I spent almost 3 hours watching the morning session of the recent Brookings conference on negative interest on reserves. Tomorrow another 3 hours, which may have more material of great interest (Kimball, Bernanke, etc.)  But today’s presentations were very good, and deserve a post.

I am indebted to JP Koning for directing me to the best part, after the 1:15 mark, where a lady from the Swiss National Bank was asked why the Japanese yen appreciated after the BOJ introduced negative IOR.  I was very glad to see her give the same answer that I’ve been giving; it didn’t appreciate, it depreciated.  She explained that you need to look at the market reaction in the hours after the announcement, not the move in the yen over the next few weeks.  When you do so, you find the yen is no different from the other currencies that adopted negative IOR—the effect is expansionary, as evidenced by the fall in the yen.  She also points out that all monetary stimulus tends to depreciate currencies, whether rates are positive or negative.  Hence the exchange rate is not some sort of special channel that is only operative at negative IOR.

The discussion of Denmark was kind of interesting.  There are actually some adjustable rate mortgages in Denmark that have recently gone negative.  Not many, because the mortgage rate is above the short term risk free rate, but a few.  In addition, the tax authorities now have to worry about people paying taxes too soon, which leads to new tax rules.  Corporate dividends have increased since negative IOR was introduced, perhaps because large institutional bank accounts offer negative rates while small retail accounts are generally set at zero.  So smaller savers earn more on their cash than big corporations.  Listening to the discussion you begin to realize that if rates stayed significantly negative for an extended period, then the public’s way of handling money would gradually evolve in unexpected ways.

The Swiss like their SF1000 bills (roughly $1000) and use them frequently.  Another Swiss expert confirmed that the currency appreciation last year had slowed inflation and reduced RGDP about as much as expected, but that the SF had now fallen to about where they wanted it—which confirms a recent post of mine.

Even the German hawk that I did not agree with gave a very impressive presentation.

HT:  Patrick Horan

David Beckworth was interviewed by Russ Roberts this morning in a special video version of EconTalk, which was held at the Cato Institute and hosted by George Selgin. Unfortunately I am not able to find a link for the talk, but I’ll put one up if someone else can direct me to it.

Update:  Here’s the link:

http://www.cato.org/events/econtalk-live-david-beckworth-monetary-policy-great-recession

Update#2:  I’m told the link no longer works, but a new link should be up in about 10 days.

There was some discussion of whether the market monetarist critique of Fed policy in 2008 is just Monday morning quarterbacking.  David seemed to concede that this complaint had some merit, and perhaps to some extent it does.  But I also think David is being too modest.  Here’s David criticizing interest on reserves, way back in October 2008, right after it was first adopted:

Is the Federal Reserve (Fed) making a similar mistake to the one it made in 1936-1937? If you recall, the Fed during this time doubled the required reserve ratio under the mistaken belief that it would reign in what appeared to be an inordinate buildup of excess reserves. The Fed was concerned these funds could lead to excessive credit growth in the future and decided to act preemptively. What the Fed failed to consider was that the unusually large buildup of excess reserves was the result of banks insuring themselves against a replay of the 1930-1933 banking panics. So when the Fed increased the reserve requirements, the banks responded by cutting down on loans to maintain their precautionary level of excess reserves. As a result, the money multiplier dropped and the money supply growth stalled as seen in the figure below.

.  .  .

Now in 2008 the Fed did not suddenly increased reserve requirements, but it did just start paying interest on excess reserves. The Fed, then, just as it did in 1936-1937 has increased the incentive for banks to hold more excess reserves. As a result, there has been a similar decline in the money multiplier and the broader money supply (as measured by MZM) which I documented yesterday. If the Fed’s goal is to stabilize the economy, then this policy move appears as counterproductive as was the reserve requirement increase in 1936-1937.

David says that in retrospect he thinks that Fed policy went off course even earlier, in the middle of 2008. Speaking for myself, I didn’t really become aware of the problems with monetary policy until September 2008, after the Fed refused to cut rates despite plunging TIPS spreads.  In retrospect, money became much too tight a couple of months earlier.

Because of data lags, it’s not always possible to predict a recession until the recession is already well underway.  During the past three recessions, a consensus of economists didn’t predict a recession until about 6 months in.  That’s right, not only are macroeconomists unable to forecast, we are also unable to nowcast.

This is why NGDPLT is so important. Under a level targeting regime, the market tends to prevent sharp drops in NGDP from occurring in the first place.  Under NGDPLT, the economy would not have fallen as sharply in late 2008, partly because level targeting would have prevented a steep plunge in asset prices, and partly because current AD is heavily dependent on future expected AD.  If you keep future expected AD rising along a 5% growth path, current AD will not fall very far during a banking crisis.

There was also some discussion of the shortage of safe assets.  Two questions came to mind:

1.  Does this theory imply that risk spreads should have widened in recent years, as the demand for T-bonds has increased faster than the demand for riskier bonds?

2.  Has this in fact occurred, and if so to what extent?

Later this afternoon, I will have a post over at Econlog, explaining why monetizing the US debt would quickly lead to hyperinflation.  In the meantime, the Brookings Institute plans to do a conference on negative IOR.  (Of course they didn’t invite the guy who invented the concept, and successfully predicted its impact on asset prices.)

Here’s the description of the conference:

In just one reminder of the extraordinary moment in economic history in which we are living, the central banks of the eurozone, as well as Japan, Switzerland, Denmark, and Sweden, have pushed their lending rates below zero — banks actually have to pay a fee to deposit money at the central bank. In some major countries, Germany and Japan among them, investors pay a fee to lend to the government instead of collecting interest. Once a fantasy of a few academic economists, negative interest rates are now seen as a tool available to monetary policymakers at times of very low inflation. But they remain controversial: are negative rates a prudent and potent response to today’s lackluster economy? Or do they squeeze bank profits and hurt lending, confuse investors and consumers, and smack of desperation?  (Emphasis added)

Why not both?  And why not both for QE as well?

And why do economists keep putting the cart before the horse?  First you need a credible policy target.  Then you figure out the best tools.  A strategy that relies on the tools to create credibility is likely to produce both the good and the bad effects described above.

In contrast, a promise to do “whatever it takes” to achieve 4% NGDPLT would not require negative IOR, and would require very little QE.  Central banks are so shy that they end up making things really hard for themselves, by trying to take the “easy way out”.  (I’m actually a bit sympathetic, as that describes my adolescence.)

HT:  Patrick Horan

PS.  Just joking about being “not invited”—I believe it’s open to those who register.

Last week, I pointed to a Financial Times headline that suggested the yen was falling on rumors of a cut in the interest rate on reserves (which is already negative):

In the long run, you want to rely on a worldview that allows you to make sense out of the myriad news events that are reported each day.  I believe that framework is market monetarism.  Let’s take an example, a headline from today’s FT:

Yen dives on talk of negative rates on loans

If you relied on the mainstream media, that headline would make no sense.  “Wait, weren’t we told on Twitter that Sumner was foolishly attached to the notion that negative IOR was expansionary, despite all indications to the contrary?  If so, how are we to understand this headline?”  On the other hand if you relied on market monetarism, there would be no cognitive dissonance to deal with.  It would all make perfect sense.

Tuesday, Tyler pointed to another FT story, this time claiming the exact opposite:

Ten weeks after BoJ governor Haruhiko Kuroda startled both financial markets and parliamentarians with Nirp, the yen has appreciated by some 8 per cent against the dollar. The stock market has rebounded sharply this month, however the Topix bank index remains 11 per cent lower since the advent of Nirp.

Under such a policy, risk assets were supposed to rise, but instead demand for Japanese government bonds rallied, rewarding the risk averse. Meanwhile, even finance ministry officials concede that the deflationary mindset is more entrenched than ever. There is agreement that Nirp has backfired and such an unsustainable monetary policy cannot support growth, let alone help financial asset prices.

Who to believe, the FT, or the FT?  Answer, the FT.  Today’s Financial Times provides the results of about as dramatic an event study as you could ever want:

Yen surges and stocks hit as BoJ stands pat

So much for the theory that negative IOR is contractionary.  And the concurrent fall in global stock markets puts another nail in the theory of “currency wars” and “beggar-thy-neighbor”.  The failure of the BOJ to devalue the yen is going to hurt the US and European economies.

Why so much confusion?  Because people forget that while a lower policy rate is expansionary on any given day, low rates are also an indication that money has been too tight.  This paradox is resolved if we make the (quite plausible) assumption that when the Wicksellian natural rate is falling, the policy rate usually tends to fall more slowly, making policy effectively tighter (as in 2008).  And when the Wicksellian rate is rising, the policy rate usually tends to rise more slowly, making policy effectively looser (as in the 1970s.)

It doesn’t take a genius to understand that you evaluate a policy’s effect by looking at the immediate market reaction, not market moves in the following weeks, which could be caused by 101 factors.  Oh wait, I guess it does take a genius.

Here’s a graph showing the fall in the yen last week on rumors of a rate cut, and the more than 3% gain today on the market disappointment at the BOJ’s inaction:

A few weeks ago, I did a post suggesting that the BOJ appears to be giving up on its 2% inflation target.  I suggested that this meeting would give us an answer:

What should Japan do?  I suppose they should do whatever they want to do.  It doesn’t make much sense to target inflation at 2% if you don’t want to target inflation at 2%.

The more interesting question is what should they want to do?  I’d say NGDPLT. But they seem to have other ideas.

Either way, we should have an answer by the end of the month.

Today we got the answer.  The FT also reports the following:

The BoJ also changed its guess of when inflation will reach 2 per cent from the “first half of fiscal 2017” to “fiscal 2017”. Any further delay would mean admitting Mr Kuroda will not reach the target during his term in office.

The whole point is to not adjust the forecast, but rather to adjust the policy instruments.  A very disappointing performance by Mr. Kuroda.  That’s not to say it couldn’t be worse, he has gotten Japan out of its nearly two-decade bout of deflation. But he’ll need to be far more aggressive at the July meeting if he doesn’t want to lose all credibility.  As it is, the BOJ lost a significant amount of credibility today.  Here’s Bloomberg:

A majority of economists surveyed by Bloomberg had predicted some action to counter a strengthening yen that had cast a shadow over the outlook for wage gains and investment spending. The explosion of volatility shows how investors have singled out central banks as the key driver for global financial markets.  .   .   .

“It’s the central banks that still set the course,” said Jan Von Gerich, chief strategist at Nordea Bank AB in Helsinki. “Even slight deviations from what people are expecting are enough to trigger market moves.” .   .   .

“The BOJ had an opportunity to at least temporarily short-circuit the yen trend but failed to act,” said Lee Hardman, a foreign-exchange strategist at Bank of Tokyo-Mitsubishi UFJ Ltd. “It has provided the green light for further yen strength in the near-term.”

The Fed has three primary ways to impact NGDP:

1.  Change the supply of base money–primarily through open market purchases (OMPs), or sales.

2.  Change the demand for base money through adjustments in interest on reserves (IOR)

3.  Change the demand for base money through adjustments in the Fed’s target (inflation, NGDP, etc.), or making it more credible though actions such as level targeting, or currency depreciation in the forex market.

Most pundits think and talk in terms of binaries, and thus underestimate the policy options available to the Fed.  Thus a pundit might say we need to ban currency and break the zero bound, because OMPs are ineffective at the zero bound—forgetting the option of impacting base money demand by adjusting the policy target.

For each of the three options, it’s useful to treat one as a given, and think about the other options in a two dimensional space.  Thus if we have a given policy target, say a 4% NGDP target path, then the Fed has two tools to get there, OMPs and adjustments in IOR.  Then you can think about how much weight the Fed should put on each tool, by considering other objectives, such as size of the balance sheet.  For any given NGDP target, the higher the IOR the larger the balance sheet, and vice versa.  If the Fed wants banks to hold lots of liquidity, they might opt for a higher IOR.  If they are worried that they’ll need to do a lot of QE to hit their target, and that this QE will be politically unpopular, they’ll go for negative IOR.  (That’s where the ECB is right now.)

But we don’t have to think of the policy target as a given.  Japan recently raised their inflation target from 0% to 1%, and then later to 2%.

Or we could assume that for some reason IOR is fixed at zero, as it was during the Fed’s first 95 years. Then the trade-off would be between steepness of target path and size of balance sheet.  The faster the desired rate of NGDP growth, the smaller the ratio of base money to GDP, and hence the smaller the central bank balance sheet.  Australia chose a high target path, and got a very small RBA balance sheet as a result.

And finally, the balance sheet itself might be a key objective.  For instance, the Swiss National Bank recently became concerned about their ballooning balance sheet.  Suppose central banks are averse to a large balance sheet.  In that case the target path and IOR become the two policy options.  The Swiss could opt for a higher rate of inflation, or they could opt for a lower rate of IOR.  In fact, they’ve opted for negative 0.75% IOR, an especially low rate.  In my view they should have changed the (effective) inflation target, by not revaluing last year.

Even within a category such as OMPs, there are several possible options.  Thus the central bank could buy Treasury bonds, or they could buy a riskier asset.  Generally speaking, the riskier the asset the more “bang for the buck”, but not as much more as you might imagine (in my view.)  Monetary policy primarily works by impacting the liability side of the Fed’s balance sheet; the asset purchases are not very important.  However when we are at the zero bound, or when the market rate equals the interest rate on reserves, it’s quite possible that the asset side becomes relatively more important.  It’s hard to say how much more, because policy at the zero bound is especially sensitive to expectations of future policy.  But if we hold the NGDP target path constant, then the specific type of assets being purchased might make some difference.

Here’s a question from Eliezer Yudkowsky:

Should market monetarists be pushing heavily to have the Fed be buying higher-priced bonds, foreign assets, or non-volatile shortable equities, instead of US Treasuries?

It seems to me intuitively that buying Treasuries with money might itself be a wobbly steering wheel, because as the Treasuries have lower yields and especially as you foolishly start to pay interest on reserves, you’re substituting two very similar assets. As the two assets get *very* similar you might be approaching a division-by-zero scenario where it takes unreasonably large amounts of money creation to change anything. And yes, there’s still an amount of money that’s enough. But maybe you would literally have to run out of short-term Treasuries to buy. Maybe you’d need to print far less money if you were buying a basket of low-volatility stocks or something. So maybe this is one of the things that market monetarists should push for, for the same reason we push for not using interest rate targeting because the meaning of the asset keeps changing? Like, if we try to create money and exchange it for Treasuries, does the meaning of that act change and diminish even as the Treasury yields get closer to zero.

If printing more of the unit of account or unit of exchange is supposed to have a mode of action that doesn’t interact with the similarity of that currency to the Treasuries that it’s replacing, then I confess that this is something I still don’t understand myself and definitely couldn’t explain to anyone else. It might need to be explained to me with some kind of concrete metaphor involving apples being traded for oranges in a village that prices everything by apples, or something. Right now, the only part I understand is the notion that people have a price/demand function for things-like-currency, which implies that if a Treasury has become a thing-like-currency, creating currency and removing Treasuries will be a wash in terms of the demand function.

I think this question needs to be broken down into pieces.  First, are we happy with the policy target?  In my view the ECB and BOJ should not be happy with their policy target, as it leads to such low NGDP growth expectations that they are forced into unpleasant decisions on IOR and/or QE.  They’d be better off with another target, say level targeting of prices, which would lead to faster expected NGDP growth and less need to do negative IOR or QE.

But let’s say the target is carved in stone, then what are the options?

I prefer starting with buying Treasuries, even if it is less effective than other assets. Recall that seignorage is basically just a form of tax revenue, which ultimately goes to the Treasury.  Unless you specifically want to build sovereign wealth fund, it’s not clear why you’d want the Fed to buy stocks.  And if you do want to build a sovereign wealth fund, it seems like it should be the Treasury’s decision.  In other words, the Treasury could borrow a trillion dollars and use it to buy index stock funds. Then the Fed would have lots more T-debt to buy.  This combined operation has the same ultimate effect as Eliezer’s proposal, but the lines of authority are clearer.

The next question is how much T-debt should the central bank buy?  I don’t really know.  I’d probably ask the Treasury how much they’d like to leave in circulation to give liquidity to the markets (which might be $5 trillion), and then stop at that red line.  At that point I’d have the Fed buy other assets, such as Treasury-backed GSE debt (i.e. MBSs), foreign bonds, AAA corporate debt, etc.  I suppose at some point you might end up buying stock, but I can’t really envision that happening.  On the other hand, a decade ago I couldn’t envision where we are right now—-6 1/2 years of nearly 4% NGDP growth and interest rates at 0.5%.  So who knows?

To summarize, I have several objections to the Fed buying stocks right now:

1.  I doubt it provides much more bang for the buck, as it’s the liability side of the Fed’s balance sheet that really matters.

2.  Even if they do need to buy more Treasury debt (relative to stocks), buying that debt is not costly, indeed the Fed usually makes a profit.

3.  Any decision to build a sovereign wealth fund should be made democratically, i.e. by the Treasury.

I could add other objections, such as that it’s “socialism”.  However I’m actually not all that worried about the Fed meddling in the management of companies.  But lots of other people would be.

Eliezer’s right that base money and T-debt are much closer substitutes at the zero bound, but I don’t see that as a problem.  So do more!

I prefer to work back from the target.  What percentage of GDP does the public want to hold in the form of base money, if the central bank is expected to hit its target?  Right now people are confusing two issues, a desire to hold base money because rates are low, and a desire to hold base money because the central bank is not expected to hit its target (as in Japan and the eurozone).  If credibility is the problem, then you need a mechanism to restore credibility.  I like my “whatever it takes” approach and/or level targeting, but other options are available.  Thus small countries like Switzerland can simply devalue their currency.

Until we get clear thinking from the central banks about the three policy levers discussed above, it’s hard to give good policy advice.  For instance, if the ECB actually has big problems hitting its inflation target at the zero bound, then the asymmetry built into their target is obviously exactly backward.  In a world where the zero bound is a big problem, the target should be “close to but not below 2%”. Right now, they have a policy target that conflicts with their operating procedure. The target reflects the assumption that it is high inflation that is difficult to control. And yet exactly the opposite seems to be true.

Then central banks need to think clearly about the inflation rate/size of balance sheet trade-off (at each IOR).  They don’t seem to know whether they are more averse to higher inflation or to a very big balance sheet, and hence end up in the worst of both worlds—missing the inflation target and thus getting an even bigger balance sheet.  Of course the lack of clear thinking might actually reflect very clear thinking by each member of the ECB, but no agreement on which of those clear paths is best.  But I think it’s worse than that, you have central bankers saying we need to raise rates so that we can cut them in the future, an EC101-type error.  So I’m not willing to give them the benefit of the doubt.

I don’t think Eliezer will be happy with this post–it’s too long to be an “elevator pitch”