Saturday, February 28, 2015

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-Morleymoment, 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.


Controlling inflation is the first main task of monetary policy. Inflation, in the blue line below, has been slowly and inexorably declining over the last two decades, from 3% in 1995 down to a bit under 2% now. Inflation declines just after  recessions and rises again as the economy recovers.

Long term interest rates, in green, are a good measure of long-term inflation expectations. Long-term rates basically follow a linear downward trend, barely interrupted by economic events or short term interest rate movements. When Fed officials say "expectations are anchored" or "trending down" this is one of their main indicators. If you, like me, believe in low inflation, it's awfully hard to complain too loudly about the Fed!

Short-term interest rates, in red, fall reliably in recessions, stay at zero while output and employment remain low,  and then rise as the economy recovers.

However, the short rate hit the "zero bound" in 2008 and has been stuck there ever since.

When rates hit zero, the Fed started buying assets and issuing bank reserves in return. In this action, the Fed is  pretty much just acting as a huge money market fund that invests in Treasuries. You can see the  big upward jump in the recession, and then the QE2 and QE3 episodes.
Reserves were a few tens of billions before 2007. Their expansion is thus really breathtaking.

These are our Michelson-Morley observations. We hit the zero bound and... nothing happened. We expanded money -- reserves -- from tens of billions to nearly 3 trillion and... nothing happened.

Doctrines Overturned

The traditional view of monetary policy, including both "Monetarists" and "Keynesians," (bad labels, but they'll have to do for now) agrees on some core doctrines:
  • The economy is unstable.  If the Fed pegs the interest rate at a fixed value, either expanding inflation or spiraling deflation will follow.

  •  Raising interest rates lowers inflation. Lowering interest rates raises inflation.
Milton Friedman's 1968 AEA address eloquently explained how an interest rate peg could lead to spiraling inflation. Pundit after pundit has warned of the deflation spiral at the zero bound.

The top left pictures  illustrate the instability proposition. Peg interest rates, and inflation or deflation will explode. On the bottom left, I graph how rising interest rates are thought to lower inflation, and answer why we don't see the unstable inflation or deflation of the top graph:  Because, if inflation breaks out, the Fed really raises rates fast and bring it back down. Or vice versa as I have graphed it.
But if the Fed can't lower interest rates past zero, the unstable deflation breaks out.

It's like balancing an umbrella in the palm of your hand. If you hold your hand still, the umbrella tips over. If you want to move the umbrella to the left, move your hand to the right. But then move it fast to the left to keep it from tipping over. If your hand gets stuck, the umbrella will crash to the floor.

The last 10 years deeply challenge this view. Interest rates got stuck at zero. No spiral broke out. Inflation just calmly came down to join the interest rates. The economy is stable, as graphed in the top right.

That means that if the Fed raises interest rates and sticks them at a higher level, bottom right, inflation will eventually rise to meet it as well, as graphed in the bottom right.

Our experiment exactly overturns the classic doctrines:
  • An interest rate peg, if credible and expected to last for a long time,  and if people trust the government to pay its debts,  is stable. 

  • In the long run, raising interest rates to a new peg must raise inflation (and vice versa). 
OK, as they say at the University of Chicago, that's fine in the real world, but how does it work in theory? Though classic Monetarism and Keynesianism both predict that pegs are unstable, the "New-Keynesian" or "DSGE" paradigm that has dominated research both in academia and central bank staffs for the last 20+ years says otherwise. (Stephanie Schmitt-Grohe and Martin Uribe at Columbia have been leaders in pointing this out.) These models predict that inflation is stable around a peg, as in the right hand section of my drawing. Delightfully, we don't need a new theory to understand the fact slapping us in the face. The standard modern  theory does so already.

Much new-Keynesian research has focused on the "indeterminacy" problem: The models don't pin down which of the red lines in the top right of my graph will emerge. But that's beside the point here. And most new-Keynesian research models away from the zero bound where the theories imagine the Fed deliberately reintroduces instability, in order to produce results that look like the older theories. That's why less attention has been paid to the remarkable fact that this modern theory overturns the classic peg results.

That theory accounts for the caveats in my statements of new doctrine. Expectations matter in these models, and the stability result only occurs if everyone knows the peg will be there for the foreseeable future. Also, the result only holds when people are not worried about the government's ability to pay its debts. Sorry, Russia, Argentina and Venezuela. A zero peg will not stop your inflations.

You'd think we know the answers to simple questions like these. But empirical work in economics is always dreadfully hard because we don't usually see simple experiments. Look again at the graph of interest rates and inflation,

Interest rates and inflation are already positively correlated until 2007.  So where do we get the idea that lowering rates raises inflation, if the correlation goes the other way?

Well, other things aren't constant. In the conventional view, recessions come along and drive down inflation. The Fed lowers interest rates to head off even worse deflation. When inflation comes back up again, the Fed aggressively raises rates to stop it from getting out of control. That ends up looking just like inflation following interest rates.

The conventional view may even be right (and likely was, in the past) in the short run, as indicated by the question mark in the bottom right hand graph. If that's our world, we never see the long run, since the Fed is always using the short run effect to move inflation around.

That's why the zero bound is so dramatic. It's not so much the bound, as it is a unique period in which interest rates are pegged, and everyone knows they will remain pegged for a long time. Now we get to measure the long run effect at last. And lo and behold, it's stable!


Quantitative easing also gave us as clean an experiment as we could hope to see on the effects of money.  The Fed raised reserves from the tens of billions to the thousands of billions and.. basically nothing happened.

Yes, there is an ongoing argument about whether QE might have lowered interest rates a few tenths of a percentage point, and whether it did so by actual portfolio effects or just by signaling that the Fed was going to keep interest rates low for a very long time. But that's not really relevant here. That argument is about whether the Fed affected bond markets by what it bought. The issue here is about the other side, whether expanding reserves are inflationary.

Again, before we saw it, reasonable people could disagree. We didn't really know what would happen when the interest rate hit zero, or equivalently, when bonds and money pay the same interest rate. We hadn't seen zero rates since the 1930s. (OK, Japan, but let's keep going.)

Monetarists (I don't like labels, but whoever thought the reserve expansion would lead to a lot of inflation) thought that "velocity is stable." Meaning, that there is a limit to how much money people want to hold, even when money pays the same interest rate as bonds. V will decline at zero rates, and M will rise without causing inflation. But at some pointV will stop declining, and more M through MV=PY will cause more P, inflation. The money demand curve hits the vertical axis and stops. With a doctrinal bullet point,
  • Velocity is stable. Even at zero interest rates, past some point, additional money (reserves) must cause inflation. 
The alternative view (mine too) is that once interest rates hit zero, or money pays the same interest rate on bonds, money and bonds are perfect substitutes. People are happy to hold unlimited quantities of money rather than short term bonds.

Well, we got about the best experiment we'll ever see.  The sheer size of the experiment is just overwhelming. MV = PY. M increases, not by 10%, not by 100%, but by 10,000% ($30 billion to $3000 billion). And inflation goes slightly down. V just took up all the slack. It turns out the equation is V = PY/M when money and bonds pay the same interest.

So once again we have a classic doctrine decisively overturned. In its place let me offer
  • Reserves that pay market interest are not inflationary. Even in enormous quantities. 
Going forward interest rates will not be zero. But reserves will pay the same interest as Treasuries. So this is a vitally important doctrine to digest. The huge balance sheet isn't doing any stimulating or inflating. There is no danger in letting it sit there. So long as the Fed continues to pay market interest on reserves.

The Mechanism 

Another huge change lies ahead. When it finally is time to raise rates, The Fed will not sell off the balance sheet. Instead, the Fed will simply pay more interest on reserves, and trust that this interest rate spreads to the rest of the economy.

This change marks a fundamentally different mechanism for monetary policy. Recall the standard story for how monetary policy works: Banks are holding as few reserves as they can, because reserves don't pay interest. The Fed reduces the amount of reserves by a few billion dollars. Now banks don't have enough reserves. They try to borrow reserves from each other, raising the interest rate. But collectively they can't get more reserves, so they have to cut lending and deposits to get back in line with reserves. Less lending or deposits cools the economy and eventually inflation.

I say "story" because I don't think that's how in fact things used to work. But we can't even pretend that's how things will work now. The Fed will just pay more interest on reserves. Banks will have trillions more reserves than they need. Raising the rate on abundant excess reserves has no direct connection at all to lending or deposits.

We're going to have "tightening" (interest rate rise) without any actual "tightening" (reductions in money, reserves.) The only way that monetary policy can work at all is from interest rate effects. Higher interest rates might  induce people to spend less today and save more, and this will reduce output and then (somehow) inflation.

So, that leaves us with big open questions. Can the Fed raise rates by just raising interest on reserves? Will the effects on the economy be the same if the Fed raises rates by raising interest on reserves as it was when the Fed raised rates by rationing reserves?

By analogy, money is like oil in cars. In the old days, if traffic on the freeway was too fast, the Fed would ration oil. Running on two quarts slowed the cars down.  It also led to higher motor oil prices (interest rates) as drivers tried to buy oil from each other. But now each car has thousands of quarts of oil, and the Fed isn't going to try to throttle the cars with oil at all. The Fed is just going to manipulate the price of motor oil, and count that drivers will slow down because they find it more expensive to drive. That's great for efficiency and financial stability. Throttling cars with oil starvation is not good for the cars. But one may wonder if the effects of a motor oil price increase will be the same under the new mechanism.

Can the Fed raise rates? 

This seems like a silly question, how can academics question such an obvious proposition. But it's not so obvious, and if you read between the lines the Fed is deeply worried about it. Will just raising interest on reserves be enough to raise all interest rates?

To give some sense of the issue, I made the following little picture of the financial system. (Yes this is almost a parody of economist charts. )

On the left, the Treasury issues debt. About $11 trillion is held directly by you, me (through private financial intermediaries including pension funds) and by foreigners including the Chinese central bank. About $4 trillion is held by the Fed, and about $2 trillion is held directly as assets by the banking system. Like any bank, the Fed just passes through assets to liabilities. Its liabilities are about $1 trillion of cash, and $3 trillion of reserves. (This is all very simplified of course.) Banks also hold about $6 trillion of commercial and real estate debt. And we hold stocks, bonds, mortgage backed securities, houses, businesses and so forth worth tens of trillions.

OK, now, the Fed wants all the interest rates in this picture to go up, by raising interest rates on reserves.


"Honey, low-wage people in this country don't get paid enough. Let's pay the nanny $50 per hour."

"Well, the nanny will be happy, but how is that going to help everyone else?"

"Don't you see? When our nanny gets $50 an hour, then the others will demand that much, and workers at Walmart and MacDonalds too, and next thing you know everyone will get $50 per hour more."

"Hmm. That's not one of your brightest ideas. But tell me please where are we going to get the extra $50 per hour?"

"That's the beauty of the whole thing. When all wages go up $50 per hour, we'll be earning $50 per hour more, and we just pass that on to the nanny!"

You can see why the Fed might be up at night worrying that it will work.

I think it should work, despite this funny story. Banks  should compete for deposits, sending deposit rates up. Treasury holders should try to dump treasuries to hold deposits, until those rates rise. And so on. But "compete" and "banks" don't sit well in the same sentence these days, so you can see why the Fed might be a bit nervous about it.

How will raising rates affect inflation? 

How will raising rates affect inflation? Again, there will be no reduction in reserves, no reserve requirement tightening, no scramble to borrow reserves from other banks. There will just be a carrot of higher rates. Will tightening without tightening, but just through rates, have the same effects?

Hence the question mark in my four-graph picture.  Monetary policy with interest on reserves worked through a simple off-the-shelf new-Keynesian model. It  finds that there isn't even a short run contractionary effect on inflation, and an increase, not a decrease, in output. I'll leave that for another day. For now, recognize that history and theory do not definitively answer the question posed by the question mark, because the mechanism is entirely different.

The future

This is a pretty radical blog post. Most of the monetary economics used by our policymakers is wrong*. That would seem to forecast disaster. But I don't think it does.

Suppose I am right, and the Fed starts very slowly and gradually raising rates, as they promise to do. The result will be a slight increase in growth and after a delay, a slight increase in inflation. The Fed will feel reassured that it raised rates at the right time in advance of the growth and inflation, not recognizing that it caused the growth and inflation. Still, though I'd rather have zero inflation rather than 2% inflation, a period of slightly greater growth and a return to 2% inflation would not be a disaster.

Despite my view that standard doctrines are completely upended by recent experience, the Fed is following a path that works well under lots of different models of the economy, a wise robustness. If it listened to people with extreme views like mine, it would have put more credence in the hyperinflation or deflationary spiral camps, to our detriment.

If you want to worry, worry about shocks that might hit the economy or the government, not the results of the Fed's slow and deliberate interest rate increases in a background of steady if too-slow growth and low inflation. Worry about Grexit, Putin, sovereign default, some new credit crisis. If you want to worry about the Fed worry about reactions to such crises, or worry about regulation gone wild.

The last big lesson we learn from recent experience is
  • Monetary policy is a lot less powerful than most people think it is. 
Bad monetary policy can screw things up. But our growth doldrums are not the result of monetary policy, nor can monetary policy do a lot to change them.


(1) In case you don't know, this is the famous physics experiment that measured the speed of the earth through ether by measuring the difference in speed of light looking forward vs. sideways given the earth's motion. The experiment found the speed of light the same in all directions. It's a famous negative result -- nothing happened, the dog did not bark -- with momentous consequences, in this case the theory of relativity.

*Update: A friend wrote to upbraid me a bit:

"Not sure why you want to try so hard to label yourself radical.  Much of what you said was conventional wisdom among the folks I talked to at the Fed.  Perhaps you should try 'The best minds at the Fed and other radicals like me think....'"

I'm happy for any company!


  1. Nice.

    If people give you grief about Neo-Fisherism, hit them with this Keynes quote:

  2. Would you expect to get a short-run contractionary effect on inflation if you included some term debt in your off-the-shelf New Keynesian model? It looks to me very much like that is what you would get.

    1. The debt you refer to must be private debt, with a bankruptcy constraint of some sort.
      The model (in "monetary policy with interest on reserves") produces contractionary effects when monetary policy shocks are paired with fiscal policy shocks. Which they usually are, as money and fiscal policy are reacting to the same events, not flipping coins for the benefit of empirical economists.

    2. No, I meant public debt. I was also assuming no fiscal shocks, i.e. holding the expected value of future surpluses constant.

      Take an extreme case where virtually all public debt is a five year zero. Then, by your valuation formula, whatever happens to rates now won't change the price level at the time of redemption of the zero, because that's fixed by the redemption value and real surpluses thereafter. So if nominal rates (on the small amount of short term debt) are higher before then, implying expected inflation, the price level has to first move to a lower starting point.

  3. In this action, the Fed is pretty much just acting as a huge money market fund that invests in Treasuries. --John Cochrane.

    Well, except that the Fed prints up (digitizes) it own cash. It does not have to draw down someone's cash to buy the Treasuries, like a private sector money fund. The Fed, in contrast, adds to someone's cash pile when it buys Treasuries.

    I understand that the Fed and Fed-followers thought for generations about expanding reserves as stimulus. (That is, when the Fed buys Treasuries, it credits the commercial bank accounts of the 22 primary dealers with deposits or reserves). Banks, with more reserves, could lend more, the multiplier and all that.

    But when the Fed buys $4 trillion in bonds, the stimulus comes from the bond buying itself. The Fed printed up (digitized) $4 trillion and bought bonds with it. The bond sellers, who before had inert bond instruments, have fresh live cash instead.

    So, when the Fed did $4 trillion in QE, it not only credited primary dealers with $4 trillion in deposits (reserves at commercial banks) it also printed up $4 trillion and flooded that into the hands of bond sellers. The Fed created $4 trillion in reserves and $4 trillion in cash. No one or the other--both.

    Do you think $4 trillion in fresh new investable or spendable funds might have been stimulative?

    1. The Fed took in $3 trillion of treasuries -- electronic book entry liquid interest paying government debt -- and gave out $3 trillion of reserves -- electronic book entry liquid interest paying government debt.

  4. "Another huge change lies ahead. When it finally is time to raise rates, The Fed will not sell off the balance sheet. Instead, the Fed will simply pay more interest on reserves, and trust that this interest rate spreads to the rest of the economy. This change marks a fundamentally different mechanism for monetary policy."

    Good post. The four graph picture is very useful.

    That being said, I disagree with you that we will be seeing a fundamentally different mechanism for monetary policy. Norway's central bank, the Norges Bank, ran a floor system for most of the 2000s and had no problem executing both a number of tightenings and loosenings. If the Norwegians got a floor system to work, so can the Americans.

    1. Yes. I was trying (!) to keep it short. But there is extensive experience with corridor systems from many countries. I think we were basically on one already; the story about reducing reserves and driving up the funds rate just wasn't true. The Fed didn't DO any actual open market operations when it raised rates, it just said rates should go up. Japan is also a longer experience at the zero bound, a bit of deflation here and there but no sign of an unstable "spiral."

    2. Just so we understand, the interest that is paid on reserves is directly equal to the interest that the federal government pays on Treasury debt held by the central bank. And so that begs the question - is interest on reserves a monetary policy action or a fiscal policy action assuming that all interest payments on Treasury debt are made from tax revenue.

  5. But our growth doldrums are not the result of monetary policy, nor can monetary policy do a lot to change them.--John Cochrane.


    Okay, let me ask it this way: From 1976 to 1979, real US GDP expanded by 20%, following the 1974-5 recession.

    Arthur Burns was Fed Chair.

    What propelled such stupendous growth (by today's standards) in 1976-79? Choose 1, 2 or 3.

    1. The election of President Jimmy Carter. A revival of animal spirits and confidence that Carter inspired (I hope you are old enough to remember this period).

    2. The Democrat-controlled U.S. Congress wiped away years of cluttering GOP structural impediments, and the economy blew the roof off. Carl Albert, House Speaker back then, is an unsung national economics hero. (I hope you remember Carl Albert, this joke will be funnier).

    3. The Fed printed money, even way too much money. Real GDP rose 20%, but prices hit near double digits.

    A good bet is that monetary policy did result in a robust expansion in 1976-9, and then inflation.

    If monetary policy provoked growth then, why not now? And probably with far less inflationary consequences...we are not as inflation-prone as back then.

    Really, I do not think the purpose of monetary policy is mild deflation. The purpose is to promote robust economic growth.

    1. Aah for the good old days when recoveries from recessions were actually recoveries. Back then if GDP went down 10%, it actually bounced back up all on its own.

      But to the point, I said "our growth doldrums," i.e. 2008 and on. Monetary policy has caused much mischief, many booms, crashes, and inflations in the past.

    2. I love your answer to Benji's 1, 2, or 3

  6. What would have happened if they had never paid IOR in the first place and stuck with textbook Open Market Operations?

    1. Until now, very little would have been different, as they're paying tiny interest on reserves. But, before raising rates they would have to sell $3 trillion of Treasuries.

  7. Cochrane: natural experiment shows that the economy is not unstable at the zero lower bound, contra predictions of theory. "We hit the zero bound and ... nothing happened" to interest rates or inflation. "The economy is stable."

    But we've also experienced punishing unemployment while at the zero lower bound.

    What happens when you include unemployment in your empirical story?

    1. John, you're on a roll here! A couple of things in relation to this:

      "Reserves that pay market interest are not inflationary. Even in enormous quantities. Going forward interest rates will not be zero. But reserves will pay the same interest as Treasuries."

      First, as I've pointed out before, interest-bearing reserves *can* be inflationary if the carrying cost is financed by money printing.

      Second, the caveat here is "as long as reserves pay market rates." But what are we (you) assuming here? It seems like you are assuming that the Fed must *follow* market forces in adjusting its policy rate (to keep inflation in line). Or, is it safe to assume that the Fed *sets* the policy rate (so that the nominal yields on bonds will follow whatever the Fed chooses as its IOER rate) and that inflation will ultimately be determined by the Fisher equation (with fiscal support)?

      That was a bit convoluted, but hopefully you can understand what I'm asking. :)

  8. The Fed has said it's targeting price stability with 2% inflation. If that is credible, and it seems to be, then neo-fisherism can't be right. Because if rates are inconsistent with 2% inflation, then it's rates that the Fed will change, not inflation. Neo-fisherism would require that a change in interest rates by the Fed cause a change in the Fed's inflation target. Why?

    1. First,

      The Fed in open market operations does not set an interest rate, it sets a bond price.

      The interest rate that any government security pays is set at auction and remains fixed. The central bank is not by law permitted to directly submit bids on U. S. government debt.

      Treasury has begun selling floating rate notes, but the interest rate offered on these is based upon the auction result of 13 week notes (Why anyone would buy these is beyond me). Again, the central bank cannot directly submit bids on these.

      Neo-Fisherism can be right because it is about interest rates not bond prices. The central bank in open market operations sets bond prices, not interest rates.

  9. John Cochrane: you are correct in that Fed created $3 trillion in reserves and took in $3 trillion in Treasuries. But Treasury bond sellers also got $3 trillion in cash. You ignore the final component. What does it mean when bond sellers get $3 trillion in cash?

  10. The Federal Reserve Bank of New York goes to its Primary Dealers and offers to buy securities. During the first two rounds of Quantitative Easing the Federal Reserve focused its purchase activities on US Treasuries. During round three it has committed to buying Mortgage Backed Securities (MBS) at the rate of $40 billion each month.

    The Federal Reserve currently deals with 21 Primary Dealers, which include banks and securities broker-dealers. These Primary Dealers have agreed to serving as the Fed's counter-party in executing its monetary policy. Note that the Primary Dealers are generally global and diversified financial institutions.

    Primary Dealers often hold inventory of US Treasuries and MBS as part of their day-to-day business activities. When the Fed goes to the market to purchase new securities, the Primary Dealer can sell the Fed its inventory as well as bid out the offer to the Primary Dealer's clients, who might include pensions, hedge-funds or sovereign wealth funds who own US Treasuries or MBS.

    At the completion of the purchase, the Federal Reserve moves the purchased security on to its balance sheet as an asset and electronically credits the Primary Dealer with cash equal to the purchase price of the security. Now this leads to an interesting question, where does the Fed get the cash to buy US Treasuries and MBS from the Primary Dealers? It can create the cash electronically and literally create money "out of thin air."

    The Primary Broker or its clients now have an option; 1) they can keep their cash or 2) they can use the cash for a variety of purposes (lending, purchase of other securities or business operations). The Fed is hoping that the Primary Broker and Clients will choose the latter. The Fed's policy results in artificial stimulation of the demand for Treasuries and now MBS and thus drives prices higher (and yields lower).

    The Fed also anticipates this to have a ripple effect through other investment vehicles as the Primary Brokers and its clients seek alternatives to deploy their new cash. The Fed may only be operating in a couple of markets, but it anticipates its impact to be felt throughout the financial eco-system and ultimately the real economy.

  11. I’d be delighted if the Fed had difficulty adjusting interest rates as a result of the large amount of base money / reserves sloshing around. Reason is that if aggregate demand needs adjusting, I see no reason to adjust ONLY lending based activity. That’s clearly distortionary: you might as well adjust only high energy consuming economic activities.

    Moreover, expanding the monetary base as a proportion of the total money supply is an inevitable consequence of a policy which John Cochrane rightly supports: removing run-prone liabilities from the liability side of commercial banks’ balance sheets. Those “run-prone liabilities” are actually plain simple old fashioned “money”, as it’s commonly called. And under the banking system advocated by JC (as I understand him), those liabilities are replaced by shares, and shares are not money. I.e. a wholesale removal of run-prone liabilities from commercial banks’ balance sheets results in the only form of money in existence being base money.

    There might seem to be a problem involved in adjusting demand JUST VIA fiscal rather than monetary means: it might see that that inevitably means getting politicians (aka Neanderthals) involved in stimulus decisions. In fact it’s perfectly possible to leave decisions of the SIZE OF STIMULUS in the hands of a committee of economists, while the exact nature of additional spending (e.g. whether the extra money goes to roads, education or whatever) stays with politicians. For details on how to do that, see p.10-12 here:

  12. Dear Prof Cochrane, your story is brilliant. However, quantitatively, your story has very disturbing implications for the real interest rate.

    So you say, the nominal interest rate hit the zero bound, and the inflation rate settled down calmly with the nominal rate instead of spiraling out... Very good, but the inflation rate settled at (positive) 2%! By the Fisher equation, the implied equilibrium real interest rate where we have settled is (negative) -2%!

    In other places you have stated that the long run real interest rate is about (positive) 6%. The real interest rate of -2% where we have settled is by 8% off from the plausible value of what long term real interest rate should be. In general, are negative equilibrium real interest rates not a problem in this class of models that you mention? (New Keynesian, RBC with some price stickiness.)

  13. "Raising the rate on abundant excess reserves has no direct connection at all to lending or deposits." Why not? Is the banking system suddenly a cartel that is fixing prices? This is related to the Fed's worry that raising IOR will not affect other interest rates. OK maybe 25 basis points wouldn't do much, but how about 100 basis points? 200 basis points? How about selling (without a promise to repurchase) some of the stuff on the balance sheet? Are financial markets still functioning so poorly that selling all of the $2.4T in treasury bonds and notes would really have "no direct effect at all on borrowing and lending"? I feel as though there are these unspoken rules that the Fed and member banks have agreed to that I'm not aware of. What are they?

  14. All quantitative easing did was transfer wealth from the middle class to the wealthy. It was socialism for the rich. Pensions and savings have been and are being wiped out.

    Also, there is no chance the Fed will ever raise rates again. They have said they will raise rates many, many times since 2009. It was talked about in Spring 2010. Spring 2011. Spring 2013. All throughout 2014. And now 2015. It will never happen. The market has already pushed back its prediction for a rate hike from 1H 2015 to October 2015 and it will continue to be put off indefinitely. Janet Yellen will never raise rates in her term.

  15. The level of interest rates is a poor metric for the stance of monetary policy. I personally like the slope of the curve.

    M1 is a poor metric for the money supply. M3 growth has been been pretty meager throughout all of this "QE."

    But the real question... does raising interest rates without reducing reserves actually do anything is an interesting one.

    1. Douglas,

      "But the real question...does raising interest rates without reducing reserves actually do anything is an interesting question"

      I am not sure which rate you mean. Are you talking about the discount window rate? Discount window lending by the central bank is a relatively small operation and so I am not sure what would happen if the Fed raised that rate while doing nothing else (no reverse QE). Would other interest rates rise with it? I imagine that credit spreads would widen. Banks making private loans may demand a higher interest rate if they use the discount window as a backstop.

  16. "OK, as they say at the University of Chicago, that's fine in the real world, but how does it work in theory? "

    Haven't you got your priorities the wrong the way around? What is so important about the theory? Are you really sure you have got the real world explanation right? That's all that matters.

    1. IT WAS A JOKE! Really, let's not totally lose perspective just because we're goofing off on the internet instead of working.

    2. Thanks for reassuring us John. I guess some of us worry about people being contained in ivory towers.

  17. Suppose the Fed credibly pegs rates at 3%, and inflation rises to 2%. What happens next - does the Fed raise (lower) rates in response to deflationary (inflationary) shocks?
    It seems reasonable that raising rates from 0 to 3% could raise inflation. But raising rates from 3% to 6% seems less likely to lead to higher inflation.

    1. Anonymous,

      You will notice in John's 4th graph (mild Neo-Fisherian view) that the inflation rate rises to a point below the nominal interest rate.

      The spread that you see is a combination of two factors - productivity growth and the tax deductibility of interest payments - or perhaps they are the same factor with two different names?

  18. Child of the 1970s here, biased toward seeing inflation under the bed, so perhaps that explains my concern here. How can the Fed afford to pay these interest rates on reserves forever and so keep the reserves from flooding out into the economy in the form of loans or other investments? It seems to me that there is a transversality problem with this prescription of infinite reserve growth paid for by infinite monetary creation.

    1. SRP,

      Interest on reserves is simply interest on government bonds paid from taxpayers through the central bank to private banks that keep money at the central bank as reserves.

      In essence, the central bank is acting as proxy for private banks - coercing them to buy up U. S. government debt.

    2. No, I don't think interest on reserves is like interest on federal bonds. The latter are obligations of the taxpayer through the Treasury. The former are not--the Fed's monetary operations aren't part of the fiscal budget of the U.S. government. Of course, the Fed owns a vast portfolio of government bonds, originally purchased with newly created money, but the actual net purchasing power being handed to the banks comes from the monetary creation. If the Fed increases its interest on reserves the taxpayer is not on the hook for increased taxes.

    3. SRP,

      "If the Fed increases its interest on reserves, the taxpayer is not on the hook for increased taxes."

      That would depend if the federal government is running a deficit or surplus / neutral at the time the central bank raises the discount rate / sells government obligations. If the federal government is running a deficit, then the increase in rate(s) will likely be reflected in interest rates on new government bond auctions, and so the tax payer would be on the hook for the increased interest costs of new government issuance.

      "No, I don't think interest on reserves is like interest on federal bonds."

      The central bank (to my understanding), cannot literally print up interest payments. It can print up money to buy government bonds, and can accept money when it sells government bonds.

      It remains to be seen whether the central bank can buy government bonds on a large scale at a premium and / or sell them on a large scale at a discount - effectively this would be the same as the central bank printing up interest payments.

  19. Good post--- very clear and insightful.

    The big problem with raising interest rates on bank reserves is that in the short run there will be quasi-rents to the banks. They'll compete for deposits, to be sure, but it takes a while to get deposits away from your competitors, and one good strategy will be to keep your depositor interest rate low and make big profits in the short run, even though in the long run youll lose customers. Or, there'll be higher interest rates for new depositors, sort of like with phone company plans. Politically, it will look bad for the Fed to give money to the banks this way.
    Would there be some way to structure it so only a bank's increase in reserves get the higher interest rate? That could be gamed, if done simply, but maybe here's fancy way to do it.

    Why not sell off Fed high-interest assets? They're not a substitute for money. Or are they, indirectly?

  20. I've a question on copyright - any advice greatly appreciated:

    On a previous post prof. Cochrane linked to a .pdf from a book copyrighted by Stanford where he has written chapter 10. Yes I do worry about fair use and the like but I'm not a lawyer so my question is if it's OK to quote the following in a different venue. Thank you.
    John Cochrane, excerpts from “Across the Great Divide”, ch. 10. (copyright Stanford University)

    “……..“liquidity” no longer requires that people hold a large inventory of fixed- value, pay- on- demand, and hence run- prone securities. With today’s technology, you could buy a cup of coffee by swiping a card or tapping a cell phone, selling two dollars and fifty cents of an S&P 500 fund,
    and crediting the coffee seller’s two dollars and fifty cents mortgage- backed security fund. If money (reserves) are involved at all—if the transaction is not simply netted among intermediaries—reserves are held for milliseconds. In the 1930s, this was not possible. “ p. 199

    “Many lenders are not legally eligible to hold the posted collateral, so those lenders may
    have to dump the collateral immediately upon receipt. Having to unload a large portfolio of securities on the Monday afternoon of Lehman’s bankruptcy is not a picnic. Better to refuse rolling over the loan on Friday.” p. 205

    “..a coordinated rise in risk premiums, even in completely un- intermediated markets and even
    after intermediation frictions washed away, was a major characteristic of financial markets in the fall of 2008…” p. 210

    “Floating- value funds generate a capital- gains tax record- keeping nightmare. Fixed- value funds appear as cash on balance sheets. Both facts are part of the implicit subsidies given to run- prone securities by many laws and regulations…” p. 225

    “…if you have a big firehouse, then people start to store gas in the basement and don’t keep their fire extinguishers ready. Sending an army of regulators around to make really sure nobody ever lights a match is not that effective. This moral hazard is well- known, but it is perhaps not so well- appreciated just how much more fragile markets are as a result of a century of crisis management….” p. 241

    “…If you still have any trust in regulatory prescience—or the ability of prescient individual regulators to take unpopular actions while trying to “bolster confidence” and prop up weak institutions—consider the astonishing fact that, with the financial crisis just behind them, European bank regulators still treated sovereign debt as a risk- free asset to banks….” p. 243

    “What happens if the sovereign defaults or severe inflation looms so there is effectively a run on government debt? Sovereign default, inflation, or currency devaluation are different kinds of
    crises altogether from a run or panic in the private financial system. […] So, creating a run- free financial system reduces the chance that a private crisis will spill over and become a sovereign crisis. Constructing a financial and monetary system which is immune both to private and to public default is an interesting question. Rather than pursue a fundamentally different monetary standard—substitute bitcoins, gold, or SDR (special drawing rights) for short- term nominal Treasury debt—I think fairly simple innovations in government debt would suffice. If the government were to issue long- term, ideally perpetual, debt that comes with an option to temporarily lower or eliminate coupons, without triggering a legal or formal default, then government financial problems could be transferred to bondholders without crisis or inflation. Reputation and a desire to issue future debt at good prices would lead governments voluntarily to pay coupons when they can.” pp. 245-246


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