The Fed's balance sheet has changed in important ways - both in size and composition - from what existed before the financial crisis. As well, other elements have been added to the policy mix. Most importantly, the Fed now pays interest on reserve balances. Taken together these changes work to make monetary policy work differently, in some respects. In other respects, policy actually works in roughly the same way, though one might think it would work differently. Changes in the balance sheet, and the payment of interest on reserves, will in the future matter for how policy decisions are made, and potentially for Fed independence. So it is important for us to figure out what is going on.
In January 2007, the Fed balance sheet looked like this (reporting only the essentials):
Total Balance Sheet, Jan. 2007: $859 billion
Currency: $820 billion
Reserves: $12 billion
T bills: $277 billion
T bonds: $502 billion
In the most recent (March 7, 2013) release it looked like this:
Total Balance Sheet, March 2013: $3,084 billion
Currency: $1,173 billion
Reserves: $1,748 billion
T Bills: $0
T Bonds: $1,756 billion
Mortgage-Backed Securities: $1,015 billion
Agency Debt: $74 billion
You can see clearly the nature of the changes in what our central bank is doing. The Fed is a financial intermediary - though it has some key properties that distinguish it from commercial banks, for example. Whatever intermediation the Fed is doing, there is much more of it now than in early 2007, as the size of the balance sheet has increased by a factor that is now getting close to 4. Indeed, if the Fed's current asset purchase program - which proceeds at the pace of $85 billion per month in purchases of long maturity Treasury debt and mortgage-backed securities (MBS) - continues until the end of the year, as expected, then the peak increase in the size of the balance sheet should be a factor of about 4.8 (nominal) using January 2007 as a base period.
As well, the composition of the balance sheet has changed - on the liabilities side, and on the asset side. In January 2007, the liabilities of the Fed consisted primarily of currency. Essentially, the Fed was providing a medium of exchange to people in the rest of the world (about 50% of the stock of U.S. currency is thought to be held abroad), drug dealers and other evasive types, and U.S. residents who still like to use currency in transactions. With the proceeds of currency issue, the Fed was financing a portfolio much more heavily-weighted (than is the case now) to short maturity government debt. In January 2007, the Fed held a substantial quantity of short-term T-bills, and the Treasury bonds it held were more concentrated than now in shorter maturities (average duration is not in the numbers above, but it has significantly increased).
In January 2007, a relatively small quantity ($12 billion) was held overnight in reserve accounts at the Fed. Reserves are used as a medium of exchange among financial institutions during the financial trading day. In January 2007, the average dollar quantity of transactions over Fedwire, the Fed's daylight payment system, was about $2.4 trillion per day, whereas annual nominal GDP in 2007 was about $14 trillion. If the average daylight quantity of reserves was $12 billion (not quite right, as $12 billion is overnight reserves, but it's in the right ballpark) in January 2007, then the transactions velocity of reserves at that time was 199. Compare that to an estimate of 1.5 for March 2013. This is the sense in which we are now awash in reserves. In January 2007, overnight reserves served no purpose but to fulfill reserve requirements, which banks were doing their best to avoid (through sweep accounts for example). With fed funds trading at 5.25% in January 2007, the opportunity cost of $12 billion in reserves held at 0% was substantial.
In January 2007, policy was implemented through the System Open Market Account (SOMA) as follows. The New York Fed would each day make a forecast of what the demand for reserves would be on that day, given the fed funds rate target it was attempting to hit, as per instructions from the FOMC. Then, the Fed would conduct open market operations - primarily using short-term government debt (even more specifically, primarily intervening in the overnight repo market). Thus, the idea was that moving the fed funds rate up, for example, required an open market sale of short-term government debt, adjusting for temporary and permanent shifts in the demand for reserves. A lot went into this intervention mechanism, including the cooperation of the Treasury in managing its reserve accounts with the Fed.
A key feature of the monetary regime that existed in January 2007 is that the size of the balance sheet mattered. Any asset purchase by the Fed would essentially be reflected ultimately in an increase in the stock of currency in circulation. The quantity theory of money was at work, with increases in the quantity of currency reflected ultimately in proportional increases in prices (everything else held constant). Of course there are short-run non-neutralities of money to worry about, and predictable and unpredictable shifts in the demand for currency. The latter factor explains why the Fed was in the business of targeting the fed funds rate and not some monetary quantity in order to control inflation.
It's also important to emphasize why monetary policy mattered - fundamentally - in January 2007. As mentioned above, the Fed is a financial intermediary, indeed a large one relative to other financial intermediaries that are active in US financial markets. Suppose, however, that the Fed had the same technology, and operated under the same regulatory constraints as private financial intermediaries. For example, suppose that the Fed were operating in early 19th century Scotland, or in Canada before 1935. Under those monetary regimes, private banks were permitted to issue circulating paper currency. If a central bank were to set itself up in such a monetary regime, and it were to issue currency as liabilities in order to buy government debt, that should have no important effects. Why? Because the central bank would have no special advantage in that type of financial intermediation over private sector intermediaries. Any actions by the central bank would be undone by profit-maximizing private banks.
Why did monetary policy matter in January 2007? Because the Fed has a monopoly over the issue of circulating currency. If the Fed essentially issued currency to buy government debt in January 2007, that would have been an activity that private financial intermediaries could not engage in. Explicitly or implicitly (there's some subtlety I won't get into here), private financial intermediaries cannot issue liabilities that look like Federal Reserve notes, or the stuff produced by the U.S. Mint.
Long-maturity government debt, while comprising a large fraction of the Fed's asset portfolio, did not play an important role in Fed policy in January 2007. The Fed would typically buy new bonds as old ones matured, and did not do much to manipulate the average duration of the SOMA bond portfolio (here I'm doing some guessing, as I have not seen the numbers).
Fast forward to March 2013. As mentioned above, the balance sheet is much larger than it was earlier, there are no T-bills on the balance sheet, currency has grown but reserves have grown enormously, T-bonds of longer duration play an important role in the portfolio, and the Fed is holding a large stock of MBS which are backed by private mortgages. The Fed not only looks like a bank - it's also an important mortgage lender. As well, since October 2008, the Fed has been paying interest on reserves at 0.25%.
What's important about the changes we have seen since before the financial crisis? I'll organize this as a series of questions, and the answers to those questions.
How does monetary policy work now? There's a sense now in which, at the margin, the size of the balance sheet does not matter. If the interest rate on reserves (IROR) stays fixed, then if the Fed purchases T-bills with reserves, that increases the size of the balance sheet, but should be irrelevant. That's a liquidity trap, which exists if there is a positive stock of excess reserves, whether the IROR is 0.25%, 5%, 10% - whatever. Why is there a liquidity trap? We're currently operating under a floor system, in which the IROR essentially determines the overnight interest rate - with some arbitrage frictions for institutional reasons - but in any case the IROR is currently determining short-term nominal interest rates. What's determining prices then? First, under this regime, short-term government debt is roughly identical to reserves held overnight, so think of those two assets as perfect substitutes. Further, reserves are convertible one-for-one into currency (by banks holding reserve accounts). Thus, in spite of the fact that reserves and short government debt bear interest (more as the IROR rises), all of those assets are essentially perfect substitutes given the IROR. Thus, think of the price level as being determined by the demand and supply for currency+reserves+short-term government debt. With a fixed IROR, an open market purchase of T-bills does not change the supply of the relevant asset quantity, and so nothing happens. However, increasing the IROR increases the demand for the relevant asset and reduces the price level. That's how we get inflation control in the current context. But notice something else important. If the Treasury increases the quantity of T-bills in circulation, that increases the price level. Under a floor system, fiscal policy actions have consequences for inflation, though of course that can be offset if the Fed moves the IROR in response - more T-bills, higher IROR.
But what if the Fed buys T-bonds with reserves, as it is currently doing on a regular basis? Clearly the T-bonds don't look like T-bills, which look like reserves. T-bonds yield a flow of future coupon payments, and a face value at maturity, which could be up to 30 years from now. But it's straighforward for a private financial intermediary to turn the T-bond into something that looks like T-bills and reserves. A special purpose vehicle (SPV), for example, could be set up by a private financial intermediary which purchases T-bonds, and finances its portfolio with overnight repos, that it rolls over. Those overnight repos look a lot like reserve accounts.
So, recall my argument from above about why monetary policy mattered in January 2007. It mattered because the Fed could do something the private sector was incapable of, or prevented from doing. Is the private sector capable of turning T-bonds into overnight assets in basically the same way the Fed does it? You bet. Future research might reveal an explanation, but none of the excuses to date for quantitative easing (QE) - e.g. "preferred habitat," "portfolio balance," "you just see it in the data" - hold water. If QE doesn't matter, then that's even more striking than the liquidity trap phenomenon I discussed above. What determines the price level in a floor system is the demand and supply of all assets that can be intermediated and transformed into assets that are used in exchange. Thus, asset swaps of reserves for government debt (of any kind) are irrelevant in a floor system, and the IROR is the only monetary policy instrument we should be concerned about.
The Fed's current predicament is that it has determined that the inflation rate is too low, but if the only policy instrument available is the IROR, there is nowhere to go if the Fed won't reduce the IROR below 0.25%. Even if it reduced the IROR to zero, that would have little effect. Mike Woodford is correct in recognizing that "forward guidance" is the only game in town right now for monetary policy, if the Fed wants more accommodation. However, Woodford's ideas are different from mine concerning how monetary policy works, and where the key current economic inefficiency lies. Our key problem is that there is a high demand for the whole spectrum of U.S. consolidated government debt - currency, reserves, short-term debt, long-term debt - relative to supply. The demand is high because the supplies of other safe assets in the world - asset-backed securities, the sovereign debt of other countries - have been destroyed, and are coming back very slowly. What is needed is a large increase in the stock of U.S. government debt outstanding. But that increase should be temporary, much like the temporary liquidity injections by central banks that solve short-term financial market problems. So what we would like is a deft injection of government debt, which can be withdrawn when the time is appropriate. Of course, this is just wishful thinking, as the U.S. Congress could not be characterized as deft.
Does the size of the Fed's balance sheet matter now? If we confine attention to pure economics, the answer is no. To start, one concern that seems to be floating about is that having the Fed pay interest on a large stock of reserves presents a problem, in part because the Fed is giving something away to private financial institutions - somehow subsidizing them. However, part (if not the only) motivation for paying interest on reserves is efficiency. Though the banking sector is highly distorted for various reasons, presumably paying interest on reserves increases economic welfare by removing a distortion. Are interest payments on reserves a subsidy? No more than the interest payments on the government debt represent a subsidy. Suppose, for example, that the IROR is 5%, in which case we would expect T-bills to be trading at an implicit interest rate of slightly less than 5%. If the Fed then swaps reserves for T-bills, basically the same financial institutions which were holding the T-bills would then be holding reserves, and there would be no economic consequences. However, the Fed would be paying more interest to those financial institutions, and the Treasury would be paying less. In terms of the flow of interest payments from the consolidated fiscal and monetary authorities (Fed and Treasury) nothing has changed.
The same arguments apply to purchases of long-term Treasury debt, though here the argument is a little more complicated. As discussed above, to a first approximation swaps of reserves for long-maturity government debt are irrelevant under a floor system. Thus, the size of the balance sheet is irrelevant - economically.
But the payment of interest on reserves matters for the flow of income from the Fed to the Treasury. The Fed is a bank that is in the business of managing its SOMA portfolio, maintaining the stock of currency, clearing some checks (a declining activity), and employing economists. The Fed is profitable - it pays its expenses, and basically returns what is left over to the U.S. Treasury. But historically most of the Fed's liabilities have been currency, which pays zero interest. In the past, issuing currency to buy T-bills would in itself turn a handsome profit, let alone purchasing long-maturity government debt. This leads to...
But is there risk associated with the current state of the Fed's balance sheet? Yes, but possibly not for the reasons you think. The Fed is currently even more profitable than it was pre-financial crisis. While the Fed is paying interest on a large stock of reserves, and the yields on the bonds in its portfolio are historically low, the IROR is only 0.25%, the Fed's asset portfolio is much larger, and the average duration of the portfolio is much higher, thus exploiting the upward-sloping yield curve.
If the Fed were a private bank, we might worry about what it is doing. The Fed is intermediating across maturities, and is now facing greater maturity risk than previously, given the longer average duration of its asset portfolio. But the Fed is not a private bank, and its liabilities are not standard debt claims. Neither currency nor reserves are a claim to anything. The Fed's "liabilities" are not promises of any kind, and so there are no promises to break - the Fed cannot default. Indeed, currency and reserves are more like private stock, with zero dividends. Just as with private stock, the Fed can buy back currency and reserves, by selling assets, and such buybacks will affect the value of the outstanding "shares."
But what happens if the Fed needs to tighten, increasing IROR? Is is possible that the Fed's income transfer to the Treasury could fall to zero? If so, for how long, and why would this matter? Fortunately, the Fed is thinking about this problem too. A recent paper written at the Board of Governors supplies the relevant institutional details, and gives projections of Fed income under particular assumptions about future interest rates and Fed asset purchases and sales. According to the projections, which possibly are too optimistic, the Fed will face a two or three-year period starting within a few years where transfers from the Fed to the Treasury fall to zero. If this happens, the Fed will begin booking "deferred assets," which are basically accounting entries so that the Fed's books balance. What will actually be happening is that the Fed will be relying on its ability to print money to pay its bills.
All of this is economically irrelevant, for reasons stated above. But of course it's not politically irrelevant. The Fed has enemies in Congress who would be all too willing to pillory the money-losing Fed and to curtail its power. The Fed understands this of course, and will do all it can to keep its income high. But that might mean holding the IROR at too low a level for too long, and thus risking excessive inflation.
Thus, the Fed has put itself between the rock and the hard place, and has gained little in the process. The expansion of the balance sheet through various rounds of QE and twisting has accomplished essentially nothing, and now the Fed could be faced with an unhappy short-run tradeoff - the risk of loss of independence vs. the risk of inflation.
Is higher inflation really a risk? If it were, why hasn't it reared its ugly head? Given my discussion above, we will get more inflation when the demand for total consolidated-government debt (currency, reserves, government debt) falls. This will happen as the prices of real estate increase in the U.S., the U.S. economy recovers further making bank lending more attractive, and as European governments in particular get their fiscal houses in order. All of this is occurring much more slowly than I think anyone expected, which is why we're not seeing a higher inflation rate. Perhaps the Fed is tougher than I think it is. Maybe that's why typical measures of anticipated inflation show no cause for alarm. But the majority of FOMC opinion seems on the reckless side to me - there's a willingness to experiment with grandiose policies which, in the case of large-scale asset purchases, have dubious science behind them.
What about targeted asset purchases? Charles Plosser, Philadelphia Fed President, has spoken (see this speech and this one) about the dangers of expansion in the Fed's perception of its mission. The Fed now has in excess of $1 trillion in MBS on its balance sheet - a quantity that exceeds the total value of the SOMA portfolio held in January 2007. Plosser - I think correctly - points out that the purchase of what are essentially private assets (MBS issued by Fannie Mae and Freddie Mac, with the MBS representing claims on underlying private mortgages) is dangerous for a central bank. If MBS purchases work as intended, then those purchases will act to redirect credit and resources away from other sectors and toward the housing sector. These obvious redistributional effects open the door for lobbying from various private-sector industries and individual corporations for help from the Fed. Either the Fed gives in to demands like that, or members of Congress and the Executive Branch could intervene to accomplish goals through Fed action rather than - more appropriately - Congressional action.
The Fed may yet dig itself out - those people are pretty smart. But I think there is plenty of cause for concern. I'm as interested as you are in the outcomes.
"In January 2007, the average dollar quantity of transactions over Fedwire, the Fed's daylight payment system, was about $2.4 trillion per day, whereas annual nominal GDP in 2007 was about $14 trillion. If the average daylight quantity of reserves was $12 billion (not quite right, as $12 billion is overnight reserves, but it's in the right ballpark) in January 2007, then the transactions velocity of reserves at that time was 199. Compare that to an estimate of 1.5 for March 2013. "ReplyDelete
Here's a quick table that shows average daylight quantity of reserves. In Jan 2007, it was $57 billion. That brings 2007 velocity down to 40-50, but in any case the velocity differential still exists.
Thanks. Differences between daylight reserves and overnight reserves are due to two factors: (i) overnight intervention by the Fed. For example, if the Fed were to conduct a reverse repo at the end of the day, reserves would be lower at night than during the day; (ii) Daylight overdrafts - the Fed extends credit during the day to Fedwire participants, which increases reserves in the day relative to what they are overnight. Did I leave anything out?
Don't think so.Delete
You'll have to expand on that. I don't think there was anything incorrect in my reply. I love to learn though, so please enlighten me.Delete
You misunderstood me.Delete
SW: "Did I leave anything out?"
JPK: "I don't think so."
I think you covered it. I suppose you could say that in Canada the afternoon auction of government deposits ("Receiver general" auction) might influence the amount of reserves held overnight by banks relative to those held during the day.
"Is the private sector capable of turning T-bonds into overnight assets in basically the same way the Fed does it? You bet."ReplyDelete
I disagree. The required return on the private sector T-bond - overnight asset arbitrage is determined by market forces. When the Fed is willing to do such intermediation at below-market cost, it has significant effects.
Consider the period from September 2008 to March 2009. During this period, the private sector used a very high required profit hurdle for such intermediation. This is visible in T-Bond market data, as T-Bonds with similar maturities have traded with wildly different prices at the same time. When the Fed stepped in with QE, it imposed a ceiling on a cost of a T-bond arbitrage.
As the capital position of private financial sector improves, such ceiling has a weaker effect. Unless the Fed is driving the cost of T-bond arbitrage to negative levels - Bernanke himself has a chart where T-bond term premium is negative.
The same applies to MBS. If the Fed is able to distort the MBS market as you seem to argue, it is doing so by driving down the required return on MBS arbitrage. Let's hope this return is still positive.
The solution is for the Fed to purchase a diversified market portfolio of assets. Diversification would reduce the chances that the Fed would reduce the required return on intermediation to below the socially optimal level. Preferrably such a portfolio would appreciate when the time to reduce the balance sheet arrives. The current T-bond portfolio is likely to crash when the time to sell it arrives.
"When the Fed is willing to do such intermediation at below-market cost, it has significant effects."Delete
Sure, but you would have to convince me that was the case. But what if it was? If the Fed is purchasing assets at less than market prices, that would be bad, wouldn't it?
"The solution is for the Fed to purchase a diversified market portfolio of assets."
The solution to what? What do you think the problem is? What's the socially optimal required return on intermediation?
"Sure, but you would have to convince me that was the case."Delete
Here is a must see video:
It depicts the treasury yield curve, and you can see how the required return on T-bond arbitrage has reached huge values between the September 2008 and March 2009.
"But what if it was? If the Fed is purchasing assets at less than market prices, that would be bad, wouldn't it?"
Financial stocks have crashed after Lehman. Treasury arbitrage became very expensive. By allocating capital to Treasury arbitrage activities at levels of return that are below market, the Fed has protected the Treasury market from even greater disruption. Was it a good thing in 2008? Compared to other activities of the federal government, it was a much better use of capital. Is it a good thing now? It is a matter of debate.
"The solution to what? What do you think the problem is?"
The problem is the safe asset shortage you have written about yourself in the post. The solution of safe asset problem requires a temporary expansion of safe assets supplied. This is an arbitrage operation between the risky and safe asset markets. The fiscal policy attempts to deal with this by issuing safe bonds and building risky bridges to nowhere in Alaska. This arbitrage is hard to reverse and leads to a suboptimal allocation of risky construction materials. QE attempts to deal with it by doing arbitrage between similar assets and as a result Bernanke has a chart where T-bond term premium is negative - have you seen it? This arbitrage is easy to reverse, but is likely to lead to losses. Proper policy would be to purchase risky assets that would appreciate when Fed's policy goals would be reached, so the arbitrage can be realized profitably.
"What's the socially optimal required return on intermediation?"
I know the required return on intermediation is too high when I see Williamson writing about the temporary safe asset shortage.
And your views about T-bonds and MBS are inconsistent. I see no big difference about the ability of private sector to reverse the T-bond intermediation, and the ability to reverse MBS intermediation.Delete
"This arbitrage is easy to reverse, but is likely to lead to losses."Delete
What arbitrage opportunity are you talking about? Try to be clear.
"And your views about T-bonds and MBS are inconsistent."
No, you didn't read carefully. I said: "If MBS purchases work as intended, then..." I don't actually think that they do work as intended.
"What arbitrage opportunity are you talking about? Try to be clear."Delete
The overnight - T-Bond arbitrage opportunity. The opportunity Bernanke has talked about in his March 1, 2013 speech "Long-Term Interest Rates". Bernanke has said: "The third and final component of the long-term interest rate is the term premium, defined as the residual component not captured by expected real short-term rates or expected inflation. As I noted, the largest portion of the downward move in long-term rates since 2010 appears to be due to a fall in the term premium, so it deserves some special discussion. In general, the term premium is the extra return investors expect to obtain from holding long-term bonds as opposed to holding and rolling over a sequence of short-term securities over the same period. "
The charts Bernanke presented show that the term premium is negative, so this "arbitrage" is likely to lead to small losses.
"No, you didn't read carefully. I said: "If MBS purchases work as intended, then..." I don't actually think that they do work as intended."
In this case you should support MBS purchases as an alternative to T-bond purchases. According to your model, private sector capital would be redeployed from the MBS market to more productive uses in other sectors. This is good. This is what would mostly happen in my view too, but I also see slight reductions in MBS risk premia.
The problem with T-bond purchases is that they have lots of regulatory advantages, so for example, for insurance companies and pension schemes it is hard to redeploy capital to other sectors because they would lose regulatory benefits. This is why the Fed was able to drive the T-bond term premium to negative levels.
1. Sorry, but Bernanke does not have a theory of the term structure which explains the data, and neither do you.Delete
2."According to your model, private sector capital would be redeployed from the MBS market to more productive uses in other sectors. This is good." No, that's not right.
"We're currently operating under a floor system, in which the IROR essentially determines the overnight interest rate - with some arbitrage frictions for institutional reasons - but in any case the IROR is currently determining short-term nominal interest rates... Thus, in spite of the fact that reserves and short government debt bear interest (more as the IROR rises), all of those assets are essentially perfect substitutes given the IROR. "ReplyDelete
There's been a lot of speculation about why the federal funds rate might be deviating from IOR. The usual argument is that the GSEs distort the market since they participate in the federal funds market but can't hold reserves overnight and get IOR.
But why are short term t-bill yields trading so far below IOR? See this data, which shows 4 week t-bill rates at 0.08%, far below 0.25% IOR. Any ideas?
GSEs distort the market but so does the FDIC fees introduced in april 2011, the fee average 8bps but for some banks can be as high as 35bps.Delete
In addition it's not correct to claim that "reserves and short government debt bear interest (more as the IROR rises), all of those assets are essentially perfect substitutes".
The Fed doesn't and never has converted [or repoed] t-bills on demand to provide reserves to banks.
1. "The Fed doesn't and never has converted [or repoed] t-bills on demand to provide reserves to banks."Delete
No, that's not what I'm saying. You don't need this for the two assets to be close substitutes. I'm saying it's close enough for my purposes.
2. "But why are short term t-bill yields trading so far below IOR?"
I'd say that's because the T-bills are actually more liquid. T-bills are more widely-tradeable - you can only trade reserves with another institution that has a reserve account. Not sure if you can use reserves as collateral.
"I'd say that's because the T-bills are actually more liquid. T-bills are more widely-tradeable - you can only trade reserves with another institution that has a reserve account."Delete
So are 10 year notes, for that matter. But why are open market operations irrelevant then? The Fed is reducing the supply of liquid bills and bonds and replacing it with illiquid reserves.
The post missed one important result of QE: the duration of liabilities of the consolidated government balance sheet is shrinking. Thus, the Fed's actions are creating duration risk for the taxpayer.ReplyDelete
The closer the Fed comes to losing money, the more the taxpayer will be aware that this creates a budget shortfall (i.e. a tax liability). The taxpayer might logically seek to shrink the duration of their assets to compensate for the Fed-created duration risk. All else equal, aversion to duration risk contributes to further inflation, which in turn causes more Fed losses, a larger budget shortfall, etc.
In other words, the significance of shorter government duration is greater vulnerability to an inflation feedback loop.
I don't have the numbers handy, but I have seen time series on the average duration of the outstanding government debt (held by the public and the Fed), and that is increasing. The Treasury has actually increased the average maturity of the debt it issues. Thus, the Fed's actions are working in the opposite direction. From what I remember, the Treasury wins - average duration of consolidated debt held by the public has increased since before the financial crisis.Delete
Here's a question though. Suppose that the Treasury issues more long-term debt. How could that increase the amount of aggregate risk the private sector has to bear?
Treasury is increasing the duration of its liabilities. However, duration of "debt held by the public" includes reserves, Treasuries and MBS (and of course muni's and corporates). By 1) selling its T-bills; 2) converting 90% of T-bond issuance to overnight duration reserves; and 3) converting MBS to overnight duration reserves, the Fed is shrinking the public's duration risk.Delete
Perhaps in absolute terms the private sector still has a bit more duration risk than it used to as a result of Treasury's actions. Relatively speaking, the taxpayer has much more than it used to. Thus, the taxpayer is much more exposed to inflation than it used to be.
But this is a general equilibrium problem where you have to think about the consequences of the structure of the government debt for future taxation and monetary policy. It's not clear at all what consequences this has for how much risk the private sector bears. Indeed, there may be no consequences at all.Delete
"If the Treasury increases the quantity of T-bills in circulation, that increases the price level. Under a floor system, fiscal policy actions have consequences for inflation, though of course that can be offset if the Fed moves the IROR in response - more T-bills, higher IROR."ReplyDelete
I think this is a needlessly confusing way of looking at things. The Fed's policy instrument is the same as always - the Fed Funds rate. How it sets the FF rate isn't important. The floor system doesn't fundamentally change anything.
What is important is that the Fed refuses to contemplate lowering the FF rate under any circumstance. That's new.
(As an aside, I think the conventional wisdom that a negative FF rate is impossible or at least impractical is quite wrong. It's just a matter of wanting to do it, and understanding that the cost imposed on currency transactions is the lesser of two evils).
"The Fed's policy instrument is the same as always - the Fed Funds rate. How it sets the FF rate isn't important. The floor system doesn't fundamentally change anything."ReplyDelete
No, that's not correct. The IROR determines the fed funds rate under a floor system. Things are indeed different. For example, the fed could announce a target of 5% for the fed funds rate. But if it sets the IROR at 2% and there is a positive excess stock of reserves held overnight, then the fed funds rate will not be 5%; it will be 2% minus a bit.
"According to the projections, which possibly are too optimistic, the Fed will face a two or three-year period starting within a few years where transfers from the Fed to the Treasury fall to zero. If this happens, the Fed will begin booking "deferred assets," which are basically accounting entries so that the Fed's books balance. What will actually be happening is that the Fed will be relying on its ability to print money to pay its bills."ReplyDelete
There's some of that, but I think it's more relying on the fact that interest rate tightening cycles tend to be finite, and that Fed interest margins will inevitably turn positive again as a result.
The deferred asset is effectively (and weirdly) a loan from the Fed to Treasury. In future years, Treasury will pay down its liability with the proceeds of profit transfers from the Fed at that time. As a result, Treasury will gain no net accumulation of that future Fed profit until the asset/liability position is eliminated.
The loan is actually recorded as a negative liability on the Fed’s balance sheet. That negative liability can be considered to be an intended reversal or retention of the same amount of future profit that would normally be payable to Treasury, until the negative liability is extinguished.
And Fed interest margins will inevitably turn positive. To the degree that the Fed exits from its bloated asset position, and gradually replaces residual assets as they mature with higher yielding assets at prevailing rates, and to the degree that the liability structure eventually resumes its normal currency dominant profile (paying no interest), and to the degree that rates don’t go up forever, the Fed will return to its normal profit position.
Or, to the degree that the Fed doesn’t exit from its bloated asset position (unlikely), it is still the case that rates don’t go up forever, and that the yield curve is on average positively sloped over time, so it is still assured that it will eventually return to a profit position.
Either way, the deferred asset accounting is justifiable.
"...the deferred asset accounting is justifiable."ReplyDelete
This is like saying double-entry bookkeeping is justifiable. It's just accounting.
The plan - I think - is that the Fed will sell off its assets in relatively short order and get back to the sort of position it was in circa early 2007. But people were talking about exit strategies in 2009, and here we are 4 years later with a Fed balance sheet that is very much larger than anyone imagined it would be. How do we know that the floor system doesn't continue indefinitely, or that the cycles of tightening and accommodation don't include more large-scale asset purchases - maybe sooner than we think?
"This is like saying..."Delete
um... no its not
the alternative is a hit to capital and a requirement to recapitalize
um...read the Board of governors paper that I link to in the post, which will give you some arcane details about what capital is at a Federal Reserve Bank, and how the members contribute to it. Then, get back to me.Delete
" Our key problem is that there is a high demand for the whole spectrum of U.S. consolidated government debt - currency, reserves, short-term debt, long-term debt - relative to supply. The demand is high because the supplies of other safe assets in the world - asset-backed securities, the sovereign debt of other countries - have been destroyed, and are coming back very slowly. What is needed is a large increase in the stock of U.S. government debt outstanding."
Why is that *needed*? If society faces a high demand for safe financial assets, won't the prices of remaining safe assets immediately rise in order to satisfy that demand? Why do we need quantities to adjust? Prices will do all the work. I don't understand why a high demand for safe assets is a problem nor why such a phenomenon would require the remedy that you advocate.
You can see it in my AER paper:Delete
There, all the prices are flexible, but you can get safe asset shortages. I don't get to the point about fiscal policy there - that's in the next paper, as yet not fit for public consumption.
If investors demand more liquidity, then liquidity premia on various assets get bid up. The demand for liquidity is now met. Where's the shortage? The market for collateral and other monetary services is now clearing. Why do people need more US gov debt?Delete
The market clears, but there's an inefficiency, reflected in the liquidity premium. More government debt creates more exchange and more credit, and we're better off - the liquidity premium also falls in the process.Delete
A non-Walrasian economy with all its various frictions will always be populated by assets bearing liquidity premia. Why do you say that a premium amounts to an inefficiency? After all, the assets that bear premia are doing the money-work that would otherwise be done by the Walrasian auctioneer. We can't "fix" the fact that there will always be liquidity premia.Delete
Yes, sometimes there are liquidity premia that are in fact efficient. In this case not.Delete
How are we to know if the low interest rates on government debt that we currently observe are examples of efficient liquidity premia or inefficient premia?Delete
Stephen, I have learned more about modern monetary theory by reading this blog than I learned in graduate school. Thanks for another great post!ReplyDelete
Now on to substance. If I understand your post and paper correctly, your viewpoint is that there is a short supply of safe assets, which serve as a medium of exchange. The shortage limits exchange in the goods market, thus reducing demand for goods and services. The remedy is to increase the supply of safe assets, as you said in another post not necessarily by following a Keynesian expansion but perhaps through a temporary tax-cut.
While it is an interesting viewpoint, there is, however, a counter-view. It is possible that the increase in the demand for safe assets is driven by a drop not only in the demand for riskier assets, but also in the demand for goods due to reasons unrelated to the financial sector. If transactions declined so much that money was no longer scarce, the private sector would convert their money holdings into safe assets until the T-bills rate is identical to that paid to reserves. But in this case, the tax-savings from the fiscal policy you recommended may simply generate additional demand for safe assets as the private sector swaps the tax-refund for T-Bills, thus offseting the increase in supply. Fiscal policy would raise demand for goods only if the government directly sold financial assets in exchange for goods (the Keynesian remedy) or reduced fiscal uncertainty thus boosting consumer and investor confidence (the conservative view). Do you have any thoughts on this?
"The shortage limits exchange in the goods market..."Delete
That's roughly the way it works in the model, but I'm also thinking more broadly in terms of the role of safe assets in financial trade, and as collateral in credit arrangements.
"...the tax-savings from the fiscal policy you recommended may simply generate additional demand for safe assets as the private sector swaps the tax-refund for T-Bills..."
I think you're asking, "why doesn't Ricardian equivalence go through?" That's because, with an asset scarcity, there is a liquidity premium associated with government debt. The price of government debt is greater than the expected discounted payoffs on government debt. If the liquidity premium is there - which reflects the value of government debt, at the margin, as collateral and in exchange - then changing the quantity of government debt matters.
By the way, thanks for the compliment. I won't ask where you went to graduate school.
" I won't ask where you went to graduate school."Delete
Ha ha, clearly not Washington U. I ended up at a small department that specializes in applied Micro, yet still ended up doing growth theory. In the pre-internet days obtaining info about graduate programs in the U.S. if you were an undergrad in Greece was very difficult. Most of what I know about monetary theory I picked up by skimming over Welsh's book on my own.
OK, I understand now why the Ricardian equivalence does not go through in terms of the model. Thanks! But how would you explain why corporations are sitting in large amounts of cash that they neither distribute to stockholders nor use to buy goods? If I am not mistaken, in the model all available liquid assets end up being used (cash in the CM and interest-bearing assets in the DM) to buy goods, so their supply limits consumption. Do you think their behavior reflects an attempt to finance investment in the future using own funds rather than issuing debt? I suppose this would be consistent with an increase, say, in the cost of monitoring that raised the cost of private borrowing. In which case the culprit does not need to be policy uncertainty as the GOP claims.
"But how would you explain why corporations are sitting in large amounts of cash that they neither distribute to stockholders nor use to buy goods?"Delete
Yes, here is a puzzle: Corporations and banks are sitting on a lot of cash - literally demand deposits in some cases for corporations, and reserves for banks. This cash bears a very low real rate of return. Surely there are higher returns out there to holding alternative assets?
I gave you an explanation for banks, which is that some assets, including bank reserves, bear a liquidity premium reflecting an overall scarcity of safe assets. Put another way, there is still a lot of uncertainty. I think everyone is worried, for example, that some dramatic event will happen in Europe - for example a sovereign default, with systemic and worldwide consequences. Best to be liquid if another financial crisis hits us. All this cash is also sitting in wait for better opportunities. The alternatives to holding cash look better currently than holding cash. But why commit to a long-term investment now if the long-term investment opportunities available in six months are expected to be much better?
Yes, I like the explanation for banks. I am just trying to figure out how this applies to the non-financial sector. Why do companies not distribute the cash to stockholders and borrow if and when worthwhile investment opportunities do become available? Unless they expect whatever dysfunction caused the financial crisis to persist and compromise their ability to finance these opportunities when they do become available.Delete
Somebody direly needs to read Fisher and Koo. What do bank bailouts, QE and expansionary fiscal policy have in common? They all lead to more public and less private debt which is the obvious cure during a balance sheet recession. Deflation is the actual danger, not inflation.ReplyDelete
But alas, right wing shlockonomists have learned nothing from Japan.
1. Risking sounding like the Cheshire cat, but who is Koo?Delete
2. And who is the "right wing shlockonomist?"
Richard Koo of "balance sheet recession" fame. He's affiliated with a Japanese consulting firm rather than academia or a central banking system, which may be why you've never heard of him. Can't blame you, I had to google to get that information as well.Delete
Richard Koo. His analysis is hardly perfect (e.g. his dismissal of monetary policy and total focus on fiscal policy) but a flow of funds approach is a decent heuristic to see the rough picture. And above all he is somebody who, like Krugman, learned the lessons from Japan.ReplyDelete
Right wing: caring more about inflation (and thus the interests of rentiers) than employment.
Shlockonomist: For how long have you warned about inflation around the corner now, 2 or 3 years? Whatever model you use, it has long since been falsified.
"When the facts change, I change my mind. What do you do, sir?"
Crackpot redetected. Repeating nonsense does not turn it into sense.Delete
"Right wing: caring more about inflation (and thus the interests of rentiers) than employment."Delete
I thought that's where you were going. This is much like saying that a right-winger is someone who opposes rent controls, and therefore must have it in for poor people. Good policy helps everyone (though of course Pareto improvements are rare). Having an interest in the rate of of inflation says nothing about how one cares for the poor or the unemployed.
You merely worry about inflation and not about employment in this post. This is either because you care about rentiers and not about workers (right-wing) or because you deny that monetary policy does have any employment effects (shlockonomics).Delete
So yeah, go on worrying about inflation, disavowing any facts and complaining about a fellow economist like Krugman who cares about employment. And please go on repeating that you always voted for Democrats, that is at least good for laughs.
you say the root of the problem is a temporarily enlarged demand for US debt, and Congress isn't deft enough to meet it. Isn't LSAP of MBS exactly the right answer, then? Temporary enlargement of the US debt through conversion of risky private liabilities into safe government debt (reserves being short-term US debt under another name), which will be reversed down the road.
[I'm posting Anonymous because of the black-out period...]
"Isn't LSAP of MBS exactly the right answer, then?"Delete
No. The Treasury determines the total debt outstanding (curency, reserves, Treasury debt). The Fed determines its composition. The whole idea is that, under current conditions, there is no conversion of risky private liabilities into safe liabilities that the Fed can accomplish, that is not already being accomplished in the private sector, at least to a first approximation.
Really interesting post! A couple questions.Delete
If I'm not concerned about inflation (and maybe I even want inflation if I think that will push us out of the ZLB) then my solution would be for the Treasury/Fed to print money and buy up MBS + whatever else has a high return right now. I don't buy the argument that the private sector is indifferent between holding whatever vehicle it can construct to approximate cash with MBS (or whatever) and cash.
Clearly there's a political dimension that would be hard to ignore in practice, but why wouldn't this satisfy the demand for safe assets and encourage the use of cash to fund investment and consumption.
Alternatively, if my goal is to get cash/reserves out of banks and into prices or goods, why not get rid of the floor on the IROR and simply start charging negative rates on all reserves, not just those held in excess of requirements?
I think the Fed should only buy US Treasuries. The buying of MBS can quickly get smelly for political reasons.ReplyDelete
That said, I don't think the Fed ever has to sell the Treasuries it buys. If need be, it can hold until maturity.
QE did not lead to inflation in Japan. The BoJ did QE from 2001-5. See John Taylor's paper on this, and he gushes about QE.
So the Fed does QE, buys on Treasuries, and helps lower the federal debt, and hopefully generates some inflation (which also helps deleverage).
The risk going forward is perma-zero-bound and deflation.
Moderate inflation and lots of QE to avoid that scenario is welcome, not a risk.
The bigger risk is doing a Japan.
Lets say the fed holds all instruments until maturity and is sitting on trillions in cash over the next 10 years.ReplyDelete
Can it rebate all this cash to the treasury without cancelling the liabilities of its portfolio? - and doesnt the fed have absolute control over its liabilities through the reserve ratio which stands it 10%? - i.e. can it not just increase this rate to starve off inflation?
In theory wont the US debt clock run backwards if the fed starts handing over principal payments to the treasury after maturity?
"Given my discussion above, we will get more inflation when the demand for total consolidated-government debt (currency, reserves, government debt) falls."
This suggests that the problem then would be a too-large budget deficit, and that the appropriate response to control inflation would be to reduce the budget deficit or even run a surplus. In contrast, by raising IOR you would actually be increasing the overall budget deficit. Is this correct?