We don’t need a higher fed funds target, we need to need a higher fed funds target

This post is partly in response to a long conversation I’ve been having with Rodney Everson.  He appears to be the first person to mention the negative interest rate on reserves idea, but I am less enthused about his argument that raising the fed funds target above zero can actually be expansionary:

Alternatively, they could raise the rate of overnight money to 1 or 2 percent which, of course, is impossible under current theory because it would be considered a “tightening.”  If you, the reader, now understand why such a “tightening” is necessary before an “easing” can be effected, then you have grasped the essence of this monograph.  You also should then understand the immediate danger we face under the current Federal Reserve policy of steadily driving the federal funds rate lower.

It is true that a zero fed funds rate promotes massive hoarding of base money, and also that base money hoarding is, ceteris paribus, highly contractionary.  But the Fed cannot solve this problem by raising the fed funds target.  Markets would interpret that action as being contractionary, as a signal that the Fed plans to withdraw funds to make the new target stick. 

How can we reconcile the following two facts:

1.  Near-zero short term rates are almost always associated with disinflation and low output, not a booming economy.

2.  In the short run, a cut in the fed funds rate target is an expansionary action.

The answer is that (as Milton Friedman said in 1997) near-zero rates are a sign that money has been tight.

So how do we solve this problem?  Some Keynesians argue that we need to promise to hold rates near zero for an extended period.  But that’s not really a satisfactory answer.  The Japanese case shows that an extended period of near-zero rates may accomplish nothing; rather it may simply reflect a period of continual NGDP stagnation. 

Instead, the Fed needs to raise inflation using a different policy tool, some tool other than the fed funds target.  This might involve QE, or it might involve cutting the IOR, perhaps to negative levels.  Or it might involve a target rate for the trade-weighted exchange rate.  But the best option is to use level targeting as a policy tool.  Set a much higher price level or NGDP target trajectory than the market currently expects, and then promise to make up for any future shortfalls. 

Higher rates are associated with prosperity.  But we can’t get to prosperity by having the Fed raise rates.  The Fed must use other steps to raise NGDP growth expectations so high that the Fed will need to raise the fed funds target in order to prevent the economy from overshooting its target.  We need to whip the horse so hard that we need to pull back on the reins to keep it from running too fast.  But pulling back on the reins, by itself, will simply slow the horse down.

We don’t need higher short term rates right now, we need to do other things that will result in the Fed needing to raise short term rates in the future.  And the sooner the Fed needs to raise short term rates the better.  Promising to hold rates near zero for an extended period is not that answer, as the Japanese have learned over the past 15 years.

PS.  Would my grammar teacher have approved of the phrase “need to need?”

PPS.  I’m actually not that far from Everson, if the Fed did the right thing with its other policy tools then it would soon be able to raise the fed funds target a bit above zero.


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63 Responses to “We don’t need a higher fed funds target, we need to need a higher fed funds target”

  1. Gravatar of Full Employment Hawk Full Employment Hawk
    24. November 2010 at 07:24

    “Higher rates are associated with prosperity.”

    Correlation can be observed. Causation must be inferred.

    To argue that the fact that higher rates are associated with prosperity it causes prosperity is a logical fallicy.

  2. Gravatar of Morgan Warstler Morgan Warstler
    24. November 2010 at 08:31

    Hmmm… what to do, what to do?

    1. Announce Fed will no longer count rents during inflation targeting of 2%, admit that housing prices will continue plummet.

    2. Raise rate target 2%.

    3. Mark to market on MBS.

    4. Stop IOR.

    5. Housing prices will plummet much faster, as major banks spiral into insolvency.

    6. Fed backstops overnight market directly.

    7. FDIC announces it will only transfer your $250K to Local Banks.

    8. Let the forcelosed use MERS violation to remove foreclosure form their credit report.

    Huge swaths of fallow housing come on market in mad $1 Auction environment.

    Borrowing from Local Banks goes ballistic even with higher rates. Local banks LOVE this environment they writing 20%+ down loans on houses that sell for 20% of their 2007 high.

    6M homes sell in 180 days.

    problem solved.

  3. Gravatar of Tom Graff Tom Graff
    24. November 2010 at 09:08

    Scott: On IOR… let’s say the Fed sets IOR at -0.25%. Let’s also say that the high excess reserve levels in banks reflect a high demand for liquidity. Wouldn’t banks just withdraw the reserves from the Fed and buy T-Bills? Would that get us anywhere?

  4. Gravatar of Mark A. Sadowski Mark A. Sadowski
    24. November 2010 at 09:26

    Scott,
    You wrote:
    “The answer is that (as Milton Friedman said in 1997) near-zero rates are a sign that money has been tight.”

    Actually, to be technical, he said it more than once. The first time Friedman said it (that I’m aware of) was in 1968:

    “As an empirical matter, low interest rates are a sign that monetary policy has been tight-in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy-in the sense that the quantity of money has grown rapidly. The broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all generally taken for granted.”

    Page 7 of:
    “The Role of Monetary Policy”
    The American Economic Review
    Vol. 58, No. 1 (Mar., 1968), pp. 1-17

    http://www.jstor.org/pss/1831652

  5. Gravatar of Benjamin Cole Benjamin Cole
    24. November 2010 at 09:41

    I have been thinking what we need is radical middle-class tax cuts combined with IOR and QE.

    If we have QE only, the upper class sells their bonds…and perhaps invests in gold, antiques, oil paintings, foreign assets etc. Racehorses.

    The middle-class must spend most of it income. If the middle class starts spending again, we are halfway home…in a sense, yes, the Fed prints money and gives it to the middle class.

    Thoughts?

  6. Gravatar of Rod Everson Rod Everson
    24. November 2010 at 10:56

    Thanks Scott, for devoting a post to the issue we’ve been discussing via email, and for posting a direct link to the 2001 paper I wrote.

    I’d be happy to attempt to defend anything in the monograph that raises concerns, and think I’ll be able to do so.

    As for the current point regarding it being difficult to raise the fed funds rate a percent or two, which would probably be enough to get excess reserves to circulate, I don’t see the main obstacle being that it would, as Scott says, be viewed as a tightening move. I’m satisfied that they could explain that away with some obfuscation, such as indicating that it would raise CD rates and enable seniors to loosen up their spending a bit, etc., Or they could just do it because, done properly, it would become clear in a matter of a month or two that they’d really managed to ease and get money growing again. The transmission mechanism is extremely rapid.

    The bigger problems are: 1) They would first need to stop the policy of paying IOER (I don’t really care about IORR at all, unless someone can convince me it’s relevant) and 2) They would need to get the current excess reserve levels down to the traditional level of less than $1bn dollars before they implement the increase in the fed funds rate.

    Stopping the IOER policy would be trivial, except for convincing those who implemented it that they made a mistake in the first place. However, reducing excess reserves by nearly a trillion dollars would certainly be viewed as a Fed tightening unless the Fed managed to convince the financial world that they were just reversing a decision that has not proven to work.

    I would appreciate some thoughts on what would happen if the Fed decided to unwind the substantial excess reserve position tomorrow. Would it just be a transferring of accounts between the Fed and banks or would there be serious impediments to doing so (other than overcoming the objections of those who think QE was a good decision in the first place.)

    My first impression is that the Fed would just sell off about 1 trillion of governments from their own position to the banks and the banks would exchange an Excess Reserve position earning interest for a T-Bill position earning interest, so the effect (other than on market psychology) would be minimal in financial terms. Thoughts?

    Rod

  7. Gravatar of Rod Everson Rod Everson
    24. November 2010 at 11:05

    “To argue that the fact that higher rates are associated with prosperity it causes prosperity is a logical fallacy.”

    No one appears to be arguing causation. Instead, they’re simply pointing out that low rates correlate with depressed economic activity and vice versa. They make that argument, one supported by historical evidence, to counter those who argue that the zero percent funds rate is evidence of easy monetary policy.

    A case could easily be made, however, that a zero funds rate is capable of trapping a monetary authority into a situation where an easing is more difficult to accomplish than a tightening. In other words, it’s possible to argue causation at that end of the rate spectrum. I don’t think that’s what’s going on here though. Scott and others are just setting the record straight.

  8. Gravatar of Full Employment Hawk Full Employment Hawk
    24. November 2010 at 12:37

    “Announce Fed will no longer count rents during inflation targeting of 2%, admit that housing prices will continue plummet.”

    Even when the price level is constant, some prices will be going up and some will be going down. If you arbitrarily remove prices that are going down in determining the cost of living, the index will obviously show that there is inflation.

    Rents are a major part of the cost of living of the typical urban household and therefore need to be included in consumer type price indexes.

  9. Gravatar of Morgan Warstler Morgan Warstler
    24. November 2010 at 12:47

    Inflation Hawk, the point is OF COURSE that is home prices fall enough, interest rates can obviously be higher, because capital on sidelines will get the “deal of a lifetime” they deserve.

    Losers must lose dear inflation hawk, even though you wish it wasn’t so.

  10. Gravatar of Full Employment Hawk Full Employment Hawk
    24. November 2010 at 12:52

    “The middle-class must spend most of it income. If the middle class starts spending again, we are halfway home”

    The way to do this is to let the tax cut for the rich expire and use the resulting revenue to finance a moratorium on payroll taxes for he next two years. (After that is paid for, the revenue can be used to reduce the deficit.) This will give the tax cut to the people who are most likely to spend it and give the economy a stimulus without increasing the deficit.

    This needs to be combined with a much stronger degree of quantitative easing and ending interest payments on excess reserves so that the fiscal stimulus is not offset by less expansionary monetary policy.

    If the Republicans block the confirmation of Diamond for the BOG before the end of the year, Obama should recess appoint him.

  11. Gravatar of Full Employment Hawk Full Employment Hawk
    24. November 2010 at 13:02

    “Losers must lose dear inflation hawk”

    Ah yes, the Protestant work ethic again. The purpose of economic policy should be to punish people who make unwise decisons for their sins, not to promote the general economic welfare.

  12. Gravatar of Benjamin Cole Benjamin Cole
    24. November 2010 at 13:03

    Full Employment Hawk–

    Methinks you are on the right track……..or flight path….

  13. Gravatar of Full Employment Hawk Full Employment Hawk
    24. November 2010 at 13:13

    “However, reducing excess reserves by nearly a trillion dollars would certainly be viewed as a Fed tightening”

    Only if the reduction in excess reserves are the result of a reduction in total reserves.

    The purpose of eliminating IOER is to get the banks to use their excess reserves to make additional loans (the preferred result) or to purchase additional securities, binging down the expected real interest rate. If the reduction in excess reserves is the result of an increase in required reserves, rather than a reduction in total reserves, this will be seen as expansionary.

  14. Gravatar of Full Employment Hawk Full Employment Hawk
    24. November 2010 at 13:20

    “As for the current point regarding it being difficult to raise the fed funds rate a percent or two, which would probably be enough to get excess reserves to circulate,”

    If the purpose of getting the excess reserves to circulate is to give the economy an additional monetary stimulus, then clearly increasing the federal funds rate target makes no sense because that is a contractionary move. It may get the excess reserves to circulate while undercutting the purpose of having them circulate.

  15. Gravatar of Doc Merlin Doc Merlin
    24. November 2010 at 13:40

    “Ah yes, the Protestant work ethic again. The purpose of economic policy should be to punish people who make unwise decisons for their sins, not to promote the general economic welfare.”

    In a system where economic actors can make mistakes the possibility of loss is essential for economic progress. When loss is removed from the system due to regulatory fiat, the institutional mistakes metastasize and overwhelm the economy all at once instead of being cleared up as they are found.

  16. Gravatar of Rod Everson Rod Everson
    24. November 2010 at 15:21

    Hawk wrote: “If the purpose of getting the excess reserves to circulate is to give the economy an additional monetary stimulus, then clearly increasing the federal funds rate target makes no sense because that is a contractionary move. It may get the excess reserves to circulate while undercutting the purpose of having them circulate.”

    It’s not at all clear. As I explain thoroughly in the monograph Scott linked to at the beginning of this post, the reason we need a positive funds rate is exactly so that the excess WILL circulate. Until it does, we actually risk further contraction as the Fed has relinquished its ability to counteract any decline in money circulation.

    You also said: “If the reduction in excess reserves is the result of an increase in required reserves, rather than a reduction in total reserves, this will be seen as expansionary.”

    Oh, you bet it would! Do you have any idea in the present fractional reserve system, how much expansion would result if nearly $1 trillion of excess reserves actually became “required reserves.” It had better not happen, as we will have a hyperinflation that will make the present issues seem trivial. On the other hand, homeowners currently underwater will be bailed out and then some. They’ll soon be lobbying Congress to raise the dollar amount of gains that they can take tax-free.

    Going back to a historical level of excess reserves should not be contractionary, though obviously many would consider it so.

  17. Gravatar of scott sumner scott sumner
    24. November 2010 at 17:47

    Full Employment Hawk, I agree.

    Morgan, I have plenty of “dry powder” so I hope you get your grand real estate auction. But I still want easier money.

    Tom Graff, That’s the whole idea–to get the banks to buy T-bills. That gets the cash out into circulation, and prices start rising. It’s not about lending, it’s about excess cash balances.

    Mark, Thanks for pointing that out. So it wasn’t a fluke, it was a core part of Friedman’s philosophy.

    Benjamin, I’m not a fan of the Fed giving the money away because I don’t think we need to rely on desperate measures. Bernanke says the Fed has plenty of other tools. Then use them!

    Rod, I agree that the effect would be minimal in financial terms, but I worry about the effects of selling assets on expectations. We have just seen inflation expectations rise on rumors of QE. So why do negative QE? But we certainly agree on IOR.

    Whether you could raise the fed funds target as part of a broader expansionary policy is an interesting question. If the Fed got rid of IOR that would be very expansionary. If they set a high NGDP (or price level) target, that would be very expansionary. If they did both of those very expansionary things they could perhaps also raise the fed funds target to 1%, and the net effect of all three actions might be expansionary. Presumably this scenario is somewhat related to your comment about the Fed communicating the reason for higher rates. So perhaps we aren’t too far apart, but I still don’t like the idea that the Fed can move short term rates around by waving a magic wand.

    FEH and Morgan, In addition to FEH’s point about rents, note that rents caused the CPI to UNDERSTATE DEFLATION during 2008-09, as housing prices fell and rents did not. Actual deflation was even worse than measured deflation, which is why we have some catching up to do (as NGDP shows.)

    I agree about the Diamond recess appointment.

    Rod, Things are a bit slow with the holiday. I hope there are more comments over the next few days. I’d love to hear what some other long time commenters think of your interest rate argument. Interest rates are endlessly paradoxical.

  18. Gravatar of Full Employment Hawk Full Employment Hawk
    24. November 2010 at 18:02

    “Oh, you bet it would! Do you have any idea in the present fractional reserve system, how much expansion would result if nearly $1 trillion of excess reserves actually became “required reserves.”

    When it comes to the effect of eliminating IOER on the money supply, we are in uncharted territory. Therefore reducing it gradually and seeing how much it has to be reduced by to get NGDP back to its desired level is the optimal strategy. I would conjecture that reducing it to zero would, under current economic conditions, would only turn a fraction of excess reserves into required reserves and therefor not stimulate NGDP beyond what is needed, but that is a conjecture.

    As a matter of fact, reducing IOER to zero may not be enough to get the money supply to grow to the needed level. Penalties on excess reserves may well be needed.

  19. Gravatar of Full Employment Hawk Full Employment Hawk
    24. November 2010 at 18:16

    “I’m not a fan of the Fed giving the money away because I don’t think we need to rely on desperate measures.”

    Agreed. The Fed is a banking system. It creates money by making loans and investments. It has no business giving money away, even by dropping it out of helicopters. If the economy gets into such dire straights that the government feels compelled to print currency and give it away, this must be done by the Treasury by printing United States Notes. Actually cash cards that must be spent by a deadline and cannot be used to purchase financial assets or pay off credit card debts would work better. Taiwan actually did something like that as part of their stimulus.

  20. Gravatar of Rod Everson Rod Everson
    24. November 2010 at 20:59

    FEHawk: “As a matter of fact, reducing IOER to zero may not be enough to get the money supply to grow to the needed level. Penalties on excess reserves may well be needed.”

    I realize that the monograph is long enough that most readers probably only skimmed it or read a few paragraphs and moved on. So, to make the point of its relevance to today’s situation, here are the final two paragraphs, under the heading “Final Caution”:

    “Above all else, think long and hard before allowing the fed funds rate to drop to near zero, as this creates a situation where only negative reserves will cause a monetary response. Excess reserves will not be circulated due to the absence of an opportunity cost, but a negative reserve balance will still cause monetary contraction.

    Under those circumstances, the Federal Reserve would be prone to inadvertently managing a further contraction in money, and the economy, as we did in the early 1930′s and as Japan’s monetary authority is doing today.”

    That was written almost a decade ago. Today, it’s reality. I agree with you that banks must be given some incentive to circulate excess reserves. I also agree that IOER needs to be dropped for that to happen, and that such an action by itself isn’t likely to be enough.

    Where we disagree is that I, along with I suspect nearly every funds desk manager active in the last three decades of the 20th century, am certain that the Fed would have absolutely no difficulty raising the fed funds rate back up to 2%, or even 3% or 4%, in just a few weeks, provided the Fed first gets the current excess reserve position down to the historical norm.

    Assuming they did so, there would be no need for an interest penalty on excess reserves, i.e., a negative IOER, even though in the monograph I suggested that it would work. It just wouldn’t be necessary. Historically, provision of several hundred million to a billion dollars of excess reserves was sufficient to get banks to circulate reserves rapidly, often driving the fed funds rate down several percentage points on the settlement day for meeting reserve balances.

    The money supply would grow over that same period, then the Fed would supply the additional required reserves to support the new, higher money supply and the process would repeat a month or so later. Unfortunately, the Fed never really, in my opinion, figured this out, thinking instead that the transmission mechanism operated over a longer term, with bank customers reacting to the level of short rates and interest rates generally.

    Under that interpretation, the growth in the money supply that they, in fact, were directly causing, was perceived as the Fed not being tight enough yet, so they’d raise the funds rate several times throughout the process. Hence, they were actually easing even as they were attempting to tighten.

    When they finally managed to go nearly six months without screwing up and supplying too many reserves during a settlement period (or offset them by supplying far too few reserves in other periods, resulting in a skyrocketing settlement day funds rate), the economy would inevitably begin to show signs of softening and the whole process would soon reverse itself.

  21. Gravatar of Morgan Warstler Morgan Warstler
    25. November 2010 at 00:19

    “FEH and Morgan, In addition to FEH’s point about rents, note that rents caused the CPI to UNDERSTATE DEFLATION during 2008-09, as housing prices fell and rents did not. Actual deflation was even worse than measured deflation, which is why we have some catching up to do (as NGDP shows.)”

    So then you agree, we should remove rents.

    My issue is this: we want measure consumption prices, not investment prices. And US home prices, without any support from the Fed would right now be 10-20% lower.

    Scott, your better Greenspan focus on home prices like a laser, I have never heard you explain why he does this, and why he is wrong.

    Anyhoo, since what we really have is falling home prices BECAUSE the investment play is sucking wind, and because we know we have major oversupply for the next couple years, not removing rents, means that we are less likely to pay attention to what happens in commodities.

    Even if the non-rent CPI target was going to be higher – 2.25% instead of 2%, removing rents would be worth it.

  22. Gravatar of Morgan Warstler Morgan Warstler
    25. November 2010 at 00:26

    http://www.bloomberg.com/news/2010-08-01/greenspan-says-decline-in-u-s-home-prices-might-bring-back-the-recession.html

    “never reason from a price change” won’t cut it, I’d prefer to hear you gut on why greenspan would focus so aggressively on home prices.

  23. Gravatar of Bill Woolsey Bill Woolsey
    25. November 2010 at 05:46

    The notion that reducing interest rates on reserves will get cash (currency) out into circulation is an error. The point is to get banks to purchase securities (or make loans.) This will expand the amount of deposit balances. The goal is for people to spend those deposit balances on goods and services. Now, it is possible that expanded deposit balances will result, one way or another, in creating a currency drain–people pulling “cash” (currency) out of banks. But there is nothing particularly beneficial to this. There is no need for people to pull currency out of banks before they spend it. They can, and do, write checks or make electronic payments.

    You are reasoning as if the banks respond to zero (or negative) interest on reserves by dumping currency on the sidewalk–giving it away. That would almost certainly result in rapid increases in expenditures, but that isn’t how banks would respond to the policy. As you recongize, they would purchase securities (or make loans.)

  24. Gravatar of ssumner ssumner
    25. November 2010 at 08:17

    Rod, You said;

    “Where we disagree is that I, along with I suspect nearly every funds desk manager active in the last three decades of the 20th century, am certain that the Fed would have absolutely no difficulty raising the fed funds rate back up to 2%, or even 3% or 4%, in just a few weeks, provided the Fed first gets the current excess reserve position down to the historical norm.”

    Fair enough, but if you are going to rely on the opinion of fed funds desk managers then don’t you also need to point out that these people would regard higher rates as contractionary? You might respond that they don’t see the big picture. But that is also my response regarding their alleged power. They don’t see the big picture that fed funds targets seem to work like magic because the markets believe the Fed has almost infinite ammunition to make them stick–so prices move immediately to where the Fed is expected to push them via more or less reserves.

    Morgan, You said;

    “So then you agree, we should remove rents”

    The problem is that you believe in growth rate targeting, I believe in level targeting. So yes, inflation would be higher now, but we’d still need more because I think we need to catch up for the past shortfall, which would be even bigger if we exempted rents.

    I’m not going to defend Greenspan.

    Bill, I’m not saying the banks give cash away. They buy assets like T-bills and the sellers then hold cash. They don’t want to hold so much cash so they start buying goods services and assets to get rid of the cash. At first they mainly buy assets, but over time they start buying more goods and services. Nothing more than the monetarist excess cash balances mechanism. Make cash a hot potato.

  25. Gravatar of Rod Everson Rod Everson
    25. November 2010 at 09:08

    Scott,

    I’m not clear what you mean by “their alleged power.” Whose alleged power? Who doesn’t see the big picture? Can you clarify?

    As for the funds desk managers viewing higher rates as contractionary, certainly they would if done today, but if the problem as I see it were clearly understood by policymakers and thoroughly explained in advance (something probably unnecessary because the transition would be so rapid that it would all be over in a month or two) then market participants might actually be waiting for the Fed to make the move, to get things back on track. After all, that’s the one common goal most of us have; it’s the route we’re to take that’s causing all the arguments.

    Rod

  26. Gravatar of Tom Tom
    25. November 2010 at 11:23

    The basic idea of charging a negative interest rate, or carry tax, on money balances to encourage their circulation goes back far beyond Rod Everson to Silvio Gesell in the 1890s. True, Gesell applied his idea to currency holdings rather than to banks’ excess reserves. But the idea is essentially the same.

  27. Gravatar of 123 123
    26. November 2010 at 06:30

    Some thoughts:
    1. The distinction between required and excess reserves is meaningless. At this time the desired ratio of reserves to bank assets is much higher than the legal minimum, this is a direct concequence of housing crisis, financial crisis and NGDP gap.
    2. The obsession with the distinction between IOER and IORR is USA-centric and sounds strange to those foreign central banks who use corridor or floor systems with IOR without any adverse consequences. The Fed has switched to the IOR system used by other central banks, and this has created a gap of understanding between the US blogosphere and the Fed.
    3. The reversal of QE1 as suggested by Rod would be contractionary, as QE1 has reduced treasury term risk premiums and Fannie/Freddie credit risk premiums. The talk of reversing of QE1 has been already tried in late 2009/ early 2010 with bad results.
    4. Scott said: “If the Fed got rid of IOR that would be very expansionary.” What matters is future expected path of monetary base and future expected path of IOR. If IOR is abolished, future expected size of montery base will shrink. It is possible to have both expansionary and contractionary policy without IOR, for this reason you and Plosser both say IOR should be abolished. You should look elsewhere for things that are very expansionary – level targets and credit easing are good options.
    5. Scott said: “Whether you could raise the fed funds target as part of a broader expansionary policy is an interesting question. If the Fed got rid of IOR that would be very expansionary. If they set a high NGDP (or price level) target, that would be very expansionary. If they did both of those very expansionary things they could perhaps also raise the fed funds target to 1%, and the net effect of all three actions might be expansionary. Presumably this scenario is somewhat related to your comment about the Fed communicating the reason for higher rates.”
    Judging by the frequency of mentions in Krugman’s blog, Sarah Palin has caused more hoarding of base money than IOR, so stopping IOR is not an important stop in a recovery strategy. High NGDP target without IOR will lead to expectations that QE will be reversed quickly, this will lead to higher volatility along NGDP target path compared to alternative with IOR. Let’s examine a strategy with IOR. It is possible (but not desirable) to have a 1% fed funds target from the start of high NGDP target, if 1% fed funds target is combined with a huge amount of credit easing – in this case the Fed reduces financial intermediation in a private sector with 1% fed funds rate target, and increases financial intermediation in the Fed’s balance sheet with no net effect. Of course 25bps fed funds rate target is prefferable, so the Fed can reach high NGDP target with lower amounts of credit easing.

  28. Gravatar of Rod Everson Rod Everson
    26. November 2010 at 08:18

    Tom wrote: “The basic idea of charging a negative interest rate, or carry tax, on money balances to encourage their circulation goes back far beyond Rod Everson to Silvio Gesell in the 1890s. True, Gesell applied his idea to currency holdings rather than to banks’ excess reserves. But the idea is essentially the same.”

    Interesting Tom, and not surprising. All I was doing is applying basic economic logic. If you want someone to hold more of something, reward them for doing so. If you want them to reduce their holdings, penalize them.

    The contribution I am really trying to make is to extend that basic logic to the operating procedures of the Fed. The opportunity cost of holding excess reserves has always been the foregone interest if they are not sold. When the system is in excess, individual banks find themselves in excess collectively no matter how hard they try to reduce them to zero at the end of the maintenance period. Therefore, they tended to circulate rapidly at such times.

    It’s a very small step in logic to realize that at a zero fed funds rate that opportunity cost becomes zero, and so there will be no incentive to circulate any excess (as has become patently obvious today.)

    So, again logically, at least two choices present themselves to restore an opportunity cost: 1) charge a penalty rate, i.e., a negative rate of IOER, or 2) restore the original opportunity cost by having the Fed manage the funds rate to a modestly positive number.

    We’re, unfortunately, struggling down the first route, having introduced both IORR and IOER now, but the Fed is, so far anyway, reluctant to move to a penalty rate of IOER. The pity is that it would have been a trivial matter to go the second route, and yet this seems to be a route unimaginable to virtually everyone, besides me, who’s commented on it thus far. So, if you have a historical example of someone who’s advocated that, I’d appreciate hearing of it.

  29. Gravatar of Rod Everson Rod Everson
    26. November 2010 at 08:39

    123 wrote: “The distinction between required and excess reserves is meaningless. At this time the desired ratio of reserves to bank assets is much higher than the legal minimum, this is a direct consequence of housing crisis, financial crisis and NGDP gap.”

    You’re saying then that individual banks are choosing to hold excess reserves because they fear that holding just the required amount will disadvantage them in some manner. Do you have any evidence of such fears, other than the fact that they are, indeed, holding them?

  30. Gravatar of Rod Everson Rod Everson
    26. November 2010 at 08:54

    123 wrote: “The reversal of QE1 as suggested by Rod would be contractionary, as QE1 has reduced treasury term risk premiums and Fannie/Freddie credit risk premiums. The talk of reversing of QE1 has been already tried in late 2009/ early 2010 with bad results.”

    Where’s the evidence that it was QE1 that flattened the yield curve? Wouldn’t fear of prolonged economic recession do the same? I’d like someone to explain to me how the Fed going out and trading their T-Bill position for Excess Reserves paying nearly the same interest will have any effect on current bank behavior, or on the economy generally. The Fed lowers both sides of its balance sheet and the banks swap one short-term asset for another. The difference?

    Well, I know the difference right now, of course. Everyone thinks that would be a tightening. But how, by what mechanism? I’m not saying my thinking is correct, so I can be convinced that I’m wrong. I just need to hear a convincing argument other than “but it’s contractionary.”

  31. Gravatar of scott sumner scott sumner
    26. November 2010 at 09:01

    Rod, Sorry, that was poorly worded. I meant the Fed’s alleged power, and the fed funds desk managers didn’t see the big picture.

    Tom, Yes, I knew about Gesell, but the negative IOR idea is more interesting because it is actually possible. Negative rates on currency aren’t really feasible in the real world.

    But I agree, that it is implicit in Gesell’s ideas. Mankiw had a post last year suggesting one of his grad students discovered the idea–then lots of commenters told him Gesell had gotten there first.

    123, You said;

    “1. The distinction between required and excess reserves is meaningless. At this time the desired ratio of reserves to bank assets is much higher than the legal minimum, this is a direct concequence of housing crisis, financial crisis and NGDP gap.”

    I don’t agree. One use of this distinction is that it refutes the notion that IOR hurts bank profits.

    You said;

    “3. The reversal of QE1 as suggested by Rod would be contractionary, as QE1 has reduced treasury term risk premiums and Fannie/Freddie credit risk premiums. The talk of reversing of QE1 has been already tried in late 2009/ early 2010 with bad results.”

    I tend to agree, but in fairness he is talking about combining that with an elimination of IOR.

    I will continue to think a lower IOR is expansionary until it is tried and failed. Bernanke has already said it is expansionary. If he suddenly did it, I presume markets would view it as expansionary. If markets view it as expansionary then it is expansionary. I freely concede that I might be wrong. But it is very easy to test, and it’s rather a shocking indictment of the Fed that they have not yet tested the idea.

    I’m assuming the Sarah Palin comment is a joke.

  32. Gravatar of Rod Everson Rod Everson
    26. November 2010 at 10:06

    Scott, you wrote: “I will continue to think a lower IOR is expansionary until it is tried and failed. Bernanke has already said it is expansionary. If he suddenly did it, I presume markets would view it as expansionary. If markets view it as expansionary then it is expansionary. I freely concede that I might be wrong. But it is very easy to test, and it’s rather a shocking indictment of the Fed that they have not yet tested the idea.”

    Just to be clear, you’re talking about a negative IOER here?
    I agree that it would be expansionary, though I think that whether markets thought so or not, but I’m afraid the Fed would immediately be faced with the problem of then getting nearly a trillion dollars of excess reserves out of circulation before the banking system served up a hyperinflation. By my model of likely events, this would happen very rapidly, and would have to be addressed as soon as the IOER went negative enough to influence funds desk behavior.

  33. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. November 2010 at 13:01

    Rod,
    “Lower IOR” does not necessarily mean a negative IOER. It could mean 0.1% for example. Let us not be afraid of experimentation (inaction is itself a form of action). We can always refine the level if the effects are determined to be undesirable.

  34. Gravatar of Rod Everson Rod Everson
    26. November 2010 at 13:40

    Mark,

    What’s the rate being paid as IOER now? I was under the impression that it was nearly zero already. Fed funds are trading so close to zero that the rate (.2%) probably reflects transactions costs on a lot of the trades. (At .2%, a bank buying 1mm overnight is only paying $5.47 in interest. I’d wager a lot of trades are small, but don’t know that for a fact.)

    I agree that the IOER rate doesn’t have to be negative, provided fed funds are trading above, say, 1% or so. But there does need to be a spread between the IOER and the funds rate or banks will not face the opportunity cost that historically has driven them to sell funds into the market at the end of a maintenance period when the excess is too high. Actually, the only purpose I can see for an IOER in the first place is to set it at a negative rate at times like this. When the fed funds rate is well above zero, the IOER serves no purpose being different from zero other than to pay banks taxpayer money. I see no sense in paying them to retain an excess, though I understand that an argument can be made for paying them IORR.

    And I question whether it’s even possible to get the fed funds rate back up to 1% when the level of excess reserves is so high. Absent an IOER, or faced with one of .1% or so, they would drive the funds rate down to the IOER level. Isn’t this more or less what happened in late 2008? The IOER rate was 75 bp lower than the fed’s target rate (where they assumed fed funds would trade) but the fed had no means to hold the actual fed funds rate above the IOER rate. During this period, if I to understand what Scott told me earlier, the Fed was unable to hold funds at the target rate. Makes perfect sense to me when the system was way overloaded with excess reserves. The banks just sold them down toward the lower IOER rate. Eventually, the Fed faced reality and no now no longer discounts the IOER rate by 75 basis points.

  35. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. November 2010 at 13:45

    Rod,
    I’m mystified by your previous comment. IOER is currently 0.25%. Anyone can verify this fact. Obviously this is hugely distorting and the main reason why we have a trillion in excess reserves.

  36. Gravatar of Rod Everson Rod Everson
    26. November 2010 at 14:36

    Sorry Mark,

    I just rejoined this whole discussion over the past week and am catching up. Hadn’t paid much attention to the details over the previous couple of years. I assumed the IOER was slightly under the prevailing fed funds rate from what I’ve already read in here, and didn’t attempt to actually locate the rate.

    However, what’s the difference between setting it at .1%, or setting it at 0%, i.e., not having it at all? The .1 is relevant?

    And we would still have the $1 trillion of excess reserves without the IOER. Fed funds would just trade a little closer to zero and we’d still be in the trap. Sorry for the confusion though.

    To reiterate my position, the Fed first needs to drain almost all of the excess by reversing QE, something that I view as a bookkeeping operation (until they load up on longer bonds…then it will be harder to unwind without significant profit risk, particularly since unwinding done now would certainly be viewed as a tightening.) Then they just need to set the target rate above 1%, preferably 2%, and enforce it with draining/adding operations as they’ve always done. That will enable them to regain control of the money supply once again. Until they do that, they will continue to creatively flail, and quite probably fail, at both their mandates.

  37. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. November 2010 at 14:44

    Rod,
    You wrote:
    “However, what’s the difference between setting it at .1%, or setting it at 0%, i.e., not having it at all? The .1 is relevant?”

    From my standpoint, none. But, evidently, you are out of the loop. Even moving it from 0.25% to 0.10 % would encounter huge resistance. The inflationistas are everywhere.

    But I suspect that eliminating IOER will totally eliminate the liquidity trap. It’s all an illusion.

  38. Gravatar of Mark A. Sadowski Mark A. Sadowski
    26. November 2010 at 15:39

    Rod,
    It’s very simple.

    Reduce the incentive to hold ER.

    As a result MS increases.

    And as a result NGDP increases.

    Any Quasi-Monetarist would understand. (or whatever you want to call us).

  39. Gravatar of 123 123
    27. November 2010 at 02:02

    Scott, you said:
    “I will continue to think a lower IOR is expansionary until it is tried and failed.

    Bernanke has already said it is expansionary. If he suddenly did it, I presume

    markets would view it as expansionary. If markets view it as expansionary then it

    is expansionary. I freely concede that I might be wrong. But it is very easy to

    test, and it’s rather a shocking indictment of the Fed that they have not yet

    tested the idea.”
    I think everybody agrees that today a lower IOR is expansionary (assuming monetary

    base does not change). The question is how much stimulus would it provide? The Fed

    prefers to talk about about stimulus in terms of old non-ZIRP fed funds rate cuts.

    A cut of IOR to zero would provide a 25bps worth of stimulus, but Bernanke decided

    that 75bps worth of stimulus was needed, so he did 600 billion QE2. Saying that

    current level of IOR is a shocking indictment is equivalent to saying that 800

    billion QE2 is needed and it’s rather a shocking indictment of the Fed that they

    have not yet tested the idea of 800 billion QE2.

    “I’m assuming the Sarah Palin comment is a joke.”
    Yes, it is. But seriously, the education of Sarah Palin could provide a 2bps worth

    of stimulus, zero IOR could provide a 25bps worth of stimulus. But we need 200+bps

    worth of stimulus…

    Rod, you said:
    “You’re saying then that individual banks are choosing to hold excess reserves

    because they fear that holding just the required amount will disadvantage them in

    some manner. Do you have any evidence of such fears, other than the fact that they

    are, indeed, holding them?”
    Banks are holding excess reserves, this is the evidence that proves that risk-

    adjusted expected return on other assets is equal to expected return on excess

    reserves. Any other evidence is not necessary.

    You said:
    “Where’s the evidence that it was QE1 that flattened the yield curve? Wouldn’t fear

    of prolonged economic recession do the same? I’d like someone to explain to me how

    the Fed going out and trading their T-Bill position for Excess Reserves paying

    nearly the same interest will have any effect on current bank behavior, or on the

    economy generally. The Fed lowers both sides of its balance sheet and the banks

    swap one short-term asset for another. The difference?”
    I did not say that QE1 flattened the yield curve. QE1 reduced term risk premiums

    but increased expected future interest rates. The net effect on the slope of the

    yield curve is ambiguous.
    When zero interest rate bound has been reached, open market operations are

    performed with medium-term and long-term bonds. The average maturity of bonds in

    QE2 is 5 years. Open market operations in T-Bills are irrelevant.

  40. Gravatar of 123 123
    27. November 2010 at 03:06

    sorry for bad formatting…
    Trying again:
    Scott, you said:
    “I will continue to think a lower IOR is expansionary until it is tried and failed. Bernanke has already said it is expansionary. If he suddenly did it, I presume markets would view it as expansionary. If markets view it as expansionary then it is expansionary. I freely concede that I might be wrong. But it is very easy to test, and it’s rather a shocking indictment of the Fed that they have not yet tested the idea.”
    I think everybody agrees that today a lower IOR is expansionary (assuming monetary base does not change). The question is how much stimulus would it provide? The Fed prefers to talk about about stimulus in terms of old non-ZIRP fed funds rate cuts.

    A cut of IOR to zero would provide a 25bps worth of stimulus, but Bernanke decided that 75bps worth of stimulus was needed, so he did 600 billion QE2. Saying that current level of IOR is a shocking indictment is equivalent to saying that 800 billion QE2 is needed and it’s rather a shocking indictment of the Fed that they have not yet tested the idea of 800 billion QE2.

    “I’m assuming the Sarah Palin comment is a joke.”
    Yes, it is. But seriously, the education of Sarah Palin could provide a 2bps worth of stimulus, zero IOR could provide a 25bps worth of stimulus. But we need 200+bps worth of stimulus…

    Rod, you said:
    “You’re saying then that individual banks are choosing to hold excess reserves because they fear that holding just the required amount will disadvantage them in some manner. Do you have any evidence of such fears, other than the fact that they
    are, indeed, holding them?”
    Banks are holding excess reserves, this is the evidence that proves that risk-adjusted expected return on other assets is equal to expected return on excess reserves. Any other evidence is not necessary.

    You said:
    “Where’s the evidence that it was QE1 that flattened the yield curve? Wouldn’t fear of prolonged economic recession do the same? I’d like someone to explain to me how the Fed going out and trading their T-Bill position for Excess Reserves paying
    nearly the same interest will have any effect on current bank behavior, or on the economy generally. The Fed lowers both sides of its balance sheet and the banks swap one short-term asset for another. The difference?”
    I did not say that QE1 flattened the yield curve. QE1 reduced term risk premiums but increased expected future interest rates. The net effect on the slope of the yield curve is ambiguous.
    When zero interest rate bound has been reached, open market operations are performed with medium-term and long-term bonds. The average maturity of bonds in QE2 is 5 years. Open market operations in T-Bills are irrelevant.

  41. Gravatar of scott sumner scott sumner
    27. November 2010 at 08:32

    Rod, I don’t believe the hyperinflation scenario is a risk at all. Core inflation changes very slowly, and in response to expectations about future Fed policy. No one expects the Fed to do a hyperinflationary policy, so prices wouldn’t take off. Of course you are right that the Fed would have to quickly remove the excess base money, but that’s very easy to do.

    123, You said;

    “A cut of IOR to zero would provide a 25bps worth of stimulus, but Bernanke decided

    that 75bps worth of stimulus was needed, so he did 600 billion QE2.”

    I don’t find these arguments very convincing, as the effect depends on expectations of future policy. There is no stable relationship between either fed funds rate cuts, or QE, and AD.

  42. Gravatar of 123 123
    28. November 2010 at 02:39

    Scott, – but this is what the Fed was trying to communicate to the public – reducing IOR is a mild stimulus, so they went for QE2. All this talk about equivalent surprise fed funds rate cuts is just a communication tool. I agree that it is a poor tool, as there is no stable relationship, but in the end the main reason Bernanke kept IOR at 25bps levels is that reducing IOR would provide only mild stimulus.

    The most important thing is expectations of future policy. In terms of expectations of future policy, lower IOR offers no precommitment benefits, and provides little information about the Fed’s exit strategy to market participants. 600 billion QE2 is useful as a precommitment device, and market participants were persuaded that the Fed’s exit strategy will start at higher levels of NGDP than they thought before.

    It is also useful to consider why the hoarding of monetary base started. I see four main reasons:
    1. The Fed did not expand monetary base enough in the early stages of the crisis, this created an inadvertent tightening of monetary policy
    2. The Fed mismanaged expectations about future monetary policy
    3. Demand for monetary base increased because of financial crisis
    4. Demand for monetary base increased because of housing crisis

    Credit easing and QE1 was an attempt to address all the four causes of hoarding of monetary base, QE2 is an attempt to address the first three causes of hoarding. Lower IOR would offer only a tiny help with the first cause of hoarding.

  43. Gravatar of ssumner ssumner
    28. November 2010 at 06:56

    123, I think we both agree that expectations of future policy and future NGDP growth are the key, and everything else matters to the extent to which it affects those expectations. It’s hard to say which second best policies are likely to have the biggest effect on expectations. I suppose if the Fed asked Congress to ban IOR, that would make people fearful of hyperinflation, and thus it would be very effective!

    I agree with your four points, except I’m not quite sure about the last one–how does that differ from point 3?

  44. Gravatar of 123 123
    28. November 2010 at 13:11

    Scott, you said:
    “It’s hard to say which second best policies are likely to have the biggest effect on expectations. I suppose if the Fed asked Congress to ban IOR, that would make people fearful of hyperinflation, and thus it would be very effective!”
    The only person from the Fed asking Congress to ban IOR is Charlie Plosser, a non-voting member of FOMC who is an extreme hawk. If Fed asks Congress to ban IOR (because IOR allowed Bernanke to overstimulate economy), and people should be fearful of deflation.

    You said:
    “I agree with your four points, except I’m not quite sure about the last one–how does that differ from point 3?”
    These points are related, but the point 3 is about weak balance sheets of financial institutions, and point 4 is more about weak personal balance sheets.

  45. Gravatar of James in London James in London
    29. November 2010 at 04:54

    We “need” to understand that deflation can be a good thing. There are no easy solutions to a messed-up, indebted, economy. Managing expectations can go both ways. Why do you only ever want people to adjust via spending money rather than saving? Sure it seems “easier” if we print more money rather than adjusting to less money being around, but is this really true? One very messy example of the US in the 1930s doesn’t really seem to be a good case, versus numerous, messy, but real hyperinflatoins.

  46. Gravatar of Bill Woolsey Bill Woolsey
    29. November 2010 at 05:52

    Scott:

    Having the Fed peg index futures on nominal GDP doesn’t mean that NGDP will be on target. It is just that the Fed will lose lots of money if it is undertarget. Are you back to assuming that the Fed issues base money to pay for contracts today?

    The change in the quantity of money is due to ordinary open market operations. But what if the Fed were to act perversely? Say, solely purchase securities with yields at zero?

    Speculators are hardly in a position to take infinite positions. And if the Fed has enough zero yield assets to buy, it could match their short positions with a large portfolio of zero interest securities. Or, hey, pay really high interest on reserves.

    The end result would be that when nominal GDP actually comes in under target is that the Fed would lose a lot of money to the speculators.

  47. Gravatar of ssumner ssumner
    29. November 2010 at 08:17

    123, The comment on Plosser is exactly my point. If Bernanke asked for Congress to ban IOR right now, people would interpret that as expansionary (because he’s now pusing for easier money). But in October 2008 when the Fed instituted IOR, Bernanke was opposed to a big fed funds rate cut and so the move was seen as contractionary.

    James; You said;

    “We “need” to understand that deflation can be a good thing. There are no easy solutions to a messed-up, indebted, economy. Managing expectations can go both ways. Why do you only ever want people to adjust via spending money rather than saving?”

    You’ve commented here before; I can’t believe you still think I am opposed to saving. I want people to save more. And I agree that deflation can be a good thing if driven by improved productivity. But not if driven by weak NGDP.

    Bill, I have always argued that the Fed should use ordinary OMOs in T-securities to avoid taking a signficant long or short position. They should do trading with a new contract each day, and they should set the monetary base at the estimated equilibrium before trading begins. Some days they will be long, but just as often they will be short. They will take on very little risk.

  48. Gravatar of 123 123
    29. November 2010 at 10:05

    Scott, you said:
    “The comment on Plosser is exactly my point. If Bernanke asked for Congress to ban IOR right now, people would interpret that as expansionary (because he’s now pushing for easier money). But in October 2008 when the Fed instituted IOR, Bernanke was opposed to a big fed funds rate cut and so the move was seen as contractionary.”

    Bernanke wants to push for easier money in a way that raises costs if the Fed prematurely tightens in the future. Such policy is IOR – it will be more costly for the Fed to prematurely tighten in the future.

    Banning IOR would ease current conditions a little bit, but it will send a bad signal about the exit strategy. Banning IOR will make it less costly for the Fed to prematurely tighten, as premature tightening will reduce the risk to Fed’s solvency in the absence of the option to raise IOR in the future.

    In October 2008 FOMC’s opposition to big fed funds rate cut was seen as contractionary, but this has nothing to do with IOR, it would be seen contractionary with or without IOR. Bernanke used IOR to bring the effective fed fund interest rate down, so introduction of IOR should be seen as expansionary.

    By the way, if you want to know the exact date when the Fed started to sterilize the monetary base here it is: September 17, 2008!
    Source: http://www.ustreas.gov/press/releases/hp1144.htm

  49. Gravatar of 123 123
    29. November 2010 at 10:12

    Scott, and I think you are inconsistent in one respect – you say that temporary expansions of monetary base are not expansionary, yet you seem to argue that temporary deviations of fed funds rate below FOMC target (that would happen in the absence of IOR) would provide monetary stimulus.

  50. Gravatar of scott sumner scott sumner
    30. November 2010 at 06:39

    123, All I can do is repeat that the impact of eliminating IOR is not a technical question, but depends on expectations. If Bernanke cheerleads the idea as a way of boosting AD, markets will cheer. If it is seen as Plosser’s ideas, markets will tank.

    The September action did not prevent a huge rise in the base, so it sterilized only a small fraction of the base injections.

    W/O IOR, the deviations from target would not be temporary. If they injected $2 trillion without IOR, rates would fall to zero, even if the target was at 2%.

  51. Gravatar of 123 123
    1. December 2010 at 06:49

    Scott, You said:
    “All I can do is repeat that the impact of eliminating IOR is not a technical question, but depends on expectations. If Bernanke cheerleads the idea as a way of boosting AD, markets will cheer. If it is seen as Plosser’s ideas, markets will tank.”
    Yes, the effect of abolition of IOR is different depending on who is the source of the idea. But technical details also matter, and Bernanke wanted to choose the way of boosting AD that has the technical benefit of costly precommitment. If you want to change IOR, it is better to choose the way that will enrage Plosser – IOR should temporarily be lowered to negative 10bps, with a promise to the markets that when the time for the exit strategy comes, IOR will be used while leaving the bloated monetary base in place.

    Bernake thinks that the practical limit for IOR is approximately positive 10bps, as with IOR lower than that, investment demand for monetary base will shift to physical cash. I think that the practical limit for IOR is a little bit lower.

    You said:
    “The September action did not prevent a huge rise in the base, so it sterilized only a small fraction of the base injections.”

    As far as I remember, approximately two thirds of additional monetary base were sterilized. IOR was a milder tool for sterilization than TSFP.

    You said:
    “W/O IOR, the deviations from target would not be temporary. If they injected $2 trillion without IOR, rates would fall to zero, even if the target was at 2%.”

    Rates that are below target provide no monetary stimulus, a good example was 9/11. And the cause of high money demand after Lehman was not IOR, it was a decline of the growth rates of broad money, and IOR became a problem only on October 22, 2008.

  52. Gravatar of Rod Everson Rod Everson
    1. December 2010 at 13:13

    Scott, you wrote: ” W/O IOR, the deviations from target would not be temporary. If they injected $2 trillion without IOR, rates would fall to zero, even if the target was at 2%.”

    True. Except that the infusion of $2 trillion of excess is inconsistent with the statement “even if the target was 2%.” The “target” historically has been a rate managed specifically by the adding or draining of excess reserves on either side of the target rate. An addition of $2 trillion in excess would be an explicit statement of the Fed’s intention to move the target to zero, and not retain a target of 2%.

    I think where we differ is in the very purpose of a “target rate” on federal funds. I suspect that you see it as a short-term rate that affects economic behavior and expectations. Please correct me if I’m wrong in that assumption. Under that assumption, there’s some value in maintaining the fiction of a target rate unrelated to the management of the level of reserves in the system.

    I see the target rate as a highly-managed rate that the Fed sets, via open market operations, that historically allowed them to efficiently manage the level of total reserves in the system by those same open market operations. Recently IOER has replaced those procedures. As a result, I’m concerned that the Fed has relinquished the control they once held over the amount of money created in the system on an ongoing basis.

    My view is that the Fed once had the ability, using the old tools, to manage the money supply very closely. The new tools they’ve adopted, which might have been needed to get through a financial crisis (or maybe not), have not been tested when it comes to managing the level of money in the system. As a result, money might now either contract or expand at rates outside the Fed’s control.

    As a monetarist, I’m concerned when the Fed chooses to jettison tools that have, historically, allowed the Fed to directly control the amount of money in the system, thereby giving them the ability to meet their mandate of maintaining a stable price level. We are not likely to get stable prices as a result. Eventually we’ll see whether that’s the case.

    Rod

    P.S. Took a break there for a while. Your blog really eats up personal time….*s*

  53. Gravatar of 123 123
    1. December 2010 at 14:28

    Scott, this is Bill Woolsey on IOR, and it perfectly explains why Plosser wants to abolish IOR:
    “The reason to raise interest rates on reserves rather than selling off assets is for the Fed to avoid capital losses on the asset portfolio. If the Fed raises interest rates on reserves enough, it will have higher costs, and perhaps its costs will rise above its earnings on its asset portfolio. But, it can suffer losses for a long time before it runs out of assets. Further, if there remains a large demand for zero-interest hand-to-hand currency for some time, that is a source of profits that could offset losses from paying interest on reserves. If the Fed had to rapidly sell off long term bonds (much less mortgage backed securities,) insolvency could arrive rapidly. Sure, there is no real distinction in present value terms, but in political terms, an open and transparent bailout of the Fed would be very different than reduced payments to the Treasury over the next 20 years.”

  54. Gravatar of Rod Everson Rod Everson
    1. December 2010 at 15:10

    @123:

    Anyone see the irony of converting the Fed from one of the few income-generating government bodies, besides the IRS, into an eventually taxpayer-funded one, all while charged with the goal of maintaining a stable monetary system?

    Maybe they’re (we’re) headed down the wrong path altogether?

  55. Gravatar of 123 123
    1. December 2010 at 15:29

    Rod,
    I see the irony. My preferred policy is credit easing. Credit easing would be much more profitable than risky QE2.

  56. Gravatar of Rod Everson Rod Everson
    1. December 2010 at 17:04

    @123:

    And how would you implement “credit easing” exactly? Just curious.

  57. Gravatar of ssumner ssumner
    2. December 2010 at 08:16

    123, Can you cite a source for Barnanke’s 10 basis point argument, I’d be very interested.

    I don’t know what you mean by the rise in the base in September 2008 being sterilized. The base rose sharply, and no interest was being paid on the base money.

    The 9/11 case is not relevant, as everyone knew that was temporary. I agree temporary policies don’t matter.

    Rod, You said;

    “True. Except that the infusion of $2 trillion of excess is inconsistent with the statement “even if the target was 2%.” The “target” historically has been a rate managed specifically by the adding or draining of excess reserves on either side of the target rate. An addition of $2 trillion in excess would be an explicit statement of the Fed’s intention to move the target to zero, and not retain a target of 2%.”

    I thought you were making the opposite argument, that the Fed could raise the target rate w/o adjusting the amount of base money.

    I don’t think the fed funds target has much direct effect on the economy, rather it affects the economy to the extent that it sheds light on the Fed’s future policy intentions.

    123. Woolsey may be right, but I don’t see much risk the Fed will need a bailout.

  58. Gravatar of Rod Everson Rod Everson
    2. December 2010 at 09:35

    Scott,

    I do make the argument that the Fed can raise the target rate without adjusting the amount of base money, or even while increasing the amount of base money. It’s all in how they manage perceptions as they do so. It’s all explained in the monograph.

    Can you show me any extended period of time when virtually all short-term interest rates weren’t clearly in line with the Fed’s target rate? The target rate doesn’t shed light on their future policy intentions; it directly illuminates their present policy intentions. Historically, a change in the target rate virtually always indicated that they were proceeding immediately with either further tightening, further easing, or a directional change in policy.

    Where we seem to differ is in our individual belief of how much direct control the Fed has over the level of short-term rates. I am convinced that, within reason (and sometimes even outside of reason) they can normally move the rate in whichever direction they choose (and have always done so, as illustrated whenever they, not the markets, decided to change the direction of fed funds at turning points) and furthermore, that they can move it several percentage points beyond what the market might expect at any particular time.

    You seem to think short rates are set by economic activity and the Fed just trails along after the economy, adjusting their target rate accordingly. Do I misunderstand your position significantly, or am I close? Because if I’m close, our positions are apparently diametrically opposed and one of us is very wrong.

    To be clear, I do realize that the Fed lags when reacting to turning points in the economy. What I’m saying is that they determine, via the fed funds rate, what level other market short-term interest rates will trade around and that they have a broad latitude when setting that level at any particular time, including the present. In particular, they could easily move the rate to 2% in short order if they decided to do so. And other short rates would follow, as they always have.

  59. Gravatar of ssumner ssumner
    4. December 2010 at 10:12

    Rod, No, you are not correctly characterizing my position. I agree that the Fed can and does almost always make market fed funds rates move in lock-step with their target rate. Where we differ is that I think the historical correlations you point to occur precisely because the Fed passively supplies the amount of reserves necessary to make the target rate equal to the target rate. It would be analogous to OPEC supplying the amount of oil necessary to make the target oil price equal to the market oil price.

    Regarding interest rates being endogenous, that is an entirely different subject. I would argue that given actual Federal Reserve policy goals, they often move the fed funds rate in response to economic developments. Thus they often decrease the rate during recessions. Were they not to do so the recesssion would be even worse, and the subsequent political pressure to reduce rates that much greater. But that is a political point I am making (when I claim rates are endogenous), I agree that in a technical sense fed funds rates can be exogenously influenced by the Fed.

  60. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    12. December 2010 at 08:46

    Scott, You said:
    ” Can you cite a source for Barnanke’s 10 basis point argument, I’d be very interested.”

    Here is the Jackson Hole 2010 speech (it is not really clear if the practical zero bound is 10bps, 0bps or 25bps according to Bernanke):
    “A third option for further monetary policy easing is to lower the rate of interest that the Fed pays banks on the reserves they hold with the Federal Reserve System. Inside the Fed this rate is known as the IOER rate, the “interest on excess reserves” rate. The IOER rate, currently set at 25 basis points, could be reduced to, say, 10 basis points or even to zero. On the margin, a reduction in the IOER rate would provide banks with an incentive to increase their lending to nonfinancial borrowers or to participants in short-term money markets, reducing short-term interest rates further and possibly leading to some expansion in money and credit aggregates. However, under current circumstances, the effect of reducing the IOER rate on financial conditions in isolation would likely be relatively small. The federal funds rate is currently averaging between 15 and 20 basis points and would almost certainly remain positive after the reduction in the IOER rate. Cutting the IOER rate even to zero would be unlikely therefore to reduce the federal funds rate by more than 10 to 15 basis points. The effect on longer-term rates would probably be even less, although that effect would depend in part on the signal that market participants took from the action about the likely future course of policy. Moreover, such an action could disrupt some key financial markets and institutions. Importantly for the Fed’s purposes, a further reduction in very short-term interest rates could lead short-term money markets such as the federal funds market to become much less liquid, as near-zero returns might induce many participants and market-makers to exit. In normal times the Fed relies heavily on a well-functioning federal funds market to implement monetary policy, so we would want to be careful not to do permanent damage to that market.”

    You said:
    “I don’t know what you mean by the rise in the base in September 2008 being sterilized. The base rose sharply, and no interest was being paid on the base money.”
    The rise in the base could have been three times larger without the Supplementary Financing Program.

    You said:
    “Woolsey may be right, but I don’t see much risk the Fed will need a bailout.”

    The risk is very low, but the Fed wants to be 100% sure. And bailout would be needed at the time Fed needs to fight inflation.

    There is another benefit of IOR – IOR gives a political cover for volatility of purchased assets. The Fed can always hold assets to maturity and say in public “asset purchases will be profitable in the end.”

  61. Gravatar of ssumner ssumner
    12. December 2010 at 10:34

    123, Thanks for the info on Bernanke.

    Regarding “sterilization,” it seems strange to call a situation where the base increase was not sterilized, “sterilization,” just because the Fed prevented the increase from being even larger.

    Regarding Fed risk, we are constantly told that the Fed can’t create higher inflation because it would impose risks on the Fed balance sheet. But when people suggest expansionary tools that don’t impose risk (level targeting, lower IOR) the Fed still refuses. Indeed they say it would be bad because it would increase inflation up to an averge of 2% during the 2008-18 period. That’s lower than the previous decade. Horrors!

    So risk is preventing them from inflating, and they wouldn’t inflate even if there was no risk, as they don’t want to.

    I’m not persuaded. Their tight money policy is what has caused the bloated MB.

  62. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    12. December 2010 at 15:15

    Scott, the term “sterilization” usually refers to the foreign currency inflows (as in China) or new asset purchases (as in credit easing). The Fed has sterilized two thirds of asset purchases after Lehman with Supplementary Financing Program. Why did they do that? To prevent fed funds rate from getting too low. Fortunately they stopped the SFP and switched to IOR to control the fed funds rate. Bad news – Trichet has revived the SFP idea (even though he has IOR), as the ECB is sterilizing the purchases of PIGS bonds by issuing 7 day deposits.

    Bloated MB has two causes – tight money, and the real shock to the shadow banking system. IOR has led to fuller (although insufficient) accommodation of the collapse of the shadow banking system.

    I think Bernanke would like to use level targeting (probably not from 2008 base), he just hasn’t got the FOMC support.

  63. Gravatar of ssumner ssumner
    13. December 2010 at 18:13

    123, I think we are going around in circles. I am not against IOR, as long as the rate is set at a level expected to produce on-target NGDP growth.

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