These are replies to comments on my previous post.
In reply to anonymous: I read the Ennis/Wolman Richmond Fed piece, and found it confused. This relies on Old Monetarist money-multiplier thinking, which I think is wrongheaded. People need to understand that, when there is a positive quantity of reserves in the system, the interest rate on reserves (IROR) becomes the relevant policy rate. Rather than, as in normal times, conducting open market operations to target the fed funds rate, what is going on now is that IROR is set by the Fed, and all the other short rates follow. If holding other assets starts looking more attractive to banks, then the price level will rise if IROR stays constant. To prevent the price level from rising, the Fed has to increase IROR to induce the banks to hold the reserves. Term deposits accomplish absolutely nothing. If there is any marginal liquidity value to the reserves in interbank transactions, then the Fed has to pay more for the reserves in the form of term deposits (the term deposit rate has to be higher than the IROR). At best, the reserves have zero marginal liquidity value and the term deposit rate is the same as IROR - but then it does not matter at all whether the outside money is reserves or time deposits. This old piece, that Ennis/Wolman cite, is even more confused.
In reply to Andolfatto: A key point is that the ECB is not "monetizing" the Greek debt. They are intermediating the debt, and what comes out the other end is interest bearing reserves, which under the current circumstances looks just like T-bills (or whatever you call a short-term riskless Euro-denominated security). The EMU may not have understood this, but when they acquired Greece as a member, they were committing to a long term policy where they have to take responsibility for Greece's debt. Right now, the ECB is hoping that it can acquire Greek debt, finance this with interest bearing reserves, and that Greece will ultimately get its act together, in which case the ECB makes a profit on the deal. If Greece ultimately defaults on its debt, then it looks like you are correct - there are inflationary implications, as the ECB somehow has to make up for the losses on its asset portfolio. Otherwise, I think we are agreed that there are no inflationary implications. Now, can the purchase of Greek bonds matter for the market prices of those bonds? That's the debatable part. I think the Fed thinks that its acquisitions of long-maturity Treasuries and MBS changed the term structure of interest rates, even though they were just swapping short maturity interest bearing reserves (i.e. T bills) for long-maturity treasuries. One might think that arbitrage would dictate that this is neutral. Maybe financial markets are somehow segmented, and this segmentation is even more acute for something like Greek debt? In that case, the acquisition of Greek debt by the ECB increases the prices of Greek bonds, and this benefits the Greeks. I'm not sure how this market segmentation might work, but if it does it is at the heart of some recent central bank interventions.
"Now, can the purchase of Greek bonds matter for the market prices of those bonds?"ReplyDelete
Yes, it does matter. Arbitrage is limited, as there are leverage and shorting restrictions.
The prices of Greek bonds also increased because ECB's intervention resolves previous uncertainty about Greece's access to LOLR facility. Increased price of Greek bonds is to some extent inflationary. If ECB funds purchases of Greek bonds by term deposits instead of reserves, this inflationary effect is partially reversed.
"Term deposits accomplish absolutely nothing."
Interest rates on term deposits are higher than IOR, that's why term deposits are contractionary.
Seems to me you've got this reversed. By "contractionary" I take it you mean "reduces the price level." Since you are a money demand person, see if this works for you. The price level is the price at which outside money trades for goods and services. Thus, the price level is determined by the demand for outside money - currency and reserves. By shifting reserves into term deposits, the central bank effectively makes the stock of outside money less liquid and therefore less desirable, so this is in fact "expansionary" in that it increases the price level. The central bank then has to pay a higher interest rate on the outside money to get the private sector to hold it if it wants to prevent the price level from rising. Terms deposits are therefore inefficient.ReplyDelete
"If Greece ultimately defaults on its debt, then it looks like you are correct - there are inflationary implications, as the ECB somehow has to make up for the losses on its asset portfolio. Otherwise, I think we are agreed that there are no inflationary implications."ReplyDelete
Well, according to Rogoff, Greece has been in default roughly one out of every two years since it first gained independence in the nineteenth century, and in 2001 set the record for the world’s largest default (in dollar terms).
You wonder why the EMU took Greece on. On the bright side, in the old default days, Greece did not have the ECB to bail it out. On the not-so-bright side, it didn't have potential bailouts as an encouragement to be undisciplined in the old days either.ReplyDelete
"By shifting reserves into term deposits, the central bank effectively makes the stock of outside money less liquid and therefore less desirable, so this is in fact "expansionary" in that it increases the price level. The central bank then has to pay a higher interest rate on the outside money to get the private sector to hold it if it wants to prevent the price level from rising. Terms deposits are therefore inefficient."ReplyDelete
You are assuming your conclusion here. Central bank has to pay higher interest rates because it wants to shift reserves into term deposits, not because it wants to prevent price level from rising. After the shift into term deposits, term structure of interest rates changes because of financial market frictions. This change in the term structure of interest rates reduces the price level.
It is true that that this intervention has costs in the form of liquidity premia. But there are also benefits for monetary policy. Let's compare a slight increase in IROR to an issuance of term deposits. The second option shifts some of the effect of tightening to later years.
You seem to have misread the Ennis/Wolman piece. They actually say:ReplyDelete
Because monetary theory often describes bank reserves as the “raw material” by which new money and, eventually, inflation is created, it is tempting to worry that the large quantity of reserves inherently represents inflationary pressure. As many writers have explained, this is not the case. The ability to pay interest on reserves means that the Fed can pursue an appropriate (non-inflationary) interest rate policy while maintaining a large quantity of reserves in the banking system.
So, they appear to be well aware of what you thought needed to be explained.
Their point, rather, is the following:
On the other hand, our view is that the large quantity of reserves does represent an increased danger for policymakers of getting behind the curve. That is, while the large quantity of reserves does not prevent the Fed from conducting appropriate policy, it does raise the risk that an inattentive policymaker will be too slow to respond to changing economic circumstances. Furthermore, policymakers may need to look at different indicators than in the past in order to avoid falling behind the curve.
I don't think that the authors' failure is the result of Old Monetarist thinking. For example, Old Monetarists have long understood the role of interest rates on reserves. The money multiplier should be a function of a spectrum of interest rates that influence the demand for currency and bank reserves (and the reserve ratio). This point was recognized by Brunner and Meltzer (1968; 1976). Under this scenario an increase in the interest rate paid on reserves reduces the money multiplier thereby preventing (or reducing) inflationary pressure. Thus, while the language might be different, they would still reach the same conclusion.
I wouldn't conflate their wrong-headed analysis with Old Monetarism, but rather a confusion of what Old Monetarism really says.
Read my last post: