Krugman on negative insider trading

If markets are efficient then the expected loss on Fed purchases of long term debt is roughly zero.  On the other hand if the Fed has inside information about its future policy, then the Fed could use that information to make expected profits or losses.  In a post today, Krugman argues that the Fed may be using the inside information in a perverse way, to generate expected losses.  His argument (which is technically correct and which I discussed here in an earlier post) is that the Fed might actually persevere and produce more inflation (and I would add more real spending growth as well) than the markets currently expect.  Because markets are skeptical about the ability or willingness (probably the latter) of the Fed to carry through on a reflationary policy, long bond yields do not currently price in the sort of inflation or nominal spending growth that the Fed presumably wants.  What do we make of this?

1.  My initial thought a few weeks ago was that the Fed should buy assets that are likely to appreciate if they are successful, which they would insure by announcing a nominal target and doing whatever was necessary to hit the target.  Who cares if traders who doubted the Fed’s word lose money?  It’s a good way to build credibility.

2.  The Fed may think my idea is too risky, and they may be right.  The markets may actually know the Fed better than it knows itself.  I.e. the markets may be able to predict future Fed behavior better than the Fed.  Think of the Fed as like a powerful but lumbering woolly mammoth, surrounded by agile saber-tooth tigers.  The markets are very good at sensing which policy targets are credible.  In Japan, the markets correctly sensed that the BOJ’s promise to end deflation was a sham, and deflation got priced into bond yields.  And they were right; the BOJ tightened policy twice while deflation was still occurring.

3.  Neither Krugman nor Bernanke seems to have noticed yet that we could get by with far less QE than is currently being discussed.  The proposal for negative interest on reserves that Bill Woolsey and I have been discussing for months has finally been discovered by Harvard University (according to a recent post in Mankiw’s blog–and with a wacky idea for negative interest on cash that is not a part of our proposal here.)  It would end the problem of excess reserve hoarding, which has been by far the biggest factor in boosting demand for base money (and hence limiting the effectiveness of QE.)  Let’s see how long it takes for the idea to get to Princeton (Krugman and Bernanke’s University.)

4.  On a serious note, I actually do agree with Krugman:

a.   QE is worth trying.

b.  By itself QE may not work (in my view due to positive interest on reserves.)

c.  And if it does work it may expose the Fed to some capital losses.

The reason that I have been prodding people like Mankiw and Krugman in recent posts is to try to raise the visibility of the proposal for negative interest on excess reserves.  I strongly believe this issue is important, and hope to attract the attention of someone who can publicize the issue much more effectively than I can.



28 Responses to “Krugman on negative insider trading”

  1. Gravatar of JKH JKH
    20. March 2009 at 11:37

    Krugman is overlooking the key point referred to in the previous post’s discussion, which is the payment of interest on reserves.

    He says:

    “The problem may come when the economy recovers, and inflation starts to become a problem rather than a hoped-for outcome. Basically, there will come a time when the Fed wants to withdraw that extra $1 trillion of money it created. It will presumably do this by selling the bonds it bought back to the private sector.”

    This is exactly the reason for paying interest on reserves. The Fed won’t be forced to sell assets in order to tighten policy (i.e. increase the fed funds target rate). The whole idea of having to withdraw the money it has created is to some degree a red herring, because the payment of interest on reserves means policy can be tightened without it. And the Fed will have the buffer of the difference between long term treasury and mortgage yields booked today under the new program, compared to the increase in the fed funds rate from today’s level that will be required in order for the Fed to begin to incur a negative margin due to its “interest rate gap” between long term assets and short term funding (reserves on which it now pays 25 basis points).

    Also, from the speech referred to in the previous comments:

    “A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds–including loans to financial institutions, temporary central bank liquidity swaps, and purchases of commercial paper–are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy–namely, by setting a target for the federal funds rate.”

    This gives the Fed additional manoeuvring room in its future balance sheet contraction, apart from the latest mortgage and long term treasury program.

  2. Gravatar of ssumner ssumner
    20. March 2009 at 11:43

    JKH, Even if you were right that it is a good idea to pay interest, the argument above implies we should pay a negative interest rate now, and a much high positive rate in the future when the economy recovers and we want to tighten policy without having to pull all those reserves out of circulation.

    In addition, in the long run paying interest on huge reserve balances would be far more costly than any capital losses the Fed is likely to incur in buying and selling medium term bonds.

  3. Gravatar of David Stinson David Stinson
    20. March 2009 at 12:00

    Hi Scott.

    A similar point was raised a couple of months ago by Levi Folk, a financial markets guy who has a column in the Financial Post. His general point was that the assets being “taken on” the by the Fed, either as purchases or collateral backing loans, may have declined in value by the time the Fed attempts to unwind the increase in monetary base. In the case of TARP-like programs, paying above-market prices seems to be the whole point.

    With respect to the treasury purchases in particular, why wouldn’t it be almost certain that, if quantitative easing (QE)is successful (in the sense of creating inflation and/or inflationary expectations), the treasuries will be worth less than the Fed is paying for them given that a) nominal interest rates will increase to reflect the inflationary expectations, and b) treasury pricing at the moment reflects i) the market’s uncertainty as to whether
    QE will work and ii) some upward price pressure resulting from Fed demand? I guess that would imply that some of the increase in monetary base will be permanent?

  4. Gravatar of JKH JKH
    20. March 2009 at 12:08

    Negative interest would compress banking system margins in the absence of buying bills. It would drive down bill yields even closer to zero if banks bought bills. Either way, it wrecks bank interest margins compared to the present arrangement. That’s not exactly in the administration’s interest right now. And I would dispute the idea that getting the banks to buy treasury bills is what the Fed is trying to achieve.

    Interest vesus capital losses depends on whether the Fed is forced to sell. That’s part of the point, which I omitted unfortunately. The Fed has a lot of room to ride current yields to maturity if the funds rate starts out at 25 basis points and current term rates are reasonably higher. They won’t necessarily need to realize capital losses, at least not on much of the portfolio. Lot’s of room for interest rate “gapping” profit from here. They also have seigniorage buffer from currency.

  5. Gravatar of joe joe
    20. March 2009 at 14:46

    This may be a stupid question but if you implement negative interest on reserves, what will replace excess reserves on the liability side of the Fed’s balance sheet?

  6. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    20. March 2009 at 19:22

    Back in November, we had this post in the FT which I endorsed:

    “The case for negative interest rates now
    November 20, 2008 12:35pm
    by FT

    By Brendan Brown

    A conundrum has long been known to monetary economists, but only comes into the open during the once in a quarter-of-a-century type of recession apparently plaguing the global economy.

    The quandary is how, in a conventional monetary economy, to bring interest rates down to the negative levels essential to speedy recovery during periods when there is a sharp decline in spending propensities.

    If interest rates fall below zero, the public would simply seek to transfer their savings into hoards of banknotes.

    The interest rate under discussion is the risk-free nominal rate as quoted on short-maturity government bonds, most obviously US T-bills or short-dated German government bonds.

    Over the course of decades, particularly during the Japanese “lost decade” of asset deflation, suggestions have emerged as to how to solve the conundrum.

    These include the periodic stamping (for a small fee) of banknotes (without the stamp they would not be valid). The idea is that by imposing a running tax on banknote hoarding, nominal risk-free rates could fall to negative levels.

    In the age of the information technology revolution, surely the authorities could devise a simple and practical method of effective taxation of banknote hoards?

    There are two cues to a practical method of taxing notes. The first comes from what happened during US financial crises in the 19th century.

    Banks under stress of cash drains (depositors withdrawing funds) suspended temporarily the 1:1 link between cash and deposits, so their notes sold at varying discounts. The second comes from the launch of the euro; a conversion of old banknotes into new.

    These cues lead to the solution.

    The relevant government would announce that existing banknotes were to be converted into new notes at a fixed date, say three years from now, at a discount (for example 100 old dollar banknotes would be converted into 90 new)…..”

    I don’t remember anyone being interested in this at the time.

    “Then, Interfluidity offered this:

    Since the current Fed loves bold and unorthodox action, I thought I’d end this with a (sort of) constructive suggestion. As the composition of the monetary base changes from mostly currency in circulation to largely electronic reserves, the zero-bound on nominal interest rates can be made to disappear. How? Simple: Rather than paying interest on reserves, the Fed can tax them. If banks were taxed daily on their reserves, banks would compete to minimize their holdings, and interbank lending rates would go negative. With a high enough tax, banks could be made desperate to lend, even though in aggregate the banking system has no choice but to hold the reserves. Presumably, banks would pass costs to depositors by eliminating interest on deposits, increasing fees, and ceasing to offer term CDs. Money in the bank would go from what everyone wants to something nobody can afford to hold. People would strive to minimize transactional balances, and invest any savings in money markets or stocks or bonds, anything not subject to the tax. (This is similar in spirit to a suggestion by Arnold Kling.)”

    Then, I asked Nick Rowe this:

    “Nick, I might ask something else, but this puzzles me:

    “because the domestic and foreign central banks want to push interest rates lower, but can’t.’

    I don’t understand why the Fed couldn’t”
    1) Add a fee to these bonds
    2) Discount them over time

    In other words, add a disincentive to buy and hold them.

    Posted by: Don the libertarian Democrat | February 03, 2009 at 04:51 PM

    Hi Don: it’s technically possible. But people would just hold cash under the mattress, or in safety deposit boxes, and get zero interest rates that way. (There are various schemes always floated to tax cash, or make it expire, etc., but they always come across as a bit sci-fi.)

    Posted by: Nick Rowe | February 03, 2009 at 05:27 PM”

    Are you advocating the same thing, or are these ideas somewhat different?

  7. Gravatar of Bill Woolsey Bill Woolsey
    21. March 2009 at 03:47


    The purpose of the Fed isn’t to make money. Its purpose is to maintain macroeconomic stability. If, after nominal income returns to target and the demand for base money falls, selling off assets involves a capital loss, then the Fed must simply take the capital loss. If those losses are such that the Fed becomes involvent, then it will be time for the Treasury to bail out the Fed. So?

  8. Gravatar of Bill Woolsey Bill Woolsey
    21. March 2009 at 04:35

    There may be many problems with the financial system, but the Fed’s job is to maintain total spending in the economy–maintain nominal income.

    Other things being equal, higher nominal income involves a higher demand for base money. If the quantity of base money is at the level necessary for nominal income to be on target, if nominal income is below target, then there will be a surplus of base money. The surplus of base money will generate increased spending. And nominal income will rise to target.

    The demand for base money doesn’t depend solely on nominal income. It depends on many other things too. If the the quantity of base money is appropriate for the target for nominal income and _anything_ raises the demand for base money, there is now a shortage of base money. Nominal inocme must fall enough to reduce the demand for base money to the given quantity.

    The Fed’s job is to change the quantity of base money to match the demand at the target for nominal income. To make sure that if nominal income falls below target, there will be a surplus of base money.

    Many things that might change the demand for base money can involve banks seeking to borrow or lend more or less overnight to one another. This causes a change in the Federal Funds Rates. By offsetting those changes, the Fed can simultaneously accomodate the changes in the changes in the demand for base money.

    However, many other things will result in changes in overnight lending rates, and if the Fed maintains its target for the Federal Funds in the face of those changes, it will create an imbalance between the supply and demand for base money at the target value of nominal income and cause nominal income to change from target.

    The Federal Funds rate is nothing but a tool. And when the target gets to be zero, or rather, slightly negative and no less than the cost of holding currency, then it is a useless tool.

    But that doesn’t mean that nominal inocme no longer depends on base money. And that the Fed cannot change the quantity of base money to meet the demand to hold base money conditional on nominal income being on target.

  9. Gravatar of Bill Woolsey Bill Woolsey
    21. March 2009 at 04:50

    “Quantitative easing” is used in two different ways.

    Old monetarists understand it to mean changing the quantity of money. This involves changing the quantity of liabilities issued by the Fed–base money. Or increasing the quantity of liabilities of the banking system– various sorts of deposits from checking to checking hidden as saving, and so on.

    The money multiplier has fallen as has velocity. A sufficient increase in the liabilities of the Fed–base money–should increase the quantity of money enough to offset the decrease in velocity, and so raise nominal income back to its previous growth path.

    The same process can be described using the demand to hold money and the quantity of money. The quantity of money–the liabilities of the Fed and/or banking system, can be increased enough to accomodate the increase in demand, and raise spending so that nominal inocme rises to target.

    However, the Federal Reserve uses the term “quantitative easing” to mean targetting certain segments of credit markets and increasing the supply of credit in those segments. They combine these efforts with policies that prevent the increase in base money (borrowing from the Treasury) or reducing the money multiplier (paying interest on reserve balances.)

    I favor “quantitative easing” in the first sense. I consider quantitative easing in the second sense to be at best a distraction and at worst, undersirable efforts to allocate credit by the Fed.

  10. Gravatar of JKH JKH
    21. March 2009 at 04:52

    Bill Woolsey 3:47,

    I agree the purpose of the Fed isn’t to make money. In my view the issue of Fed solvency or any central bank solvency is partly delusional. The only way to approach the “solvency” of the Fed is to analyse the “solvency” of the consolidated government sector, which means in this case consolidating the balance sheets of the Fed and the government, such as the latter has a mismatched balance sheet. The correct analysis is to examine the continuum of liabilities of the entire sector, including banking clearing balances, currency issued, treasury bills and bonds.

    But the purpose of the Fed is also not to lose money. The balance sheet intermediation intervention of the Fed is occurring at a time of potentially deflationary deflection. Short rates are extremely low. Moreover, the Fed is reasonably committing to keeping them low. The yield curve is positive, reflecting some probability of reflation. The Fed is developing a classic asset liability mismatch, more so now as a feature of intentional policy to fight deflation risk. The low rate of interest paid on clearing balances is part of the overall short funding interest rate risk profile. Given the likelihood of a low funds rate for some time under this policy stance, the Fed can accrue a positive interest margin through its interest rate “gapping profile” for some time. The purpose of such a strategy is not to make money. The purpose is to rationalize why this is a viable alternative to the possibility of being “forced” (a la Krugman) to sell treasury bonds sometime in the future at a capital loss. Such sale is unnecessary for monetary policy purposes, as the payment of interest on reserves effectively sterilizes much of the excess effect, particularly as short rates move higher. The marked to market pricing of treasury bonds doesn’t necessarily reflect the realized margin accrual on portfolio assets, particularly when such margin has been accruing in a policy environment engineered by the Fed itself. This is all consistent with the general idea that the same environment is operationally attractive for broader banking system margins, notwithstanding the head winds of loan losses and further marked to market write downs. More generally still, the Fed and the consolidated sovereign have the distinct advantage of not having to offer up “capital” raises that are solely due to mark to market write downs, as is currently forced on the private banking sector, but which hopefully will be alleviated with upcoming MTM adjustment. The Fed and the government are accrual beasts that can withstand a good deal of MTM volatility because they are not constrained by the nonsensical MTM framework/obsession of private sector banking.

    Fed solvency is not the issue. Making money is not the issue. Choosing the best asset liability strategy in term of the mix of hold to maturity versus forced selling (a la Krugman) is the issue. There is no reason to realize losses on portfolio holdings if an alternative strategy is more sensible in terms of optimizing the ultimate taxpayer position in the consolidated sovereign entity.

  11. Gravatar of JKH JKH
    21. March 2009 at 05:09

    Bill Woolsey,

    Unfortunately, I can’t relate to the “demand for base money” idea at all. This is a function of my personally twisted experience and thinking.

    My view:

    The Fed controls the level of aggregate bank clearing balances held at the Fed. Full stop.

    The Fed responds to the public’s demand for currency. Full stop.

    Of these two monetary base components, the first is the pre-eminent influence on monetary policy. The Fed controls the level of clearing balances in normal times to control the effective fed funds rate relative to target. It does so in these extraordinary times to facilitate unconventional credit easing and balance sheet expansion, and to control the effective fed funds rate relative to target. More generally, there is a reason it’s called the “target” fed funds rate.

    As far as the so-called “money multiplier” is concerned, it’s my view that this is a complete fiction whose causality is reversed from what actually occurs in practice. The Fed supplies the level of required reserves in response to deposit growth, not the other way around. Starting from that required base, the Fed tweaks the excess position in normal times to control the funds rate. In these extraordinary times, the Fed is supplying the level of required reserves in response to deposit growth as usual. It is also supply an extraordinary level of excess reserves in response to its own strategy for balance sheet expansion. Expansion of excess reserves and the monetary base is an otherwise unnecessary consequence of the main balance sheet strategy. Therefore, the Fed ahs institutionalized the payment of interest on reserves going forward, in order to communicate to the market that it intends to continue to control the funds rate and to put a floor on the funds rate at such time that it decides in the future to commence policy tightening by increasing the target for the funds rate.

  12. Gravatar of JKH JKH
    21. March 2009 at 05:15

    And much of what seems to be attributed to the “money multiplier” by convention is in fact explained by the process of internal bank capital allocation. The banking system creates money by expanding credit. And it expands credit based on capital, not based on clearing balances held at the central bank.

  13. Gravatar of Bill Woolsey Bill Woolsey
    21. March 2009 at 05:24

    The interest rate margin that banks make is the difference between the interest rates they earn and the interest rates they pay.

    If the banks can only earn less, then they will lower the interest rates they pay, maintaining their margin.

    The lower limit for the banks is the cost of storing currency. That is, if they begin charging people for leaving money in the bank, and they charge more than it costs to store currency, then they will suffer a currency drain.

    While the money multiplier has fallen because banks are holding more reserves relative to deposits, velocity has fallen as well. One of the factors that influences velocity is the interest yield on money.

    If the banks reduce the interest rates they pay on deposits, including deposits that play the role of money, then this should raise velocity.

    If, on the other hand, Fed policy is aimed at making sure that banks can earn money by holding riskless assets, and so helps them keep interest rates on deposits from falling, then the Fed is causing lower velocity.

    In my view, the fundamental change in the financial system is an increase in the demand for lower risk, short term assets and a reduction in the demand for longer term, higher risk assets. Some of this is a reduction in intermediation. The shadow banking system is no longer able or willing to issue short term “low risk” assets and finance long term, higher risk, assets.

    Reserve balances at the Fed and FDIC issured bank deposits are very low risk, short term assets. The increase in the demand for these has an impact on the quantity of money or the demand to hold money. And so, they impact nominal income.

    T-bills have a money price which can change to clear supply and demand. But as the yields on T-bills fall, there is an incentive to shift to other low risk, short term assets, reserve balances at the Fed and FDIC insured bank deposits.

    If the market clearing yield on T-bills is negative and hits the cost of storing currency, then this motivation to shift will become absolute. Why hold T-bills with it is cheaper to keep currency in a safe deposit box?

    Of course, if banks can earn interest on reserve balacnes and FDIC insured deposits have positive yields, then the cost of storing currency isn’t very relative. Banks will hold reserves and everyone else will be motivated to hold FDIC deposits, keeping T-bill yields up.

    But, this process has a monetary impact. Holding reserves reduces the money multiplier and holding those FDIC insured deposits that are money, reduces velocity.

    Now, the Federal Reserve can increase the quantity of base money enough to accomodate the increase in demand for reserves. Even if banks just hold more reserves, purchasing some kind of assets increases deposits and offsets the impact on velocity.

    But the higher the interest rates on these short term assets, the larger the increase in base money necessary, and so, the more assets the Fed must purchase.

    While I believe that the Fed should buy up all the T-bills to increase base money, my understanding of the situtiona is that buy reducing the outstanding quantity of T-bills, the Fed is going to cause those people who were holding them to shift to choosing to hold reserve balances (if they are banks) or else FDIC insured deposits. In other words, the increase in the quantity of money created will actually be entirely absorbed by added demand.

    I believe that the Fed will need to purchase longer term and higher risk assets. The reason it should do this isn’t because the demand for those assets are too low and there is too little lending. It is rather, that it is just a side effect of meeting the demand for money. Both reserve blances by banks and FDIC insured monetary deposits by the nonbanking public.

    But, we can see that what is happening is that the Fed is providing financial intermediation. It is offering low risk and short term assets for people to hold and demanding long term and higher risk assets. In other words, it is counteracting what has happened in the market. Again, it needs to do this not because the past risk and term structure was ideal, it is rather that it is accomodating the increase in the demand for money.

    Anyway, getting the interest rates on reserve balances at the Fed, FDIC insured deposits, and T-bills as low as possible–zero or slightly negative, clears markets without the Fed taking on all the risk.

  14. Gravatar of ssumner ssumner
    21. March 2009 at 05:38

    David, You are probably right on both accounts, but it doesn’t really change my mind. The TARP program may have been a bailout, but I was addressing the issue of T-bond purchases, which probably are not a bailout of the Treasury.

    You are also correct in your formal analysis of the insider trading issue. If the Fed is successful they should lose money. And this will be because markets had doubts about the whether the Fed would carry through with its policies. My somewhat counterintuitive point was that the Fed may not able to take advantage of their seeming possession of inside information. The are a big bureaucracy tied down by all sorts of political constraints—starting with the obvious constraint that Bernanke may have trouble convincing the board to persevere in the stimulus he favors.
    That was the purpose of the tiger/mammoth metaphor. The mammoth is very powerful (like the Fed) but not very agile. the markets are very agile, perhaps able to predict what the Fed will do better than the Fed itself. So to conclude, I agree with your analysis if the Fed is able to outsmart markets, and I agree that it seems like they have the tools necessary to outsmart markets. But are they actually agile enough? If not, then there is no expected loss on the T-note purchases.

    JKH, The Fed may not want the banks to buy T-bills, but if the Fed doesn’t want the banks to buy SOMETHING with the reserves, then what is the Fed trying to do? The whole point of an expansionary monetary policy is to get the new money out there circulating, not have it hoarded. Regarding interest and capital losses, I thought you had made the opposite argument–that the Fed should pay interest permanently so that they wouldn’t have to sell of bonds later, but could have banks hold them without creating inflation. If your argument is for having the Fed hold the medium term bonds to maturity, and then gradually wind down the interest rate program to zero, then fine. But if you were saying the Fed should pay interest on reserves forever, that would be very expensive.

    And even if you are right about interest on reserves, the rate should be negative right now. Yes, lower nominal rates might hurt bank profits a bit (although T-bill yields are already near zero), but the gain to profits from much higher nominal growth (plus 5% vs. minus 6%), dwarf those tiny losses many times over. Protecting bank profits is a horrible argument for deflationary monetary policies such as the one we have had for the past 6 months. These Fed policies are devastating to the banking system.

    In your later post which responds to Bill you say that the Fed is committed to a low interest rate policy for a long period of time. When I read that it sounds to me that the Fed is committed to failing for a long period of time. That is what Japan did. As I have said a number of times in this blog, low nominal interest rates are not indicator of an expansionary monetary policy, they are an indicator of a highly contractionary monetary policy. The goal of my interest penalty idea is to RAISE interest rates, not lower them. Some might argue that this makes no sense. Then go back to my rational expectations post from February and explain to me how a contractionary surprise by the Fed in December 2007 lowered interest rates from 3 months to 30 years. The answer is that the contractionary surprise made investors expect recession, and rates fall in recession. I want an expansionary surprise which creates expectations of strong nominal growth. If we get that, long, and probably even medium term yields will rise (due to the income and Fisher effects.)

    I agree with Bill that we should focus on the excess cash balance mechanisms. Qualitative credit policies (such as operation twist in the 1960s) are not very effective, and distract policymakers from the urgent need for a much more expansionary monetary policy. Today, the best way to do that is by reducing the demand for reserves (via interest penalties and explicit NGDP targets.)

  15. Gravatar of Bill Woolsey Bill Woolsey
    21. March 2009 at 05:41

    In an earlier post, Sumner criticized the approach to nominal income determination that sums up the elements of spending. C+I+G+X. At the time, I was inclined to focus on the value of that approach. On the other hand, I more and more see this as an element of the confusion between money and credit.

    When I read comments about the impact of quantitaive easing on the economy, it seems to be the following–

    Federal Reserve policy increases the amount of lending. Borrowers then can spend. They spend more on C or I. Nominal income rises.

    The reasoning appears to be that nominal income is made up of the parts of nominal income. Consumption and investment, especially, are funded by borrowing sometimes. And so, measures of the price or availability of lending will impact consumption and investment. And so, nominal income.

    But then, there are other factors that impact consumption and investment. Expectations about the economy. Existing amounts of debt. Etc.

    But surely we know that nearly all consumption is funded out of current income. Further, funds fund investmnet out of profit too.

    Credit involves shifting funds between households, between firms, between firms and households.

    Now, these are “theoretical” insights and perhaps are not especially useful for forecasting next years nominal income. But it remains true.

    Implicit in the notion that spending might fall because C+I+G+X has fallen is that people are accumulating money. Money balances are treated as if they passively adjust.

    Or, of course, the quantity of money (in the since of the amount of the medium of exchange that exists for people to hold rather than funds available to borrow) can also adjust to accomodate the demand.

    Of course, “more complete” models take the supply and demand for money into account. But it appears that many economists who discuss these matters at first pass just think of the quantity of money or the demand passively adjusts.

    How can anyone pretend to analyze monetary policy if they treat the quantity and/or demand to hold money as an afterthought?

    Well, I guess what happens is they confuse money and credit.

  16. Gravatar of Bill Woolsey Bill Woolsey
    21. March 2009 at 06:07


    The Fed controls the aggregate quantity of base money. It does this by purchasing or selling assets or else making loans.

    The nonbanking public controls the allocation of base money between clearing balances at the Fed and currency. They control this because bank deposits are redeemable in currency.

    That the Fed chooses to manipulate the quantity of base money in order to manipulate the supply and demand conditions for interbank loans and so manipulate the market Federal Funds rate in order to reach a target for the Federal Funds rate is not something that it must do.

    In looking at your discussion of these matters, you seem to be very focused on explaining what you think the Fed does. My view is that they need to try something different.

    The roots of monetarism was in a critique of the real bills doctrine. A careful analysis of what the Fed was trying to do would be useful for some purposes, I suppose. But exploding this foolish theory was by far more important.

    Anyway, cars are used for consumption and investment. The total demand for cars is the sum of those demands. The supply and demand for cars determines the price and quantity of cars.

    I realize that there might be separate sales offices at the car firms, one of which markets to firms and the other that markets to households. I am sure the people in these sales offices could talk all day about the differences between these two markets.

    My point, of course, is that the demand for base money is the relevant issue, even if the Fed passively meets currency demand and manipulates clearing balalnces to manipulate overnight lending rates. That approach failed. But that isn’t the same thing as monetary policy.

    Recent Fed practice (well, a decades long tradition) is only a subset of “monetary policy.”

  17. Gravatar of ssumner ssumner
    21. March 2009 at 06:40

    Joe, Good question. There are two possible answers. Suppose the Fed doesn’t want the reserves back, but the banks want to hold less, then the reserves go out into circulation, where they are called “cash held by the public.” In that case the balance sheet does not change, as the MB is just as big as before. But this might be very inflationary, so the Fed will probably want to take back at least a portion of those now unwanted reserves. To do this they do an “open market sale” which means they sell bonds to banks, in exchange for these now unwanted reserves. Both the asset and liability side of the balance sheet fall by equal amounts. I they don’t have enough regular Treasury securities, and don’t want to unwind their unconventional programs, then they should make the penalty rate a bit smaller, so that banks don’t cut their reserve demand too sharply.

    Don, Thanks for the link, I need to link to that blog, as he has the same idea as I do. The FT idea of interest on cash, however, is probably a nonstarter. If I understand your idea, it is for negative rates on T-bills (once nominal rates had fallen to zero.) Is that right? If so, I am afraid that Nick Rowe is right, it wouldn’t work because of private currency hoarding. It is the same logic as my idea, and is a good idea, but here is the difference. The Fed cannot police the public and prevent them from hoarding cash as a way of avoiding negative rates. But the Fed can police commercial banks and prevent them from hoarding vault cash as a way of avoiding the tax on bank reserves.

  18. Gravatar of ssumner ssumner
    21. March 2009 at 07:03

    Bill, I would just add one comment about recent Fed policy. Why did it work pretty well from 1982 to 2007? Because the Taylor Rule is very similar to a backward looking activist monetary rule, like McCallum’s proposal to have changes in the base offset past changes in velocity. How does the Taylor Rule do this? Well if NGDP rises too fast, that means M*V is rising too fast. The Taylor rule says in that case raise fed funds rates very sharply. But the implicit assumption is that (due to the liquidity effect) raising fed funds rates very sharply is equivalent to cutting the monetary base (at least relative to its previous path.) The Taylor rule fails when things change so fast that a backward looking policy won’t work. Thus in the fall of 2008 the Fed cut rates substantially based on a slowdown in NGDP growth. But not fast enough, and not as fast as they would have if they had used a forward-looking Taylor rule. Using our preferred terminology, the Fed didn’t increase the base fast enough, relative to a forward looking rule (of course interest on reserves was the bigger problem here.)
    Here’s where the base might be better than interest rates. A stable interest rate (i.e. slow to adjust to the new situation) is highly procyclical. It could even lead to hyperinflation. A stable base might also be a bit procyclical, but probably less than with the interest rate.

  19. Gravatar of Bill Woolsey Bill Woolsey
    21. March 2009 at 07:16


    When the banks report that they have vault cash and want to count them as reserves, the Fed can spot check to see if they are lying.

    It would be more challenging to search the banks to see if they have more currency somewhere or other that they aren’t reporting.

    Of course, making the banks cheat would presumably be more costly to them than just letting them hold vault cash.

  20. Gravatar of Bill Woolsey Bill Woolsey
    21. March 2009 at 07:21

    When the Fed purchases a T-bill from a bank’s customer, this increases the checkable deposit of the bank’s customer and the bank’s reserve balance at the Fed. If the bank uses the funds to buy a T-bill, then increases the checkable deposit of sell of the T-bill and reduces the banks reserve balance at the Fed.

    So, the bank has created money buy purchasing the T-bill. This has not impacted the bank’s capital all all. And of course, the bank of the person selling the T-bill now has the reserves.

    This process goes on until banks are willing to hold the reserves or else, balances in checkable deposits expand to the point that people would rather hold more currency.

    How exactly does the net worth of the banks come into it?

  21. Gravatar of JKH JKH
    21. March 2009 at 07:50

    Bill Woolsey 6:07,

    “The nonbanking public controls the allocation of base money between clearing balances at the Fed and currency. They control this because bank deposits are redeemable in currency.”

    Sort of, I guess. The non-banking public controls their own allocation of currency from a monetary base whose total they don’t control. They don’t control the level of clearing balances, so they don’t control the total, so they don’t control the allocation of the total in that exact sense. Any “purchase” or redemption of notes between the commercial banks and the central bank has a corresponding effect on clearing balances that can easily be offset by central bank OMO. The central bank controls the level of clearing balances, whatever the preferences of the nonbanking public with respect to their portfolio holdings of currency.

    “In looking at your discussion of these matters, you seem to be very focused on explaining what you think the Fed does.”

    That’s true, unfortunately. I get stuck in discussions wherein I fail to reach agreement on how it works now, which tends to impede moving on to discussing changes that might be improvements. My initial reaction to negative interest rates on reserves is probably defensive in this sense. Quite frankly, I haven’t considered it enough to be totally confident about it one way or the other.

  22. Gravatar of JKH JKH
    21. March 2009 at 08:07

    Bill Woolsey 7:21,

    The purpose of bank capital is to support risk taking. Banks allocate capital internally to various types of risk – credit, interest rate, market, operational etc. etc. The normal function of banking is to make loans that have risk attached to them, which uses up capital. The level of capital is the primary constraint on banking.

    Treasury bills are the least risky asset of course – arguably zero credit risk, with a small amount of the other risks. A bank that wanted to do nothing but buy treasury bills would be less constrained and require less capital, to be sure. But that’s not the normal business of banking and that’s not what the Fed ultimately wants to achieve in getting the banking system functioning properly again. And I’m really not convinced that the Fed is all that anxious to see banks going out and buy massive amounts of treasury bills with their bloated clearing balances. The first round effects of “quantitative easing” are quite pronounced on the asset side of the Fed balance sheet and on the liability side of the banking system (M1 type deposits). I don’t think the Fed is after a particular “multiplier” effect simply due to bloated reserved balances. The reserve balances are more the consequence of the Fed’s own credit expansion into risky assets. The Fed wants to see the banking system move back into normal risk lending, which takes capital. Reserve balances are a side show.

  23. Gravatar of JKH JKH
    21. March 2009 at 08:35

    Scott 5:38,

    “But if you were saying the Fed should pay interest on reserves forever, that would be very expensive.”

    The “exit strategy” will include a tightening of the target fed funds rate, and a gradual return of the Fed balance sheet back to “normal”.

    “Normal” in this sense means an asset portfolio whose composition is more conventional (mostly treasuries) and whose size is consistent with a “normal” level of excess clearing balances at the Fed. This means a level of excess clearing balances that historically has been almost unbelievably miniscule – about $ 10 billion or so – in comparison to a $ 20 trillion balance sheet for the banking system. The order of magnitude here is often overlooked, but indicates the leverage the Fed has in steering the path for the Fed funds rate, simply due to the requirement for keeping clearing balances at the Fed. A very small amount does the trick.

    By definition, a normal level of excess reserve balances is a level that requires no interest payments in order to set the lower bound for the fed funds range. The tight setting for the excess itself and the associated competition for required reserves combine to provide the lower bound dynamic. So interest payments can cease after a return to the normal level.

    By definition, any level of excess reserves above normal requires interest payments in order to set the lower bound for the fed funds range.

    So yes, the Fed should pay interest so long as its balance sheet profile requires an abnormal level of excess clearing balances (e.g. extraordinary credit initiatives that haven’t yet run off or been sold). But it won’t be unduly expensive provided that the target fed funds rate has not gone to the moon and the extraordinary assets are eventually wound down. In the interim, the Fed will have earned a spread between the interest it has paid on reserves and the rates it has earned on its extraordinary assets.

  24. Gravatar of ssumner ssumner
    22. March 2009 at 16:48

    Bill, Maybe I am too naive about people, but I don’t think banks would hide much cash (a little yes, but not much.) Remember:

    1. This would probably be made a felony conspiracy
    2. In a large bank one disgruntled employee could anonymously tip the Feds–leading to jail time for the top brass. All over saving a few bucks on excess reserves?

    Bill#2, Sorry, I forgot where we were on the net worth argument. I don’t recall that discussion.

    JKH and Bill, Actually both R/D and C/D matter. The distribution of the base is determined by the relative size of those ratios. During normal times R/D is essentially fixed by the Fed, and the public basically determines the distribution, as Bill indicated.

    JKH#2, I think your point here confuses means and ends. The purchase of T-bills is not a permanent solution, I agree. But if it gets money out into the economy, and prices moving up, then maybe loan demand would increase.

    JKH#3, The transition you describe seems reasonable.

  25. Gravatar of David Stinson David Stinson
    23. March 2009 at 09:40

    Hi guys.

    To return to a couple of points above. Hope I’m not too late:

    On the use of the term “quantitative easing” (QE), it appears to me that it has generally be used to mean open market operations involving unorthodox asset classes, i.e., assets other than very short term government debt.
    Regarding the potential for the Fed to lose money on assets it purchases through QE, it is relevant in the sense that it could have consequences for the reversibility of current Fed actions. (Perhaps that concern is the source of the Fed’s practice up until now of limiting itself to assets in which there is essentially little or no capital risk.) I would have thought that that was a non-trivial concern given the argument that we need have no fear of excessive inflation given the widely-professed (at least in some quarters) confidence in the Fed’s ability to withdraw, in its infallibly precise way, liquidity in the future.

    What I don’t understand is why the Fed felt it was necessary to engage in QE now. Setting aside the question of whether one expects to QE to be successful, the story for some time was that QE might be necessary in order to avoid deflation. However, the CPI rose in February alone by 0.4% (and in January by 0.3%), implying a pretty fair annual rate of inflation. With the Fed shouting from the rooftops for several months now that it wants inflation and is prepared to print money and with the level of scrutiny that Fed policies get these days, the Fed presumably isn’t expecting QE to generate any real effects.

    From a larger perspective, having the government lurching and flailing about in the financial markets targeting various assets or elements of the risk/term structure of interest rates, more than it already does, seems to be unwise, to put it mildly.

    I can’t claim to have read much about Japan’s problems but, from what I have read, I have been struck by the fact that activist central bank policies (such as QE) to provide liquidity, “free-up” the credit markets, etc., etc., by overpaying for assets and underpricing risk have had (what appears to me to be the eminently foreseeable) consequence of significantly undermining private sector participation in Japan’s capital markets. This strikes me as something one would want to avoid at all costs – how can any economy recover or prosper without a vibrant capital market?


    “Of course, “more complete” models take the supply and demand for money into account. But it appears that many economists who discuss these matters at first pass just think of the quantity of money or the demand passively adjusts.

    How can anyone pretend to analyze monetary policy if they treat the quantity and/or demand to hold money as an afterthought?

    Well, I guess what happens is they confuse money and credit.”

    For what little it’s worth, I totally agree. My completely data-free and a priori theory (as a budding Austrian) is that most macroeconomists (present company excepted of course) don’t really have a micro-foundation mindset. They still tend to think in terms of accounting-type aggregates, and the manipulation thereof, not in terms of individual maximizing behaviour (unless they are trying to figure out how to overcome or reverse individual maximizing behaviour through clever central-planning-type policies otherwise known as counter-cyclical macro policies).

  26. Gravatar of ssumner ssumner
    24. March 2009 at 04:45

    David, QE may involve medium term debt, indexed bonds, high quality foreign government debt, but these aren’t really very risky if the government is determined to hit their target. Certainly the losses would be trivial compared to what they are about to lose through fiscal policy. More importantly, if the Fed were being held back by fear of capital losses, then why in the world would they be paying a positive rate of interest on excess reserves, causing reserves to explode in size?

    Monthly CPI date are almost meaningless. The 5 year inflation forecast is still way below the Fed forecast. In any case, the government has decided for better or worse (I think better) that NGDP growth (now negative 6.5%) is far too low. So if we must have stimulus, lets have monetary policy, not massive deficit spending. (I am not saying you favor that, just presenting a pragmatic argument here.)

    I agree that flailing around with the risk/term structure is a mistake. I agree that that’s what they have been doing. I want to go back to old-fashioned monetary policy–controlling the supply of (non-interest bearing) base money.

    Yes, we should avoid the highly deflationary policies of Japan, which has had 14 years of almost continuous GDP deflator deflation. That means we need a much more expansionary M-policy than they had.

    I agree with most of your response to Bill. I just want to emphasize that my plan would not be regarded by Austrians as highly countercyclical. I favor NGDP targeting just like Bill, George Selgin, Hayek, etc. I just favor a slightly higher trend rate, but would also be very happy with the 3% figure mentioned by Bill.

  27. Gravatar of David Stinson David Stinson
    24. March 2009 at 07:34

    Good points, thanks.

  28. Gravatar of TheMoneyIllusion » Can insider trading overcome the time inconsistency problem? TheMoneyIllusion » Can insider trading overcome the time inconsistency problem?
    17. June 2009 at 05:35

    […] (Thanks to Current for the link.)  A few months ago I discussed the issues raised when the central bank was an “insider trader.” […]

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