Miles has taken the trouble to write at length in reply to my comments on one of his posts, so I'm encouraged to carry on the discussion.
For some background on liquidity traps, quantitative easing (QE) and what it can and cannot do, you can browse my archive, or read these particular pieces:
1. QE irrelevance.
2. An example.
3. Liquidity traps.
To understand QE, we need to know the difference between a channel system and a floor system. A good example of a channel system is the central banking framework within which the Bank of Canada works. The Bank sets a deposit rate (the interest rate on reserve accounts) and a higher rate at which it lends to financial institutions, and targets an overnight rate that lies between those two rates (i.e. the target rate lies in the "channel"). In a channel system, as long as the overnight rate lies within the channel, open market operations matter - purchases or sales of assets by the central bank will move the overnight rate.
Prior to the financial crisis, the Fed worked within what was essentially a channel system. The interest rate on reserves (IROR) was zero, excess reserves were essentially zero overnight, and the overnight fed funds rate fell between zero and the discount rate (there are some complications involving what the "fed funds rate" is, and how lending at the discount window takes place, but ignore that for now). Pre-financial crisis, if the Fed bought or sold assets (T-bills, long Treasuries, whatever), that would move the fed funds rate.
A floor system is different. Under such a system, the central bank sets an interest rate on reserves and a central bank lending rate, and plans to have a positive supply of reserves in the system overnight. As a result, the overnight rate must be equal to the IROR, by arbitrage. An open market operation in short-term government debt in a floor system will have no effect, at the margin, as the central bank is simply swapping one interest-bearing short-term asset for another. The instrument of monetary policy in a floor system is the IROR, which determines short-term nominal interest rates.
Currently, the Fed operates under a floor system. The supply of excess reserves is enormous, and the IROR determines short-term interest rates. There are some weird features of the system, such as the fact that the GSEs receive no interest on their reserve accounts, and there is some lack of arbitrage which results in a fed funds rate less than the IROR, but I think those weird features are irrelevant to how monetary policy works.
Under a floor system, we are effectively in a perpetual liquidity trap. Conventional open market operations in short-term government debt do not matter, whether the IROR is 5%, 0.25%, 10%, or zero. But, not to worry, the central bank can always change the IROR except, of course, when it hits the zero lower bound (neglecting the possibility of taxation of reserve balances, which is another issue altogether).
My irrelevance argument goes one step further. First, we have to understand why open market operations move the overnight rate in a channel system. An open market purchase of T-bills under a channel system essentially involves the transformation by the central bank of T-bills into currency. Remember that, in a channel system, overnight reserve balances are zero. The increase in outside money has to show up somewhere, so currency outstanding has to increase. Private financial intermediaries cannot convert T-bills into currency, as they are not permitted (either explicitly or implicitly in the US) to issue currency. That's why monetary policy matters in a channel system - central bank intervention works by varying the quantity of liquidity transformation.
But what happens if, for example, the central bank purchases long Treasury bonds under a floor system? The Fed issues reserves, and purchases Treasury bonds, thus transforming T-bonds into overnight reserves. Does that do anything? Why should it? A private financial institution can create a special purpose vehicle (SPV) whose only function is to hold T-bonds as assets, and finance that portfolio by rolling over overnight repos. The SPV performs exactly the same asset transformation as the central bank is performing when it purchases T-bonds. Imagine, for example, that there is an SPV that sells T-bonds to the Fed, and suppose that the overnight repos of the SPV were held by a financial institution with a reserve account. Suppose further that this financial institution increases its reserve account balance by exactly the amount of the reduction in its repo holdings after the Fed purchases the T bonds. Clearly, the financial institution does not care whether the T-bonds that back its overnight assets are held by the Fed or the SPV. Nothing changes.
This is just a more elaborate liquidity trap. Under a floor system, the only instrument the central bank has is the IROR. Asset purchases - of whatever - are irrelevant. Under current circumstances, this means that, as long as the Fed does not change the IROR, the inflation rate is passive. Changes in the price level are determined by the demand and supply of liquid assets - the whole array of that stuff, i.e. currency, reserves, interest-bearing government debt of all maturities, liquid asset-backed securities. The Fed can only change the composition of the total stock of liquid assets under a floor system, and so it can't change the price level without changing the IROR. What will move the price level, as long as the IROR is fixed? First, if the private sector creates more liquid assets that compete with reserves, that will increase the price level, and we will get more inflation. That is what I was worried about a while back. Not right now. If it looks unlikely that the private sector will be creating more liquid assets, and if the demand for US-dollar-denominated liquid assets rises, the price level falls and we get less inflation. That's our problem now. Of course there's nothing the Fed can do about that, as the IROR does not have far to go to reach zero.
Some specific comments in reply to Miles's post:
1. Miles argues that, even if we have some doubts about QE, why not try it? At worst it's irrelevant, so no big deal. The problem is that the Fed wants to believe it works, otherwise it looks silly, given the massive QE operations that it has engaged in. Various economists in the Fed system have been falling all over themselves to justify the actions of their superiors, and smart people like Miles are buying the arguments. The Fed has now convinced itself that QE works. In particular, the Fed thinks it works both ways. Thus, if we ultimately see what we think is too much inflation (a more remote possibility at the moment, obviously), the Fed will think it can control it through asset sales. It certainly can, but the sales only start to bite at the point where excess reserves get very close to zero.
2. Miles isn't sure exactly what friction makes QE work, but he seems confident that the friction is small, and so QE must be carried out on a very large scale in order to do much. In fact, as he says:
Balance sheet monetary policy can powerfully stimulate the economy if the Fed does enough.That seems inconsistent with the rest of the argument. Suddenly we go from statements about how little we know to confident predictions about what we can accomplish if only we do "enough." You have to be more specific about the "enough" to give that content.
Scott Sumner likes to point to the stock market's reaction to QE announcements. The speculators don't seem to think it's irrelevant. You've indicated before you're not so convinced of the EMH and are willing to disagree with markets (on expected inflation, I believe). Do you maintain that stance on the stocks-QE reaction?ReplyDelete
Talk of doing "enough" seems misguided when credibility/expectations are at play. Switzerland was supposedly unable to stop the franc from appreciating despite their massive operations, but then when they announced a target they hardly had to do anything because markets did the work for them.
much clearer. I am glad you understood Kimball's posts cause honestly, i did not. some hand-wavy stuff about Fermats last theorem and fans. I read it three or four times and still didn't get it.ReplyDelete
Naturally, i still do not agree because there are 8 other ways QE is effective, but I agree with you that the IOR policy mostly sterilizes a major channel (which is the intention).
"...8 other ways QE is effective..."Delete
I was being hyperbolic, sort of. During normal times one might argue QE lowers rates (mortgages and treasury rates), or there is a portfolio balance effect (Fed taking duration risk off the private sector balance sheet).Delete
I don't put a lot of weight though on those channels right now, if they exist they are small. Low rates are not the stumbling block for mortgage refinance or project finance. Nor are low rates being passed through to consumers to the extent they were in the passed.
Mainly as i've said before I put weight on the signalling / expectations channel (some you note below): Tolerance for above normal growth or inflation; changes in the date of the return of normal monetary policy; or changes in the probability of a future change in IOR.
If asset prices go up, there is probably a small wealth effect too.
But IMO QE is only effective to the extent the Fed clearly communicates the goal.
dwb, the portfolio balance effect makes no sense. If the Fed takes on private sector risk, this risk is really just being borne by the Treasury who will have to adjust taxes in response to those earnings, hence, households after-tax income is just as dependent on the asset risk as before - nothing as changed.Delete
i said small because this effect makes more sense when the markets are seized up.Delete
That would seem to imply lump-sum taxation. If proportional taxes are levied on income and income differs across individuals, then the policy would have a distributional effect. If the policy has distributional effects, then we know that it has real effects.
Market participants are forward-looking, of course. You can get an effect on market prices from the QE announcement because it changes market participants views, either on the future course of the interest rate on reserves, or the future date at which the Fed reverts to channel-system monetary policy. The fact that market prices move on the announcement doesn't tell you that the actual asset purchase is doing the work.ReplyDelete
You acknowledge that Fed policy works through expectations in this comment, yet you also say this, " Under current circumstances, there are no actions the Fed can take that could necessarily achieve such an outcome. Indeed, it is possible that the Fed could promise to keep the policy rate at 0.25% for five years in the future, and NGDP growth could fall below the target."Delete
That seems contradictory, if there's nothing the Fed can do, expectations shouldn't matter.
Bernanke has said over and over he won't change the inflation target. If instead he said, the fed will target three years of 4%the inflation, 1 year of 3%, and then return to our 2%Chinese trend. We will target this price level path, making up for past mistakes.
Your view is nothing would happen, correct?
On my phone. Not sure how the word chinese got in my post. Should be inflationDelete
Does it matter whether it's the assets purchases or the signal that works?Delete
I don't have much to add beyond saying that I am very very happy to see someone arguing the New Keynesian viewpoint without also being an insipid hack.ReplyDelete
Good for you, Miles Kimball. This exchange has been great so far.
"First, we have to understand why open market operations move the overnight rate in a channel system. An open market purchase of T-bills under a channel system essentially involves the transformation by the central bank of T-bills into currency. Remember that, in a channel system, overnight reserve balances are zero. The increase in outside money has to show up somewhere, so currency outstanding has to increase."ReplyDelete
When you say currency, do you mean reserves, reserves + notes, just notes?
Currency as defined on the central bank's balance sheet. Those notes signed by the Governor of the Bank of Canada, loonies, twoonies, etc.Delete
"Remember that, in a channel system, overnight reserve balances are zero. The increase in outside money has to show up somewhere, so currency outstanding has to increase. Private financial intermediaries cannot convert T-bills into currency, as they are not permitted (either explicitly or implicitly in the US) to issue currency. That's why monetary policy matters in a channel system - central bank intervention works by varying the quantity of liquidity transformation."Delete
This is confusing. You seem to saying that in a channel system, an open market purchase creates reserve balances. Because no reserve balances are allowed to exist at the end of the day in a channel system, the only way to balance the system if for currency (paper money, notes, etc) to be withdrawn, thereby destroying the excess reserves. Is that what you are saying?
The total quantity of outside money (currency plus reserves) cannot change unless the central bank takes actions to change it - private sector economic agents can't "destroy" the stuff. Therefore, if the central bank conducts an open market purchase, and the quantity of reserves held overnight is zero, it must be the case that the quantity of currency held overnight has increased. So, as you say, if the open market purchase initially increased reserve balances, the reserves must have been withdrawn as currency.Delete
Ok. But how does the withdrawal of cash move the overnight rate?Delete
"In a channel system, as long as the overnight rate lies within the channel, open market operations matter - purchases or sales of assets by the central bank will move the overnight rate."
Austrians think QE results in X, Old Monetarists think it produces Y, some New Monetarists think it gives rise to Z and some to A, etc. Doesn’t the effect of QE therefore depend on the distribution of expectations regarding the effect of QE? And can’t the Fed affect this distribution of expectations, bearing in mind that most wealth-holders aren’t making decisions on the basis of a well-worked out monetary theory?ReplyDelete
So purchases of T-bonds should have no effect on long rates then? I would guess the idea behind it is "increased demand for T-bonds raises their price and lowers their yield", so I presume that intermediation would be immediately be undone by the private sector? Except maybe it can lower rates through some weak forward guidance, as discussed above with stock prices. Is that correct?ReplyDelete
If that's the case, why does the Fed bother with QE? Why not use a much stronger form of forward guidance like an unconditional promise for the path of interest rates or a level target?
Good question. I actually thought that some of the Fed's forward guidance amounted to an unconditional promise (low rates out to the end of 2014), but that does not seem to be the case. In the minutes they've told us that the 2014 date is subject to change.Delete
"but that does not seem to be the case. In the minutes they've told us that the 2014 date is subject to change."Delete
Yep, the Feds words and actions have been distinctly different and the reaction to the last Bernanke press conference was awful.
If the chief mechanism of monetary policy is expectations, and the message is muddled and confusing, isn't the transmission mechanism of monetary policy weak or nonexistent??
Have you seen the recent Gali/Smets/Wouters paper on the jobless recovery?ReplyDelete
"...Our findings suggest that the slower recoveries are not due to structural change in the U.S. economy. Instead we uncover a dramatic change in the sign of demand shocks experienced during the recovery itself and, according to some estimates, during the preceding recession as well. If our interpretation is correct, there is no fundamental reason why recoveries should remain slow in the future, especially if there is room for expansionary fiscal and monetary policies that may counteract any adverse demand developments."
From their recent paper titled "Jobless Recoveries: We Got Nothin"
Stephen, I got to say when I first came across your blog I was not a fan. Why? Basically you seemed to me to have this extreme hatred for Krugman-who I like.ReplyDelete
I know it had something to do with you not liking his attacking Macro in 2009 for not predicitng the crisis. Your asnwer as far as I can tell is that Krugman's criticism is wrong and trifling because no model could possibly be expected to predict the crisis-that's not the test of a good model.
In any case reading your dialouge with Kimball I'm seeng maybe there's more to you than to assumed. For me attacking Krugman probably meant you were just another Right wing flack. But I see you're not so easy to charactrize.
However based on what your saying about the passivity of the Fed right now what do you make of Scott Sumner's NGDP targeting I wonder.
If anythhing you sound like Krugman in beleiving there's a liquidity trap-actually you seem to believe this even more strongly than him.
Anyway here's a commment Sumner made in the comments section over at Money Illusion
1. If Williamson believes in liquidity traps, why in the world does he call himself a “monetarist?” Not believing in liquidity traps is pretty much the definition of monetarism.
2. If he thinks QE doesn’t work, how does he explain the huge impact of rumors of QE on the asset markets?
I'm curious what your reaction is to it? How about your overall opinion on his idea of NGDPT which works mainly through expectations.
"If he thinks QE doesn’t work, how does he explain the huge impact of rumors of QE on the asset markets?"Delete
I asked the same question above, here is Steve's response.
"If Williamson believes in liquidity traps, why in the world does he call himself a “monetarist?” Not believing in liquidity traps is pretty much the definition of monetarism."
Post-Keynesians complain that Neo/New Keynesians (who stole their rightful name!) aren't really Keynesians. So maybe "New" means "not". I think Buchanan's "New Institutionalist" economics has hardly reflected the old "Institutionalist" school of Veblen & Galbraith.
Evilsax: Do you see the 'Search' button at the top? Find it, use it, and stop being deluded into thinking you have deep thoughts and observations to share with the world (about Steve's true nature and other sundry topics).ReplyDelete
Anon why don't you go play in traffic? I was asking about his thoughts on NGDPT-nothing to do with any sundry topics.ReplyDelete
Who the heck are you-another tea party dummmy?
You guys are always Anonymous huh?ReplyDelete
nice posting.. thanks for sharing..ReplyDelete
You sure are clever. All you got to add to the conversation is trifling snark huh?ReplyDelete
Different Anon here,ReplyDelete
Steve is a registered democrat, but doesn't like Krugman's playground insults and self-aggrandizement. Don't assume he's a conservative because he wants economists to act like grown ups towards each other.
I think the chap 10 stuff in Bruce C. and Scott F.'s textbook is a pretty elegant way to explain why open market operations are sterilized when the IROR equals the overnight rate. May save you some effort trying to explain this to non-money folks.
Thanks for some civility different Anon. I wasn't trying to insult Steve-I said I used to think he was just a Righty. I have after learned there's more to him.ReplyDelete
I was honestly curious whether he has heard of Sumner's NGDP targeting idea-I of course presume he has-and what he might think of it.
As it sounds like he believes in the liquidity trap.
what do you mean "liquidity trap"?Delete
do you mean "qe is ineffective"? do you mean "monetary policy is ineffective" do you mean "some kinds or channels of monetary policy are ineffective"?
PK likes to say we are in a liq. trap but how is that possible since we know physically printing money or minting coins to payoff the national debt must be inflationary? maybe we are just in a policy trap and unwilling to undertake monetary policy that would work? or maybe QE works we just have not read the instructions?
1. Here's something I wrote on NGDP targeting:Delete
2. "I used to think he was just a Righty..."
My neighbors think of me as just another Lefty.
I think this article is saying something important, but I'm not sure I understand it. Is the key point that there *is a channel* in one system and *no channel* in the other system?ReplyDelete
Further, does the existence of the channel depend on
(1) whether or not there are excess reserves kept at the central bank (CB)
(2) or, whether or not there is interest on such reserves
What exactly happens overnight in the Canada system? Are banks with excess reserves lending the full excess to other banks? I think you're saying that the channel lower bound is controlled by interest on CB reserves (no bank would lend to another bank for less than this amount). The upper bound is controlled by the discount rate (no bank would borrow for more than this rate). Is this accurate?
Now what has happened in the US to remove this channel? Has the upper bound (the discount rate) fallen to match the lower bound (IROR)? If so, then it seems that the overnight lending market will disappear. Further, it seems that QE will not improve the interbank lending market, since the channel bounds have collapsed.
However, what does this have to do with the liquidity trap which [I've always assumed] is related to bank lending to *non-banks* ? Won't it still be profitable to lend to consumers at higher rates?
"Is the key point that there *is a channel* in one system and *no channel* in the other system?"ReplyDelete
It's convenient to think that there is a channel in both. In the floor system, though, the channel is set in such a way that the lower bound (the interest rate on reserves) determines the overnight rate.
"If so, then it seems that the overnight lending market will disappear."
It should have disappeared, except for the quirk in the system whereby GSEs do not get interest on their reserve accounts. I think that essentially all overnight lending is done by GSEs so they can get some interest on their reserve balances.
"Won't it still be profitable to lend to consumers at higher rates?"
You might think so. But apparently banks are thinking this is a bad bet. Also some banks are capital constrained, but I'm not sure how important that is.
"whether or not there are excess reserves kept at the central bank (CB)"
Yes, in the floor system there are excess reserves held overnight.
"whether or not there is interest on such reserves"
No, that doesn't matter. You can have a channel system where the interest rate on reserves is zero, or a floor system where the overnight rate is zero.
"Are banks with excess reserves lending the full excess to other banks?"
Yes, financial institutions could be lending and borrowing among themselves overnight, but typically the quantity of reserves held with the central bank overnight is essentially zero.
> It's convenient to think that there is a channel in both. In the floor system, though, the channel is set in such a way that the lower bound (the interest rate on reserves) determines the overnight rate... It should have disappeared, except for the quirk in the system whereby GSEs do not get interest on their reserve accounts. I think that essentially all overnight lending is done by GSEs so they can get some interest on their reserve balances.Delete
Ah! I see. This reminds me of http://www.econbrowser.com/archives/2008/11/the_new_improve.html [referenced recently on Sumner's blog].
Banks are willing to pay up to 1 percent (the "interest on reserves" rate) for this. Since FDIC insurance costs 0.75 percent, they are willing to pay the GSEs up to 0.25.
> Yes, financial institutions could be lending and borrowing among themselves overnight, but typically the quantity of reserves held with the central bank overnight is essentially zero.
Fantastic! I've never really thought carefully about this until now, but it makes thinking about this a bit easier.
"An open market operation in short-term government debt in a floor system will have no effect, at the margin, as the central bank is simply swapping one interest-bearing short-term asset for another."ReplyDelete
"Under a floor system, we are effectively in a perpetual liquidity trap. Conventional open market operations in short-term government debt do not matter"
So if open market operations are in long-term debt, or even equities, then they matter?
I'm saying that it's obvious that, under a floor system, OMOs in short-term debt are irrelevant. What is less obvious, is that OMOs in long-term debt are also irrelevant, which is the general point here.Delete
"Remember that, in a channel system, overnight reserve balances are zero."ReplyDelete
1) But, in the US system, long before the liquidity trap we've had required reserves. Excess reserves were zero, but not required reserves. As I've learned this, and as I've seen this taught many places, when the Fed creates new money and buys securities, that money reverberates through the system, getting deposited in banks, then the banks put the required percentage in reserves, and loan out the rest, and then that ends up in banks which puts the required percentage in reserves and loans out the rest, and so on, until the whole thing ends up in reserves in the end (all as required reserves).
2) Even if there were no required reserves, why would people hold so much of their money in paper with dead presidents (unless you're a drug dealer)? My wealth is vastly greater than when I was young, but I hold no more currency (in real terms). There's no reason to ever hold more than the small convenience amount. Why hold additional money in paper that's bulky and can get stolen, when I can have it held electronically as reserves? Why incur the extra storage costs and risks when you get extra money? Why not keep the extra at the Fed electronically instead? Why would not one party put even one cent there, instead of the entire increased amount going to more currency?
1. That's just the usual money multiplier story. Pretty much irrelevant even before the financial crisis. There may still be reserve requirements in the US, but they don't matter (didn't matter) much.Delete
"why would people hold so much of their money in paper"
Why indeed? But they do. About 6% of US annual GDP. That's a lot of currency. Even if about half of this is held abroad, it's still a lot of currency per US resident held within US borders. Everyone is not like you apparently.
Thinking about currency further, I could see the 6%. I've known a lot of poorer and less educated people. They tend to hold their wealth in currency a lot more. A lot of them are unsure about banks, or they had a checking account that was closed due to overdrafts. And a lot of them owe money and they know bank accounts can be seized, or that's actually happened to them. So, they hold their money in currency. As proof, look at all the check cashing places. A lot of people are paying an arm and a leg so they can have currency instead of electronic bank debits. Sad, but true. Then, you also have the illegal economy running on currency, which influences the legal one.Delete
And poorer people have a very high marginal propensity to consume. Increase currency and they start spending a lot more, the velocity of money churns.
Your argument seems to rely on the fact that if the Fed. buys long term bonds with reserves, that's something that the private economy could have done if it wanted to, so there must be no effect.Delete
You use the MM analogy where a corporation can't improve the well being of shareholders by taking on debt, because if that was good, shareholders would have done it already themselves for their personal portfolios, and it would be equivalent for them. And the shareholders would just un-do what the corporation did in their personal portfolios.
I could go through all of the assumption violations that are long accepted in economics and finance to make MM far from true, but there's also the fact that it's all about what's best for individual shareholders, not the economy as a whole.
If the government taxes everyone in the sunbelt and buys them solar panels, you could say this will have no effect, because people could have done this themselves (and no new currency was created). But, this is obviously untrue, right. The economy could have done it on its own, but it didn't, and wouldn't. Because individual actors don't fully consider externalities, they can't risk pool like the government (no one can), they can be liquidity constrained, there's asymmetric information,...
When an individual or a firm is deciding whether they will buy long-term securities, they don't think about whether it will help the unemployed. This is not a factor, or fully considered, even though it's obviously important for the economy and society as a whole. So individuals will under-do this even if it is better for the economy as a whole.
It's not not done by the private sector because it can't help, so the government shouldn't even try. It's not done because personal interest doesn't fully coincide with economy-wide interest; the invisible hand does not fully hold.
That the private sector could have done it does not necessesarily mean that the government doing it won't help, or can't have any effect, Q.E.D. You need more than that.
What about individual risk aversion?Delete
I'll give a quick specific: The government buys trillions in 30 year bonds.
The current rate is 2.73%.
The government starts buying big. This will pressure that rate down, but you say the government can have no effect. So, ceterus paribus, when the rate starts to drop, to 2.72%, parties in the private sector must want to jump in and buy! 2.72% is a bargain.
What about heterogeneity of investors? When bonds are 2.73%, then everyone in the market who had a forecast, and level of risk aversion, such that 2.72% was a good deal would have already bought. So there is no one else additional left to jump in when the price drops to 2.72%.
But, you may say, when the government buys that changes peoples' forecasts. It makes people think short term rates in the future will be higher, so this urges them to buy when the government pushes the rate down – a perfect information and foresight story, like in Wallace.
But what about risk? People rightly don't know their information and foresight is perfect over 30 years, and may be risk averse to go against the government's buying? And if long term rates do drop this can increase the velocity of money, more houses sold with lower payment, projects turn to positive NPV.
I'm trying to understand how this is consistent with the idea that the Fed must be able to raise the price level eventually otherwise it could go and buy up every good in the economy without affecting prices, which is absurd.ReplyDelete
I thought maybe it's because the private sector can create financial assets "out of thin air" to quickly offset any intermediation the Fed does, whereas it can't quickly create more, say gold; so the Fed purchasing gold would raise gold prices.
But then the transmission mechanism for monetary policy you seem to discuss is the idea that the Fed eases by making base money less scarce relative to other safe assets, so purchasing any amount of goods and services won't decrease the scarcity of base money and shouldn't be able to raise prices.
Any help would be appreciated.
"...it could go and buy up every good in the economy without affecting prices..."ReplyDelete
Monetary policy is not about printing money and buying goods. Monetary policy is about asset swaps. Even in a liquidity trap, if the government issues debt so it can purchase some goods, and the central bank then swaps outside money for the new government debt, that will indeed raise the price level. The consolidated government has indeed printed money to buy goods, but that is fiscal policy. That's not what we are talking about here. QE involves the Fed issuing reserves to purchase long-term Treasury securities or other assets.
"...whereas it can't quickly create more, say gold; so the Fed purchasing gold would raise gold prices."
No, in a liquidity trap, if the Fed purchases gold, it does not change the price of gold, just as it will not change the prices of Treasury bonds if it purchases them.
On the first point, isn't the essentially what is happening? We're running deficits and the Fed is buying some of the bonds that finance that. Or did you mean that the Fed portion doesn't matter at all, just the spending?Delete
On the second point, I know you've been trying to explain it, but I really don't understand how that can be. If the Fed is buying gold in large quantities, what's the offsetting action that keeps the price of gold the same?
Brad DeLong has an interesting and semi-plausible explanation for Wallace neutrality, see:ReplyDelete
But, look in the comments; he agrees with me that investor heterogeneity can make QE have an effect, "Yes, investor heterogeneity breaks it."
What do you think?
Thanks for this post, it was well written. Question about the aribtrage. An SPV holding even T-bonds will have some haircut, i.e. the repos will be less than 100% of the assets. So the Fed's action can be thought of as unwinding the repo, but it also seems to change the nature of the equity sliver of T-bonds by essentially undwinding the leverage. This still changes the overall portfolio of the private sector by reducing its risk, particular its term premium risk.ReplyDelete
Or are you arguing that playing with the term structure won't matter because it simply transfers the term premium to the government? But isn't that the point? That is, if the government increases the risk of safe nominal assets it might be just as effective as increasing the supply of safe assets in raising the price level.