled machine.<br />
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When the repo market went crazy on September 17, much to everyone's surprise, the Fed intervened by lending in the repo market. That intervention has continued. Here's the Fed's overnight repo activity since then:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhtx9Ev-0bUX5Np7aeTy0Fkx6XtNYLE6vPFAjKhoXahnLwwrfsQxt0Zs0zhjSM2h-NkgX5fL_80mKdpicyH-Ad2S8hu4xreuUGee9WcvH1NrQ7vELpqOtVO1GW93wQDeUD9n0YWsS1MMEH_/s1600/figure5.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhtx9Ev-0bUX5Np7aeTy0Fkx6XtNYLE6vPFAjKhoXahnLwwrfsQxt0Zs0zhjSM2h-NkgX5fL_80mKdpicyH-Ad2S8hu4xreuUGee9WcvH1NrQ7vELpqOtVO1GW93wQDeUD9n0YWsS1MMEH_/s640/figure5.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>As well, the current Fed balance sheet data indicates that there is about $191 billion in repos held by the Fed, which includes term repos of 14 days, in addition to the overnight repos in the chart. So, if you thought that whatever was causing the September 17 repo rate spike was temporary, it wasn't, as the Fed has had to maintain a substantial presence in the repo market in order to hold overnight rates down.<br />
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The FOMC's model of overnight credit market intervention, in the third figure, is misleading for a number of reasons. First, it's not a good idea to think that there's some stable demand for reserves in the financial system. Reserves are necessary for clearing and settlement of interbank transactions during the day, but intraday velocity is so high, basically, that a small quantity of reserves can support a very large quantity of intraday transactions. For example, before the financial crisis $10 billion in reserve balances could support a volume of intraday transactions on the order of annual U.S. GDP. So, issues related to reserve balances in excess of $1 trillion, as is the case currently, relate to the role reserves play as overnight assets, and we can safely ignore issues to do with the functioning of intraday wholesale payments. How useful banks find overnight reserve balances is determined by regulation, and by the stocks of other assets, particularly Treasury securities, which play an important role as collateral in the repo market, and as a liquid asset in banks' asset portfolios. A possibly superior way to look at the overnight market is to think in terms of the demand and supply of overnight credit. For example:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwsrzZH8gbrRvc_ZyML1Il7nd3T_6ld5pXBFg6YBNGBDXJt2duZmQ8z9aPslt2nhaDavaGC4nYgqxlBZHQ_otrqadU4vCNJBEjp5a3T9sTCD4FWVZQftgNY55KRrLkcbmNgLCHuIxmwFsP/s1600/figure2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwsrzZH8gbrRvc_ZyML1Il7nd3T_6ld5pXBFg6YBNGBDXJt2duZmQ8z9aPslt2nhaDavaGC4nYgqxlBZHQ_otrqadU4vCNJBEjp5a3T9sTCD4FWVZQftgNY55KRrLkcbmNgLCHuIxmwFsP/s640/figure2.png" width="640" height="360" data-original-width="1280" data-original-height="720" /></a></div>In this figure, by setting IOER at <i>R*</i> the Fed is lending perfectly elastically, over the relevant range, in the overnight credit market by supplying reserves. We're still thinking in terms of a frictionless world in which secured and unsecured credit are perfect substitutes (more about that later).<br />
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We can then think about all systems for pegging overnight interest rates in exactly the same way as in the last figure. The Fed has to intervene in such a way that either overnight credit demand, or overnight credit supply, is perfectly elastic at the target interest rate. For example, in this context, the operating regime for the Fed before the financial crisis looks like this:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMo_BqORf1tOgexsp4nRBjCnLixf5xWSxg3enq4sIVmohG78g1SWoY3inaP5EYVaSxKiaXp2-aYPItpoKXF5xg1EbfUeUDYiJBUnsxu9c5GGmP-5EO3YWU5zDXpn76P-IQn55p0y5HyCWB/s1600/figure3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMo_BqORf1tOgexsp4nRBjCnLixf5xWSxg3enq4sIVmohG78g1SWoY3inaP5EYVaSxKiaXp2-aYPItpoKXF5xg1EbfUeUDYiJBUnsxu9c5GGmP-5EO3YWU5zDXpn76P-IQn55p0y5HyCWB/s640/figure3.png" width="640" height="360" data-original-width="1280" data-original-height="720" /></a></div>That is, before the financial crisis, the Fed intervened in the repo market, as an indirect way of pegging the fed funds rate, under the theory that secured and unsecured lending are close substitutes. By varying the amount of repo market intervention each day to peg the fed funds rate, the Fed was effectively making the supply of overnight credit perfectly elastic at the targeted rate. If they had wanted to, they could have intervened through reverse repos, which we could represent as in the previous figure - this works just like the floor system, except the variability is in a different Fed liability. Thus, there's nothing special about the floor system - it fits in a class of intervention mechanisms that work through variability in Fed liabilities rather than Fed assets (as in repo market intervention on the lending side).<br />
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But there's more to it. The Econ 101 approach to the overnight market in the last couple of figures isn't a good way to analyze a market with substantial frictions. For example, if there were no significant frictions in the overnight credit market, then it would make no difference whether the Fed permanently swapped, say, $100 billion in reserves for $100 billion in T-bills, or intervened by lending $100 billion in the repo market every day forever, taking T-bills as collateral. Clearly, the Fed thinks there's a difference, as they're now planning to buy about $60 billion in T-bills every month until the second quarter of next year, which looks like a potential planned purchase of $300 billion or more in T-bills. Somehow the Fed thinks that's better than continuing to intervene in the repo market at the current intensity - note that current repos outstanding, including term repos, amounts to about $191 billion.<br />
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So what's the Fed up to, and why? For more information, let's go to a <a href="https://www.newyorkfed.org/newsevents/speeches/2019/wil191017">recent speech by John Williams,</a> President of the New York Fed. Williams says: <blockquote>The key benefit of this approach is that it’s a simple, effective way of controlling the federal funds rate and thereby influencing other short-term interest rates.</blockquote>Well, in my book, "simple" means easy to explain. It's actually quite complicated to explain features of the current floor system, such as the ON-RRP facility, and why it's there, or why the repo market went phooey on September 17. A lot of people are spending valuable time trying to figure this out. Nothing simple about it. Further, "effective," I think, means it works. The floor system definitely does not work as advertised. Simply setting IOER should peg overnight rates, but that only happened (roughly) for just over a year. Before early 2018, the ON-RRP facility was holding up overnight rates from below, and after mid-September 2019 the Fed was lending in the repo market to hold down overnight rates from above. The floor system does not work, except in some sweet spot. And that sweet spot isn't determined only by reserves outstanding. There is a host of other poorly understood factors that matter for whether the floor can work on its own.<br />
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Here's something else Williams said in his speech: <blockquote>In light of these events, we have learned that the ample reserves framework has worked smoothly with a level of reserves at least as large as we saw during summer and into early September. Although temporary open market operations are doing the trick for the time being, anticipated increases in non-reserve liabilities would cause reserves to decline in coming months without further actions.</blockquote>The "events" he's referring to are all included in the charts above. It's certainly not correct to say that everything worked smoothly prior to September. As I've pointed out, things were creaky before 2018, even given the ON-RRP intervention, and month-end spikes in the repo rate were apparent before the blowup on September 17. But, the key problem with Williams's statement here is that he doesn't tell us why the Fed prefers to buy T-bills rather than to intervene in the repo market every day - as he says, that's "doing the trick," so what's the problem?<br />
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Conclusions:<br />
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1. If the answer to the problem of overnight interest rate control is more reserves, that can be achieved by reducing the size of the foreign repo pool and the Treasury's general account, which together currently come to a total of about $672 billion. That's a lot larger than the $300 billion in T-bills the Fed plans on purchasing. The size of the foreign repo pool and the Treasury's general account are purely discretionary, and both were tiny before the financial crisis. None of the communications coming from the Fed have explained what these items are about. Why is it important to the Fed's goals that foreign entities, including central banks, hold what are essentially reserve accounts at the Fed? How does it help monetary policy that the Treasury carries a large and volatile reserve balance with the Fed? Why can't foreign central banks park their overnight US dollars elsewhere? Why can't the Treasury park its accounts with the private sector, as before the financial crisis?<br />
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2. Experience with a floor system in the U.S. since December 2015 should tell us that it's ineffective for the Fed to attempt to intervene in overnight markets by narrowing their engagement with the financial sector to commercial banks. The fed funds market is a small market, and reserve accounts are held by only a fraction of financial institutions. The repo market is a large market, and intervention by the Fed in that market reaches all the nooks and crannies of the financial sector. A more effective approach, as many other central banks have discovered, is to peg a repo rate - stop worrying about the fed funds market - and intervene in the repo market, either on the lending or borrowing side, depending on circumstances.<br />
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3. The only advantage reserves have over Treasury securities, as a liquid asset, is that reserve balances can be transferred among financial institutions with reserve accounts, on Fedwire during the day. Otherwise, Treasuries are more widely held, and they're the primary form of collateral in the repo market. In general, if the Fed takes Treasuries out of financial markets and replaces those assets with reserves, that will make the financial sector less efficient. Some people have tried to argue that post-financial crisis banking regulations somehow make banks prefer reserves to Treasuries. I don't buy it. Treasuries and reserves are equivalent as high-quality liquid assets in banking regulation. And I've never seen a bank "living will" that articulates a special role for reserve balances. And if regulators are encouraging banks to hold reserves rather than Treasuries as liquid assets, there's no good reason for them to do that, given what seems to be written in the law.<br />
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So, the Fed seems to be floundering on this issue. Balance sheet policy seems to be more about the FOMC sticking to what they decided in early 2019, than with responding to what they should have learned since then.Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com1tag:blogger.com,1999:blog-2499715909956774229.post-74646436810662559762019-09-26T11:24:00.001-07:002019-09-26T11:24:25.092-07:00The Fed's Failed ExperimentLast week, on Tuesday September 17 in particular, overnight credit markets were misbehaving. Since then, various folks have been struggling to understand what is going on, with little assistance, apparently, from the Fed, whose job it is to prevent such misbehavior, and to tell us exactly what is going on. Here's what happened. On Tuesday of last week, the market in overnight repos became very tight:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjgAFA4wfalG-Hmld8mCCS1682JKT3D_kck0NvKUw47_RCdQYdVydxX05R_a4a76IZaxFKmib_kmmt7YfA7eLR6ZjYnojZw6HRXWQ9RR59EF1D-2UxqBbqyYMEQHP-rVZK3LLZEcglx9jM2/s1600/repoday.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjgAFA4wfalG-Hmld8mCCS1682JKT3D_kck0NvKUw47_RCdQYdVydxX05R_a4a76IZaxFKmib_kmmt7YfA7eLR6ZjYnojZw6HRXWQ9RR59EF1D-2UxqBbqyYMEQHP-rVZK3LLZEcglx9jM2/s640/repoday.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>The chart shows the repo rate (secured overnight financing rate), the effective fed funds rate, the interest rate on reserves, and the four-week T-bill rate. On September 17, these interest rates were, respectively, 5.25%, 2.30%, 2.10%, and 2.06%. It's important to note that the repo "market" and the fed funds "market" are not markets in the Econ 101 sense. Some repo and fed funds trades are done through intermediaries (tri-party repo for example), but much trading overnight is over-the-counter, that is bilateral exchange. As a result, there is typically dispersion in market prices, and on September 17 that dispersion was much higher than normal. Roughly, repo market trades were between 2.25% and 9.00%, and fed funds trades were between 2.05% and 4.00%. Further, on September 17, the interest rate on reserves was 2.10%. So, apparently, banks holding reserves were foregoing large profit opportunities to lending in the repo market and fed funds market, and fed funds market lenders were similarly lending unsecured overnight and foregoing large profit opportunities to secured lending in the repo market.<br />
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The New York Fed attempted to intervene to push down repo rates on September 17 but, due to some unexplained glitch, couldn't do the job. However, Fed intervention continued - it was still happening yesterday:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj6dwFhq1KLHTeNgzLhRDZw8YGCzObkOJ1A4h6JvX_tGZPWed5Y_EdtaejE8PzIh3gTQJ0BwhMxXRnDtiI338im-1seLbtTHVCtYaihyphenhyphenSRXXNsHOSaAu2KQJ1oKYuW2nPcHM5MG4PHJhGWH/s1600/intervention.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj6dwFhq1KLHTeNgzLhRDZw8YGCzObkOJ1A4h6JvX_tGZPWed5Y_EdtaejE8PzIh3gTQJ0BwhMxXRnDtiI338im-1seLbtTHVCtYaihyphenhyphenSRXXNsHOSaAu2KQJ1oKYuW2nPcHM5MG4PHJhGWH/s640/intervention.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>Three points to note are: (i) The Fed has now controlled the problem; the repo rate has been brought down, and fed funds are currently trading within the Fed's 1.75%-2.00% target range. (ii) At from $50-$60 billion in repos outstanding on the Fed's balance sheet, this is a large intervention; (iii) Whatever is causing this is persistent; it's not a one-day event.<br />
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Why am I saying $50-$60 billion in repo market intervention is large? In the old days, prior to the financial crisis, the Fed controlled the fed funds rate through repo market intervention:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5NkCtVwl5h5RB9B3patTFq_h1i7cj8WtsILujLhgCrKeiWxFfHPxfBnBDrXGhiw6MDzLYUk-Qe0wwiXYzrSAVshPBNXUHodT3uS4VAlIKEG4nN_jMq7PHB-GUQCCLXf65WRiYei5aXA2N/s1600/fedrepo.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5NkCtVwl5h5RB9B3patTFq_h1i7cj8WtsILujLhgCrKeiWxFfHPxfBnBDrXGhiw6MDzLYUk-Qe0wwiXYzrSAVshPBNXUHodT3uS4VAlIKEG4nN_jMq7PHB-GUQCCLXf65WRiYei5aXA2N/s640/fedrepo.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>In the chart, you can see some unusual stuff going on during the financial crisis, but pre-financial crisis, repos outstanding varied between about $20 billion and $40 billion. So, if the New York Fed's lending on the repo market goes from zero to $50 billion in a couple of days, that's a huge intervention relative to what used to happen in normal times.<br />
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So, what's going on? Essentially all central banks in countries with well-developed overnight credit markets intervene so as to peg some overnight rate, under a directive from the decision-making body in the central bank. The Fed likes to articulate the directive in terms of a target range for the fed funds rate, and then it's the job of the New York Fed to achieve that target, through whatever means it has at its disposal. So, in terms of the policy directive, which last Tuesday was to target the fed funds rate in a range of 2%-2.25%, the New York Fed failed - but the top of the range was exceeded by only 5 basis points. So why the panic? The Fed's unstated short-run goal is to control all short-term market interest rates. And the repo market is a much larger market than the fed funds market, and potentially more important in terms of the transmission of monetary policy. Further, volatility of any kind in financial markets is typically perceived to be bad. If such volatility can be avoided through central bank intervention, then the central bank should probably do it.<br />
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But what caused the spike in the repo rate, and why didn't the New York Fed's ongoing approach to pegging overnight rates work? Sometimes we like to differentiate between corridor systems (e.g. how central banking currently works in Canada) and floor systems (how it currently works in the U.S.). But in any system of monetary policy implementation, the central bank stands ready, typically on a daily basis, to intervene either on the demand side or the supply side of the overnight credit market - basically, either demand or supply is perfectly elastic at the central bank's interest rate target. Before the financial crisis, the Fed intervened on the supply side of the overnight credit market by varying the quantity of its lending in the repo market so as to peg the fed funds rate. Typically, we would call that a corridor system, as the central bank's interest rate target was bounded above by the discount rate, and below by the interest rate on reserves, which was zero at the time. But, the Fed could have chosen to run a corridor by intervening on the other side of the market - by varying the quantity of reverse repos, for example. Post-financial crisis, the Fed's floor system is effectively a mechanism for intervening on the demand side of the overnight credit market. With a large quantity reserves outstanding, those financial institutions holding reserves accounts have the option of lending to the Fed at the interest rate on reserves, or lending in the market - fed funds or repo market. Financial market arbitrage, in a frictionless world, would then look after the rest. By pegging the interest rate on excess reserves (IOER), the Fed should in principle peg overnight rates.<br />
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The problem is that overnight markets - particularly in the United States - are gummed up with various frictions. First, fed funds credit is not the same thing as repo market credit. The former is unsecured and the latter is secured with collateral - primarily Treasury securities. The timing can be different for when funds go out one day and are returned the next. Only financial institutions with reserve accounts at the Fed participate in the fed funds market, whereas the repo market has a wider array of participants. Second, there are regulatory constraints. New Basel III requirements, particularly the liquidity coverage ratio (LCR) requirement, constrain banks to holding liquid assets that can finance specified funding outflows, should they arise. Dodd-Frank regulations for systemically important financial institutions have resolution plans that include providing for sufficient liquidity. There are capital constraints, etc. Finally, as mentioned above, much of the trade in overnight credit markets is over-the-counter. Market participants develop long-term relationships with counterparties, but there can be shocks to markets that disrupt those relationships, making it difficult to find a counterparty for a particular desired trade.<br />
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Friction in U.S. overnight credit markets, and its implications for monetary policy, is nothing new. Indeed, the big worry at the Fed, when "liftoff" from the 0-0.25% fed funds rate trading range occurred in December 2015, was that arbitrage would not work to peg overnight rates in a higher range. That's why the Fed introduced the ON-RRP, or overnight reverse-repo, facility, with the ON-RRP rate set at the bottom of the fed funds rate target range, and IOER at the top of the range. The idea was that the ON-RRP rate would bound the fed funds rate from below. During 2016, these were the paths of short-term interest rates:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhIbT8hmjL8h6N5brXk5tKWSJfz7gaoyWsQmGKhoxeex08PbWx2GYDxWd8lX7-c7ybOh2ZlvasMd_IxHRgAIM1JVVUPCxqT138IDvir9pN5u8UltASvnXjV3x9J7NzSOzmhnWD6MOK1JKjk/s1600/2016.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhIbT8hmjL8h6N5brXk5tKWSJfz7gaoyWsQmGKhoxeex08PbWx2GYDxWd8lX7-c7ybOh2ZlvasMd_IxHRgAIM1JVVUPCxqT138IDvir9pN5u8UltASvnXjV3x9J7NzSOzmhnWD6MOK1JKjk/s640/2016.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>Until the December 2016 meeting, the ON-RRP rate was set at 0.25% and IOER at 0.5%. But the fed funds rate was 9-12 basis points lower than IOER, and the one-month Treasury bill rate was typically in the 0.1% to 0.3% range. As well, note the downward spikes in the fed funds rate, which occur at month's end. There were some stories to explain that configuration of interest rates, but in retrospect, I'm not sure any of those make sense. ON-RRP intervention by the Fed looks like this:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiCvIJnqSVlptLDU46q-xufzmVQkP4AK4958MrQrXLWBSjLOoiJEhnUPvGAZ3eNWiB8-XdwKmpzFDRDN2U5s2njXScaNXfREPFYnUeVfwnR0JAUCgTDlulCd8lQc29cHR2ynfgWmclAuHYm/s1600/onrrp.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiCvIJnqSVlptLDU46q-xufzmVQkP4AK4958MrQrXLWBSjLOoiJEhnUPvGAZ3eNWiB8-XdwKmpzFDRDN2U5s2njXScaNXfREPFYnUeVfwnR0JAUCgTDlulCd8lQc29cHR2ynfgWmclAuHYm/s640/onrrp.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>That chart isn't picking up everything, as it's only for Wednesdays, but this gives you some idea what was going on. This makes the recent repo intervention by the Fed (on the other side of the market) look small. Until early 2018, it was considered normal for the takeup on the ON-RRP facility to be anywhere from $100 billion to $200 billion each day, with spikes of $500 billion or $600 billion (not in the chart, as again it's only Wednesdays) at the end of the quarter. This was basically borrowing by the Fed on the repo market to hold up the repo rate.<br />
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But note that, in early 2018, the ON-RRP facility became moribund - zero takeup essentially. What happened then? <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEggC7CQylg1tJyinNQEU77YdITwWtLqJdJ2U0Am1gPU4iiG1jt_pqmNBNRhNzMisWU98HWqh9_BDFJFcrV1AF6RnoVpfPNRU7WSO-nFXRFrBtfEIYgj5cYUHOOlzT4LLEe28ZDvARquYDxu/s1600/2018a.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEggC7CQylg1tJyinNQEU77YdITwWtLqJdJ2U0Am1gPU4iiG1jt_pqmNBNRhNzMisWU98HWqh9_BDFJFcrV1AF6RnoVpfPNRU7WSO-nFXRFrBtfEIYgj5cYUHOOlzT4LLEe28ZDvARquYDxu/s640/2018a.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>During 2018, the Fed's floor system actually seemed to have been working properly. Particularly in the September-December 2018 period, IOER appeared to be pegging the fed funds rate, the repo rate, and the one-month T-bill rate - arbitrage seemed to be working. But, beginning in 2019, funny things started happening in the repo market. Those downward month-end spikes in the fed funds rate that you can see in the 2016 data started to appear as upward month-end spikes in the repo rate. The one at year-end 2017 is particularly large. As <a href="http://newmonetarism.blogspot.com/2019/05/can-fed-control-overnight-rates.html">yours truly pointed out (with some prescience) in May of this year,</a> <blockquote>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.</blockquote>There's something else that's odd in the last chart, which is that the one-month T-bill rate has dropped below the interest rate on reserves, even if you account for market anticipation of Fed rate cuts.<br />
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So, how to make sense of this? There are several aspects of the problem we need to be concerned with:<br />
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1. Every central bank needs to be concerned with fiscal authority actions. For example, if the fiscal authority holds its available cash as deposits at the central bank, then inflows into that deposit account due to tax receipts or government security issuance have monetary implications. There has to be a mechanism in place to deal with that. For example, the Bank of Canada auctions these funds off in the repo market.<br />
2. Large scale asset purchases (QE) by the Fed had, and have, implications for how the overnight market works.<br />
3. How do new bank regulations (LCR and resolution liquidity) matter?<br />
4. Central bankers, for good reasons, want to project confidence, and they don't like to admit errors. Large scale asset purchases were a large-scale experiment, and there appear to be no strong voices on the FOMC that question the efficacy of QE, and the current floor system. Indeed, the committee decided early this year to stick with the floor system indefinitely, and the revinvestment program, that replaces Fed assets as they roll off, was resumed in August. Given this, you'll find plenty of Fed employees - management, economists - supporting the party line. If there are no good reasons for justifying a large balance sheet indefinitely, folks at the Fed will make them up.<br />
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Let's start with fiscal actions and how they matter here. Here's the Treasury's general account with the Fed.<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi86-26PzQloGo5CwSSzlFkVaEpQdfeTTQ7vQVMEok6yXnz9ju2GuqHHyxoP14alW8bdswDeIg7eoDza_ZCtns_xs6uUPYQwxWGjQze7gKmA2IRWn9sp2-e1P0ptQRU2XOLla87QG9xqPRn/s1600/treasury.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi86-26PzQloGo5CwSSzlFkVaEpQdfeTTQ7vQVMEok6yXnz9ju2GuqHHyxoP14alW8bdswDeIg7eoDza_ZCtns_xs6uUPYQwxWGjQze7gKmA2IRWn9sp2-e1P0ptQRU2XOLla87QG9xqPRn/s640/treasury.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>Before the financial crisis, Treasury parked its deposits in the private sector - so that inflows and outflows from those accounts wouldn't mess with monetary policy. You'll notice that, after the financial crisis, the balance in the Treasury's general account became substantial, and became quite large on average in 2016, and much more volatile. Recently, this account balance has been anywhere between $38 billion and $420 billion. Note that, if total reserves outstanding are constant and general account balances go up, then reserve balances held in the private sector must go down by the same amount. The Fed permits these large and fluctuating Treasury balances, apparently because they think this won't matter in a floor system, as it shouldn't. But, if anyone at the Fed suggests that the answer to the problem highlighted by the repo market dysfunction last week is to purchase more assets, someone should tell that person that if the problem is too little reserves, more reserves can be had if the Treasury parks its deposits in the private sector, just like in the old days.<br />
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Another drain on private sector reserve balances is the foreign repo pool:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxCLsi20W6Q1QYcVUO52xdENL7fa9gTx4nY2FeUfHLFLkA3HM7VMbjjNhR30mekL6rwsvkOj6VyGzJws96xtWdaoDlSadynhDORv03m72GvaSB6JLMUcL62HqSByGozoljCx5Yq12JjyLZ/s1600/repopool.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxCLsi20W6Q1QYcVUO52xdENL7fa9gTx4nY2FeUfHLFLkA3HM7VMbjjNhR30mekL6rwsvkOj6VyGzJws96xtWdaoDlSadynhDORv03m72GvaSB6JLMUcL62HqSByGozoljCx5Yq12JjyLZ/s640/repopool.png" width="640" height="247" data-original-width="1168" data-original-height="450" /></a></div>This balance isn't as volatile as the Treasury general account, but it's large and growing, and it's unclear what its purpose is. Like the Treasury account, it's purely discretionary. The Fed once had caps on this, which for some reason were lifted. All very murky. Some of this could be foreign governments and central banks which are permitted by the Fed to hold what are effectively interest-bearing reserve balances at the Fed - much more attractive than previously given low or negative government security yields in other countries. But again, if the problem is low reserve balances in the private sector, those balances could be increased by about $300 billion if the Fed eliminated the foreign repo pool.<br />
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Some people blame new bank liquidity requirements, at least in part, for the repo fiasco last week. The problem here is that, for both LCR and resolution liquidity requirements, Treasury securities and reserves are essentially equivalent - both are high-quality liquid assets (HQLA). Thus, if the problem is that liquidity is being hoarded, creating pressures in the repo market, it's a dearth of Treasuries plus reserves that's the problem. That can't be fixed by having the Fed swap reserves for Treasuries - that has zero effect on the total. Some people have tried to make the case that reserves are somehow significantly superior liquid assets to Treasury securities, and that liquidity requirements have increased the demand for reserves in particular. But that notion is inconsistent with what we see in the data. As I pointed out in <a href="http://newmonetarism.blogspot.com/2019/08/is-fed-doing-anything-right.html">this blog post,</a> banks have accumulated a lot of Treasuries, and a lot of reserves, but are not demanding a premium in the market to hold Treasuries - indeed, it's currently the other way around. That is, T bill rates are below IOER.<br />
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In the past, I've made the case that QE causes dysfunction in overnight markets. In the 4th chart above, the 2016 interest rate data can be viewed as reflecting a collateral shortage in the overnight market. That's what kept the Fed's ON-RRP program alive. The Fed had sucked up a large fraction of the securities useful as collateral in overnight markets, so that it could turn around and borrow in the overnight repo market - at a rate below IOER. That shortage appears to have gone away in early 2018. But one might then expect that, with plentiful collateral in overnight markets, that things would settle down. But now there appears to be sporadic high demand for overnight loans in the repo market, and things are going the other way.<br />
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What I'm leading up to is the conclusion that we shouldn't characterize the problem here as a "scarce reserves," particularly as some seem to think that implies the Fed needs to buy more assets. The key problem is that the Fed is trying to manage overnight markets by working from the banking sector, through the stock of reserves. Apparently, that just won't work in the American context, because market frictions are too severe. In particular, these frictions segment banks from the rest of the financial sector in various ways. The appropriate type of daily intervention for the Fed is in the repo market, which is more broadly-based. If $1.5 trillion in reserve balances isn't enough to make a floor system work, without intervention through either a reverse-repo or repo facility, then that's a bad floor system.<br />
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The arguments for having a large Fed balance sheet are two-fold. First, it's supposed to make monetary policy implementation easy. Just set IOER, and arbitrage looks after the rest. Second, Fed asset purchases are supposed to be "stimulative," increasing inflation and aggregate economic activity. Well, apparently, the first argument is wrong - nothing easy about this at all. In this respect, the implementation has left people scratching their heads and wondering if the people at the New York Fed and the Board have their heads screwed on properly. On the second, there's no evidence that QE is helpful in achieving any of the Fed's ultimate goals, and it may just be harmful, in that the Fed swaps inferior reserves for superior Treasury securities. The reserves are crappy assets because they're only held by a segment of financial institutions, and because of the market frictions I've been discussing. If the Fed takes away good collateral and gives the financial market crappy assets, nothing good happens.<br />
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Conclusion? For now, the Fed needs to be intervening in the repo market on a regular basis, and it's possible that the intervention could go back to the other side of the market, with an active ON-RRP facility. Intervention - either way - should be at IOER. None of this target range nonsense. In the long run, the Fed should get rid of the large balance sheet. Please. Make the secured overnight financing rate the policy rate, and run a corridor system. That's what normal central banks do.<br />
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Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com4tag:blogger.com,1999:blog-2499715909956774229.post-7076382379607862992019-08-05T19:32:00.000-07:002019-08-05T19:32:00.940-07:00Is 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?<br />
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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 <a href="https://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf">"Statement on Longer-Run Goals and Monetary Policy Strategy,"</a> 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.<br />
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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.<br />
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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.<br />
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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:<br />
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1. Weak global growth.<br />
2. Trade policy uncertainty.<br />
3. Muted inflation.<br />
4. The neutral rate of interest is down.<br />
5. The natural rate of unemployment is down.<br />
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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: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEizm2dGx7zLOfbQNJeYsvF58B-05zbeMhOvFZ73IXg4T-A_skEXLj0vryNlw3QMbiQZYxKwPXnBZva-qYbhzHmYxWEC4ColuwT7zl65ITMbdirsyDxPCVZPUtxAXgbrECJelC_h7wPWHIlr/s1600/GDP.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEizm2dGx7zLOfbQNJeYsvF58B-05zbeMhOvFZ73IXg4T-A_skEXLj0vryNlw3QMbiQZYxKwPXnBZva-qYbhzHmYxWEC4ColuwT7zl65ITMbdirsyDxPCVZPUtxAXgbrECJelC_h7wPWHIlr/s640/GDP.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>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:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgWbln_nM13nNMbYFiP3SacEvlAGdVaumRMKk0LpDE1N2BHZzz0PEhNOnrUSJThvwlD6zG0l3Y9H0KVEjLWByiBMR8-hwAovFycioQjjbqKWrBSIUemXwxKhQPjQVu6YdfRP8ibPph3p3qQ/s1600/tightness.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgWbln_nM13nNMbYFiP3SacEvlAGdVaumRMKk0LpDE1N2BHZzz0PEhNOnrUSJThvwlD6zG0l3Y9H0KVEjLWByiBMR8-hwAovFycioQjjbqKWrBSIUemXwxKhQPjQVu6YdfRP8ibPph3p3qQ/s640/tightness.png" width="640" height="280" data-original-width="1075" data-original-height="470" /></a></div>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: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgSlAQyZlcOGujK_1BEoVNdIbDvgXyhWEYJGrsj5v9Fvnj5n2an4SFrRyNOtdZwXn-9lkL5VhjyqOt_LuFOCApDz_BD-N25xqnwuZUm0yo1w73sMdCXhG7UWWKehVRHawUz4IHppnE6yxcw/s1600/investment.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgSlAQyZlcOGujK_1BEoVNdIbDvgXyhWEYJGrsj5v9Fvnj5n2an4SFrRyNOtdZwXn-9lkL5VhjyqOt_LuFOCApDz_BD-N25xqnwuZUm0yo1w73sMdCXhG7UWWKehVRHawUz4IHppnE6yxcw/s640/investment.png" width="640" height="280" data-original-width="1075" data-original-height="470" /></a></div>No significant weakening in year-over-year real investment growth since September, as far as I can tell.<br />
<br />
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:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg5ce2ZZTalED5ri798D-KcpltkX0Ip_AeVx3pSrlNw7fRcClmILaVgLYMbtTAPSLZKEczsKgfGirBeH4B8LNboy1NL2ag2pWaiN18XBmyEJc8Nig3BtzMwL85mTVbhwZMqOatrEQcXuCyQ/s1600/global+growth.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg5ce2ZZTalED5ri798D-KcpltkX0Ip_AeVx3pSrlNw7fRcClmILaVgLYMbtTAPSLZKEczsKgfGirBeH4B8LNboy1NL2ag2pWaiN18XBmyEJc8Nig3BtzMwL85mTVbhwZMqOatrEQcXuCyQ/s640/global+growth.png" width="640" height="280" data-original-width="1075" data-original-height="470" /></a></div>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: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjQu_gwC-FVVSainWtjxy09tDX0MWOdh2oho1TiHexl47bfjDHKtrKWmYfzFC8KsVzJPogXBjySoHMO4mQ6up9onrynYuarWtej5ZLiHbEObjzpFrKgIzVsRL_aueQbVXAvtUdQbaEi1MKY/s1600/Japan.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjQu_gwC-FVVSainWtjxy09tDX0MWOdh2oho1TiHexl47bfjDHKtrKWmYfzFC8KsVzJPogXBjySoHMO4mQ6up9onrynYuarWtej5ZLiHbEObjzpFrKgIzVsRL_aueQbVXAvtUdQbaEi1MKY/s640/Japan.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>Or the Euro area: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgNai-Mf30TPGV-DG-NXwMpLSDGyUoUkwOpMF3auZjSGS6fJFUFagOrFKY1WQtdyHCQDEBctgj4WypepSuYhTHxz0zyAc6JSmXDhM9mEWy9d8TpuXhyphenhyphenUwnyWcB-jVD9zF4aUZ3OYKFg9RIb/s1600/euro+area+labor_Page_2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgNai-Mf30TPGV-DG-NXwMpLSDGyUoUkwOpMF3auZjSGS6fJFUFagOrFKY1WQtdyHCQDEBctgj4WypepSuYhTHxz0zyAc6JSmXDhM9mEWy9d8TpuXhyphenhyphenUwnyWcB-jVD9zF4aUZ3OYKFg9RIb/s640/euro+area+labor_Page_2.png" width="640" height="637" data-original-width="760" data-original-height="756" /></a></div>Or the UK: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEixx1NMpm63HpwsjTgMsXdMi9EJVLjPAwWvnwZpamwKoR_tBdAuD7YNNNdrHy0BmWFubs3Qa_sAO-pOY0VKPHQMF_7l5KUSblelDZRo-7G3hGk-04g_n2Op4jDRrZyLlKExioxH9jVgMvAm/s1600/UK.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEixx1NMpm63HpwsjTgMsXdMi9EJVLjPAwWvnwZpamwKoR_tBdAuD7YNNNdrHy0BmWFubs3Qa_sAO-pOY0VKPHQMF_7l5KUSblelDZRo-7G3hGk-04g_n2Op4jDRrZyLlKExioxH9jVgMvAm/s640/UK.png" width="640" height="427" data-original-width="600" data-original-height="400" /></a></div>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?<br />
<br />
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.<br />
<br />
But what's the story with inflation? <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgAlIPozBGhgCRLRtZsJ36wm063InZoaXjOfmMMrDkARmFGjEtQt2NKllPb7gsxnPB1XoweXCAgulo9f683mmXcwXoA1yZBmvdrVaxM9tDcHQB-vkL-Ylv04kNq7wXfJRHp0xvKoh-u4paw/s1600/inflation.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgAlIPozBGhgCRLRtZsJ36wm063InZoaXjOfmMMrDkARmFGjEtQt2NKllPb7gsxnPB1XoweXCAgulo9f683mmXcwXoA1yZBmvdrVaxM9tDcHQB-vkL-Ylv04kNq7wXfJRHp0xvKoh-u4paw/s640/inflation.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>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.<br />
<br />
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.<br />
<br />
But, as everyone knows, I think, there are issues with the Phillips curve. AOC knows it, and Jay Powell knows it, as <a href="https://www.c-span.org/video/?c4806495/aoc-asks-phillips-curve-fairy-tale">we can see in this exchange.</a> 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.<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiPQUILHPZh0yrZkBLxByhxprKcVngPJcl6CHdwPG7K-g_Z1_oVyih6kjTDcDTxG2cwfQDGO1MU40TljhryXIdoL7psZTZ3zLzoEMKqRKHEqGjNDyiIQ3G9e6gZ0oxE0h0oXwVhQLSBeLB3/s1600/breakeven.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiPQUILHPZh0yrZkBLxByhxprKcVngPJcl6CHdwPG7K-g_Z1_oVyih6kjTDcDTxG2cwfQDGO1MU40TljhryXIdoL7psZTZ3zLzoEMKqRKHEqGjNDyiIQ3G9e6gZ0oxE0h0oXwVhQLSBeLB3/s640/breakeven.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>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.<br />
<br />
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: <blockquote>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.<br />
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.</blockquote>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.<br />
<br />
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.<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhtrXx9HBkOVRL_LIGrwIdY-idTofV3ukFLKOXFHMfKhlQLUhbOnP3oZ3WwTNyi12jTxbx0cUGGYtYzsFerVuLGRWQ20KIECyNboKmD5gLrjWZ_YVFo3GRudYVDZBlWDxJeZAkDWu7x17tT/s1600/fed+reserves+etc.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhtrXx9HBkOVRL_LIGrwIdY-idTofV3ukFLKOXFHMfKhlQLUhbOnP3oZ3WwTNyi12jTxbx0cUGGYtYzsFerVuLGRWQ20KIECyNboKmD5gLrjWZ_YVFo3GRudYVDZBlWDxJeZAkDWu7x17tT/s640/fed+reserves+etc.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>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.<br />
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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? <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgTqQUzmIiGTpBQuk9dweRobeuWxLQKdRqW3UYS77oN8xAtw8myMVyRP5gE59vYQed4jvFarb3OD-xvmiM9KHjH45cq2QDUZuzvficljipg7KsAcuTQzUdLGRnyR1DgXRqU1g7lqsPosFhM/s1600/overnight+rates.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgTqQUzmIiGTpBQuk9dweRobeuWxLQKdRqW3UYS77oN8xAtw8myMVyRP5gE59vYQed4jvFarb3OD-xvmiM9KHjH45cq2QDUZuzvficljipg7KsAcuTQzUdLGRnyR1DgXRqU1g7lqsPosFhM/s640/overnight+rates.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>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. <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhbf8u34zAB8y4Hfnsx3uwA_TJprWmj_sXe-ARRS1GK03J4erZLFd42EreWO4BHCclpOvh7fXDWJUb120t-_6bmB1t1EUy51L_mfBWtEOPCJcgrmWD8s6lsWOZQufxS0KGXX70WY3Tcv5UV/s1600/banks.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhbf8u34zAB8y4Hfnsx3uwA_TJprWmj_sXe-ARRS1GK03J4erZLFd42EreWO4BHCclpOvh7fXDWJUb120t-_6bmB1t1EUy51L_mfBWtEOPCJcgrmWD8s6lsWOZQufxS0KGXX70WY3Tcv5UV/s640/banks.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>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.<br />
<br />
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.<br />
<br />
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. <br />
<br />
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. <br />
Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com14tag:blogger.com,1999:blog-2499715909956774229.post-57164721057382699422019-06-21T13:59:00.000-07:002019-06-21T13:59:07.245-07:00Libra: 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 <a href="https://libra.org/en-US/white-paper/">"white paper"</a> 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.<br />
<br />
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.<br />
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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.<br />
<br />
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.<br />
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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.<br />
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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 <a href="https://libra.org/en-US/about-currency-reserve/#the_reserve">"The Reserve"</a> 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."<br />
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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.<br />
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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.<br />
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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 <a href="https://cointelegraph.com/news/new-study-says-80-percent-of-icos-conducted-in-2017-were-scams">cesspool of fraud.</a><br />
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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.<br />
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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.<br />
Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com6tag:blogger.com,1999:blog-2499715909956774229.post-18740721114751457352019-05-02T07:54:00.001-07:002019-05-05T11:01:47.289-07:00Can 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.<br />
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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.<br />
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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.<br />
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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 <a href="http://newmonetarism.blogspot.com/2018/07/fed-balance-sheet-news.html">in this post,</a> in <a href="http://newmonetarism.blogspot.com/2018/07/fed-balance-sheet-policy-and-treasury.html">this one,</a> and <a href="http://newmonetarism.blogspot.com/2018/08/feds-portfolio-manager-says-not-to-worry.html">in this one.</a> 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.<br />
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Recently, something unexpected has happened. These are daily observations on the fed funds rate and a <a href="https://www.newyorkfed.org/markets/treasury-repo-reference-rates">Treasury repo rate</a>:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTukrA0W_SA_0uxUcgW6W2Uj_9QceSryLgTYCIEpgIFkDKfVOSVHTCNqGuoSG6tK0oD-UfQVCD4iSOukrNR-ju5VWSKe2bf8eUuXnm3B5hOXR2Z5tWA9nF-rPdXqfJsjx2Bj3d45_vmajw/s1600/fedfig2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTukrA0W_SA_0uxUcgW6W2Uj_9QceSryLgTYCIEpgIFkDKfVOSVHTCNqGuoSG6tK0oD-UfQVCD4iSOukrNR-ju5VWSKe2bf8eUuXnm3B5hOXR2Z5tWA9nF-rPdXqfJsjx2Bj3d45_vmajw/s640/fedfig2.png" width="640" height="536" data-original-width="1009" data-original-height="845" /></a></div>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.<br />
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For good measure, the next chart shows 1-month and 3-month T-bill secondary market yields. <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiRRUk0eaDUsK9I5IRKRSf_AMFZ5RpL0uo8f7xBRYBTfTFYAJ_tLd5RPUwBW3F-bznmOToMWxbHQuNsyILMby4kVBu2TNKTCrGo_PvzGPq-0JOcGT49txNA9UxqoEZRrzOp1lgEG9-K-VCp/s1600/fedfig1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiRRUk0eaDUsK9I5IRKRSf_AMFZ5RpL0uo8f7xBRYBTfTFYAJ_tLd5RPUwBW3F-bznmOToMWxbHQuNsyILMby4kVBu2TNKTCrGo_PvzGPq-0JOcGT49txNA9UxqoEZRrzOp1lgEG9-K-VCp/s640/fedfig1.png" width="640" height="529" data-original-width="1023" data-original-height="845" /></a></div>So, T-bills are actually trading <i>lower</i> than fed funds recently - for the most part.<br />
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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.<br />
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There's an easy fix, however, and that's <a href="https://www.stlouisfed.org/on-the-economy/2019/march/why-fed-create-standing-repo-facility">Andolfatto and Ihrig's standing repo facility</a> (see also <a href="https://www.stlouisfed.org/on-the-economy/2019/april/fed-standing-repo-facility-follow-up">this post</a>) - 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?<br />
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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?<br />
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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.Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com2tag:blogger.com,1999:blog-2499715909956774229.post-13146578394236826692019-02-21T12:17:00.000-08:002019-02-21T12:17:08.502-08:00Balance Sheet NewsThe FOMC minutes for the <a href="https://www.federalreserve.gov/monetarypolicy/fomcminutes20190130.htm">January 29-30 meeting</a>, 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.<br />
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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: <blockquote>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.</blockquote>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: <blockquote>Some recent survey information and other evidence suggested that reserves might begin to approach an efficient level later this year.</blockquote>So, what to do? <blockquote>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.</blockquote>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.<br />
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What's going on? Total securities held outright by the Fed look like this: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi62Hm8Ewds-sqWkvSJfvQOrJoi1Yknpmn5jS-uzc88oNNG9LHDsCtsRoK5eXhQkp9dy1cKCuQ-Hx5GLSriLEQc13BeIAPkaVqAdGZUh69Jx1d_I5AHMSceWqjOliGh6c1D_0sXm2-uq3uv/s1600/securities.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi62Hm8Ewds-sqWkvSJfvQOrJoi1Yknpmn5jS-uzc88oNNG9LHDsCtsRoK5eXhQkp9dy1cKCuQ-Hx5GLSriLEQc13BeIAPkaVqAdGZUh69Jx1d_I5AHMSceWqjOliGh6c1D_0sXm2-uq3uv/s640/securities.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>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: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgYrcUvAJa_0LCKNcBAGpPJTmoxXqj3I2GBNlSr3bj0ivsJF7siTX3uPXWqyVa4-iY033Uw0WYE1Z58VrGbzRe8iDATtYU756jw7KAYYr6hWwkDnvqg6Gjarad8MKFYsIkPgIWCee-TTyd1/s1600/assets-gdp.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgYrcUvAJa_0LCKNcBAGpPJTmoxXqj3I2GBNlSr3bj0ivsJF7siTX3uPXWqyVa4-iY033Uw0WYE1Z58VrGbzRe8iDATtYU756jw7KAYYr6hWwkDnvqg6Gjarad8MKFYsIkPgIWCee-TTyd1/s640/assets-gdp.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>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?<br />
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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: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg-INkyS3ZFDIJFHUS_5OFuFQv_qbD-e9AQPFxxh3n4ODOchWpeyI8sVMp0GuxFfAYLLL6-1Z34Dbazb3N8btRP97A3hV-8vQ7V5nXcrhGOw14hhg_-CtmKoN-X00HLL6eEYhghCuT05C7x/s1600/currency.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg-INkyS3ZFDIJFHUS_5OFuFQv_qbD-e9AQPFxxh3n4ODOchWpeyI8sVMp0GuxFfAYLLL6-1Z34Dbazb3N8btRP97A3hV-8vQ7V5nXcrhGOw14hhg_-CtmKoN-X00HLL6eEYhghCuT05C7x/s640/currency.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>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:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEihe4O5ZhRJelUnTs1sIQriys2XlgI9mZgyvvx6DJJNjiMTx89RgFa6sc924iqDWmtCe5xayODeOS5jo30eQ-DAQPQMuc7GWlrgCvdOwWdHWIxcvxCvtCh-t2RYgM666pcsyvboNLApvDLG/s1600/currency-gdp.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEihe4O5ZhRJelUnTs1sIQriys2XlgI9mZgyvvx6DJJNjiMTx89RgFa6sc924iqDWmtCe5xayODeOS5jo30eQ-DAQPQMuc7GWlrgCvdOwWdHWIxcvxCvtCh-t2RYgM666pcsyvboNLApvDLG/s640/currency-gdp.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>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%.<br />
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With respect to those weird Fed liabilities, look at this:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj2yUyl3sAjwKZlZBrqnhzS762PoHlwlbfGhuXbfMh8AYnVfUw5D3uqmxId8_-8znXxNx3B7OzWO8XL41NC6H4AFovIqjLN9hLHcmn7NXzyk6SJSyasEbs2ECkNzW5UhspVzvnoAKGATxTE/s1600/other.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj2yUyl3sAjwKZlZBrqnhzS762PoHlwlbfGhuXbfMh8AYnVfUw5D3uqmxId8_-8znXxNx3B7OzWO8XL41NC6H4AFovIqjLN9hLHcmn7NXzyk6SJSyasEbs2ECkNzW5UhspVzvnoAKGATxTE/s640/other.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>First, what are those reverse repos, "foreign and international accounts?" Details on this are on the <a href="https://www.newyorkfed.org/aboutthefed/fedpoint/fed20">New York Fed's website.</a> 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: <blockquote>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.</blockquote>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.<br />
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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. <br />
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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 <a href="https://www.newyorkfed.org/aboutthefed/fedpoint/fed21.html">Treasury Tax and Loan Program,</a> 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.<br />
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In total, the weird Fed liabilities comprise roughly 3% of GDP, so this is significant.<br />
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What's left, in terms of Fed liabilities? Reserves, of course: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgo7NY9BU4AzKzisTI98Hd0t1IW2zV3BYHsAE7kkZE7vW00c9-k1_j2WFHBkVPzXpiRfCd0zJphLmJxy8SaFrc9uq-WcMWznZDd25OGPrwlN4Lpl81F_WOZ6n3qE94OoSkVGt0Ygt2K78Zd/s1600/reserves.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgo7NY9BU4AzKzisTI98Hd0t1IW2zV3BYHsAE7kkZE7vW00c9-k1_j2WFHBkVPzXpiRfCd0zJphLmJxy8SaFrc9uq-WcMWznZDd25OGPrwlN4Lpl81F_WOZ6n3qE94OoSkVGt0Ygt2K78Zd/s640/reserves.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>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."<br />
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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?<br />
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1. <i>Transitioning back to a corridor system would be difficult.</i> 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.<br />
2. <i>Survey evidence indicates that the demand for reserves is large.</i> The survey evidence comes from the <a href="https://www.federalreserve.gov/data/sfos/files/senior-financial-officer-survey-201809.pdf">Senior Financial Officer Survey.</a> 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 <a href="https://www.newyorkfed.org/markets/treasury-repo-reference-rates">repo rates measured by the NY Fed</a> 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.<br />
3. <i>Regulation has increased the demand for reserves.</i> On this one, a <a href="https://www.federalreserve.gov/newsevents/speech/quarles20180504a.htm">speech by Randy Quarles</a> 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: <blockquote>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.</blockquote>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 <i>more</i> 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.<br />
4. <i>Short-term interest rates are more volatile in a corridor system than in a floor system.</i>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.<br />
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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:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiXZpK9FvLpf0-_bWvdSF9azuV673-neHYGF-emogRLYseCwbpAkBbkyFe1ac9d71CCB7oR0ZJlCBDtGWmWPE3Ywyrw97KO-YjGsBdUWyF1B3CBdJGsY5m-csxOe3NKvyT2ydR9x2LczZc-/s1600/repos.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiXZpK9FvLpf0-_bWvdSF9azuV673-neHYGF-emogRLYseCwbpAkBbkyFe1ac9d71CCB7oR0ZJlCBDtGWmWPE3Ywyrw97KO-YjGsBdUWyF1B3CBdJGsY5m-csxOe3NKvyT2ydR9x2LczZc-/s640/repos.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>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.<br />
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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?<br />
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As <a href="http://macromarketmusings.blogspot.com/">David Beckworth points out,</a> 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 <i>huge</i> financial market frictions relative to Canada to justify a threshold of $1 trillion to make a floor system work.<br />
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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 <a href="http://newmonetarism.blogspot.com/2018/07/fed-balance-sheet-policy-and-treasury.html">here</a> and <a href="http://newmonetarism.blogspot.com/2018/08/feds-portfolio-manager-says-not-to-worry.html">here,</a> 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.Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com0tag:blogger.com,1999:blog-2499715909956774229.post-28589970043684476612019-01-01T12:59:00.000-08:002019-01-01T15:09:04.126-08:00The Fed and the New YearMuch 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.<br />
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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.<br />
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But is the Fed doing the right thing? And what's in store for 2019? In terms of achieving its Congressional mandate, as it <a href="https://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf">interprets that mandate,</a> the Fed is doing a great job. Inflation is on target:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhmgf3C9u6RrI9Ocu3hrUp9lmWY4RFx28LaRLOSQUDOzjscO59PHjqZlXSOelZJDQvfO2l2h4lGUhIUaWfD8PxwsX-GXQSK4AO2d5glLmSu0blNxcfsuWnQSgTP7-PqXbldlzefLDD8aUeb/s1600/inflation.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhmgf3C9u6RrI9Ocu3hrUp9lmWY4RFx28LaRLOSQUDOzjscO59PHjqZlXSOelZJDQvfO2l2h4lGUhIUaWfD8PxwsX-GXQSK4AO2d5glLmSu0blNxcfsuWnQSgTP7-PqXbldlzefLDD8aUeb/s640/inflation.png" width="640" height="280" data-original-width="1075" data-original-height="470" /></a></div>The labor market is tighter than it's been since the BLS began collecting JOLTS data: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg8PaxRrLLHiJ0j_8pCu1NLTMMoPPgd2KrVWsm1-WuXZhHjhVym8L30ZyEweaYsv6VN0marRYi9ZvPdqx7E935dNuiYpfyLmmPC8kFIw53pfnAsWs_1ZBgJ1xaxkIZb013SNna260A8DiK0/s1600/tightness.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg8PaxRrLLHiJ0j_8pCu1NLTMMoPPgd2KrVWsm1-WuXZhHjhVym8L30ZyEweaYsv6VN0marRYi9ZvPdqx7E935dNuiYpfyLmmPC8kFIw53pfnAsWs_1ZBgJ1xaxkIZb013SNna260A8DiK0/s640/tightness.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>And real GDP is growing at a good clip, relative to the post-recession history: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj6s8wJ8syqaX3PMEj6wmBkyCzdhTcfmsq-DlCTEQgXVvkZR4kuqzZscTc-PCGXjsOIrGCmkoVe2V_uo9irAdoaeT_hHFY4smGJ6qSsMPwzfzmTLlzdjGRXXl6PXbq8xyUyXVdZi4xTlrKJ/s1600/rgdpb.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj6s8wJ8syqaX3PMEj6wmBkyCzdhTcfmsq-DlCTEQgXVvkZR4kuqzZscTc-PCGXjsOIrGCmkoVe2V_uo9irAdoaeT_hHFY4smGJ6qSsMPwzfzmTLlzdjGRXXl6PXbq8xyUyXVdZi4xTlrKJ/s640/rgdpb.png" width="640" height="521" data-original-width="1031" data-original-height="839" /></a></div>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?<br />
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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 <a href="https://www.newyorkfed.org/newsevents/speeches/2018/wil181130">low real interest rates</a> and <a href="https://www.newyorkfed.org/newsevents/speeches/2018/wil181009">monetary policy normalization.</a> 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 <a href="https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20181219.pdf">December 2018 projections:</a> <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiBddCATA2TjZADD6bPuoPaAByBQ70CVn_vOUaN6MfkXdNvQWB3j2k-vaLUtGC3Uy75LG15noj5GZjXpC16XF36QIkSzOhlpeG0cI9pDey3jZfNA3-9OTxeip4V3q9Y338cimaxVQo_9ixF/s1600/dotplotb.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiBddCATA2TjZADD6bPuoPaAByBQ70CVn_vOUaN6MfkXdNvQWB3j2k-vaLUtGC3Uy75LG15noj5GZjXpC16XF36QIkSzOhlpeG0cI9pDey3jZfNA3-9OTxeip4V3q9Y338cimaxVQo_9ixF/s640/dotplotb.png" width="640" height="441" data-original-width="1341" data-original-height="924" /></a></div>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%.<br />
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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:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEifH_CTFIEVuiZVBGta-Cpbp8zXE3oIMsrP9NV38It_YyrgAftKvW8eaPaVbtGkD7ftjJpWZxBJSu4kxdcSFI_LkcNKVTlJYWLnuTJLB86FsFUHRtdebhNsbx6sxf5tSQo1G4WiebY7um3Y/s1600/realrate.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEifH_CTFIEVuiZVBGta-Cpbp8zXE3oIMsrP9NV38It_YyrgAftKvW8eaPaVbtGkD7ftjJpWZxBJSu4kxdcSFI_LkcNKVTlJYWLnuTJLB86FsFUHRtdebhNsbx6sxf5tSQo1G4WiebY7um3Y/s640/realrate.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>As well, we could look at TIPS yields:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjPCQ-MOP0FpLjD00RSOiIs8AHi65xi0RdeM_sRDq_hQdJ1qEEP8MbNQVZOV_-DAKvefNaTV4CGttDbKF0vDdcyEBMwZWQtWotVu148_dh-qORX37WeB_Q6k5feEZYQVVP1UqYr3QIY53LU/s1600/yieldreal.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjPCQ-MOP0FpLjD00RSOiIs8AHi65xi0RdeM_sRDq_hQdJ1qEEP8MbNQVZOV_-DAKvefNaTV4CGttDbKF0vDdcyEBMwZWQtWotVu148_dh-qORX37WeB_Q6k5feEZYQVVP1UqYr3QIY53LU/s640/yieldreal.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>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.<br />
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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 <a href="http://newmonetarism.blogspot.com/2018/08/feds-portfolio-manager-says-not-to-worry.html">in a previous blog post,</a> 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.<br />
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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.<br />
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Things to look out for in 2019:<br />
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1. <i>The Fed's balance sheet:</i> In the <a href="https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20181108.pdf">November 2018 meeting,</a> 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.<br />
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2. <i>Appointments:</i> 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.<br />
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3. <i>Voting FOMC Members:</i> 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.Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com4tag:blogger.com,1999:blog-2499715909956774229.post-56095797591885802018-08-07T11:08:00.001-07:002018-08-07T11:08:15.020-07:00Fed's Portfolio Manager Says Not to WorryI ran across an interesting talk by <a href="https://www.newyorkfed.org/newsevents/speeches/2018/pot180803">Simon Potter,</a> who is responsible for the System Open Market Account at the New York Fed. Potter is a powerful person in the Fed system, as he looks after the specifics of monetary policy implementation. His talk addresses issues that I discussed in <a href="http://newmonetarism.blogspot.com/2018/07/fed-balance-sheet-policy-and-treasury.html">this previous blog post.</a><br />
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The first order of business in the talk is the phasing out of the Fed's reinvestment policy. Recall that, after the buildup in the Fed's balance sheet that occurred from 2009-2014, the size of the Fed's asset portfolio, in nominal terms, was held constant by purchasing new assets as the existing assets matured. In fall 2017, the FOMC began a phaseout of the reinvestment program which will be completed this fall. After that, the size of the balance sheet will continue to fall until the Fed either decides reduction should cease, or it resumes asset purchases. There have been no public statements about whether the Fed might choose to maintain a significant stock of excess reserve balances in the financial system (retain the current floor system) or revert to the system in place before the financial crisis, perhaps modified in some fashion.<br />
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Potter provides a useful figure that shows what happens as reinvestment is phased out, and after:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh76p2Z_nIVh0hHwOAAumvUvPfvJd5xorrRnr6JHMlqZAtmTioPIhsJsjc0MrLYUIA899wz1cTsq02Rs1jt3OCoNMStekhWW3ox-XwLrMmAy33MvQ-Zuc2eBHcJkMDfymbkGLfjaorb7X10/s1600/reinvest.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh76p2Z_nIVh0hHwOAAumvUvPfvJd5xorrRnr6JHMlqZAtmTioPIhsJsjc0MrLYUIA899wz1cTsq02Rs1jt3OCoNMStekhWW3ox-XwLrMmAy33MvQ-Zuc2eBHcJkMDfymbkGLfjaorb7X10/s640/reinvest.png" width="640" height="480" data-original-width="1000" data-original-height="750" /></a></div>That's interesting, as it shows us how the caps on balance sheet reduction work. When the FOMC set up the phaseout in its reinvestment program, it included specific caps (increasing over time as shown in the figure) for Treasuries and for MBS. The caps limit the quantity of assets that can mature without triggering some reinvestment. Ultimately, these caps won't bind in the near term for MBS, but you can see that they matter for Treasury securities. Intuitively, caps might seem reasonable. You can see in the figure that Treasury securities on the Fed's balance sheet mature in a rather lumpy fashion, so smoothing might appear to be an OK idea. Indeed, as Potter says:<br />
<blockquote>The cap-based program to normalize the balance sheet...is the mechanism by which the decline in the balance sheet is kept to a gradual and predictable pace.</blockquote>But I'm wondering why this matters. The concern seems to be that if reserves fell by a large amount in a given month, this could be disruptive. Consider this though. Here's the Treasury's general account with the Fed:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiGCGrK4VLnxr8cT5V7Ege4sWl5Ll_A_fwUHvuL9w_nxSKAo6n-sB00ZH4jMP_M1uIbsq3bmfE2TMCfoCocOoLQrXXaWRIIW8mu8UzJhTaCsSxnGSV5gtfvSmVvy-48aaQ1MWlTSeEkl5GG/s1600/general+account.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiGCGrK4VLnxr8cT5V7Ege4sWl5Ll_A_fwUHvuL9w_nxSKAo6n-sB00ZH4jMP_M1uIbsq3bmfE2TMCfoCocOoLQrXXaWRIIW8mu8UzJhTaCsSxnGSV5gtfvSmVvy-48aaQ1MWlTSeEkl5GG/s640/general+account.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>Every time the balance in the Treasury's general account increases, reserves held in the private sector decrease by the same amount, everything else held constant. So, apparently reserves can move by two or three hundred billion dollars over a short time, and the Fed does not consider that disruptive, at the current time. So why do we need a cap on balance sheet reduction to prevent $20 or $30 billion of assets from running off? I think you could make a case that the caps are disruptive, as that means the Fed is engaging in on-again off-again purchases of on-the-run Treasury securities.<br />
<br />
Next, there's an issue concerning the recent reconfiguration in overnight interest rates that I discussed in <a href="http://newmonetarism.blogspot.com/2018/07/fed-balance-sheet-policy-and-treasury.html">my previous post. </a> Basically, the FOMC set up a system of monetary policy implementation with a target range of 25 basis points for the fed funds rate, bounded by the interest rate on reserves (IOER) on the high side and the interest rate on reverse repurchase agreements issued by the Fed (the ON-RRP rate), on the low side. But recently, the fed funds rate has moved up very close to IOER, and overnight repo rates have moved up close to IOER as well. Further, other than at quarter-end, there is essentially no takeup for the Fed's ON-RRPs, so the ON-RRP facility has become irrelevant - basically that "lower bound" on the fed funds rate isn't bounding anything.<br />
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What does Potter think is going on? Well, apparently he's sticking to the same story that appeared in the FOMC minutes for the June FOMC meeting, with some more details. That is,<blockquote>...a shift in flows in the Treasury market had the effect of pushing both Treasury bill yields and repo rates higher in February and March. Figure 6 shows cumulative net Treasury bill issuance since the beginning of last year, as well as projections through the third quarter of this year as reported by a private-sector forecaster. The substantial run-up in net bill issuance over the past few quarters, along with other factors, contributed to notable growth in securities dealers’ inventory of Treasury securities, shown in Figure 7—inventories that likely required financing in the repo market.</blockquote>Here's Figure 6, so you can see what he's referring to:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJBmLsb032KrEFXMzy4-tTJvN8F3rNyzYM9M3R5QpxBkL_jedK1gS13F1O6xZhogd1QBNZG3L6jzUqHkFwB-fTqX2M7RqMxTd3pXlc_G1XtplcD8iKlVvrjl70zA9E20DdlHhORVnjrhDX/s1600/bill+issuance.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgJBmLsb032KrEFXMzy4-tTJvN8F3rNyzYM9M3R5QpxBkL_jedK1gS13F1O6xZhogd1QBNZG3L6jzUqHkFwB-fTqX2M7RqMxTd3pXlc_G1XtplcD8iKlVvrjl70zA9E20DdlHhORVnjrhDX/s640/bill+issuance.png" width="640" height="480" data-original-width="1000" data-original-height="750" /></a></div>So, Potter's claiming that the reason that overnight rates tightened up around IOER is that there was a (possibly temporary) increase in the supply of Treasury bills, which increased the quantity of collateral available in repo markets, thus expanding the supply of overnight credit.<br />
<br />
I'm not sure what to make of that argument, so I thought I would look at more details of Treasury issuance, and the composition of outstanding Treasury debt. Here's annual data on Treasury bills, notes, and bonds. If you're not familiar with the terminology, bills are 1-year maturity and less, notes are 2, 3, 5, and 10-year securities, and bonds are anything exceeding 10 years. <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5fiZMhGXBfxszQ1Df1fndmABnbT0bz_ZkJOHN0F5GlZKUjbzW0KLXS8_ot1STpoBHX4Z_nAltYafCh9GNG7wpQZF-E5JwJzp9OGMsynk0XpHZVG7m6KRCiDDhMicsvKlksDPxukEnDshF/s1600/outstanding.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5fiZMhGXBfxszQ1Df1fndmABnbT0bz_ZkJOHN0F5GlZKUjbzW0KLXS8_ot1STpoBHX4Z_nAltYafCh9GNG7wpQZF-E5JwJzp9OGMsynk0XpHZVG7m6KRCiDDhMicsvKlksDPxukEnDshF/s640/outstanding.png" width="640" height="512" data-original-width="1048" data-original-height="839" /></a></div>That data goes up to 2017, but currently the stock of bills outstanding is about $2.2 trillion, the stock of notes is over $9 trillion, and the stock of bonds is about $2 trillion. And that's a big difference from before the financial crisis - the average maturity of outstanding Treasury debt has increased considerably. Indeed, at the same time the Fed was attempting to reduce the average maturity of consolidated government debt outstanding, the Treasury was increasing it. So, a back-of-the-envelope calculation is that the Fed purchased about $3.75 trillion in long-maturity assets from before the recession through the end of 2014. From the last chart, it looks like those purchases were more than offset, in terms of average maturity of the outstanding debt, by what the Treasury was doing. So, if people try to tell you that QE worked in practice because it reduced the average maturity of Treasuries outstanding, that can't be correct - the combined effect of Treasury/Fed debt management was to lengthen average maturity. This point has been made by others - John Cochrane in particular I think - at least concerning an earlier period.<br />
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But the fact that the Fed's QE programs were not working the way Ben Bernanke envisioned - by reducing average maturity of the consolidated government debt outstanding - doesn't mean that these purchases didn't do something. Large scale asset purchases can have detrimental effects simply by replacing Treasury securities (useful collateral) with reserves, which are not so useful, at least as overnight assets. And flows seem to be important, as on-the-run Treasury securities are apparently a key form of collateral in repo markets.<br />
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We should check on the net flows of Treasury issuance, by type security. To provide some smoothing, I'll take 6-month moving averages:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj8Hl3HiZQQkb37EHQfTjDcWNvtSYo7_LzjXHoflOol4VrwcHugCP_U9EpJHGUQEL_Rnv9sXOq9pSUQepMA27ve94hsP56rPuX48tY6hZ3ljUjEwXdJ0pqymUlv2thTsAfXZNBJttS33s_j/s1600/netissue.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj8Hl3HiZQQkb37EHQfTjDcWNvtSYo7_LzjXHoflOol4VrwcHugCP_U9EpJHGUQEL_Rnv9sXOq9pSUQepMA27ve94hsP56rPuX48tY6hZ3ljUjEwXdJ0pqymUlv2thTsAfXZNBJttS33s_j/s640/netissue.png" width="640" height="513" data-original-width="1045" data-original-height="837" /></a></div>Total net issuance of Treasuries will of course tend to move with the federal government deficit:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhGHkDJTOVSy0bOwULoClBnUgHV_1EC4SKi9J-fzkmSduOKhjeUEnR19aX16uXJ1OFhEzyWTtiazvDTyiaiKbEj8o_bO8wOn1kzo9j0mS3St0QP2Itwr9DaQXoTbkq8QsoY31jdGf9kLvBw/s1600/deficit.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhGHkDJTOVSy0bOwULoClBnUgHV_1EC4SKi9J-fzkmSduOKhjeUEnR19aX16uXJ1OFhEzyWTtiazvDTyiaiKbEj8o_bO8wOn1kzo9j0mS3St0QP2Itwr9DaQXoTbkq8QsoY31jdGf9kLvBw/s640/deficit.png" width="640" height="258" data-original-width="1168" data-original-height="470" /></a></div>But the deficit numbers are seasonally adjusted. Part of what the debt managers in the Treasury department do is to smooth out effects due to lumpy incoming revenue by using Treasury bill issues as a buffer. For example, every February and March there are typically large issues of T-bills, which are then retired when you pay your income taxes in April. Thus, you can see in the second to last chart that T-bill issues (even though I've used moving averages) are quite volatile relative to notes and bonds. Net T-bill issuance has indeed been increasing on trend recently, but as I noted in my previous post, there's nothing so unusual about total net Treasury issuance, and good reasons to think that there's strong, if not increasing, demand for Treasuries in the market, in part due to regulatory reasons.<br />
<br />
So, I'm inclined to think that it's the change in the Fed's reinvestment policy that's to blame for the tightening up in overnight interest rates - I don't think it's the Treasury's fault. But why won't the Fed admit it? Because it doesn't fit their narrative. QE was sold as a good thing - Bernanke claimed it would flatten the yield curve, reduce long bond yields, and increase spending. But it appears that QE may have sucked good collateral out of markets for secured overnight credit, thus reducing overnight secured rates relative to overnight unsecured rates. There's nothing good about that - it just reflects inefficiency.<br />
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Finally, Potter discusses what he calls a "technical adjustment" in administered interest rates. The range for the fed funds rate is 1.75%-2%, but currently the ON-RRP rate is set at 1.75%, and IOER at 1.95%, as there appeared to be some worry that the fed funds rate would trade above the stated range. Here's what's happened since the June meeting to the key overnight rates:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjMzjXQXkn8KpxR-F4GxkhkzFUYkiUNeELohMwmHSspb8erOoUnFbs5LZT91gB9YAwWsMI13ge9cD9hvJtFIC636AEBvgtZc0SV6_AVXN_wMpS_5bxk_rYtCBs50idxiY4S35hhu0BWJYbp/s1600/overnight.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjMzjXQXkn8KpxR-F4GxkhkzFUYkiUNeELohMwmHSspb8erOoUnFbs5LZT91gB9YAwWsMI13ge9cD9hvJtFIC636AEBvgtZc0SV6_AVXN_wMpS_5bxk_rYtCBs50idxiY4S35hhu0BWJYbp/s640/overnight.png" width="640" height="517" data-original-width="984" data-original-height="795" /></a></div>As you can see, the fed funds rate has settled in at four basis points below IOER, basically the narrowest persistent spread observed since interest rate hikes began in late 2015. But, in terms of control over the Fed's target interest rate, this looks like a big success. Under the current operating procedure the New York Fed can nail the fed funds rate target. The unexpected feature here, which Potter doesn't comment on, is that the ON-RRP program is irrelevant - the IOER is doing all the work.<br />
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An interesting feature of the last chart is that the repo rate, while much closer than it was to IOER and the fed funds rate, does not track IOER closely. That's a puzzle to me as, in other countries where central banks target a repo rate, for example in Canada, the interest rate on reserves essentially pegs the overnight repo rate (e.g. Spring 2009 to Spring 2010 in Canada) with a floor system.<br />
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Potter comments on the reasons for the "technical adjustment" of setting IOER five basis points below the upper bound on the fed funds target range:<br />
<blockquote>The target range is an important feature of the FOMC’s public communications, and maintaining federal funds rates within it is therefore taken quite seriously. Public confidence in our ability to maintain rates within the target range is important for ensuring that expectations for the FOMC’s future policy stance are properly incorporated into the term structure of interest rates, and thereby appropriately affect financial conditions and the broader economy.</blockquote>For me, the public confidence issue of whether the fed funds rate might exceed the top of the range by a few basis points is a minor one compared to what I've been discussing. No one in the Fed System, including the guy who implements monetary policy, can give a convincing story about why the whole target range approach still makes any sense, why the ON-RRP facility is now irrelevant, and why IOER, overnight repo rates, and the fed funds rate are now about the same. I'm feeling somewhat underconfident, and look forward to being enlightened.Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com2tag:blogger.com,1999:blog-2499715909956774229.post-2649561367009392892018-07-29T13:47:00.001-07:002018-07-29T13:50:07.216-07:00Should You Be As Excited About GDP Growth As Donald Trump Claims to Be?In Friday's report on <a href="https://www.bea.gov/iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=3&isuri=1&1921=survey&1903=1">real GDP growth in the second quarter,</a> the BEA reported a quarterly growth rate of 4.1%, which exceeds both the post-WWII US average growth rate of about 3%, and the average growth rate since the end of the last recession of about 2.2%. Trump <a href="https://twitter.com/realDonaldTrump/status/1022877332858650624">seems to be claiming that recent GDP performance has been better than it was,</a> and is hoping for future growth of 3% or more in real GDP. This seems more modest than <a href="https://www.businessinsider.com/trump-4-gdp-growth-promise-2017-1">his early 2017 claim</a> that growth would proceed at 4% or more. What should we make of this?<br />
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It's always useful in these circumstances to remind yourself what is being reported. GDP is a flow - output per unit time - but the BEA reports a number which is seasonally adjusted at annual rates. That is, it's reported as if the seasonally adjusted flow had continued for a year, instead of just for a quarter. So, what we're supposed to get excited about is that real GDP for the second quarter is measured to be about 1% higher (seasonally adjusted) than it was in the first quarter. The average quarterly growth rate since the end of the last recession has been 0.55%, so we got an extra 0.45 percentage points in growth relative to the recent average, which might not seem so exciting.<br />
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Further, quarterly real GDP growth rates are quite noisy. There's substantial measurement error, due to imperfect raw data, and imperfect seasonal adjustment. Here are the quarterly growth rates since the end of the last recession - seasonally adjusted at annual rates:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxL_Qw2memavRFq-qpR51jwpgl0oj7wkrnpve68JmZbAddB3ZCIrfNm_fuBpN5RXCo602YBcXx7i2Z78zd7SLSt4CpNv7yO4jOHTZoua8pTpYvqMUcuAx5kNJRrPlqESd02IsVn3yU2Ozs/s1600/quarterly.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxL_Qw2memavRFq-qpR51jwpgl0oj7wkrnpve68JmZbAddB3ZCIrfNm_fuBpN5RXCo602YBcXx7i2Z78zd7SLSt4CpNv7yO4jOHTZoua8pTpYvqMUcuAx5kNJRrPlqESd02IsVn3yU2Ozs/s640/quarterly.png" width="640" height="452" data-original-width="897" data-original-height="634" /></a></div>The noise is obvious, I think. Over the last 36 quarters, growth rates have exceeded 4% on five occasions. With one observation exceeding 4% in his 6 quarters in office, Trump is doing about average in post-recession excess-of-4% terms.<br />
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We might look at year-over-year growth rates, which will smooth out some of the noise. Here's what that looks like:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjjATSE7xcIfWjm2IRvp8va5N4Uv68NL1rmI-SHFFu0UxGQ6XcxWpYeY3MNffEb8zi38PgzF-pbTbBDrTKXRjELWWobEHgq6Pqa2fLtFCT3GvLedYBo7tHQOkCnO0aGRt7TKobNlQHREek0/s1600/yoy.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjjATSE7xcIfWjm2IRvp8va5N4Uv68NL1rmI-SHFFu0UxGQ6XcxWpYeY3MNffEb8zi38PgzF-pbTbBDrTKXRjELWWobEHgq6Pqa2fLtFCT3GvLedYBo7tHQOkCnO0aGRt7TKobNlQHREek0/s640/yoy.png" width="640" height="452" data-original-width="895" data-original-height="632" /></a></div>Current year-over-year growth is 2.8%, which exceeds the post-recession average of 2.2%, but 2.8% isn't unusual in the second chart.<br />
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Finally, just to cover all the bases, we could look at the whole post-recession time series of real GDP, and the 2.2% trend:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgBR3yRhUYFIAaGsKAQM2rCxV7XnddvXuXkQkiPdmIGA3k5kWBgtyg7_Ne8Mm5ZnU9mMUk0lvzhT5QALpDuReCwbdy6yH-UFi7sRc1_v1KV18W6cCytQ-m3KP1IAm48khKST2JPbLTtSCn0/s1600/GDPtrend.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgBR3yRhUYFIAaGsKAQM2rCxV7XnddvXuXkQkiPdmIGA3k5kWBgtyg7_Ne8Mm5ZnU9mMUk0lvzhT5QALpDuReCwbdy6yH-UFi7sRc1_v1KV18W6cCytQ-m3KP1IAm48khKST2JPbLTtSCn0/s640/GDPtrend.png" width="640" height="521" data-original-width="1031" data-original-height="839" /></a></div>So, real GDP is a little above trend, but there's nothing in the behavior of the time series to indicate a sustained upside departure from the 2.2% trend.<br />
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Thus, any hope that Trump has of seeing 3+% sustained real GDP growth is yet to be realized. What would we tell the Donald about the future, if he asked, and had the attention span required to take in the information? This is where we get into measures of potential GDP <a href="https://www.nytimes.com/2018/07/28/opinion/why-one-quarters-growth-tells-us-nothing.html">(see also this piece by Paul Krugman)</a>. What's potential GDP? Depends who you're asking. The OECD, in its <a href="https://stats.oecd.org/glossary/detail.asp?ID=2094">"Glossary of Statistical Terms,"</a> defines potential GDP to be: <blockquote>Potential gross domestic product (GDP) is defined in the OECD’s Economic Outlook publication as the level of output that an economy can produce at a constant inflation rate. Although an economy can temporarily produce more than its potential level of output, that comes at the cost of rising inflation. Potential output depends on the capital stock, the potential labour force (which depends on demographic factors and on participation rates), the non-accelerating inflation rate of unemployment (NAIRU), and the level of labour efficiency.</blockquote>Whatever good reputation the OECD has, it didn't earn it by writing definitions, apparently. The OECD says that, if inflation is constant for an unspecified period of time, then we're observing potential output, whether the inflation rate is 5,000% per annum or 2%. That can't be right.<br />
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What's the goal here? The idea is to make a long-term forecast for the growth path of real GDP, over the next two to five years. Further, this forecast is going to be made under the assumption that there are no events that will happen over this future period that would cause a major disruption - no financial crisis, no recession. A crude approach would be to observe what is going on in the last chart, and forecast that real GDP will follow a 2.2% growth path. In the past, sometimes that approach would have worked well. For example, in first quarter 1960, we would have observed that average real GDP growth over the last 10 years was 4.1%. If we took that as a forecast growth path for the next 5 years, here's how we would have done:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgWi89qjpwZlszSyV1GjoSxTuROedr4hCbOuJZVjddx_Ss_QgCYgC1CvlzSTML8m5FDQs60T_X5LazLJwYuG9UmXnKTj1iIRogfogQLSKsBbz8S7ntb_cJWggNkAo6-lSdzmXdBbDec4vNf/s1600/1960fore.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgWi89qjpwZlszSyV1GjoSxTuROedr4hCbOuJZVjddx_Ss_QgCYgC1CvlzSTML8m5FDQs60T_X5LazLJwYuG9UmXnKTj1iIRogfogQLSKsBbz8S7ntb_cJWggNkAo6-lSdzmXdBbDec4vNf/s640/1960fore.png" width="640" height="525" data-original-width="1031" data-original-height="845" /></a></div>Excellent! Dish out the advice in 1960, and in 1965 everyone's calling you a genius. Unfortunately, that won't work every time. In fourth quarter 2007, average real GDP growth over the previous 10 years was 3.0%. Forecast a 3% growth path five years ahead, and here's what it looks like:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh4pOAY6IR_Lx-fGjbxDpMdXaXqH0c72XA8nJBqBYKbKjabndX3hSJu_tIYCstzroFcdwuw0a-1OcZ9SHioqDCz5O6YE-k121IHpdpfX2gypxfF9i_5TMqh-CUqp6wq7re3PCxubzGu7wHV/s1600/2007.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh4pOAY6IR_Lx-fGjbxDpMdXaXqH0c72XA8nJBqBYKbKjabndX3hSJu_tIYCstzroFcdwuw0a-1OcZ9SHioqDCz5O6YE-k121IHpdpfX2gypxfF9i_5TMqh-CUqp6wq7re3PCxubzGu7wHV/s640/2007.png" width="640" height="521" data-original-width="1031" data-original-height="839" /></a></div>Dish out that advice in 2007, and by 2012 people are laughing at you.<br />
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Potential GDP measures, such as the <a href="https://www.cbo.gov/about/products/budget-economic-data#6">CBO's potential GDP measures,</a> aren't so different from that, and the CBO made errors on the order of what is in the last chart in forecasting the recovery from the recession. The CBO's approach to long-term forecasting is more or less consistent with what conventional models of economic growth predict. In a neoclassical growth model with exogenous labor force growth, exogenous total factor productivity (TFP) growth, and constant returns to scale, the economy converges to a steady state in which output grows at the TFP growth rate plus the growth rate in the labor force. So, the CBO makes long-run forecasts based on an assumption about the aggregate production function, and projections for TFP growth and labor force growth. Here's actual year-over-year real GDP growth, and year-over-year growth in the current CBO potential GDP measure.<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhau-AReYUR7E6w3GTDkd13ovgcdDUNIPGnJpBt_HveDWMUVs6tjFnxDNuk9pRSK1-NW9y2zQYujjjLQ8jKdWwhaSYKogq2ucdhqwlyQGqGwPX_EkJQFNtgdoNi7zzeIHyah4c0iLq9PzwB/s1600/cbo.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhau-AReYUR7E6w3GTDkd13ovgcdDUNIPGnJpBt_HveDWMUVs6tjFnxDNuk9pRSK1-NW9y2zQYujjjLQ8jKdWwhaSYKogq2ucdhqwlyQGqGwPX_EkJQFNtgdoNi7zzeIHyah4c0iLq9PzwB/s640/cbo.png" width="640" height="447" data-original-width="897" data-original-height="627" /></a></div>Currently the CBO potential year-over-year growth rate is 1.9%, and the potential growth rate is lower than actual growth has been, on average, as the CBO does not think that 2.2% growth can be sustained. Presumably that's mainly because unemployment has been falling as employment has been growing, since the end of the recession. Employment growth is ultimately bounded by growth in the labor force (employment plus unemployment), and labor force growth in turn is bounded by growth in the working age population.<br />
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To see what has been going on, let's look at employment growth (establishment and household survey measures) and labor force growth:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgIkWjmkNs52qoY5nVaQeqKIGjrAty7tFcElcW7fNEQ7u6O-6aW1-t7HbhuplLmOybd40OmiarwR6lJ1M_5IYB8ZbavKy6ZEyLG-JDEeakUPVGmfxl6PN0dDWGz5hdT3VVzVvnPOEQVG9a4/s1600/labor+market.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgIkWjmkNs52qoY5nVaQeqKIGjrAty7tFcElcW7fNEQ7u6O-6aW1-t7HbhuplLmOybd40OmiarwR6lJ1M_5IYB8ZbavKy6ZEyLG-JDEeakUPVGmfxl6PN0dDWGz5hdT3VVzVvnPOEQVG9a4/s640/labor+market.png" width="640" height="443" data-original-width="902" data-original-height="624" /></a></div>Since the last recession, payroll employment (establishment survey) grew on average at 1.5%, household survey employment grew on average at 1.2%, and the average labor force growth rate was 0.6%. Labor force growth (year over year) and growth in working-age population (also year over year) look like this:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjlrpAJKjTeDUArstBbhmSywzCEgtJLO1dZ5LyL4eCqTtj62yVusozEh3gvqg_mq887qSbmOUnYrVOIK2Eh-azHiulRAduWOdmoAMWFMV0Cji3BHFv10WlSmCDEZMY3yrDfAbE5AkzGUsw-/s1600/population.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjlrpAJKjTeDUArstBbhmSywzCEgtJLO1dZ5LyL4eCqTtj62yVusozEh3gvqg_mq887qSbmOUnYrVOIK2Eh-azHiulRAduWOdmoAMWFMV0Cji3BHFv10WlSmCDEZMY3yrDfAbE5AkzGUsw-/s640/population.png" width="640" height="454" data-original-width="889" data-original-height="631" /></a></div>Recently, labor force growth has increased somewhat to around 1%, while working-age population growth (no idea exactly how these numbers are constructed - growth rates look a little odd) has been on a secular decline and is currently in the neighborhood of 0.5%.<br />
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What about productivity? <a href="https://www.frbsf.org/economic-research/publications/working-papers/2012/19/">John Fernald,</a> at the San Francisco Fed, has constructed TFP series for the United States that are adjusted for capacity utilization. As far as I know, this is the state of the art, though I know people get in heated arguments about this. Here's the growth rate in Fernald's annual TFP series, 1948-2017:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj9I8djj_Uli4ret_noXf-LlJRJ19UzCVBmJfPq7lkGwYwlU5UyQqrgxPwBkG34BUtp5WP59xi2MXq9wKjCoExDnzmOvFGW_TpmBuqtE4ADnHowrraaXIxNfv8_Ea-_XOkABzQMq6vJ8Yg8/s1600/tfp.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj9I8djj_Uli4ret_noXf-LlJRJ19UzCVBmJfPq7lkGwYwlU5UyQqrgxPwBkG34BUtp5WP59xi2MXq9wKjCoExDnzmOvFGW_TpmBuqtE4ADnHowrraaXIxNfv8_Ea-_XOkABzQMq6vJ8Yg8/s640/tfp.png" width="640" height="531" data-original-width="1012" data-original-height="839" /></a></div>That's somewhat depressing. Since the recession, TFP growth has mostly been lower than the post-WWII average growth rate of 1.3%. The average since the last recession is 0.3%.<br />
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So, the most pessimistic scenario is that TFP continues to grow at 0.3% per year, employment grows at the working-age population growth rate of 0.5%, and we get sustained growth of 0.8% per year in real GDP. TFP growth, as we know from growth economics, is key though. Higher TFP growth means higher growth in real wages, which means higher growth in the labor force (labor supply effect - provided the substitution effect is large on the extensive and intensive margins). And then higher TFP growth and higher labor force growth both contribute to output growth. But, optimistically, supposing TFP grows at 1% (just short of the post-WWII average) and the labor force grows at 1%, that only gives us 2% growth in real GDP. To get to 3% or, more outlandishly, 4%, requires a serious miracle.<br />
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So, where could a miracle come from? Well, people are always inventing things, and the miracle could be the implementation of a new technology. There's plenty of debate about this, <a href="https://www.wsj.com/articles/economists-duel-over-idea-that-technology-will-save-the-world-1402886301">indicating that economists aren't much better at predicting technological innovations five or ten years hence than your average person.</a> Are we going to get a government-induced economic miracle? From the current US government, that would be another kind of miracle altogether. Some people think that regulation is a big deal - excessive regulation leads to inefficiency and lowers TFP. But regulation can cut both ways. Remember the financial crisis? If we unwind financial regulation that was introduced to prevent crises, that of course won't help the average rate of economic growth. Some people think that taxation is a big deal. The US tax code could in principle be redesigned to collect the same amount of revenue in a far more efficient way, potentially increasing TFP and the size of the labor force. But it's hard to argue the the tax changes recently passed by Congress would do much in this respect. Further, tariffs are indeed taxes, and the way these ones work isn't going to grease the wheels of the US economy.<br />
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Governments can potentially increase productivity through policies related to public education. But apparently the US Secretary of Education thinks public education is a waste of resources. Governments can provide public infrastructure that makes the private sector more productive. Haven't seen much of that. Donald Trump likes to spend on the military and keeping people out of the country, neither of which is going to contribute to measured GDP.<br />
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It would be nice to be more optimistic, but it looks like what you see is what you get.Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com1tag:blogger.com,1999:blog-2499715909956774229.post-52528013616303449412018-07-08T15:46:00.002-07:002018-07-08T18:42:12.788-07:00Don't Fear the Inversion - It's the Short Rate That Kills You<a href="https://www.wsj.com/articles/fed-officials-debate-signal-from-flattening-yield-curve-is-this-time-different-1531051200">Nick Tamaraos</a> has a nice summary of issues to do with the flattening US Treasury yield curve, and the implications for monetary policy. Some people, including <a href="https://www.bloomberg.com/view/articles/2018-06-08/fed-could-get-more-aggressive">Tim Duy</a>, and some regional Fed Presidents, are alarmed by the flattening yield curve, and the issue entered the policy discussion at the <a href="https://www.federalreserve.gov/monetarypolicy/fomcminutes20180613.htm">last FOMC meeting.</a><br />
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What's going on? While it's typical to focus on the margin between 10-year Treasuries and 2-years, I think it's useful to capture the very short end of the yield curve as well. I would use the fed funds rate for the short end, but that's sometimes contaminated by risk, so the 3-month t-bill rate, which most of the time seems to be driven primarily by monetary policy, seems like a good choice. Here's the time series of the 3-month T-bill, the 2-year Treasury yield, and the 10-year:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjoiD-0R2Tamw3CKQDXexEzRyO0oVy38a7opEYbO8ydCEbojDu0YjAyc-sUENkh_tyB40NtkhbkZvVZokaGR6-63vG4GOlk9godUdJDiouc_Vb9EuL8nXGvloCRKZFUKJK1k8E3i7zwFBfn/s1600/yield+curve.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjoiD-0R2Tamw3CKQDXexEzRyO0oVy38a7opEYbO8ydCEbojDu0YjAyc-sUENkh_tyB40NtkhbkZvVZokaGR6-63vG4GOlk9godUdJDiouc_Vb9EuL8nXGvloCRKZFUKJK1k8E3i7zwFBfn/s640/yield+curve.png" width="640" height="445" data-original-width="898" data-original-height="624" /></a></div>What people have pointed out is a regularity in the data. A flat or inverted yield curve tends to lead a recession. In the chart above, we're looking for compression in the 3 time series I've plotted. You can certainly see that compressions tend to lead the NBER-dated recessions (the shaded areas). To get a closer look at this, plot the difference between the ten-year yield and the 2-year yield, and the difference between the 2-year yield and the 3-month T-bill rate: <div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiJrzxQy_KqBw5GPsyr5iB3acvSYpnrNzW1JD0Z1Vi4p2sHQGycch-NLoh0jdeixDYlfVU5x_qZ9e3nEfSdHKFL7x3ccxSDN-N9dI2aK_3sl_F6BjrBzFoSni1oOI89nJrwQQFtHEkVLW8-/s1600/slope+yield+curve.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiJrzxQy_KqBw5GPsyr5iB3acvSYpnrNzW1JD0Z1Vi4p2sHQGycch-NLoh0jdeixDYlfVU5x_qZ9e3nEfSdHKFL7x3ccxSDN-N9dI2aK_3sl_F6BjrBzFoSni1oOI89nJrwQQFtHEkVLW8-/s640/slope+yield+curve.png" width="640" height="451" data-original-width="875" data-original-height="617" /></a></div>In this second chart, you can see that those two interest rate differentials go negative before recessions. But there are a couple of episodes in the sample, in 1996 and 1998, when the yield curve is pretty flat, but there's no ensuing recession. What's different about those two episodes is that (see the first Chart) the compression is caused more by long bond yields moving down, rather than the short rate moving up, as we observe in the cases where compression precedes a recession. If you were worried about an oncoming recession right now, based only on yield curve observations, you shouldn't be. All the recent flattening in the yield curve is in the long end. The margin between the two-year yield and the three-month T-bill rate hasn't been falling, as it did prior to previous recessions.<br />
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I think it's fair to conclude that what's going on in the data isn't a phenomenon related to the slope of the yield curve at the long end (2 years to 10 years), but at the short end. Recessions tend to happen when the short rate goes up a lot, and that's driven by monetary policy. As an alternative recession indicator, let's look at the real interest rate, measured by the difference between the three-month T-bill rate and year-over-year core inflation:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhDrLEk1DZ4TlyzjLsuEwFdqOFetkmABeeJVj_OM_XDoHpGugxRZaz_n3NFcc9Pa4bTi8TM9gGI7YEaVZSLHwt8t837oa8toJ67xv4Vn1JLNwvKQWAW00fVfVV4ihVI5zqd6qXW0LDWOCqU/s1600/real+rate.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhDrLEk1DZ4TlyzjLsuEwFdqOFetkmABeeJVj_OM_XDoHpGugxRZaz_n3NFcc9Pa4bTi8TM9gGI7YEaVZSLHwt8t837oa8toJ67xv4Vn1JLNwvKQWAW00fVfVV4ihVI5zqd6qXW0LDWOCqU/s640/real+rate.png" width="640" height="441" data-original-width="893" data-original-height="615" /></a></div>Typically, when the real interest rate moves from trough to peak by a large amount, a recession happens. That seems to work pretty well, except during the 1980s disinflation. So, for example, from trough to peak, the real rate moves about 420 basis points before the 2001 recession, and about 400 basis points before the 2008-09 recession. Recently, the movement from the trough to where we are now is about 200 basis points, so by that criterion, it's not time to worry yet.<br />
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What's the policy issue here? Well, apparently some members of the FOMC are starting to question whether continued rate hikes are a good idea, and are looking for arguments that will convince their colleagues to hold off. For example, in <a href="https://www.stlouisfed.org/~/media/Files/PDFs/Bullard/remarks/2018/Bullard_JCIF_Tokyo_29_May_2018.pdf?la=en">a talk at the end of May,</a> Jim Bullard gave three reasons for holding off on interest rate increases: (i) inflation expectations are about where they should be; (ii) the Fed is achieving its goals; (iii) the yield curve is flattening. One measure of anticipated inflation is the breakeven rate - the margin between a nominal bond yield and the TIPS yield for the same maturity. Here are the five-year and 10-year breakeven rates:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgC4gYGjdTGD5fxWw7sjMMSJ5bMtwhG3_xxp35-MNYaTUdxElSSKkp0fSZ_0uPDjzb8559WKzTg4vj5ZuFcHYq8iJLMv8oD8EVhM46p2xzVvVquvoLbo2FGKNz4vSX6whUzgttcypRj6jOD/s1600/breakeven.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgC4gYGjdTGD5fxWw7sjMMSJ5bMtwhG3_xxp35-MNYaTUdxElSSKkp0fSZ_0uPDjzb8559WKzTg4vj5ZuFcHYq8iJLMv8oD8EVhM46p2xzVvVquvoLbo2FGKNz4vSX6whUzgttcypRj6jOD/s640/breakeven.png" width="640" height="447" data-original-width="891" data-original-height="622" /></a></div>Both of those have moved up above 2%, and the increase in the five-year breakeven is particularly important, as that's telling you more about near-term inflation expectations. As well, for good measure, the Philadelphia Fed's survey of forecasters gives a measure of anticipated CPI inflation for the next year:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgz_-8xnvEhDc-TZQYU9M7lU1d8_JVsjpx-Y9G9WLWCX2PufDqe2IAI-eASwhIcqPI7uJEZAZbVhJ71CfH8BjWU5CakNR-wtPBtXlOA5yqu87DdCFuFaJdOyxKk_VNEw-28kqdiK89Q4VF5/s1600/forecast.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgz_-8xnvEhDc-TZQYU9M7lU1d8_JVsjpx-Y9G9WLWCX2PufDqe2IAI-eASwhIcqPI7uJEZAZbVhJ71CfH8BjWU5CakNR-wtPBtXlOA5yqu87DdCFuFaJdOyxKk_VNEw-28kqdiK89Q4VF5/s640/forecast.png" width="640" height="524" data-original-width="1025" data-original-height="839" /></a></div>That measure has also moved well above 2%, in line with 2% inflation - more or less - in terms of the Fed's inflation target measure, the PCE deflator. In terms of achieving its goals, the Fed is essentially nailing its inflation target, and the labor market is tighter than anyone would have imagined possible a few years ago. But what about the flattening yield curve, the third item on Jim Bullard's list?<br />
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There was a discussion about the flattening yield curve at the last FOMC meeting, as documented in the <a href="https://www.federalreserve.gov/monetarypolicy/fomcminutes20180613.htm">most recent FOMC minutes.</a> Here's the relevant paragraph:<blockquote>Meeting participants also discussed the term structure of interest rates and what a flattening of the yield curve might signal about economic activity going forward. Participants pointed to a number of factors, other than the gradual rise of the federal funds rate, that could contribute to a reduction in the spread between long-term and short-term Treasury yields, including a reduction in investors' estimates of the longer-run neutral real interest rate; lower longer-term inflation expectations; or a lower level of term premiums in recent years relative to historical experience reflecting, in part, central bank asset purchases. Some participants noted that such factors might temper the reliability of the slope of the yield curve as an indicator of future economic activity; however, several others expressed doubt about whether such factors were distorting the information content of the yield curve. A number of participants thought it would be important to continue to monitor the slope of the yield curve, given the historical regularity that an inverted yield curve has indicated an increased risk of recession in the United States. Participants also discussed a staff presentation of an indicator of the likelihood of recession based on the spread between the current level of the federal funds rate and the expected federal funds rate several quarters ahead derived from futures market prices. The staff noted that this measure may be less affected by many of the factors that have contributed to the flattening of the yield curve, such as depressed term premiums at longer horizons. Several participants cautioned that yield curve movements should be interpreted within the broader context of financial conditions and the outlook, and would be only one among many considerations in forming an assessment of appropriate policy.</blockquote><br />
What's going on here? The flattening yield curve is being used as an argument for a pause in interest rate hikes, so the people in favor of more interest rate hikes are looking for reasons why things are different now, and the drop in the margin between the 10-year yield and the 2-year yield doesn't mean what it used to. People may be able to come up with explanations about what's going on with respect to the 10-year vs. the 2-year Treasury bonds, but as I discussed above, that's not really important - it's what's going on at the short end of the yield curve that matters. The key question is: What are the benefits and costs of further rate hikes, given the current state of the economy? In evaluating the costs, we need to be concerned about the effects of these hikes on real economic activity. What's it take for the Fed to kick off a recession, and does the Fed really want to do the experiment to find out, if everything looks OK? As a side note, I thought the part of the FOMC discussion where the staff gives a presentation relating to an alternative indicator - the difference between the current fed funds rate and what the market thinks the future fed funds rate will be - was good for a chuckle. If the FOMC thinks the market knows more about what it's going to do than what it knows about what it's going to do, we're all in trouble.<br />
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What's the bottom line here? The case for continued rate hikes the FOMC has made is based on a faulty theory of inflation. The Fed thinks that tightness in the labor market will inevitably cause inflation to explode, and it thinks that increasing unemployment will keep inflation on target. But: (i) Phillips curve theory is not a theory; (ii) the central bank does not control inflation by controlling the unemployment rate; (iii) there is no such thing as an overheating economy. There is some question about what real interest rate we would see when the US economy settles down - supposing monetary and non-monetary factors don't change from what they are currently. Possibly that real interest rate - r* if you like - has increased somewhat from where it was earlier this year <a href="http://newmonetarism.blogspot.com/2018/07/fed-balance-sheet-news.html">due to the phasing out of the Fed's QE program.</a> But, given the current state of the economy, I think the onus should be on members of the FOMC who want further hikes to justify them, not the other way around.Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com7tag:blogger.com,1999:blog-2499715909956774229.post-68668951929974924942018-07-06T10:17:00.000-07:002018-07-06T10:17:40.051-07:00Fed Balance Sheet Policy, and Treasury Debt ManagementI happened to be entertaining myself, reading the <a href="https://www.federalreserve.gov/monetarypolicy/fomcminutes20180613.htm">FOMC minutes from the June 12-13 meeting,</a> when I ran across this, in a discussion led by the people from the New York Fed who manage the System Open Market Account (SOMA): <blockquote>The deputy manager followed with a discussion of money markets and open market operations. Rates on Treasury repurchase agreements (repo) had remained elevated in recent weeks, apparently responding, in part, to increased Treasury issuance over recent months. In light of the firmness in repo rates, the volume of operations conducted through the Federal Reserve's overnight reverse repurchase agreement facility remained low. Elevated repo rates may also have contributed to some upward pressure on the effective federal funds rate in recent weeks as lenders in that market shifted some of their investments to earn higher rates available in repo markets.</blockquote>First, it seems a good sign that the Fed is paying attention to Treasury debt management. After all, the large asset purchase programs the Fed engaged in from late 2008 to late 2014 were a form of debt management. The Fed conducted assets swaps of short-maturity reserves for long-maturity Treasuries and mortgage backed securities, and swaps of shorter-maturity Treasuries in its portfolio for long-maturity assets. In so doing, the Fed wanted to change relative asset supplies at different maturities with the purpose of altering the term structure of interest rates - basically, flattening in the yield curve. Or, that was the theory, at least.<br />
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But in conducting its quantitative easing (QE) programs, the Fed appeared to be paying no attention to what the Treasury was doing. That's somewhat disturbing, as one of the Treasury's jobs is to manage the government debt - to decide when to issue debt, how much to issue, and what maturities to issue. If the Fed wants to manage the government debt, maybe it should be coordinating with the Treasury, or maybe it should ask Congress to add debt management to the Fed's job description.<br />
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But, back to the FOMC minutes. The quote is factually correct, in that there was larger issuance of Treasury securities in the first part of this year:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgml_-oJcIGzOJ_qPN9n2ukzJV02P2n4bCSIrEGb6ILNWH-UMbVG9Bg9OlBFzbbL3NqiJNaq_RfkYWGfxYLYLa8Ol24OqQ_K6vwvHUTfiKrd61Nv9wwjj0nVMyu1cdJ0_G2brr08G6x756b/s1600/iss.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgml_-oJcIGzOJ_qPN9n2ukzJV02P2n4bCSIrEGb6ILNWH-UMbVG9Bg9OlBFzbbL3NqiJNaq_RfkYWGfxYLYLa8Ol24OqQ_K6vwvHUTfiKrd61Nv9wwjj0nVMyu1cdJ0_G2brr08G6x756b/s640/iss.png" width="640" height="511" data-original-width="1048" data-original-height="837" /></a></div>You can't quite see it in that chart, but it helps to take a 6-month moving average:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjS0uLmNToo_qkH5uOGZJsc2Jsr7wn83XlfkRgPEEtp7JBUHYEMH7moHMkpZtvZtnztQr730nEj2bnzU_jlm8HL343fGwzoZSjGudlEVSTWB5rRbJFIo3A1Up0PzIzbQF-zf7O1pTVQc9hV/s1600/aver.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjS0uLmNToo_qkH5uOGZJsc2Jsr7wn83XlfkRgPEEtp7JBUHYEMH7moHMkpZtvZtnztQr730nEj2bnzU_jlm8HL343fGwzoZSjGudlEVSTWB5rRbJFIo3A1Up0PzIzbQF-zf7O1pTVQc9hV/s640/aver.png" width="640" height="521" data-original-width="1034" data-original-height="842" /></a></div>So, indeed, average issuance over the last six months took a jump of about $100 billion per month early this year, relative to last year. If you thought about that in the context of a reduction in the Fed's uptake of Treasuries and close substitutes, with the reduction in that monthly uptake currently capped at $30 billion, then it might seem like the Treasury's activities are more important. In <a href="http://newmonetarism.blogspot.com/2018/07/fed-balance-sheet-news.html">my last post,</a> I was blaming the cessation of the Fed's reinvestment program for the tightening up of overnight interest rates. That is, all overnight interest rates - repo rates, the fed funds rate - are close to the interest rate on reserves (IOER) currently, and that's a new phenomenon. In the quote above, it looks like the SOMA people are blaming the Treasury for this. A bit of an odd tactic that, as one might think the Fed would take the blame when their floor system starts to work the way it should.<br />
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But, that increase in new Treasury issues in January through May of this year didn't occur for no reason. When the Treasury has a month when a lot of government debt matures, it will issue more Treasuries to finance the principal payments and to fill the holes in financial markets left by the departing Treasuries. We should actually be more interested in net Treasury issue - the value of new securities sold minus the outflow from maturing debt. Here's what that looks like:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEghyphenhyphenw7mn4fHRQr1rmk8_7jNDwcPq5lYg1BAhtP9a8sZq07Rw4FVMd4ZZ1T1QPvWarZy8z-8Dlb12SLdsewlHPzi22YjIjI2Ni6eOERFpZJC7F1qFn5qqbymRu8VioDkXGW88BrGgeqkesMD/s1600/net.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEghyphenhyphenw7mn4fHRQr1rmk8_7jNDwcPq5lYg1BAhtP9a8sZq07Rw4FVMd4ZZ1T1QPvWarZy8z-8Dlb12SLdsewlHPzi22YjIjI2Ni6eOERFpZJC7F1qFn5qqbymRu8VioDkXGW88BrGgeqkesMD/s640/net.png" width="640" height="513" data-original-width="1045" data-original-height="837" /></a></div>So, nothing particularly unusual going on there recently. Just for good measure, we'll look at a 6-month moving average as well:<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjRLctggUwPHhJIW6p5jtmZDvvlgyOuG5eGSerGRpUQzYoQeKTXWNvcJJltJjh43vEpvuBG3qRsxMT9GEAm2VQa2vYnti-JZ3NTAnaOTs0igRRNDdR4ALWl-hL-YUmpmrWOXnnIhPyX3Ncu/s1600/netav.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjRLctggUwPHhJIW6p5jtmZDvvlgyOuG5eGSerGRpUQzYoQeKTXWNvcJJltJjh43vEpvuBG3qRsxMT9GEAm2VQa2vYnti-JZ3NTAnaOTs0igRRNDdR4ALWl-hL-YUmpmrWOXnnIhPyX3Ncu/s640/netav.png" width="640" height="518" data-original-width="1034" data-original-height="837" /></a></div>That spikes up in the first part of this year, but it was also way down in the last part of last year. Also, note the quantities here. The cap on the value of securities in its portfolio the Fed will allow to mature is currently $30 billion, and that will increase to $40 billion in July, and finally $50 billion. The net flow of new Treasuries has averaged about $60 billion since 2014, so $30-$50 billion is large relative to that and, I think, consistent with the idea that it's the Fed's non-reinvestment policy that's mitigating a scarcity of safe collateral in the repo market. We have to account for mortgage-backed securities in the calculation, but I don't think that changes the story.Stephen Williamsonhttp://www.blogger.com/profile/01434465858419028592noreply@blogger.com3