How does Operation Twist differ from QE?

In a direct sense, almost none at all. Despite the common perception that “Operation Twist” is an ineffectual, conservative move, while further quantitative easing would be a powerful and risky one, the fundamental economic difference between them is quite minor.

But maybe perception itself is the problem.

In its press release two weeks ago, the Fed pledged to:

…purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less.

Is this different from quantitative easing? QE2 was equivalent to the combination of two open market operations:

  • (1) Buying short-term Treasuries with newly created money.
  • (2) Swapping short-term Treasuries for longer-maturity ones.

The Fed’s new policy is just operation (2), disconnected from (1). Operation Twist is less effective than a potential QE3, therefore, to precisely the extent that operation (1) makes a difference.

Does it? First, let’s be even more precise, breaking down (1) into two smaller components:

  • (1A) Buying T-bills (extremely short term Treasuries with duration less than a year) with newly created money.
  • (1B) Swapping T-bills for a broader mix of short-term Treasuries (e.g. those with remaining maturity “3 years or less”).
  • (2) Swapping short-term Treasuries for longer-maturity ones.

Virtually everyone agrees that (1A) is useless: yields on 1-year T-bills hover around 0.1%, which is almost exactly the same as the effective federal funds rate. Yields on shorter T-bills are even lower. For all practical purposes, T-bills and reserves are equivalent assets—they’re both extremely liquid and offer a safe nominal return. Exchanging them does nothing.

If there’s a difference between Operation Twist and QE, then, it really has to be in (1B). This is already a little amusing: all the rhetoric contrasting Twist and QE, if it has any logical interpretation, boils down to an extremely specific statement about the effects of a particular maturity swap. (I’m pretty sure this is not what everybody is thinking!)

Of course, it’s conceptually possible that (1B) matters. Maybe reserves and T-bills do have some special “moneyness” (e.g. liquidity value) that 1-3 year Treasuries do not, and by expanding the relative supply of this moneyness we can make it less valuable—thereby pushing down yields on the securities that lack it. But this is easy to check: let’s just look up the difference in yields! This will tell us the maximum possible effect of the policy.

The yields on 2 and 3-year Treasuries are currently 0.25% and 0.42%, respectively. Needless to say, these aren’t much different from the current 0.1% yield on reserves and 1-year T-bills. But that actually isn’t the right comparison—we should be looking at the rates on 2 or 3-year debt versus the rate expected on reserves/T-bills over the next 2 or 3 years. This will tell us whether slightly longer-term securities are trading at a discount because they lack the features of money. As it turns out, the average rate over the next two years on the Fed Futures market is 0.15%, while the average rate over the next three years (assuming Sep. 2014, which is missing, is the same as Aug. 2014) is 0.32%.

In both cases, the Treasury yields are 0.1% higher than the corresponding average of forward rates. This is the gap that (1B) might address. It’s not zero, but it’s incredibly small relative to the other possible impacts of the policy, like the impact on long rates (even a 0.1% decrease in yield on the 10-year would be vastly more important, since it implies a much larger increase in price than the same change on a 2-year), or signaling.

To sum up: the fundamental difference between Operation Twist and QE, which boils down to the effect of a very specific asset swap, is extraordinarily minor.

Of course, most people disagree with this analysis—they think, for whatever reason, that QE is much stronger stuff. As I’ve explained, this doesn’t make sense from a fundamental perspective, but nevertheless it may be partly self-fulfilling. After all, perceptions matter.

This is possible even if you assume market participants themselves are rational and understand monetary policy. Consider the following simple model of the Federal Reserve: it wants to make monetary policy easier, but it’s constrained by political pressure from the Rick Perrys of the world and internal pressure from the Richard Fishers. Its decision to try Operation Twist, a mostly equivalent but marginally less effective alternative to QE, is a signal that it’s bowing to pressure from politicians and FOMC hawks, who irrationally think that QE is much more dangerous. While the true effect of replacing QE with Twist is minor, this signal about the Fed’s decision process has serious implications for how policy will be set in the future, and that’s extremely important.

Alternatively, maybe 20% of the market doesn’t understand monetary policy and thinks that QE will be wildly inflationary. Here we hit upon a quirk of monetary policy: expectations of inflation can be partly self-fulfilling, especially at the zero lower bound (where the Fed doesn’t move to counteract them). That 20% will purchase more (after all, their savings are about to be inflated away!), write contracts that embed inflation, hike prices, and so on. This leads to a little more inflation. Anticipating this, the other 80% adjusts its inflation expectations upward. This will lead to even more inflation. Anticipating this, the rational 80% adjusts expectations even more, and so on. Bottom line: under conditions of strategic complementarity, which many economists believe apply to price-setting, a small population with irrational beliefs can make a big difference.

Both these effects probably play a role. And that’s why, even though economics tells us that Twist is essentially the same as QE, it may ultimately have far less of an impact—precisely because so many people think it’s less potent.

(Yes, it’s frustrating to be an economist sometimes.)

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Why the zero lower bound matters

The zero lower bound is not an insurmountable obstacle: by shaping expectations of future interest rates, the Fed can have a tremendous influence on the macroeconomy, even when the current interest rate can’t go any lower. But it’s not irrelevant either: instilling the right expectations is trickier than simply moving around the federal funds rate, and a central bank unprepared to make a visible commitment can be remarkably ineffective.

Some economists argue that the zero lower bound is irrelevant, or at least overrated, for other reasons. In his response to an earlier post of mine, for instance, David Beckworth suggested that the Fed’s ability to buy other assets (e.g. long-term Treasuries, or corporate bonds) even when short-term interest rates are zero means that monetary policy retains its effectiveness. This has historically been one of the main arguments against a “liquidity trap”: sure, the Fed can’t do any more by buying 6-week T-bills, but why not 20-year corporate debt?

In fact, I agree to an extent: unconventional asset purchases can make a small difference in yields, and possibly a larger difference in times of financial disarray. But they are vastly, vastly less effective than the Fed’s traditional tools, and it takes an extraordinary expansion of the Fed’s balance sheet to have much effect at all.

Why is this? The Fed is a monopolist in the market for base money: no other institution is allowed to print paper currency that’s legal tender, or create electronic reserves that satisfy reserve requirements. Although base money is a relatively small market (about $1 trillion pre-QE), it has a dramatic effect on the rest of the economy because prices are quoted in money, in much the same way that Snickers bars would become pivotal if prices were quoted and transactions conducted in units of candy. By wielding its monopoly power in this market, the Fed can change a key rate (the federal funds rate) that determines the cost of credit across the economy.

At the zero lower bound, however, base money is no different from all other short-term, riskless assets. And that’s a much larger market, one that’s no longer dominated by the Fed. There’s $1.5 trillion in Treasury bills, $1 trillion in commercial paper, $2.7 trillion in money market funds, $900 billion in checkable deposits at commercial banks, more than $1 trillion in Treasury notes with less than a year until maturity, at least $1 trillion in the federal funds and repo markets, and a several trillion more in liquid savings deposits. To be sure, this involves a little double counting: for instance, money market funds invest some of their money in Treasuries. But the total is still very large: even if you take out the $1 trillion in currency, “Money Zero Maturity” is estimated at almost $10 trillion, and that excludes many assets. It’s a big market!

Just as importantly, short-term assets aren’t in fixed supply: financial intermediaries create them when they become sufficiently profitable. Maybe a bank holds a 5-year Treasury note using funds obtained through repo, effectively transforming a 5-year asset into a zero-maturity one. This makes the Fed’s job even harder. If it creates money and buys up Treasury notes in the hope of bringing down yields, financial institutions may start to unwind their own positions, offsetting much of the effect.

Here’s an extreme example: suppose that banks are only willing to borrow short and lend long (i.e. hold longer-maturity Treasuries) when the spread between short and long is at least X%. Then the Fed will have an extremely difficult time bringing the spread below X%; every bank will unwind its positions first, and the Fed will be forced to purchase even more to compensate.

This is why unconventional policy is so difficult, and why the best empirical estimates suggest that its effects are measurable but small. Away from the zero bound, a $400 billion purchase would immediately revolutionize monetary policy, forcing the fed funds rate down to zero (even if it started at a very high level). But at the zero bound, you’re lucky if a $400 billion purchase reduces long-term yields by 15 basis points.

There are two ways to spin this. First, we can’t pin all our hopes on quantitative easing: it’s fundamentally different in character from ordinary monetary policy, and much less likely to have a substantial effect.

On the other hand, we should recognize that normal intuition about magnitude doesn’t work for quantitative easing. I often hear statements like the following: “The Fed has engaged in absolutely unprecedented monetary policy, more than doubling the size of its balance sheet, and there wasn’t much of an impact. Clearly the Fed is out of ammunition.”

This sounds reasonable at first blush, but it doesn’t really make sense. When it’s purchasing assets at the zero lower bound, the Fed is participating in a market that’s fundamentally different from the market in which it usually intervenes—a market that’s far bigger, in which the Fed is no longer a monopoly player. There’s no reason to think that even a doubling or tripling of the Fed’s balance sheet is enough to achieve a meaningful stimulus. And there is still plenty of room for action: after all, there’s still more than $6 trillion of T-notes and T-bonds that the Fed doesn’t own, and even more in the market for agency securities and other debt. (But don’t expect $6 trillion in purchases anytime soon.)

Summing up: life at zero is hard. No longer can the Fed simply nudge rates up or down. It must either commit to lower rates in the future (testing its credibility in the process), make extraordinarily large asset purchases, or both. This requires courage and flexibility—qualities that Ben Bernanke is known to possess, but that the Fed has not consistently displayed.



Edit: I’ll be away starting in a couple days for my wedding and honeymoon. Despite my normal attachment to the internet, I do not plan on blogging or responding to comments during this period! I’ll be back in September.

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A primer on the new era of monetary policy

I’ve seen a lot of misleading commentary on how monetary policy will work in the next few years, particularly given the Fed’s enormous balance sheet. Many people seem to think that the Fed’s recent money creation is inherently inflationary—if not now, then eventually.

Once upon a time, this might have been true. Today, however, the Fed has a tool that renders the size of its balance sheet mostly irrelevant as a constraint on monetary policy: interest on reserves. Monetary policy using interest on reserves is almost exactly the same as old-style monetary policy—in fact, the mechanics are maddeningly simple. Yet there is still a great deal of confusion on this issue, and I think it’s helpful to go back to the basics.



Monetary policy works primarily by modifying the riskless short-term interest rate*: at what price can a dollar at time T be exchanged for a dollar at time T+1?

The instrument of choice, the federal funds rate, is determined by banks. If a bank has a dollar in reserves, it can either (1) keep the dollar for itself, earning whatever interest is paid on reserves or (2) lend the dollar in the overnight market to another bank. For most purposes, option (2) is just as good as option (1): there’s (essentially) no default risk, and the bank gets the dollar back the very next day. It shows up on the bank’s balance sheet as a liquid, riskless asset, just like reserves.

But of course, (2) isn’t quite the same as (1), or else banks would be willing to lend reserves at exactly the interest rate the government pays on them. Since that interest rate has traditionally been 0%, this would mean a federal funds rate of 0%, which clearly hasn’t always been the case! There are indeed a few differences between keeping a dollar in reserves and lending it out. First, a dollar in reserves can be used to settle interbank transfers on Fedwire. Second (and more importantly for determining the federal funds rate in practice), holding Fed reserves is the only way to satisfy the 10% reserve requirement on checking accounts. Since these are important for a bank—it’s penalized if its account is overdrawn, or if it fails to meet the reserve requirement—it’s willing to sacrifice some yield to hold reserves. In other words, there’s a premium (sometimes called a “liquidity premium”) on reserves: the rate a bank earns when it holds reserves is less than the rate it earns when it lends them out.

The federal funds rate is the simply the sum of this premium and the interest rate paid on reserves**:

Federal funds rate = (Interest rate paid on reserves) + (Premium on reserves versus overnight loans)

Traditionally, the Fed has worked through the second term on the right side of this equation, the premium on reserves. It changes this premium by adjusting the supply of reserves with open market operations. If it sells bonds for money, it makes reserves scarcer and more valuable, pushing up the premium. If it creates money to buy bonds, on the other hand, it makes reserves less scarce, bringing the premium down. Since the interest rate paid on reserves has traditionally been zero, the premium has been the sole determinant of the federal funds rate.

This is a perfectly fine way to conduct monetary policy. But as the equation above makes clear, it’s not the only way: the Fed can also control the federal funds rate by adjusting the interest rate paid on reserves. In fact, this is arguably a simpler way to conduct monetary policy. There’s no need to bother with open market operations every time you want to change the rate: just pay a different rate on reserves!

Why does this make a difference? Multiple rounds of quantitative easing have left the Fed’s balance sheet far larger than ever before: $2.6 trillion, versus roughly $1 trillion before the crisis. Banks’ reserves at the Fed are now $1.4 trillion, up from only $20 billion pre-2008. If the Fed wants to maintain this large a portfolio, and continue funding it with money***, there’s no way that the premium on reserves will go above zero for a long, long time. There’s simply too much money relative to demand. Banks have far more reserves than they need to execute transactions and satisfy reserve requirements. In this environment, the only way the Fed can control the federal funds rate is by adjusting the first term in the equation above: the rate paid on reserves.

And this is fine! There’s no inherent inflationary risk from having such a large balance sheet—that only happens if the Fed refuses to use its new tool, interest on reserves. The basic principles of monetary policy are exactly the same as before: you adjust the current and future trajectory of the federal funds rate to maintain macroeconomic stability. The only economic difference is the removal of a slight implicit tax on checking accounts, since required reserves now pay market rates of interest—and this is an incredibly, incredibly minor point.

In other words, all the rhetoric surrounding the Fed’s recent money creation is vastly overblown. Looking forward, monetary policy has as much power as ever, regardless of what happens to the Fed’s balance sheet.



*You may have heard from Scott Sumner, among others, that interest rates are a terrible indicator of monetary policy. This is actually true if we’re talking about current interest rates: it’s possible for monetary policy to be effectively tight because the Fed’s policy rule is contractionary, even if the current rate is very low. (Maybe it plans to raise interest rates dramatically in a few years, or whenever the economy shows signs of an expansion.) The key is to remember that monetary policy works through the entire expected path of future interest rates, not just the current rate. But interest rates are ultimately the key mechanism through which monetary policy affects the economy.

**Right now, the “premium” is actually slightly negative, as the federal funds rate is below the interest rate paid on reserves. This is partly due to identifiable factors (i.e. a minor tax on reserves, which lowers the effective rate earned by banks), but to some extent it suggests an unexplained failure of arbitrage. The gap is very slight in absolute terms, however, and there’s certainly no reason to think that it will expand when the Fed decided to raise rates. Barriers to arbitrage are not that large!

*** Since 2008, the Fed has possessed the power to accept term deposits; if it decides to replace reserves with term deposits, most of this discussion is moot. It can also drain reserves using reverse repo.

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What makes commitment difficult?

(No, I’m not talking about relationships.)

Back in the early to mid 2000s, many leading monetary economists proposed policy responses to a liquidity trap, all of which involved commitment of some kind. Lars Svensson argued for the “foolproof way”: a currency devaluation and temporary exchange-rate target, along with a price-level target path. Alan Auerbach and Maurice Obstfeld suggested large, sustained open-market purchases. Clouse et al. offered a massive list of possibilities, including writing options on future interest rates that would pay out if the Fed raised rates beyond a certain level. Gauti Eggertsson modeled “committing to be irresponsible”, suggesting that the government increase its total nominal debt to create inflation incentives. And, of course, Eggertsson and Woodford’s classic 2003 paper argued that the benefits from an optimal interest-rate policy could be approximated through an appropriate price-level target.

There are really two issues here.

First, there’s the question of how the Fed can make its promises credible. As I’ve discussed before, effective policy in a liquidity trap involves making expansionary commitments that will be uncomfortable when the time comes to implement them. Both Clouse et al. and Eggertsson focused on creating fiscal incentives for the Fed to follow through on its commitment: making prolonged low interest rates profitable for either the Fed or the government as a whole.

There are many ways to do this. If the government has lots of longer-maturity nominal debt, it will be (relatively) happy to see inflation. If it has shorter-maturity debt, it will benefit from rolling over the debt at low nominal interest rates. Either way, there’s a benefit from loose monetary policy. The problem, of course, is that goosing the Treasury’s balance sheet isn’t part of the Fed’s mandate: it cares about ensuring macroeconomic stability, not implicit default through inflation. There isn’t a monolithic “government” making these decisions; there’s a central bank, which for good reasons has been given a great deal of independence from the rest of the public sector.

Even if the Fed doesn’t care about the balance sheet at the Treasury, might it care about its own balance sheet? In normal times, the two objectives are identical: the Fed remits virtually all its profits to the Treasury. It’s possible to imagine, however, that a massive expansion of the Fed’s balance sheet could separate the two, by raising the specter of losses so dramatic that they wipe out the Fed’s profits and leave it undercapitalized. This isn’t likely with QE or QE2, but it could happen with a sufficiently large intervention. If the Fed soaked up virtually the entire supply of Treasury and Agency debt—a little over $15 trillion—and funded its acquisitions with interest-paying reserves, it would suffer a hit of $150 billion annually for every 1% it raised interest rates. This is well above its usual profit level from seignorage, and it’s easy to see how the Fed might be swayed at this point by its balance sheet. Large capital losses are embarrassing: can you imagine how a bailout from Congress would affect the Fed’s independence?

So indeed, if the Fed cares about its balance sheet and is willing to make sufficiently dramatic purchases, it can bind itself to a more expansionary course of action in the future. Other proposals, like Clouse et al.’s option-writing, might also do the job—and perhaps more efficiently.

Recent events, however, suggest that elaborate commitment devices aren’t really necessary. The key constraint for the Fed isn’t sticking to its promises. The Fed cares a great deal about its credibility, and has a decent record of keeping promises whenever it has the nerve to make them. Instead, the problem is what kind of commitment to make: how can the Fed make tangible promises about future policy that don’t run the risk of creating larger problems down the road? This is the second issue in the literature, and it’s not trivial.

Svensson’s “foolproof way”, for instance, is best viewed as a simple, explicit type of commitment. It’s commonly misinterpreted: since exchange rate devaluation is a central part of the proposal, people assume that it stimulates by increasing net exports. This is true to an extent, but it’s no more important in Svensson’s proposal than any other. The United States has incredibly open capital markets, and in this environment an exchange rate peg necessitates a specific path for monetary policy. If the peg is intentionally low, expected monetary policy must be loose—and that’s where the stimulative effect arises. The plan uses exchange rates not because they have any wonderful direct influence, but because they are a tangible and easily observable method of commitment.

When Auerbach and Obstfeld suggest long-term open market purchases, they’re also talking about a type of commitment: using money to buy bonds, and (more importantly) not reversing the transaction in the future. This is implicitly a commitment to keep nominal interest rates at zero for a long time, even after the economy has recovered and the policy becomes inflationary. And that’s where the proposal is problematic: thanks to the unpredictability of money demand, the commitment to a keeping a certain amount of money in circulation may correspond to many very different trajectories of monetary policy. Maybe rates will be low until 2013; maybe they’ll be low until 2020. Maybe improved technology for electronic transactions will push money demand so low that the policy will be wildly inflationary. Who knows? Nothing too crazy can happen with Svensson’s proposal; virtually anything is possible in Auerbach and Obstfeld’s. That makes legitimate commitment difficult: can a central bank really promise it won’t reverse open market purchases, even when 20% inflation is in view?

Eggertsson and Woodford have a model in which they can calculate the exact optimal interest rate policy. This is a valuable exercise. But the mathematically optimal policy cannot readily be described in an FOMC statement—it’s too complicated, and too model-contingent. Eggertsson and Woodford recognize this, and show that a price-level target achieves most of the benefits of the “optimal” policy. Like Svensson, they’re looking for a rule that escapes the liquidity trap and is practical for the Fed to follow.

This is the central question in monetary policy today. Until now, the Fed has relied upon meaningless phraseology (“extended period”) or exceedingly indirect signaling mechanisms (QE). Now, it has kinda-sorta promised to keep rates near zero through mid-2013. This is good, but it’s not enough. Yet it’s difficult to see how the Fed can do too much more while making this kind of promise: making a pledge to keep rates at zero for a certain period of time is simply too crude, and extending it much further would be irresponsible. (After all, who knows what the world will look like in 2015?)

It needs some way to make a stronger but more specific promise. Svensson and Eggertsson and Woodford provide one possibility: price level targeting, perhaps with a commitment to devaluation. Scott Sumner and David Beckworth, who stress the benefits of nominal GDP targeting, provide another. Mankiw and Rogoff seem to be arguing for a higher inflation target over the next few years. I’m honestly not sure which of these proposals is best, but I do know that a more aggressive expansionary commitment is necessary to ensure that America doesn’t experience its own lost decade.

If only someone who assailed Japan’s “self-induced paralysis” was in some kind of position of power…

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Macroeconomics in action

A decade of macroeconomic research is finally making a difference.

As everyone knows by now, the Fed’s August 9 statement marked a major change in the communication of policy:

To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent.  The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. (bold added)

This is straight out of Eggertsson and Woodford’s 2003 BPEA piece, the key article for understanding how to conduct monetary policy in a liquidity trap. As Eggertsson and Woodford observe, once you’ve hit the zero lower bound, it’s not clear why massive money-financed asset purchases (like QE2) should have any direct effect. In fact, taking the path of the Fed Funds rate as given, their model shows that there is no effect. For various reasons, this probably isn’t quite true, but it’s not a bad approximation to reality either, and it provides a strong counterpoint to claims that the zero lower bound is somehow not a barrier.

So what then? If it can’t push rates below zero, and asset purchases are useless, is the Fed “out of ammunition”? Not at all: rates can’t go any lower today, but they can go lower in the future. After all, no one expects the liquidity trap to last forever—at some point, the Fed will raise rates above zero in line with improved macroeconomic conditions, in order to maintain its implicit targets for inflation and the output gap. If, when the time comes, it decides to delay these increases, the Fed will induce a boom—a period of above-target inflation and output. And if everyone today expects a boom in the future, conditions today will be better: higher expected inflation will push down real interest rates, and the expectation of future prosperity will increase demand. Eggertsson and Woodford show that these effects can be very powerful indeed—that the optimal policy can nearly eliminate the negative effects of a liquidity trap.

But there’s a catch: the Fed has to commit to a policy that, in the future, will no longer be optimal. When the time comes, the Fed will prefer not to create an inflationary boom—after all, that’s a violation of its mandate, and the Fed takes its inflation-fighting credibility seriously. They can say “we’re briefly violating our mandate now to keep a promise that prevented a far more serious violation of our mandate two years ago”, but unless everyone understands the importance of commitment (and knows what the Fed’s commitment actually was), this won’t be too convincing. And if the market today anticipates that the Fed will eventually buckle under pressure, the Fed really is impotent.

It’s imperative, therefore, that the Fed’s commitment is explicit and concrete. By moving from a wishy-washy pseudo-promise to hold interest rates low for “an extended period” (which can mean anything) to a pseudo-promise to hold interest rates “through mid-2013”, the Fed has taken a tremendous step in the right direction. It’s still not the ideal commitment: it’s a little evasive, saying that “economic conditions are likely to warrant” near-zero rates rather than articulating any actual policy. Many commentators want a more systematic commitment, like a price level or nominal GDP target. But this is still much better than what we’ve seen from the Fed in the past, and the announcement has done a decent job of anchoring expectations: futures markets show a federal funds rate below 0.1% through mid-2013, exactly as the Fed’s statement suggests.

Much has been made of the following dissent:

Voting against the action were: Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period. (bold added)

Of course, the “extended period” language is absolutely useless for making a commitment: it’s deliberately ambiguous, designed to give the Fed as much flexibility as possible going forward.

We can only conclude that Fisher, Kocherlakota, and Plosser are not interested in even a mild expansionary commitment of the kind in the August 9 statement. This would be understandable if they had some alternative proposal—say, an aggressive price level target—for escaping the current morass. In reality, however, their votes seem to be determined (at least for Fisher and Plosser) mainly by a wildly distorted view of macroeconomic conditions.

Fortunately, the rest of the FOMC is a little more worried about the worst recession the United States has endured in over a half-century, and less sanguine about the prospects for recovery. We can only hope that they continue their turn toward more aggressive policy commitment.



Edit: I should mention the intellectual history behind the Eggertsson and Woodford piece, in particular Paul Krugman’s classic 1998 BPEA article on the liquidity trap and Japan, which was the first to give us the deliciously counterintuitive idea of “credibly promising to be irresponsible”, and reintroduced macroeconomics to the long-forgotten yet deeply important paradoxes of the zero lower bound.

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Avoiding the word “tax”

I have a new way to balance the budget. When employees are paid, I will require their income to spend one day in an escrow account, where it will be invested in “Liberty Bills”. Liberty Bills are government-issued bonds with a daily return of negative 5%. I am confident that this simple reform will eliminate the deficit.

Of course, you might argue that I’m effectively just hiking income taxes by 5%. You’d be right! “Escrow accounts” and “Liberty Bills” are just a needlessly complicated way for me to impose an income tax. Only someone incredibly naive would think that my policy was substantively different from an income tax, right?

Maybe not. In fact, I see similar proposals all the time.

Consider the following: when Dean Baker proposes that we cancel the Treasury debt held by the Fed, he’s essentially saying (aside from the temporary accounting gimmick) that we should undertake a long-term shift in the composition of debt, from bonds to money. Why? Most observers suspect that the Fed will eventually pull back the money created through quantitative easing. To so, however, it needs to sell lots of assets—and if half of its assets disappear, this is no longer a viable option. Under Baker’s proposal, then, the Fed will be forced to leave over $1 trillion in excess reserves in the system, until it recapitalizes through profits (far in the future) or is bailed out by Congress (in which case the proposal is completely circular). Debt that would otherwise be issued by the Treasury will be left in the form of money instead.

What happens then? Quite possibly nothing. With so many reserves in the system, the premium on reserves will linger around zero—no one will sacrifice yield to hold reserves when equivalent riskless assets are available. The rate paid on reserves, the federal funds rate, and the short-term T-bill rate will all be roughly the same. In this environment, issuing debt in the form of money rather than bonds is completely useless: you can borrow at the same rate with T-bills. Monetization changes nothing.

What Baker proposes, however, is to vastly increase the burden of reserve requirements, such that there is no longer an excess supply of reserves. At this point, banks are willing to pay a premium for reserves, the Fed is able to pay interest on reserves at a rate lower than the rate on T-bills. Money becomes a cheaper form of finance than bonds, and we see a fiscal benefit.

But what’s really happening? The Fed saves money in this scenario only because the new reserve requirements force banks to carry a low-yield asset (reserves) in order to accept deposits. In other words, the Fed is taxing bank deposits. In fact, Congress could impose precisely the same tax through legislation: a statutory tax of (federal funds rate – interest on reserves)*(reserve requirement) would be equivalent.

Of course, hardly anyone* wants us to enact an ad-hoc tax on certain types of bank deposits: it’s not a very efficient way to raise money, and it’s quite possibly regressive. I can easily think of a dozen more effective ways to boost revenue. So why does anyone take this proposal seriously? As far as I can tell, it’s because a “reserve requirement” doesn’t sound like a tax. It’s not obvious that this policy is just another distortion-inducing way to gather revenue, and that it should be subject to the same cost-benefit analysis as any tax. As with many proposals for means testing, we’re so eager to escape uncomfortable fiscal tradeoffs that we invent a new, needlessly circuitous way to tax, one that’s even less efficient than the existing tax code.

I’m still fond of Liberty Bills myself.


*As I mentioned in my last post, there are serious proposals for taxing “liquidity creation”, but properly implementing these proposals would produce a policy so different from today’s reserve requirements that it’s a stretch to use the same name.

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Required reserves: much smaller than you think

The blogosphere has already responded in force to Dean Baker’s strange proposal to destroy the $1.6 trillion in Treasuries held by the Fed and use increased reserve requirements to maintain the Fed’s balance sheet once QE is withdrawn. Greg Mankiw poses it as an “exam question”, and rightly observes that the proposal is a mixture of accounting gimmickry and financial repression. (To be fair, the “accounting gimmick” is part of the intent: the idea is to circumvent the statutory debt limit.)

But there’s also a simpler, quantitative problem with Baker’s analysis: he doesn’t seem to have any clue how small required reserves currently are. Let’s take a look:

Currently, banks need to hold only $80 billion in reserves. And that’s in the midst of an ongoing recession, where consumers and businesses have plowed money into liquid assets and, through interest on reserves, the Fed has eliminated the cost of keeping money in accounts with a reserve requirement. Before the spectacular recent increase, the level of required reserves was closer to $40 billion.

The difference between $40 billion and $80 billion, however, is minimal compared to the $1.6 trillion that Baker proposes to capture using a reserve requirement. Currently, the reserve requirement is set at 10% of checking account balances. Even if we increased the reserve requirement to 100%, we’d only be halfway to $1.6 trillion—and that’s under the extraordinarily unrealistic assumption that these balances would stay at their recessionary highs even after a vast expansion in the cost of holding reserves!

How hard is it to get to $1.6 trillion? Let’s say that we broadened the scope of the reserve requirement to cover everything contained in the M2 aggregate: savings deposits, money market deposit accounts, small-denomination time deposits, and retail money market funds. That’s roughly $9 trillion, or $8 trillion after we subtract currency. $1.6 trillion is 20% of $8 trillion. So yes, we can induce a demand for reserves of $1.6 trillion by doubling the reserve ratio and vastly expanding the pool of deposits covered. But even this ignores the fact that depositors would quickly abandon the assets covered by the new requirement, to the point where the total would be far less than $8 trillion.

Of course, if you cast a wide enough net, it’s quite possible to reach $1.6 trillion: US households have almost $50 trillion in financial assets. But you have to ask why this would be a remotely desirable way to raise money. Reserve requirements are effectively a tax on deposits: at the very least, banks are forced to sacrifice the spread between perfectly safe assets (like T-Bills) and reserves (which have traditionally paid zero). Why does Baker think this is a efficient tax? It seems awfully bizarre to me: not only are you taxing savings, which is already inefficient, but you’re restricting the tax to a certain form of savings, which is all the more arbitrary and inefficient. (Not to mention regressive—Grandma’s savings account is taxed while hedge funds are not.)

To be fair, there are serious proposals to use reserve requirements as a regulatory tool, taxing risky liquidity creation to bring it down to the socially optimal level. But to do this properly, you’d need to completely redefine the requirements’ scope: the real risk to the financial system comes from “shadow banking” like repo and commercial paper, not traditional retail deposits. Is this what Baker is proposing? If so, that’s fine—but he certainly doesn’t give any hint of it.

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The problem with velocity

Nick Rowe argues that the “natural rate of interest” in modern New Keynesian economics is no better than the “velocity” in monetarist models, and quite possibly worse:

The Old Keynesians have been replaced by New Keynesians. And the Old Monetarists have been replaced by….umm…mostly New Keynesians too. (Us “quasi monetarists” are too few and too lacking in influence to really count). So the old debate is now moot. But velocity isn’t totally dead as a concept…

So now I’m going to respond with “Y tu mama tambien!”.

Very very crudely, and over-simplifying massively, New Keynesians replace PY=MV with delta(PY)=(natural rate of interest – actual rate of interest). If the central bank sets the actual rate of interest below (above) the natural rate of interest, then nominal income will rise (fall)…

So. Neither is constant. Which is more stable? Velocity, or the natural rate of interest?

At least velocity never goes negative, which is more than you would say yourselves about your natural rate of interest. And your mother wears army boots!

“Stability” isn’t the right criterion. Consider this: over the past 50 years, the ratio of GDP to government spending has been remarkably consistent, always confined between 4 and 6, and staying within even narrower intervals over the medium term. That’s more stable than velocity! If I were a fanatical Old Keynesian, I might use this as evidence that we should really be looking at the government expenditure multiplier as the key to policy.

Of course, this would be silly. Government expenditure doesn’t create all other activity in the economy through some “multiplier” process. Instead, it’s relatively consistent with respect to GDP because voters and politicians want it that way: their preferences over taxes and government services are such that they’ve sought a government that accounts for somewhere between one-sixth and one-fourth of the economy. In other words, the causation runs from GDP to government spending, not the other way around.

Is velocity any different? I doubt it. To the extent that velocity is “stable”, what’s actually happening is that consumers want to hold money balances as a relatively consistent fraction of nominal income. Sure, the ratio is stable, but the denominator causes the numerator, not the reverse.

This is tough to verify, of course—if the relationship actually is stable, then without auxiliary assumptions we can’t say where the causation lies. But some historical episodes offer hope. Consider, for instance, the savage recession of the early 80s, which is near-universally acknowledged as the result of Volcker’s fight against inflation. Can we identify a change in the monetary base that matches the magnitude of the recession, or even comes close? Not at all; it’s barely a blip. What about a higher-level monetary aggregate like M2? Again, nothing. Compare that to the obvious slump in nominal GDP. When it mattered, velocity wasn’t so stable after all.

Why? It’s easy to interpret with the right theory. Consumers desire money balances roughly in proportion to their nominal income, with some adjustments made for the nominal interest rate. Consumers are also sluggish in reoptimizing their portfolios. When the Fed contracts the supply of base money even slightly, slow reoptimization means that a dramatic increase in the nominal interest rate is necessary to clear the market. Since interest rates are now well above the “natural rate”, we see recession and disinflation.

Does velocity-centric monetarism offer any similarly coherent account of the Volcker recession? I don’t see it. What made velocity collapse between mid-1981 and 1983?

Ultimately, velocity is just a residual, one without much practical role in monetary policy.

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There has never been a money multiplier

In an interesting talk last week, San Francisco Fed president John Williams spoke about the need to modernize economics education. His remarks on the death of the “money multiplier” caught my eye:

The breakdown of the standard money multiplier has been especially pronounced during the crisis and recession. Banks typically have a very large incentive to put excess reserves to work by lending them out… If a bank were suddenly to find itself with a million dollars in excess reserves in its account, it would quickly try to find a creditworthy borrower and earn a return on that one million dollars…

But, this hasn’t happened—not at all. The Federal Reserve has added $1.5 trillion to the quantity of reserves in the banking system since December 2007. Despite a 200% increase in the monetary base—that is, reserves plus currency—measures of the money supply have grown only moderately….

Why has the money multiplier broken down? Well, one reason is that banks would rather hold reserves safely at the Fed instead of lending them out in the still struggling and risky economy. But, once the economy improves sufficiently, won’t banks start lending more actively in order to earn greater profits on their funds? And won’t that get the money multiplier going again? And can’t the resulting huge increase in the money supply overheat the economy, leading to higher inflation? The answer is no, and the reason for this is a profound, but largely unappreciated change in the inner workings of monetary policy….

I’m referring to the 2008 legislation that allowed the Fed to pay interest on bank reserves…

John Williams is an outstanding macroeconomist, far more knowledgeable that I am—and when he attributes the death of the money multiplier to interest on reserves, I’m hesitant to disagree with him. But as far as I can tell, this dramatically overstates the impact of interest on reserves. In reality, the “money multiplier” broke down because it never really existed in the first place.

Here’s the textbook story: as the Fed pumps reserves into the system, banks suddenly have the ability to increase their lending and create new money. Since the reserve requirement on checking accounts is 10%, any increase in bank reserves will lead to money creation ten times the size of the initial injection.

Casual observation suggests some problems with this story. After all, money market funds share many of the characteristics of checking accounts, and yet they have a reserve requirement of zero. Shouldn’t that make the money multiplier infinity? Since the money supply clearly isn’t infinity, there must be something other than reserve requirements limiting money creation.

And that’s the key point: even in normal times, the cost of meeting the reserve requirement accounts for only a small portion of the cost of creating money. If you’re accepting checking deposits and lending them out when the riskless nominal interest rate is 4%, you’re losing 10%*4% = 0.4% each year because the reserve requirement forces you to hold base money rather than T-bills. That’s not trivial, but it’s hardly overwhelming: the much more challenging part of a bank’s job is finding a decent borrower. If the reserve requirement falls from 10% to 5%, and the cost of holding reserves declines from 0.4% to 0.2% (if the riskless rate stays the same), you’re not going to suddenly find twice as many places to lend the money.

I’ve been over this before, but let’s try another analogy. Suppose you live on an isolated island filled with peanut farms, where peanuts are turned into peanut butter with tiny, handheld machines. There are lots of peanuts, but not many machines; since each machine can only produce a certain amount of peanut butter each month, local economists observe a extraordinarily close relationship between the supply of machines and the supply of peanut butter. They call this relationship the “peanut butter multiplier”.

Suddenly, unexpected visitors descend on the island with a boatload of peanut butter machines. There are now so many machines that the supply of peanuts can’t keep up. Many machines sit idle, and economists are shocked to see the “peanut butter multiplier” disappear. The ratio of peanut butter production to peanut butter machines plummets.

Obvious enough, right? Now that peanuts are the scarce input rather than machines, the direct relationship between machines and peanut butter production no longer holds. But the mechanics of the “money multiplier” are really no different: like the machines in my story, bank reserves are one input for money creation. They’re not the only input, however, or even the most important one; you can’t have peanut butter without peanuts, and you can’t have money creation without creditworthy borrowers.

It’s true that historically, there has been a direct relationship between reserves and deposit creation. Excess reserves have stayed at roughly zero, as banks hold precisely the amount necessary to satisfy their reserve requirements. But that’s just an artifact of how monetary policy is conducted: at the margin, the only reason banks hold reserves is that they need to meet reserve requirements, and as long as the federal funds rate is greater than zero (so that reserves are costly), they will limit their holdings to the bare minimum that’s acceptable under the rules. Since the federal funds rate was always significantly greater than zero until the last few years, there were no excess reserves. And now there are:

Technically, the federal funds rate is still a little higher than zero. With interest on reserves, however, there is now zero cost to holding reserves—in fact, the cost is slightly negative, as mysterious technical issues prevent banks from arbitraging away the (small) gap between the rate paid on reserves and the federal funds rate. Now that reserves are costless to hold, textbook microeconomics tells us that the relationship between reserves and money creation will break down: the reserve requirement is no longer a binding constraint, and the other costs of taking and lending deposits will determine banks’ activity.

Is there any reason to think this would be different if there was no interest on reserves, and the federal funds rate fell to zero? Not at all. We’d see the same pattern: with the rate at zero, reserves would no longer be a costly input, and other costs would dominate instead.

Lest you think this is all overconfident theorizing on my part, let’s consider the obvious empirical example: Japan. In 2001, Japan began its policy of quantitative easing, which resulted in an enormous increase in the supply of base money. Interest on reserves, however, wasn’t paid until 2008. What happened in the meantime? A 2003 paper asking “Who Killed the Japanese Money Multiplier?” makes the outcome clear enough.

I often see articles attributing the breakdown of the money multiplier to some special feature of the current economic climate: interest on reserves, or banks’ reluctance to lend during a recession. In truth, the reason is much simpler. The money multiplier has never been a deep structural relationship. The apparent “multiplier” in the data is no more profound than the relationship between peanut butter machines and peanut butter. When an input is scarce, output will move with it. When the input is no longer scarce, output will not.

No surprises here.

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Why do safe, liquid assets become so expensive in a financial crisis?

In my last post, I argued that the “liquidity” premium was one of the fundamental drivers of the recession. In exactly the same way that a small drop in the supply of cash can cause a massive spike in the nominal interest rate (quite possibly leading to a recession), small shifts in the supply and demand for liquidity can drive up the liquidity premium and push other interest rates to disastrously high levels—even when the Fed does its best with conventional monetary policy.

But why should the liquidity premium change so much, anyway? Brad DeLong is rightly skeptical:

Now we understand why demand for money–what I call liquidity–is so interest-inelastic. You need money to buy stuff. If you don’t have money, you can’t buy stuff–and so when you are short of money you cut back your spending because you must and so build your money balances back up.

But why is the demand for what Matt calls “liquidity” and I call “safety” so interest-inelastic in a financial crisis? It’s not that you have to cut back on your spending on currently-produced goods and services–you have plenty of cash money. But you are unwilling to part with some of your cash money because it is now–and here our terminological problem begins–part of your holdings of liquid cash money are now in the the delong-safe or the rognlie-liquid tranche of your portfolio that you feel you must retain at all costs.

But why must you retain it? Why not buy risky assets when there is blood in the streets? Why not become a stabilizing speculator and become a supplier of rather than a demander of delong-safe or rognlie-liquid assets?

First, to clear up my self-imposed terminological confusion, I’ve been using “liquidity” as a catch-all for many properties that distinguish base money: its complete lack of nominal risk, its short (indeed, zero) maturity, and its usefulness in transactions (which is what we’d often call “liquidity”). The key idea is that many assets resemble base money in all these respects, but aren’t quite the same—they can’t be carried around on green pieces of paper or used to satisfy the reserve requirements on checking accounts. I’ll call these assets cashlike.

What are cashlike assets? T-bills, commercial paper, and repo—plus the money market funds that invest in them. Traditional checking deposits, too—though perhaps only up to the cap on deposit insurance.

Why is the demand for cashlike assets so inelastic? To some extent, it’s for the same reasons that Brad argues the demand for cash money should be interest-inelastic: you need it to buy stuff, or more generally to conduct transactions. If the premium on cashlike assets rises, cutting back on the cashlike part of your portfolio might make it very difficult to go about business as usual—and that’s potentially much more costly than just coughing up the premium.

Now, this isn’t a fully satisfying answer. It’s not as if every dollar in a money market fund is absolutely necessary for some business to continue its operations. But the same is true for cash: when interest rates rise to 6%, paying all your bills with cash (or keeping a pile of $100s under the bed) should be much less attractive. You’d think there would be some demand response—a few holdouts finally deciding to pay with debit cards, or drug lords maneuvering their cash stockpiles into a bank account. And yet there’s virtually none: the naked eye cannot identify even dramatic shifts in monetary policy from the trajectory of currency over the last 40 years.

For some reason, portfolio substitution away from cash is incredibly, incredibly slow and weak. Why should we be surprised if the same is true for cashlike assets as well?

Inelastic demand, of course, isn’t sufficient to cause large swings in the premium on cashlike assets. We also need inelastic supply. And as Brad points out, it’s not clear why this should be true either:

We know why people don’t turn around and become suppliers of liquid cash money when the money stock contracts: they can’t, for nobody else’s liabilities are good as payment for transactions in currently-produced goods and services. But surely Berkshire Hathaway or Microsoft or Northrup-Grumman could have sold lots of bonds at attractive values. Why didn’t they?

According to the Federal Reserve Flow of Funds tables, at the end of 2008 there was $3.8 trillion in bonds issued by nonfinancial corporations, along with $132 billion in commercial paper. But only a small fraction of that $3.8 trillion was issued by corporations with credit sufficiently good that it could plausibly be transformed into a cashlike asset. (After all, the companies with really good credit ratings tend to be precisely the ones with low leverage.)

Even if every AAA corporation doubled its debt overnight, issuing all the new debt in the form of commercial paper, the supply of cashlike assets wouldn’t increase by anything close to $1 trillion—which is a lower bound on the decrease in supply associated with the financial crisis. (Flow of Funds table L.207 shows a nearly $1 trillion drop from 2007 to 2008 in repo + federal funds. Over the same period, table L.208 shows that there was a $200 billion decline in open market paper—which becomes a $900 billion decline if you compare the 2006 peak to the 2010 trough.)

But AAA corporations didn’t even do this; in fact, there was barely any response to the sudden availability of extremely cheap financing. Why? I’m not completely certain, but this isn’t much of a mystery next to all the other mysteries of corporate finance. If it’s hard to explain why Berkshire Hathaway didn’t immediately take advantage of, say, a 4% premium on cashlike debt, it’s infinitely harder to explain why a financially sound corporation doesn’t lever up when the tax advantages could add 15% to firm value in an instant.

Bottom line: corporations, at least in the short run, are unlikely to provide a very elastic supply response to a change in the premium on cashlike assets.

What other asset suppliers might step in? Again using Flow of Funds Table L.2, we can see the amount of various debt instruments owed by nonfinancial sectors in 2008:

  1. Mortgages: $14.4 trillion
  2. Treasuries: $6.3 trillion
  3. Corporate bonds: $3.8 trillion
  4. Municipal securities: $2.7 trillion
  5. Consumer credit: $2.6 trillion
  6. Bank loans not elsewhere classified: $1.8 trillion
  7. Other loans and advances: $1.8 trillion
  8. Commercial paper: $0.1 trillion

Aside from money created by the Fed, any additional supply of cashlike assets has to come from one of these categories—maybe it’ll be packaged by a financial intermediary, but ultimately it must rest on some claim on the nonfinancial sector. But which one? Treasuries, eventually—but in the meantime, what elastic source of supply is there?

Clearly the biggest category, mortgages, was useless in 2008: the whole point of the crisis was that previously riskless mortgage-backed securities suddenly became questionable. As the possibility of 10% unemployment loomed, consumer credit wasn’t looking good either. And it has never been very practical to turn other loans—loans to idiosyncratic borrowers, without standard collateral like a house or office building—into securitized assets that can be traded like cash. (That’s why we have traditional banks in the first place.)

Now, with enough time and energy, financial institutions could have stepped in and created new assets: you could take a diversified portfolio of Baa corporate bonds and mark off the top 50% as an AAA tranche. (Short of the Rapture, it’s hard to imagine the default losses on a large portfolio of Baa bonds being even 10%, much less 50%.) But this kind of financial alchemy isn’t instantaneous—it takes time and resources, both of which were in short supply during the crisis of 2008.

And there’s still the problem of maturity mismatch: even if banks manage to put together a new crop of nominally riskless long-maturity assets, transforming them into cashlike assets requires someone to borrow short and buy long. In the midst of the financial crisis, this was not easy to do; the banking system was largely incapacitated, with institutions either unwilling or unable to subject themselves to more rollover risk. Anyone using repo funding had to cough up the haircut, which was 6% even for long-term Treasuries in fall of 2008. (Not to mention 20% for A-/A3 or greater corporate bonds, 30% for many asset-backed securities, and 40% for “AAA” MBS, as documented by Table 4 in Arvind Krishnamurthy’s excellent piece.)

In short, there were very powerful forces keeping the supply of cashlike assets inelastic during the financial crisis.

Of course, this still feels unsatisfying. Shouldn’t someone have stepped in when the premium on cashlike assets was high enough to cause a deep recession—a recession that led to perhaps $20 trillion in financial losses? The magnitudes don’t match: why did a comparatively tiny shortfall in this one market lead to catastrophic outcomes in the broader economy?

As I pointed out in the last post, the answer is that there’s an externality, potentially a very large one. Once the federal funds rate hits the zero lower bound, the premium determined in the market for cashlike assets has a direct impact on the yield of every asset in the economy. It doesn’t matter how small the market for cashlike assets is compared to the economy as a whole: if the premium on T-bills increases by 2%, the cost of capital for everyone (at least everyone who can’t issue cashlike debt) will go up by 2%. In this setting, a bank deciding to issue more commercial paper internalizes only a tiny fraction of the social benefits from its decision: sure, it gets some cheap funding, but by bringing down the premium on cashlike assets it changes financing decisions across the board.

We typically think that banking crises are bad because banks play an important role in providing credit. No doubt this is true to an extent. But banks are also important because they are uniquely responsible for the creation of cashlike assets—assets that become fully substitutable for cash at the zero lower bound, and whose premium influences every interest rate in the economy. This is where the true power of a banking crisis kicks in: if the central bank doesn’t respond in the right way, all credit (even credit not provided by banks) becomes ruinously expensive.

That is what we faced in 2008—and what I hope we never face again.

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