This week, I seem to have been focused on central banking this week, which is not my favourite topic, but is all the rage over the last several days given the decision of the Bank of Japan to use negative interest rates on any new bank reserves and then continue to pump reserves into the system via its so-called QQE policy (swapping public and corporate bonds for bank reserves), and then imposing a tax on the reserves so created. Crazy is just one euphemism which comes to mind. So still on that theme and remembering that the Bank of Japan explicitly stated that the combination of QQE and the tax on reserves (they call it a negative interest rate – same thing) was introduced to increase the inflation rate back up towards its target of 2 per cent per annum, I thought the following paper was interesting. The paper from the Research Division of the Federal Reserve Bank of St Louis (published July 2015) – Current Federal Reserve Policy Under the Lens of Economic History: A Review Essay – considers the unconventional monetary monetary policy interventions taken by the US Federal Reserve Bank between 2007 and 2009 and comes to the conclusion that “there is no work, to my knowledge, that establishes a link from QE to the ultimate goals of the Fed inflation and real economic activity”. Maybe the Bank of Japan and the ECB bosses should sent this researcher an E-mail and request his evidence. They don’t seem to have been able to escape from the straitjacket of their neo-liberal Groupthink.
The Federal Reserve Bank of St Louis Research Paper initially considers a brief history of central banking and makes the point that:
… the Bank of England … was a central bank, which had a symbiotic relationship with one of its key borrowers, the British Crown. The Crown, by granting the Bank monopoly respect to circulating currency, was able to finance its spending more cheaply than would otherwise be the case. Further, the Bank’s monopoly, as well as its size, created the possibility that its actions would matter for asset prices and aggregate economic activity.
Interestingly, while the Bank of England was also a “typical private” bank, it “actually had a lot to lose from excessive risk-taking – its monopoly on currency issue – and this tended to reinforce actual conservative behaviour”.
The author (Stephen D. Williamson) contended that historical experience “tells us that”:
(i) a key element of central banking is the relationship between the central bank and the fiscal authority; (ii) the central bank’s power comes from its monopoly with respect to the liabilities it issues …
There is no financial crisis that a central bank cannot alleviate given this power. It also has the obvious power to fund any necessary fiscal plans that a sovereign government might consider appropriate to implement.
The paper then considers the “Great Recession” in the US.
We learn that in the early days:
A key problem early in the financial crisis was that the Fed wished to lend, but there appeared to be a reluctance of banks to borrow through conventional means at the Fed’s discount window.
In 2008, there was a lot of hype about bank’s not having sufficient liquidity to allow for loans to be made. The actual problem was not that financial institutions were illiquid in terms of making loans and then being able to access reserves from the central bank to ensure checks drawn on deposits cleared.
The problem was that many financial institutions relied on wholesale funds borrowed at maturities which were coming due and could not re-finance their own debt.
The overwhelming reality, though, was that the banks were not so reluctant to lend but they were struggling to attract borrowers from the household and corporate sector.
The demand from credit-worthy customer declined dramatically in 2008, which was no surprise given the collapsing housing market and the massive debt overhang that the past decade or so had left in the private domestic sector.
The paper considers that the Term Auction Facility (TAF) that was introduced by the US central bank in December 2007 was essentially a broader type of open market operation was the main difference being the type of “eligible collateral” that the financial institution can offer the central bank in return for a loan.
In other words, the US central bank “purchased some troubled assets” in addition to “commercial paper” as it sought to reduce financial fragility.
He concludes that the main impact of this form of intervention was to prevent the “runs on commercial bank deposits and disruption of retail payments that occurred during the Great Depression”, which were absent during the GFC. He realises that the other major difference in comparing the outcomes during the Great Depression and the more recent financial crisis was the introduction of the “credit deposit insurance” scheme in 1933.
But even taking that into consideration he believes that “one could also make the case that the Fed’s support of Önancial institutions gave the non-insured holders of bank liabilities the confidence not to run”.
He then moved on to consider the other unconventional monetary policy interventions following 2009, when the US economy had resumed growth.
There were three major interventions:
1. The “zero-interest-rate policy”.
2. The “large-scale asset purchases” (QE).
3. The “forward guidance” where the Federal Reserve makes public statements about its thinking and the possible future policy shifts to shape the public’s expectations. The author considers the US central bank failed in this regard because its statements were too vague and ill-defined.
I will only focus on the second element, given that has largely been of interest in the discussions of inflation targets etc. The Bank of Japan has just added a second dimension to the QE – negative rates. But, in effect, they are seen as part of the same deal.
Pump in reserves to give the bank’s ‘cash’ to loan out. Then impose a tax to create an additional incentive to make the loans.
The Research Paper notes that with excess reserves in the banking system “the interest rate on reserves will determine short-term interest rates”. Why? Because it becomes the point of indifference between holding the reserves within the bank’s central bank account and trying to loan those reserves to other banks in the interbank market.
Of course, when there is a system-wide excess, the loans between banks in the interbank market may help a bank get rid of their reserve excess and put reserves elsewhere to shore up a specific reserve shortage within another bank, but the surplus, ultimately cannot be offloaded this way.
The introduction of a interest payment on excess reserves from the central bank effectively stops the banks trying to off-load their excesses in the interbank market and therefore sets the short-term interest rate floor.
The paper claims that:
… so long as the interest rate on reserves in greater than zero, the Fed can ease in a conventional way by reducing the interest rate on reserves. But, if the interest rate on reserves cannot go below zero, then the Fed cannot ease conventionally.
Which suggests that the author considers open market operations (conventional interventions), which exchanges cash (from the central bank) for bonds is a stimulatory measure – that is, stimulates the real economy.
We need to be careful here because the same logic is often applied to QE. The stimulus does not come from the extra reserves that an open market purchase by a central bank makes (buying bonds for reserves).
The stimulus, if there is any, comes from the fact that by pushing up the demand for bonds, the central bank drives down the yields on those assets at the relevant maturity, which then influences other returns on financial assets within that maturity range.
So, the presumption is that lower interest rates then stimulate private sector investment spending and/or reduce the value of the currency (financial flows move out in search of higher relative returns), which stimulates real GDP growth.
The uninformed version of the story is that the increase in bank reserves arising from the open market operation provides them with more money to loan out.
Of course, anyone holding that view, including a substantial number of mainstream macro and monetary economists, disclose their lack of understanding of how the banking system works. Banks do not loan out reserves. They shuffle them between themselves to facilitate the efficiency of the so-called payments system (the ‘clearing house’) so that checks don’t bounce.
But bank lending is not reserve constrained.
Please read the following blog – Building bank reserves will not expand credit – for more detail on this.
And please read Monday’s blog – The folly of negative interest rates on bank reserves.
Once the Federal Reserve Bank had driven the short-term interest rate down to near zero, it decided:
… to engage in QE – purchases of long-maturity Treasury securities and mortgage-backed securities …
The logic was clearly expressed at the time:
1. “The basic idea is that finnancial markets are posited to be segmented by asset maturity.” Some institutions match long-term assets with long-term liabilities, while others operate at different ‘maturity segments’.
2. “… if the Fed issues short-term liabilities (reserves) in exchange for long-maturity assets, then this should, according to the theory, increase the price of long-maturity assets, and therefore reduce long-term bond yields. With the nominal short-term interest rate fixed at zero, this should flatten the yield curve.
The yield curve is just the term structure of interest rates from short-term out to the very long-term investment rates. A flatter yield curve is theoretically posited to act as a stimulus for investment-type borrowing (capital formation) because the longer-term borrowing rates become cheaper.
So the stimulus comes, if at all, from increased borrowing because of cheaper finance, rather than the banks having more cash to loan out.
The research paper then assesses the evidence as to whether the QE had any impact on inflation or real GDP growth.
He concludes that:
… there is no work, to my knowledge, that establishes a link from QE to the ultimate goals of the Fed inflation and real economic activity. Indeed, casual evidence suggests that QE has been ineffective in increasing inflation. For example, in spite of massive central bank asset purchases in the U.S., the Fed is currently falling short of its 2% inflation target. Further, Switzerland and Japan, which have balance sheets that are much larger than that of the U.S., relative to GDP, have been experiencing very low inflation or deflation.
He further considered the inflation issue – a key focus of the Bank of Japan plan.
The Research Paper notes that the inflation fears arise directly from the mainstream quantity theory of money which says that a rising money supply will transmit directly into higher prices in the economy.
Too much money chasing too few goods – is one of those awful (false) aphorisms that conservatives and smug economists like to say to summarise their position as if it is meaningful and insightful.
Stephen Williamson writes:
A conventional quantity-theory-of-money view of the world would tell us that, if commercial banks lend out excess reserves, that this will lead to an increase in monetary aggregates – through the “money multiplier” process – and therefore to an increase in the price level.
Please read my blog – Money multiplier and other myths – for more discussion on why this theory is deeply flawed.
The Federal Reserve Research Paper agrees with my assessment here.
It concludes that:
The available theory and empirical evidence says no … QE can actually lead to lower inflation. When government debt is in short supply as collateral, this imparts a liquidity premium to safe assets, and the real interest rate is low, just as has been the case in the United States since the beginning of the Great Recession. Under these circumstances, if the central bank conducts a swap of short-maturity government debt for long-maturity debt, as it did under Operation Twist, this acts to increase the effective stock of collateral. As a result, the liquidity premium falls, and the real interest rate rises. If the nominal interest rate is zero, then an increase in the real rate implies a decrease in the inflation rate, i.e. QE causes inflation to fall.
The “informal empirical evidence on QE and inflation” aka facts shows that most central banks have “undershot” their inflation targets over the last several years.
And, “in some cases, particularly Japan, Switzerland, and the Euro area, there have been substantial increases in the quantity of high-powered money and the central bank’s balance sheet, which have accompanied this low inflation experience.”
But excuse me, says the mainstream economist – these facts must be wrong. Our theory predicts heavy inflation arising from the expansion of central bank balance sheets.
Then all sorts of conspiracy theories emerge about how the national statistical agencies are rigging the books and deliberately under-reporting the national inflation statistics to avoid acknowledging how bad things are.
There have been many such conspiracy articles since the GFC started.
The reality is binding. There has been no cooking of the statistics. QE was never going to cause inflation. Inflation is highly unlikely when there are elevated levels of mass unemployment and weak spending – and then, on top of that, the fiscal authority embarks on a manic, ill-conceived austerity campaign.
Try getting inflation out of that.
In the Eurozone case, it is time to acknowledge that all the sophistry being pumped out of Frankfurt on a regular basis by Mario Draghi and his ‘executives’ about stimulus measures such as negative interest rates and continued QE is just hot air.
The serious research evidence backs the logic of Modern Monetary Theory (MMT) in allowing us to conclude that all these unconventional monetary policy interventions will neither push the inflation rate up nor stimulate real GDP in any significant way.
Refresh yourself about yesterday’s blog – The ECB could stand on its head and not have much impact.
The reality tells us that Japan and the Eurozone, which are both facing chronic deflation and slow growth, require substantial demand-side stimulus.
What allowed the US to recover relatively quickly was not the unconventional monetary policy interventions from the Federal Reserve Bank, but rather, the massive fiscal stimulus in 2009 (of the order of $US830 billion) which has been estimated to have pushed real GDP up by around 1 per cent per annum between 2009 and 2014 (Source).
Japan clearly has the capacity to do that. The dysfunctional Eurozone would need to abandon its neo-liberal Groupthink that is obsessed with austerity and use what flexibility there is in the Treaty to override the Stability and Growth Pact fiscal constraints.
In my latest book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale – I show how that could, in theory, be facilitated.
But then, the reality of Germany and the collection of buffoons in Brussels masquerading as key European Commission official, intervenes.
That is enough for today!
(c) Copyright 2016 William Mitchell. All Rights Reserved.