Not much time for blogging these days, but I thought I would contribute to this discussion by David Andolfatto, Tyler Cowen, Paul Krugman, and Brad DeLong.
Here are the facts: (i) The short-term nominal interest rate is essentially at the zero lower bound (ZLB); (ii) real bond yields (of all maturities) are very low relative to history. People have a hard time explaining those facts with Keynesian models. In a typical sticky price New Keynesian model, the problem that the ZLB can present for monetary policy is that the real rate of interest is too high, and there is no way to lower it. But if one thinks that history is a guide to what is right, then it looks like what is wrong is that the real rate is too low, not too high.
How do New Keynesians deal with this? If you read Ivan Werning's paper, for example, you'll see that he sidesteps the question. In Werning's model, the central bank wants to be at the ZLB because there is a negative shock to the natural rate of interest, and he analyzes how policy should deal with that problem. But what's a natural rate shock? I don't think we want to think of the financial crisis as a change in preferences, with everyone becoming contagiously more patient, any more than we would want to think of the Great Depression as a contagious attack of laziness.
If you press New Keynesians on this question, they will say that the natural rate shock - or preference shock - stands in for something that is going on in another type of model. One explanation I have heard appeals to incomplete markets frameworks. In such models, if exogenous debt limits for individuals fall, then the real interest rate will go down. In those models, the real rate is always below the "natural rate," which is the rate of time preference, and the gap between the natural rate and the actual real rate depends on how tight borrowing constraints are. There's something like this going on in Eggertsson and Krugman's paper.
But carry that one step further. Why would borrowing constraints be tighter in the world we're living in now? One explanation could be that collateral has become more scarce. The financial crisis essentially destroyed a large quantity of privately-produced collateral, which took the form of asset-backed securities. Government debt is a substitute for privately-produced collateral, and with a lot of sovereign debt in the world looking very dodgy, the world demand for the debt of the US government is very high. Assets that are used in financial exchange, and which serve the role of collateral in credit transactions carry a liquidity premium. The prices of those assets are higher than their "fundamental," where the fundamental price is what would be justified purely by the future payoffs on the assets and risk. The more scarce the assets are, the higher the liquidity premia, and the higher the prices. Higher asset prices is the same thing as low real interest rates. Simple.
Thus, the explanation is not a drop in "natural" rates of interest. It's the scarcity of safe assets for use as collateral and for exchange in financial markets.
I've been thinking about this a lot lately, and think I have come up with something interesting. I'm presenting some preliminary work on this on Monday at this conference. I'll tell you more later when I have the bugs worked out.
Friday, April 12, 2013
Tuesday, March 19, 2013
Ben Bernanke and the Term Structure of Interest Rates
The FOMC meets today and tomorrow, and will likely vote to continue with its current program of purchases of $85 billion per month in mortgage-backed securities and long-maturity Treasury bonds - "quantitative easing." A few weeks ago, Ben Bernanke publicly articulated some of the economics behind quantitative easing. It's useful reading, but for me it was far from reassuring.
The core of Beranke's talk uses empirical work from a paper coauthored by D'Amico, English, Lopez-Salido, and Nelson at the Board of Governors. We can take this as honest empirical work, I think, but we can infer - as usual - that the work was done in part as reverse engineering. Quantitative easing (QE) came before the empirical and theoretical work that was done at the Fed to justify the policy.
But leaving aside our suspicions for now, what does D'Amico/English/Lopez-Salido/Nelson (henceforth DELN) have to say? The authors think that there are three avenues through which QE might work:
1. Expectations/signaling: QE may move asset prices because it signals something about future Fed policy actions that actually matter - through this channel the QE asset purchases don't matter directly.
2. Preferred habitat/scarcity: QE might matter because markets for assets of different maturities are at least partially segmented. Then, central bank actions that change the relative supplies of assets of different maturities will cause the term structure of interest rates to change.
3. Duration risk: The yield curve may typically be upward-sloping because long-maturity bonds are riskier assets - their prices are more volatile. If the Fed removes long-maturity bonds from public circulation, this could remove some duration risk, and therefore make asset holders more willing to bear duration risk at the margin, thus making the yield curve less steep.
If you've read this previous post, you'll understand that I don't think that either of (2) or (3) hold water. Certainly (1) does, and I wrote about that in my previous post. Basically, for political reasons QE may constrain future Fed actions in particular ways.
To address preferred habitat, we have to think about the asset transformation activities of private financial intermediaries, vs. what the Fed is capable of doing when engaging in the same types of activities. Particular individuals may have well-defined preferences over future payoffs (a preferred habitat, if you like), but private financial intermediaries are in the business of taking assets with particular future payoff streams and transforming them into liabilities with different payoff streams. Banks intermediate across maturities; and derivatives and asset-backed securities are designed to reallocate risk in particular ways, for example. Like private banks, the Fed can also transform long-maturity assets into short-maturity liabilities. If you want to construct a model of "preferred habitat," you need to model intermediation - by the Fed and private financial intermediaries. If QE is to matter in this context - for the better - it must be because the Fed is somehow better at intermediating across maturities than are private sector financial intermediaries. No one has to date carried out such a theoretical exercise. Certainly Vayanos/Vila, cited by DELN, do not do that. In the Vayanos/Vila model, preferred habitat is represented by defining preferences over assets - a poor place to start.
On duration risk: This is dubious, for two reasons. First, suppose the Treasury is considering financing its deficit with short-maturity debt vs. long-maturity debt. Why would a choice to issue long-maturity debt imply that the private sector faces more aggregate risk? Second, if the Fed purchases long-maturity bonds by issuing reserves, this does not relieve the private sector of risk, as the Fed's future payments to the Treasury (which have implications for future debt issue and taxes) are more risky. It is hard to see how the private sector can unload risk to the Fed's balance sheet.
(1)-(3) is the "theory" in the DELN paper, but most of the authors' effort went into the empirical work. Basically, they construct measures from the data that allow them to decompose nominal bond yields in ways that they think will give us a handle on the effects of QE. That part of the paper is summarized in Bernanke's speech. Here's a chart of Bernanke's that helps to explain it.
In the chart, the 10-year nominal bond yield has been broken down into three components: (i) expected average inflation (inflation premium); (ii)expected average real short rate; (iii) term premium. With risk neutrality, the first two components should explain everything. That's basically the expectations theory of the term structure, which implies that the real yield is the average of the real future short rates, plus average anticipated inflation (that's Irving Fisher). The "term premium" is then just a residual. It's not at all clear what it means, but Bernanke wants to think of it this way:
In any case, what you see in Bernanke's chart is: (i) a slow decrease in the measured expected average inflation rate, beginning in 2007; (ii) a decrease in the expected average real short rate from about 1.5% in 2007 to about 0% today; (ii) a volatile term premium that declines into negative territory beginning in the latter half of 2011. Bernanke wants to claim credit for that term premium decline - he thinks that's driven by QE. But do we trust the measurement?
I'm finding it hard to square what DELN and Bernanke are seeing with what I can eyeball in the 10 year nominal bond and TIPS yields, and in the inflation data. Here's a plot of the breakeven inflation rates from the 10-year bond yield data, and the twelve-month pce inflation rate (I know that TIPS is contingent on the CPI - I used PCE here for a specific reason).
Before the recent recession, the breakeven rate seemed roughly consistent with the average rate of inflation we were actually observing. And the breakeven rate has roughly returned to pre-recession levels, which might lead us to believe that the expected average inflation rate is about at what the average was for 2003-2007, which my eyeball tells me is 2.6-2.8%. But Bernanke is telling me that anticipated inflation has fallen, to about 2.2% currently.
Next, let's look at the raw 10-year nominal and TIPS yields.
Note in particular that Bernanke is telling us that the TIPS yield has dropped by about 2.3 percentage points from the end of the recession, but he wants us to believe that the expected average real short rate has dropped by only 1.5 percentage points. We are supposed to believe that 10-year TIPS prices are so high because TIPS have become really scarce and/or because market participants think there is less duration risk. Well, to the best of my knowledge, the Treasury has been working away to extend the average duration of the government debt, and that effect outweighs the effects of Fed asset purchases, on net. Thus government/Fed actions have made long bonds less scarce. Further, the contortions the Fed is going through would surely make most market participants more uncertain about real future rates, which would tend to increase any duration risk that might exist out there.
Some other problems:
1. DELN estimate their model for the period 2002-2011. Obviously the monetary policy regime changed dramatically after the financial crisis. How can we think of the pre-2008 data as useful for thinking about the problem?
2. The current scarcity of safe assets (for use as collateral and in financial exchange) implies that Fisher relations don't hold, so inflation premia aren't going to work as in the crude theory outlined in DELN.
3. The key problem is that the Fed is lacking a structural model. They need a model that can successfully explain the term structure of interest rates, and capture the key details of how monetary policy works - both pre-crisis and post-crisis. Without that QE, and attempts like Bernanke's to rationalize it, are just mumbo-jumbo.
The core of Beranke's talk uses empirical work from a paper coauthored by D'Amico, English, Lopez-Salido, and Nelson at the Board of Governors. We can take this as honest empirical work, I think, but we can infer - as usual - that the work was done in part as reverse engineering. Quantitative easing (QE) came before the empirical and theoretical work that was done at the Fed to justify the policy.
But leaving aside our suspicions for now, what does D'Amico/English/Lopez-Salido/Nelson (henceforth DELN) have to say? The authors think that there are three avenues through which QE might work:
1. Expectations/signaling: QE may move asset prices because it signals something about future Fed policy actions that actually matter - through this channel the QE asset purchases don't matter directly.
2. Preferred habitat/scarcity: QE might matter because markets for assets of different maturities are at least partially segmented. Then, central bank actions that change the relative supplies of assets of different maturities will cause the term structure of interest rates to change.
3. Duration risk: The yield curve may typically be upward-sloping because long-maturity bonds are riskier assets - their prices are more volatile. If the Fed removes long-maturity bonds from public circulation, this could remove some duration risk, and therefore make asset holders more willing to bear duration risk at the margin, thus making the yield curve less steep.
If you've read this previous post, you'll understand that I don't think that either of (2) or (3) hold water. Certainly (1) does, and I wrote about that in my previous post. Basically, for political reasons QE may constrain future Fed actions in particular ways.
To address preferred habitat, we have to think about the asset transformation activities of private financial intermediaries, vs. what the Fed is capable of doing when engaging in the same types of activities. Particular individuals may have well-defined preferences over future payoffs (a preferred habitat, if you like), but private financial intermediaries are in the business of taking assets with particular future payoff streams and transforming them into liabilities with different payoff streams. Banks intermediate across maturities; and derivatives and asset-backed securities are designed to reallocate risk in particular ways, for example. Like private banks, the Fed can also transform long-maturity assets into short-maturity liabilities. If you want to construct a model of "preferred habitat," you need to model intermediation - by the Fed and private financial intermediaries. If QE is to matter in this context - for the better - it must be because the Fed is somehow better at intermediating across maturities than are private sector financial intermediaries. No one has to date carried out such a theoretical exercise. Certainly Vayanos/Vila, cited by DELN, do not do that. In the Vayanos/Vila model, preferred habitat is represented by defining preferences over assets - a poor place to start.
On duration risk: This is dubious, for two reasons. First, suppose the Treasury is considering financing its deficit with short-maturity debt vs. long-maturity debt. Why would a choice to issue long-maturity debt imply that the private sector faces more aggregate risk? Second, if the Fed purchases long-maturity bonds by issuing reserves, this does not relieve the private sector of risk, as the Fed's future payments to the Treasury (which have implications for future debt issue and taxes) are more risky. It is hard to see how the private sector can unload risk to the Fed's balance sheet.
(1)-(3) is the "theory" in the DELN paper, but most of the authors' effort went into the empirical work. Basically, they construct measures from the data that allow them to decompose nominal bond yields in ways that they think will give us a handle on the effects of QE. That part of the paper is summarized in Bernanke's speech. Here's a chart of Bernanke's that helps to explain it.
In the chart, the 10-year nominal bond yield has been broken down into three components: (i) expected average inflation (inflation premium); (ii)expected average real short rate; (iii) term premium. With risk neutrality, the first two components should explain everything. That's basically the expectations theory of the term structure, which implies that the real yield is the average of the real future short rates, plus average anticipated inflation (that's Irving Fisher). The "term premium" is then just a residual. It's not at all clear what it means, but Bernanke wants to think of it this way: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.
In any case, what you see in Bernanke's chart is: (i) a slow decrease in the measured expected average inflation rate, beginning in 2007; (ii) a decrease in the expected average real short rate from about 1.5% in 2007 to about 0% today; (ii) a volatile term premium that declines into negative territory beginning in the latter half of 2011. Bernanke wants to claim credit for that term premium decline - he thinks that's driven by QE. But do we trust the measurement?
I'm finding it hard to square what DELN and Bernanke are seeing with what I can eyeball in the 10 year nominal bond and TIPS yields, and in the inflation data. Here's a plot of the breakeven inflation rates from the 10-year bond yield data, and the twelve-month pce inflation rate (I know that TIPS is contingent on the CPI - I used PCE here for a specific reason).
Before the recent recession, the breakeven rate seemed roughly consistent with the average rate of inflation we were actually observing. And the breakeven rate has roughly returned to pre-recession levels, which might lead us to believe that the expected average inflation rate is about at what the average was for 2003-2007, which my eyeball tells me is 2.6-2.8%. But Bernanke is telling me that anticipated inflation has fallen, to about 2.2% currently.Next, let's look at the raw 10-year nominal and TIPS yields.
Note in particular that Bernanke is telling us that the TIPS yield has dropped by about 2.3 percentage points from the end of the recession, but he wants us to believe that the expected average real short rate has dropped by only 1.5 percentage points. We are supposed to believe that 10-year TIPS prices are so high because TIPS have become really scarce and/or because market participants think there is less duration risk. Well, to the best of my knowledge, the Treasury has been working away to extend the average duration of the government debt, and that effect outweighs the effects of Fed asset purchases, on net. Thus government/Fed actions have made long bonds less scarce. Further, the contortions the Fed is going through would surely make most market participants more uncertain about real future rates, which would tend to increase any duration risk that might exist out there.Some other problems:
1. DELN estimate their model for the period 2002-2011. Obviously the monetary policy regime changed dramatically after the financial crisis. How can we think of the pre-2008 data as useful for thinking about the problem?
2. The current scarcity of safe assets (for use as collateral and in financial exchange) implies that Fisher relations don't hold, so inflation premia aren't going to work as in the crude theory outlined in DELN.
3. The key problem is that the Fed is lacking a structural model. They need a model that can successfully explain the term structure of interest rates, and capture the key details of how monetary policy works - both pre-crisis and post-crisis. Without that QE, and attempts like Bernanke's to rationalize it, are just mumbo-jumbo.
Wednesday, March 13, 2013
Alan Blinder Discusses the Fed's Balance Sheet
Alan Blinder has a piece in the Wall Street Journal on the size of the Fed's balance sheet and why it does and does not matter. Mostly this looks fine, but at the end of the article, he discusses a possible exit strategy from some difficult choices for the Fed:
Is there a way out? Here's one thing that could help. As I have argued for some time, the Fed should reduce the interest rate it pays on the roughly $1.7 trillion of banks' excess reserves. If it did so, banks would keep less cash on deposit at the Fed. The liberated funds would probably flow mainly into the money markets, but some would probably find their way into increased lending—which would give the economy a little boost.This is incorrect. No funds are "liberated" if the Fed reduces the interest rate on reserves. Outside money (currency plus reserves) does not go away unless the Fed actually sells assets. For example, a reduction in the interest rate on reserves from 0.25% to 0% would reduce the willingness of financial institutions to hold reserves, but that can only mean that, ultimately, that currency will increase and reserves will decrease by the same amount, in nominal terms. Prices would have to change as a result. For example, suppose that the demand for currency is fixed in real terms. Then prices have to rise as a result of the reduction in the interest rate on reserves. The balance sheet would be smaller, in real terms. Obviously this is not a "way out," as the key problem has to do with what happens if inflation gets too high and the Fed needs to tighten. See my post on The Balance Sheet and the Fed's Future.
In either case, if banks wanted to hold fewer reserves—a Fed liability—the Fed could, and naturally would, shrink its assets by an equal amount. Balance sheets do, after all, balance. And that would make the eventual exit easier.
Monday, March 11, 2013
Jeffrey Sachs and Keynesian Economics
Jeff Sachs characterizes himself as a progressive. He wrote this piece on "America's New Progressive Era?" and finished it with this:
A lot of progressives are Keynesians and, not surprisingly, Jeff Sachs appears to be one too. But Keynesians come in many different types. John Taylor is a Keynesian. Ben Bernanke is a Keynesian. So is Greg Mankiw. There are New Keynesians, like Mike Woodford and Mark Gertler. More than likely, if we could re-animate Keynes, he would have a hard time recognizing his work in any of what those people do.
Though Jeff Sachs is a Keynesian, he views himself as a particular kind of Keynesian, and he has taken issue recently with Keynesians he calls "crude Keynesians." Sachs recently wrote this post, which I found interesting. It's pretty bold, actually, and I agree with most of it. The gist of Sachs's piece is in line with some arguments I have made here. For example read this.
Here are some of the juicy parts of Sachs's post. He says that there are four elements of crude Keynesianism, and that all of those positions are "misguided":
Sachs characterizes the problems of the U.S. economy as structural, and not the result of some sort of "aggregate demand deficiency."
I especially like this one:
Predictably, the usual cast of characters is calling Sachs an idiot. Someone should take him out to lunch and give him a pat on the back.
Implementation of public policy is just as important to good governance as the vision that underlies it. So the next task is to design wise, innovative, and cost-effective programs to address these challenges. Unfortunately, when it comes to bold and innovative programs to meet critical human needs, America is out of practice. It is time to begin anew, and Obama’s full-throated defense of a progressive vision points the US in the right direction.I'm certainly on board with that. We need vision, but the government needs to find a practical path to getting things done. Government needs to be wise and innovative. There are elements of American society that are a mess and need to be fixed, and some of that fixing needs to be done by the federal government.
A lot of progressives are Keynesians and, not surprisingly, Jeff Sachs appears to be one too. But Keynesians come in many different types. John Taylor is a Keynesian. Ben Bernanke is a Keynesian. So is Greg Mankiw. There are New Keynesians, like Mike Woodford and Mark Gertler. More than likely, if we could re-animate Keynes, he would have a hard time recognizing his work in any of what those people do.
Though Jeff Sachs is a Keynesian, he views himself as a particular kind of Keynesian, and he has taken issue recently with Keynesians he calls "crude Keynesians." Sachs recently wrote this post, which I found interesting. It's pretty bold, actually, and I agree with most of it. The gist of Sachs's piece is in line with some arguments I have made here. For example read this.
Here are some of the juicy parts of Sachs's post. He says that there are four elements of crude Keynesianism, and that all of those positions are "misguided":
(1) The belief that multipliers on tax cuts and transfers are stable, predictable and large;
(2) The belief that America's employment and growth problems are overwhelmingly cyclical, not structural, and therefore remediable by short-term aggregate demand management;
(3) The belief that a growing debt burden is a minor nuisance as long as the economy is in recession;
(4) The belief that for practical purposes, the most urgent need is to raise aggregate demand rather than to focus on the quality and type of public spending.
Sachs characterizes the problems of the U.S. economy as structural, and not the result of some sort of "aggregate demand deficiency."
What are some of the structural problems? These include large-scale offshoring of jobs, large-scale automation of jobs, decline in demand for low-skilled workers, skill mismatches, broken infrastructure, and rising global energy and food prices. These require various kinds of targeted public investment spending, not simply aggregate demand.
I especially like this one:
The US economic emergency in late 2008 and early 2009 wasn't really an aggregate demand crisis but a financial crisis.That should be pretty obvious, but many people don't seem to get it.
Predictably, the usual cast of characters is calling Sachs an idiot. Someone should take him out to lunch and give him a pat on the back.
Sunday, March 10, 2013
The Balance Sheet and the Fed's Future
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
Liabilities:
Currency: $820 billion
Reserves: $12 billion
Assets:
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
Liabilities:
Currency: $1,173 billion
Reserves: $1,748 billion
Assets:
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 Fed balance sheet looked like this (reporting only the essentials):
Total Balance Sheet, Jan. 2007: $859 billion
Liabilities:
Currency: $820 billion
Reserves: $12 billion
Assets:
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
Liabilities:
Currency: $1,173 billion
Reserves: $1,748 billion
Assets:
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.
Sunday, February 17, 2013
Lacker and Bernanke
Jeff Lacker (President, Richmond Fed) has a very interesting speech posted on the the role of economic theory in structuring our view of the financial crisis. Lacker gives a nice review of what we know about the theory of information, banking, and financial intermediation more generally. Then there is a tie-in to the financial crisis, and monetary policy decisions that were made before the crisis, particularly in late 2007.
The ideas are nicely summarized by Lacker as relating to two alternative theories of financial instability. If we observe a financial system that exhibits recurring crises, or even if we observe one crisis or panic, we might think that such a financial system is inherently unstable. That's the Diamond-Dybvig view of the world. Banks are about maturity transformation. That's socially useful, but leaves the banking system vulnerable to runs. The run problem, according to this view, can be eliminated or mitigated through interventions such as deposit insurance. We will need other regulations as well, for example capital requirements, to correct the moral hazard problem that is induced by deposit insurance.
Alternatively, we might think that financial instability arises from induced fragility. In this view, there are several dimensions to moral hazard. Deposit insurance induces excessive risk-taking by banks, too-big-to-fail induces excessive risk-taking by all large financial institutions, and the behavior of the Fed can also give rise to moral hazard. For example, suppose two alternative scenarios:
1) An increase in perceived risk in financial markets causes markets for short-term credit to "freeze." Financial intermediaries borrowing short and lending long face higher borrowing rates, with the spreads between these borrowing rates and safe rates of interest rising, and some investors are reluctant to lend to these institutions at any rate. The central bank does not intervene, so financial institutions have to be creative in adjusting to the increase in perceived risk. They develop new contracts and new modes of intermediation and exchange, that mitigate the problem. The knowledge they gain will then be useful the next time such an event happens.
2) The same event occurs as in case (1), but now the Fed intervenes through the discount window, or some related lending facility. Interest rate spreads have gone up, and the quantity of short-term lending has gone down, but now the Fed intervenes by lending to the financial institutions at the heart of the freeze, using the "undervalued" assets of the financial institutions to collateralize the loans. The concern here is that financial institutions come to expect this Fed intervention in times of stress, and they depend on it. Now they don't bother thinking about the alternatives. It's standard moral hazard, of course.
Alternatives (1) and (2) are not just hypothetical. Those were real policy choices that the Fed confronted in late 2007. Some recent discussion of the recently-released minutes of the 2007 FOMC meetings has focused on soundbite issues - some FOMC participant said something in 2007 that appears silly with hindsight. For example, this New York Times article quotes then-President of the St. Louis Fed Bill Poole:
But the following is much more interesting. In its September 18, 2007 meeting, at which there was a reduction in the fed funds target rate by 50 basis points, there was a discussion of the Term Auction Facility (TAF), which was to play an important role in the subsequent financial crisis. The FOMC was concerned that a previous reduction in the margin between the fed funds target rate and the discount rate was not having much effect. The concern was that banks were not borrowing, in part because of "stigma," the idea being that borrowing at the discount window signals a troubled bank, which deters banks from borrowing when they should. If discount window funds are essentially auctioned off through the TAF, then the result could be to mitigate the stigma effect.
Here's what Lacker has to say in the September 18, 2007 meeting:
Here's the key issue. Some people - a plethora in fact - have been willing to tell us two things. First, they claim that existing economic theory is useless in addressing financial crisis issues. Second, they argue that policymakers failed to do anything in advance of the financial crisis that would have prevented it or mitigated its effects. My claim has been that there is plenty of off-the-shelf economic theory and evidence that can be brought to bear in organizing our thinking about the financial crisis and the recent recession. Indeed, a good part of that theory is what Jeff Lacker discusses in his recent speech, and uses in the FOMC discussion from September 2007 that I quoted above. Further, we can see from Lacker's 2007 discussion that he's concerned about exactly the right issues - with the benefit of hindsight, he looks pretty good.
If we buy into the induced fragility view in a big way, then we have to take what Lacker says in his recent speech seriously. Moral hazard in financial markets is not just a long-term issue, but can propel events during a financial crisis. According to this view, in 2007 the Fed began to make decisions - such as establishing the TAF program - that caused large financial institutions to relax and let the Fed do the worrying. Indeed, the assisted purchase of Bear Sterns confirmed that view, and then everyone was surprised when Lehman was allowed to fail. Can we make the case that the Fed's behavior in 2007 and later contributed in a big way to the severity of the financial crisis and the recession? Maybe. We should at least be studying this seriously, though I'm sure some of you can lead us to some interesting work that is already doing that.
The ideas are nicely summarized by Lacker as relating to two alternative theories of financial instability. If we observe a financial system that exhibits recurring crises, or even if we observe one crisis or panic, we might think that such a financial system is inherently unstable. That's the Diamond-Dybvig view of the world. Banks are about maturity transformation. That's socially useful, but leaves the banking system vulnerable to runs. The run problem, according to this view, can be eliminated or mitigated through interventions such as deposit insurance. We will need other regulations as well, for example capital requirements, to correct the moral hazard problem that is induced by deposit insurance.
Alternatively, we might think that financial instability arises from induced fragility. In this view, there are several dimensions to moral hazard. Deposit insurance induces excessive risk-taking by banks, too-big-to-fail induces excessive risk-taking by all large financial institutions, and the behavior of the Fed can also give rise to moral hazard. For example, suppose two alternative scenarios:
1) An increase in perceived risk in financial markets causes markets for short-term credit to "freeze." Financial intermediaries borrowing short and lending long face higher borrowing rates, with the spreads between these borrowing rates and safe rates of interest rising, and some investors are reluctant to lend to these institutions at any rate. The central bank does not intervene, so financial institutions have to be creative in adjusting to the increase in perceived risk. They develop new contracts and new modes of intermediation and exchange, that mitigate the problem. The knowledge they gain will then be useful the next time such an event happens.
2) The same event occurs as in case (1), but now the Fed intervenes through the discount window, or some related lending facility. Interest rate spreads have gone up, and the quantity of short-term lending has gone down, but now the Fed intervenes by lending to the financial institutions at the heart of the freeze, using the "undervalued" assets of the financial institutions to collateralize the loans. The concern here is that financial institutions come to expect this Fed intervention in times of stress, and they depend on it. Now they don't bother thinking about the alternatives. It's standard moral hazard, of course.
Alternatives (1) and (2) are not just hypothetical. Those were real policy choices that the Fed confronted in late 2007. Some recent discussion of the recently-released minutes of the 2007 FOMC meetings has focused on soundbite issues - some FOMC participant said something in 2007 that appears silly with hindsight. For example, this New York Times article quotes then-President of the St. Louis Fed Bill Poole:
My own bet is the financial market upset is not going to change fundamentally what’s going on in the real economy...
But the following is much more interesting. In its September 18, 2007 meeting, at which there was a reduction in the fed funds target rate by 50 basis points, there was a discussion of the Term Auction Facility (TAF), which was to play an important role in the subsequent financial crisis. The FOMC was concerned that a previous reduction in the margin between the fed funds target rate and the discount rate was not having much effect. The concern was that banks were not borrowing, in part because of "stigma," the idea being that borrowing at the discount window signals a troubled bank, which deters banks from borrowing when they should. If discount window funds are essentially auctioned off through the TAF, then the result could be to mitigate the stigma effect.
Here's what Lacker has to say in the September 18, 2007 meeting:
MR. LACKER. Thank you, Mr. Chairman. I’ve been thinking a lot about this since I heard about it last week. I want to start by complimenting the staff at New York and the Board who wrote the summary memo. I think it does a very good and balanced job of articulating the costs and benefits of this proposed facility. I was going to say that they undoubtedly did it in a compressed timeframe, but then I heard you guys have been working on it for weeks. [Laughter] But in any event, my hat is off to them.That's a pretty sophisticated take on the issues involved with the TAF. Anyone who thinks that economic theory is useless for policymaking, or that real policymakers don't bring it to bear on practical problems should read that. Here's what Bernanke comes back with:
I very much agree with the staff that weighing the costs and benefits to reach an assessment about the desirability of this is inherently a difficult judgment. For me the critical question concerns the normative implications of what we’re seeing in the marketplace for term funding and the normative implications of this proposed intervention. Banks that are borrowing at term now are paying up for insurance against the eventuality that their funding costs rise—for example, because of a deterioration in their perceived creditworthiness. Banks that have viewed themselves as more at risk are naturally willing to pay more for such insurance, and some reports suggest, as Mr. Dudley did this morning, the presence of an adverse-selection problem in the sense that borrowing at term reveals oneself to be a borrower of high risk, and so only high-risk borrowers are willing to
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pay more. Banks that are reluctant to lend at term are placing a high value on being able to use their liquidity to accommodate assets that may come on their balance sheet soon. We had a lot of discussion about this in the morning. Balance sheet capacity appears genuinely to be a scarce valuable commodity these days. That’s consistent with the notion that raising bank capital is expensive in the current environment. I think the adverse-selection story is worth considering seriously in this context because it’s the interpretation of what we’re seeing that provides the best hope for this being an intervention that improves market functioning in the microeconomic sense of the term.
But if adverse selection is what has impaired the functioning of the term market in this normative sense, then there must be lower-risk banks that are unwilling to borrow at the same high rates as high-risk banks but that are rationed because they’re unable to distinguish themselves from high-risk banks. Now, if this is the case, the only way to improve market efficiency by lending is to lend more than the current volume of term lending because otherwise we’re just going to lend it to the current term-lending borrowers and none of these rationed-out, lower-risk banks are going to get access to it. In other words, if we do lend through an auction facility to draw in disadvantaged borrowers to try to reach them with credit, we can do so only by subsidizing the high-risk borrowers as well. Now, I’ll mention that, from the discussion this morning, my understanding is that we have very little idea what the volume of that term lending is. So I don’t see how we chose this number and how we can be confident that it’s going to do this and reach through the high-risk borrowers to pick up the low-risk borrowers.
More broadly, I’m not sure I see how this facility could improve the normative functioning in the market. We’re going to auction off only the same contracts that market participants are capable of offering now, only we’re also going to subject ourselves to the additional constraints September 18, 2007 144 of 188
imposed by our single-price auction format. So we’re not improving on any contract out there. The only unique attribute we would appear to bring is our ability to subsidize lending terms. We could conceivably improve market functioning if adverse selection is the right story here by doing something that market participants are incapable of doing, and that would be compelling borrowing by everybody or by a set of people to achieve a superior pooling allocation. But I don’t think we want to do that. Or we could conceivably improve market functioning by acting on information that’s superior to that of market participants—a knowledge of the creditworthiness of institutions, for example. But it isn’t clear that this is a key part of the proposal either, because institutions have to be rated 3 or above to get access and I think virtually all the currently affected institutions in these sorts of high-risk and low-risk categories are in the 3 or above categories already. A related point here is that, if we really think information constraints are at the heart of the problem, it might be better to address this problem by addressing those constraints directly by using our supervisory authority to encourage and facilitate greater transparency. So my sense is that this facility would just subsidize borrowing banks without doing anything to mitigate underlying informational asymmetries or any other type of market friction that I can think of. That means to me that this proposal raises the usual moral hazard concerns. The staff memo was very clear and articulate about those. I think there’s a danger with this facility of raising expectations that, in the future, significant increases in interbank funding spreads are going to be ameliorated by central bank intervention. If we raise that expectation, we’re going to undermine to some extent market mechanisms for assessing the relative risk of institutions.
I’m a little worried that if this does not produce a demonstrable effect on relevant market conditions, it could erode confidence in us, and I feel so especially in light of our previous change in discount window policy, which I think is widely viewed as having had little substantive effect so
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far. I think that’s the view out there. I also worry that this could complicate the resolution of failing institutions whose condition, as Vice Chairman Geithner suggested, deteriorates while they’re borrowing from this auction facility. It would put us in a very awkward place. As Governor Kohn said, this isn’t like a one-day emergency kind of thing—it takes some time. But some institutions in questionable situations, some problem institutions, look for term funding and are willing to wait four days to get it and know enough about their condition to line it up ahead of time. I worry about this sounding like a cloak for the ECB, for us to give money to the ECB, and I worry about President Rosengren’s issues as well, and I’d be more comfortable with the swap line than I am with the domestic facility. If those foreign authorities want to extend credit and have the knowledge and capacity to do so, and it’s on their dime and they’re bearing the credit risk and they want to borrow the dollars from us, I see that as a reasonable step for a central bank to take. I also worry about valuing collateral. I don’t think that our mechanisms for doing that are robust and strong, especially in the current environment with at least standard haircuts.
Now, I can appreciate the broader problem articulated by the staff and others that banks that are constrained in the term funding market might tighten borrowing terms for consumers and businesses and that might have real economic consequences. But if that’s the problem, I think it would be better for us to just cut the funds rate rather than alter the relative funding costs of different banks. This is essentially what we did today. We cut the funds rate to offset the macroeconomic effects of higher credit spreads.
Just a final set of comments. More broadly, I’ve been hoping for some time that banking policy in our country was moving slowly but surely toward greater reliance on market discipline and away from forbearance and subsidization. I’ve been hoping that we as a central bank would gradually move away from things that are tainted with credit allocation. Times like these don’t September 18, 2007 146 of 188
come around very often—you know, once a decade—and my sense is that the precedent we set here is going to be remembered for a long time and it’s going to affect market behavior for a long time to come as well. In my opinion, we ought to look at these episodes of market stress as an opportunity to make some reputational progress on the time-consistency problem that is at the heart of moral hazard. So for me the balance of considerations weighs heavily against this proposal, Mr. Chairman.
CHAIRMAN BERNANKE. Let me echo what you first said and congratulate the staff on an enormous amount of work and a terrific presentation. I do want to just say a word, President Lacker. Most of your arguments are premised on the idea that markets are basically in some kind of equilibrium and we’re just messing with the equilibrium. There’s a longstanding tradition, both in central banking and in theoretical analysis, that you can have periods when there is insufficient cash in the market and prices are, therefore, driven away from fundamentals by the lack of cash. What central banks do is provide cash against collateral. I refer you, for example, to Franklin Allen and Douglas Gale’s new book, Understanding Financial Crises, in which they present a model with exactly that property.There you have it. Lacker is thinking about induced fragility; Bernanke is thinking about inherent instability. Bernanke's discussion is at a high level too (note the literature citation), though I think his characterization of Lacker as only willing to think about "some kind of equilibrium," is silly. I haven't read Allen and Gale's book, and I'm not familiar with their model, but I'm sure they are thinking about "some kind of equilibrium" too.
The moral hazard issue is the following: There is a good reason to allow some deviation of cash-based valuations from fundamentals because it creates incentives for providing sufficient liquidity and rewards those who have sufficient liquidity. But beyond a certain range, the models as well as central banking experience suggest that, when you have a fire sale type of situation, then the central bank can be useful by providing cash against that collateral. Essentially this process would take $140 billion of undervalued, hard-to-sell, or illiquid assets onto the central bank’s balance sheet and provide term liquid funding in its place, which I find totally consistent with Bagehot and the traditions of central bank lending. Now, the question arises whether the market is in sufficient September 18, 2007 147 of 188
distress. If it’s not, then we’re in the first regime where some deviation of values from fundamentals is legitimate. If the market is in extreme distress, I think—I repeat what I said before—there can be situations in which markets are simply not functioning well and there could be a lot of reasons for that in which case the central bank could help the market function better. I agree that some of these issues about bid size and so on do confuse the issue. We need to make a strong distinction between helping these markets to function better—we can address, for example, some of the counterparty risk because we have all this collateral in our discount windows—and helping or bailing out any individual institution. I agree with you that we certainly want to avoid that perception if at all possible.
Here's the key issue. Some people - a plethora in fact - have been willing to tell us two things. First, they claim that existing economic theory is useless in addressing financial crisis issues. Second, they argue that policymakers failed to do anything in advance of the financial crisis that would have prevented it or mitigated its effects. My claim has been that there is plenty of off-the-shelf economic theory and evidence that can be brought to bear in organizing our thinking about the financial crisis and the recent recession. Indeed, a good part of that theory is what Jeff Lacker discusses in his recent speech, and uses in the FOMC discussion from September 2007 that I quoted above. Further, we can see from Lacker's 2007 discussion that he's concerned about exactly the right issues - with the benefit of hindsight, he looks pretty good.
If we buy into the induced fragility view in a big way, then we have to take what Lacker says in his recent speech seriously. Moral hazard in financial markets is not just a long-term issue, but can propel events during a financial crisis. According to this view, in 2007 the Fed began to make decisions - such as establishing the TAF program - that caused large financial institutions to relax and let the Fed do the worrying. Indeed, the assisted purchase of Bear Sterns confirmed that view, and then everyone was surprised when Lehman was allowed to fail. Can we make the case that the Fed's behavior in 2007 and later contributed in a big way to the severity of the financial crisis and the recession? Maybe. We should at least be studying this seriously, though I'm sure some of you can lead us to some interesting work that is already doing that.
Wednesday, January 16, 2013
Jon Stewart vs. Paul Krugman
Jon Stewart and Paul Krugman have been butting heads over the trillion-dollar coin idea. Stewart concludes that it is a "dumb f*****g idea," and Krugman thinks Stewart is "lazy" and "unprofessional." You can find the video here.
As someone who has called Krugman lazy in the past, I'm quite willing to offer you my opinion on this contoversy. Krugman is on shaky ground here. It's a bit much for Krugman to be criticizing Stewart for not getting all the subtleties of the idea behind #mintthecoin. In fact, many economists seem confused about it, and Krugman himself does not entirely get it (see this post). I think we can cut Stewart some slack - he's one of the more intelligent human beings on the tube, and he's trying to get a laugh. Obviously Krugman does not have much patience for people who don't take him seriously.
More to the point, #mintthecoin is interesting in that it draws attention to monetary economics and the relationship between monetary and fiscal policy. Other than that, Stewart has it nailed as a dumb f******g idea. The key problem is that this vehicle for circumventing the federal debt ceiling threatens central bank independence. Wherever the trillion-dollar coin is deposited, it constitutes a monetary policy action, and our institutions are set up so as to keep the Fed at arm's length from the Treasury. This would be like having President Obama show up for an FOMC meeting. Bad idea.
As someone who has called Krugman lazy in the past, I'm quite willing to offer you my opinion on this contoversy. Krugman is on shaky ground here. It's a bit much for Krugman to be criticizing Stewart for not getting all the subtleties of the idea behind #mintthecoin. In fact, many economists seem confused about it, and Krugman himself does not entirely get it (see this post). I think we can cut Stewart some slack - he's one of the more intelligent human beings on the tube, and he's trying to get a laugh. Obviously Krugman does not have much patience for people who don't take him seriously.
More to the point, #mintthecoin is interesting in that it draws attention to monetary economics and the relationship between monetary and fiscal policy. Other than that, Stewart has it nailed as a dumb f******g idea. The key problem is that this vehicle for circumventing the federal debt ceiling threatens central bank independence. Wherever the trillion-dollar coin is deposited, it constitutes a monetary policy action, and our institutions are set up so as to keep the Fed at arm's length from the Treasury. This would be like having President Obama show up for an FOMC meeting. Bad idea.
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