Doctrines Overturned

(This post is based on a few talks I've given lately. There's not much terribly new. But the effort to revisit, clarify and repackage may be useful even if you're a devoted blog reader, as it is to me.)

The Future of Monetary Policy / Classic Doctrines Overturned

Everyone is hanging on will-she or won't-she raise rates by 25 basis points.

I think this focus misses the more interesting questions for current monetary policy. The last 10 years or so are a remarkable experience, a Michelson-Morley¹ moment, which overturn long-held monetary policy doctrines. The plan to raise rates via interest on reserves in a large balance sheet completely changes the basic mechanism by which monetary policy is said to affect the economy.

Facts 

Controlling inflation is the first main task of monetary policy. Inflation, in the blue line below, has been slowly and inexorably declining over the last two decades, from 3% in 1995 down to a bit under 2% now. Inflation declines just after  recessions and rises again as the economy recovers.

Long term interest rates, in green, are a good measure of long-term inflation expectations. Long-term rates basically follow a linear downward trend, barely interrupted by economic events or short term interest rate movements. When Fed officials say "expectations are anchored" or "trending down" this is one of their main indicators. If you, like me, believe in low inflation, it's awfully hard to complain too loudly about the Fed!

Short-term interest rates, in red, fall reliably in recessions, stay at zero while output and employment remain low,  and then rise as the economy recovers.

However, the short rate hit the "zero bound" in 2008 and has been stuck there ever since.

When rates hit zero, the Fed started buying assets and issuing bank reserves in return. In this action, the Fed is  pretty much just acting as a huge money market fund that invests in Treasuries. You can see the  big upward jump in the recession, and then the QE2 and QE3 episodes.
Reserves were a few tens of billions before 2007. Their expansion is thus really breathtaking.

These are our Michelson-Morley observations. We hit the zero bound and... nothing happened. We expanded money -- reserves -- from tens of billions to nearly 3 trillion and... nothing happened.

Doctrines Overturned

The traditional view of monetary policy, including both "Monetarists" and "Keynesians," (bad labels, but they'll have to do for now) agrees on some core doctrines:

• The economy is unstable.  If the Fed pegs the interest rate at a fixed value, either expanding inflation or spiraling deflation will follow.


•  Raising interest rates lowers inflation. Lowering interest rates raises inflation.

Milton Friedman's 1968 AEA address eloquently explained how an interest rate peg could lead to spiraling inflation. Pundit after pundit has warned of the deflation spiral at the zero bound.

The top left pictures  illustrate the instability proposition. Peg interest rates, and inflation or deflation will explode. On the bottom left, I graph how rising interest rates are thought to lower inflation, and answer why we don't see the unstable inflation or deflation of the top graph:  Because, if inflation breaks out, the Fed really raises rates fast and bring it back down. Or vice versa as I have graphed it.
But if the Fed can't lower interest rates past zero, the unstable deflation breaks out.

It's like balancing an umbrella in the palm of your hand. If you hold your hand still, the umbrella tips over. If you want to move the umbrella to the left, move your hand to the right. But then move it fast to the left to keep it from tipping over. If your hand gets stuck, the umbrella will crash to the floor.

The last 10 years deeply challenge this view. Interest rates got stuck at zero. No spiral broke out. Inflation just calmly came down to join the interest rates. The economy is stable, as graphed in the top right.

That means that if the Fed raises interest rates and sticks them at a higher level, bottom right, inflation will eventually rise to meet it as well, as graphed in the bottom right.

Our experiment exactly overturns the classic doctrines:

• An interest rate peg, if credible and expected to last for a long time,  and if people trust the government to pay its debts,  is stable. 


• In the long run, raising interest rates to a new peg must raise inflation (and vice versa). 

OK, as they say at the University of Chicago, that's fine in the real world, but how does it work in theory? Though classic Monetarism and Keynesianism both predict that pegs are unstable, the "New-Keynesian" or "DSGE" paradigm that has dominated research both in academia and central bank staffs for the last 20+ years says otherwise. (Stephanie Schmitt-Grohe and Martin Uribe at Columbia have been leaders in pointing this out.) These models predict that inflation is stable around a peg, as in the right hand section of my drawing. Delightfully, we don't need a new theory to understand the fact slapping us in the face. The standard modern  theory does so already.

Much new-Keynesian research has focused on the "indeterminacy" problem: The models don't pin down which of the red lines in the top right of my graph will emerge. But that's beside the point here. And most new-Keynesian research models away from the zero bound where the theories imagine the Fed deliberately reintroduces instability, in order to produce results that look like the older theories. That's why less attention has been paid to the remarkable fact that this modern theory overturns the classic peg results.

That theory accounts for the caveats in my statements of new doctrine. Expectations matter in these models, and the stability result only occurs if everyone knows the peg will be there for the foreseeable future. Also, the result only holds when people are not worried about the government's ability to pay its debts. Sorry, Russia, Argentina and Venezuela. A zero peg will not stop your inflations.

You'd think we know the answers to simple questions like these. But empirical work in economics is always dreadfully hard because we don't usually see simple experiments. Look again at the graph of interest rates and inflation,

Interest rates and inflation are already positively correlated until 2007.  So where do we get the idea that lowering rates raises inflation, if the correlation goes the other way?

Well, other things aren't constant. In the conventional view, recessions come along and drive down inflation. The Fed lowers interest rates to head off even worse deflation. When inflation comes back up again, the Fed aggressively raises rates to stop it from getting out of control. That ends up looking just like inflation following interest rates.

The conventional view may even be right (and likely was, in the past) in the short run, as indicated by the question mark in the bottom right hand graph. If that's our world, we never see the long run, since the Fed is always using the short run effect to move inflation around.

That's why the zero bound is so dramatic. It's not so much the bound, as it is a unique period in which interest rates are pegged, and everyone knows they will remain pegged for a long time. Now we get to measure the long run effect at last. And lo and behold, it's stable!

MV=PY

Quantitative easing also gave us as clean an experiment as we could hope to see on the effects of money.  The Fed raised reserves from the tens of billions to the thousands of billions and.. basically nothing happened.

Yes, there is an ongoing argument about whether QE might have lowered interest rates a few tenths of a percentage point, and whether it did so by actual portfolio effects or just by signaling that the Fed was going to keep interest rates low for a very long time. But that's not really relevant here. That argument is about whether the Fed affected bond markets by what it bought. The issue here is about the other side, whether expanding reserves are inflationary.

Again, before we saw it, reasonable people could disagree. We didn't really know what would happen when the interest rate hit zero, or equivalently, when bonds and money pay the same interest rate. We hadn't seen zero rates since the 1930s. (OK, Japan, but let's keep going.)

Monetarists (I don't like labels, but whoever thought the reserve expansion would lead to a lot of inflation) thought that "velocity is stable." Meaning, that there is a limit to how much money people want to hold, even when money pays the same interest rate as bonds. V will decline at zero rates, and M will rise without causing inflation. But at some pointV will stop declining, and more M through MV=PY will cause more P, inflation. The money demand curve hits the vertical axis and stops. With a doctrinal bullet point,

• Velocity is stable. Even at zero interest rates, past some point, additional money (reserves) must cause inflation. 

The alternative view (mine too) is that once interest rates hit zero, or money pays the same interest rate on bonds, money and bonds are perfect substitutes. People are happy to hold unlimited quantities of money rather than short term bonds.

Well, we got about the best experiment we'll ever see.  The sheer size of the experiment is just overwhelming. MV = PY. M increases, not by 10%, not by 100%, but by 10,000% ($30 billion to $3000 billion). And inflation goes slightly down. V just took up all the slack. It turns out the equation is V = PY/M when money and bonds pay the same interest.

So once again we have a classic doctrine decisively overturned. In its place let me offer

• Reserves that pay market interest are not inflationary. Even in enormous quantities. 

Going forward interest rates will not be zero. But reserves will pay the same interest as Treasuries. So this is a vitally important doctrine to digest. The huge balance sheet isn't doing any stimulating or inflating. There is no danger in letting it sit there. So long as the Fed continues to pay market interest on reserves.

The Mechanism 

Another huge change lies ahead. When it finally is time to raise rates, The Fed will not sell off the balance sheet. Instead, the Fed will simply pay more interest on reserves, and trust that this interest rate spreads to the rest of the economy.

This change marks a fundamentally different mechanism for monetary policy. Recall the standard story for how monetary policy works: Banks are holding as few reserves as they can, because reserves don't pay interest. The Fed reduces the amount of reserves by a few billion dollars. Now banks don't have enough reserves. They try to borrow reserves from each other, raising the interest rate. But collectively they can't get more reserves, so they have to cut lending and deposits to get back in line with reserves. Less lending or deposits cools the economy and eventually inflation.

I say "story" because I don't think that's how in fact things used to work. But we can't even pretend that's how things will work now. The Fed will just pay more interest on reserves. Banks will have trillions more reserves than they need. Raising the rate on abundant excess reserves has no direct connection at all to lending or deposits.

We're going to have "tightening" (interest rate rise) without any actual "tightening" (reductions in money, reserves.) The only way that monetary policy can work at all is from interest rate effects. Higher interest rates might  induce people to spend less today and save more, and this will reduce output and then (somehow) inflation.

So, that leaves us with big open questions. Can the Fed raise rates by just raising interest on reserves? Will the effects on the economy be the same if the Fed raises rates by raising interest on reserves as it was when the Fed raised rates by rationing reserves?

By analogy, money is like oil in cars. In the old days, if traffic on the freeway was too fast, the Fed would ration oil. Running on two quarts slowed the cars down.  It also led to higher motor oil prices (interest rates) as drivers tried to buy oil from each other. But now each car has thousands of quarts of oil, and the Fed isn't going to try to throttle the cars with oil at all. The Fed is just going to manipulate the price of motor oil, and count that drivers will slow down because they find it more expensive to drive. That's great for efficiency and financial stability. Throttling cars with oil starvation is not good for the cars. But one may wonder if the effects of a motor oil price increase will be the same under the new mechanism.

Can the Fed raise rates? 

This seems like a silly question, how can academics question such an obvious proposition. But it's not so obvious, and if you read between the lines the Fed is deeply worried about it. Will just raising interest on reserves be enough to raise all interest rates?

To give some sense of the issue, I made the following little picture of the financial system. (Yes this is almost a parody of economist charts. )

On the left, the Treasury issues debt. About $11 trillion is held directly by you, me (through private financial intermediaries including pension funds) and by foreigners including the Chinese central bank. About $4 trillion is held by the Fed, and about $2 trillion is held directly as assets by the banking system. Like any bank, the Fed just passes through assets to liabilities. Its liabilities are about $1 trillion of cash, and $3 trillion of reserves. (This is all very simplified of course.) Banks also hold about $6 trillion of commercial and real estate debt. And we hold stocks, bonds, mortgage backed securities, houses, businesses and so forth worth tens of trillions.

OK, now, the Fed wants all the interest rates in this picture to go up, by raising interest rates on reserves.

Analogy:

"Honey, low-wage people in this country don't get paid enough. Let's pay the nanny $50 per hour."

"Well, the nanny will be happy, but how is that going to help everyone else?"

"Don't you see? When our nanny gets $50 an hour, then the others will demand that much, and workers at Walmart and MacDonalds too, and next thing you know everyone will get $50 per hour more."

"Hmm. That's not one of your brightest ideas. But tell me please where are we going to get the extra $50 per hour?"

"That's the beauty of the whole thing. When all wages go up $50 per hour, we'll be earning $50 per hour more, and we just pass that on to the nanny!"

You can see why the Fed might be up at night worrying that it will work.

I think it should work, despite this funny story. Banks  should compete for deposits, sending deposit rates up. Treasury holders should try to dump treasuries to hold deposits, until those rates rise. And so on. But "compete" and "banks" don't sit well in the same sentence these days, so you can see why the Fed might be a bit nervous about it.

How will raising rates affect inflation? 

How will raising rates affect inflation? Again, there will be no reduction in reserves, no reserve requirement tightening, no scramble to borrow reserves from other banks. There will just be a carrot of higher rates. Will tightening without tightening, but just through rates, have the same effects?

Hence the question mark in my four-graph picture.  Monetary policy with interest on reserves worked through a simple off-the-shelf new-Keynesian model. It  finds that there isn't even a short run contractionary effect on inflation, and an increase, not a decrease, in output. I'll leave that for another day. For now, recognize that history and theory do not definitively answer the question posed by the question mark, because the mechanism is entirely different.

The future

This is a pretty radical blog post. Most of the monetary economics used by our policymakers is wrong*. That would seem to forecast disaster. But I don't think it does.

Suppose I am right, and the Fed starts very slowly and gradually raising rates, as they promise to do. The result will be a slight increase in growth and after a delay, a slight increase in inflation. The Fed will feel reassured that it raised rates at the right time in advance of the growth and inflation, not recognizing that it caused the growth and inflation. Still, though I'd rather have zero inflation rather than 2% inflation, a period of slightly greater growth and a return to 2% inflation would not be a disaster.

Despite my view that standard doctrines are completely upended by recent experience, the Fed is following a path that works well under lots of different models of the economy, a wise robustness. If it listened to people with extreme views like mine, it would have put more credence in the hyperinflation or deflationary spiral camps, to our detriment.

If you want to worry, worry about shocks that might hit the economy or the government, not the results of the Fed's slow and deliberate interest rate increases in a background of steady if too-slow growth and low inflation. Worry about Grexit, Putin, sovereign default, some new credit crisis. If you want to worry about the Fed worry about reactions to such crises, or worry about regulation gone wild.

The last big lesson we learn from recent experience is

• Monetary policy is a lot less powerful than most people think it is. 

Bad monetary policy can screw things up. But our growth doldrums are not the result of monetary policy, nor can monetary policy do a lot to change them.

----

(1) In case you don't know, this is the famous physics experiment that measured the speed of the earth through ether by measuring the difference in speed of light looking forward vs. sideways given the earth's motion. The experiment found the speed of light the same in all directions. It's a famous negative result -- nothing happened, the dog did not bark -- with momentous consequences, in this case the theory of relativity.

*Update: A friend wrote to upbraid me a bit:

"Not sure why you want to try so hard to label yourself radical.  Much of what you said was conventional wisdom among the folks I talked to at the Fed.  Perhaps you should try 'The best minds at the Fed and other radicals like me think....'"

I'm happy for any company!

On RRP Pro and Con

Thanks to a comment on the last post, I found The Fed working paper explaining Fed's thinking about overnight reverse repurchases, Overnight RRP Operations as a Monetary Policy Tool: Some Design Considerations by Josh Frost, Lorie Logan, Antoine Martin, Patrick McCabe, Fabio Natalucci, and Julie Remache.

(I should have found it on my own, as it's the top paper on the Fed's working paper list.) Cecchetti and Shoenholtz also comment here

My main question was just what "financial stability" concerns the Fed has with RRP, and this paper explains.

Background and recap

A quick recap and background, informed by comments and some helpful emails (thanks): Banks have about $3 Trillion reserves, corresponding to $3 Trillion of securities that the Fed bought. When it's time to raise rates, the Fed plans to just pay higher interest on these reserves. The Fed is worried banks will just say "thank you" and not raise deposit rates. So the Fed is effectively offering money market funds (etc) the opportunity also to invest in interest-paying reserves. If banks don't raise deposit rates, funds will, and try to attract bank deposits. The funds will also try to sell Treasuries, raising those rates.

In a reverse repo, the lender gives the Fed cash (reserves), and the Fed gives the lender securities as collateral. Why reverse repos? A correspondent explains, "The Federal Reserve Act allows the Fed to take deposits only from depository institutions and the U.S. government (including GSEs) and to pay interest only to depository institutions. It would take an act of Congress to allow the Fed to pay interest on accounts held by MMMFs. However, the law allows the Fed to engage in open market transactions in U.S. government securities ... with just about anyone."

Key points: The Fed is still controlling the size of the balance sheet. If the Fed really wanted an ironclad (rocket-powered?) liftoff tool, it would say "Bring us your Treasuries. We will give you interest-paying reserves in return." Then, if bond markets give the Fed $1 trillion of treasuries, the Fed creates an extra $1 trillion of reserves. (Yes, increasing the balance sheet is a tightening move. Welcome to our new world.) If you want to peg a price (interest rate), announcing "do what it takes" quantities is a good idea.  The Fed is not planning to do this. (Yet!)

The Fed is also contemplating caps on the size of the facility, rather than "full allotment." Full allotment is obviously more powerful. One wonders what happens if the Fed says 1%, Deposit rates go up 0.2%, treasury rates go up 0.2%, and the Fed hits the cap.

Important point: every dollar of new reverse-repo "deposits" at the Fed must come from one dollar less bank reserves at the Fed. The money market fund desiring to do an RRP must sell treasuries (or something else), get some reserves, give those reserves to the Fed. The only place those reserves can come from is a bank. So, on net, bank reserves go down $1, and money fund holdings of reserves go up by $1. It's a shift from left pocket to right pocket.

Moreover, the Fed is offering nothing that a money market fund backed by short-term Treasuries and agency securities can offer. The Fed is nothing but a money market fund backed by Treasury and agency securities!

With this background, I find it hard to understand how the ON RRP can have any "financial stability" problems. How can opening up a money market fund invested in Treasuries and Agency securities be dangerous?

The paper

The summary:

... an ON RRP facility could have repercussions for financial stability. These might include beneficial effects arising from the increased availability of safe, short-term assets to investors with cash management needs.

Yes!   Translation 1) Interest-paying narrow banking is great for stability.

However, there may be adverse effects stemming from the possibility that such a facility—particularly if it offers full allotment—could allow a very large, unexpected increase in ON RRP take-up that might enable disruptive flight-to-quality flows during periods of financial stress. In addition, very large usage of an ON RRP facility, particularly if it were permanently in place, would expand the Federal Reserve’s footprint in short-term funding markets and could alter the structure and functioning of those markets in ways that may be difficult to anticipate. Indeed, FOMC policymakers have expressed concerns about a sustained expansion of the Federal Reserve’s role in financial intermediation and the risk that ON RRPs might magnify strains in short-term funding markets during periods of financial stress (FOMC 2014a,b).

2) But maybe it would facilitate a flight to quality or run. 3) Banks won't like it if we take over their business.  4) Our bosses have already opined on this question, so don't expect us to take a strong stand.

The paper starts with point 3)

3.1. Potential effects of a very large ON RRP facility on financial intermediation 

By offering a new form of overnight risk-free investment, an ON RRP facility could attract cash from investors who otherwise might provide funding for private institutions and firms. That is, the facility could expand the Federal Reserve’s role in financial markets by offering investors a new tool to manage liquidity and thus could crowd out some private financing...

I think this is just wrong, and it reflects a classic confusion of the individual and the aggregate. As above, the Fed holds the same number of treasuries. For every dollar of reserves held by money market funds under RRP, banks must hold one dollar less.

Importantly, increased ON RRP take-up does not expand the size of the Federal Reserve’s balance sheet or the volume of private short-term funding required to finance that balance sheet. Instead, such an increase shifts the composition of the Federal Reserve’s liabilities from reserves held by banks to RRPs that can be held by a wider range of institutions. ...

This paragraph, following the last, seems to validate exactly my point.

..., a permanently expanded role for the Federal Reserve in short term funding markets could reshape the financial industry in ways that may be difficult to anticipate and that may prove to be undesirable. For example, a permanent or long-lasting facility that causes very significant crowding out of short-term financing could lead to atrophying of the private infrastructure that supports these markets. Partially in response to some of these concerns, the FOMC has made clear that an ON RRP facility is not intended to be permanent (FOMC 2014c).

These markets failed! The run on repo was central to the financial crisis! This is like the 19th century US deciding that we shouldn't issue Federal currency, as it will displace private banknotes.  The Fed seems to see no problem in displacing or regulating out of existence many other contracts and practices. From a bit later

a recent literature has emphasized the benefits of the public provision of safe short-term assets, such as ON RRPs, in enhancing financial stability by displacing private money-like assets that are prone to runs.

Yes!

Now, the central point 2) financial stability in a run.

3.2. Potential effects of an ON RRP facility on financial stability 

In principle, there are two distinct channels through which the establishment of an ON RRP facility could affect financial stability. First, the availability of an elastically supplied risk-free asset could influence the likelihood that money market investors would shift rapidly from providing private short-term funding to holding only very safe assets. That is, the facility could affect the chance of a widespread run. Second, an ON RRP facility could affect the dynamics and severity of such a shift, once it is under way.... The academic literature does not provide strong guidance regarding the effects of a new risk-free asset on the likelihood of sudden shifts toward safe assets. 

Again, I think this is  wrong, and confuses the individual with the aggregate. Sorry to be blunt. Investors wanting to run can, and did, hold bank accounts, cash, money market funds invested in Treasuries, or short-term treasuries. The aggregate amounts of these are not changing.

It is also quite a curious attitude that the Fed should limit the provision of money-like assets in a run, and insist that prices plummet instead. By and large the Fed does exactly the opposite. The Fed flooded the market with money in the crisis, as it is supposed to do and will do again. (As the paper explains nicely).

If the Fed does not buy assets, the private sector cannot in total sell them.

Mistaking individual flows for aggregate flows is one of the most basic (and easy) errors in thinking about financial markets. Daily, news outlets tell us that "investors fled from stocks to bonds" or vice versa. No they didn't. For every seller there is a buyer.

... once a run is underway, the availability of ON RRPs could allow greater flight-to-quality flows during a run and thus could exacerbate the run and its effects. These effects might be particularly significant with a full-allotment ON RRP facility, but they also could occur with facility that does not offer full allotment if its structure leaves the potential for a sudden and unexpected large increase in take-up.

But for every dollar of MMF take up, there must be a dollar less of bank take up. The paper says the same thing several times.

3.2.2. Effect on the dynamics and severity of a run (once it is underway) 

Absent an ON RRP facility, in the event of a widespread run from private short-term funding markets, the supply of safe assets, such as Treasury securities, would not expand automatically to accommodate increased demand. Hence, without ON RRPs, opportunities to run may be constrained by a limited supply of risk-free assets, and greater demand for those assets is likely to push up their prices and make running more costly.

By contrast, an ON RRP facility that elastically supplies a very safe asset and which has the potential to increase in size by very large amounts would provide no immediate mechanism to slow a run. Hence, some market observers have suggested that such a facility could exacerbate flight-to-quality flows and their repercussions (Wrightson ICAP 2014). 

But the RRP facility does not "elastically supply a safe asset," on net. The size of the balance sheet, and the total amount of reserves, remains fixed. (Except that the Fed will be dramatically expanding the balance sheet in any run anyway, buying up all sorts of dodgy debt, not forcing people to sit on such debt as this argument envisions.)

There is a bit of sense in this:

... Cash that, in the absence of ON RRPs, might have moved quickly to liquid deposits at banks could go instead into a risk-free ON RRP facility through, for example, government MMFs that invest in ON RRPs. The sources of flight-to-quality flows, such as prime MMFs, could experience larger outflows than in past episodes, and the availability of short-term funding for broker-dealer and nonfinancial firms through vehicles like repo and CP could decline more quickly.

It starts by repeating my puzzle. People who want to run, can run to bank accounts. So RRP makes no difference. But (not said), large investors can't get insured deposits. So maybe maybe, an investor holding a prime fund (invested in Lehman debt) would be more likely to run if funds that invested in RRP were available?

But... money market funds that invest in short term treasuries remain available. Treasuries themselves are available (we're talking large institutional investors here not mom and pop.)

Later,

all else equal, increased ON RRP usage implies reduced short-term financing for other borrowers. If, for example, MMFs quickly shift from investing in commercial paper or repo to holding ON RRPs, they would reduce the availability of short-term credit for private firms and institutions. More generally, in contrast to classic central bank liquidity provision, which creates reserves, increased ON RRP take-up diminishes reserves.

I still think this confuses individual portfolio shift for aggregates. For a fund to increase ON RRP, it has to get reserves from somewhere. If it sells an asset to another investor in exchange for the reserves, now that other investor holds the asset. 

We're going around in circles, so I'll stop here.

I heard one very good argument at lunch today: If there is a large RRP facility, and if many large money market funds are half invested in, say, Greek bank debt and half invested in RRP, then the Fed may feel that these funds are "too big to fail" because they're holding so much reserves, and feel the need to bail them out of their Greek debts. That, however, is a cynical colleague at lunch and not in this paper.

In response to these concerns, the Fed is planning to hobble the effort:

... the FOMC has already indicated in its Policy Normalization Principles and Plans that the facility will be phased out when it is no longer needed to help control the FFR, and its temporary nature should mitigate some concerns about impacts on short-term funding markets (FOMC 2014c). In addition, caps on ON RRP usage could be imposed to limit the Federal Reserve’s footprint in short-term funding markets or to contain potentially destabilizing inflows into the facility during periods of financial stress.

I am reminded of the wisdom shown in our foreign policy since the Johnson Administration, of announcing troop withdrawals and all the things we will not do, to allay political fears.

Last thoughts

On a long plane flight yesterday I watched Janet Yellen's testimony in the Senate Banking Committee. I was impressed by her masterful handling of the questions. And I gained a new appreciation of the political constraints the Fed is operating under here. Paying large interest on reserves and opening that up to Wall Street is going to be tough, no matter how great as a matter of economics. I understand the strong desire to label monetary policy "normal."

Here I think the Fed dug itself in a bit of a hole. By trumpeting how great QE was, and how much stimulation it did, the Fed now would find it very hard to say "we've been reading Cochrane (and many others) and the huge balance sheet is doing nothing at all stimulative and is kinda nice for financial stability. So we'll just leave it all outstanding and pay IOR, and call that 'normal'."

Another colleague's brilliant lunch insight. The Fed may have deliberately dug itself in a hole. By buying lots of long-term bonds, the Fed will take big mark to market losses if interest rates rise, and stop remitting money to the Treasury. This is a precommitment not to raise rates. So, a good answer to "how did QE 'work'" is not just by implicitly promising to keep rates low for a long time, but by making it very hard to raise rates!

Run Free Video

This is a talk I gave at the joint Mercatus/Cato "After Dodd-Frank" conference last spring.  It's based on Toward a Run-Free Financial System.

Liftoff Levers

I read the minutes of the January FOMC meeting. (I was preparing for an interview with WSJ's Mary Kissel) There is a lot more interesting here, and a lot more important, than just when will the Fed raise rates.

Mainstream media missed the interesting debate on "liftoff tools." Maybe the minute the Fed starts talking about "ON RRP" (overnight reverse repurchase agreements) people go to sleep.

Background

Here's the issue.  Can the Fed raise rates? In the old days there were $50 billion of reserves that did not pay interest. The Fed raised rates, so the story goes, by reducing the supply of reserves. Banks needed reserves in proportion to deposits, so they offered higher rates to borrow reserves.

Now, there are about $3 trillion of reserves, far more than banks need, and reserves pay interest. They are investments, equivalent to short-term Treasuries. If the Fed reduce their quantity by anything less than about $2,950 trillion, banks won't start paying or demanding higher interest.  And the Fed is not planning to reduce the supply of reserves at all. It's going to leave them outstanding and pay higher interest on reserves.

But why should that rise transfer to other rates? Suppose you decide that the minimum wage is too low, so you pay your gardener $50 per hour. Your gardener is happy. But that won't raise wages at McDonalds and Walmart to $50. This is what the Fed is worried about -- that it might end up paying interest to banks, but other interest rates don't follow.


In my analysis of this issue, it will work, gardener story aside ("Monetary Policy with Interest on Reserves." Ungated here). Banks should compete for deposits, driving up deposit rates. And deposits should compete with money market funds and Treasuries, driving up those rates. More deeply, central banks already seemed to raise rates more by "open mouth operations" than by actually buying and selling things. They say rates should go up 25 bp, rates rise. That experience is likely to continue.

But "compete" and "banks" don't necessarily sit well in the same sentence anymore, and just why open-mouth operations worked so well is a bit of a mystery. In the past there was some sort of credible threat to do something if rates did not go up.

So you can see why the Fed is worried. What if the Fed announces the long-awaited interest rate rise, the Fed starts paying banks 50 bp on reserves and.. nothing happens. Deposit rates stay at zero, treasury rates stay at zero. Congress notices "the Fed paying big banks billions of dollars to sit on money and not lend it out to needy businesses and households." Mostly foreign big banks by the way. Nightmare scenario for the Fed.

Enter ON RRP. It's a natural idea. If the Fed raises interest on reserves, and banks just eat the profits, then the Fed can counter by offering reserves to other investors. A money market fund, say, earning 0 on treasury bills, would jump at the chance to earn 50 bp on reserves. In turn, as more money funds do this, dumping treasuries, Treasury rates must rise. A rush of depositors to the money market funds forces banks to raise deposit rates and then lending rates.

This is, in a nutshell the ON RRP idea. I'm a big fan.  I think a large balance sheet open to all is a great thing for financial stability, opening up narrow banking. (More in "Toward a run free financial system.")

You can see why big banks might not be fans. If they can pay 0 for deposits and earn 50bp in reserves, why undermine the profits with competition?

You can also see from my story, that if the ON RRP facility is important for transmitting higher interest on reserves to other assets, the Fed might need to do a lot of it. A lot. We're trying to raise the interest on Treasuries, Agencies, commercial paper, etc. etc. etc. by having money market funds attempt to sell those and hold reserves. They might buy a lot of reserves before rates are equalized.

The total quantity of reserves need not change, and won't if the Fed does no open market operations. But the money market funds will get bank depositors to send them reserves, pay higher interest, and park those reserves at the Fed. Basically the ON RRP will facilitate a big shift of reserves and deposits to money market funds -- if the banks don't raise deposit rates pronto. But that shift could be huge. Did I mention that banks might not like this?

This is Big Stuff for monetary policy. Whether the overnight rate inches up 25 bp in summer or fall is angels dancing on heads of pins. The shift to an interest rate target on a huge balance sheet is a night and day change. And it had better work.

The FOMC minutes

With that background, maybe the whole section on "liftoff tools" makes more sense. So, the Fed opens up reserves to one and all, and stands ready to take trillions. What's the problem?

A couple of participants expressed continued concerns about the potential risks to financial stability associated with a large ON RRP facility and the possible effect of such a facility on patterns of financial intermediation.

I don't get this at all. I gather the story is something like, if interest paying reserves are available, then funds might in a new crisis want to dump all their assets and move to interest paying reserves. But they can just as well dump assets and buy cash or treasuries too. The existence of interest paying reserves open to non-bank institutions just makes very little difference.

It seems to me exactly the opposite. Every dollar invested in interest-paying reserves at the Fed is a dollar not invested in run-prone, financial-crisis-prone, overnight private lending, like the overnight paper Lehman was using at 30:1 leverage the night before it failed. More ON RRP means more financial stability.

If anyone knows a coherent explanation of how offering the most perfect narrow banking in the world (interest paying reserves backed by Treasuries) is bad for financial stability, I'd like to hear it. Are there speeches or papers by the "participants" I don't know about?

You can see the nervousness all over the discussion

Moreover, some participants were concerned that a decision to allow a temporary increase in the maximum size of the ON RRP facility could be viewed by market participants as a signal that a large ON RRP facility would be maintained for a longer period than those participants deemed appropriate.

OK, maybe as an emergency tool to help "liftoff," but they want a promise it ends soon.

While acknowledging these concerns, many participants believed that a temporarily elevated cap on the ON RRP operations at a time when the Committee saw conditions as appropriate to begin normalization would likely pose limited risks; another participant judged that an ON RRP program was, in any case, unlikely to materially increase the risks to financial stability. Some participants noted that a relatively high cap could be established and then reduced fairly soon after the initial policy firming if it was determined that it was not needed, and that such a reduction could help underscore the Committee's intent to use such a facility only to the extent necessary. A number of participants emphasized that the Committee should develop plans to ensure that such a facility is temporary and that it can be phased out once it is no longer needed to help control the federal funds rate.

You can see a big fundamental argument here, and the natural compromises such an argument leads to. OK, just this time. But promise it's limited. Impose a cap.

Alas, this is a lot like promising ahead of time that you won't send ground troops to a war.  Just what happens when, the Fed raises interest on reserves to 50 bp., deposits and treasuries don't budge overnight RRP demand hits the cap immediately. And now what, ladies and gentlemen? "Well, we wanted to raise rates, but we hit a self-imposed cap, so I guess that's it for now?"

You will not lower the oceans with an eyedropper. Pegging prices with a cap on quantities is a dangerous affair. Ask the Swiss National Bank.  If Mario Draghi had said "we'll do what it takes to save Greece and Italy, up to a cap" do you think it would have worked?

Here you see a huge divide, unlike anything involving the path of rates. (Members seem to pretty much agree on the rules of that game, just differing in their assessment of inflation vs. output dangers.)

The committee goes on to Term RRP, i.e. letting money market funds invest in interest-paying reserves but only for fixed time periods, like a CD.  I presume they hope that  might equalize rates without "financial stability concerns." But again, I can't figure out what these "financial stability" concerns are, so it's hard to evaluate. But you can see it again as a compromise.

Bottom line, if a bit repetitive. What are the "financial stability" concerns? Or are they really "bank profitability" concerns? Or are they "unwarranted Congressional attention" concerns? (If you think "the Fed is paying banks not to lend" is bad, wait until "the Fed is paying money market funds not to invest" hits the airwaves.)

A few other thoughts. 

Reading the report,  I was unaware how much foreign currency intervention the Fed does. I'm interested in knowledgeable commentary.

On the whole when-do-we-raise-rates thing, the Fed is clearly in a bit of a pickle.  We all know that stable expectations, transparency, etc. are good things, and that the Fed should not induce volatility by adding uncertainty about interest rate movements. So, Ben Bernanke started an admirable effort to give "forward guidance" about what the Fed would do. As the time to raise rates comes nearer, the Yellen Fed has sensibly wanted to telegraph "data-dependent" decisions. Even John Taylor would cheer at that, as "data dependent" is the heart of the Taylor Rule.

But the Fed also wanted to maintain its "flexibility." And without a Rule, "data dependent" looks to markets a lot like "whim-dependent." Without a rule, the "data" can be "we changed our mind."

So bit by bit, good intention by good intention, the Fed finds itself back in the corner that markets are parsing tiny differences in phrasing -- will She say that soon she might moderate "patience" to "tolerance?" FOMC members are arguing it out in speeches, and the Fed ends up creating more volatility than reducing it.

Source: Torsten Slok

I'm soon going to be nostalgic for the zero bound. It had a great advantage -- everyone knew exactly what interest rates were going to be!  The neo-Fisherite prediction of gently declining inflation was bearing out.

Mary Kissel asked me if I thought raising rates now is a good idea, so the Fed has some room to lower them later. I fumbled a bit, with an analogy that it's like wearing tight shoes because it feels good to take them off.

It's a good and deep question, asked by many, and I see that sort of opinion from many Fed-watchers: Raise now so we have room to stimulate if something goes wrong.

That view embodies a nonlinear or state-dependent idea of how monetary policy works. "Stimulus" is not just the level of the rate, but the rate relative to recent history. So, a zero rate in the crisis of 2018 is more effective if it has been preceded by tightening than if not. It's certainly possible, if rates push around some slow-moving state variable. If someone holds this view and can name the state variable I'd like to hear it.

Mary also asked if I thought the Fed was "politicized" when I opined they were worried about Congressional attention above and beyond economic issues. I fumbled a bit. A perfectly a-political agency would be nuts not to consider how its actions might or might not attract attention from Congress.  And that's how it should be in a democracy. Congress should pay more attention to many agencies, both sides respecting the trade of independence for limited powers. In this case, I agree that Congress may misunderstand perfectly good ideas -- paying interest on reserves, that the interest comes from Treasuries so is a wash to the taxpayer -- but that raises the onus on the Fed to explain these simple concepts so Congress and the rest of us understand what they're up to. Eschewing good economic policy because one worries Congress can't understand it is a bad way to run things.

A last thought: If the US's main economic problem, and financial markets' main shock,  is whether the overnight federal funds rates rises by 0.25 percentage point, in the context of a slowly improving real economy and very low inflation,  there to sit another 6 months to a year, this will be great news. The world is blowing up, Russia is invading Ukraine, Greece could go under, bond markets could go haywire. Look to the variance, not the mean. How the Fed will react to a big shock is far more important than what they will do in a perpetually quiet world. There will be more shocks!

Update: More (if you can stand it) in a second post, here.

Pennacchi on Narrow Banking

I stumbled across this nice article, "Narrow Banking" by George Pennacchi. The first part has a informative capsule history of U.S. banking.

George defines a spectrum of "narrow" banks. For example he includes prime money market funds -- borrow money, promise fixed value instant withdrawal, buy Greek bank commercial paper. But that is "narrower" than traditional lending, as the assets are short term and usually marketable.

Some interesting tidbits:

Prior to the twentieth century, British and American commercial banks lent almost exclusively for short maturities. Primarily, loans financed working capital and provided trade credit for borrowers who were expected to obtain cash for repayment in the near future

Therefore,

... the typical structure of these early banks contrasts with the modern view of banks, according to which the received wisdom is that “[t]he principal function of a bank is that of maturity transformation---coming from the fact that lenders prefer deposits to be of a shorter maturity than borrowers, who typically require loans for longer periods” (Noeth & Sengupta 2011, p.8)....maturity transformation was often considered a violation of prudent banking.

On the nature of assets:

Following the US Civil War, many banks ... invested in commercial paper... With the establishment of the Federal Reserve System in 1913, commercial paper became especially desired because it was eligible collateral for borrowing from the Fed’s Discount Window. According to Foulke (1931), prior to the 1930s, banks and trust companies held more than 99% of commercial paper....In contrast, banks today hold very little commercial paper

so "bank" then = "prime money market fund" today -- but, after 1913, with discount window liquidity support. Some disintermediation makes a lot of sense. In 1830, you could not hope to sell commerical paper in 10 milliseconds on an electronic exchange, so the "liquidity creation" by banks was more necessary.  The struggles the SEC is having with prime funds today has deep roots.

Credit lines:

One credit service of banks that is ubiquitous today but was completely absent from banks in the nineteenth and early-twentieth centuries was the loan commitment. In recent years, more than 70% of business lending was from loan-commitment drawdowns.

This was an especially interesting issue in the crisis. Chari,  Christiano, and Kehoe noticed bank lending going up in fall 2008. Lending freeze, what lending freeze?  Scharfstein and Ivashina argued increased lending was mostly companies grabbing cash promised under existing lines of credit.

Prior to the 1930s, banks often had long-term relationships with particular borrowers: Banks would lend repeatedly for short terms to the same borrower....During the financial panic period of 1857--1858, the [Black River] Bank’s number of borrowers declined by nearly 75%,..early banks made virtually no formal loan commitments.

so rolling over loans without commitment is a way to preserve the option not to lend in a crisis. Perhaps Fed liquidity support is what changed rolling over to promising to do so.

Narrow deposit creation and the viability of equity-backed banking:

...[the] Louisiana Banking Act of 1842. ...required a bank to hold specie (gold) and bills of exchange and promissory notes maturing in 90 days or less in amounts at least equal to its deposits and notes issued. Moreover, the ratio of specie to the total of deposits plus notes had to be at least one-third. The bank could make loans with maturities greater than 90 days, such as mortgages, and hold real estate and other fixed assets but they must be funded with equity capital, not deposits or notes.

Hammond (1957, p.683) states, “The available evidence is that the system operated with distinguished success…Although the banks of New Orleans were well known throughout the country for their strength and integrity, the law governing them was not generally emulated.” Sumner (1896, pp. 387, 389) is more enthusiastic, calling the act “the most remarkable law to regulate banks, which was produced in this period, in any State…"

We seem doomed to constantly reinvent the steam engine, then to forget how it worked.

In summary, prior to the early-twentieth century, many US banks functioned similarly to narrow banks by holding primarily short-maturity assets to match their short maturity liabilities. Despite the several episodes of banking panics, it may be argued that panics occurred primarily at banks that deviated from the narrow-banking ideal. 

A new kind of moral hazard:

A more important response to the 1907 panic was the establishment in 1913 of a government lender of last resort and central bank in the form of the Federal Reserve System. Access to the Fed’s Discount Window made it less costly for banks to hold longer-term and more illiquid loans. Indeed, Friedman & Schwartz (1963) argue that the Fed’s existence changed banks’ behavior in ways that led to more bank failures during the early 1930s. Banks shifted to higher credit-risk loans and felt less need to lend to each other during times of stress because that was now considered the Fed’s responsibility (which the Fed failed to perform adequately).

...bank capital-asset ratios were trending downward since the 1840s (when they were over 50%), but the decline accelerated following the founding of the Fed and the FDIC. The capital ratio then stabilized in the range of 6%–8% starting in the early 1940s

and half of that at the start of the financial crisis in 2007.

As with other proposed bank reforms, recommendations for narrow banks appear most frequently following major financial crises. With the exception of the Louisiana Banking Act of 1842, and possibly the U.S. Postal Savings System, proposals involving narrow banks have not been implemented.

Well, not yet!

The rest of the paper has a nice summary of narrow banking proposals, and theoretical analysis.

Regulation and competition

From taxis to banks, regulation is quickly captured to stifle competition. Only it's usually polite not to say it out loud. Today's WSJ has a lovely little piece, Regulation is Good for Goldman confirming the former and violating the latter pattern.

the Goldman Sachs CEO explained how higher regulatory costs are crushing the competition.

“More intense regulatory and technology requirements have raised the barriers to entry higher than at any other time in modern history,” said Mr. Blankfein. “This is an expensive business to be in, if you don’t have the market share in scale...

he said his bank is “prepared to have this relationship with our regulators”—and the regulators are prepared to have a deep relationship with Goldman—“for a long time.”

.. it is unusual to see a financial CEO like Mr. Blankfein state the effect so candidly. Goldman can afford to hire battalions of lawyers and lobbyists to commune with regulators... As ever, powerful government mainly helps the powerful.

I have met several people who started financial companies in the pre-Dodd-Frank era. They all say there is no way they could start their businesses now. Working out of the garage, you can't afford a multi-million dollar compliance department.

Run-Free Funds Expand

Louise Bowman at Euromoney reports

Fidelity Investments has announced plans to convert up to $125 billion-worth of prime US money market funds (MMFs) into government-only funds –

Meaning, funds that invest only in government securities.

...a move that is a direct consequence of the new SEC regulations covering this business that were announced in July.

...From October next year, MMFs must hold at least 99.5% of total portfolio assets in cash or government securities and repos collateralized by such instruments to be exempt from new regulations imposing fees and gates on such funds in times of stress. The rules are designed to slow deposit runs and reduce systemic risk

In case you missed it, in the financial crisis the Reserve Fund, which held a lot of Lehman debt, suffered a run, and too big to fail quickly expanded to money market funds.

What are they invested in now?

Of the $125 billion in the three Fidelity funds, only 22% is currently invested in government fund-eligible assets, according to BAML. That means $97 billion (78%) now invested in CDs, CP, non-government repo and other instruments will need to be rolled into government holdings. Of this, $9 billion is bank CP, $2 billion non-financial CP and $15 billion non-government repo....less than 10% of the $97 billion in short-term unsecured bank paper held by the three Fidelity funds marked for conversion was issued by US institutions.

This is, in my view, great news. Money market funds were promising complete safety -- you can take your money out at any time -- and lending it, unsecured and uninsured, to banks. Not just too big to fail American banks, but (say) Greek banks.

I thought this would be more of a challenge. You can always promise greater yields during good times and hope for a bailout in bad. Or, each investor hopes to get out ahead of the others. Apparently not,

"Many investors have told us that they want access to money market mutual funds with a stable NAV that will not be subject to liquidity fees or redemption gates," stated Fidelity when news of the conversion became public. 

Though to some extent that's because the temptation is low right now.

With credit spreads on non-government funds as low as they are, the returns are simply not attractive enough versus government funds ... 

Louise worries that this spread will rise.  

The expectation is that...unsecured funding costs for the banks will rise. This has particularly serious implications for non-US banks, as they are far greater users of this market than their US counterparts, which have ready access to cheap deposits.

It will. It should. But paragraph 1 should inform paragraph 2. A higher rate will induce people to take the risk and hold commercial paper directly, or suffer the indignities of the fees and gates in return for higher yields. Supply does equal demand!

Like the other Squam Lakers, I think that floating values are a better solution for non-government funds. But I like emergence of run-free, treasury-backed money market funds!

(This is "narrow banking" but I try not to use that word. The point is not to "narrow" banking. Using that word reinforced the fallacy that the size of credit creation must contract. The point is that risky investments should have floating-value or run-free liabilities, and fixed-value liabilities should be backed by government securities. For more, "Toward a run-free financial system")