Monday, March 16, 2020

What Sort of Financial Panic Is This?

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

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

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

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

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

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

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

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

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

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

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

Thursday, March 5, 2020

Coronavirus and Monetary Policy

On 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.

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 FOMC statement 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 his short press conference, 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.

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.

But maybe Steve Poloz knows something that Powell doesn't know? The Bank of Canada statement 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: 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.
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.

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:
And here's the Chicago Fed's financial conditions index:
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:
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?

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 stock of about $280 billion in T-bills. 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.

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.

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.

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.

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.

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:
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.

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?

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.

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.

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.

Tuesday, February 18, 2020

Is Inflation Targeting the Best We Can Do?

In the U.S., the Fed is considering modifications to its longer-run goals and monetary policy strategy, and last year Fed officials went on a listening tour 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 policy agreement with the government of Canada. The Bank conducts in-house research, runs conferences, and interacts with the public in various ways, 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 "The Role of Central Banks," 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.

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 longer-run goals and monetary policy strategy, 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:
This is perhaps surprising. The Fed actually does quite well relative to a 2% price level 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.

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 goals, that is it could specify a different objective rather than 2% inflation - an NGDP (nominal GDP) target for example. It could change its policy rule, 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 implementation strategy, for example the specific actions or mechanism for achieving a specific fed funds rate target.

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 P(t) is the price level, and i* is the inflation target, then in an period t the target for next period's price level is

(1) P*(t+1) = (1+i*)P(t)

Or, in logs (approximately),

(2) p*(t+1) = i* + p(t).

An advantage of this conventional approach is that there is only one number that describes it, 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*, it's easy to evaluate the central bank's performance. If p(t)-p(t-1) deviates from 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.

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 b, a rate of adjustment a, and an inflation rate i*, which implies (see my paper) that next period's price level target is (in logs),

(3) p*(t+1) = (1-a)p(t) + ap(b) + [1+a(t-b)]i*.

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* over a long horizon could be substantial, as was the case over the last 6 or so years.

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.

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 Ben Bernanke's argument for temporary price level targeting. 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.

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 Benhabib et al. (2001) 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, R(t), the inflation rate, i(t), as measured by the year-over-year percentage increase in the pce deflator, and the unemployment rate, u(t), 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:
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:
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

(4) R(t) = 0.06i(t) - 0.71u(t)

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 some states of the world, otherwise the central bank is doomed to perpetually undershooting its inflation target.

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 s periods by compensating for these misses over the next s periods. This yields a target for next period's price level,

(5) p*(t+1) = (1-1/s)p(t) + (1/s)p(t-s) + 2i*

Note that (5) is just (3) with a = 1/s and b = t - s. 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.

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,

MV = PY,

where M is some measure of money, V is the income velocity of money, P is the price level, and Y is real GDP, so PY is nominal income. One could say that Friedman's argument was that V 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 M caused instability in both P and Y. In practice, V 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 V instability, the central bank might just as well target PY, which would solve the problem.

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:

1. What's the connection between nominal income and the things the Fed should actually care about?
2. Is it even feasible for the Fed to achieve an NGDP target, with some reasonable degree of accuracy?

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.

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.
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.

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.

Advocates of NGDP targeting make three claims:

1. The costs of variable inflation are negligible.
2. Inflation-targeting central banks - the Fed in particular - are singularly focused on inflation control.
3. There are large untapped welfare gains from output stabilization.

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.

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.

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.

Conclusion: The FOMC's "Statement of Longer-run Goals and Monetary Policy Strategy" is fine for now. No need for changes.

Friday, January 10, 2020

The FOMC: Where It's Come From, and Where It's Going

After 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?

What does the data look like? First, the labor market has become increasingly tight:
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:
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.
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.

So, relative to the objectives the FOMC laid out for itself in the Statement of Longer-Run Goals and Monetary Policy Strategy, 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.

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:
At 1.8%, that's not so low, but it's lower than seems consistent with 2% inflation over a 10-year horizon.

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 January 4 New York Times as saying, at the ASSA meetings, that:
We don't have a really good understanding of why it's been so difficult to get inflation back up...
And, this makes here want to predict that:
...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.
She also concludes that:
...a new policy framework will likely be required...
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.

I've been saying this for a long time (e.g. this paper in the St. Louis Fed Review, this one in the CJE, 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 perils of Taylor rules. 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.

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.

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.

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?

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.

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 this paper. 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.

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.

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:
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:

r(t)=a + bu(t) + di(t),

where a is a is a constant, b < 0, d > 0, and r(t), u(t), and i(t) 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 b = -0.95, d = 0.13, and a = 0 by construction. This says that, indeed, the Fed has not been a Taylor-rule central banker, which would imply d > 1. 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.

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.

Sunday, October 27, 2019

An Attempt to Sort out the Fed's Overnight Market Issues

First, 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.

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:
Better still, we can look at Fed assets minus currency outstanding, which is the quantity of non-currency Fed liabilities, along with reserves:
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 Fed balance sheet snapshot, 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.

How does the FOMC think about overnight interest rate determination in a floor system? Typically, they're relying on this:
In the figure, R is the fed funds rate, and Q* 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 Q*, according to this story, if the Fed wants to target the fed funds rate at R*, it simply pegs the interest rate on reserves (IOER) at R* and then the market clears at R*.

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 Q*. As a reminder of what has happened to overnight interest rates in the US since interest rate hikes began in December 2015:
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.

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:
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.

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:
In this figure, by setting IOER at R* 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).

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:
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).

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.

So what's the Fed up to, and why? For more information, let's go to a recent speech by John Williams, President of the New York Fed. Williams says:
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.
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.

Here's something else Williams said in his speech:
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.
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?


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?

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.

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.

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.

Thursday, September 26, 2019

The Fed's Failed Experiment

Last 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:
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.

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:
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.

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:
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.

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.

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.

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.

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:
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:
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.

But note that, in early 2018, the ON-RRP facility became moribund - zero takeup essentially. What happened then?
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 yours truly pointed out (with some prescience) in May of this year,
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.
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.

So, how to make sense of this? There are several aspects of the problem we need to be concerned with:

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.
2. Large scale asset purchases (QE) by the Fed had, and have, implications for how the overnight market works.
3. How do new bank regulations (LCR and resolution liquidity) matter?
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.

Let's start with fiscal actions and how they matter here. Here's the Treasury's general account with the Fed.
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.

Another drain on private sector reserve balances is the foreign repo pool:
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.

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 this blog post, 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.

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.

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.

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.

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.