Tuesday, June 4, 2013

Monetary Policy Puzzle

Might raising interest rates, but not paying interest on reserves, actually be "stimulative," inducing banks to lend out reserves?

Last week, I gave a talk on monetary policy at a forum organized by the Becker-Friedman institute.  I explained my view, that as long as reserves pay the same interest rate as very short-term Treasuries, and as long as banks are holding huge amounts of excess reserves, that monetary policy and pure quantitative easing -- buy short-term treasuries, give the banks more reserves -- has absolutely no effect on anything. Interest-paying excess reserves are exactly the same thing as short-term treasuries.

When the time comes to tighten, I said, I hope dearly that the Fed continues to pay a market interest rate on reserves and allow huge amounts of excess reserves to continue. (I had lots of financial-stability reasons, which will wait for another day here.)   But that means that conventional open market operations and quantitative easing -- more reserves, less Treasuries -- will continue to have no effect whatsoever.

An audience member asked a very sharp question: Suppose the Fed raises interest rates but does not raise the rate on reserves? Now, banks do have an incentive to lend them out instead of sitting on them. Wouldn't velocity pick up, MV=PY start to work again, and the Fed get all the "stimulus" it wants and then some?

It's a particularly sharp question, because it gives sensible-sounding mechanism why the conventional sign might be wrong: why raising rates now might give monetary "stimulus" that is otherwise so conspicuously lacking. There are a few other of these stories wandering around. One: Low rates are said to discourage retirees and other savers, who now "can't afford to spend."  (Quotes around things that don't make much economic sense.)   John Taylor, wrote a very provocative WSJ oped, (too subtle to summarize in one sentence here) and also came close to saying the sign is wrong and higher rates would be more stimulative.

But is the suggestion right? I sort of stammered, and needed the weekend to think it through. (Giving talks like this is a great way to clarify one's ideas. Or maybe this just reveals my shocking ignorance. In any case, it makes a good exam question.) Think about it, and then click the "read more."

The answer is no, I think, but revealing about what the Fed can and cannot do.

How exactly would the Fed raise interest rates?

In the new interest-on-reserves regime (the one I hope will continue) the Fed simply announces, "we borrow and lend reserves at 3%." Interest rates go up to 3%. But so do interest rates on reserves.

The standard mechanism, which allows reserves not to pay interest,  would be for the open-market desk to sell securities in exchange for reserves, in order to drive down the supply of reserves until interest rates rise on the inter-bank (federal funds) market. Banks who need reserves then are willing to pay interest to borrow non-interest-paying reserves overnight to satisfy reserve requirements on their checking accounts.

You see the trouble. Rather than "get banks to lend out the reserves,"  the Fed has to soak up all those reserves in order to raise interest rates in the first place.

Like other central banks, the Fed could offer prices rather than control quantities. Other central banks set rates in the interbank market, by simply saying "we borrow and lend at 3%. Come and get it." (They may leave a window, borrow at 2.9%, lend at 3%, to keep a private market going.)

If the Fed were to do this, banks would simply take all the reserves --  money lent to the Fed overnight -- and... lend it to the Fed overnight at the higher interest rate. This is interest on reserves by another name, no more no less. To the extent that the Fed ties up the money -- borrows at term, or otherwise makes its offer more "bond" like -- this action just synthesizes the huge open market operation that drains reserves from the system. (It's not a bad idea, though, if the Fed wants to shrink reserves without selling assets!) Again, the desired incentive to get banks to "lend out" the reserves vanishes.

What if the Fed offers a price target for Treasuries, and also refuses to pay interest on reserves? Could the Fed offer to buy and sell 3 month Treasuries at 3%, but insist on no interest on reserves and no open market operations to soak up reserves? No, because offering to buy and sell Treasuries means offer to take reserves and give out treasuries, which ipso facto soaks up the reserves again.

The Treasury could (and arguably should) take over interest-rate policy. After all, in the interest-on-reserves regime, when the Fed says "3%, come and get it," short-term Treasury rates will also jump to 3%. (Banks dump Treasuries and give the proceeds to the Fed, driving up Treasury rates.)  It is exactly as if the Treasury said, "Rather than auction 3 month debt, we'll set the rate at 3%, and the market sets the quantity." If you think the quantity reaction might be large, you've figured out some usually unspoken limits on the Fed's interest-rate setting abilities.

But reserves are our numeraire. Pegging interest rates at 3% means the Treasury rather than the Fed takes in reserves in exchange for debt, and parks it in the Treasury account rather than bank's accounts at the Fed. The banks will  again drain reserves rather than "lend them out."

The Treasury could commit to immediately spend the money... But now we're in the land of fiscal, not monetary stimulus, and a reminder that the two always come together.

I'll be interested to hear comments on this one.  The standard stories by which interest rate increases are contractionary are very weak and full of holes. The idea that perhaps raising interest rates is "stimulative" is fun to think about. And a number of schemes around to get banks to "lend out the reserves" are also fun to think about. I don't think this one works, but maybe one of you can get it to work.


  1. Paying interests on reserves didn't save Brazil from hyperinflation in the 80s, much on the contrary, it was one of the main causes of hyperinflation. It hastened hyperinflation because the supply of high-powered money became incredibly endogenous to increases in nominal rates of return. In other words, the monetary and price systems became utterly unstable.
    In Brazil, central bank open market operations at the time got to be known as "wiping ice": the more they tried to wipe off liquidity, the more they created liquidity.

  2. There seems to be a lot of confusion over the causal connections when it comes to lending. Capital markets are large and liquid. Hedge funds, arbitragers and derivative contracts operate to link all of the capital markets together. Corporate and bank balance sheets are awash with cash and some of that shows up as excess reserves. Long term interest rates are at all time lows. If banks are not lending it is because either: (1) no one wants to borrow or (2) the lending channel is in some way broken.

    Alternative (2) is worth considering but it seems likely that if there was an appetite for borrowing and existing channels were broken we would find new channels (charging a higher spread) developing in a hurry.

    If the problem is no demand for borrowing, it is difficult to understand how raising the Federal funds rate would increase the demand to borrow funds. Reducing the rate on reserves might slightly increase the supply of loans available.

    The empirical question is: with record low real interest rates why is the private sector not borrowing?

    1. Absalon,

      Good call.

      In regards to the Grumpy Economists point -- when it comes time for the fed to raise rates.... we must assume that the recovery is well underway. Whether 1) or 2) as outlined above is to blame of the current malaise, we must assume that it will have been largely fixed by that point.

      In which case, there will not be piles of excess reserves, and the question will prove to be moot.

    2. I think the answer is simple: money is too tight, and will probably remain tight until the Fed gets their act together and pulls us out of ZLB territory.

      As Friedman pointed out, low interest rates are often a sign money has been tight. Expectations uber alles.

  3. Absalon, I'll answer to your question with my own personal experience: I tried to borrow at low rates to buy real estate as rental property. The answer from the three banks I have accounts with was that or (1) I was too much of a risk or (2) they offered me a rate that was many percentage points above the headline rate.
    In other words, at least in my case the demand is there but the supply is not.
    The problem is that the realistic nominal rates that most people have access to at this moment imply high ex-ante real interest rates given typical inflation expectations. But inflation expectations have been unanchored by central bank policies during the last five years. In my opinion we are navigating in a sea of multiple equilibria with sunspots, and we were lucky that nothing triggered a change of state until now.

    1. Pedro - I don't know what counts as "many percentage points" for you. I think for me, "many" would start at or over 2. Your personal circumstances that made you too risky for one bank is probably the same thing that drove another bank to ask for a higher spread.

      If your experience is typical then the trillion dollar question is when and why are the banks demanding big mark ups above the headline rate?

    2. Absalon, yes, you got it right: "many" for me meant 2 to 3%, enough to make my rental arbitrage strategy unfeasible. My guess, concerning the banks, is that their behavior depends on the "lending business model," for example, the origin of the funds. Lending to risky entrepreneurs is surely not the same as lending through FHA. The rate spread may represent the pricing of risk that cannot - in their view - be easily transferred to the Treasury.

    3. Pedro three banks told you that that the risk-reward ratio for the proposed business plan isn't what you think it is. Maybe they've been burned on residential rental deals and require a risk premium. Maybe your credit history or income wasn't good enough - after all, they did say you were "too much of a risk".

      If three banks all said the same thing maybe you should re-think your business model.

      The default risks are higher these days, and the artificially low rates diminish the rewards. It's not encouraging for lenders unless, as you said, they have a taxpayer backstop.

    4. JB, I don't want to make much of my personal example, maybe it's not really representative, but let's put it like this: my credit score is top decile and I have been a costumer of those banks for 10 to 15 years. I cannot offer any guarantee other than the purchased property itself - which in normal times should be enough for a small entrepreneur, but clearly this is not my case.
      In other words: if I cannot get such a simple loan with feasible rates for a straightforward business proposal, then very few can.

    5. I was in the same position for a rental refi. I was surprised, aside from my credit (770ish iirc) they only seemed to care about LTV (they did not even ask for a signed lease). Once they were satisfied on that score it was just some paperwork. OTOH the amount was relatively small, and I do think banks are making it harder for marginal borrowers.

      I do not think inflation expectations are unanchored, nothing in TIPS or bond yields suggests that (yet). I think if (not to say when) that happens it will be because people see the Fed as unable to resist political pressure to monetize an unsustainable sovereign debt problem -- and I think it will happen very fast, the Plank curve is very steep.

    6. To echo above: Steve Hanke addressed this on Econ talk - namely that because of regulation and basal, the equity requirements on banks have risen considerably, thus discouraging lending at the moment. He noted a story about a friend of his trying to secure a loan for a house and despite his incredible wealth, the bank still was hesitant to make any kind of loan. Whether its regulation alone thats busted the channels is more of a debate, but it sure doesn't seem like its purely a money demand issue.

  4. Thinking about Cochrane's question: If the Fed unconditionally fix the nominal interest rate paid on reserves, it means that, as Cochrane suggested, all government deficit can be monetized at a nominal interest rate that may or not be consistent with stable inflation. In this sense, excessive reserves is a trap, since the central bank cannot regain control over liquidity before it sterilizes the entire stock of reserves.
    The problem is that the central bank may lose control of inflation before sterilization: suppose the Treasury is enjoying the ride and is monetizing as much deficit as it wants. Inflation is now rising. The Fed fix the interest rate at a higher level before sterilization is achieved. This leads automatically to increased liquidity in the near future (as reserves are paid with more reserves). And the Treasury can continue to monetize its spending, now at a higher interest rate, but the Treasury doesn't care because its ability to monetize debt repayments at any rate is infinite (until the system breaks).
    Notice that if the Fed doesn't increase the headline rate hyperinflation is guaranteed, while increasing the headline rate ex-post leads to a slower but equally lethal inflationary spiral. An inflationary trap, exactly like it happened in Latin America in the 80s and 90s.
    The only way to get out of the trap is to apply a huge contractionary fiscal shock, plus count on sheer luck regarding the recoordination of expectations, or use some nominal anchor such as a peg to a strong foreign currency - normally both. The latest option BTW isn't available to the US.

  5. I think there are business and demographic reasons for low demand.

    On the business side I believe businesses don't have anywhere productive to deploy money, however cheap. The main symptom of this is how they are using money: buying back shares to buff EPS or raising dividends. Buyback announcements are back to nosebleed 2008 levels. The ratio of CapEx to buybacks/dividends used to be around 70/30 until about 2003, it hit almost 50/50 5 years ago and has been sputtering at about 60/40 since then.

    As Alfred Marshall said, "Economics is the study of people in the ordinary business of life" and there is a lot happening in the demographic arena.

    Young people are having a hard time in the job market and they are deferring forming families. There goes your market for houses, mini-vans, and other child-related expenditures.

    Households are deleveraging - some by necessity, but a lot of others by choice. Boomers are sick of the burdens of owning "stuff". They don't want the things that you need credit for. When the kids are gone they sell their house and use the equity to buy a smaller place for cash. Or maybe just rent. In the 90s we used to brag about how we were doing in the market. Everyone was showing off their wealth. Now we brag about how great life is when you have no debt and how much money we saved by buying a used loaner instead of a new car, or how our car has 120,000 miles and it's still running like a top.

    Austerity is the new black.

    "Too Much Stuff" by Delbert McClinton:

    Big house, big car, back seat, full bar.
    Houseboat won't float. Bank won't tote the note.
    Too much stuff. There's just too much stuff.
    It'll hang you up dealing with too much stuff.

    Hangin' out on the couch puttin' on the pounds.
    Better walk, run, jump, swim. Try to hold it down.
    You're eatin' too much stuff, too much stuff.
    It'll wear you down, carrying around too much stuff.

    Hundred dollar cab ride, fogged in, can't fly.
    Greyhound, Amtrak, oughta bought a Cadillac.
    Too much stuff. Too much stuff.
    It'll slow you down, fooling with too much stuff.

    Well, it's way too much.
    You're never gonna get enough.
    You can pile it high
    but you'll never be satisfied.

    Rent-a-tux, shiny shoes, backstage, big schmooze.
    Vocal group can't sing, won awards for everything.
    Too much stuff. Too much stuff.
    They just keep on going, rolling in all that stuff.

    Got hurt, can't work, got a lot o' bills,
    But the policy don't pay 'less I get killed.
    Too much stuff. Too much stuff.
    Just my luck, counting on too much stuff.

    Well, it's way too much.
    You're never gonna get enough.
    You can pile it high
    but you'll never be satisfied.

    Running back can't score till he gets a million more.
    Quarterback can't pass. Owner wants his money back.
    Too much stuff. Too much stuff.
    You know, you can't get a grip when you're slipping in all that stuff.

    Women every which-a-way messing with my mind.
    You know, I fall in love every day three or four times.
    Too much stuff. Too much stuff.
    It'll mess you up, fooling with too much stuff.

    Yeah, too much stuff. Too much stuff.
    Too much stuff. Too much stuff.
    You never get enough 'cause there's just too much stuff.
    You know you can hurt yourself, fooling with too much stuff.
    Yeah, it'll tear you down, fooling with all that stuff.

    1. Those are good points JB, and I tend to agree with you. But mostly on the consumer side of the equation. On the investor side, I think it's less clear. I would bet that at headline rates the demand for entrepreneurship credit is significant. Changes in the lending business model and regulations probably made life harder for risk takers at the bottom of the pyramid. I wouldn't be surprised if Bill Gates would have had a much harder time finding capital today than when he started.

  6. I have some sympathy with the notion that reducing interest rate expectations could be having a perverse effect on private sector preferences. It seems likely that in saving for retirement many households use some sort of heuristic based on targeting a level of income. If this is correct, their desired savings rate will rise if interest rates decline.

    I am reminded of a perverse relationship between hourly wages and labour supply I recently observed in Ireland. Irish cab drivers have experienced huge declines in nominal hourly wages, but anecdotally many respond by increasing their supply of hours. This is because they are targeting a level of income, presumably because many of their costs are fixed (such as mortgages).

    The CEO of Wells Fargo also made a very interesting remark recently. He suggested that they were holding back on making loans because they expected interest rates to be higher in the future. This is a novel variant of the old idea of the speculative demand for money. But it seems reasonable. If you are bank, and you believe that current long term rates are abnormally low, why would you commit to lend now?

    1. If a bank thinks interest rates are going to rise, and does not want to lend money, the bank can make only variable-rate loans. Or, better, it can make any loan the customer wants, and then swap out the interest rate risk in a plain vanilla fixed for floating swap. It could do double the number of swaps as loans and then profit from a rise in rates. The CEO of Wells Fargo should know this!

    2. When the CEO of a TBTF institution says "I cannot do it," I have always an impression that what he really means is "I won't do it without free government insurance to back it."

    3. Naturally a bank with a hedged interest rate position like Wells is eager for rates to rise, because less prudent banks are making more money, which makes the prudent CEO look dumb.

      (As an aside, why do we even allow banks to speculate on interest rates? The idea that banks "borrow short and lend long" is so old fashioned. Banks don't know anything about interest rates that you and I don't know. There is no problem of asymmetric information).

    4. Its also possible that scrutiny by all parties concerned are curtailing these options. Hard to know without being privy to the board meetings, but I suspect the murkiness of the future has played a game of wait and see with most financial institutions, TBTF notwithstanding.

    5. The reason the banks do not lend as much as we would like is because they are scared that weak aggregate demand will destroy the borrowers' ability to make loan payments. Banks don't want to take much credit risk, not until they see a stronger economy - that includes doing swaps. That's why QE works not just through inflating bond prices/lowering yields, but also through inflating stock prices and subsequent wealth effect.

  7. The whole idea of trying to get banks to lend is wrongheaded. It comes from, I think, a naive version of monetarism that holds that if an expansion of base money has no effect (the "money multiplier" is broken), it must be because "zombie banks" are not making loans. Maybe they lack capital, or they are being oppressed by regulators, or something.

    No. There's no evidence that there's anything wrong with the financial system. It has been working smoothly since the end of the 2008-2009 crisis.

    What would work is getting rid of the zero bound, but central banks are not even talking about that.

    1. I don't understand the popularity of zero bound theories in some quarters when we do know that (a) people are being asked 5% nominal or more on business loans, (b) accumulated CPI inflation since 2009 is about 8%, and (c) the rise in prices of some assets has been very high for a few years now.

  8. We can assume: a) that the CEO of Wells Fargo knows of the existence of interest rate swaps; and b) that he thinks there is interest rate risk. If this effects his lending (which we do not know for sure - it may be an excuse) we must assume either: it costs to hedge, or for some reason he cannot fully hedge. As Wells Fargo is now the largest provider of mortgages in the US, both may be true.

    Of course, if he just wants to bet on rates rising, there are a multitude of instruments available, from shorting fed funds futures to buying out of the money swaptions (which look cheap given how low implied interest rate volatility is!) However, hedging interest rate risk incurs transaction costs, counterparty risks, and correlation risk. Also, I don't know what the regulatory treatment of the hedge is: If a bank makes a series of loans and then hedges the interest rate risk of their entire book, are they required to provide additional capital for the hedge?

  9. This came out yesterday at Cato. The thesis seems to be that ZIRP causes a choke on interbank lending which then impairs lending to small businesses.


    He makes a large leap though. He proposes a mechanism as to why this could decrease willingness to lend but he doesn't connect the dots showing that banks aren't lending for this reason. He cites “Fed ‘stimulus’ chokes indirect finance to SMEs” by McKinnon but I can't access it because it's behind a paywall.

    Why not just ask real people? The NY Fed small business poll seems to indicate that it's a demand problem. http://www.newyorkfed.org/smallbusiness/2013/pdf/summary-of-key-findings-2013.pdf.

    "Most business owners we polled cite access to capital as a top growth concern, but only a third of firms actually report applying for credit in 2012."

    "Among the non-applicants, fewer firms self-identified as being discouraged or not applying because they anticipated being declined."

    "Future credit demand was reported by firms who applied in the year but received only partial funding because they had insufficient collateral or had been in business only a few years."

    "While two-thirds of non-applicant firms are as high performing as applicants, most do not plan to apply for credit in the next six months. These non-applicants don’t plan to seek credit because they either don’t need credit or are debt averse."

    1. Could it be that many may perfectly know that they will be denied credit before they apply, so they just avoid the hassle?

    2. Pedro, "Among the non-applicants, fewer firms self-identified as being discouraged or not applying because they anticipated being declined."

      The number of discouraged applicants was actually down.

      Bolstering my "demand deficiency" argument is this from Zillow (http://zillow.mediaroom.com/index.php?s=159&item=354):

      "13 Million U.S. Homeowners Still Underwater in Q1, But More Than 9 Million More May Lack Enough Equity to Move"

      Even worse, contrast new home sales vs mortgage applications. New home sales have been rising for about a year but mortgage applications have been flat. IOW, the hedge funds have been behind the move in new home sales. And that is about to collapse. From the WSJ:

      "Colony American Homes Inc. postponed the pricing of its initial public offering Tuesday, citing market conditions, according to a person familiar with the matter."

      This is a REIT that specializes in the single family rental market. It also looks like the big players are leaving the building. Six months ago JPM invested $70M in "American Homes 4 Rent". They are now listed as a "selling shareholder". Once again, the people closest to the newly printed money got in and got out.

      This might be another reason that banks were not receptive to your loan request. Indeed, they might have done you a huge favor.

      So the true housing consumer is either zombified or has been priced out of the market as big money drove up prices. Furthermore, back during the housing bubble expensive houses were within reach of buyers due to the free-wheeling loans being written (no money down, ARMs, NINJAs, etc). Now that we're back to more stringent conventional mortgages a home purchase is even further away than before for many people even with lower nominal prices.

      There have also been huge layoffs in the mortgage industry recently and refi applications are way down.

    3. Thanks for clarifying. But no, they didn't do me a favor. I'm not buying for flipping but for rental arbitrage. The risk is extremely low no matter the state of the economy, as long as fixed interests on the loan are low. Losses are tax deductible and nominal capital gains add to amortization. Besides it's the cheapest insurance against long-term inflation available right now, a scenario that I'm betting on. Just the nominal revaluation of the last six months would have been a huge wealth boost, almost risk free.

  10. Your logic is correct. If the central bank wants to sustain a positive Fed Funds rate, it must either pay interest on reserves or mop up all excess reserves. If there are any excess reserves, the first thing that happens is that the Fed Funds market rate falls to 0%.

    This world of interest-bearing money is essentially close to a Wicksellian credit economy and has many implications which mean that the usual separation of fiscal and monetary functions doesn't make any sense. Money and T-bills are equivalent. I wrote a post on this topic a while ago - Monetary and Fiscal Economics for a Near-Credit Economy

    1. Good text. But central banks have been using some neo-Wicksellian arrangement since much before the crisis, so what is new? Well, reserves replaced bonds in banks' T-accounts. Is there a problem with this? Yes: in the Wicksellian world, when banks have bonds as assets, higher interest rates reduce asset value, leading to nominal credit contractions. But what happens when banks carry interest-bearing reserves? Exactly the contrary, the value of banks' assets rise with interests.

      An extreme case happens when the Treasury replaces fixed-rate bonds by floaters. Increases in interest rates not only increase the volume of interest-bearing reserves, but also the volume of floaters and, therefore, the value of higher monetary aggregates. The transmission can be fast given the nature of floaters.

      The irrelevance of monetary policy in the hyperinflationary economies of the late 80s and early 90s is mostly explained by these mechanisms. The most successful stabilization plans would try to reintroduce negative interest rate risk in banks' portfolios, as a way to revive monetary policy.

    2. Ashwin,

      Of note:

      "Less documented but equally important are the attempts to improve the supply and safety of the credit economy via collateral. The idea is simple – assets can be used as security to back the credit, thus improving the supply as well as the safety of credit."

      But the credit and the collateral must have some similar traits. For instance a mortgage bond can be sliced and diced and sold to 20 different investors. But if the borrower defaults, can the underlying collateral (the house) be divided among those investors?

      Ultimately, collateral that is borrowed against must be as liquid and divisible as loan that is created. In addition to avoid cascading defaults, the collateral must always have a value greater than the loan. With market pricing of collateral (houses for instance) that is impossible.

  11. I'm not sure how much our host wants to wander off-topic into rental housing but I promise I will include the original topic in this discussion.

    The nominal revaluation higher in residential housing is a blip. There are hot markets right now where outside money has been coming in and scarfing up houses at the asking price sight unseen and unconditionally (e.g., not requiring an inspection). Note what I mentioned above - sales are up but mortgages are flat. This is private equity money inflating markets. They are going to securitize this and walk away leaving a trail of Muppet tears behind them.

    Mr. Bernanke's market distortion has driven up housing prices by flowing easy money to large scale buyers and locked out the retail home buyers. If you hike the price of a $200K house by 20% (San Francisco, Vegas, Atlanta, Phoenix) the retail buyer with 20% down needs to save up an extra $8K. Not that you could actually buy a house in SF for $200K but let's pretend.

    Now, for inflation and housing. There is usually an inverse relationship between interest rates and prices. I say 'usually" because the last housing bubble was so severe that we are now talking about why nobody is borrowing despite low rates (back on topic!). Most people "buy the payment". IOW, the question is usually "How much can you afford for a monthly payment?" The payment will be largely dependent on two figures - the principal and the interest. If inflation goes up, so do interest rates so the interest piece of the payment goes up. If wages are sticky, constraining a rise in the affordable payment, that means less money available for principal. Principal is directly related to the price of the house. So your house could drop in price with inflation. If low rates can't boost purchases then I don't want to see what higher rates will do.

    There is always risk to rental property no matter how low your payments are. If you don't have tenants you have a guaranteed negative cash flow even if you own it free and clear (due to upkeep and taxes).

    "Borrowing to save" is a fool's game. You don't borrow money and justify it by the tax deduction. You can only write off part of the loss. And if you do make a nominal profit on an eventual sale, all your depreciation can come back to bite you. And the IRS doesn't mark down the nominal gain adjusted for inflation.

    Real estate is also rather illiquid which limits your ability to extricate yourself from a bad situation or raise cash quickly. And it's usually purchased with leverage, which can magnify your losses as well as your gains. If you follow CRE at all you can see that large amounts of money are both made and lost. Donald Trump almost took down the NYC banking system when he flat-lined back in the 90s. He was over-leveraged and the CRE market went against him. Then they bailed him out and he wrote a book called "The Art of the Comeback" (instead of "How I Failed So Spectacularly I Became a One-Man TBTF").

    Depending on your location you may see a significant retreat in prices. Don't be the "greater fool", which IMHO is what many incoming small rental home investors are doing right now. They've been reading the headlines and want to get in. Once again, those banks might have done you a favor, saving you from yourself.

    1. Your host thinks you guys have wandered way, way off topic! I don't put that much stock in the "banks lend out the money" channel of monetary transmission in the first place.
      But you did it politely and coherently, so I haven't put the kabosh on it yet.

    2. I'm confused. If you don't think monetary transmission through lending is significant then why worry about how to increase it?

      The discussion seems to highlight once again that the Fed can really only control very few variables simultaneously, perhaps only one at a time. When it grabs control of one aspect of the system it relinquishes it somewhere else.

    3. I second JB McMunn's question: if monetary policy does not operate through bank lending, how then is it to stimulate the economy? What do you believe is the transmission mechanism?

      I was a young lawyer in 1981 and when Volcker jacked up the rates it sure as heck operated on the real economy through bank lending. I would be sympathetic to an argument that monetary policy is effectively a string: the Fed can pull on it (and ease off by pulling less hard) but pushing on it does nothing.

    4. This is really way off topic, but I'll be short:
      JB, it's hard to lose when your interests are aligned with the interests of the Treasury. In a possible scenario where inflation is used to corrode the value of public debt, it's the owning of nominally fixed debt that will bring you the goods. Cheap hedging, as I said.

    5. "I don't put that much stock in the banks lend out the money channel of monetary transmission in the first place."

      Not really that perplexing when you think about it. Banks are both borrowers and lenders. They can also borrow without lending - see investment banking.

  12. "But that means that conventional open market operations and quantitative easing -- more reserves, less Treasuries -- will continue to have no effect whatsoever."

    It's a good point, but I think it's one they could easily fix by deciding to move out of ZLB, which is basically an expectations game. QE is always fighting against the credibility of the long-term Fed inflation target, so change the target. Have a higher target, have a flexible target that bends with circumstances, or best of all target NGDP directly. That should make QE much less necessary -- the Chuck Norris effect will then work for easing instead of both for and against it.

    The markets keep saying this is what will create growth.

  13. I really struggle with notion that the Fed should mess around with interest rates on reserves etc. in order to manipulate the behaviour of banks. Banks should lend when they think it is appropriate, and borrowers should determine their balance sheets as they see fit. QE is a tortuous and hugely inefficient way to influence "demand". I cannot accept that the optimal way to increase private sector spending is through distorting asset pricing or balance sheets. For this reason, I do not understand why there is not more widespread advocacy of helicopter drops, particularly among those with a preference for market-based solutions. If Bernanke wants private sector spending to rise he should stop playing around with reserves and interest rate expectations, and simply credit household sector bank accounts with newly created money. This of course will increase reserves, without a counterpart on the asset side of the Fed's balance sheet. But so what? If inflation can be controlled by simply raising rates on reserves this does not matter. To summarize: if we want the private sector to spend more, give the private sector more money. It is semantics whether this is deemed monetary or fiscal policy (is it monetary policy if it involves base money?). Would it work? I think it would obviously work. It would be more direct. And the private sector would be doing the spending, not the government. And there would be no need to interfere with banking, with rate expectations, or with asset prices. What am I missing? Is it that no one really wants any of these policies to have any effect …

  14. "If the problem is no demand for borrowing, it is difficult to understand how raising the Federal funds rate would increase the demand to borrow funds."

    The problem is not demand for borrowing. The problem is what this country has gotten for its borrowing. Consider:

    Real GDP / Total Credit Market Debt Owed - Basically a measure of the efficiency of the U. S. economy:


    Or how about household asset / liability ratio:

    2012 4th quarter
    See page 113
    Assets - $79.5 trillion
    Liabilities - $13.45 trillion
    Asset / Liability Ratio - 5.91 to 1

    Contrast that with 1950
    See page 104
    Assets - $1.1 trillion
    Liabilities - $76.8 billion
    Asset / Liability Ratio - 14.32 to 1

    A declining asset / liability ratio will eventually go below 1 and render the borrower insolvent.

    1. Just because the asset / liability ratio declines does not mean that it must fall below 1.

      I would expect that as financial markets mature, and the economy becomes more capital intensive, GDP/market debt would decline without it being a sign of any problem. Changes in the structure of capital markets, and in particular the introduction of additional layers of financial intermediaries (for example, hedge funds), can cause the GDP/total market debt ratio to decline and the only problem is the systemic risks created by the existence of the additional intermediaries (more links in the chain which are capable of breaking).

      The change in household asset/liability ratios from 1950 to 2012 may be entirely the result of more efficient and effective capital markets for financing cars and home ownership.

    2. Absalon,

      "Just because the asset / liability ratio declines does not mean that it must fall below 1."

      What is to stop it from falling below 1?

    3. http://www.federalreserve.gov/releases/z1/Current/z1.pdf

      See page 73 - L.109 - Private Depository Institutions

      Assets: $15.244 Trillion
      Liabilities: $15.519 Trillion

      If it can happen to depository institutions then why can't it happen to the entire household sector?

    4. "What is to stop it from falling below 1?"

      For one thing, every debt liability is someone else's debt asset. If the ratio is calculated as (all non debt assets plus all debt assets) / (all debt liabilities) where by definition debt assets equals debt liabilities then the ratio cannot fall below one.

      The Federal Reserve chart you refer to just counts financial assets. Banks can have non-financial assets.

    5. In a closed economy that would be correct - all debt in an economy is held as another person's asset. In an open economy that is not the case (external debt).

      Also, I was pointing to a specific sector in an economy (households). Even in a closed economy, there can be sector imbalances in asset / liability ratios.

      And so the question remains - what prevents the household asset / liability ratio from falling below 1?

  15. Dear Professor Cochrane

    Of course, the correct answer is that you and and everyone above is wrong.

    June 22, 2013 will be the 6th anniversary of when Bear Stearns pledged a collateralized loan of up to $3.2 billion to "bail out" one of its funds, the Bear Stearns High-Grade Structured Credit Fund, while negotiating with other banks to loan money against collateral to another fund, the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund.

    Yes, this Depression is now 6 year old, proving that in the last 75 years monetary theory has developed nothing, really, to offer.

    Reserves are not a motive to lend; at best, they are a condition to lending. If no one wants to borrow, reserves to the moon will not matter nor will the lack of reserves matter.

    People will not borrow because of two five letter words: China and Robot

  16. Reserves, monetary theory do nothing about this


  17. While it seems clear that QE is having a limited impact on demand, this cannot be because reserves do not matter. Reserves are money, in the unambiguously defined sense: an electronic version of notes and coins. Money held by the private sector is an asset, adding to the stock of assets in the private sector boosts the private sector's stock of wealth - and therefore creates demand (park Ricardian equivalence for the time being!).

    The problem must therefore be the way reserves are being created. Prof Cochrane is right: why would substituting an interest bearing asset held by the private sector with a lower interest-bearing asset (money) increase private sector demand? It has no impact on private sector net wealth, but reduces the private sector's net income.

    The conclusion is obvious: create reserves without buying assets. If the fed adds to the stock of money held by the private sector without removing an asset held by the private sector the net wealth of the private sector rises.

    So the only question is can the Fed increase reserves without swapping them for treasuries or MBS etc. Of course it can. Lets get on with!

    1. That is a gold bug's wet dream. I can easily see the resulting panic taking the COMEX and bullion banks down as people stand for physical delivery. MF Global on steroids.

      I think we might see that experiment run in the EU in the near future.

      But I don't understand why you think adding printed money to the private sector means it is wealthier. The people closest to the newly printed money will buy assets with it before the inflationary impact hits and they'll get wealthier, but by the time it trickles down to Main Street it will just be diluted down.

      New money needs to get directly into the hands of consumers, not large financial institutions. I'd say either do Bernanke's helicopter drop directly on the common folk or better yet, decrease taxes. If you're going to run a deficit at least run one that puts money into people's hands to spend into circulation and rev up velocity, eliminating the banking middleman who is driven by his own agenda. That spending would increase tax revenues in a good way.

      So if you're going to do something daring and different, cut taxes instead of Abenomics, or as Grant Williams recently called it, "more cowbell". Cultural meme found here: http://vimeo.com/39387904

      And get rid of the abomination called ObamaCare which has had the unique effect of distorting the economy before it's even been implemented. Let the folks at Olive Garden work 40 hours per week.

  18. Is it not more likely that raising the interest rate on existing reserves and not changing the fed funds would create the desired effect?

    An extreme example makes this clear. Let’s say the Fed announces that it will pay 20% IOR on existing reserves and keep the Fed funds rate at 0.25% on new reserves. What would happen?

    QE doesn't work because a higher yielding bond is being replaced with a lower yielding cash deposit (reserves). A 20% IOR would be a $400bn annual transfer from the Fed to the banks! Bank equity prices would go to the moon, increasing private sector net wealth.

    What this mental exercise makes very clear is that paying interest on reserves at a level below that of the assets the fed purchases is a tax on the private sector (how else can the Fed be so "profitable"?), paying a higher interest rate is a transfer.

    Increasing reserves only raises economic activity if liquidity is a constraint on growth. That is what differentiates reserves from all other assets. Liquidity is not a constraint on growth any more. So what matters is the impact on the private sector's net wealth, or net income (the same thing really). At the moment, QE is reducing the private sector's net income. One way to make it "work" would be to reverse this.

  19. Gara Afonso and Ricardo Lagos have the best model I've seen to address the issue of how interest on reserves works. I'm not sure which paper, but probably one of these:

  20. A agree with your analysis. But a hike in the policy rate, i.e. the interest rate on reserves, might be inflationary.

    Suppose inflation expectations and the price level are flexible and that the natural real rate of interest is constant. According to the Fisher equation an increase in the nominal interest rate will the raise inflation expectations. Also, with a higher interest rate on reserves, the rate of growth of the public debt increases for a given fiscal policy stance. Actual inflation then increases in order to keep the real value of the consolidated public debt in line with the present value of the present value of expected real primary public surpluses.

    Am I mistaken in thinking that these are implications from your papers on the fiscal theory of the price level and the Taylor principle?

  21. I found this post a bit obscure. I thought interest on excess reserves is set by fiat, i.e. changing IOER doesn't require open market operations. In contrast, the Fed Funds Rate is targeted using open market operations.

    Is the argument above basically thus: if the Fed keeps interest on reserves low while simultaneously conducting open market operations to raise interest rates on marketable securities, then banks will transform their excess reserves into marketable securities? This is just portfolio rebalancing argument isn't it?

    We would also expect the same thing if IOER went negative today, wouldn't we?

  22. Banks don't lend reserves they lend ratios and regulations, as long as the ratios or the regulations prevent substantial increase in lending then banks will continue to be cautious and pretend that it's a lack of demand. I do believe that banks think the relative level of rates is too low for them to consider the risks associated with lending, while there is always an ability to swap out into a floater, woohoo let me go put that trade on and make ZERO money for carrying this counterparty risk that i underwrote, while i'm getting continually beaten by the regulators to make my balance sheet less risky!! With that in mind, consider what happens if the Fed were to raise rates and not raise IOER, my argument would be... absolutely nothing! their 'rate raise' would be effectively impotent as the reserves sloshing around the system would eventually drive interest rates right back down to zero. So the IOER mechanism is just a tool to make sure that their rate statement is effective and respected. This will create the 'floor' in the new channel mechanism that the Fed would like to employ going forward, i think**. I am somewhat sympathetic to the destruction of the interest income channel, if you just do some back of the napkin math from the NIPA tables, you can clearly see that the interest income that has been taken from the economy has HAD AN IMPACT, there is a balance that needs to be taken into consideration in my mind that if fiscally the government won't spend/function effectively the benefits of negative real rates are significantly reduced...
    think thats a long enough rant.

  23. This comment has been removed by the author.

  24. I'm by no means a pro at this, and perhaps this point has been made, but aren't we leaving out risk premiums in all of this discussion? A few commenters asked the question "Why are banks demanding a large spread" but take a step back and remember that we have seen historically low interest rates. In my view, the risk sensitivity is extremely high coming off a time of crisis, and add on top of that the expectation that interest rates won't sit on the floor forever, and you can find a larger-than-normal risk premium.

    I think those on the borrowing side of the equation want close to prime rates regardless of the actual number. Borrowing at 6% when prime is 5.5% "feels" better than borrowing at 5% when prime is 3%. Couple borrowers feelings with an inflated risk premium and I think you see a massive slowdown. Maybe I'm naive, but aligning interest rates with expected future "normal" interest rates would drive down the risk premium and get things moving again?

  25. I'm coming late to this debate, but there is a model that suggests that raising rates can be expansionary.

    Admittedly, it's an IS-LM model (definitely published by Smyth and Holmes, in the late 1970's, I believe it was in De Economist).

    Anyway, they develop a model in which the IS can be modestly upward sloping. If memory serves, this was because private saving was more elastic with respect to income than in the typical IS-LM model.

    The end result was that monetary policy that would typically be thought of as contractionary could be expansive.


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.