John Taylor on the Big Think (part three)

In an earlier post I discussed John Taylor’s answers to two questions I asked about monetary policy in late 2008.  One of his answers included this comment:

In fact, if I could just add. One thing I think people should recognize is that while the federal funds rate target of the FOMC came down gradually in the fall of 2008, the actual rate came down quite a bit more rapidly. In fact, each of the FOMC decisions effectively ratified what the rate was already at. And that rate came down so rapidly because of the large expansion in the reserves. So, it’s hard to see how measured in terms of interest rates policy could be much easier in the October, November, December period.

It isn’t just John Taylor that holds this view, as far as I can tell most economists look at the fed funds rate as the indicator of the stance of monetary policy.  But Taylor overlooked something else the Fed did in late 2008, which made the fed funds rate almost meaningless.  On October 3rd 2008 the Fed adopted a policy of paying interest on reserves.  The program was a bit complicated, but eventually settled on a policy of paying interest at a rate equivalent to the fed funds target.  In December it became slightly more complicated when the fed funds rate target became a range (0% to 0.25%) rather than a single number.  In addition, the interest payments on reserves were set at 0.25% percent.  However, I think Taylor was discussing the situation September, October, and November, when the market equilibrium fed funds rate was often far below the official target, and also far below the rate of interest the Fed was paying on reserve balances.

[Update 1/24/10:  The commenter Jon questioned my facts, and another commenter named dlr indicated that October 3rd was the day Congress authorized the policy, it was announced by the Fed on the 6th, and implemented on the 9th.  In addition, the rate paid on reserve balances was set below the fed funds target prior to November 5th.  But even so, during October the actual fed funds rate in the free market was generally below the interest rate that the Fed paid on reserves.]

The gap between the interest rate on reserves and the market fed funds rate was viewed as being very puzzling, as it seemed to suggest that banks were giving up easy arbitrage opportunities.  A number of studies looked at the issue, and some explanations were offered, although none were completely satisfactory.  I recall one explanation had to do with the fact that some institutions (such as Fannie Mae and Freddie Mac) were significant lenders of reserves, but were not eligible to receive interest on their reserve holdings.

Now let’s think about what this all means for monetary policy.  Economists are used to thinking about the fed funds rate as the banking system’s opportunity cost of short term loanable funds.  And usually it is.  But what happens when the market fed funds rate is 1%, but banks are earning 2% percent on their reserve holdings?  In that case there seem to be two different opportunity costs of fed funds.  Which one is correct?  Which one determines how banks view the opportunity cost of short term loanable funds?  To solve this problem I went back to my economics 101 text, and found this definition of ‘opportunity cost.’

The opportunity cost of choosing X is the highest valued alternative foregone.

OK, so in this case what is the banks highest valued alternative to lending out reserves?  Is it holding them as excess reserves?  Or lending them out to other banks through the fed funds market?  Obviously the former.  Economists need to recognize that once the Fed starts paying interest on reserves, the relevant opportunity cost of funds is the interest rate on reserves any time that this rate is above the equilibrium rate in the fed funds markets.

Many economists engaged in sloppy reasoning last year, arguing that the Fed had already cut rates to zero, and that hence nothing more could be done via conventional monetary policy.  But that is not correct, they only cut rates to 0.25%.  There must have been some reason why the Fed didn’t go all the way down to zero.  Perhaps as James Hamilton argued they feared the inflationary consequences of not paying interest on reserves.  But make no mistake about it, the Fed deliberately decided to not ease policy any further after mid-December.  (And the ECB, faced with a similar macro environment held rates even higher than the Fed.)  But because most economists focused on the market rate for fed funds, they completely missed the contractionary nature of this program.  A further cut in the fed funds target to 0% would have boosted AD at least slightly, but the Fed obviously thought that the economy didn’t need any more demand, that NGDP growth expectations were satisfactory.  I think that was nuts, but even if you don’t agree with me it is important to recognize what the Fed actually did.  Even today very few economists understand the contractionary nature of this policy.

BTW,  If you don’t think a quarter point sounds very important, keep in mind that the famous decision by the Fed to raise reserve requirements in 1937 merely increased short term rates from 0.10% to 0.35%.  And that policy shift is now widely viewed as a major blunder.  Indeed the nature of the error was quite similar, as both the October 2008 policy and the 1937 policy had the effect of increasing the demand for reserves, and reducing the money multiplier.


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26 Responses to “John Taylor on the Big Think (part three)”

  1. Gravatar of 123 123
    23. January 2010 at 13:31

    Quarter point is not important. Fed response function is important. With strong enough QE Fed could have generated much more stimulus even if Fed funds rate never went below 1. Example of Hong Kong in 1998 shows that QE has big stimulus effect even when interbank rates are extremely elevated.

  2. Gravatar of Jon Jon
    23. January 2010 at 13:31

    On October 3rd 2008 the Fed adopted a policy of paying interest on reserves.

    The gap between the interest rate on reserves and the market fed funds rate was viewed as being very puzzling, as it seemed to suggest that banks were giving up easy arbitrage opportunities.

    Scott, your history and dates are misleading. “The revisions to Regulation D and the other changes will take effect on Thursday, October 9, 2008.” Why nit-pick about the date?

    John Taylor has in his sights the discrepancy that emerged between the Fed Fund target and the prevailing rate beginning a few weeks earlier in mid-September.

    And there is more, you write:

    However, I think Taylor was discussing the situation September, October, and November, when the market equilibrium fed funds rate was often far below the official target, and also far below the rate of interest the Fed was paying on reserve balances.

    However, I think you are confused as to what interest-rate was being paid on reserves in September-November:

    Here is the official policy statement which held true until December:
    “The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points. … The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points.

    Rather than the FF effective rate equilibrating below the interest on reserves rate. It stabilized AT that the excess reserves rates. This is of course what would be expected given that excess-reserves are by definition marginal.

    After December, the situation changed, but as you freely admit, Taylor was responding to a question about September-November and during that period he is not “overlooking” the interest-on-reserve policy. His response in the paragraph you quote is dead-accurate. The FOMC continued expanding the base until it was caught by the excess-reserves rate which was placed below the FF target.

    Consequently I urge you to stop trying to hook his response to your meme about ignorance in the profession. Your observations–relevant from December onward are independent from his remarks in response to a question posed about September – November.

    It was only in December, when the Fed compressed all of the rates to 0.25% that your story as written begins to take shape.

  3. Gravatar of StatsGuy StatsGuy
    23. January 2010 at 13:33

    Complete aside –

    There’s a little stir at Baseline over a reco to appoint Krugman to Chair the Fed. There is a little window of opportunity here, if indeed Bernanke loses enough support – but instead of Krugman, I think you have pointed to an even better name, and one without the political baggage.

    Michael Woodford. Would you care to make an endorsement?

    Too bad Lars isn’t a US citizen.

  4. Gravatar of JimP JimP
    23. January 2010 at 13:41

    Wodford would be fine.

  5. Gravatar of JimP JimP
    23. January 2010 at 13:42

    even if I cant spell

  6. Gravatar of malavel malavel
    23. January 2010 at 13:57

    I don’t understand how Freddie or Fannie could have pushed the rate down under 0.25%. Shouldn’t demand for reserves be infinite for rates below 0.25%? And since F&F didn’t have infinite supply of reserves the rate should go up to 0.25%.

  7. Gravatar of dlr dlr
    23. January 2010 at 17:35

    I still have trouble understanding why you think that 25bp mattered. You mention general consensus about the 1937 reserve hikes, but appeal to general consensus isn’t very convincing. Can you mechanically explain what process you envision where the difference between a 25bp opportunity cost and 0bp opportunity cost had important implications for AD? Is it because you believe these marginal 25bps were particularly important in the bank profit calculus (or to the elasticity of borrowing) and thus would encourage a ton of lending? I doubt that’s your case.

    Or is it the importance of expectations: any symbolic willingness toward tightness substantial changed expectations about overall Fed policy? How do you think these expectations work? In another thread, you said you believed that only a few hundred people in the world really understand monetary policy and the relevant expectations are really about the effects of monetary policy. Presumably, observed demand indications. I don’t understand the link between such a small, nuanced policy and a rapid decline in demand expectations.

    Moreover, why wouldn’t any “expectational” ramifications of interest on reserves rapidly reverse themselves soon after when the Fed made it clear that it was willing to engage in quantitative easing despite having hit its version of the zero bound? If the biggest problem with the 25 bps was that it indicated some kind of satisfaction with AD at the Fed, surely the willingness to print money to buy Treasuries and Mortgages immediately showed that the Fed did *not* implement IOR in order to be tighter than 0bps and restrain AD. So any harmful effects should have been reversed quickly.

    Also, I thought the most compelling explanation of why the Fed wanted to keep a floor on the FFR and instituted IOR to do so was because money market funds and even primary dealers were threatening to shut down as rates approached zero and they had to subsidize more and more of their overhead.

  8. Gravatar of ssumner ssumner
    23. January 2010 at 18:27

    123, I don’t think a quarter point is important in and of itself, the reason it matters is because it sterilized $800 billion worth of QE. So if you believe in QE you should worry a lot about the interest on reserves.

    Jon, I think you are wrong. First of all I believe the interest on reserves program was announced on October 3rd. The annoucement date is of course when it would have begun impacting the economy.

    I also disagree with your timeline on the interest on reserves program. It did start below the fed funds target rate, but I am almost positive it got there well before the December announcement. The Fed published articles discussing the puzzle of why the fed funds rate was far below the interest rate paid on reserves. Even Bernanke had an article discussing the puzzle. And this was long before rate had reached 0.25%. Surely if you were correct the Fed would not have been puzzled by the gap. I’ll have to check this again tomorrow, but I am pretty sure that you are wrong.

  9. Gravatar of Marcus Nunes Marcus Nunes
    23. January 2010 at 19:01

    Jon Scott
    The announcement of interest payment on reserves was October 6 and implementation began on Oct 9.
    The Fed on November 5 moved to the New Zealand system, where the interest rate on both required and excess reserves is set right at the target Federal funds.

  10. Gravatar of scott sumner scott sumner
    23. January 2010 at 19:49

    Statsguy and JimP, Yes, Woodford would be fine. But if he were currently chair I be recommending Bernanke on the basis of his writings. You also have to think about leadership qualities. I don’t know anything about Woodford’s personality.

    Malavel, Yes that is a puzzle. I recall a paper that discussed several theories, but I am afraid that I cannot recall the answer.

    dlr. I don’t think interest rates are the right indicator of monetary policy. But when T-bill yields have fallen to 0.10%, even a quarter point is enough to lead to massive hoarding or reserves. The demand for reserves is highly elastic at low rates. And an increase in the demand for reserves is deflationary even if it has no impact on interest rates.

    As for the role of expectations, I think they are always important, not just at low rates. Even if the fed funds rate is 5%, a cut to 4% has little direct effect on AD, rather it only affects AD if it causes a change in the future expected money supply.

    By the way, lots of prominent economists think the interest on reserve program had a big effect, including James Hamilton and Robert Hall. So it isn’t just me.

    I mention 1937 not because I think it was the biggest factor in the 1937-38 recession, (I don’t) but rather to point out to economists that they should at least be consistent—if they think 1937 was a big deal, they should also think this was a big deal.

    I sure hope the Fed wasn’t conducting a tight monetary policy in order to protect the profits of money market funds. In the long run those funds would have been much better off with a highly expansionary policy that raised NGDP growth and nominal interest rates far above zero.

    Marcus, Thanks. I guess we were both wrong about the date. In any case I still think the news of the interest program leaked out on the 3rd, but perhaps I better double check that as well.

  11. Gravatar of 123 123
    24. January 2010 at 03:08

    “I don’t think a quarter point is important in and of itself, the reason it matters is because it sterilized $800 billion worth of QE. So if you believe in QE you should worry a lot about the interest on reserves.”

    No, 0.25 interest on reserves did not sterilize almost anything. When banks are bad, interest on reserves has almost no effect.

  12. Gravatar of dlr dlr
    24. January 2010 at 06:24

    Although IOR authority was passed with the TARP on Oct 3 (Friday) and announced on October 6, it began at Target FFR – 75bps. On October 22, they announeced a reduction in the rate to Target FFR – 35 bps. It wasn’t until November 5th that the rate paid on ERs was equal to the FFR (at that point, the FFR target was stil 1%; it wasn’t until 12/16 when the target was lowered to 0-25bps that the IOR remained at 25bps and was effectively higher than the midpoint of the FFR target).

    So up through November 5, if you are going to say the IOR was preventing banks from plowing into T-Bills, you are really just saying the Target FFR was too high — because IOR was lower (and T-bills were for the most part even lower). At this point, the IOR stated motive was to help control the FFR rate, which was bouncing all over the place(in October, regularly showing 400bps intraday moves and hitting 0% every day).

    Even when IOR was brought equal to the FFR on November 5th, the opportunity cost was 1% either way. At least, the target opportunity cost. In practice, the effective FFR was generally below 50bps and often below 10bps, despite the Fed 1% target and 1% IOR. The persistence of this puzzle (a 90bp arb between money and money) really makes it sound odd to later claim that a 12 bp arb between money and not-money was important.

    It isn’t until December 16 that I think any real question comes up: why did the Fed decide to set IOR to 25bps as opposed to 0bps when the FFR target was 0-25bp. Here for the first time they are setting up at least the possibility to increase the opportunity cost of federal funds to the top of their range. This is where I have heard that the threats for primary dealers and also MMFs to shut down came into play. But regardless, 4-wk T-bills are bouncing around zero after December 16 (they averaged around 3-4bps for the next six weeks), while the effective FFR remained below the IORs. And T-bills are still not money. I just don’t get the idea that banks would be moving into 4bps T-bills or anything else if IORs if IOR had been zero.

  13. Gravatar of scott sumner scott sumner
    24. January 2010 at 07:47

    123, Again, lots of studies suggest that the demand for reserves is very elastic at low nominal rates. Interestingly both the Fed itself, and the Fed’s opponents (like Hall and Hamilton) seem to agree with me. The policy was aimed at preventing the reserve injections from having an inflationary effect.

    And even if I am wrong, no one doubts that a strongly negative rate would have dislodged a lot of these ERs. Banks could hold T-bills, and T-bill yields cannot go strongly negative because otherwise the public would hold cash.

    In any case the debate is fairly academic in my mind, because if the Fed had adopted an expansionary policy then NGDP growth expectations would have been far higher and people and banks would have had much better uses for their funds than hoarding cash and reserves.

    dlr, Thanks, I think the data you provide strongly support my interpretation, although you don’t seem to see it that way.

    Lets start with the fact that the bill was passed on the 3rd, the plan was announced on the 6th, and implemented on the 9th. Gee, what else happened in the first 10 days of October? All the debate between Taylor/Cochrane and their opponents revolves around events that occurred before or after the stock crash, not during.

    Second, despite the wild fluctuations you point to, I recall seeing graphs that show the market fed funds rate was far below the target rate throughout almost all of the period in question. I will go even further and argue that I am pretty sure it was mostly below the fed funds target minus 35 basis points between Oct 22 and November 5. Also look at the Taylor quotation, he refers to Oct-Dec, not Sept-Nov, as Jon asserted. So for the vast bulk of the Oct-Dec period I am right. Technically I made a small error in assuming the fed fund target was equal to the IOR from October 9th onward. But my broader point is still correct, the op. cost of reserves is their most valued alternative, and that is the IOR, not the fed funds market rate throughout almost all of the Oct-Dec period. So Taylor is wrong.

    Regarding your point about what would have happened if no interest was paid, I have never claimed that we know it would have been much more expansionary.

    Rather I have claimed:

    1. Other experts like Hamilton and Hall saw the effect as contractionary. As did the Fed.
    2. Regardless of what would have happened in the absence of IOR, we know for sure that with IOR set above the T-bill rate there was little or no chance that the reserve injections would act as “quantitative easing.” They were sterilized.
    3. If a zero rate wasn’t enough to reduce ERs signficantly, a negative 2% or 3% rate surely would have done the job. Indeed I doubt any serious economist would question that conclusion.

    And yet Taylor ignores all this in blandly assuming money must have been easy because the free market fed funds rate was very low.

  14. Gravatar of Jon Jon
    24. January 2010 at 10:45

    Jon, I think you are wrong. First of all I believe the interest on reserves program was announced on October 3rd. The annoucement date is of course when it would have begun impacting the economy.

    That’s a subtle change of terms. I though we were discussing when it would impact the FF market. Since that market is characterized by overnight loans I do not agree.

    Nonetheless, the critical point is that the realized FF rate–what the Fed calls the effective rate–dipped sharply below target two weeks earlier on September 15. After–for the sake of moving forward, lets be vague–the first week of October the FF effective rate tracked the excess-reserves rate which was set 75 basis points below the FOMC’s target for the the FF rate. This was not exact tracking and likely that is due to increased volatility and perhaps other secondary effects such as certain organizations in the reserve market not being eligible.

    I simply do not believe that data ratifies your claim stated as follows:

    But Taylor overlooked something else the Fed did in late 2008, which made the fed funds rate almost meaningless … However, I think Taylor was discussing the situation September, October, and November, when the market equilibrium fed funds rate was often far below the official target, and also far below the rate of interest the Fed was paying on reserve balances.

    In particular the data does not show the FFeff being “far” below the the rate of interest on excess reserve balances. *I* checked the data before writing my first response to you which I was so outraged about your treatment of Taylor.

  15. Gravatar of Jon Jon
    24. January 2010 at 10:53

    Also look at the Taylor quotation, he refers to Oct-Dec, not Sept-Nov, as Jon asserted.

    Scott:
    1) You mentioned the Sept-Nov period. “However, I think Taylor was discussing the situation September, October, and November”.
    2) The question Taylor was responding to mentioned the Sept-Nov period.
    3) Taylor ends a sentence in your quote mentioning October-December. What does this mean? Well I suppose we can agree that makes it ambiguous. But rather than just being Sept-Nov as *I* asserted. *You* asserted the same thing too.

    Now maybe we can set this aside, and try to focus on a more precise claim? IMO, you are right December onward, but you have to give up the topical hook.

  16. Gravatar of scott sumner scott sumner
    25. January 2010 at 08:14

    Jon, Obviously you don’t agree with the facts presented in dlr’s comments. Perhaps you can tell me precisely which facts dlr presents that are wrong, and also your source for information proving him wrong.

    dlr claims the interest on reserves was equal to the target for almost all of November, and that it was only 35 basis points below in late October. but the market fed funds rate was far more than 35 basis points below the target rate.

    BTW, I updated the post yesterday, if the update is incorrect, please tell me why. The update in no way changed the thrust of my criticism of Taylor.

  17. Gravatar of dlr dlr
    25. January 2010 at 09:34

    This probably won’t work as there is no preview button and this stuff is not my strong suit, but this is an attempt to show the daily Effective FFR, the intraday Hi and Lo, the Target FFR, and the Interest Paid on ERs along with when changes to the IOR policies were announced (A) for late 2008. The IOR isn’t always clear at it was sometimes backward looking for the lowest target FFR during the previous maintenance period (one or two weeks).

    DATE DAILYLo Hi Target IOER
    12/31/2008* 0.14 0 10 – 0.2 0.25
    12/30/2008 0.09 0.03 0.50 – 0.2 0.25
    12/29/2008 0.1 0.03 0.50 – 0.2 0.25
    12/26/2008 0.09 0.03 0.6250 – 0.2 0.25
    12/24/2008 0.11 0.01 0.50 – 0.2 0.25
    12/23/2008 0.11 0.01 0.50 – 0.2 0.25
    12/22/2008 0.11 0.01 0.50 – 0.2 0.25
    12/19/2008r 0.11 0.01 0.50 – 0.2 0.25
    12/18/2008 0.110.0313 0.60 – 0.2 0.25
    12/17/2008* 0.12 0.01 0.50 – 0.2 0.25
    12/16/2008 0.17 0.01 10 – 0.2 0.25A
    12/15/2008 0.18 0.01 11   0.25
    12/12/2008 0.150.0313 11   0.25
    12/11/2008 0.14 0.01 11   0.25
    12/10/2008 0.11 0.01 11   1
    12/9/2008 0.13 0.01 11   1
    12/8/2008 0.12 0.01 11   1
    12/5/2008 0.12 0.01 11   1
    12/4/2008 0.2 0.01 1.51   1
    12/03/2008* 0.360.1875 1.251   1
    12/2/2008 0.470.1875 1.251   1
    12/1/2008 0.52 0.2 1.251   1
    11/28/2008 0.52 0.125 1.251   1
    11/26/2008 0.53 0.125 1.251   1
    11/25/2008 0.59 0.25 1.3751   1
    11/24/2008 0.62 0.125 1.3751   1
    11/21/2008 0.57 0.125 1.251   1
    11/20/2008 0.49 0.125 1.251   1
    11/19/2008* 0.380.0625 1.251   1
    11/18/2008 0.38 0.19 1.251   1
    11/17/2008 0.37 0.19 1.191   1
    11/14/2008 0.34 0.125 1.251   1
    11/13/2008 0.350.0625 1.251   1
    11/12/2008 0.35 0.125 1.51   1
    11/10/2008 0.29 0.125 1.251   1
    11/7/2008 0.27 0.125 1.251   1
    11/6/2008 0.230.0938 1.251   1
    11/05/2008* 0.230.0938 11   0.65A
    11/4/2008 0.230.0313 11   0.65
    11/3/2008 0.23 0.05 11   0.65
    10/31/2008 0.22 0.01 1.51   0.65
    10/30/2008 0.3 0.05 1.51   0.65
    10/29/2008 0.36 0.01 1.51   0.65
    10/28/2008 0.67 0.125 21.50   1.15
    10/27/2008 0.92 0.25 21.50   1.15
    10/24/2008 0.95 0.25 21.50   1.15
    10/23/2008 0.93 0.25 21.50   1.15
    10/22/2008* 0.81 0.25 21.50   0.75A
    10/21/2008 0.67 0.25 21.50   0.75
    10/20/2008 0.7 0.25 21.50   0.75
    10/17/2008 0.6 0.125 2.251.50   0.75
    10/16/2008 0.83 0.125 2.251.50   0.75
    10/15/2008 1.04 0.125 2.251.50   0.75
    10/14/2008 1.1 0.25 21.50   0.75
    10/10/2008 0.79 0.125 31.50   0.75
    10/9/2008 1.4 0.01 5.51.50   0.75
    10/08/2008* 2.24 0.01 71.50  
    10/7/2008 2.97 0.01 6.252  
    10/6/2008 1.96 0.25 42   A
    10/3/2008 1.1 0.05 3.52  
    10/2/2008 0.67 0.01 2.52  
    10/1/2008 1.15 0.01 42  
    9/30/2008 2.03 0 102  
    9/29/2008 1.56 0.01 32  
    9/26/2008 1.08 0 32  
    9/25/2008 1.23 0 32  
    09/24/2008* 1.19 0.01 3.252  
    9/23/2008 1.460.0625 32  
    9/22/2008 1.51 0 3.52  
    9/19/2008 1.48 0 3.52  
    9/18/2008 2.16 0 62  
    9/17/2008 2.8 0.25 62  
    9/16/2008 1.98 0.01 62  
    9/15/2008 2.64 0.01 72  
    9/12/2008 2.1 1.75 2.93752  
    9/11/2008 2 1 2.52  
    09/10/2008* 2.12 1.5 2.6252  
    9/9/2008 1.96 1.625 2.18752  
    9/8/2008 1.92 1 2.52  
    9/5/2008 1.97 1 2.252  
    9/4/2008 1.99 1 2.52  
    9/3/2008 2.01 1.5 2.52  
    9/2/2008 1.96 0.125 2.3752  

  18. Gravatar of 123 123
    25. January 2010 at 16:49

    “In any case the debate is fairly academic in my mind, because if the Fed had adopted an expansionary policy then NGDP growth expectations would have been far higher and people and banks would have had much better uses for their funds than hoarding cash and reserves.”

    I think that in October 2008 Fed had completely lost credibility and the only way to regain it was to promise to do enough QE to restore NGDP expectations. A promise to keep interest on ERs at zero would not be sufficient, as it would not have generated additional expansionary effect because banks were bad.

  19. Gravatar of Jon Jon
    26. January 2010 at 01:47

    Here is the data plotted:

    http://lostdollars.org/static/reserverate.png

    Here is the run of the “facts”:
    1) Prior to the interest on reserve policy the NYFED trading desk was allowing FFeff to drop well below the FOMC target. This is what John appears to refers to

    One thing I think people should recognize is that while the federal funds rate target of the FOMC came down gradually in the fall of 2008, the actual rate came down quite a bit more rapidly. In fact, each of the FOMC decisions effectively ratified what the rate was already at.

    2) After the imposition of the interest on reserve policy, the FFeff stabilizes around that rate through October 23–which is when the FOMC adjust policy regarding the payment of interest.

    3) FOMC reduces the penalty for excess reserves. COF rises, but the FF lags

    4) Starting Nov 6, excess reserves begin earning the target rate (no penalty). However, the NYFED auctions TAF liquidity coincident with this, well below target rate. This sets the marginal cost of funds lower.

    5) After November 20, the FFeff tracks the TAF auction rates very closely.

    6) After December 3th, the FFeff and TAF are both near the interest being earned on excess reserves. Note: this later change to the rate on excess reserves was not announced until 16th, but the announcement was leaked earlier and the announcement backdate the policy change to the start of the prior reserve period. i.e., December 3rd/4th which is precisely the change-point observed in the FFeff timeseries.

  20. Gravatar of ssumner ssumner
    26. January 2010 at 07:49

    dlr, Thanks, that’s roughly how I remembered it.

    123, You said;

    “I think that in October 2008 Fed had completely lost credibility and the only way to regain it was to promise to do enough QE to restore NGDP expectations.”

    I look at thinks differently. I recall the process of them losing credibility. They certainly hadn’t lost all credibility at he biginning of October. Rather they lost it during October. They should have taken steps to avoid the loss of credibility. I think NGDP targeting, level targeting, would have been far more effective than QE. But QE might have helped, along with negative rates on ERs.

    Jon, I don’t follow your argument at all. We don’t seem to disagree about facts, but interpretation. I claimed the interest on reserves rate puts a floor on the cost of funds to banks. Even if the market rate is lower, or if the TAF auction rate is lower, it doesn’t matter. The basic idea of “opportunity cost” is that it is the highest valued alternative. Throughout all of November and December, as well as part of October, the interest rate on reserves was above ther fed funds rate in the market. That means the interest rate on reserves was the opporunity cost of any funds that banks chose to lend out.

  21. Gravatar of Jon Jon
    26. January 2010 at 20:46

    Scott:

    There are a great many claims being made–more than simply your claim about the interest on reserves-rate affecting the cost-of-funds. Yes, I agree theoretically as to that claim.

    I objected to your claim that the excess-interest-rate was “far” above the FFeff. I believe Taylor expressed a correct view: the cost-of-funds, even as you define it, was below the FOMC policy-rate through most of the fall–baring an exceptional period in November.

    Now the curve ball: the prevailing rate in the commercial paper market tracked the FF target UNTIL November. At which point nominal-rate on short-dated credit was well below the cost-of-funds as you define it.

    I’ve updated my plot to show this detail.

  22. Gravatar of scott sumner scott sumner
    27. January 2010 at 19:57

    Jon, I don’t understand what was so “exceptional” about November, as far as I can tell the same relationship held in December.

    I am not sure the point of your “curve ball.” What were the maturity of the commercial paper loans? How about the risk? Why are you comparing them to the cost of funds?

  23. Gravatar of Jon Jon
    27. January 2010 at 20:49

    Scott:

    I think I used the word “UNTIL” which does not imply December to be different from November but rather implies that November was different than earlier months.

    Its the rate of 30-day, AA commercial paper. Historically, the CP rate and the FF rate have tracked very closely. Now in November, the cof as you’ve defined it essentially moved well above the prevailing rates in the CP market. Consequently, I do not think your cof argument matters.

    Simply, there was no coupling between the two. Therefore, we can conclude that the FF rate coupled to public markets even despite the supposed higher cof.

    The reason for this should be clear: demand accounts do not consist of base money. Therefore, there is no interest to forgo when making the loans.

    The primary medium of exchange is no longer base money. Its bank ‘notes’ taking the form of credit-cards, checks, and electronic transfers. None of which consist of or involve the use of the base money.

  24. Gravatar of ssumner ssumner
    29. January 2010 at 06:22

    Jon, So I was almost completely right about Nobvember and December, and partly right about late October. That’s not bad. September doesn’t matter because the IOR didn’t exist in September.

    The historical relationship between the fed funds rate and the CP rate isn’t really relevant to whether the IOR rate was the op cost of funds. It was clearly a minimum estimat eof the op cost of funds, the only real debate is whether the op cost of funds was higher than the IOR.

    In any case I’d bet you’d find that the correlation between the the ffr and the cp rate was weaker when the fed funds target was falling rapidly.

    You seem to want to deny that the Fed payment of interest mattered when the ff rate was lower than the IOR. But again, op cost cost is the highest valued alternative foregone. It isn’t a debatable point. That’s the definition of op cost.

  25. Gravatar of Jon Jon
    29. January 2010 at 21:25

    Scott:

    You must be seriously overwhelmed with comments, but your responses make no sense. You were dead wrong with this statement:

    John commented, “In fact, if I could just add. One thing I think people should recognize is that while the federal funds rate target of the FOMC came down gradually in the fall of 2008, the actual rate came down quite a bit more rapidly.”

    And then you said, “But Taylor overlooked something else the Fed did in late 2008, which made the fed funds rate almost meaningless.”

    But of course that’s wrong. In September and October, the interest-paid on reserves was below the Fed Funds target. Ergo, even in your worldview, the cost-of-funds fell faster that the rate-target. Now, you during that last three weeks of November, things were different. As they were in December, by which time the FOMC ratified what already been.

    So that clearly makes Taylor more right than wrong.

    Second, you claimed, “However, I think Taylor was discussing the situation September, October, and November, when the market equilibrium fed funds rate was often far below the official target, and also far below the rate of interest the Fed was paying on reserve balances.

    This latter claim is wrong as well. I grant you though, its only wrong in October.

    You seem to want to deny that the Fed payment of interest mattered when the ff rate was lower than the IOR. But again, op cost cost is the highest valued alternative foregone. It isn’t a debatable point. That’s the definition of op cost.

    You’re switch terms again. Look, I’m challenging that the reserves market matters macro-economically when the pool of excess reserves is so large.

    I don’t doubt that the interest-on-reserves rate was an opportunity cost with-in the reserves market.

    A priori these are different concepts.

    You claim they are linked (without proof). I showed you proof that they are not linked.

    So… please present proof that they are linked. John Taylor claims that they are linked via the use of libor as an index in contracts.

  26. Gravatar of scott sumner scott sumner
    31. January 2010 at 08:10

    Jon, We’ll just have to agree to disagree about how wrong I was. I admit my facts were slightly off, but I think my basic point was accurate. But just to be clear, I was not arguing that the IOR is some sort of macroeconomically important interest rate because of its role in the credit markets. I agree that is very debateable. Rather I assumed that Taylor was using the standard argument that the fed funds rate is the op cost of short term funds. Otherwise why would he have even mentioned the fed funds rate?

    As you know, I think the key to demand side macro is the supply and demand for money, not the supply and demand for credit. Thus I view the IOR as being importance because it greatly increased the demand for money, and hence was highly contractionary. I thought Taylor was mentioning the low fed funds rate as some sort of evidence that money was easing, like “look, no problem, the Fed was cutting rates in late 2008 so how can anyone say policy was contractionary.” If that’s not what Taylor was implying, then so be it. I retract my criticism. But I think if you asked most people who read his answer they would agree with me that he seemed to be implying that the low fed funds rate was evidence that the Fed was easing. And that is flat out wrong.

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