"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Monday, August 30, 2010

Really good links - QE - Kocherlakota - Mother of all bank runs - Flight to safety - Basel - Bond bubble

Alan Blinder - QE - "If the FOMC is serious about re-entry into quantitative easing, it should buy private assets, not Treasurys. Which assets? The reflexive answer is: more MBS. But with mortgage rates already so low, how much further can they fall? And would slightly lower rates revive the lifeless housing market?
        To give quantitative easing more punch, the Fed may have to devise imaginative ways to purchase diversified bundles of assets like corporate bonds, syndicated loans, small business loans and credit-card receivables. Serious technical difficulties beset any efforts to do so without favoring some private interests over others. And the political difficulties may be even more severe. So the Fed will go there only with great reluctance."

Adam P - Kocherlakota - "the very worst part of what Kocherlakota said is that he was advocating for a policy and that policy was to tighten monetary policy *TODAY*.
        If the Fed stands ready to raise rates before inflation has increased (based on other indications of a normalization) then that is a change in the reaction function that constitutes a tightening. (Look at it this way, in Sumner's phrasing it is a statement that the Fed stands ready to reduce the money supply even earler than we though, the monetary injection has gotten *less permanent*)."

Brad DeLong - Mother of all bank runs - "However, at some future time the dollar will cease to be the linchpin of the world financial system, in which case the Federal Reserve's financing its balance sheet via overnight borrowing will leave it vulnerable to the mother of all bank runs. It would be very good to fix this now: to give the Federal Reserve now the option to borrow not in what are essentially demand but rather in time deposits--to grant the Federal Reserve the power to issue its own bonds. This diminishes the chance of a great financial crisis in 2050 or so, with no downside that I can see"

David Pearson - Flight to safety? - "To further confuse the picture, the "flight to safety" or "safe haven" explanations for zero 5yr real yields simply do not fit with other asset prices. Investment grade corporate bond spreads, for instance, are at very tight levels -- indicative of little credit fear. High yield bonds are also enjoying a boom. So the bond market is sending mixed signals: corporate default risk is very low, but required real returns on a risk-less asset are zero. Further, record-high gold prices are indicative of some level of long term inflationary fear, and while TIPS inflation has declined, it is still positive. How could these prices all be reconciled?"

Craig Pirrong - Basel - "Risk-based capital requirements are like a regime of price controls, in this instance, risk price controls. If some risks are mispriced, and particular, priced too low, all affected institutions face the same incentives to take on those particular risks. The more institutions that fall under the capital regime, the more institutions that will take on these underpriced risks. That’s why I am very leery of global capital regimes, a la Basel. If they screw up the prices–and screw them up they will, with metaphysical certainty–the effect of the perverse incentives will be global."

Nick Rowe - Bond bubble - "I approach the question of "fundamental value" as a macroeconomist, not a microeconomist -- from a general equilibrium, not partial equilibrium perspective. If we define the "fundamental" value of an asset as the price that asset would have if all markets, not just the market for that asset, were in long-run equilibrium (and with inflation at target), then bond prices are above their fundamental values. And if we define "bubble" as a price above that fundamental value, then bond prices are a bubble."

Friday, August 27, 2010

Really good links - Fed&TIPS - Monetary policy - Bailout risks - Krugman, Christ and the resurrection of Milton Friedman - Kocherlakota and Zimbabwe - Scott Sumner - 3% inflation

Steve - Fed and TIPS spreads - "If the Fed makes a policy announcement that the market deems deflationary, TIPS spreads will *immediately* shrink. Directionally, the market renders an immediate verdict on the Fed decision as you said.
        However, the *magnitude* of the reaction depends on circularity: does the Fed trust the market (they will correct their decision next time) and does the market trust the Fed.
        If the Fed renders a “bad” decision, but their is mutual trust between the market and the Fed, TIPS spreads will fall a little and stocks will fall a little, even if the decision is terrible. What is the cost of six weeks?
        However, if the Fed renders a “bad” decision and says it is smarter than the market, the TIPS spreads and the stocks will both crash. If the Fed thinks it knows better than the market, the market will price in the full extent of any perceived bad decision immediately. See September/October 2008."

Scott Sumner - The empathetic, the amoral, and the sadistic monetary policy - "Instead, I’d like to argue that central bankers are a bunch of well-meaning (or at worst amoral) people who act like sadists because they have the wrong model in their heads. They think that it is “natural” for inflation to fall during periods of high unemployment. And we know that ‘natural’ means good. After all, natural foods are good for you, aren’t they? Why do they think low inflation is natural in a weak economy? Because it almost always happens. When it doesn’t happen, e.g. 1974, the event is viewed as bizarre. "

Andy Harless - The Real Activity Suspension Program - "Think of this as a guest post by the Cynic in me. <..> Now this bailout program is not without its risks. The biggest risk is that the economy will recover, which would be a disaster for the program. Suddenly, not only would banks be holding losses on their Treasury notes, but their cost of funds would go up, as depositors realized that there were more attractive investments available than zero-interest bank deposits."

Paul Krugman - Christ and the resurrection of Milton Friedman

Karl Smith - Kocherlakota on Deflation - Apparently Kocherlakota was right - zero interest rates will cause deflation. But he forgot to tell us that we are going to see hyperinflation before that. Case study - hyperinflation and deflation in Zimbabwe.

Tweet of the day - Garett Jones - Scott Sumner - "If the U.S. Congress were functional, then Scott Sumner would be testifying monthly."

Ben Bernanke (Jackson Hole) - 3% inflation - Price level targeting is a bad idea because we didn't screw things up that much  - "A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.
        However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability. In this context, raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets--including inflation risk premiums--would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy."

Wednesday, August 25, 2010

Krugman and the bond bubble

Ten assorted thoughts about the government bond bubble (please also see these excellent posts by Krugman and DeLong):

1. You could have earned a lot of money in bonds by following Krugman's analysis during last four years. Bond market is clearly not incorporating and reflecting the very public information from Krugman's blog in a timely manner, this means that the Efficient Market Hypothesis (EMH) is false for government bonds.

2. Rober Shiller has shown that volatility of stocks is much larger than can be explained by the news about economic fundamentals. The same applies to bonds; they are too volatile, with bubbles and anti-bubbles forming.

3. In early 2010, bonds were in the anti-bubble territory. Investors were overestimating the probability that the recovery will remain on the V shaped track. You should be allowed to talk about bond bubble only if you said bonds were cheap in early 2010, otherwise you should be using EMH.

4. Krugman has a model that says 10-year bond is trading at the right price now. The problem is that Krugman is assuming that the only tool Fed will use is zero interest rates. There is approximately 20% probability that Fed will do the right thing by restarting aggressive quantitative easing and credit easing as suggested by Bernanke in 2003. Bond market is ignoring this possibility and 10-year bond is already overpriced.

5. Many economists think that bubbles are harmful and that the Fed should actively lean against the bubbles. Well, the bond bubble is also very harmful, as bonds are pricing in extended unemployment and below-trend inflation. Bernanke should print more money ASAP in order to burst the bond bubble.

6. Fiscal stimulus can also successfully deflate the bond bubble. Tax cuts that can be reversed in the future cause no significant long term fiscal damage while stimulating the economy, healing the private sector balance sheets and containing the growth of the bond bubble.

7. Noise traders are a key source of stock market inefficiency. They are a big problem for bond market too. As asset maturities get shorter, the noise trader risk is diminished, and the short end of the bond market is pretty efficient. This means that we can rely more on the prices of short term treasuries when formulating public policy. Temporary tax cuts are a no-brainer, while it is much harder to reliably measure the NPV of infrastructure investments with long payback periods.
        There are a lot of trend-following momentum players in bonds, and a fall in Treasury bond prices would certainly induce further selling.

8. The most important noise trader in the interest rate markets is China. Authorities are pushing for a much higher level of the savings than can be justified by the preferences of the Chinese people.

9. Every bubble has faulty valuation models. There is no exception now, as we have Gluskin Sheff's David Rosenberg:
"Well, the Fed just told us that it has no intention of hiking rates for a long, long time. So, Fed tightening risks are off the table and at a time when the policy rate is almost zero. And we have a long bond yield of 3.6%. That is a 360 basis point curve from overnight to 30 years, and historically, that spread averages out to be 200bps.
        As we invoke Bob Farrell’s Rule 1, which is about reversion to the mean, we should see the long bond yield approach or even possibly test the 2% threshold before its final resting stop is reached. If we are right on -1% to -2% deflation in coming years as the post-bubble excesses continue to unwind, nominal yield will actually be quite juicy in “real” terms."
10. Every bubble has excessive trader sentiment, here is David Rosenberg again:
"We have also been hearing that bullish sentiment towards Treasuries is now 98%, according to some surveys, approaching the incredible 99% on December 16, 2008, right as yields were plunging to their trough (the 10-year note approaching 2%). <..>
        At the Grant’s Conference in April, Jim labeled the event we closed down together on stage as “Bonds are for losers.” Even in June, the Barron’s poll showed the vast majority of forecasters calling for higher yield activity. Now every bond bear, from the 5.5% yield projectors at Morgan Stanley, to my old shop who are now broadly filled with perma-bulls (now are calling for a 2.5% yield on the 10-year note) outside of Mary Ann Bartels, have thrown in the towel."

Tuesday, August 24, 2010

Really good links - Interest on reserves - China - S&P correlation - Recalculation

Roger Farmer - Interest on reserves - "May 18, 2006 was an important day. It was the day when the Bank of England began to pay interest on reserves. In October 2008 the Fed followed suit. This monumental change in policy gave the Bank an important new tool in its arsenal. It allowed the Bank to influence the economy not just through expansion or contraction of the stock of money, but also through the composition of its balance sheet."

Ambrose Evans-Pritchard - China - "Diana Choyleva from Lombard Street Research said China has a delicate task ahead. Rampant overheating has given way to a "sharp cyclical downswing", yet China cannot easily unleash another stimulus blitz without risking inflation. They are in the "nasty quadrant " of the economic cycle where all choices are hard, though China is not as far gone as over-cooked India."

James Mackintosh - S&P correlation - "In fact, the tendency of the top 1,000 US stocks to move in the same direction as the overall market – their correlation – hit its highest point since at least 1950 in July, according to Barclays Capital. Correlations between the blue-chip S&P 500 index and the mid-sized S&P 400 reached 98 per cent while the blue-chip and small company indices were 99 per cent correlated over three months; contrast this with Citigroup’s figures showing just 68 and 72 per cent correlation, respectively, over 10 years. The options market is pricing in high levels of future correlation, too.
        This matters. The whole point of paying a fund manager to select stocks is that he or she is supposed to beat the market. But if the shares of both “good” and “bad” companies perform similarly, that manager has little chance of success. It is bad enough that so few mutual fund managers are able to beat the market even in normal times. Additional headwinds for active managers will persuade more investors to give up on highly-paid humans and switch to cheap computer-run index trackers."

Tweet of the day - Garett Jones - Recalculation and ZMP (Zero marginal product) workers - "Kocherlakota and Williamson find a Recalculation, with some ZMP workers loitering nearby. http://ow.ly/2t3HH"

Scott Sumner is back.

Thursday, August 19, 2010

Really good links - Deficit economics - Econometrics - Unemployment - Deflationary expectations

Brad DeLong - Deficit economics - "It deals with the case in which the macroeconomic market failure is one of promise-keeping on the part of the government. As the late economist Milton Friedman put it, for the government to spend is for the government to tax. Whenever the government spends money to purchase something, it is also promising explicitly or implicitly to tax somebody, either in the present or the future, either directly or indirectly, to pay for that purchase.
        The government can tax now to pay for spending later—and so run a budget surplus. The government can spend now and promise to tax later—and so run a budget deficit and increase the national debt. But what happens when the government runs up too great a debt and the political system tries to get the government to break its promise to tax, or even when investors and savers and managers and workers and spenders fear that the government will explicitly or implicitly try to break its promises? How to guard against such attempted promise-breaking by the government and what happens when attempted promise-breaking occurs is deficit economics. And once again it is not pretty: capital flight, disinvestment, stagflation, currency collapse, and hyperinflation."

Arnold Kling - Econometrics - "There simply is not enough information in the data to make a convincing case for any particular theory of macroeconomics."

Narayana Kocherlakota (President, Federal Reserve Bank of Minneapolis) - Unemployment - "Of course, the key question is: How much of the current unemployment rate is really due to mismatch, as opposed to conditions that the Fed can readily ameliorate? The answer seems to be a lot. I mentioned that the relationship between unemployment and job openings was stable from December 2000 through June 2008. Were that stable relationship still in place today, and given the current job opening rate of 2.2 percent, we would have an unemployment rate of closer to 6.5 percent, not 9.5 percent. Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy."

Narayana Kocherlakota (President, Federal Reserve Bank of Minneapolis) - Deflationary expectations - "To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.
        That sounds easy—but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation."

Monday, August 16, 2010

Really good links - Liquidity trap - Zero bound - Fed

Brad DeLong - Liquidity trap - "I have always understood "liquidity trap" to mean a situation in which cash is effectively a perfect substitute for Treasury bills and in which as a result open-market operations in their standard form have no effect on anything.
        However, that does not mean that central banks are powerless in a liquidity trap:
        By taking duration, default, and systemic tail risk onto their balance sheets, they can diminish default and risk premia on debt instruments other than short-term Treasury bills.
        By changing expectations of future inflation rates, they can alter business decisions without taking any action to change the current levels of nominal interest rates."

Bill Hester - The Paradox of the Zero Bound - "Promising low rates for long periods of time is particularly pernicious following periods of credit crises, points out Arun Motianey, now with Roubini Global Economics, in his book SuperCycles. In a discussion of Japan's low policy rates over the last 15 years, Motianey points out that deflation became worse the longer Japan's equivalent Fed Funds rate stayed at zero.
        Motianey argues a slightly different transition mechanism that pushes the economy into deflation, mainly through lending markets. He argues that after a credit crisis, government-supported banks are borrowing at close to government rates and at the same time being coerced to lend at rates lower than they would otherwise demand for the risk of default. The result is that they demand higher credit standards (typically higher operating cash flow) of their borrowers. Borrowers, mostly companies, oblige by halting the growth in or cutting the nominal wages of workers. Generalized price deflation typically follows wage deflation."

Tim Duy - A Bleak View - "Deferring to the faltering economy, the Federal Reserve stepped up its policy efforts last week. Barely. Almost imperceptibly. Indeed, it is almost as if the Fed could muster nothing better than throwing a bone to its critics. Will they throw more bones in the coming months? In this environment, I suspect the Fed will continue to do more than I expect, but less than is necessary."

Wednesday, August 11, 2010

Really good links - FOMC - Limits of arbitrage - Director's law - Public sector employees

Paul Krugman - The FOMC has spoken - "What the FOMC announced was a slight change in policy: rather than allowing its balance sheet to shrink as the mortgage-backed securities it owns mature, it will maintain the balance sheet’s size by reinvesting the proceeds in long-term government bonds. Roughly speaking, it has gone from a completely crazy policy of monetary tightening in the face of massive unemployment and incipient deflation, to a policy of standing pat in the face of same."

Kenneth R. French - To what extent do the limits of arbitrage discredit the idea of market efficiency? - "I think there are many papers that show the limits of arbitrage framework can help us understand the behavior of financial prices. <..> Although the limits of arbitrage argument is based on the premise that prices do not fully reflect all publicly available information, it also says that mistakes in prices do not imply easy profits. In fact, I think the argument implies that almost all investors should act as if prices are right."

Eric Falkenstein - Director's law - "Friedman states that it is a common myth to think the government takes from the rich and gives to the poor. He mention Director's law--really an empirical tendency in the US circa 1960--that the rich and poor pays for programs to the middle class.
        As depressing as Friedman's argument may be, there are worse things than tyranny of the middle class: a coalition of the elites with the lowest classes. We have legislators bestowing all sorts of sinecures, pensions, and welfare on the masses, creating a coalition of the unproductive, and they grow in popularity and power by granting more entitlements. The end game is bankruptcy. " - but where is the data, Eric?

Steve Landsburg - Are public-sector employees overcompensated? - "Quit rates in the public sector are about one third what they are elsewhere. In other words, government employees sure do seem to like holding on to their jobs."

Tuesday, August 10, 2010

Good news from the Fed

While the Fed did not implement any of our favourite proposals, the Fed eased monetary policy by stopping the exit strategy and reinvesting principal payments from agencies in longer-term Treasuries. The direct benefits of such QE-lite are minor. However, the good news is that this action by the Fed should be interpreted as a signal that further easing will be forthcoming if adverse economic developments continue.

Really good links - Fed - QE

Tim Duy - Fed - "That said, despite Fedspeak that appears resistant to further easing, the press has been fueling speculation that more easing - albeit largely symbolic - is imminent. From where does this chatter emanate, other that unnamed sources? Perhaps from high ranking staff. Word on the street is that Fed staff are increasingly frustrated with the lack of action from leadership."

Tyler Cowen - Will QE work? - "I hold the default belief that such policies could prove effective today. There's also the broader point that QE can work by stimulating AD, without having to push around long rates very much."

Monday, August 9, 2010

Really good links - QE2 - Bernanke - Eurozone breakup - Housing boom - China bubble

Ambrose Evans-Pritchard - QE2 - "After digesting Friday's jobs report, Goldman Sachs' chief economist, Jan Hatzius, thinks the Fed will abandon its exit strategy and relaunch QE this week, taking the first "baby step" of rolling over mortgage securities. Future asset purchases may be "at least $1 trillion". He is not alone. Every bank seems to be gearing up for QE2, even the inflation bulls at Barclays. The unthinkable is becoming consensus.
        Unfortunately, such obscurantism is taking hold in the US as well. Alabama Senator Richard Shelby has blocked the appointment of MIT professor Peter Diamond to the Fed Board, ostensibly because he is a labour expert rather than a monetary economist but in reality because he is a dove in the ever-more bitter and polarised dispute over QE.
        The Senate has delayed confirmation of all three appointees for the board, who all happen to be doves and allies of Fed chairman Ben Bernanke. The Fed is in limbo until mid-September. So the regional hawks who so much misjudged matters in 2008 have unusual voting weight, and now they have a commodity spike as well to rationalise their Calvinist preferences.
        Whatever Dr Bernanke wants to do this week - and I suspect he is eyeing the $5 trillion button lovingly - he cannot risk dissent from three Fed chiefs: one yes, two maybe, but not three. He faces a populist revolt from the Tea Party movement, with its adherents in Congress and the commentariat."

Tim Duy - Bernanke does not appear overly concerned with the incipient second half slowdown - "Bottom Line: The Fed shows no sense of urgency with respect to the current economic situation, and appears prepared to endure a weaker second half with no policy shift. Moreover, even if the economy does worsen more than they expect, the likely candidates for policy action are more smoke than fire. The Fed knows this, and doesn't want to lose credibility on actions with little likelihood of success. A more aggressive policy stance Gagnon-style appears off the table as long as the Fed fears the possibility that such policy might actually work and push up long term rates. That means more significant action only after outright deflation expectations are evident. Appears extreme, but central bankers tend to be a conservative lot. Lacking a financial crisis, the need for more action is not apparent to them. They fundamentally believe they have done pretty much all that can be reasonably expected. Moreover, we need to reassess the Fed's inflation comfort level; they may think they are hitting one mandate just fine."

Tyler Cowen - Collapse of the Eurozone - "You might think that the collapse of the current Eurozone, and the devaluations, are good in the longer run (I do), but in the short run the entire process would be a nasty, volatility-laden, solvency-revaluing shock to the entire global economy."

Scott Sumner - Housing boom - "So here is my suggestion. Never reason from a price change. Don’t ever say “oil prices will be high next year; hence I expect oil consumption to decline.” That’s bad reasoning. And don’t ever talk about high or low interest rates causing some sort of change in the economy. Instead say something like ”I believe the high tech bust helped boost the housing industry.” That sort of reasoning is consistent with the central idea of economics—scarcity. If less resources are devoted to making one type of capital good, then you’d expect more resources to be devoted to making other types of capital goods. Interest rates are merely the transmission mechanism that facilitates the “recalculation.”
        Of course I am not suggesting that the tech bubble bursting caused the housing boom. GGG find only about 20% of the boom is explainable via interest rates, and the tech bubble bursting is just one of many variables that can affect real interest rates. High Asian savings rates are another factor, and Fed policy is a third. However, the liquidity effect is less significant than usually assumed, as interest rate changes far more often reflect economic conditions than exogenous changes in Fed policy. So even if low interest rates had caused the housing boom, you would still not be able to claim that a Fed easy money policy contributed to the housing boom. "

Edward Chancellor - How states nurture bubbles and strife - "The part played by governments in fostering financial crises is not just a matter of historical interest. Beijing is engaged in another risky experiment in bubble economics.
        Last year the Chinese authorities instructed state-controlled banks to boost their loan books by a third. The result has been a rapid pick-up in real estate prices and construction.
        A recent National Bureau of Economic Research paper, Evaluating Conditions in Major Chinese Housing Markets, notes that Beijing land prices have nearly tripled since early 2008. Land sales have become the main source of income for local governments.
        These sales also support some Rmb10,000bn (£946bn, €1,129bn, $1,475bn) of bank loans to local government infrastructure projects. Meanwhile, Chinese banks are repackaging their loans and selling them on to investors, says Fitch."

Wednesday, August 4, 2010

Should Fed stop paying interest on reserves?

FT Alphaville asks:
Is the policy of continuing to pay interest on the bank reserves held at the Federal Reserve a good idea, a bad idea, or completely irrelevant?
The quick answer is that Fed should stop paying interest on reserves in the process of driving fed funds rate down closer to zero. But with many serious misconceptions about interest on reserves floating around a longer discussion is needed.

Paying interest on reserves is expansionary

Milton Friedman in 1959 advocated the policy of paying interest on reserves held at central bank. He was worried that if reserves earn no interest, this is equivalent to a distortionary tax on reserves. This distortionary tax harms the activities of banking sector and the whole economy.

Recent research by Vasco Curdia and Michael Woodford supports Milton Friedman's conclusion that paying interest on reserves is a good idea. Curdia and Woodford explain that there are three independent dimensions of monetary policy: target for the federal funds rate, credit policy (funds lent to the private sector by central bank) and interest rate paid on reserves. Curdia and Woodford show that if federal funds rate is held constant, higher levels of interest on reserves are associated with lower lending spreads and higher levels of economic activity. When central bank removes artificial scarcity of reserves that was caused by zero interest rates on reserves, the quantity of reserves increases and commercial banks can expand lending even though fed funds rate stays the same. This is why some countries like Canada and New Zealand have long ago started paying interest on reserves.

Credit crisis and the start of interest on reserves program in September/October 2008

If we return to the above-mentioned three independent dimensions of monetary policy, it is important to note that the only dimension of policy that Fed got right during the crisis was interest on reserves policy (IOR policy). Starting in October 2008, Fed began moving interest rate paid on reserves closer to fed funds rate. As recommended by Curdia and Woodford, eventually these two interest rates became equal. Alas, Fed has misjudged the severity of credit crisis and federal funds rate was not cut fast enough, and despite multitude of acronyms such as TALF, Bernanke's credit policy was too weak to save the economy.

Critics of the IOR policy

Fed's IOR policy was immediately criticized by James Hamilton and David Beckworth. But their criticism suffers from two shortcomings. First, they picked the wrong target by saying that interest rate paid on reserves is too high. Because the primary tool used by the Fed is fed funds rate, Hamilton and Beckworth should have argued instead that fed funds rate is too high. Second, it is not true that hoarding by banks of massive quantity of excess reserves under IOR regime is somehow more harmful than hoarding of a small quantity of required reserves under previous zero interest rate regime.

Scott Sumner, another famous critic of IOR, deserves a separate mention. He focuses on opportunity cost of reserves. He argues that interest paid on reserves discourages lending by providing alternative source of income to banks. This is not true. Under IOR policy the opportunity cost of reserves is IOR rate. However, under previous zero IOR policy regime opportunity cost of reserves was not zero, because quantity of reserves was artificially scarce, and banks were willing to hold reserves that pay zero interest, because they were earning liquidity related convenience yield. The size of such convenience yield is equal or greater than fed funds rate, so IOR policy does not reduce the willingness of banks to lend.

What the Fed can do?

Back in February we warned that "extended period of exceptionally low levels of the federal funds rate will last longer than many think." Developments since then have vindicated this forecast, as markets have postponed the date they think the Fed will start raising interest rates; in addition to that, TIPS market is indicating that inflation will be lower than Fed's implicit target of 2% during next five years, this means that aggregate demand is too low and monetary policy is too tight.

Current target of federal funds rate is the range of 0.00 - 0.25. The Fed should cut federal funds rate target to zero; and the Fed should stop paying interest on reserves while fed funds rate is zero. The primary benefit of such move is that a signal would be sent to markets that a majority of FOMC members believe they should combat deflationary shocks, thus providing at least a short term support to stock market. Direct benefits of 25bps reduction are not so large, as Stephen Williamson says:
"Now, what would be the effects of a decrease in IROR to zero? As Bernanke says, not much. Reserves would become slightly less attractive to banks, and in the course of trying to shed them, the price level would rise by a small amount, reserves would fall, and the quantity of currency (in nominal terms) would rise."
The most important steps that the Fed should take are different. First, the Fed should be more explicit about policy goals and should switch to explicit target of price level path, or even better, nominal income path. Second, the Fed should restart the support of private credit markets by purchasing commercial investment grade-bonds with maturities of up to three years.

Tuesday, August 3, 2010

Really great links - What is the Fed thinking? - Time-varying capital requirements - Stress testing central banks

Arnold Kling - Cynical explanation for the Fed's actions - "If the Fed were to make a dramatic change, it would have to explain what it is doing. This is always a problem for the Fed, where part of the mystique comes from its vague communication about policy. Even worse, it probably would have to be specific about the target that it is aiming for, such as future nominal GDP (Scott Sumner's favorite) or inflation (DeLong's choice). Any time you announce a target ahead of time, you do two things:
        a) you reduce the significance of the open market committee. With the target in place, policy is set. What the Fed does in the money market to try to hit the target becomes an operational/technical question, not a policy question. So a lot of people lose the prestige that they enjoy when policy is subject to frequent reviews and can be changed ad hoc.
        b) you run the risk of missing the target (what if that nutcase Kling turns out to be correct about monetary impotence?), and that would damage the Fed's prestige, perhaps irreparably.
        So, from a status-preservation point of view, I can understand why the Fed would not do what seems to make the most economic sense from a textbook macro perspective."

Samuel Hanson, Anil Kashyap, Jeremy Stein - A Macroprudential Approach to Financial Regulation (pdf) - Time-Varying Capital Requirements - "One intuitively appealing response to the problem of balance-sheet shrinkage is to move to a regime of time-varying capital requirements, with banks being asked to hold higher ratios of capital to assets in good times than in bad times. This way, when an adverse shock hits, banks can draw down their buffers, and continue operating with less pressure to shrink. Kashyap and Stein (2004) argue that time-varying capital requirements emerge as an optimal scheme in a model where the social planner maximizes a welfare function that weights both: i) the microprudential objective of protecting the deposit insurance fund; and ii) the macroprudential objective of maintaining credit creation during recessions. The idea is that in bad times, when bank capital is scarce and credit supply is tight, it is optimal for a planner concerned with both objectives to tolerate a higher probability of bank failure than in good times.
        A challenge in designing such a regime is that in bad times, the regulatory capital requirement is often not the binding constraint on banks. Rather, as the risk of their assets rises, the market may impose a tougher test on banks than do regulators, refusing to fund institutions that are not strongly capitalized.5 Table 1 shows that, as of 2010Q1, the four largest U.S. banks had an average ratio of total Tier 1 capital to risk-weighted assets (RWA) of 10.7%, and an average ratio of Tier 1 common equity to RWA of 8.2%.6 These are both well above the regulatory standard, which requires a ratio of total Tier 1 capital to RWA of 6% for a bank to be deemed “well capitalized”. Thus even as we emerge from a deep financial crisis, the regulatory constraint is manifestly non-binding.
        This implies that in order to achieve meaningful time-variation in capital ratios, the regulatory minimum in good times must substantially exceed the market-imposed standard in bad times. Thus if the market-imposed standard for equity-to-assets in bad times is 8%, and we want banks to be able to absorb losses of, say, 4% of assets without pressure to shrink, then the regulatory minimum for equity-to-assets in good times would have to be at least 12%.
        Moreover, a loss on the order of 4% of assets is actually less severe than the experience of the major banks during the recent crisis; the IMF (2010) estimates that cumulative credit losses at U.S. banks from 2007 to 2010 will be on the order of 7% of assets. Using this figure, one could argue for a good-times regulatory minimum ratio of equity-to-assets of 15%. Either way, these are high values, significantly higher than obtained from a microprudential calculation that asks only how much capital is needed to avert failure."

Terrence Keeley - Now let us stress-test the central banks - "The European Central Bank, Federal Reserve and Bank of England have the advantage of denominating the bulk of their assets and liabilities in the same currencies. With combined balance sheets of 20 per cent of their collective GDP, however, their credit and interest rate exposures are no less worrisome than the foreign currency translation risks faced by their Swiss and Asian counterparts.
        It is now estimated that the European System of Central Banks (ESCB) owns as much as 40 per cent of Greek and 20 per cent of Spanish government bonds outstanding. Depending on their severity, federal debt restructurings for Greece and Spain could generate billions in losses for the ESCB. In the case of the Fed, with more than a trillion dollars’ worth of US mortgages now in hand, a 1 per cent increase in US interest rates could generate marked-to-market losses of as much as $50bn. This is more than the entire profit the Fed paid to the US Treasury last year."

Administrivia - Subheading of the blog was changed from "Delicious Journeys Through Macroeconomics for the Purpose of Making Central Bankers Visibly Uncomfortable in the Presence of Really Great Links about Their Errors" to ""If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008".

The Money Demand