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Fed chairman not quite getting it …

In an article in yesterday’s WSJ The Fed’s Exit Strategy, federal Reserve Chairman Ben Bernanke provides an account of some of the operations of the monetary system that I write about in billy blog. While he doesn’t say it explicitly, he confirms that debt is issued to support interest rates (not fund net government spending) and that debt is not necessary at all if the central bank pays a “competitive” rate on overnight bank reserves held at the central bank. He also confirms that inflation is not an inevitable aspect of an expansionary package but it could be. All fundamental propositions of a modern monetary view of macroeconomics. So in one week, a Nobel Prize winner and now the Chairman of the Fed are stumbling around logic that confirms the neo-liberal driven deficit-debt-inflation-higher-taxation hysteria is without foundation.

Don’t get me wrong though – Bernanke is not providing pearls of widsom here. He seems to stumble through this explanation, occasionally heading in a direction that is supported by an understanding. But then, just as he is on the verge of revealing he knows how the whole fiat monetary system works, he slips back into erroneous reasoning that reveals he doesn’t really get it at all.

The aim of his article is to show how the Fed (US central bank) has the capacity to withdraw its “required … highly accommodative monetary policy” once growth returns. However, he starts off on the wrong foot.

Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.

The problem is that I have seen no empirical evidence to support the claim that the monetary policy changes (interest rate cuts) have done much other than transfer huge amounts of public spending into the hands of the top end of town and provided windfall gains to the financial barons like JP Morgan and Goldman-Sachs.

Has anyone really done a study to show that the losses from those on fixed incomes (via the interest rate cuts) have had smaller effects on aggregate demand than the gains from those exposed to interest rates via debt? Certainly this research hasn’t been done here in Australia.

Further, the reserve-adds that the Fed made provided no “extra” capacity for the banks to lend. What was missing was the desire to borrow from credit-worthy customers who had become ultimately risk-averse. Loans create deposits which then are backed by reserves added later. The causality does not run the other way around. So while the Fed actions may have boosted bank reserves they did not increase the desire of borrowers to seek credit. Inasmuch as credit is flowing again in the US (and elsewhere) it is probably the fiscal impacts on demand (creating a floor to spending) that has increased the confidence of borrowers.

Finally, while the other Fed actions – Term Asset-Backed Securities Loan Facility (TALF), supported by the Treasury’s Troubled Assets Relief Program (TARP) – have probably improved the functioning of the financial markets somewhat there were more obvious ways to accomplish the same end. The TALF involved the Fed lending billions “on a non-recourse basis to holders of assessed AAA rated asset-backed securities which were backed by newly and recently originated consumer and small business loans.” The TARP then provided credit protection to the Fed for their TALF exposure. A much more direct way to achieve the same end – promoting confidence – would have seen the Federal Deposit Insurance Corporation (FDIC) merely extending its credit default insurance coverage to a wider net of “risk-assessed” banks. The scheme has been functioning since the Great Depression, is largely understood and would require no additional machinery to accomplish the extension. Also, politically, it would not have been seen as handing over the “crown jewels” to the financial barons!

Bernanke continues by asserting the expansionary (and contractionary) influence of monetary policy.

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.

The basis of neo-liberal macro policy is that inflation is the key problem and has to be managed via monetary policy impacts on aggregate demand. So interest rate increases contract the economy because, allegedly the dominant effect is the rising cost of credit chokes spending; while interest rate falls are expansionary for the opposite reason. Fiscal policy is deemed to be a passive player in this sense “staying out of the way” of monetary policy. This means that fiscal policy should never compromise the inflation-first monetary policy stance.

Neo-liberals believe the fiscal policy stimulus will increase inflation which would require higher interest rate settings from the central bank to choke of the demand. They thus argue that in normal times it is better to avoid fiscal policy (run surpluses) and let monetary policy do the counter-stabilisation effort.

Note here that counter-stabilisation used to mean – manipulate spending to ensure the real economy delivered high employment levels. Now it largely means – manipulate the real economy to ensure inflation remains low and stable. Under this latter interpretation, policy has become a vehicle whereby unemployment has become a policy tool rather than a policy target.

The problem with this logic, apart from the erroneous view of fiscal policy, which I have considered often here, is that monetary policy is not nearly as powerful a stabilisation tool as it was once thought to be. The real economy is not very sensitive to interest rates movements. During recessions, monetary policy has little proven effects in activating an economy. In bad times lower interest rates do not induce consumer expenditure. And likewise, lower interest rates do not induce more investment (by making borrowing cheaper) as during these periods there tends to be excess capacity and output is not sold. Empirical evidence suggests that the interest elasticity of investment is at best low, non-linear, and asymmetric. While an increase in interest rates might in some cases moderately reduce investment during economic booms (when the economy is at or above capacity), the reverse is not true. In general, it is the outlook for profitability, rather than the price of credit, that influences investment.

Further, rate hikes add income to some agents within the non-government sector which may add to inflation.

So a reliance on monetary policy to control inflation is probably misplaced and interest rates have to be increased significantly before real effects are noted.

After describing how an “exit strategy” (the anti-inflationary strategy) is “tied to the management of the Federal Reserve balance sheet”, Bernanke notes that reserve accounts held by banks at the Fed are higher than usual. He says:

And given the current economic conditions, banks have generally held their reserves as balances at the Fed. But as the economy recovers, banks should find more opportunities to lend out their reserves.

What? So this implies that reserves will fall once banks start lending again. If a first-year macro student said that they would fail. In terms of the macroeconomic system bank lending does not diminish the reserves held by the banks at the central bank. The reserves are high at present because of the large policy injections (vertical transactions). But the reserves will not fall in aggregate unless further vertical transactions drain them (for example, government bond sales).

The non-government sector cannot create new net financial assets. That is basic national accounting.

Bernanke then says that as bank lending recovers inflation might result. The transmission mechanism that he doesn’t outline would have to be – increased loans, stimulate increased aggregate demand, which then pushes nominal spending beyond the real capacity of the economy to absorb that impulse and the firms react by price-adjusting rather than quantity-adjusting. It has nothing to do with the “higher than usual level of reserves”.

Bernanke then seemingly oblivious to his previous inference (that a lack of loans is responsible for the “high” level of reserves) says that:

When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.

It is true that the central bank can create net changes in the level of commerical bank reserves (and reserves of other deposit institutions). So they could drain the (“eliminate”) reserve balances by selling government bonds which would swap a financial asset (reserve) for another one (bond) $-for-$.

The only reason that you would consider doing this is if the banks were trying to get rid of the excess reserves they held overnight by lending them on the interbank market and this competition was driving the overnight rate below the desired target (policy) interest rate. More on this later. You would not try to do this to stabilise aggregate demand. There are more direct measures available such as … fiscal policy (as we are starting to relearn).

Bernanke then explains that the central bank controls the interest rate:

… we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

While this might be obvious to you think about it in the context of the financial crowding out story whereby interest rates are alleged to be determined by the interaction of the supply of loanable funds and the demand for them. At any point in time, the supply is fixed by so-called intertemporal preferences and so a rising budget deficit which has to be “financed” by debt will impose an increasing call on the scarce funds (supply) and the rising interest rates are then said to ration the demand so that it is rendered compatible with the increasing supply (as preferences dictate that current consumption becomes more costly relative to future consumption due the rising premium (higher rates).

This is such a loony but pervasive depiction of the way financial markets work. Bernanke is right here – the central bank can just as easily increase the interest rate in the economy (which sets the term structure of rates out across the maturity curve) as decrease it … as leave it unchanged. They also have other devices available to influence the term structure (see below). Further, given loans create deposits, and saving rises with income, and net public spending increases income and provides the “funding” which it then borrows back (voluntarily) via debt issuance … you quickly see how ridiculous the financial crowding out story is.

The other point worth noting is his reference to “paying interest on reserve balances” which the Fed started doing late last year. The US Fed previously paid nothing on reserves held overnight and so there was always an incentive for the banks with excess reserves to lend them overnight to banks which were reserve deficient.

Bernanke mentions it again saying that the:

Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate.

As regular readers will note if the “cash system” has surplus reserves overall (that is, all banks net have more than zero reserves assuming no formal positive reserve requirements are in place), then when banks with positive reserve balances (which are currently earning zero) try to seek a competitive return by lending then to other banks (which may have a negative balances), this action places downward pressure is put on the overnight interest rate in the interbank market. If the central bank has a positive target (policy) rate (and a zero support rate – the rate paid on excess reserves) then this competition will drive the overnight rate to zero and the central bank will “lose control” of monetary policy.

In the absence of the support rate, the only option available to the central bank in these situations is to drain the excess reserves by issuing public debt. The fact that excess reserves are associated with the stimulatory effects of increased net public spending provides commentators with the easy correlation that the deficits are being financed by the debt issuance. Clearly this is false. The deficits do not need financing in a fiat monetary system. The debt is being issued to support the current interest-rate targets of the central bank.

So the introduction of a positive support rate (it is 0.25% below the RBA’s target rate in Australia) means that the interbank competition will be attenuated and the overnight rate would fall to the support level rather than zero if no debt was issued. So if you set the support rate equal to your target rate then the central bank has complete control over its monetary policy stance (the target policy rate) even if there are excess reserves overall in the cash system and does not need to issue public debt to drain these reserves. This is because the banks would be happy with the support rate and not require an interest-bearing public bond to substitute for their reserve holdings.

If they really understood all of this and also were not under the spell of the neo-liberal mantra about placing public debt $-for-$ into private markets to cover net spending (deficits) then the government would have an easier time. It would not issue any debt and would leave the reserves that were added by the net spending to earn the support rate. Nothing real would be altered. It would have exactly the same impact on the real economy as issuing the debt. The only difference would be in the mix (not the level) of financial assets held by the non-government sector. It could sack the Australian Office of Financial Management staff and re-train them as cancer researchers or Job Guarantee managers. Of-course, there would be a hue-and-cry from the bond markets as their guaranteed government pension lollypop (the bond annuity) was no longer offered to them on a plate.

Bernanke reinforces these operational insights:

Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.

Thus the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the federal-funds rate …

Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank’s liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates.

Note that in the Japanese case, the zero support rate they paid until recently was the reason they were able to hold short-term policy rates at zero for a decade and a half. I have written about this several times.

You get a sense of the overall level of ignorance out there about the way the fiat monetary system operates in an accounting sense (no theory here) when you read Bernanke say:

Despite this logic and experience, the federal-funds rate has dipped somewhat below the rate paid by the Fed, especially in October and November 2008, when the Fed first began to pay interest on reserves. This pattern partly reflected temporary factors, such as banks’ inexperience with the new system.

However, this pattern appears also to have resulted from the fact that some large lenders in the federal-funds market, notably government-sponsored enterprises such as Fannie Mae and Freddie Mac, are ineligible to receive interest on balances held at the Fed, and thus they have an incentive to lend in that market at rates below what the Fed pays banks.

So if they had really understood what was going on they would have included these huge institutions in the scheme if they had wanted the support rate to equal the federal-funds rate. It seems they were surprised that funds rate (what Australians call the target policy rate) has fallen below the support rate. The operational factors I have explained provide the obvious solution! Pay Fannie and Freddie the support rate on their reserves irrespective of whether they conform to the previous concept of a member bank.

Again, Bernanke recognises the arbitraging behaviour of the banks in relation to the target interest rate and its implications for debt issuance:

Under more normal financial conditions, the willingness of banks to engage in the simple arbitrage noted above will tend to limit the gap between the federal-funds rate and the rate the Fed pays on reserves. If that gap persists, the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets – the second means of tightening monetary policy.

He proposes “four options for doing this”. The first two options are obvious – they substitute an interest-bearing asset for a reserve balance. The third option does the same thing but also identical in impact to issuing government debt which means it can provide maturity (or term) structure to interest rates by offering a rich term deposit structure.

The fourth option again allows the central bank to influence the term structure – this time at the investment end of the yield curve (long-term rates).

These are Bernanke’s four options:

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks – analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

So overall, Bernanke appears a little confused to me.

But he does express an optimism which is shared by our own central bank. The latest RBA Board Meeting minutes are also fairly bullish and they expect our carbon economy to sail back into growth on the back of Chinese economic growth and our fiscally-stimulated retail sales sector. The minutes come for the meeting where the RBA sets the short-term interest rate for the month ahead.

The minutes say that:

The information … provided further evidence that the global economy was stabilising. Importantly for Australia, the Chinese economy was growing quite robustly, partly due to strong public-sector construction, and production had also picked up in a number of other Asian economies. Conditions in international credit markets had continued to improve … the most likely outcome for the world economy over the next year or two would be subdued growth … Nonetheless, significant vulnerabilities remained … A subdued global recovery would see further increases in spare capacity, which meant that disinflationary pressures were likely to persist over the period ahead.

Recent information on the domestic economy suggested that economic activity was not as weak as had been expected. Exports had been surprisingly strong, which primarily reflected demand from China. Some mining companies and ports were reporting that they were again operating close to capacity. Household spending had increased due to the effects of the fiscal stimulus and low interest rates, and most indicators for the housing market suggested that demand in that sector was picking up. Housing loan approvals had recorded a strong increase, and house prices were again picking up, with the rises becoming more widespread. Both consumer and business confidence had rebounded strongly from their low points …

I doubt that the monetary policy changes in Australia have had much impact overall – see above on my view of monetary policy. Distributional impacts occur with interest rate changes and you cannot be sure which way they will impact on aggregate demand. Probably very mildy positive (given that those who live on interest incomes perhaps have a slightly lower propensity to consume than those who borrow).

But it is clear to me that the fiscal intervention has helped ward off the worst impacts of the global downturn. However, that doesn’t mean we do not need a third stimulus package. A Financial Review journalist asked me about this today. I said that a third stimulus was definitely required.

Why? The subdued growth forecast means that GDP will not be growing fast enough to absorb the growth in labour productivity (which is pro-cyclical) and the growth in the labour force. And you know what that means … rising unemployment for the period ahead. Unless GDP growth gets back above 3 per cent very quickly (which it won’t) then unemployment will continue to rise. I expect it to keep rising for another 18 months or so yet and once GDP growth does get back on trend we will be left with a huge pool of long-term unemployed who will miss the growth boat for years to come.

There is an urgency in my view to provide large-scale direct public sector job creation immediately. But I will write about that next time.

Coming up: is it better to be inside or outside the tent?

I was in Sydney yesterday speaking at the ACTU Jobs Summit. On the way home I thought about the famous quote attributed to Lyndon B. Johnson who was asked about his position on the then FBI Director J. Edgar Hoover. LBJ had tried to shaft him but realised evidently that it would be more trouble than it was worth getting rid of him. A NYT journalist wrote on October 31, 1971 that LBJ’s reaction to retaining Hoover was:

Well, it’s probably better to have him inside the tent pissing out, than outside the tent pissing in.

Tomorrow I will write about why the Summit was dominated by those in the tent and why I always stay outside of it. This will underping my call for a third stimulus package.

Unless, that is, something else comes to mind that is more interesting.

This Post Has 4 Comments

  1. Bill

    what we have learned about housing over the last few years is that it is boosted by the availability of credit, such i think are the animal spirits as far as housing as investment is concerned in places like australia and the UK. What we’ve seen appears to be low interest rates, or in this case a ZIRP, having a delayed reaction in putting a tentative floor below house price drops. The closer we are to a perceived bottom, the more confident banks are to lighten lending restrictions. It could be argued that increased confidence is stimulating this perceived recovery, but aren’t some of the monetary policy decisions about restoring confidence to the consumer and financial sector.

    Isn’t that an example of interest rates having an effect on the real economy. The housing market appears to have been disconnected from econmoic fundamentals for some time, but then housing is such a huge part of the economy.

  2. Dear Tricky

    I am not sure whether the low interest rates have added confidence or the guarantees and the fiscal support. The point is that there are reasons why interest rate changes add and subtract demand. So an empirical study needs to be done (that is unambiguous) to disentangle those effects. I am not aware of a convincing study that show the borrowers gain more than the creditors lose.

    best wishes

  3. Bill,

    There is another consideration here. While you write your blog for the purpose of exposition, many central bankers see their public pronouncements as another policy tool in their tool-bag. A 5th option to add to the four in the list, if you like. For that reason, Bernanke is likely to express himself in terms market participants will relate to, whether or not they are based on a sensible understanding of the the system, with the aim of putting downward pressure on long-dated interest rates.


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