Doctrines Overturned

(This post is based on a few talks I've given lately. There's not much terribly new. But the effort to revisit, clarify and repackage may be useful even if you're a devoted blog reader, as it is to me.)

The Future of Monetary Policy / Classic Doctrines Overturned

Everyone is hanging on will-she or won't-she raise rates by 25 basis points.

I think this focus misses the more interesting questions for current monetary policy. The last 10 years or so are a remarkable experience, a Michelson-Morley¹ moment, which overturn long-held monetary policy doctrines. The plan to raise rates via interest on reserves in a large balance sheet completely changes the basic mechanism by which monetary policy is said to affect the economy.

On RRP Pro and Con

Thanks to a comment on the last post, I found The Fed working paper explaining Fed's thinking about overnight reverse repurchases, Overnight RRP Operations as a Monetary Policy Tool: Some Design Considerations by Josh Frost, Lorie Logan, Antoine Martin, Patrick McCabe, Fabio Natalucci, and Julie Remache.

(I should have found it on my own, as it's the top paper on the Fed's working paper list.) Cecchetti and Shoenholtz also comment here

My main question was just what "financial stability" concerns the Fed has with RRP, and this paper explains.

Run Free Video

This is a talk I gave at the joint Mercatus/Cato "After Dodd-Frank" conference last spring.  It's based on Toward a Run-Free Financial System.

Liftoff Levers

I read the minutes of the January FOMC meeting. (I was preparing for an interview with WSJ's Mary Kissel) There is a lot more interesting here, and a lot more important, than just when will the Fed raise rates.

Mainstream media missed the interesting debate on "liftoff tools." Maybe the minute the Fed starts talking about "ON RRP" (overnight reverse repurchase agreements) people go to sleep.

Background

Here's the issue.  Can the Fed raise rates? In the old days there were $50 billion of reserves that did not pay interest. The Fed raised rates, so the story goes, by reducing the supply of reserves. Banks needed reserves in proportion to deposits, so they offered higher rates to borrow reserves.

Now, there are about $3 trillion of reserves, far more than banks need, and reserves pay interest. They are investments, equivalent to short-term Treasuries. If the Fed reduce their quantity by anything less than about $2,950 trillion, banks won't start paying or demanding higher interest.  And the Fed is not planning to reduce the supply of reserves at all. It's going to leave them outstanding and pay higher interest on reserves.

But why should that rise transfer to other rates? Suppose you decide that the minimum wage is too low, so you pay your gardener $50 per hour. Your gardener is happy. But that won't raise wages at McDonalds and Walmart to $50. This is what the Fed is worried about -- that it might end up paying interest to banks, but other interest rates don't follow.

Pennacchi on Narrow Banking

I stumbled across this nice article, "Narrow Banking" by George Pennacchi. The first part has a informative capsule history of U.S. banking.

George defines a spectrum of "narrow" banks. For example he includes prime money market funds -- borrow money, promise fixed value instant withdrawal, buy Greek bank commercial paper. But that is "narrower" than traditional lending, as the assets are short term and usually marketable.

Some interesting tidbits:

Prior to the twentieth century, British and American commercial banks lent almost exclusively for short maturities. Primarily, loans financed working capital and provided trade credit for borrowers who were expected to obtain cash for repayment in the near future

Therefore,

... the typical structure of these early banks contrasts with the modern view of banks, according to which the received wisdom is that “[t]he principal function of a bank is that of maturity transformation---coming from the fact that lenders prefer deposits to be of a shorter maturity than borrowers, who typically require loans for longer periods” (Noeth & Sengupta 2011, p.8)....maturity transformation was often considered a violation of prudent banking.

Regulation and competition

From taxis to banks, regulation is quickly captured to stifle competition. Only it's usually polite not to say it out loud. Today's WSJ has a lovely little piece, Regulation is Good for Goldman confirming the former and violating the latter pattern.

the Goldman Sachs CEO explained how higher regulatory costs are crushing the competition.

“More intense regulatory and technology requirements have raised the barriers to entry higher than at any other time in modern history,” said Mr. Blankfein. “This is an expensive business to be in, if you don’t have the market share in scale...

he said his bank is “prepared to have this relationship with our regulators”—and the regulators are prepared to have a deep relationship with Goldman—“for a long time.”

.. it is unusual to see a financial CEO like Mr. Blankfein state the effect so candidly. Goldman can afford to hire battalions of lawyers and lobbyists to commune with regulators... As ever, powerful government mainly helps the powerful.

I have met several people who started financial companies in the pre-Dodd-Frank era. They all say there is no way they could start their businesses now. Working out of the garage, you can't afford a multi-million dollar compliance department.

Run-Free Funds Expand

Louise Bowman at Euromoney reports

Fidelity Investments has announced plans to convert up to $125 billion-worth of prime US money market funds (MMFs) into government-only funds –

Meaning, funds that invest only in government securities.

...a move that is a direct consequence of the new SEC regulations covering this business that were announced in July.

...From October next year, MMFs must hold at least 99.5% of total portfolio assets in cash or government securities and repos collateralized by such instruments to be exempt from new regulations imposing fees and gates on such funds in times of stress. The rules are designed to slow deposit runs and reduce systemic risk

In case you missed it, in the financial crisis the Reserve Fund, which held a lot of Lehman debt, suffered a run, and too big to fail quickly expanded to money market funds.

What are they invested in now?

WIlliamson on Fisher, Phillips and Fjords

Steve Williamson has an excellent blog post "Pining for the Fjords" Point 1, the Phillips curve is dead, UK version. (And, too many are cheering, "Long live the Phillips curve!"). Point 2, Steve seems to have signed on to the new-Fisher view that a zero rate fixed for a long time, with apparently credible fiscal policy, will drag inflation slowly down, not up.

Point 1: The Phillips curve in the UK.

Source: Steve Williamson

Steve:

 ...from peak unemployment during the recession, the unemployment rate drops about 2 1/2 points, while the inflation rate drops about 3 points... Presumably utilization has been rising in the U.K., but inflation is dropping like a rock.

See his post for early and late samples, core inflation, etc.

The Phillips curve is not resting, sleeping, or pining for the fjords. It is dead, deceased, passed away. It has bought the farm. Rest in peace.

 Or, borrowing another picture from Steve,

Steve continues

The Bank Rate has been set at 0.5% since March 2009. Here's the latest inflation projection from the Bank: (Inflation returns to 2% now that unemployment has decreased.) So, like Simon, the Bank seems not to have learned that the parrot is dead. In spite of a long period in which inflation is falling while the economy is recovering, they're projecting that inflation will come back to the 2% target.

The best part, which you might miss at the bottom of his post

...20 years of zero-lower-bound experience in Japan and recent experience around the world tell us that sticking at the zero lower bound does not eventually produce more inflation - it just produces low inflation.

Beware of Greeks Bearing Bonds

Once again, the news is full of opinions that Greece might be forced to leave the Euro. Once again, it makes little sense to me. U.S. corporations, municipalities, and even states default, and do not have to leave the dollar zone as a result.

Most recently, the story goes, if Greek banks can't use their Greek government bonds as collateral with the ECB, the Greek government will have to leave the euro so it can print Drachmas to bail out the banks. There are of course many ways in which this makes little sense -- if the bank has promised Euros, then a Drachma bailout does not stop a default. The government would have to pass a law "converting" euro deposits to Drachmas. But consider the story anyway.

Another common story right now: If Greece were to default, it would have a hard time borrowing to fund primary deficits. By leaving, it can print up Drachmas to pay bills.

OK, here's the obvious solution: Greece can print up small-denomination zero-coupon bearer bonds, essentially IOUs. They say "The Greek government will pay the bearer 1 euro on Jan 1 2016." Greece can roll them over annually, like other debt. Mostly, they would exist as electronic book entries in bank accounts, but Greece can print up physical notes too.

Bachmann, Berg and Sims on inflation as stimulus

Rüdiger Bachmann, Tim Berg, and Eric Sims have an interesting article, "Inflation Expectations and Readiness to Spend: Cross-Sectional Evidence" in the American Economic Journal: Economic Policy.

Many macroeconomists have advocated deliberate, expected inflation to "stimulate" the economy while interest rates are stuck at the lower bound. The idea is that higher expected inflation amounts to a lower real interest rate. This lower rate encourages people to spend today rather than to save, which, the story goes, will raise today's level of output and employment.

As usual in macroeconomics, measuring this effect is hard. There are few zero-bound observations, fewer still with substantial variation in expected inflation.  And as always in macro it's hard to tell causation from correlation, supply from demand, because from despite of any small inflation-output correlation we see.

This paper is an interesting part of the movement that uses microeconomic observations to illuminate such macroeconomic questions, and also a very interesting use of survey data. Bachman, Berg, and Sims look at survey data from the University of Michigan. This survey asks about spending plans and inflation expectations. Thus, looking across people at a given moment in time, Bachman, Berg, and Sims ask whether people who think there is going to be a lot more inflation are also people who are planning to spend a lot more. (Whether more "spending" causes more GDP is separate question.)

The answer is... No. Not at all. There is just no correlation between people's expectations of inflation and their plans to spend money.

In a sense that's not too surprising. The intertemporal substitution relation -- expected consumption growth = elasticity times expected real interest rate -- has been very unreliable in macro and micro data for decades. That hasn't stopped it from being the center of much macroeconomics and the article of faith in policy prescriptions for stimulus. But fresh reminders of its instability are welcome.

At first blush, this just seems great. Finally, micro data are illuminating macro questions.