Sunday, November 17, 2013

An Explicit Qualifier


Glad to see Josh Wojnilower is active again.

I'm going to assume he is now fully capable of writing things that are fully beyond my comprehension. I'm not going to try to participate in any discussion of his new paper on the endogeneity of money. But I do want to look at one small piece of the abstract that he shares. I think it makes particularly explicit something that needs to be particularly explicit:

The theory behind endogenous money is that banks issue new loans (credit) on demand and look for reserves later. The Federal Reserve must ultimately accommodate increases in demand for reserves from the banking sector to maintain an interest rate target...

In other words, if the Fed fails to "accommodate" the demand for reserves, interest rates are affected.

That is absolutely clear and absolutely true and, to my mind, it is a simple case of supply and demand. If demand increases and supply does not, prices must rise.

If the demand for reserves increases, and the supply of reserves does not, the interest rate on reserves must rise.

It bears repeating, because it is so often left unsaid. It is the way the system works.

Too often, the afterthought "to maintain an interest rate target" is left out of the original text. Leave it out, and you're left with a statement that's not really true. But people say it all the time. People say the Fed must accommodate the demand for reserves.

No, it doesn't "must" accommodate the demand for reserves. No, it doesn't. It depends what the Fed wants to do. As a rule, though, the Fed has been known to let interest rates change quite often. Ha! I just looked at FRED's FEDFUNDS page and guess what I saw:

Averages of daily figures.

The FedFunds rate changes every day.

Graph #1: FedFunds in the ZLB Era
What brings this to a head? Why do I write of it? Because I came across something called Explainer: How does the Fed stimulate the economy? where we read:

Yellen emphasized that one of the Federal Reserve's primary duties is to pursue its dual mandate for maximum employment and stable prices.

The Fed attempts to pursue these two goals through changes in its target interest rate.

See? They like to change the interest rate. It's what they do.

13 comments:

Luke Smith said...

"The theory behind endogenous money is that banks issue new loans (credit) on demand and look for reserves later."

I read one of those cheesy real-estate investment books earlier this year. My favorite quote was "Deals come before the money". That is a salesman's mentality: sell things you cannot provide.

Luke Smith said...

*Oops, meant to say "sell things you do not have". That is the art of hustling -- you just make it happen.

geerussell said...

Too often, the afterthought "to maintain an interest rate target" is left out of the original text. Leave it out, and you're left with a statement that's not really true.

It's important to emphasize here that if you leave off "to maintain an interest rate target" the counterfactual is not unmet demand for reserves it is that the rate moves away from the target (and probably with some volatility).

Between overdrafts, daylight and overnight lending facilities, reserves are never supply constrained. Always available, at some cost. Scott Fullwiler goes into these operations in gross detail here.

Yellen emphasized that one of the Federal Reserve's primary duties is to pursue its dual mandate for maximum employment and stable prices.

The dual mandate steals all the press but the primary duty of the Fed is the functioning and stability of the payments system:

"An Act To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes."

If demand for reserves isn't met, the currency fails to be elastic, the payments system goes off the rails and we're back to the pre-Fed era where bank obligations don't trade at par with one another and with government money.

Rates and liquidity. Everything else is an afterthought, including the dual mandate that was tacked on later.

The Arthurian said...

An elastic currency, yes, but not infinitely elastic. If we stretch a dollar to cover $5 bank credit, then $10 must be okay... If $10, then $20... if $20, then $40. Where does it end? It ends in financial crisis, unless policymakers are smarter than ours seem to be.

Anyway, it's not only the Fed. Congress creates an environment that demands always more use of credit. Therein lies the problem.

geerussell said...

Yes, infinitely elastic or the system fails. Quantity of reserves is not and can not be a systemic constraint.

Where does it end? The front for expansion of private credit is bounded by solvency as loosely enforced with capital requirements and demand for loans which is the more operative constraint as a healthy lender with performing loans will generally find no shortage of people willing to put in equity.

When it comes to putting the brakes on that expansion, the brakes have to be applied at the front in the area of solvency where loans are written, capital is required and demand is operative.

Putting the squeeze on liquidity (in contrast to solvency) via reserves does have an effect comparable to a tax on lending. It makes it less profitable but it operates via price, not quantity. Making liquidity more expensive may reduce the volume of lending or it may just get passed through in the spread lenders charge their customers. Here too, demand for loans and the state of the broader economy is driving the bus.

geerussell said...

An afterthought here on this:

If we stretch a dollar to cover $5 bank credit, then $10 must be okay... If $10, then $20... if $20, then $40.

Just to elaborate on the relationship here, the prior fact is extant credit. $10 or $20 or $40 of credit already created. The choice then becomes whether to uphold the promise of central bank backing to make those deposits money-good at settlement. Break the promise, break the system. After that $40 of credit has been created it's too late to have misgivings about it.

If I'm concerned that $40 of credit is problematic, I need to choke it off at the point of issuance.

The Arthurian said...

"the prior fact is extant credit."

The prior fact is the fact that the economy cannot function when the costs of credit use become too great.

Joshua Wojnilower said...

Art - Thank you for sharing the link and for highlighting the importance of qualifying how the Fed elects to conduct monetary policy in pursuit of its broader goals. As a side note, I wouldn't sell short your own ability to comprehend complex topics as evidenced by your efforts on this blog.

A quick comment on the effective Federal funds rate during the period you highlight. Under the "permanent floor" system currently employed by the Fed (explained brilliantly by Scott Fullwiler), the rate of interest on reserves (currently 0.25%) is expected to serve as a lower bound ("floor") for the effective Fed funds rate. This expectation is based on the notion that no firm would sell/loan a reserve at a price below that attainable by simply depositing the reserve at the central bank.

As your chart shows, the effective Federal funds rate has consistently been below the rate of interest on reserves over the period in view. One explanation for this anomaly is that GSEs and foreign-based institutions are not eligible to receive interest on reserves deposited at the central bank. However, assuming the interbank market is relatively competitive, commercial banks would effectively compete away the arbitrage ("free money") opportunity from buying risk-free reserves at a lower rate and then depositing them at the Fed for profit.

This leads to a second possible explanation. Apparently the GSEs, which remain largely owned by the Treasury, have chosen to only transact in the interbank market with clearing banks. To my knowledge, only two clearing banks exist: Bank of New York and JP Morgan. By eliminating competitive bidding for its reserves, the GSEs are essentially giving away money to the clearing banks. My speculation is that this is politically motivated, but that is merely speculation.

The above discussion is currently included in a separate forthcoming paper on "The Political Economy of Paying Interest on Reserves."

geerussell - You make a number of good, interesting points and highlight a fabulous paper by Fullwiler. One minor critique I will make is that reserves are "always available, at some cost" only because of the method in which the Federal Reserve elects to conduct monetary policy. The Fed is not required to fulfill this duty, although I completely agree failing to follow that rule would result in severe financial instability and eliminate any chance of approaching their currently mandated goals.

Sorry, one other note. I think when discussing an infinitely elastic supply of reserves it may be worthwhile to distinguish between a point in time and over time. I would agree the supply is infinitely elastic at a point in time, at the prices set by the central bank. I'm not sure I would agree reserves are infinitely elastic over time, as the Fed has methods by which it could limit the supply.

Most people will understand your valid points whether or not you mention above the distinctions, but it may help avoid some critiques from those unaware of Fed operations or simply inclined to disagree with this approach.

The Arthurian said...

Thanks, Woj.

When I think of "Fed policy" I don't think of what they're going to do the next time somebody wants reserves. I think of what they're going to do until further notice. The Fed may be "raising" interest rates, or "holding them steady" or lowering" them. That's really about all it can do.

I think Wojnilower's remarks on elastic "at a point in time" and "over time" deal with this exactly. A "point in time" is the next time somebody wants reserves. "Over time" is until further notice.

I think Woj hits the nail on the head. He seems to have found the point of disagreement between geerussell and me. I'm not thinking that the next time somebody wants to borrow reserves, if the Fed says "no" the functioning and stability of the payments system will collapse.

I'm thinking: Rates are going up, boys! What that means is that, over time, the quantity of reserves is going to be increasing at a slower pace than it has been. Obviously the Fed can do this.

I find it most frustrating when people say things that imply the Fed cannot do that -- things like "the Fed must accommodate the demand for reserves" with no explicit qualifier.

geerussell said...

I think when discussing an infinitely elastic supply of reserves it may be worthwhile to distinguish between a point in time and over time. I would agree the supply is infinitely elastic at a point in time, at the prices set by the central bank. I'm not sure I would agree reserves are infinitely elastic over time, as the Fed has methods by which it could limit the supply.

I think Wojnilower's remarks on elastic "at a point in time" and "over time" deal with this exactly. A "point in time" is the next time somebody wants reserves. "Over time" is until further notice.

Joshua and Art- I'm going to double down here on the idea that it's a simply monopoly and the Fed as monopolist controls price and lets quantity float and the reason this is their only option is there is no time frame where failure to provide demanded reserves will not cause settlement failure and/or failure to meet regulatory requirements. It holds a a point, it holds over time.

Yes, the Fed has ways to change the supply but these too are rate maintenance not supply constraints. When the Fed drains supply, it's a price move that pushes banks towards the higher rate options of overdrafts and overnight lending. The reserves are still available, at some price. When the Fed adds supply, this too is a price move that pushes the rate towards zero or the policy floor.

As presented, that concept of "until further notice" wrt quantity demanded translates into is the Fed saying "we won't cause settlement and regulatory failure... until further notice" and I'll argue they aren't saying that implicitly or explicitly.

The message and commitment is "we will never crash the system but we will exert policy control over the price at all times".

Joshua- On that leaky 0.25% floor and GSEs, they have other complimentary policy tools to deploy to reach those reserves that don't receive IOR. Term deposits and a reverse repo facility, detailed here. Reverse repo also functions as a sort of unwind to mitigate the squeeze on collateral availability caused by QE.

Joshua Wojnilower said...

geerussell - Here are my two plausible counter arguments:

1) The Federal Reserve, instead of supplying reserves, could assess a fine for failure to comply with regulations or settle payments. This would affect the price of reserves, but not require changing supply.

2) The Federal Reserve has powers, which it no longer uses, to directly restrict the extension of credit. In doing so, it would also reduce the need to supply reserves.

Regarding your comments on IOR, I'm not sure I quite understand your argument, so hopefully you can clarify. Are you saying the Fed has tools to raise the effective funds rate to the rate of interest on reserves? How would those tools work? And if so, why would it not make use of those tools? I'm obviously really interested in this topic so I appreciate the links and suggestions.

geerussell said...

Joshua - On your first counterargument, I'll just say let's hope we never have to see that premise tested. I'm with you 100% on the second, the Fed has broad powers in that regard and it's a good place to apply the brakes.

. Are you saying the Fed has tools to raise the effective funds rate to the rate of interest on reserves? How would those tools work? And if so, why would it not make use of those tools? I'm obviously really interested in this topic so I appreciate the links and suggestions.

The general problem is as you pointed out with the GSEs, some account holders at the Fed can't receive IOR. I believe (recalling from memory, don't have a source handy) it breaks down along the lines of deposit taking or institutions that are technically banks getting IOR and everyone else not.

The idea is to have tools that can offer a rate on reserve balances that don't receive IOR in order to bring the FFR up to the IOR rate.

Term deposits work like certificates of deposit at a commercial bank. They're just time deposits that pay interest and lock up balances for some duration.

In reverse repo, the Fed would short-term borrow reserves using securities from its own balance sheet as collateral. This too is a way to pay some interest on reserve balances and it has the further feature of acting in reverse of QE, swapping securities into private hands, draining reserves out. Securities which in turn can be used as collateral in credit markets.

Basically the reason they haven't done it already is they haven't had the tools in place/needed to raise rates. They only just rolled out the reverse repo facility and it's probably fair to say it's still in shakedown mode working out the procedural kinks. However, when the day comes they want to raise the floor or just firm it up, these will be essential rate maintenance tools to compliment IOR.

For some further reading, Peter Stella has done some nice work on exit strategy and collateral chains here and here. Scott Skyrm is another good resource, diving into the details of repo and its implications here.

Joshua Wojnilower said...

geerussell - Thanks for clarifying your point and providing extra links/references. In my paper on IOR, I argue that the Fed will raise short-term interest rates in the future by adjusting the IOR rate. A concern had been whether or not the mechanism would be effective given the current anomaly. Your explanation definitely gives the Fed a method to enforce the price floor, which helps the argument, so thank you.