Two types of currency intervention

There are two types of currency intervention; policies aimed at moving the nominal exchange rate, and policies aimed at moving the real exchange rate.  I notice that many economists confuse these two policies, even though they are so different that they shouldn’t even be taught in the same course.  Nominal exchange rate control is properly taught in monetary economics, and real exchange rate control is properly taught in intermediate macro.

To make this distinction easier to see, I’m going to create two imaginary examples; Switzerland and China.  Switzerland will try to depress the nominal exchange rate to prevent deflation, and China will attempt to depress the real exchange rate to boost exports.  I am not claiming that these examples conform to the actual policies of Switzerland and China, indeed I think they do not.  Rather they conform to how many people visualize these two countries, so I’ll play along and use them as pedagogical devices.

Let’s say that both countries implement their policies by having the central bank buy foreign exchange.  Why are these policies totally different?  To answer that question, we need to focus on two key variables; the monetary base and government saving.  You decrease the real exchange rate by increasing government saving.  Period.  End of story.

You reduce the nominal exchange rate (and prevent deflation) by increasing the monetary base.  It doesn’t much matter what you buy, although the Swiss might find it convenient to buy euros, as they are using the euro/SF exchange rate as a policy instrument.  They change the monetary base in order to change the exchange rate, in order to change the price level.  Why not cut out the middleman and target CPI futures?  Good question.

A recent Wall Street Journal article discussed recent Swiss policy

The Swiss National Bank SNBN.EB +1.00% has pulled off what was thought to be a near-impossible trick: unloading billions of euros without the wider market noticing.

Switzerland’s central bank said Wednesday that the proportion of its currency reserves held in euros fell to 48% at the end of September, down from 60% at the end of June, indicating that it aggressively sold euros for other currencies throughout that time, most notably in favor of sterling and dollars.

.  .  .

The SNB had imposed its lower limit on the euro’s exchange rate against the Swiss franc in September 2011, amid a relentless surge in the value of the franc against the euro—the currency of its biggest trading partners. As a result, the bank bought a huge pile of euros in order to keep the franc competitive. A too-strong currency makes it more difficult for Swiss exporters to compete in global markets, because their products either become more expensive overseas or their profit margins drop, or a combination of both.

So far, the SNB’s so-called floor has been broken only once, when the euro dipped fractionally under 1.20 franc in April.

The bank has repeated its resolve to hold the floor in place, and with the situation in the euro zone improving, its policy is unlikely to change.

“We feel that the central bank can easily still defend the floor, so there is very limited downside to the euro against the Swiss franc,” said Jaco Rouw, senior investment manager at ING Investment Management in Amsterdam.

Of course if the Swiss swapped those dollars for US equities, nothing would happen to the SF/euro exchange rate.  And if they swapped the US equities for Swiss equities, nothing would happen to the SF exchange rate.  It makes no difference what the SNB purchases, what matters is the monetary base.  The only reason they purchased euros is that it made it slightly easier to hit their SF/euro target exchange rate.  That’s all.

During normal times when interest rates are positive, you only need a very small purchase of foreign exchange to raise the base enough to hit your nominal exchange rate target.  Have the central bank buy 1% of GDP in financial assets, and you’ll depreciate your currency by 10% to 20%.  (Of course when at the zero bound central bank purchases may be less inflationary, especially if viewed as temporary.)

In contrast, even during normal times it takes massive government saving to have a significant impact on the level of national saving, and hence the real exchange rate.  And a central bank purchase of forex need not have any effect of national saving.  If they add T-securities to the balance sheet of the central bank and delete an equal amount of domestic assets, then there is no impact on national saving.

I’m no expert on Chinese forex purchases, but the amounts are so large that I presume it’s not being used as ordinary “open market operations.”  That is, I assume the $3 trillion in purchases far exceeds the rise in the monetary base.  So somehow the central bank is acting as an agent of the Chinese government, and making purchases that boost total government saving.  And this depreciates the real exchange rate.

Why do people confuse these two types of intervention?  Because they look similar at first glance.  Although the Swiss central bank may buy foreign currency, it is obviously the quantity of SF that matters, not the asset being bought.  And although the PBofChina might buy lots of foreign exchange, it’s obviously the impact on Chinese government saving that matters, not the fact that saving is being boosted via central bank purchases of US Treasury debt.  The same impact on the real exchange rate would occur if a Chinese sovereign wealth fund gobbled up lots of French and British and Brazilian equities, and the central bank let the yuan float.

However because wages and prices are sticky, any policy that depreciates the real exchange rate will also tend to depreciate the nominal rate in the short run.  And vice versa.

PS.  I’m in Singapore right now.  I recommend Japan Airlines for the following reasons:

1.  Low price, short travel time (only 24 hours from Boston!)

2.  They use the new Dreamliner.  It doesn’t seem to fly faster (wasn’t that a claim?) but they are better than the average airplane.  More spacious.

3.  They show Japanese films!  Previous to this flight I’d watched maybe two films in my life on airplanes.  I watched two Japanese films on just the Boston-Tokyo leg of the flight.

4.  Ultra-polite Japanese stewardesses.

5.  Some of the meals (not all) were not awful.

Just got here, but my initial impressions are that taxis and hotels are cheap and everyone drives luxury cars (presumably due to the big car tax.)  And everything in Singapore seems to go smoothly, just as people claim (knock on wood.)


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31 Responses to “Two types of currency intervention”

  1. Gravatar of Saturos Saturos
    17. November 2012 at 21:25

    Horrible secret… I actually kind of like airplane food.

    Wonderful post Scott.

  2. Gravatar of Major_Freedom Major_Freedom
    17. November 2012 at 23:52

    I’m just glad that Sumner is calling all currency plans “intervention”.

    It’s a start.

  3. Gravatar of Jim Crow Jim Crow
    18. November 2012 at 03:34

    So, as a typical male, I like to imbibe. Singapore may be very highly rated as a place to do business, but when it comes to my beer and whiskey needs it really knows how to spread economic pain. Nanny state, indeed. That being said, I do recommend the Singapore Zoo if you’re in tourist mode.

  4. Gravatar of gmacd gmacd
    18. November 2012 at 15:00

    Major Freedom, aren’t all governments “intervening” by issuing a currency in the first place? Would you rather the world barter?

  5. Gravatar of Major_Freedom Major_Freedom
    18. November 2012 at 16:25

    gmacd:

    Major Freedom, aren’t all governments “intervening” by issuing a currency in the first place?

    To the extent that the government uses force to stop or hamper free competition, then yes, that’s intervention.

    Would you rather the world barter?

    No, I’d rather have free market in money production.

    It is not true that the only alternative to state monopoly in X is to not have X at all. If X is money, then an alternative is free competition in the production of money. Let the market process decide what the money commodity or commodities will be, the same way the market process decides which computers are manufactured.

  6. Gravatar of johnleemk johnleemk
    19. November 2012 at 01:05

    Scott, I am in next-door Malaysia right now! Will be off to Vietnam for a brief holiday tomorrow till Thursday, but if you (for whatever reason) make it to KL before Sunday, dinner and our sin-taxed drinks are on me. In response to your points:

    #1 – Flying from DC to KL took me only 20 hours on Emirates…

    #2 – Fair enough, I’ve heard great things about the Dreamliner

    #3 – I think most international airlines have a fair to good selection of international films! I will grant that JAL probably has some good Japanese fare compared to other airlines.

    #4 and #5 – Again, this seems standard for international (i.e. non-American) airlines to me.

    Your first observations of Singapore describe Malaysia quite well too, other than things going quite smoothly! I was actually wondering today why so many people drive luxury cars here when the taxes are sky-high (even for domestic sedans, 9-year car loan terms are the norm, to give you a sense of how burdensome these tariffs are), but your explanation does make a lot of economic sense. All the economics graduates I know here either don’t drive, or drive incredibly beat-up ancient domestic cars which would not be road-safe in a developed country like, say, Singapore. Just wait till you try dining out — that’s the other incredibly cheap thing to do in Singapore and Malaysia.

  7. Gravatar of Costard Costard
    20. November 2012 at 09:27

    “And although the PBofChina might buy lots of foreign exchange, it’s obviously the impact on Chinese government saving that matters, not the fact that saving is being boosted via central bank purchases of US Treasury debt.”

    With respect to the depreciation of China’s real exchange rate, yes. But this is a very narrow view. The PBoC also wants to avoid risk and cyclical volatility in its forex reserves, which severely limits its options. And from the U.S. perspective these Treasury purchases are extremely important. Any other dollar-denominated asset would be bid up by Chinese purchases.

    The Treasury market, on the other hand, has expanded to accomodate China’s policy — has expanded because of Chinese policy, as the economic cost of funding deficits has become cheaper than the political cost of raising taxes or cutting spending. China’s economics, and our politics, are a study in co-dependency.

    The PBoC would not be willing to hold cash for a 2% annual loss; investing in dollar-denominated financial assets would simply displace domestic and international investment into foreign markets (and depreciate the dollar); selling dollars and buying foreign bonds would have the same effect; and the purchase of hard assets or commodities would feed inflation and/or drive up the costs of Chinese manufacturing. In any of these situations, the point of diminishing returns would be reached very quickly, and China would have no choice but to abandon its manipulations.

    As it is, the loss of Chinese demand will be very severe for Treasury markets when it happens. More worrisome, since ZIRP has led China to lengthen the duration of its Treasury holdings, holding to maturity may not be an option for them if the dollar situation deteriorates. All of this “matters”.

    It matters even more if you happen to be advocating a monetary policy that would, on the margins, produce more inflation. The Fed is not the only cook in the kitchen; change its recipe, and who knows what will come out of the oven.

  8. Gravatar of DOB DOB
    20. November 2012 at 10:02

    Thanks for another thought-provoking post.

    Question on this: “You reduce the nominal exchange rate (and prevent deflation) by increasing the monetary base. It doesn’t much matter what you buy [..]”

    Imagine the CB just executed reverse repos on Swiss Govt bonds, or equivalently just purchased short term Swiss Govt bonds (instead of Euros). What would that achieve?

    Prior to the intervention, the foreigners could purchase Swiss Govt bonds. Post intervention, they can just purchase CHF currency which pays the exact same rate of interest (pretty much zero). Did this intervention, which increased the monetary base, have any effect on the CHF/EUR exchange rate or anything else for that matter?

    Alternatively imagine that the CB doesn’t intervene at all, but the Swiss government decides to issue bonds and purchase Euros with the proceeds. I submit this would have a meaningful impact on EUR/CHF. (I’m certainly not defending this sort of intervention)

    Ultimately, I think nominal interest rates are the key determinant to the evolution of the price-level. A change in the monetary base only matters insofar as it serves to push interest rates (which doesn’t happen when IO(E)R is equal to the marginal cost of funds, i.e. at the zero bound).

    Moreover, it seems to me that (risky) asset purchases are fiscal operations since any profit or loss resulting from the operation will be passed on from the central bank to the treasury.

    Would love to hear your thoughts on this.

  9. Gravatar of ssumner ssumner
    21. November 2012 at 18:02

    Costard, Yes, it might matter in other ways.

    DOB, All asset purchases are “risky”. It makes no sense to call central bank asset purchases “fiscal policy” if the expected return is roughly zero.

    It is not clear whether asset purchses at the zero bound are effective, but I see that question as being mostly unrelated to the question of what gets purchased.

    Lars, Enjoy Malaysia.

  10. Gravatar of Ari Tai Ari Tai
    22. November 2012 at 04:39

    Almost all sectors of Australian business are struggling with high exchange rates (due to their traditional dependence on having at least some export revenues) – which have doubled (AUD-USD) over the last decade. And some believe it will double again (ditto for all natural-resources dominated economies).

    Would a Swiss-style intervention have an effect? At what costs?

  11. Gravatar of DOB DOB
    22. November 2012 at 05:23

    Scott,

    Thanks for the response.

    “All asset purchases are “risky”” -> Absolutely. This is why I don’t think the central banks should be doing any of them: they should stick to reverse repurchase agreements (with haircuts). I assume you agree those are pretty much risk-free?

    I’m not sure why the expected return is what matters to classify as fiscal vs monetary: the fiscal impact is contingent on market levels rather than fixed, but it’s still there.

    The fact that the Swiss taxpayer is exposed to profits and losses in essence means that, when the SNB purchases Euros, it has implicitly sold them in unfunded form (like an FX forward) to the the Swiss government. So the book of the SNB looks something like this:

    +1 EUR
    -1 CHF
    -1 EUR/CHF FX forward

    The book of the Swiss govt has the other side of the FX fwd:

    +1 EUR/CHF FX forward

    If the Swiss govt decided to not play along and liquidated that FX forward into the market, I submit it would offset the effect the SNB actions had on the nominal exchange rate, but not the effect it had on the monetary base. Do you agree?

  12. Gravatar of ssumner ssumner
    22. November 2012 at 12:16

    DOB, You said:

    “If the Swiss govt decided to not play along and liquidated that FX forward into the market, I submit it would offset the effect the SNB actions had on the nominal exchange rate, but not the effect it had on the monetary base. Do you agree?”

    No I do not. The nominal rate is determined by the supply and demand for the monetary base, not the specific assets purchased. I always view government accounts as being (de facto) consolididated, so it makes no difference which part of the Swiss government holds a particular asset.

    I also favor having the central bank purchase safer assets. But you can’t look at this issue in isolation. When they buy long term government bonds they do not add risk to the overall consolidated government balance sheet, which is what matters. Indeed they subtract risk.

    At the zero bound the equilibrium base will be larger. If you don’t like this result then the solution is a higher NGDP/inflation target. If you do like this result, then the central bank balance sheet may end up being much larger than otherwise. It might become so large that the central bank is forced to purchase something other than zero risk assets in order to hit its NGDP target. Indeed it might have to buy longer term bonds.

  13. Gravatar of DOB DOB
    22. November 2012 at 13:11

    Scott,

    “The nominal [exchange?] rate is determined by the supply and demand for the monetary base, not the specific assets purchased.” ->

    Ok, so let’s forget the fiscal vs monetary classification for a second and simplify the example further:

    1) I own Euros
    2) SNB comes and purchases my Euros and gives me Swiss Francs instead
    3) At the same time, the SNB and I trade an FX forward whereby I agree to hand the CHF over back to them and take back the Euros in a year’s time

    The CHF monetary base has indeed increased, but I fail to see why this would have any impact on the nominal exchange rate CHF/EUR or anything for that matter? Could you please explain the transmission mechanism?

    For all intents and purposes, I own a EUR denominated asset issued by the SNB. My actions are going to be no different than if I still had Euros. The bank I deposit my CHFs at could already source reserves at 0%, so it’s not going to do anything it wouldn’t otherwise have done either.

    “When they buy long term government bonds they do not add risk to the overall consolidated government balance sheet, which is what matters. Indeed they subtract risk.” ->

    I completely agree about looking a the consolidated government balance sheet, but that has to include assets as well. There’s an implicit assumption in what you said that government assets have no duration. Presumably, most government investments pay off over a number of years (a bridge for instance). Expenses that aren’t investments, such as unemployment benefits, have no duration and shouldn’t be funded by bonds anyway, but that’s separate topic.

    If it was doing its job right, I think the treasury should issue bonds whose maturities would lead to the best possible asset-liability match. And by buying back those bonds, the central bank would effectively mess up the ALM match.

    I don’t think we have any idea what the maturity profile of the government’s portfolio is, so it’s hard to argue whether QE increases or reduces the government’s risk. I tend to think that the government assets are probably longer than its debt, but I have no data to back that up.

    “At the zero bound the equilibrium base will be larger.” -> I don’t think a larger monetary base does anything at the zero bound: if it did, why would the Central Banks engage in QE rather than continue to enlarge the base by executing overnight reverse repos like they always do?

  14. Gravatar of Major_Freedom Major_Freedom
    22. November 2012 at 14:19

    ssumner:

    I also favor having the central bank purchase safer assets.

    Not from the low and middle class I hope. The last thing we need is for those people to get the new money before the prestigious and stabilizing primary dealer banks. The dealers have the only assets worth buying.

    I recommend safe assets like the sovereign debt of a country heading for a fiscal cliff and another debt downgrade. Guaranteed multiplier, or something.

  15. Gravatar of Scott Sumner Scott Sumner
    23. November 2012 at 09:35

    DOB, You said;

    “3) At the same time, the SNB and I trade an FX forward whereby I agree to hand the CHF over back to them and take back the Euros in a year’s time

    The CHF monetary base has indeed increased, but I fail to see why this would have any impact on the nominal exchange rate CHF/EUR or anything for that matter? Could you please explain the transmission mechanism?”

    I agree that temporary currency injections do nothing. Indeed they do almost nothing even if you are not at the zero bound. Whenever I discuss the impact of increasing the monetary base I am always implicitly assuming that the increase is permanent, and that the zero nominal rate condition is temporary. Otherwise OMOs have no impact.

    When I was discussing the impact of OMOs on risk I was referring to the price risk associated with fluctuating nominal interest rates. When the central bank buys government debt it reduces price risk of the consolidated balance sheet.

    The Fed has been increasing the monetary base by purchasing bonds ever since the 1920s–there is nothing new about QE.

  16. Gravatar of DOB DOB
    23. November 2012 at 10:38

    Thanks for correcting me on QE, I really should have said “maturity extension program”.

    I’m not sure what you mean by permanent operations. Let me formulate an example in the context of our SNB conversation, which I think would fall under your definition of a permanent operation, yet in my opinion would have no effect:

    Do you agree that if the Swiss national bank purchased a 30-year floating rate Swiss government bond (assuming such a thing existed), it would have no effect on the nominal exchange rate (or anything else)?

    My argument is that they would just be substituting one safe-asset for another. And since both pay the same rate of interest, nothing has changed.

    “When I was discussing the impact of OMOs on risk I was referring to the price risk associated with fluctuating nominal interest rates. When the central bank buys government debt it reduces price risk of the consolidated balance sheet.” ->

    Yes I understand, but the metric of risk is really a function of accounting methodology. From an economic standpoint, it’s correct to value the bonds at their market prices, depending on the prevailing level of rates. But then it’s also correct to value the revenue streams from the assets based on level of rates as well. Specifically, I don’t think the government should expect citizens to pay more taxes for the use of a bridge just because interest rates have gone up. In that sense, the tax revenue derived from the bridge is a fixed rate asset, and should be hedged by a matching fixed rate liability.

  17. Gravatar of Max Max
    23. November 2012 at 11:11

    “Whenever I discuss the impact of increasing the monetary base I am always implicitly assuming that the increase is permanent, and that the zero nominal rate condition is temporary. Otherwise OMOs have no impact.”

    I appreciate the clarification, but what I don’t understand is why you associate an exogenous increase in bank reserves with a “demand for money”. Have you increased your holdings of bank reserves? Silly question, right, because the public’s demand for base money is measured by currency alone, not bank reserves.

    So the question is, how much does hitting the zero bound affect the demand for currency? And the answer is: not much! So we can basically view the size of the central bank’s balance sheet as being independent of monetary policy. It’s not exactly right, but it’s close enough.

    Can we please drop this talk about CBs needing to expand their balance sheets to accommodate an alleged vastly increased demand for money. There is no such demand. The demand for currency only *slightly* increases at the zero bound. The slight increase in money demand has nothing to do with the increase in bank reserves due to QE. QE is not about satisfying a “demand for money”, it’s just a method of funding the CB’s purchases. The CB could just as well issue bonds instead of reserves (in fact that would be better, since it would eliminate the arbitrage that exists today between reserves and t-bills).

  18. Gravatar of Max Max
    23. November 2012 at 11:38

    “When I was discussing the impact of OMOs on risk I was referring to the price risk associated with fluctuating nominal interest rates. When the central bank buys government debt it reduces price risk of the consolidated balance sheet.”

    Government funding risk is measured by volatility of tax rates, not volatility of debt. More debt volatility due to long term bonds is risk reducing, since an unexpected increase in interest rates reduces the debt.

  19. Gravatar of DOB DOB
    23. November 2012 at 16:03

    Max,

    “So we can basically view the size of the central bank’s balance sheet as being independent of monetary policy. It’s not exactly right, but it’s close enough.” ->

    The central bank’s balance sheet can be driven to any desired size, regardless of the level of interest rates, using the methodology described at the end of this post and on this page.

  20. Gravatar of Max Max
    23. November 2012 at 16:30

    DOB, I’m enjoying your blog, good stuff.

  21. Gravatar of DOB DOB
    23. November 2012 at 16:48

    Max,

    Very glad to hear! Thanks a lot :)

    I just started so eager to get feedback.

  22. Gravatar of Max Max
    24. November 2012 at 09:59

    Scott – further on the government debt maturity subject, you should read this article by John Cochrane. It’s really excellent:

    http://johnhcochrane.blogspot.com/2012/11/debt-maturity.html

  23. Gravatar of ssumner ssumner
    26. November 2012 at 06:23

    DOB, You said;

    “I’m not sure what you mean by permanent operations. Let me formulate an example in the context of our SNB conversation, which I think would fall under your definition of a permanent operation, yet in my opinion would have no effect:

    Do you agree that if the Swiss national bank purchased a 30-year floating rate Swiss government bond (assuming such a thing existed), it would have no effect on the nominal exchange rate (or anything else)?

    My argument is that they would just be substituting one safe-asset for another. And since both pay the same rate of interest, nothing has changed.”

    Isn’t this just the standard liquidity trap argument? If so, my response is the same as always:

    1. If the liquidity trap is expected to last forever then long term bonds are essentially cash, and the central bank needs to buy something else to have an impact.

    2. If rates are expected to be positive in the future, then in the future that enlarged montary base will not be a perfect substitute for bonds, and will push up prices and push down the ER via the hot potato effect. Expectations of that happening in the future will reduce the current ER. The dollar fell sharply against the euro when QE1 was announced.

    The second case seems far more plausible to me. But let me also say that this post wasn’t really about the zero bound at all, it was about the question of whether it matters what the central bank buys. It’s possible that if you are at the zero bound and currency injections are expected to be temporary, then it matters a little bit–but not much.

    Max, Does Cochrane sort of ignore the expectations theory of the term structure?

  24. Gravatar of DOB DOB
    26. November 2012 at 09:34

    Scott,

    Thanks for clarifying. As you’ve said before, sounds like we were in much closer agreement than I thought. Let me summarize to confirm:

    For the sake of clarity, I need to define a couple things first. Let’s divide central bank Open Market Operations into two categories:

    OMO1: those change the size of the monetary base but do not bring any risk on the CB’s balance sheet
    OMO2: those bring risk on the CB’s balance sheet, but have no impact on the monetary base

    OMO1 includes short term repos, short term treasury purchases, floating rate govt bond purchases (if we ignore the credit risk)

    Most asset purchases them can be decomposed in an OMO1 and an OMO2 component.

    For instance, when the Fed purchases a Treasury Bond, the orthogonal components are:
    OMO1 = Fixed Rate Treasury Bond minus Interest Rate Swap
    OMO2 = Interest Rate Swap

    When the SNB purchases Euros, the components are:
    OMO1 = Euros – EUR/CHF cross-currency swap
    OMO2 = EUR/CHF cross-currency swap

    etc.

    Please let me know if you disagree with any of the following statements:

    A) OMO1s only have an effect on the overnight nominal rate. All OMO1s can be reversed and therefore they are by definition temporary. However, expectations of future OMO1s have an effect on the expected future nominal rate.

    B) Any OMO1, or announcement of future OMO1, that does not affect the nominal interest rate spot or forward rates couldn’t have done anything the price-level, or inflation expectations. A special case of this is the inability of OMO1s to ever boost the price-level when the entire rate-curve is at 0%, as you said in your last comment.

    C) If the market did not believe a bit of forward guidance given the by the central bank, there’s no reason to believe it more just because they did some OMO1. i.e.: CB announces it would keep rates at 0% for 10y. Market doesn’t think that’s credible. CB buys a bunch of 10y floating rate government bonds does not make it any more credible. Therefore what really matters is credible forward guidance of better yet, level targeting as you’ve been advocating. OMO1s don’t help there.

    D) OMO2s serve to push specific prices by taking risk on the government’s consolidated balance sheet. It’s effectively a battle of market-power, between the central bank who is backed by the taxpayers of its country, and the market to push a certain price one way or the other (as in the case of the SNB). It very much matters which price they’re pushing on.

    E) The taxpayer is at great risk of loss in OMO2s. Not only should we expect government to be a poor investor, but here it’s specifically buying something to push its price higher than where the market would otherwise clear. For that reason, I personally think that OMO2s are a horrendous proposition.

    I think you’ll disagree with at least D) given you said: “It doesn’t much matter what you buy”?

  25. Gravatar of Max Max
    1. December 2012 at 18:37

    DOB, OMO2s will definitely increase the price level if the central bank is inadequately capitalized, because in that case CB losses will be balanced by inflation (so that CB assets > CB liabilities). In other words, the CB can raise the price level by trashing its balance sheet (I don’t mean buying negative expected return assets – any risky asset will do).

    But in the case where CB losses are eaten by taxpayers or (in case of default) bondholders, then it’s not clear that prices will be affected.

  26. Gravatar of DOB DOB
    2. December 2012 at 02:30

    “[..] in the case where CB losses are eaten by taxpayers [..]” -> That’s the case in every advanced economy as far as I know.

    “[..] it’s not clear that prices will be affected.” -> At least the price of the things the CB is trading should be affected, just due changes in supply & demand. That’s what I’m trying to get Scott to agree on: the EUR/CHF exchange rate is affected predominantly because the SNB is taking FX risk in the form of OMO2s, not because of the OMO1s.

  27. Gravatar of Max Max
    2. December 2012 at 06:59

    “At least the price of the things the CB is trading should be affected, just due changes in supply & demand.”

    Maybe, but price changes are limited by arbitrage. It’s a lot easier to conjure a bond than to conjure a barrel of oil, so it’s not right to think of financial assets as being like commodities.

    More importantly – the CB is not doing any favors if it’s unnaturally pushing prices around. The price changes will revert, the CB will lose money, and nobody wins except for speculators.

    The CB can help if it’s opposing a temporary price change (as in a forced liquidation of assets); in that role it’s no different than a normal investor, except that it has a lot more firepower. And it will make money.

  28. Gravatar of Max Max
    2. December 2012 at 07:07

    One more thing – the CB can use purchases to underline a prior policy commitment, to “put its money where its mouth is”. But the point is to change expectations, not to create a “supply and demand” effect.

  29. Gravatar of ssumner ssumner
    2. December 2012 at 07:43

    DOB, I think where we disagree is the temporary/permanent distinction. When considering monetary policy options I believe the baseline assumption should be that changes in the base are permanent. In that case it doesn’t matter (very much) what the central bank buys. The important changes occur because the base is larger, and that raises rates via the hot potato effect.

    If you insist on assuming that monetary injections are viewed as temporary, then I agree they won’t have much impact, regardless of what the central bank purchases. Even if they bought residential real estate, and simultaneously announced that the next month the portfolio of real estate would be sold off, it would have almost no effect on real estate prices.

    But I also believe there is no evidence that central banks have ever, at any time in history, had trouble convincing the public that they want to inflate–so I don’t see that as an issue worth worrying about. But if they did have that problem (again I don’t think they do) then it would not be at all clear to me that massive OMOs would not help convince the public that they are serious about inflating. It could be a very powerful signal. So I don’t agree with assumption C either.

    As far as balance sheet risk, it’s not something I worry about for several reasons:

    1. Losses to the Fed from higher inflation/interest rates are more than offset by gains to the Treasury. And the consolidated government balance sheet is what matters.

    2. Losses to the Fed from changes in bond prices are likely to be several orders of magnitude smaller than deadweight losses from fiscal stimulus, or losses from letting the economy stagnate in real terms.

    So yes, there is some risk to the Fed, but given the EMH they’ll come out even in the long run, and the risk is very modest. Fed assets are often about 5 year maturities, where risk is low.

    I don’t believe that taking on risk is a very effective policy tool, as the markets correctly understand that the Fed never really takes on very much risk. They are part of the Federal government. Rather OMOs at the zero bound matter because they raise the expected future base (the base when interest rates are positive) and that raises current assets prices, as we saw after announcement of each of the three QE programs.

    I agree that a monetary action that has zero impact on the entire time path of future interest rates is likely to be ineffective, but that’s true of almost everything. A monetary action that has no impact on the nominal price of zinc is also likely to be ineffective. It doesn’t mean that zinc is important.

  30. Gravatar of Saturos Saturos
    2. December 2012 at 07:53

    Scott, with the temporary vs. permanent distinction, it raises interesting prospects for the role of expectations in equilibria. People hoard temporary injections as they expect the extra money to be gone later, so future NGDP doesn’t rise, so current asset prices aren’t worth bidding up. But then current NGDP doesn’t rise. But that leads to the deduction that even if the money were not withdrawn in future, so long as people expected it to be withdrawn later, the demand would rise to match and even future NGDP would not rise. But that means… the central bank might in fact leave extra money out permanently, but also cause a permanent rise in the demand to hold it, by permanently credibly threatening to withdraw it at some future date… monetary policy really is all about expectations.

  31. Gravatar of Quantity doesn’t matter! | Catalyst of Growth Quantity doesn’t matter! | Catalyst of Growth
    11. January 2013 at 07:14

    [...] Sumner has argued that by creating more base money today, the central bank is signaling that it will keep the base [...]

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