The Monetary Base, Part II

As I stated in my previous post, there are those who interpret the recent expansion of the monetary base as a sign of rising future inflation. In addition, there are those who interpret the failure of that surge in the monetary base to have real effects as evidence of a liquidity trap.

With the Fed paying interest on reserves, open market operations literally entails the Fed exchanging debt for debt — specifically, Federal Reserve debt for Treasury debt. Commenter ‘The Money Demand Blog’ points out that this distinction is irrelevant as without interest on reserves the T-bill rate would fall to zero would therefore remain perfect substitutes for reserves. This might be so, but it is not necessarily the case that it would go all the way to zero and there is a difference between near-zero rates and a zero rate (see this post by Tyler Cowen). Nonetheless, by paying interest on reserves, the Fed has rendered any such distinction moot.

Regardless, when thinking about monetary policy in terms of open market operations, it should be clear that the Fed is not being expansionary when it exchanges debt for debt. Nonetheless, this is not the same thing as saying that the Fed cannot be expansionary.

Brunner and Meltzer (1968) demonstrated some time ago that the existence of a liquidity trap is not possible when the model consists of a spectrum of interest rates rather than “the” interest rate — as is typical in the majority of macroeconomic models. To understand why, one needs a grasp of the monetarist transmission mechanism.

Monetarists emphasize the role of monetary policy on relative prices and a variety of asset substitutions. For example, an open market purchase is likely raises the price of bonds and reduces the yield. Following the open market purchase, the seller(s) will seek to re-balance their portfolio(s), most likely by trying to buy other financial assets. This process bids up the price of financial assets relative to non-financial assets, like capital, which increases the demand for the latter. Initially, the lower relative price leads to an increase in the demand for existing non-financial assets. However, as the price of existing non-financial assets gets bid up, this increases the demand for newly produced non-financial assets and leads to increased capital accumulation. In addition, these higher asset prices boost wealth, which increases the demand for consumption. These asset substitutions generate real effects and ultimately the price level will rise to bring real money balances in line with desired money balances.

It follows that the central bank’s ability to affect the price and corresponding yield of financial assets through open market operations is essential to understanding the effects of monetary policy. This is where quantitative easing comes in. Some commentators have assumed that the sole effect of quantitative easing is to reduce long-term interest rates and stimulate investment. This is wrong-headed and demonstrates — or at least after reading this post, I hope will demonstrate — why obsessions with the interest rate effect are misguided. The point of quantitative easing is not to reduce the long-term interest rate, but rather to resolve monetary disequilibrium.

Suppose that there is an excess demand for money. Since money is the medium of exchange and is traded on all markets, this necessarily causes an excess supply of goods and services. The central bank can eliminate the excess demand for money by increasing the money supply. However, as has been discussed above, if the central bank is exchanging interest-bearing reserves for interest-bearing debt, it is essentially exchanging perfect substitutes. If this is the case, traditional open market operations will not resolve the excess demand for money. Rather, the central bank needs to exchange the interest-bearing reserves for something that is not a perfect substitute. Potential assets that satisfy this criteria could be anything from long-term bonds to a portfolio of stocks. The central bank purchases these assets in order to increase the money supply and resolved monetary disequilibrium.

In addition, these asset purchases will have real effects as well. As the monetarist transmission mechanism highlights, open market purchases can resolve monetary disequilibrium, but also lead to real effects through capital accumulation and wealth effects. As Nick Rowe recently highlighted, rising stock and bond prices that result, directly or indirectly, from open market purchases can lead to increased investment due to the effect on Tobin’s Q.

So what is the point of all of this? The point is that much of the focus on quantitative easing is misguided. The purpose of QE is to resolve monetary disequilibrium. Given that the Fed is paying interest on reserves, traditional open market operations will not suffice. An exchange of interest-bearing reserves for interest-bearing government debt is unlikely to lead to portfolio re-balancing and therefore the increase in the monetary base is unlikely to resolve the excess demand for money. A shift toward other types of asset purchases is much more likely get the increase in the monetary base circulating the resolve monetary disequilibrium.

11 responses to “The Monetary Base, Part II

  1. It is possible that without IOR yield on T-bills would be slightly negative, as some market participants do not have accounts at the Fed, T-bills are also useful as a collateral.

    The Fed should restart credit easing. Buying stocks is too risky, cost of equity has a term structure, and there is a possibility that wrong parts of term structure would shift.

  2. If this statement is true, isn’t the interest paid on reserves a moot point anyway?
    “This will put many banks in the awkward position of earning less on their reserves than they pay. The Fed is paying banks 25 basis points on reserves; the FDIC is charging over 30 basis points to most banks for deposit insurance.”

  3. I think reserves are best understood as government debt regardless of the interest rate being paid. Open market operations always involves a change in the form of government debt. Traditionally, reserves were like currency and the shift was from interest bearing debt to zero-interest debt.

    Today, reserves remain money (though only banks and a few other institutions can use them.) That part of money pays interest. That is nothing new. A large portion of MZM bears interest.

    However, the monetary disequilibrium version of the liquidity trap works through a spillover to money demand when the yields on some securities approach zero. A bit above, at, or a bit below zero, and any remaining excess demand for some security is almost certainly going to spill over to an increased demand for money. Yeager discussed this in his 1956 piece, a cash balance approach to depression.

    The monetary policy problem you describe here exists if the Fed responds to the added demand for money correctly, by increasing the quantity of money, but does so by purchasing the very same securities whose excess demand near the zero nominal bound resulting in the initial increase in money demand. The quantity of money increases, yes, but the quantity of the bonds outside the fed falls, which creates an excess demand and an additional spillover to a further increase in money demand.
    The Fed needs to purchase something else. Longer term bonds will do.
    If the Fed pays interest on reserves, they are still money, but the zero yield is no longer relevant for the securities. It is now the yield on reserves.
    I will grant that T-bills may have better liquidity services for some people than reserves, and so the lower bound for those securities will be somewhat less than the yield on reserves. And further, that charges for FDIC impacts the trade off for nonbankers. Still, the higher the yield the Fed pays, the more securities that become ineffective for open market operations.

  4. Money Demand,

    You wrote, “Buying stocks is too risky, cost of equity has a term structure, and there is a possibility that wrong parts of term structure would shift.”

    Indeed. I have not been an advocate of buying stocks and we do need to be mindful of the knowledge problem associated with central banking — or any central planning for that matter. Nonetheless, I think that broadening one’s scope of assets serves to highlight the erroneousness of the view that monetary policy is impotent.

    Bill,

    You wrote, “Open market operations always involves a change in the form of government debt. Traditionally, reserves were like currency and the shift was from interest bearing debt to zero-interest debt.”

    You are sounding like a fiscalist — not that there is anything wrong with that.

  5. Josh,

    You wrote, “Nonetheless, I think that broadening one’s scope of assets serves to highlight the erroneousness of the view that monetary policy is impotent.”
    I fear that broadening one’s scope of assets should be a matter of practical priority, as monetary policy will get only a limited traction with government securities. This is why I am talking about return to credit easing operations.

    Bill Woolsey,
    You wrote, “Still, the higher the yield the Fed pays, the more securities that become ineffective for open market operations.”
    The problem is that in current situation, only at very negative yields (such as minus 500bps) short term treasury securities would become effective for open market operations. This is probably the reason why Bernanke dismissed the option of cutting IOR.

  6. Is the Fed actually allowed to buy stocks? What exactly can the Fed legally buy, besides government securities?

    Thanks.

  7. Pingback: The Real Objective of QE2 : Invest My Money

  8. Pingback: Alan Reynolds and the Straw Man | The Everyday Economist

  9. I’ll ask my question again. Suppose the Fed pays me $1,000 for a 90-day T-Bill and credits the reserve account at my bank. My bank’s deposits have increased by $1,000 and reserves have increased by $1,000. If the FDIC charges 30 bp for the deposits and the Fed pays 25 bp on the reserves, hasn’t the Fed essentially exchanged a negative-interest asset for a slightly positive-interest one? Wouldn’t that mean they are not perfect substitutes anyway?
    Thanks.

  10. Pingback: Blinder on QE2 | The Everyday Economist

  11. Pingback: Welcome NRO Readers | The Everyday Economist

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s