Rick Santelli explains the real reason for QE3

I usually disagree with Rick Santelli, who’s a monetary hawk right now.  But in this interview he clearly explains why the Fed needs to do so much QE: the money market industry.

Back in late 2008 a few money market funds got into trouble and were in danger of “breaking the buck.” That’s due to their policy of pricing each share at $1.  The solution is to allow the price to fluctuate.  The Fed should have given the industry 6 months to prepare for negative interest rates.  Instead they bailed them out and propped up interest rates at 25 basis points, in order to insure they would never break the buck.

If not for the money market industry the Fed could have already cut the fed funds target to around negative 0.25%, and the same for the interest rate on reserves.  In that case (and assuming the IOR also applied to vault cash) it’s likely that most of the ERs would exit the banking system and end up in safety deposit boxes.  But three trillion dollars is a lot of Benjamins, and despite the cash hoards you observe in places like Japan, a more likely outcome would have been hyperinflation.  Obviously that would not be allowed, so what this thought experiment really shows is that with that sort of negative IOR the Fed could have gotten the stimulus it wanted with much less QE.

Santelli is one of the few people who understands the real reason for the massive QE program.  Kudos to CNBC. (Louis Woodhill also frequently discusses IOR.)

PS.  On balance I’d prefer the old policy of no IOR, rather than negative IOR.  But negative IOR is preferable the current sluggish recovery in NGDP.


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33 Responses to “Rick Santelli explains the real reason for QE3”

  1. Gravatar of Ben Ben
    19. November 2013 at 11:40

    You just brushed past hyperinflation there. Can you elaborate a bit? This is tricky stuff.

  2. Gravatar of Ralph Musgrave Ralph Musgrave
    19. November 2013 at 11:51

    I quite agree that money market fund shares should be allowed to fluctuate. In fact Laurence Kotlikoff takes that idea further (correctly in my view) and argues that whenever a depositor at a bank or bank like institution (e.g. a money market fund) wants their money loaned on so that they can earn interest, it should be illegal for the bank to promise to return 100 cents in the dollar. Instead, depositors should buy into a mutual fund of their choice, where their stake will fluctuate in value.

    That makes sudden bank failures near impossible, though banks can SLOWLY dwindle to nothing. Hence credit crunches would be far less volatile.

  3. Gravatar of seriously? seriously?
    19. November 2013 at 13:12

    Love your reasoning.

    Negative fed funds rate leads to people withdrawing money en masse to put the cash in safe deposit boxes which leads to hyperinflation.

    Hilarious. If everyone holds cash then you think the world will be more like your model that has no banking.

    Just when it seems like you can’t write anything stupider you top yourself with this nonsense. Thanks for the laugh!

    Also, I could be wrong but, I think the money market problem is one of scarcity of high quality collateral not one of positive rates of interest.

  4. Gravatar of seriously? seriously?
    19. November 2013 at 13:25

    I take it back. Just watched the video you link to. Rick Santelli’s thoughtful and reasoned analysis is difficult, if not impossible, to dispute. Thanks.

  5. Gravatar of ssumner ssumner
    19. November 2013 at 14:03

    Ralph, Good point.

    Ben, This is a very tricky subject, which is hard to explain. FWIW, I believe an attempt to force $3 trillion in currency into circulation would lead the public to expect higher inflation. This is especially true if it were done with no IOR, and no promise to withdraw the money if inflation developed. This would lead to higher velocity, and eventually hyperinflation.

    Now of course I might be wrong, the public might continue to have confidence in the dollar despite all that cash. But I believe the public would ask themselves “what the hell is the Fed doing?” and then lose confidence in policy.

    As with anything in monetary economics, it depends on expectations. Hence there is no clear right and wrong answer. I gave my best guess.

  6. Gravatar of JP Koning JP Koning
    19. November 2013 at 15:20

    Why hyperinflation? Excess reserves aren’t currently being spent away at a rate that causes hyperinflation, nor would they be if interest-on-reserves were reduced to 0%. Right? If IOR is dropped to -0.25%, and banks all convert into 0% cash, they are basically in the same situation that they were in when the owned reserves that yielded 0%. If $3 trillion worth of 0% yielding reserves didn’t cause hyperinflation, neither should $3 trillion worth of 0% cash cause hyperinflation.

  7. Gravatar of Jared Jared
    19. November 2013 at 15:31

    Scott, don’t you think negative IOR could have some disruptive and contractionary effects? I’m thinking of higher fees charged to bank depositors; lower margins and earnings on bank interest income, which could lead to less lending; or just no change in lending unless banks lowered their credit standards, but why would a lower return cause them to take on riskier borrowers? And one of the best interest-avoidance schemes would be for banks to overpay their taxes in advance. Any funds overpaid would be returned $ for $ instead of paying the interest charged for holding the money in reserves. And who knows what other kinds of socially unproductive, contractionary interest-avoidance schemes the market could come up with.

  8. Gravatar of Michael Michael
    19. November 2013 at 15:32

    This is just one more of the many ways that the Fed is trying to HARM SAVERS! Oh, wait…

    BTW, Glasner on QE:

    http://uneasymoney.com/2013/11/18/the-internal-contradiction-of-quantitative-easing/

    “The answer, it seems to me is the following. If everyone believes that the Fed is committed to its inflation target “” and not even the supposedly dovish Janet Yellen, bless her heart, has given the slightest indication that she favors raising the Fed’s inflation target, a target that, recent experience shows, the Fed is far more willing to undershoot than to overshoot – then Fed purchases of assets with currency are not going to stimulate additional private spending. Private spending, at or near the zero lower bound, are determined largely by expectations of future income and prices. The quantity of money in private hands, being almost costless to hold, is no longer a hot potato. So if there is no desire to reduce excess cash holdings, the only mechanism by which monetary policy can affect private spending is through expectations. But the Fed, having succeeded in anchoring inflation expectations at 2%, has succeeded in unilaterally disarming itself. So economic expansion is constrained by the combination of a zero real interest rate and expected inflation held at or below 2% by a political consensus that the Fed, even if it were inclined to, is effectively powerless to challenge.”

  9. Gravatar of ssumner ssumner
    19. November 2013 at 16:06

    JP, You said:

    If $3 trillion worth of 0% yielding reserves didn’t cause hyperinflation, neither should $3 trillion worth of 0% cash cause hyperinflation.”

    This is simply incorrect. I suggested a 50 basis point cut in interest rates. You might disagree with the numbers, but it’s not nothing. Cash has a negative yield because it’s costly to store.

    As far as the effect on inflation, that of course depends on expectations. I explained in an earlier comment why I believe expectations would shift. Cash is very different from reserves. I may be wrong, but you’ve given me no reason for thinking so.

    Suppose I was in Britain in the 1980s and made this argument:

    “Let’s suddenly triple the money supply. It will drive interest rates to zero, and thus it will not be inflationary.”

    That’s possible, but is it plausible? This example is different, but the British hypothetical shows that expectations are very important. Context matters.

    Jared, I don’t understand how overpaying their taxes reduces IOR?

    Michael, Glasner also says:

    “So it does seem possible that, after all, QE and low interest rates may well have made things measurably better than they would have otherwise been. But don’t expect to opponents of QE to acknowledge that possibility.”

    He’s talking about you.

  10. Gravatar of JP Koning JP Koning
    19. November 2013 at 16:55

    “Cash is very different from reserves.”

    That’s probably the crux of the argument. Abstracting from storage costs, it seems to me that a 0% yielding reserve deposit is almost exactly the same as a 0% paper bill. So when banks embark on mass conversion of reserves into 0% cash the moment IOR is pushed below 0%, I don’t see how expectations change. All that’s happening is that $3 trillion of X is converted into $3 trillion of X. (I certainly agree that the move from 0.25% to 0% would be inflationary). But I don’t have a link for the previous post you mention, so it’s hard for me to understand your point about the specialness of reserves.

  11. Gravatar of Geoff Geoff
    19. November 2013 at 17:03

    Everyone who understands the creation of the Federal Reserve, who understands the interested parties, and who understands the reason for why the Fed ultimately does what it does, knows that QE was designed to recapitalize the numerous banks that would have otherwise incurred massive losses, and bankruptcy.

    The original Fed and its technocrats had to take their selfish desires and translate them into feel good social needs speak. So we are now told that the banks are a necessary and crucial component in a growing economy with low unemployment. The Fed will print whatever quantity of money is necessary to keep the inter-connected and inter-dependent banks afloat. To them this is equivalent to “helping everyone.”

    Since the amount needed during the financial crisis was so substantial, it threatened hyperinflation, so the Fed had to find a way to prevent this money from leaving the banking system. Ergo, they started to pay banks to keep a large portion of their payments from other banks, at the Fed, where that money won’t cause a rise in consumer prices.

    ——————-

    NGDP should not grow at a constant rate. It should grow to whatever extent results from free market activity in money production.

  12. Gravatar of Michael Michael
    19. November 2013 at 17:38

    “He’s talking about you.”

    Huh? I’m only an “opponent of QE” in the sense that it (and Fed policy generally) has not been accomodative enough. As for “QE and low interest rates may well have made things measurably better than they would have otherwise been”, I agree.

    But… are inflation expectations SO well-anchored that even massive QE has a limited effect on nominal income growth? This seems plausible.

  13. Gravatar of TravisV TravisV
    19. November 2013 at 17:38

    Ben Bernanke Just Gave A Superb Speech That Explained All Of His Biggest Decisions

    Read more: http://www.businessinsider.com/ben-bernanke-speech-on-communication-and-monetary-policy-2013-11#ixzz2l982SwPj

    Read Bernanke’s whole speech here:

    http://www.federalreserve.gov/newsevents/speech/bernanke20131119a.htm

  14. Gravatar of dtoh dtoh
    19. November 2013 at 18:35

    Scott,
    I would look at it this way. Money is dual purpose. It can either be held as a Medium of Exchange (MOE) or Store of Value (SOV). When it’s held as an SOV, it’s just another financial asset.

    The amount of money held as an MOE is the amount that’s needed for transactions so the amount of MOE money is basically a fixed ratio of NGDP. There is a close correlation between NGDP and the amount of MOE money.

    Any money not held as MOE money is being held as SOV money. There is little correlation between the amount of SOV money and NGDP.

    When the nominal price of financial assets approaches zero or the IOR rate, OMP will cause an increase in the amount of SOV money being held.

    OMP will also raise AD if it causes a marginal increase in the exchange by the non-banking sector of financial assets for goods and services. The marginal increase in exchange is caused by higher asset prices (APE) and expectations of higher NGDP. When this marginal increase in the exchange of financial assets for goods and services occurs, there is an increased demand for MOE money in order to effect these exchanges.

  15. Gravatar of dtoh dtoh
    19. November 2013 at 18:41

    Scott,
    Interesting thought experiment. What would happen if the Fed today announced that they were prohibiting banks from holding ER effective January 1, 2014.

  16. Gravatar of Dan W. Dan W.
    19. November 2013 at 19:26

    Scott,

    Why do Monetarists feel the need to bleed the patient to death? Instead of QE or negative interest rates there is an even simpler solution. Abolish all debts. Write them off. Voila. In the stroke of a pen you make underwater mortgages vanish. You make insolvent banks solvent. All the taxes and revenues spend to paying interest on bonds can now be spent on real goods and real salaries.

    Sure those invested in bonds and debt in general lose. But these savers are going to lose anyway, what with the steady destruction of the underlying currency. So make the death swift and painless, rather than slow and torturous.

    If debt and interest are the reasons why Central Bankers must set out to destroy a nation’s currency would not cancelling all debts be the more efficient and more effective solution?

  17. Gravatar of Benjamin Cole Benjamin Cole
    19. November 2013 at 21:27

    Amazing post. Really? Textbooks are going to have to change…

  18. Gravatar of Saturos Saturos
    19. November 2013 at 22:37

    Interesting, Scott, so without IOR there would be hyperinflation? What about your previous views that it is mainly the temporary nature of the injections that is neutralizing their impact on demand, and that IOR in and of itself makes not that much difference? What do you think of Louis Woodhill’s view that IOR was the “smoking gun” in 2008? John Aziz is also incredulous: http://twitter.com/azizonomics/status/402936399952764928

  19. Gravatar of lxdr1f7 lxdr1f7
    20. November 2013 at 00:13

    “If not for the money market industry the Fed could have already cut the fed funds target to around negative 0.25%, and the same for the interest rate on reserves.”

    Too much liquidity preference amongst existing fed counterparties. Why not just make the fed operate with counterparties that have a reasonable liquidity preference and who actually spend money not just rebalance portfolios?

  20. Gravatar of Jonathan Monroe Jonathan Monroe
    20. November 2013 at 02:20

    @Dan W (19)
    Remember that the one person’s debt is another person’s financial asset. The asset end of bank debt is checking and savings accounts. The asset end of mortgage debt is the MBS in someone’s pension funds. If the debt is jubileed away, all financial assets (except equities, which are a proxy for the real assets of the company) become worthless.

    But of course, Scott Sumner does support a debt jubilee if it is necessary. The reason why Scott’s views are unpopular with the ignorant is that he is seen as pro-inflation. And inflation is just a debt jubilee on the installment plan. Doing it on the installment plan makes it a lot less disruptive.

  21. Gravatar of MikeF MikeF
    20. November 2013 at 03:32

    “it’s likely that most of the ERs would exit the banking system and end up in safety deposit boxes. ”

    I’m not convinced of that…the main reason I have money in a savings or checking account is that it is insured and I trust I can get it back on a moments notice. If I need to pay .25% instead of getting 0.25% on my money well that bothers me…but I don’t have a lot of good alternatives.. Safety deposit boxes are not insured and they also cost money if you don’t already have one and I can’t move it around electronically….I might reduce it some and move more into my brokerage account…but it would not be a mass exit….

  22. Gravatar of MikeF MikeF
    20. November 2013 at 03:41

    I’m just talking about my own reserves..as far as all the excess reserves the bank is holding…that might be a different story..

  23. Gravatar of Jon Rodney Jon Rodney
    20. November 2013 at 05:45

    I honestly don’t understand the logic here. Can’t banks just convert their excess reserves to currency if they want, and stick the currency in their vault? How would that be so different from our current situation as to cause hyperinflation?

  24. Gravatar of ssumner ssumner
    20. November 2013 at 06:41

    Everyone, Not sure why people are focusing on the hyperinflation comment, which was a throwaway line not really related to the post.

    JP, You are ignoring two factors:

    1. Banks can’t hold “cash.” Any currency they hold is considered reserves, and would be taxed under my plan. So IOR falls by 50 basis points.

    2. The storage costs of cash are not certainly zero.

    Michael, Sorry, I must have misinterpreted your comment.

    You asked;

    “But… are inflation expectations SO well-anchored that even massive QE has a limited effect on nominal income growth?”

    Yes, but it depends how large. Obviously there is SOME level of QE that creates lots of inflation.

    dtoh, You asked;

    “Interesting thought experiment. What would happen if the Fed today announced that they were prohibiting banks from holding ER effective January 1, 2014.”

    Banks would scream and asset prices would rise sharply.

    I don’t think the MOE/SOV distinction is that useful in analyzing QE. Monetary injections are likely to be shared by the two categories.

    Dan, I don’t see anyone proposing the “steady destruction of the underlying currency.”

    Saturos, You asked:

    “Interesting, Scott, so without IOR there would be hyperinflation?”

    No, I never claimed that.

    Jonathan, Congratulations on the most moronic comment of the day. The competition is often quite stiff.

    MikeF, Yes, that’s possible, but it then proves my point that the Fed is not at the zero bound, and can cut rates by 50 basis points. In that case change my example to a negative 0.5% IOR. That would surely work.

    Jon, Vault cash is part of reserves, my proposal would tax vault cash as well.

  25. Gravatar of Ben Ben
    20. November 2013 at 07:18

    Scott, one more q. You seem to be in favor of negative IOR, but also remiss that we can’t do it without causing hyperinflation. What do you think is the way forward from where we are wrt ER?

    thanks, love the site.

  26. Gravatar of dtoh dtoh
    20. November 2013 at 07:52

    Scott,

    “I don’t think the MOE/SOV distinction is that useful in analyzing QE. Monetary injections are likely to be shared by the two categories.”

    But I think you need the distinction to explain why the HPE correlation of M to NGDP breaks down at the ZLB.

  27. Gravatar of 123 123
    20. November 2013 at 07:56

    “so what this thought experiment really shows is that with that sort of negative IOR the Fed could have gotten the stimulus it wanted with much less QE.”

    I think you are overstating the significance of the exact position of ZLB. BoE is paying 50bps, and that is not a big deal compared to the what Fed is doing. There is an effect (EUR has fallen by half a percent minutes ago on rumours ECB is considering negative 10bps on reserves), but it is not a very important one. It is the expected future policy that really counts.

  28. Gravatar of JP Koning JP Koning
    20. November 2013 at 08:14

    Just to make sure we are on the same page. How do the $3 trillion in ERs exit the banking system? Are you saying that depositors convert their chequing accounts (which would probably be negative yielding when IOR=-.5%) into cash and hold it in vaults? If so, why would they be more likely to bid prices higher if they own cash than if they own chequing deposits?

  29. Gravatar of Dan W. Dan W.
    20. November 2013 at 09:33

    Scott,

    A famous phrase says that “the power to tax is the power to destroy”. When you tell Jon that you would tax cash (you say vault cash but does it really matter where it resides? you are calling for the destruction of the currency.

    Clearly such policy would destroy savings for how can one save if government policy is to deliberately destroy the value of those savings? But the policy would also destroy the currency as it would discourage anyone from holding that currency for any duration. Rational people would find a substitute, whether it be precious metal, bitcoins or personal IOUs.

    One problem with debt is that eventually and often unpredictably a call on that debt is made. Those who cannot pay their debt are financially ruined and often this ruin cascades and hurts may others. Such has been the case throughout history. Good luck changing that!

    The larger problem with debt, and in particular, cheap money debt, is that it enables the lie that one has wealth when in fact one does not. Even worse, access to cheap money encourages activities that might actually be destroying wealth faster than otherwise.

    The 2nd Law says the world is always in decay. Only work can reverse the inevitable. The law of Opportunity Cost says that no matter what one spends time and money doing these might have been spent on something else. Thus, all demands CANNOT be satisfied.

    The only means of knowing how best to work and how best to spend one’s time and money is to allow unproductive endeavors to exhaust themselves. But when unproductive efforts are sustained through debt and that debt is sustained by cheap money the ability to assess the value of all things is distorted.

  30. Gravatar of ssumner ssumner
    20. November 2013 at 13:29

    JP, If IOR fell to minus 0.25%, it is unlikely T-bill yields would fall that far. Thus IOR would go from being above the T-bill yield to below. Creating slightly more hot potato effect.

    Ben, No, they could do negative IOR without hyperinflation:

    1. Reduce the base.
    2. Promise the QE is temporary.

    dtoh. The demand for base money is negatively related to nominal rates, at any interest rate, not just near zero.

    123, Yes, the expected future policy matters, but see my new post.

    JP, See my new post.

    Dan, I recommend my short course on money, link in the right column.

  31. Gravatar of dtoh dtoh
    21. November 2013 at 19:00

    Scott, you said;

    “The demand for base money is negatively related to nominal rates, at any interest rate, not just near zero.”

    We have had this discussion before. I agree, and/but

    1. I suspect at higher rates the relationship is more negatively sloped than at lower rates.

    2. At low rates I think the effect is small. For almost any amounts of base money that are reasonably held by firms or individuals, we are talking about an effect which is pennies.

    3. This is a different argument than HPE. HPE is primarily based on people having a greater quantity of money than they need for transactions.

  32. Gravatar of Why Interest on Reserves? | askblog Why Interest on Reserves? | askblog
    23. November 2013 at 06:58

    […] Scott Sumner writes, […]

  33. Gravatar of Vince Cate Vince Cate
    23. April 2014 at 22:05

    I am collecting different explanations for the details of how hyperinflation works. If anyone has any that are not in my post, please comment at the end of my post.

    http://howfiatdies.blogspot.com/2013/09/hyperinflation-explained-in-many.html

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