Josh Hendrickson on IOR and demand for bank reserves

Josh Hendrickson has an important new (forthcoming) paper in the Journal of Macroeconomics. Here’s the abstract:

Over the last several years, the Federal Reserve has conducted a series of large scale asset purchases. The effectiveness of these purchases is dependent on the monetary transmission mechanism. Former Federal Reserve chairman Ben Bernanke argued that large scale asset purchases are effective because they induce portfolio reallocations that ultimately lead to changes in economic activity. Despite these claims, a large fraction of the expansion of the monetary base is held as excess reserves by commercial banks. Concurrent with the large scale asset purchases, the Federal Reserve began paying interest on reserves and enacted changes in its Payment System Risk policy. In this paper, I estimate the effect of the payment of interest on reserves (as well as other payment policy changes) on the demand for daylight overdrafts through Fedwire. Since Fedwire provides overdrafts at a fixed price, any fluctuation in the quantity of overdrafts is a change in demand. A reduction in overdrafts corresponds with an increase in the demand for reserves. I show that the payment of interest on reserves has had a negative and statistically significant effect on daylight overdrafts. Furthermore, I interpret these results in light of recent theoretical work. I argue that by paying an interest rate on excess reserves that is higher than comparable short term rates, the Federal Reserve likely hindered the portfolio reallocation channel outlined by Bernanke. Thus, the payment of interest on reserves increased payment processing efficiency, potentially at the expense of limiting the ability of monetary policy to influence economic activity.

And here Josh describes the role of overdrafts:

Reserves are held both to meet unexpected withdrawals and to settle payments between banks, with the latter motive being substantially more significant. Large-scale wholesale payments processed through Fedwire are done through a real-time gross settlement system. This means that payments to and from banks are credited and debited in real-time. If the bank has insufficient reserves to cover a debit in their reserve account, the bank is extended credit that is expected to be repaid by the end of the Fedwire day. Historically, a large portion of these daylight overdrafts have been backed by pledged collateral of the bank.3 It follows that banks can hold either highly liquid, short-term debt such as Treasury bills and other forms of short-term debt that can be sold quickly or used in repurchase agreements in the event of an overdraft or banks can hold reserves sufficient to fund payments. Prior to the paying of interest on reserves, banks faced a trade-off of holding short-term debt or reserves. If the bank held reserves it would enable more efficient settlement of payments at the cost of foregone interest on short-term debt. Holding interest-bearing assets provided a positive rate of return, but overdrafts due to insufficient reserve balances were subject to fees. With the payment of interest on excess reserves, this tradeoff is eliminated because the policy change allows banks to earn interest comparable to alternative assets while avoiding fees associated with overdrafts. The market for daylight overdrafts therefore provides an opportunity to analyze the effect of the payment of interest on reserves.

The paper confirms that the adoption of interest on reserves in October 2008 was indeed a serious (contractionary) policy error.  More broadly, it reconfirms the importance of looking beyond interest rates when evaluating monetary policy, and specifically the importance of the portfolio rebalancing channel as a transmission mechanism for changes in the quantity of base money.


Don’t let Trump be Trump

People my age recall the “Let Reagan be Reagan” chant from his true believers. With Trump it’s the opposite; you don’t want him to to be himself. Here’s what Steve Bannon thinks is the real Trump:

“We still have a huge movement, and we will make something of this Trump presidency. But that presidency is over. It’ll be something else. And there’ll be all kinds of fights, and there’ll be good days and bad days, but that presidency is over,” Bannon said. He added that it would be a miscalculation to assume Trump will change.

“His actual default position is the position of his base,” Bannon said. “I think you saw it this week on Charlottesville.”

I think that’s right.  The real Trump is a guy who’d like to be a fascist dictator committing war crimes, but our country won’t let him fill that role.  (That’s why Trump respects people like Duterte and Putin more than the Angela Merkels of the world.)

Right after the election, I pointed out that early appointments like Flynn and Bannon were either loony or scary.  Now they are gone, as are many others.  Don’t get me wrong; it’s still a bad administration, but it’s no longer horrific, off-the-charts bad.  People like Cohn and Kelly are now in charge.

It’s been interesting to watch the National Review pivot once again.  They were strongly anti-Trump during the campaign, before tilting more in his favor after the election.  Now they are once again appalled:

In One Tweet, Donald Trump Just Spread Fake History, Libeled a Hero, and Admired an Alleged War Crime

[Trump’s recent tweet] is almost certainly referring to a story he told during the campaign. He claimed that General John J. Pershing crushed an Islamic insurgency in the Philippines by committing a heinous war crime. Here’s Trump at a South Carolina rally:

They were having terrorism problems, just like we do,” Trump said. “And he caught 50 terrorists who did tremendous damage and killed many people. And he took the 50 terrorists, and he took 50 men and he dipped 50 bullets in pigs’ blood — you heard that, right? He took 50 bullets, and he dipped them in pigs’ blood. And he had his men load his rifles, and he lined up the 50 people, and they shot 49 of those people. And the 50th person, he said: You go back to your people, and you tell them what happened. And for 25 years, there wasn’t a problem. Okay? Twenty-five years, there wasn’t a problem . . .

Trump isn’t just spreading falsehoods, he’s doing so in a context that puts a presidential stamp of approval on war crimes. Even worse, he’s doing it in direct defiance of the warrior ethos of the American military. There is no possible way that any of Trump’s generals would approve of this sentiment. I’ve never met an American officer who would carry out an order to commit an atrocity like this.

Trump is careening out of control. He says what he wants, when he wants, and neither truth nor consistency nor wisdom nor prudence dictates a single syllable that comes out of his mouth. By many accounts he’s taken to directly defying his advisers simply for the sake of declaring that he’s in charge. This isn’t leadership. It’s a collection of temper tantrums. Unfortunately, those tantrums have consequences.

People are shocked that we’ve ended up with a madman in the White House, but this was all clearly spelled out in the campaign.  GOP voters apparently had no problem with a candidate advocating war crimes.

Going forward, the key will be whether the grownups in the room can keep the big baby in his crib.  I hope and pray that our generals have privately decided not to carry out a order to launch a nuclear attack, unless of course the generals agree with Trump that there is a threat that would justify that sort of action.

PS.  Heh Mr. Macho Trump: How come you didn’t tell us during the campaign that there was a Washington establishment that would emasculate you once you took office?  You told us that you were a man of action that would get things done.  “Who knew the deep state could be so complicated?”

PPS:  The bigger the threat, the bigger the overreaction:

1.  WWII leads to internment camps for Americans wrongly called “Japanese”.

2.  Stalin leads to McCarthyism

3.  9/11 leads to TSA and NSA abuses, plus the Iraq war

4.  The alt-right is leading to a rise in left-wing opposition to free speech.

The right attitude was to oppose internment camps, McCarthy, and the NSA, but to oppose the Nazis, Stalin and Al Qaeda even more strongly.  Much more strongly. That seems pretty simple, but it’s remarkable how few people are able to do so.

So oppose the left-wing overreaction, but oppose what provoked that overreaction even more strongly.

Slippery slope arguments

1.  “If we set up no smoking sections on airlines, then eventually you won’t be able to smoke at all on airlines.  Then they’ll ban smoking in restaurants, then bars, then offices, then spaces outside offices, then hotel rooms and apartment complexes.  Then they’ll start going after sugary drinks.”

“Don’t be ridiculous.”

2.  “If we legalize homosexuality, then eventually they’ll ask for gay marriage.”

“Don’t be ridiculous.”

I’m old enough to recall these slippery slope arguments, and I lived long enough for them (and many others) to come true.  I have no idea what the future will look like, except that I’m pretty sure it will look ridiculous from our perspective.  And that’s fine; it’s their world, not ours.

This post is motivated by a Ilya Somin piece in the Washington Post:

Perhaps because efforts to separate the Confederacy from slavery are so implausible, defenders of keeping Confederate monuments in place increasingly resort to slippery slope arguments. Here’s Donald Trump making the case earlier today:

“I wonder, is it George Washington next week?” Trump asked….

He went on to make a slippery slope argument — equating Confederate general Robert E. Lee with presidents like Washington and Thomas Jefferson, who were slave owners…

“So, this week it’s Robert E. Lee,” Trump said. “I notice that Stonewall Jackson is coming down. I wonder is it George Washington next week, and is it Thomas Jefferson the week after? You know, you really do have to ask yourself, where does it stop?”

In fairness, the slippery slope argument is sometimes advanced by more intellectually serious advocates than Trump. It is wrong, even so. The argument fails because there are obviously relevant distinctions that can be made between Washington and Jefferson on the one hand and Confederate leaders on the other.

On the issue of Confederate statues, I agree with Somin.  But on the slippery slope argument I agree with our sleazy, lying, white nationalist President.  They will eventually come after Washington and Jefferson.  Washington is my favorite President, but he was also a slave owner. That’s not a small insignificant flaw; it’s a massive moral failure, far worse than anything Dennis Hastert was accused of.

I don’t favor re-naming the Washington Monument, nor do I think eating meat is immoral, but I fully expect future generations to decide that eating (non-test tube) meat is immoral, and I expect them to rename the Washington Monument.

Our current world is our business, and the ethical standards adopted by the future world is their concern.  That’s the real problem with slippery slope arguments.

Was the zero bound holding back the Fed during 2009-15?

Most people thought the answers was yes.  I thought it was no.  Here’s a question for the zero bound worriers.  If the zero bound was holding back the Fed during 2009-15, then what’s been holding back the Fed over the past 20 months? Inflation is still below target.

Ignacio Morales set me an interesting graph from JP Morgan, which shows the correlation between global NGDP growth and growth in global profits:
Notice that the correlation seems particularly strong since 2009.

Ben Southwood sent me a ECB study by Luca Gambetti and Alberto Musso, which shows that the ECB’s asset purchase program worked via many different channels. Here’s the abstract:

This paper provides empirical evidence on the macroeconomic impact of the expanded asset purchase programme (APP) announced by the European Central Bank (ECB) in January 2015. The shock associated to the APP is identified with a combination of sign, timing and magnitude restrictions in the context of an estimated time-varying parameter VAR model with stochastic volatility. The evidence suggests that the APP had a significant upward effect on both real GDP and HICP inflation in the euro area during the first two years. The effect on real GDP appears to be stronger in the short term, while that on HICP inflation seems more marked in the medium term. Moreover, several channels of transmission appear to have been activated, including the portfolio rebalancing channel, the exchange rate channel, the inflation re-anchoring channel and the credit channel.

Ben Klutsey pointed me to a Larry Summers piece in the FT:

Historically, the Fed has responded to recession by cutting rates substantially, with the benchmark funds rate falling by 400 basis points or more in the context of downturns over the past two generations. However, it is very unlikely that there will be room for this kind of rate cutting when the next recession comes given market forecasts. So the central bank will have to improvise with a combination of rhetoric and direct market intervention to influence longer-term rates. That will be tricky given that 10-year Treasuries currently yield below 2.20 per cent and this would decline precipitously with a recession and any move to cut Fed funds.

As a result, the economy is probably quite brittle within the current inflation targeting framework. This is under-appreciated. Responsible new leadership at the Fed will have to give serious thought to shifting the monetary policy framework, perhaps by putting more emphasis on nominal gross domestic product growth, focusing on the price level rather than inflation (so periods of low inflation are followed by periods of high inflation) or raising the inflation target. None of these steps would be easy in current circumstances, but once recession has come effectiveness will diminish.


The labor market will recover, with or without the Fed

I recently read by a paper by Laurence Ball, which advocated the use of a “high pressure economy” to bring the unemployment rate down to low levels. I’m generally opposed to that sort of policy, as I believe it leads to a procyclical monetary policy—high inflation during booms and low inflation during recessions. That makes the business cycle more unstable.

I initially assumed that it was a recent article, but rereading the piece I saw it was actually from March 2015. That provides slightly more justification for an expansionary monetary policy, but it also raises another interesting question. Consider this prediction:

FOMC members want to accommodate this return to long-run equilibrium while avoiding an overheating of the economy that would push inflation above target. Based on FOMC statements, it appears likely that the Fed will pursue its goals by raising short-term interest rates above their current near-zero levels at some point around the middle of 2015.

This essay argues that a different path for monetary policy would be better for the economy. The Fed should seek to push the unemployment rate well below 5%, at least temporarily. A likely side effect would be a temporary rise in inflation above the Fed’s target, but that outcome is acceptable. To push unemployment down, the Fed should keep interest rates near zero for longer than is currently expected, certainly past the end of 2015.

Notice that Ball thought it would take high inflation to push unemployment down below 5%.  Instead, unemployment has fallen to 4.3% with inflation actually remaining slightly below the Fed’s 2% target (currently it’s closer to 1.5%).

I’ve never believed in “hysteresis” theories that claim unemployment can get stuck at high levels due to a lack of aggregate demand.  I think this theory was based on a misdiagnosis of the European labor market after 1980, where the high unemployment that was assumed to be labor market slack was actually caused by statist labor market regulations.  In the US, the unemployment rate will fall back to the natural rate regardless of whether the Fed pushes inflation above their 2% target.  Thus it’s better for the Fed to focus on stable NGDP growth, and let the labor market take care of itself.

If you want more jobs (and I do), then advocate supply-side labor market reforms.

PS.  A recent piece by Paul Krugman points out that the fall in unemployment to 4.3% also refutes claims made during the recovery period that the high unemployment was partly “structural”.  I was also skeptical of the structural unemployment claim, but even I did not expect unemployment to fall quite this low.

HT:  David Lapidus