Thursday, August 2, 2012

The Fed "disappoints" and that is good

Seems there were a lot of people hoping that the FOMC might decide to "do something" about the persistently weak recovery. Instead, while yesterday they acknowledged that economic growth has "decelerated somewhat over the first half of this year," they added merely that they will "closely monitor incoming information ... and provide additional accommodation as needed." That's hardly a clarion call for more aggressive monetary ease, and that's a good thing, because there's not much more they can or should do at this point.

Thanks to two Quantitative Easing programs, the Fed has already created an astounding $1.6 trillion of bank reserves—17 times the amount that existed prior—of which $1.5 trillion remain on deposit at the Fed in the form of Excess Reserves. In order to support the current level of bank deposits, banks only need about $100 billion of "required" reserves, leaving $1.5 trillion available to make new loans and otherwise expand the money supply. If banks are content to hold $1.5 trillion of excess reserves today, would they be much less willing to hold the same amount of reserves if the Fed cut the Interest on Reserves to 15 bps (from the current 25) as many have suggested they should? It's hard to believe that a 10 bps reduction in the yield on excess reserves would make a significant difference. (Going to zero might make a small difference, but it would also drive money market funds out of business or force them to pay negative interest rates.) If the banking system prefers to earn almost nothing on a mountain of excess reserves instead of making loans at a rate that is many multiples of that, then that can only mean that banks are too risk-averse to make more loans today, and/or borrowers in aggregate are too risk-averse to take on more debt.

In other words, the problem of weak growth cannot be traced to any shortage of money or lack of sufficient reserves, or to the level of short-term interest rates. Risk aversion and a lack of confidence are the most likely culprits, and it's hard to see how a Fed that repeatedly acknowledges that it is very concerned about the outlook for growth is making any positive contribution to the problem.

Should the Fed attempt to force-feed the financial markets with new lending? Argentina is trying to do this, by ordering banks to increase their lending between now and year end, and to do so by making loans with interest rates lower than the current level of inflation. Last time I checked, that move hasn't made a whit of difference to the Argentine economy, but it has helped push down the value of the peso on the black market, where pesos now trade at a 32% discount to the official exchange rate.

Should the Fed adopt negative interest rates? That's just another way of force-feeding money into the economy: encourage more borrowing by ensuring that borrowing costs will be lower than inflation and lower than nominal GDP. Borrowers are almost sure to win, but lenders are almost sure to lose. That's a zero-sum game that can't result in any positive contribution to growth. Money gets pumped into real estate and commodities (i.e., into real assets that will likely benefit from higher inflation) and into speculative (e.g., leveraged) activities, but not necessarily into productive (i.e., job-creating) activities. Indeed, the transparently inflationary nature of policies such as this can only induce greater risk-aversion. That's why Argentina's economy is sinking rather than picking up, precisely because the government is so transparently trying to goose lending.

Can the Fed do anything to reduce risk aversion and boost confidence, and thus address the real underlying problems? Well, yes: they could refrain from pumping yet more reserves into an already-over-stuffed banking system, and they could refrain from reducing already-very-low short-term interest rates to zero. And that's exactly what they did with their statement yesterday. They have reduced risk aversion because they have reduced the chances of a catastrophic error of monetary policy, in which they are slow to reverse their accommodation, thus creating a huge excess supply of money which could be very inflationary. That helps explain why the dollar today is trading at close to a two-year high against other major currencies, and why gold is down 16% from last year's high.

What the Fed has yet to do is explain in greater detail why monetary policy cannot provide a magical solution to the world's problems at this point—that fiscal policy holds the key to future progress. On that score we are still waiting to see credible attempts to rein in the size and scope of government and to minimize tax and regulatory burdens in most of the world's major economies. Draghi can't come up with a ECB program that will fix that overnight; the ECB, like the Fed, can only do so much.


Squire said...

Really, the goal has to be to cast off all the shackles of political correctness, public employee privilege, and the false promise of egalitarianism. One idea for reducing the monopolistic powers is to eliminate the IRC (Internal Revenue Code). It is an edifice to the greatest corruption that 30 to 40 years of liberal legislatures (both Republican and Democrat) could devise. Elimination of such eliminates a major amount of lobbying for government privilege as there would be no way to provide it any longer through the tax code. Think of all the lawyers and accountants that would be made available to do real work again.

John Short ad sinorazum said...

FED should remove interest on excess reserves. The payment of the interest is deflationary, and the excess reserves interfere with the money market mechanism as it competes for the same liquidity. So if they remove the interest on excess reserves being paid, they create an inflationary effect, which is needed to get the economy going again. The ECB noticed that and took action, yet the FED is incompetent.

Dan said...

That's one of the most logical ideas I've heard yet. How does it stand up to all the pundits here?

scottmba09 said...

With new Tier 1 requirements coming, regulations crimping bank earnings coming, and the U.S. gov't playing russian roulette with the economy, would you lend? These banks just passed stress tests (not all of them!) in March, did we all forget that?

Benjamin Cole said...

There is a newish school of thought (although the school draws heavily upon Milton Friedman), Market Monetarism, that contends there is a great deal more the Fed could do, and the consequences would be beneficial, and involve little inflation.

Paying interest on excess reserves is a dubious policy at this point, since we are so close to zero bound. Banks have an incentive to merely collect interest on their excess reserves, as paid by the Fed. Free money at no risk.

A sustained QE program, with the target being nominal GDP growth rather than a set amount in a set tim frame, is another good idea.

Milton Fridman addressed these very issues in his classic pice for the Hoover Institution, here:

To Japan's stagnated economy, Friedman advised:

"The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia."

So Friedman contended even if banks tend to sit on the money, the increase in th money supply would be beneficial, provided the central bank has enough resolve (which Bernanke lacks, and did the BoJ).

It saddens me that the American right-wing has devolved from orthodoxy into dogma, and now incorrectly recounts the lessons the Friedman and others. The menace to American prosperity is now equally threatened from the right and left.

Happy voting, all.

Monetary policy is not only about "fighting inflation," it is there also to provoke real growth, as so admirably understood and related by Milton Friedman.

Oddly enough, back when inflation was running at 4 percent to 5 percent, Reagan Treasury Secy Don Regan suggested moving the Federal Reserve, or at least key powers, back into the Treasury Department. Regan was lividd at Volcker's inflation-fighting stance, after the back of inflation hard been broken.

See here:,8412282&hl=en

The current inflation-phobia (when inflation is running in sub-twos, and for the last four years at record low rates) is simply inexplicable. Some sort of monetary asceticism or Theo-monetarism has seized people who should be more concerned with gal growth.

Mitt Romney is, of course, a cipher on monetary policy and nearly everything else, except he wants tax breaks for people who have $250 million in Cayman Island bank accounts. Romney recently praised Poland's economy, a nation that devalued its current by 50 percent, and sidestepped Euro-troubles. But Romney is so inarticulate we do not know what part of Poland's policies has was enamored of.

Without Fed resolve for growth, look for the DJIA and property markets to remain soft, possibly for many many years. See Japan.

KD said...

Scott, I'm still really confused about how you can come to the conclusion that it's fiscal policy that will 'work' at this point, but also think that the key is fiscal contraction. At a sector balance level the government deficit has to equal private sector savings (excluding the foreign sector) so if the government doesn't run a deficit then the private sector as a whole, by definition isn't saving- that's just simple accounting.

I don't think there's any question that the private sector is trying to deleverage from the huge levels of debt that had been accumulated so it seems like pretty basic logic that the government needs to fund that through deficits. There is certainly a political question about the best way to run a deficit (bridges to nowhere or tax cuts etc), but how can cutting the deficit do anything other than tank a deleveraging economy right now? Confidence? That seems like a pretty weak argument against accounting logic and with treasuries around 0 or negative. The supply side is doing great right now with record profits, I find a hard time believing that the major problems aren't clearly on the demand side right now.

Also I think at the operational level, banks make their loans based on the perceived credit worthiness of borrowers and then borrow reserves to meet requirements. Operationally the reserves themselves can't be loaned out so there's no inflationary pressure there at all.

Squire said...

KD. Wa What? Citizens in aggregate can’t save money unless the government runs a deficit? What is that, Modern Monetary Theory? If it is then the answer is I just don’t understand Modern Monetary Theory as that is always the answer from MMT’ers.

KD said...

Squire. That's not MMT specifically, it's an old-fashioned boring accounting identity. Type 'sector balances' into Google and you'll see charts going back showing the government and private sector run exactly opposite balances (with the foreign sector comprising the difference).

The difficulty with national accounting is how different it is from personal accounting. Of course I can decide to forgo a latte, drive my old car another year and save that money regardless of what the government does with it's budget, but the problem then is that at the national level my spending is somebody else's income so my saving is somebody's lost income. If we all collectively decide to save more (as we're doing now collectively paying down debt) then overall income and therefor spending is going to drop... unless the other sectors pick up the slack.

The accounting identities point to a requirement for government deficits to finance private savings. Again, it's a political question about how that should best done and there are obviously better and worse ways to handle it. But unless you disagree with the need for the sectors to balance out to 0 the logic is tough to disagree with.

Squire said...

MMTer’s don’t understand balance sheets and their interaction with income statements and are stuck on the income statement. Savings from surplus doesn’t take away from the income of someone else. Wealth creation actually does happen and it shows up on the balance sheet.

Another wacky MMT thing is the belief that there can be no money created without deficits. That is, government bonds are needed for the creation of money.