Might raising interest rates, but not paying interest on reserves, actually be "stimulative," inducing banks to lend out reserves?
Last week, I gave a talk on monetary policy at a forum organized by the Becker-Friedman institute. I explained my view, that as long as reserves pay the same interest rate as very short-term Treasuries, and as long as banks are holding huge amounts of excess reserves, that monetary policy and pure quantitative easing -- buy short-term treasuries, give the banks more reserves -- has absolutely no effect on anything. Interest-paying excess reserves are exactly the same thing as short-term treasuries.
When the time comes to tighten, I said, I hope dearly that the Fed continues to pay a market interest rate on reserves and allow huge amounts of excess reserves to continue. (I had lots of financial-stability reasons, which will wait for another day here.) But that means that conventional open market operations and quantitative easing -- more reserves, less Treasuries -- will continue to have no effect whatsoever.
An audience member asked a very sharp question: Suppose the Fed raises interest rates but does not raise the rate on reserves? Now, banks do have an incentive to lend them out instead of sitting on them. Wouldn't velocity pick up, MV=PY start to work again, and the Fed get all the "stimulus" it wants and then some?
It's a particularly sharp question, because it gives sensible-sounding mechanism why the conventional sign might be wrong: why raising rates now might give monetary "stimulus" that is otherwise so conspicuously lacking. There are a few other of these stories wandering around. One: Low rates are said to discourage retirees and other savers, who now "can't afford to spend." (Quotes around things that don't make much economic sense.) John Taylor, wrote a very provocative WSJ oped, (too subtle to summarize in one sentence here) and also came close to saying the sign is wrong and higher rates would be more stimulative.
But is the suggestion right? I sort of stammered, and needed the weekend to think it through. (Giving talks like this is a great way to clarify one's ideas. Or maybe this just reveals my shocking ignorance. In any case, it makes a good exam question.) Think about it, and then click the "read more."
The answer is no, I think, but revealing about what the Fed can and cannot do.
How exactly would the Fed raise interest rates?
In the new interest-on-reserves regime (the one I hope will continue) the Fed simply announces, "we borrow and lend reserves at 3%." Interest rates go up to 3%. But so do interest rates on reserves.
The standard mechanism, which allows reserves not to pay interest, would be for the open-market desk to sell securities in exchange for reserves, in order to drive down the supply of reserves until interest rates rise on the inter-bank (federal funds) market. Banks who need reserves then are willing to pay interest to borrow non-interest-paying reserves overnight to satisfy reserve requirements on their checking accounts.
You see the trouble. Rather than "get banks to lend out the reserves," the Fed has to soak up all those reserves in order to raise interest rates in the first place.
Like other central banks, the Fed could offer prices rather than control quantities. Other central banks set rates in the interbank market, by simply saying "we borrow and lend at 3%. Come and get it." (They may leave a window, borrow at 2.9%, lend at 3%, to keep a private market going.)
If the Fed were to do this, banks would simply take all the reserves -- money lent to the Fed overnight -- and... lend it to the Fed overnight at the higher interest rate. This is interest on reserves by another name, no more no less. To the extent that the Fed ties up the money -- borrows at term, or otherwise makes its offer more "bond" like -- this action just synthesizes the huge open market operation that drains reserves from the system. (It's not a bad idea, though, if the Fed wants to shrink reserves without selling assets!) Again, the desired incentive to get banks to "lend out" the reserves vanishes.
What if the Fed offers a price target for Treasuries, and also refuses to pay interest on reserves? Could the Fed offer to buy and sell 3 month Treasuries at 3%, but insist on no interest on reserves and no open market operations to soak up reserves? No, because offering to buy and sell Treasuries means offer to take reserves and give out treasuries, which ipso facto soaks up the reserves again.
The Treasury could (and arguably should) take over interest-rate policy. After all, in the interest-on-reserves regime, when the Fed says "3%, come and get it," short-term Treasury rates will also jump to 3%. (Banks dump Treasuries and give the proceeds to the Fed, driving up Treasury rates.) It is exactly as if the Treasury said, "Rather than auction 3 month debt, we'll set the rate at 3%, and the market sets the quantity." If you think the quantity reaction might be large, you've figured out some usually unspoken limits on the Fed's interest-rate setting abilities.
But reserves are our numeraire. Pegging interest rates at 3% means the Treasury rather than the Fed takes in reserves in exchange for debt, and parks it in the Treasury account rather than bank's accounts at the Fed. The banks will again drain reserves rather than "lend them out."
The Treasury could commit to immediately spend the money... But now we're in the land of fiscal, not monetary stimulus, and a reminder that the two always come together.
I'll be interested to hear comments on this one. The standard stories by which interest rate increases are contractionary are very weak and full of holes. The idea that perhaps raising interest rates is "stimulative" is fun to think about. And a number of schemes around to get banks to "lend out the reserves" are also fun to think about. I don't think this one works, but maybe one of you can get it to work.
Tuesday, June 4, 2013
Sunday, June 2, 2013
Forward Guidance vs. Commitment
He: "Honey, I'm getting tickets for Sunday's football game. Do you want to come?"
Forward guidance. She: "As things look now, I think I'll feel like coming when Sunday rolls around. Of course that might change. If my mother calls and wants to go shopping I might well feel differently."
Commitment. She: "Sure, honey, that sounds like fun. Get the tickets. I know my mom might call, and I'll regret it later, but we have to get the tickets now, so count me in."
Commitment means declaring a plan, even a contingent plan, that you will follow, even if you will regret it later. Forward guidance means announcing now what you think you will feel like doing in the future, but not giving up any discretion to change your mind later. Obviously, to someone who has to plunk down money for tickets, commitment is useful.
These issues came up in the last year's fascinating discussions about monetary policy, and brought to the forefront again by Fed Chairman Ben Bernanke's testimony on May 22, the subsequent question and answers, the FOMC meeting, and market gyrations and controversy surrounding these events.
The words that roiled the markets were, most briefly, "in considering whether a recalibration of the pace of its purchases is warranted, the Committee will continue to assess the degree of progress made toward its objectives in light of incoming information." Recalibration? Says the market.
Perceptions matter as much or more than actual statements here (this is the "managing expectations" game). The Wall street journal wrote
Why does this matter? It's an interesting denoument to a big discussion in academia, the Fed, and the broader evolution of central banking doctrine (I hate to say "theory" as it's all pretty loosey-goosey).
The idea was that the Fed can stimulate the economy by committing now to keep policy expansionary for longer than it will want to do ex-post. I last wrote about this in "managing a liquidity trap." For the previous year, highlighted by a stellar speech by Mike Woodford at Jackson hole (see previous post), this idea was all the rage.
In the standard new-Keynesian model, consumption is low today because its future level is anchored, and a too-high path of real interest rates makes consumption grow too fast. Hence the current level of consumption is too low. That level can be raised by lowering expected future interest rates and hence expected future consumption growth just as effectively as by lowering today's interest rates and today's consumption growth. (If this all seems insane, read here.) So, goes the story, the key to stimulus when interest rates are zero is for the Fed to commit to keeping interest rates low, lower than than we and the Fed know it will want them to be when the time comes.
I expressed some doubts that the Fed would ever make such a commitment, or that people would believe it if it tried to do so. (I also expressed some doubts at the whole modeling approach, but that's not important now.) These events seem to prove that conjecture in spades.
The vast market gyrations, and the Economist's trenchant quote are especially interesting. If the Fed had been committed to a path, or even to a rule (no change until unemployment falls below 6.5%), and most of all if people thought it had such a commitment, then Mr. Bernanke's answers to questions from congressmen should have no effect.
If only commitment now to do things you will regret later were so easy as it is in our models. This is not a criticism of the Fed. Imagine the Fed chair explaining to Congress that he is keeping rates lower than everybody thinks they should be, with unemployment down to 5% and inflation heating up at 4%, because he made that commitment in order to stimulate the economy back in 2012. Commitments need more than words. It's easy in a model to write "the Fed commits to x," like a new inflation target or interest rate path. It's easy to write opeds that "the Fed should commit to x." Generating such a commitment -- which means, by definition, something that constrains your actions in the future -- is not so easy.
Benn Steil has a nice blog post and more media links.
Forward guidance. She: "As things look now, I think I'll feel like coming when Sunday rolls around. Of course that might change. If my mother calls and wants to go shopping I might well feel differently."
Commitment. She: "Sure, honey, that sounds like fun. Get the tickets. I know my mom might call, and I'll regret it later, but we have to get the tickets now, so count me in."
Commitment means declaring a plan, even a contingent plan, that you will follow, even if you will regret it later. Forward guidance means announcing now what you think you will feel like doing in the future, but not giving up any discretion to change your mind later. Obviously, to someone who has to plunk down money for tickets, commitment is useful.
These issues came up in the last year's fascinating discussions about monetary policy, and brought to the forefront again by Fed Chairman Ben Bernanke's testimony on May 22, the subsequent question and answers, the FOMC meeting, and market gyrations and controversy surrounding these events.
The words that roiled the markets were, most briefly, "in considering whether a recalibration of the pace of its purchases is warranted, the Committee will continue to assess the degree of progress made toward its objectives in light of incoming information." Recalibration? Says the market.
Perceptions matter as much or more than actual statements here (this is the "managing expectations" game). The Wall street journal wrote
Wednesday's flurry of new information jostled markets, which moved up when Mr. Bernanke's congressional testimony was released in the morning, then pared triple-digit gains when he began taking questions and turned negative when the minutes were released in the afternoon....Taken together, the chairman's testimony before the Joint Economic Committee and the minutes suggested that Fed officials aren't yet near consensus on when to begin to wind down the bond buying but that a decision appears to be approaching in the months ahead. ...
"Rather we would be looking beyond that to seeing how the economy evolves and we could either raise or lower our pace of purchases going forward. Again that is dependent on the data," he [Mr. Bernanke] said.
The minutes of the most recent policy meeting said "a number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth."The Economist wrote (my emphasis)
But, the minutes added, "many [officials] indicated that continued progress, more confidence in the outlook, or diminished downside risks would be required before slowing the pace of purchases would become appropriate."
One of the main points Mr Bernanke tried to make was that if QE slows, it will "not be an automatic mechanistic process." For example, if it drops from $85 billion to $65 billion, it need not drop to $45 billion at the next meeting. It could stay at $65 billion or if the data worsen, go back to $85 billion. This isn’t that surprising; the Fed always reserves the freedom to respond to the data and hates feeling boxed in by market expectations.This all scores somewhere between total discretion (we'll do whatever we think is right given the data at the time) to a degree of forward guidance (here is an outline of what we think now we'll feel like doing, but of course we might change our minds.)
Why does this matter? It's an interesting denoument to a big discussion in academia, the Fed, and the broader evolution of central banking doctrine (I hate to say "theory" as it's all pretty loosey-goosey).
The idea was that the Fed can stimulate the economy by committing now to keep policy expansionary for longer than it will want to do ex-post. I last wrote about this in "managing a liquidity trap." For the previous year, highlighted by a stellar speech by Mike Woodford at Jackson hole (see previous post), this idea was all the rage.
In the standard new-Keynesian model, consumption is low today because its future level is anchored, and a too-high path of real interest rates makes consumption grow too fast. Hence the current level of consumption is too low. That level can be raised by lowering expected future interest rates and hence expected future consumption growth just as effectively as by lowering today's interest rates and today's consumption growth. (If this all seems insane, read here.) So, goes the story, the key to stimulus when interest rates are zero is for the Fed to commit to keeping interest rates low, lower than than we and the Fed know it will want them to be when the time comes.
I expressed some doubts that the Fed would ever make such a commitment, or that people would believe it if it tried to do so. (I also expressed some doubts at the whole modeling approach, but that's not important now.) These events seem to prove that conjecture in spades.
The vast market gyrations, and the Economist's trenchant quote are especially interesting. If the Fed had been committed to a path, or even to a rule (no change until unemployment falls below 6.5%), and most of all if people thought it had such a commitment, then Mr. Bernanke's answers to questions from congressmen should have no effect.
If only commitment now to do things you will regret later were so easy as it is in our models. This is not a criticism of the Fed. Imagine the Fed chair explaining to Congress that he is keeping rates lower than everybody thinks they should be, with unemployment down to 5% and inflation heating up at 4%, because he made that commitment in order to stimulate the economy back in 2012. Commitments need more than words. It's easy in a model to write "the Fed commits to x," like a new inflation target or interest rate path. It's easy to write opeds that "the Fed should commit to x." Generating such a commitment -- which means, by definition, something that constrains your actions in the future -- is not so easy.
Benn Steil has a nice blog post and more media links.
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