Apparently Mark Thoma didn't like my last piece on QE2. I've had a fairly peaceful time here for a while. Thankfully my fellow bloggers have not been paying much attention to me, and my readers are typically thoughtful and helpful in the comment box.
Now, as my mother (rest her soul) would have said, "Mark, did you get out of the wrong side of the bed this morning?" Hopefully my mother is not reading Thoma's blog, wherever she is, or she would think I had turned into a nasty piece of work.
Thoma was right about a couple of things, though. First, I did not lay out all the details of my arguments. Most of those are in previous posts, and obviously I can't assume everyone is reading all these things. Second, there is an inconsistency in there.
First, the details. What causes inflation? I'm with Milton Friedman on this one. Inflation is everywhere and always a monetary phenomenon. I'm not with Milton Friedman in the sense that I don't think the demand for an asset is anything like the demand for potatoes. Trying to find stable demand functions for monetary quantities is a waste of time. Think of the price level as being the terms on which the private sector is willing to hold the stock of outside money - currency and reserves. The Fed determines the total stock of outside money, and the private sector determines how that total gets split up between currency and reserves. What makes the price level go up? That would be anything that increases the supply of outside money relative to the demand.
Now, what is QE2 about? Under the current circumstances, with a large stock of excess reserves held in the financial system, it seems clear that a conventional exchange of reserves for T-bills cannot matter at all in the present. The Fed swaps one interest-bearing short-term asset for another, and nothing much should happen, short of some minor effects due to the somewhat different roles played by T-bills and reserves in the financial system. On the other hand, swapping reserves for long-maturity Treasuries, as in the QE2 plan, is a different story. We're now swapping a short-term interest-bearing asset for a long-term one. But what will the effects be? Unfortunately there is no good theory to tell us. To the extent that this matters in the present, for example by moving asset prices in the way that Bernanke seems to expect, this depends on some kind of financial market segmentation. Private financial intermediaries cannot be capable of undoing what the Fed is about to do.
Now, what I discussed in the previous paragraph is just about the current effects of the QE2 open market operations. What about the medium-term effects? There are two important points to note here about QE2. The first is that, while interest-bearing reserves, when they are held by banks, look essentially like T-bills, they have one feature that is very different from T-bills. This is that they can be converted one-for-one into currency. For a bank, a reserve account is a transactions account, and currency can be withdrawn from that account in the same way that you withdraw cash from the ATM. Thus, in contrast to T-bills, interest-bearing reserves can be converted into an asset that can be used in retail transactions.
Therefore, the more reserves that the Fed floods the financial system with, the more potential there is for inflation. As the economy recovers, other assets will become more attractive to banks relative to reserves, the demand for outside money will fall, and the price level must rise. Further, there could simply be a net increase in the supply of outside money relative to the demand at the outset of the QE2 operation. What I have in mind here is that, in spite of the fact that a QE2 open market operation simply swaps one consolidated-government liability for another, there may be some friction that implies that, on net, banks will not want to hold the extra reserves at market prices. Surely this is part of what the Fed has in mind. They think that long bond yields will fall. However, part of the adjustment should be an increase in the price level as well.
Now, if the inflation rate starts to rise, what happens then? There are three forces here that are going to make inflation control difficult. First, QE2 will have lengthened the maturity of the Fed's asset portfolio, so that the Fed has a lot more to lose from an increase in short-term interest rates. To tighten, the Fed will have to increase the interest rate on reserves (thus increasing all short rates), which results in a capital loss on its portfolio that will be larger the longer the average maturity of the Fed's assets. If the Fed continues to hold those assets, its income will fall, and if it sells the assets it will be selling them at a loss. If the Fed does not tighten, then inflation rises. None of these outcomes is very appealing. The second force at play is that Bernanke in particular thinks that monetary policy matters for real activity in a big way, and he will be very reluctant to tighten as he will think that he risks another recession. Third, and I may be wrong about this, but I think Bernanke is probably a wuss. He does not want to bear the short term pain associated with people screaming at him if tightening occurs.
Finally, on the inconsistency, I said here, by implication, that I did not think that QE2 would have much in the way of real effects. But I also said that it is costly to bring inflation down. Seems a little goofy, right? Some people think they understand nonneutralities of money well, but I don't feel like I do. Keynesians (new and old) have not convinced me that sticky wages and prices imply that a monetary expansion gives aggregate output a big kick in a positive direction. Some people, including me, made a case that market segmentation could imply a substantial redistributive effect of monetary policy, but this seemed to matter more for asset prices and allocation than for aggregate activity. New Monetarist ideas may give us short-run nonneutralities of money associated with asset trading and liquidity, and with credit market activity, but we haven't worked all of that out. Given what we know, my forecast is that the net real effects of QE2 will be insignificant. Now, what if inflation takes off, Bernanke is not a wuss, and substantial monetary tightening occurs? Do we have to suffer a lot to bring inflation down, or not? The "Volcker recession" was severe, but in the early 1980s inflation came down over a relatively short period from about 15% to 5%. There were plenty of people at the time who thought that the consequences of tightening would be much more severe. Possibly with the benefit of our 1970s and 1980s experience we can manage this inflation better. Who knows?
"Keynesians (new and old) have not convinced me that sticky wages and prices imply that a monetary expansion gives aggregate output a big kick in a positive direction."ReplyDelete
Apparently Milton Friedman didn't convince you either? Wasn't that one of his 11 tenets of monetarism from his 1970 lecture that Ben Bernanke cited in a speech a few years back?
Tenet 1: "There is a consistent though not precise relationship between the rate
of growth of money and the rate of growth of nominal income."
Tenet 4: "The change in the rate of nominal income growth shows up first in output and hardly at all in prices."
With respect, I think you’re a lot closer in your understanding of how the monetary system works than your monetarist brethren, and you seem to write more clearly about it. (Does anybody really understand it?). However, I would disagree on a few important operational points:ReplyDelete
“The Fed determines the total stock of outside money, and the private sector determines how that total gets split up between currency and reserves.”
You all say that, and it’s wrong. That’s not the way the system works.
The way it works is that the private sector determines the amount of currency it wants to hold. The Fed determines the amount of reserves it wants outstanding. Neither has anything direct operational connection with the other. Because of this, it makes absolutely no sense to assert that either the Fed or the private sector determines the total or the allocation of the total.
The Fed always provides aggregate reserves sufficient for banks to redeem when they “purchase” currency, in order to maintain its control over the residual amount of reserves it wants outstanding at a point in time. The fact that the Fed provides the reserves required for currency redemption doesn’t mean it determines the amount of reserves and currency outstanding in total, because it doesn’t determine currency demand or currency outstanding. It only responds to the demand for currency as it materializes.
I suppose one could assert that the Fed determines the total, conditioned on assuming the demand for currency as a given. But that’s a very weak statement, because the Fed does not determine the demand for currency.
“While interest-bearing reserves, when they are held by banks, look essentially like T-bills, they have one feature that is very different from T-bills. This is that they can be converted one-for-one into currency. For a bank, a reserve account is a transactions account, and currency can be withdrawn from that account in the same way that you withdraw cash from the ATM. Thus, in contrast to T-bills, interest-bearing reserves can be converted into an asset that can be used in retail transactions.”
None of that matters. As I noted, in fact the Fed always supplies reserves sufficient to meet the reserve redemption requirement association with currency “purchases” by the banks. This in no way depends on the system reserve setting at any point in time. Specifically, it does not depend and is not affected by the current system excess reserve setting. Bank customers are not going to start asking for more currency merely because the Fed has pumped the banks with excess reserves. Conversely, the Fed will not refuse any demand for currency, and will not withhold the supply of currency based on its reserve setting apart from that. What it might do is hike interest rates if it decides currency demand a warranting factor. But this has nothing to do with the reserve setting it wishes to maintain net of currency flows.
“Therefore, the more reserves that the Fed floods the financial system with, the more potential there is for inflation.”
If that’s the case (and arguably it isn’t) it has nothing to do with excess reserves posing a unique source of currency supply. The reserve setting isn’t unique in that sense. Currency supply does not depend on the reserve setting, chronic excess or not.
“QE2 will have lengthened the maturity of the Fed's asset portfolio, so that the Fed has a lot more to lose from an increase in short-term interest rates.”
Entirely separate subject, but it is extremely unlikely this will be a problem. The Fed’s balance sheet will have enough heft in terms of zero cost currency and the running accrual spread between its treasury yields and the overnight rate, that the effect of any interest margin pinch is likely to be very slow and gradual. Moreover, the Fed will steadily be maturing its treasuries off the balance sheet and sucking up reserves as it does so. Finally, the Fed runs an accrual accounting book on its treasuries, consisting with maturing rather than selling most of them, thereby minimizing capital losses from actual sales. In addition, the Fed gets the benefit of “rolling down the curve” on its treasury holdings over time. Original 5 years become 2 years for example, providing some additional loss protection in rising rate environments. And the fact that the Fed has announced not unduly long maturities with QE2 will be beneficial in the sense of these various factors.
The advantageous effect of all of these forces in combination over time is fairly powerful. Somebody should run some actual dynamic simulations. The results would be surprising. BTW, I’m sure the Fed does this, and has chosen its QE2 maturities with that in mind.
"First, QE2 will have lengthened the maturity of the Fed's asset portfolio, so that the Fed has a lot more to lose from an increase in short-term interest rates."ReplyDelete
Oh, my! The Fed will have to make a bigger entry in their computer! This is just a silly concern - the Fed can never run short of money.
Yes, there are some things about Friedman I like, and some I don't. For the two tenets you mention, it's hard to interpret those things. Are they empirical observations, statements about responses to exogenous policy shocks, or what?
"The Fed always provides aggregate reserves sufficient for banks to redeem when they “purchase” currency, in order to maintain its control over the residual amount of reserves it wants outstanding at a point in time. The fact that the Fed provides the reserves required for currency redemption doesn’t mean it determines the amount of reserves and currency outstanding in total, because it doesn’t determine currency demand or currency outstanding. It only responds to the demand for currency as it materializes."
Yes, exactly. That's what the Fed does in normal times, when the stock of overnight excess reserves is essentially zero. Each day they are trying to accommodate things like fluctuations in currency demand so as to hit the fed funds rate target. Now, with interest on reserves and a positive quantity of excess reserves in the system, it works like I described.
"Bank customers are not going to start asking for more currency merely because the Fed has pumped the banks with excess reserves."
Yes, but if the interest rate on reserves stays fixed, and the demand for reserves falls, something has to give. What gives is the price level, which rises to induce people to take more currency (in nominal terms).
On the second part: Again, part of what you are describing is normal practice, which is that Treasury bonds were typically held to maturity and rolled over. What happens in the future when the Treasury is holding few T-bills and thinks it is advantageous to sell assets. Obviously those have to be T-bonds. As you say, there are some mitigating factors involved in the maturity mismatch, e.g. average maturity falls over time when you stop acquiring the assets. Also, as you say, the Fed has to have worked some of this out, which probably explains why they are hedging their bets by not going out 20 or 30 years. I'll ask around and see if there is anything publicly available.
No, it's not silly. In terms of the consolidated government (Fed and Treasury), the average maturity of the debt outstanding is going to be shortened. If and when short rates go up, this makes the total interest payments on the outstanding consolidated government debt much more sensitive to an upward movement in short rates. As you are implying, you can print money to finance the interest payments, but that would create more inflation.
“Now, with interest on reserves and a positive quantity of excess reserves in the system, it works like I described.”ReplyDelete
Right, but my response was based on your description early on in the post, before you got to the specific case of QE - or at least I thought so. It appeared to be a generic description, following directly from a pretty big picture explanation of inflation and the price level. And then you started the next paragraph with “Now, what is QE2 about?” If you meant the point in question to be dependent on QE, it didn’t come across that way in the paragraph structure, at least not to me. It’s a qualification and a distinction well worth noting around QE, I think. The generic rendering is also my best recollection of how a number of other people position it as well – which again is why I made the point. It’s only in the case of QE that the causality I described gets transformed and conforms to your point. It’s an exception, unless QE becomes the norm.
Why do you think that *outside* money determines the price level? It seems to me that the price level is determined by the demand for goods, which will be higher when people have more money to spend. The money people use to buy goods is mostly inside money, e.g. from checking accounts.
Empirically, broader measures of money such as M1 or M2 are more correlated with inflation, so why the obsession with the monetary base?
Bernanke was making the point that although there has been a big increase in outside money, this is mostly reserves, which are not directly used to buy things and hence aren't important for inflation.
Why should the Fed care about experiencing "losses"? Even in the event that these exceed the Fed's capital, would the Treasury necessarily have to "replenish" it? Why does the Fed even need capital to carry out its basic function of buying/selling assets?ReplyDelete
I imagine politically, the Fed might suffer if losses reduced or eliminated the transfer of its profits to Treasury. Perhaps the prospect of Ron Paul hearings on interest rate losses caused the Fed to all but abandon 30yr buying in its QE2 plan.
Sorry, I didn't make that clear. I have been focused on how things work currently. The key thing is the difference between how central banking works with and without a positive quantity of excess reserves held overnight.
Yes, the inside money has to matter, in the sense that the demand for currency is in part determined by how good the substitutes are. Debit card technologies lower the demand for currency, for example. However, if you look at the behavior of M1 or M2, growth rates in those aggregates are not highly correlated with the inflation rate, particularly since 1980. That's why central banks abandoned money targeting, after trying it out for a few years. There is not much point in trying to identify some set of assets that we are going to think of as media of exchange, call that a monetary aggregate, and attach some importance to its behavior. There is a whole spectrum in terms of the liquidity or usefulness in exchange of assets. T-bills are used in some times of financial trades. Should they be defined as money. I prefer to avoid all that, and focus solely on the liabilities of the central bank - currency and reserves. Then I can think about factors that affect the demand and supply of those liabilities and how that determines the price level.
Reserves are actually used to buy things. In fact, they are used intensively during the day to make interbank transactions. Of course, currently the quantity of reserves in the system is so large that one unit of extra reserves has zero value in transactions. However, as I discussed, reserves can be converted in to currency, which is used in retail transactions. If the reserves are unloaded by the banks, they have to become currency, and that will increase the price level.
"if you look at the behavior of M1 or M2, growth rates in those aggregates are not highly correlated with the inflation rate, particularly since 1980. That's why central banks abandoned money targeting"ReplyDelete
I'm pretty sure that historically there is a strong correlation between m2 growth and inflation. It has broken down recently but thats due to the change in regime: if the cb is commited to low inflation there can be temporary deviations in the money stock.
" I prefer to avoid all that, and focus solely on the liabilities of the central bank - currency and reserves."
What makes you think the relationship between these and inflation is stronger than broader aggregates? The evidence on Thoma's blog for Japan suggests otherwise.
"If the reserves are unloaded by the banks, they have to become currency, and that will increase the price level.
Only if the currency is used to buy stuff. What if its kept under the bed?
1. The Fed has been committed to low inflation since the early 80s. That's the period when the link between money growth and inflation (at high frequencies) is lowest.ReplyDelete
2. "What makes you think the relationship between these and inflation is stronger than broader aggregates?" Nothing. Currency demand seems more stable, but there is no reason to think that it will continue to be so. I would not council the Fed to target the rate of growth in currency or the monetary base as a means of controlling inflation. However, looking at the growth in these things can give us some information about where inflation might be headed.
"What if its kept under the bed?"
In some parts of the world, people do hoard cash, and some of the outstanding stock of US currency may be held this way. In Japan, currency is much more widely used in transactions. If my memory is correct, the currency stock in Japan is about 15% of annual GDP, while it is about 6% in the US and 3% in Canada, with a lot of US currency held overseas, though we don't know how much. Two useful points here: (i) Japan is very different from the US in terms of how retail transactions are executed. Interpreting Japanese money data in terms of the US is misleading. (ii) I doubt that any more US currency is being hoarded under US beds than before the financial crisis. There is plenty of "cash" hoarding going on, but not that kind.
"Japan is very different from the US in terms of how retail transactions are executed."ReplyDelete
Really? How so?
"I doubt that any more US currency is being hoarded under US beds than before the financial crisis."
You may be right, I don't have any evidence one way or another. But it's at least a possibility, and I think that was part of the story in Japan.
In any case, it's no more accurate to say that an increase in currency must lead to inflation than to say an increase in reserves or M2 must lead to inflation.
Plus, I think it's misleading to say that as the reserves are "unloaded" by banks they have to become currency. That depends on whether the public wants to hold currency, doesn't it? The other possibility would be that the reserves are lent out and become demand deposits, time-deposits etc.
"Really? How so?"ReplyDelete
They use a lot more currency.
"In any case, it's no more accurate to say that an increase in currency must lead to inflation than to say an increase in reserves or M2 must lead to inflation."
Though we cannot know exactly where the currency is and what it is doing, there are sound economic reasons for thinking that it is not being hoarded in the US. The cost of theft is simply too high to make it sensible to store large quantities of cash in the mattress. Thus, currency outstanding is being spent, it's not in the mattress. In contrast, we know exactly where the reserves are, and currently we know that most of the stock of reserves is just sitting - they look like T-bills.
The other possibility would be that the reserves are lent out and become demand deposits, time-deposits etc.
Wrong. Outside money is outside money. It can't turned into a demand deposit or time deposit any more than I can turn into a carrot. This is a misleading idea you got from thinking about money multipliers.
"They use a lot more currency."ReplyDelete
Well I guessed that much, but if anything that should mean a stronger link between between currency and inflation, whereas you seem to be implying the link is stronger in the U.S.
"Wrong. Outside money is outside money. It can't turned into a demand deposit or time deposit any more than I can turn into a carrot."
No, it's not wrong but there is something I left implicit because I thought it was obvious: the total amount of outside money is the same. So, if reserves are lent out and deposited in another bank part of them become reserves for that bank, and so on. But it's simply not accurate claim that either the banks sit on the reserves with no consequences for inflation, or they get turned into currency. It's entirely possible for the total amount of reserves to stay the same, yet for the reserves to be used to support more lending and hence the money in checking accounts, etc. Currency is irrelevant.
In your previous post you floated a scenario where inflation could reach 6% but unemployment would stay at 10%. I'm having trouble imagining how this could happen, and I was hoping for an explanation in your post above. I didn't see it.ReplyDelete
My understanding is that growth/recovery is a necessary precondition for inflation insofar as it provides the incentive for banks to put their reserves into circulation. Is this incorrect?
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