On the Fed’s Shift to Quantitative Easing « naked capitalism

Monday, November 24, 2008

On the Fed’s Shift to Quantitative Easing

A nice article in the Financial Times by Wolfgang Munchau, “Double jeopardy for financial policymakers,” discusses the Federal Reserve’s move to quantitative easing. There has been some mention of this in the media, as a Bloomberg story from last week indicates, but it hasn’t gotten the attention it deserves. The use of quantitative easing is an extreme move, a sign the Fed is desperate.

Some quick background from the Bloomberg piece:

The Federal Reserve’s efforts to rescue the U.S. from financial collapse risks the eclipse of the central bank’s benchmark interest rate as the most important signal of monetary policy.

Record injections of liquidity have driven the overnight lending rate between banks to less than half the 1 percent target set by officials last month. The gap is shifting investors’ focus toward the amount of money in the banking system as a better gauge of Fed intentions.

The Fed’s failure to meet its target risks pricing billions of dollars in short-term debt at interest rates lower than the Federal Open Market Committee intends. It also makes it harder for traders to bet on the central bank’s future course of monetary policy….

Fed Vice Chairman Donald Kohn said today the central bank is simultaneously reducing interest rates and expanding its balance sheet in quantitative easing, while not adopting one strategy “in favor of another.”…

“There has been a policy shift, but the Fed is not transparently announcing what it is doing and why,” said former St. Louis Fed President William Poole, now a senior fellow at Cato. “Monetary policy works best when the markets understand what the central bank is doing.”….

“It is a move to quantitative easing, to force lots and lots of reserves into the banking system with the expectation that banks will start to trade them for a higher-yielding asset,” said Poole, a Bloomberg contributor, said yesterday in a Bloomberg Television interview.

The object of this exercise is to lower the long end of the yield curve, as Bernanke described in a paper on Japan.

Am I the only one who finds this development ironic? The Fed, which used money supply targets with enormous success in the Volcker era, renounced them when they started behaving inconsistently with historical patterns as banking deregulation created all sorts of forms of near money. To me, that never argued for abandoning the use of various money supply measures, but perhaps de-emphasizing them out of necessity for a few years while throwing the brightest minds at the Fed on the problem to understand how to make use of them in a deregulated world. Instead, Alan Greenspan had the Fed whizzes studying…..stock prices. (I am NOT making this up, see the front page of the Wall Street Journal, May 8, 2000. All my doubts about Greenspan were confirmed then).

Now we are back to using money in a brute force fashion, but with no benchmarks. Lovely.

Now to the key section from the Munchau article:

Statisticians distinguish two types of errors: type one and type two. Suppose we believe that another Great Depression is about to happen. A type-one error would be to reject our depression scenario when it is true, while a type-two error would be to accept it when it is false.

The US Federal Reserve’s policy is about avoiding a type-one error – underestimating the threat of a depression – at all costs. I was quite surprised last week – though perhaps should not have been – when I learnt that the Fed had quietly adopted a policy of “quantitative easing”.

The Fed conducts open-market operations normally with the goal of keeping the actual Fed funds rate close to the target rate set by the Fed’s open-market committee. The Fed funds rate is the rate at which banks lend their balances to each other overnight. But, more recently, the actual Fed funds rate has fallen much below the target rate, which is 1 per cent. Under a strategy of quantitative easing, the Fed does not care about the rate. The goal is to increase the money supply, by swamping the Fed funds market with liquidity. The calculation is that this would give banks an incentive to buy higher yielding securities, which would reduce long-term interest rates, over which the central bank has no direct influence.

For a central bank, this is comparable to the deployment of the nuclear option – your last or last-but-one policy option. Ben Bernanke, the chairman of the Fed, once co-wrote a paper on the subject of what a central bank can do when interest rates hit the “zero bound”* – a zero rate. The answer is that there are a few options, quantitative easing among them. It is interesting, though, that he has already deployed his weapon of mass desperation while still some distance away from the zero bound.

The US policy establishment regards this crisis principally as carrying a “one-tailed”, or one-sided, risk of a deflationary depression, to be avoided at all costs. But there are also grave risks associated with making a type-two error. A subsequent rise in US inflation could trigger a mass flight out of dollar assets and a large rise in US market interest rates, followed by a huge recession. The main difference is that the policy options would be a lot more constrained under such a scenario. In fact, a type-two error could also give rise to a depression – only later. I still think it is best to treat the crisis as an event with a “two-tailed” risk.

39 Comments:

alexblack says:

November 24, 2008 at 2:35 am

“Reesk management? We don’t got to show you no steenking reesk management!”

ndk says:

November 24, 2008 at 2:39 am

These articles neglect an enormous change in the Fed Funds market, and they’re way behind the times. Anyone watching the balance sheet knew quantitative easing had already occurred without the Treasury’s help.

The Fed currently pays .65% interest on excess balances on deposit. Excess reserves are $363.8b right now, so this clearly isn’t working. With our FFR way below the target, banks are actually earning a positive spread here, which makes about as much sense as negative swap spreads. The risk-adjusted return on capital is apparently judged by the banks to be less than 1%, and I think they’re right.

Christopher Sims has written an excellent and reasonably simple primer on the way the new world works. I highly recommend it to anyone.

The Fed’s balance sheet makes me blanche. I maintain that that will be a focal point in the future.

Anonymous says:

November 24, 2008 at 3:03 am

wouldn’t eliminating the interest rate paid on deposits just flood the market with cash now too?

ndk says:

November 24, 2008 at 3:17 am

wouldn’t eliminating the interest rate paid on deposits just flood the market with cash now too?

Anonymous, good question. :D Just the opposite, probably. It would cause the FFR to immediately plunge to zero, and the NY Fed would have to drain a lot of reserves from the system.

However, those reserves aren’t doing anything right now except sitting on deposit at the Fed, which due to interest rate differentials siphons money from the Fed to the participants in the Fed Funds Market, while making the Fed’s balance sheet worse. Maybe that’s the goal, but it’s a weird way to go about it.

Does that make sense?

Yves Smith says:

November 24, 2008 at 3:25 am

ndk,

I beg to differ. The use of the corridor was first discussed in the media last spring, as you correctly point out, but was mainly seen then as a way for the Fed to get around its balance sheet constraint, i.e., even though it would make quantitative easing possible, that was not seen as its main objective.

In keeping, until the last month or so, the Fed seemed to be trying to keep Fed funds rate in reasonable correspondence to its policy rate (and that is inconsistent with quantitative easing. The effective Fed funds rate started deviating seriously from the target in September, undershooting most of the time, but that was viewed as a function of the stressed conditions in the market, and possible unintended consequences of various Fed emergency actions at the time. When the Fed started paying interest on reserves (at 1%, same as the policy rate) in early November, that should have guaranteed that effective Fed funds stayed at the target.

For instance, Jim Hamilton has a post from the week before last trying to puzzle out why the Fed funds market is acting so oddly. Nowhere does he mention quantitative easing.

ndk says:

November 24, 2008 at 3:37 am

I beg to differ. The use of the corridor was first discussed in the media last spring, as you correctly point out, but was mainly seen then as a way for the Fed to get around its balance sheet constraint, i.e., even though it would make quantitative easing possible, that was not seen as its main objective.

You’re right, but I often wonder about official rationales. Reserve bank balances started spiking around September 25. This can’t have gone unnoticed. Regardless of intent, it’s certainly been used that way in practice.

When the Fed started paying interest on reserves (at 1%, same as the policy rate) in early November, that should have guaranteed that effective Fed funds stayed at the target.

But it didn’t. Let’s hope this week’s better. Thanks a lot for that great piece by Hamilton. I’m glad he’s as confused as I am.

doc holiday says:

November 24, 2008 at 3:38 am

Please remain calm, I'm just offering background:

Re: "The object of this exercise is to lower the long end of the yield curve, as Bernanke described in a paper on Japan."

Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment

http://www.federalreserve.gov/pubs/feds/2004/200448/200448pap.pdf

Bernanke and Reinhart (2004) discuss three alternative, though potentially complementary, strategies when monetary policymakers are confronted with a short-termnominal interest rate that is close to zero. As discussed in the introduction, these alternatives involve (1) shaping the expectations of the public about future settings of the policy rate, (2) increasing the size of the central bank’s balance sheet beyond the level needed to set the short-term policy rate at zero (“quantitative easing”); and (3) shiftingthe composition of the central bank’s balance sheet in order to affect the relative supplies of securities held by the public. We use this taxonomy here as well to organize our discussion of non-standard policy options at or near the zero bound.

In particular, even with the overnight rate at zero, the central bank may be able to impart additional stimulus to the economy by persuading the public that the policy rate will remain low for a longer period than was previously expected. One means of doing so would be to shade interest-rate expectations downward is by making a commitment to the public to follow a policy of extended monetary ease. This commitment, if credible and not previously expected, should lower longer-term rates, support other asset prices, and boost aggregate demand. Bernanke and Reinhart (2004) note that, in principle, such commitments could be unconditional (that is, linked only to the calendar) or conditional (linked to developments in the economy). Unconditional commitments are rare. Perhaps the Federal Reserve’s commitment to peg short-term and long-term rates during the decade after 1942, discussed below, might be considered an example of an unconditional commitment, in that the pegging operation was open-ended and did not specify an exit strategy.

In April 1999, describing the stance of monetary policy as “super super expansionary,” then-Governor Hayami announced that the BOJ would keep the policy rate at zero “until deflationary concerns are dispelled,” with the latter phrase clearly indicating that the policy commitment was conditional.

* Increasing the size of the central bank’s balance sheet (quantitative easing)

Whether quantitative easing can be effective in relieving deflationary pressures, and if so, by what mechanism, remains controversial. As already noted, EW have provided theoretical reasons to doubt the efficacy of quantitative easing as an independent tool of policy. Specifically, they show that, in a world in which financial frictions are limited and in which a clear dichotomy is maintained between monetary and fiscal policies, quantitative easing will have no effect, except perhaps to the extent that the extra money creation can be used to signal the central bank’s intentions regarding future values of the short-term interest rate.

In particular, there is no reason to expect the velocity of money to be stable or predictable when the short-term interest rate (the opportunity cost of holding money) is close to zero, and thus no reason to expect a stable relationship between money growth and nominal income under those conditions. To make the case for quantitative easing, we need more explicit descriptions of how additional money growth might stimulate the economy even when the short-term interest rate has reached zero.

At least three channels through which quantitative easing may be effective have been advanced.

Because the private sector collectively cannot change its asset holdings,attempts to rebalance portfolios will tend to raise the prices and lower the yields of non-money assets if money and non-money assets are imperfect substitutes. Higher asset values and lower yields in turn stimulate the economy, according to this view.

>>> Because the private sector collectively cannot change its asset holdings,attempts to rebalance portfolios will tend to raise the prices and lower the yields of non-money assets if money and non-money assets are imperfect substitutes. Higher asset values and lower yields in turn stimulate the economy, according to this view.

A second possible channel for quantitative easing to influence the economy is the fiscal channel. This channel relies on the observation that sufficiently large monetary injections will materially relieve the government’s budget constraint, permitting tax reductions or increases in government spending without increasing public holdings of government debt (Bernanke, 2003; Auerbach and Obstfeld, 2004).

A third potential channel of quantitative easing, admittedly harder to pin down than others, might be called the signalling channel. Simply put, quantitative easing may complement the expectations management approach by providing a visible signal to the public about the central bank’s intended future policies. For example, if the public believes that the central bank will be hesitant to reverse large amounts of quantitative easing very quickly, perhaps because of the possible shock to money markets, this policy provides a way of underscoring the central bank’s commitment to keeping the policy rate at zero for an extended period.

Temin and Wigmore (1990) addressed that question, arguing that the key to the sudden reversal was the public’s acceptance of the idea that Roosevelt’s policies constituted a “regime change.” Unlike the policymakers who preceded him showing little inclination to resist deflation and, indeed, seeming to prefer deflation to even a small probability of future inflation, Roosevelt demonstrated clearly through his actions that he was committed to ending deflation and “reflating” the economy.

Altering the composition of the central bank’s balance sheet

Unless it were to invoke some emergency provisions dormant since the 1930s, however, the Federal Reserve is restricted to purchasing a limited range of assets outside of Treasury securities, including someforeign government bonds, the debt of government-sponsored enterprises, and somemunicipal securities. These restrictions might effectively be made less binding by various methods. For example, the Fed has the authority to accept a wide range of assets for collateral for discount-window loans.

Perhaps the most extreme example of a policy keyed to the composition of the central bank’s balance sheet is the announcement of a ceiling on some longer-term yield, below the rate initially prevailing in the market. Such a policy would entail an essentially unlimited commitment to purchase the targeted security at the announced price. (If these purchases are allowed to affect the size of the central bank’s balance sheet as well as itscomposition, ultimately the policy might also involve quantitative easing. A “pure pegging policy would require the central bank to sell other securities equal in amount to its purchases of the targeted security.)

In the United States, the Federal Reserve maintained ceilings on Treasury yields at seven maturities between 1942 and the 1951 Accord, among them caps of 3/8 percent on ninety-day Treasury bill rates (raised to ¾ percent in July 1947) and of 2-1/2 percent on very long-term bonds. The peg on bills appeared to be binding, in that for most of the period the rate on bills remained precisely at the announced level, while Fed holdings of bills grew steadily, exceeding 90 percent of the outstanding stock by 1947 (Toma, 1992). In contrast, the 2-1/2 percent cap on long-term bond yields was maintained without active intervention throughout much of the period, suggesting that the cap was not a binding constraint.

A second well-known historical episode involving the attempted manipulation of the term structure was the so-called Operation Twist. Launched in early 1961 by the incoming Kennedy administration, Operation Twist was intended to raise short-term rates (thereby promoting capital inflows and supporting the dollar) while lowering, or at least not raising, long-term rates (Modigliani and Sutch, 1966). The two main actions underlying Operation Twist were the use of Federal Reserve open-market operations and Treasury debt management operations to shorten the average maturity of government debt held by the public; and some easing of the rate restrictions on deposits imposed byRegulation Q. Operation Twist is widely viewed today as having been a failure, largely due to the classic work by Modigliani and Sutch (1966, 1967).

But the fact that yields on bonds as opposed to notes declined sharply over a month in which important information about the elimination of the issuance of long-term securities was released seems suggestive of the possibility that relative supplies matter. We can also look at this episode using our estimated term-structure model to control for variations in the economy and monetary policy over the period surrounding the buyback news. Figure 7 shows the prediction error of the model for the twenty-year Treasury yield in the period around the debt buyback. We see that yields during this period dropped about 100 basis points below what is predicted by the model. This is a significant deviation in economic terms, although errors of this size are not unusual as indicated earlier in Table 4. These results are only suggestive, of course, in that the term-structure model is unlikely to capture all the determinants of yields or control adequately for shifts in expectations. In addition, the precise magnitude of the effects is not clear, in that the size of the shock is hard to determine as we do not know the probability that investors were attaching to a sizable paydown.

Of course, the FOMC never undertook targeted purchases of Treasury securities, but in an efficient market even the (incorrect) anticipation of such an event should affect yields. Figure 9 above shows a sharp downward spike in the model errors in May and June 2003, which is reversed in July. These findings, taken at face value, suggest that the perceived possibility of Treasury purchases had an impact on the order of 50 basis points or more.

If the Federal Reserve were willing to purchase an unlimited amount of a particular asset, say a Treasury security, at a fixed price, there is little doubt that it could establish that asset’s price.

Ok, I'm burned out, but I get the point…

doc holiday says:

November 24, 2008 at 4:18 am

One final comment on that Empirical Assessment: That old paper looks to me, to be The Fed/Bernanke Blueprint for future policy actions. Even though it is long and seemingly boring, it offers some great hints as to where things may drift.

Operation Twist is a nice structure to ponder in general, because it is symbolic of a challenge by Treasury to telegraph a message, i.e, that it intends to punish short term investors with zero returns. Your short term cash is currently worth nothing and has zero future value (for three months). The message in reality is, that too much money is being hoarded in this panic, by banks and investors — and this is very similar to The Great Depression in that respect.

Hence, Treasury is helping investors flood this short-end section of The Titanic with massive excess inventory — but why? We are at extreme bubble valuations here with short term Treasury prices on the moon, yielding zip. Ipso facto, Is there a new policy in the wings related to a structural floor, where Treasury will simply move the bar higher, as it distorts short term investments? If you know that 3 months equal zero, isn’t that a proxy for an annual discount rate, which will pull down other rates and act like a black hole? Instead of having investments looking at future yield, we seem to be headed the opposite direction, being sucked backward in time with deflationary gravity that is destroying the value of money.

Will investors that have zero confidence remain frozen in fear accepting a reward of zero, while Citi and Ford and GM, AIG and thousands of corporations beg for Treasury to offer them tax payer revenues?

The freaky part for me, is to think that if money is being destroyed and if deflation is like cancer, Treasury is burning up money it can’t replace, just like people that bet on stocks, who jump in on a great deal on a share of Ford or Citi, only to find a week later, they just burned up money which they may never get back!

Roubini needs to start thinking in terms of hyper-deflation, because what if, the money you or The Treasury have today, is all you will have for the next ten years? What if there is no future value and no way to re-inflate the global economy … huh, huh, what about that, punk?

bena gyerek says:

November 24, 2008 at 5:17 am

I think Munchau’s point on two-tailed risk needs elaborating.

The core of the problem is the difference between now and the 1930s, i.e. that the USA is a big net importer now, whereas it was a big net exporter then. This means the USA is suffering not so much from an output glut as from an import glut.

Now add to the mix the fact that there is a bubble in the dollar/short-term treasury market. A bubble driven by (a) technical factors to do with the credit crunch (particularly unwind of the carry trade), (b) flight to quality, and (c) official policy in the Far East. Without these factors, the dollar should be plummeting (just like sterling).

Yet none of these factors is sustainable in the medium term as (a) unlimited cross currency swaps to central banks have revived short term dollar lending, (b) the Treasury is doing everything it can to erode the “quality”, (c) the Far Eastern policy of export-led growth is broken when your export markets will not buy at any price.

I suspect that most market participants understand that there is a bubble, and that they therefore will price in an increasing risk of a sudden flight from treasuries / the dollar at some point in the next few months. This would be reflected in increasing steepness of the Treasury curve.

This leads to the Fed’s dilemma. Unlike in the 1930s, where the deflationary spiral was driven largely by domestic factors, today a major factor is the counter-intuitive rally in the dollar. Based on the imbalances that clearly need to be worked out now, you would normally expect the dollar to be plummetting. Net exports need to be playing as big a role as fiscal policy in stimulating demand. And rising import prices should be helping offset deflation.

Instead we have a perverse situation where (a) short term rates are near zero, (b) despite this the dollar is rallying, and yet (c) in my opinion the Fed will find it increasingly difficult to “talk down” long term rates as every time the Fed quantitatively eases, markets will just price in a bigger risk of the dollar bubble bursting, meanwhile (d) credit spreads remain at all time highs as the strong dollar continues to help kill of US manufacturing / tradable sector.

JKH says:

November 24, 2008 at 6:59 am

The article is flat out wrong. It defines quantitative easing as a strategy where the Fed doesn’t care about the funds rate, and then charges that the Fed has engaged in quantitative easing.

But there is no reason to believe that the Fed doesn’t care that the actual rate has deviated from the target rate. Quite the contrary. Bernanke admitted in last week’s testimony they’re having a problem controlling the rate. Dave Altig has alluded to same on Macroblog. And Jim Hamilton has been all over this in expert fashion. For some unexplained reason, the newly instituted payment of interest on reserves hasn’t acted as a floor on the funds rate in this environment. And it’s not because that’s the Fed’s intention.

Quantitative easing is one of those terms that is subject to sloppy definition and interpretation. If you define it as an expansion of excess reserves, anybody following the Fed balance sheet knows that’s already happened. But it hasn’t happened for the reason and according to the evidence given in the article.

ruetheday says:

November 24, 2008 at 7:29 am

The Fed is pursuing quantitative easing right now because they have no choice. The FF rate is effectively zero, primarily as a side-effect of all of their alphabet soup programs throwing liquidity at the market.

However, I do not believe that engaging in quantitative easing out of necessity under dire circumstances should be interpreted to mean that money supply targetting as opposed to interest rate targetting is better policy in general. Far from it. Yves highlighted one problem with that approach – financial deregulation has made it difficult to pinpoint what monetary aggregate should be targetted. The other problem, the one that caused the wholesale abandonment of monetarism in general, is that the velocity of money is unstable, and becomes more unstable as the economy hits turning points in the business cycle. MV=PQ depends on V being a constant or close to it.

JKH says:

November 24, 2008 at 8:29 am

From the St. Louis Fed:

“Federal Reserve programs implemented since the mid-September failure of Lehman Brothers that seek to restore credit activity in the economy’s nonbank financial sector have added large amounts of liquidity to financial markets—but most also have caused large increases in the excess deposits held by depository institutions at the Federal Reserve Banks. To the extent that the Federal Reserve seeks to continue and expand such programs in nonbank financial markets, it will be crucial to provide incentives for depository institutions to hold ever-increasing amounts of deposits at the Federal Reserve Banks.”

If quantitative easing is defined as an expansion of excess reserves, then the reason explained here is that QE is necessary in order to fund asset expansion of the Fed balance sheet. This is distinct from the objective of encouraging commercial bank asset expansion via the same excess reserve signalling.

Independent Accountant says:

November 24, 2008 at 8:47 am

Doc Holliday:
I read your posts and laughed. Yes, I remember Operation Twist (OT). I posted on it twice, 11 August and 7 September 2008. OT was a failure. Why would the Fed want long rates to come down? I believe the Fed wants them up to let the banks “ride the yield curve” to solvency.
If you live long enough almost everything comes back in style. The Japanese are talking about the Treasury issuing modern day Roosa Bands. Be patient. I figure call options on poodle skirts may be a big winner!

FairEconomist says:

November 24, 2008 at 9:33 am

In particular, there is no reason to expect the velocity of money to be stable or predictable when the short-term interest rate (the opportunity cost of holding money) is close to zero, and thus no reason to expect a stable relationship between money growth and nominal income under those conditions.

This is key. By driving short-term interest rates to zero, the Fed has put us into a liquidity trap. Low rates are indeed stimulatory – until the point that they destroy the credit market. Now nobody will bother to lend, credit doesn’t work, and interest rates are irrelevant. In order for monetary policy to even be possible, the Fed has to pull rates back up to a few percent so the credit market will function again. It then needs to print large quantities of money – the old-fashioned way, bills into circulation – to make up for the resulting deflation.

The process will indeed result in the Fed sucking back all the alphabet soup money, but that’s just as well. The alphabet soup puts money into the economy via the banking system; but the banking system is broken so the money doesn’t actually get there. The Fed should take that money and put it into the economy directly via loans or printing.

Right now they can print all they want and it just sits around. There’s no reason to deposit it.

FairEconomist says:

November 24, 2008 at 9:39 am

Ruetheday – interest rate targeting may seem more exact than money supply targets, but that has been misleading. Targeting interest rates has led to a monster bubble we’re now paying for. The complex changes in “money” over the were not corrected for by targeting interest rates – since interest rates are driven by money, the meaning of a given interest rate became as opaque as the meaning of a particular money aggregate.

In any case, with a problem of this magnitude, you can’t target interest rates anymore. Once interest rates approach zero, lowering rates becomes contractionary by lowering the banking multiplier. We must target the money supply. Which one? Nobody knows; we’re just going to have to pick one and hope it’s close enough.

ruetheday says:

November 24, 2008 at 9:44 am

FairEconomist – This recalls the “Greenback debate” of almost 150 years ago. If monetary policy is impotent because rates are already at zero and quantitative easing just results in banks sitting on more reserves, then what are the options? The first option is fiscal stimulus via deficit spending. That creates more debt in an existing environment of indebtedness and is constrained by the federal government’s ability to make interest payments in the future (particularly bad if deflation heats up). The other option, that no one talks about any more, is for the federal government to simply spend the money into existence without incurring any new debt.

Anonymous says:

November 24, 2008 at 10:01 am

Good discussion here and comments:

http://macroblog.typepad.com/macroblog/2008/11/the-changing-op.html

http://macroblog.typepad.com/macroblog/2008/11/more-on-the-cha.html

FairEconomist says:

November 24, 2008 at 10:07 am

Ruetheday, spending money into existence is exactly what I’m proposing. Money is disappearing right now as leverage gets unwound and 0% interest is accelerating the process. That money needs to be replaced, and simply printing it and having the government spend it is the only reliable way to do that in the current circumstances, with the banking system locked up.

The banking innovations of the past 20 years vastly increased high-order monies like M3 (or even higher-order money substitutes) while low-order monies like M1 were stable. My take is that process went too far, so now the ratio must return to “normal”. That could be via M1 inflation, M3 deflation or some combination. My inclination is to split the difference. The Fed has been acting to keep M1 “normal”, probably because it’s best correlated to standard inflation. Right now we’re seeing the effects of keeping M1 steady while M3 deflates and it’s not working. Fixing the ratio by keeping M3 or other high-order monies up would produce staggering inflation in consumer goods – IIRC M3 has been growing 10% faster than M1 for many years and that will probably all need to be corrected in a year or too. Perhaps the best approach is fiscal targets, where the government simply prints enough to keep unemployment high but not disasterous – say 10%.

Once the printing takes effect inflation will start up and that will lift us out of the liquidity trap. At that point monetary policy will start to function again and the Fed can pull back on the printing.

joebhed says:

November 24, 2008 at 10:29 am

rue,
Are you f-ing kidding me?

The only REAL option is for the government to expend debt-free money into existence?

Are you some kind of wacko debt-free money-solution compadre of that joebhed poster here?

oh wait !
That would be me.

OK, maybe someone else has a better idea.

But I doubt it.
Thanks for your boldness in thinking this through.

Alfred says:

November 24, 2008 at 10:35 am

First things first!
our elected officials and those whom they appoint to central positions within the government have one overarching demon, which trumps everything else in their whole spectrum of fears and threats:
Deflation, the general decline in wages and prices.
Deflation leads to long lasting rise in unemployment and social unrest as a consequence of it. The policies of the Federal Reserve and the Treasury are therefore expected and not a surprise. The question if they are warranted at this point in time is moot because the threat of deflation is too powerful.

Anonymous says:

November 24, 2008 at 10:49 am

“…for Federal government to simply spend money into existence without incurring any new debt.”

The age old financial alchemists delima. Until recently government and trade deficits have been financed by US trade partners.
I would appreciate some comments on Axal Merk’s article
http://www.financialsense.com/fsu/editorials/merk/2008/1121.html
on how the FED loans money to US banks and they then buy Treasuries thus elimanating having to pay foreigners interest on deficits.
Money for nothin’

Anonymous says:

November 24, 2008 at 11:09 am

Nationalize the Federal Reserve banking system. Make it a part of the Treasury Department. Print money. http://prorev.com/moneyreform.htm

FairEconomist says:

November 24, 2008 at 11:30 am

Just to give an indication of how bad this deal is, the Fed has effectively written a CDS on Citi’s bad debt. It’s like Citi took a 20% writeoff and the Fed wrote a CDS on the bad debt for about 7 billion/300 billion/5 years = 50 basis points. If Citi had to get a CDS on the open market, do you think they could get 50 basis points?

doc holiday says:

November 24, 2008 at 11:30 am

A thought on Bernanke's paper.

Re1: "Perhaps the most extreme example of a policy keyed to the composition of the central bank’s balance sheet is the announcement of a ceiling on some longer-term yield, below the rate initially prevailing in the market."

Re2: "A third potential channel of quantitative easing, admittedly harder to pin down than others, might be called the signalling channel. Simply put, quantitative easing may complement the expectations management approach by providing a visible signal to the public about the central bank’s intended future policies"

> The conceptual theory that The Fed can telegraph or shock the market with policy that will influence market behavior was a fine idea 6 years ago, but in these days of Fed hyperactivity, they are currently achieving the opposite in policy telegraphing, i.e, The Fed has lost the ability to influence the market, because, confidence in what they are doing, has been eroded by the attention deficit hyperactivity of spinning out new improved plans on a bi–weekly basis. The Fed has been out of control with efforts to shock the market and has ended up looking like pimps for wall street. The cocaine analogy of pimps, whores and pirates is now the the fantasyland stuff of their market intervention — thus, my point here, is that The Fed having LOST its credibility, is in no position to influence policy and thus be able to use outdated policy theory. How many programs and emergency announcements have we seen from them this last year — or month? I'm way too tired to go back and look and whatever they do going forward has to be more of the same bullshit which will drop into the gutter and be either meaningless or abusive.

This is also the problem for Obama, because he was elected as result of his ability to speak of ideological policy reforms, which are not related to this current crisis. America elected someone for change, but they fell for the bait of old cheese which was in an old trap and, and thus Obama never had to speak in terms of what changes he might offer for deflation, so now he reads from a telepromter and has no clue what the problem is about, or how to bring about change!

ndk says:

November 24, 2008 at 11:40 am

For some unexplained reason, the newly instituted payment of interest on reserves hasn’t acted as a floor on the funds rate in this environment. And it’s not because that’s the Fed’s intention.

JKH, why are you so sure of that? I’m not comfortable with the answer “because they stated it.”

By driving short-term interest rates to zero, the Fed has put us into a liquidity trap. Low rates are indeed stimulatory – until the point that they destroy the credit market.

I agree, and I think this is going to be one of our major realizations coming out of crisis. Stimulatory monetary policy certainly works, but it only works so many times in a row.

If Citi had to get a CDS on the open market, do you think they could get 50 basis points?

Treasury CDS are trading at 49.8 today. :D

doc holiday says:

November 24, 2008 at 11:54 am

I can't let this go, because to do otherwise would be treason:

Fed Pledges Top $7.4 Trillion to Ease Frozen Credit (Update1)

The U.S. government is prepared to lend more than $7.4 trillion on behalf of American taxpayers, or half the value of everything produced in the nation last year, to rescue the financial system since the credit markets seized up 15 months ago.

“Whether it’s lending or spending, it’s tax dollars that are going out the window and we end up holding collateral we don’t know anything about,” said Congressman Scott Garrett, a New Jersey Republican who serves on the House Financial Services Committee. “The time has come that we consider what sort of limitations we should be placing on the Fed so that authority returns to elected officials as opposed to appointed ones.”

http://bloomberg.com/apps/news?pid=20601109&sid=arEE1iClqDrk&refer=home

(*&%(&%YTGI^$%&(^%$@%)E!$*&YY,… Fuc-ing insane bastards! The more cash they toss at the fire, the more they waste!

Anonymous says:

November 24, 2008 at 12:03 pm

Munchau misses the third error, The Fed pours all sorts of money into system and it doesn’t make it into the real economy, the economy continues to contract, deflation continues, assets go down, everyone loses more money.

Why does Munchau miss this? Because we still live in a monetarist defined world. Deflation is not primarily a monetary problem. Repeat until understood, deflation is not primarily a monetary problem….

Carlosjii says:

November 24, 2008 at 12:14 pm

I look forward to the demise of the Monster from Jekyll Island in 2009. Mark my words well.

“The combat and instability would continue because its real source was the political contract struck between democracy and capital back in 1913, the implicit decision that democratic politics could not be trusted to act responsibly in the national interest. Therefore, the authority and responsibilities of elected politicians were permanently curtailed. Put another way, the elected government was allowed to be permanently irresponsible – free to indulge its own follies and protected from the accountability by the higher authority, the non-elected central bank. The creation of the Federal Reserve represented a great retreat from democratic possibilities. The maturing of self-government was forever stunted.” Pg. 534, Secrets of the Temple – How the Federal Reserve Runs the Country, William Greider, Simon and Schuster, 1987

Tortoise says:

November 24, 2008 at 12:25 pm

Good article and discussion. Here are some points I would like to make regarding quantitative easing (QE):
1. QE is not an extreme measure. It is part of the arsenal of a central bank.
2. QE is very powerful.
3. QE can be applied in many ways and has winners and losers. A method friendlier to the taxpayer is for the central bank to lend large amounts of money directly to the government. Who loses? Bond holders, savers and rentiers, bond traders, and banks.

S says:

November 24, 2008 at 12:40 pm

The fallacy here that motivates the idea that you can p[rint yopur way to offset the contraction pre supposes that the point of equilibrium that existed ex anti is the same as the ex post. It isn;t So pumping money into the system to keep the water level steady is simply a flawed premise. The economy has to contract. There is no other way.

The dollar will collapse before they can execute such a plan.

Flow5 says:

November 24, 2008 at 12:47 pm

the money supply can never be managed by any attempt to control the cost of credit

“The Fed, which used money supply targets with enormous success in the Volcker era” — what planet were you on?

Flow5 says:

November 24, 2008 at 1:01 pm

"Far from it. Yves highlighted one problem with that approach – financial deregulation has made it difficult to pinpoint what monetary aggregate should be targetted. The other problem, the one that caused the wholesale abandonment of monetarism in general, is that the velocity of money is unstable, and becomes more unstable as the economy hits turning points in the business cycle. MV=PQ depends on V being a constant or close to it"

This is tripe. Monetarism has never been tried. It is mathematically impossible to miss expansions & contractons (yes, bubbles). Economists are pollocks.

ndk says:

November 24, 2008 at 1:06 pm

2. QE is very powerful.

Is it? It’s a policy tool that would never be used in normal times, and in the extraordinary times during which it would and has been tried, it’s been ineffective. When risk-adjusted returns on capital are perceived to be less than 0, quantitative easing will just balloon balance sheets to little effect.

Flow5 says:

November 24, 2008 at 1:21 pm

The sine qua non of monetary management is total current control by a central monetary authority over the volume of legal reserves held by all money creating institutions, and over the reserve ratios applicable to their deposits.

Monetary authorities have long recognized that the volume of bank legal reserves, combined with the reserve ratios applicable to various class of bank deposits, determined the limits and, since 1942, the amounts of bank credit creation.

The first rule of reserves and reserve ratios is to require that all money creating institutions have the same legal reserve requirements, both as to types of assets eligible for reserves, as well as the level of reserve ratios.

Monetary policy should limit all reserves to balances in the Federal Reserve banks (IBDDs), and have uniform reserve ratios, for all deposits, in all banks, irrespective of size.

Flow5 says:

November 24, 2008 at 1:24 pm

First, there is no ambiguity in forecasts. In contradistinction to Bernanke (and using his terminology), forecasts are mathematically "precise” (1) nominal GDP is measured by monetary flows (MVt); (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, demand deposit turnover) that matters; (3) “money” is the measure of liquidity; & (4) the rates-of-change (roc’s) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;

Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.

The lags or ocillations for monetary flows (MVt), i.e. proxies for (1) real GDP and the (2) deflator are exact, unvarying – respectively. Roc’s in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact; as demonstrated by a scatter plot diagram).

Not surprisingly, adjusted member commercial bank "free" legal reserves (their roc’s) corroborate/mirror, both lags for monetary flows (MVt) –– their lengths, or frequency, are identical — (as the weighted arithmetic average of reserve ratios remains constant)

The lags for both monetary flows (MVt) & "free" legal reserves are indistinguishable or synchronous. Consequently it has been mathematically impossible to miss an economic forecast (housing bubble, commodity bubble, etc.).

This is the “Holy Grail” & it is inviolate & sacrosanct.

The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly.

Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP.

Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.

Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 percentage points. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.

Some people prefer the devil theory of inflation: “It’s all Peak Oil's fault.” This approach ignores the fact that the evidence of inflation is represented by "actual" prices in the marketplace. The "administered" prices of the world's oil producing countries would not be the "asked" prices were they not “validated” by (MVt), i.e., validated by the world's Central Banks ( i.e., as Friedman maintained "inflation is always and everywhere a monetary phenomenon")

Flow5 says:

November 24, 2008 at 1:26 pm

So why are there so many idiots that call themselves economists?

Tortoise says:

November 24, 2008 at 3:21 pm

I would like to expand on why “quantitative easing” is powerful and in what sense. First, the name quantitative easing is a hell of a misnomer and can mean several different things. If we we do try to hide behind our fingers, quantitative easing is basically printing money out of thin air. That sounds bad and also reveals that it can definitely be a horrible thing if overdone — like a medication, it has to be taken with caution and only when needed. It does not necessarily stop recessions and certainly does not solve fundamental problems of the economy. If it did, Zimbabwe would be an economic superpower.

Now you can print money but the question is who benefits? The Fed can give money to banks at 1% or less so they can buy US treasuries at 3.3%, an easy way to subsidize banks. Or the Fed can give a 3 trillion loan to the US government. The government can then lower its cost of borrowing money and do what it needs to do without concern of the bond markets. That is what was essentially done in the US during WW II (but not before) and, you know what, it got rid of deflation and any signs of depression in a jiffy.
Japan did not do much quantitative easing during its long “crisis” because their intention was not to stimulate the economy but to remain competitive in exports AND to maintain a high savings rate. So, they managed to have both a strong currency and a trade surplus, which is wuite a feat.
Quantitative easing (degree and method of application) has winners and losers, so you can like it or you can hate it. But it is really powerful as both medicine and as poison.

Richard Kline says:

November 24, 2008 at 7:52 pm

Good post, Yves, and high value-added by commentators sundry and diverse.

Munchau: "I was quite surprised last week – though perhaps should not have been – when I learnt that the Fed had quietly adopted a policy of “quantitative easing”." No, he shouldn't have been surprised: quantitative easing has been in effect since the Alphabet Windows of Spring, by different means but with non-negligible effects. If you repo for 28 days, that's sterilized. Rolled over for 28 weeks, that has effects as real reserve losses are 'simulated' by the swaps. for 28 months or Until Hell Unfreezes Over, that effect is quantitative for the duration.

But I'm unsurprised that the more overt shift recently, including 1% on reserves with the Fed has been "quiet," even less so that it has taken place "before the zero bound." In real terms, even with inflation dropping toward 3% a 1% policy rate is -2% real, plus exceeding high credit risk in the capital markets. Boys, day money's trapped. What fool would lend into the 'normal' capital markets under those conditions? Hence quantitative easing, like blowing air into the vaults to force the money out the ventilation systems onto the public sidewalks.

—Except it is unlikely to work. FairEconomist, you, too, picked out what was the key paragraph in that long and interesting Fed paper [for which, thanks doc], an alacrity I've come to expect from you. Once we get into real neg rates for more than a few days, velocity of money goes wobbly and sideways. (Velocity of transactions, too, Flow5, they aren't inseparable even if they are coupled rather than invariant.) But wait, it gets worse. As bena gyerek makes the point, the US financial economy _is not a closed system_. If quantitative easing was tried in China, where the movements of the renminbi are controlled, and the banks closely watched, it might yield effects as intended; not as much as hoped, but in proportion to the intervention. In the US, there is no constraint on private capital _having_ to lend into the real US economy if they are suffocated by 'digit push' from the Fed. They can speculate—and did, first on oil, now on Treasuries. They can work the CDS markets looking for a deal. In principle, they could lend off shore, but it's hard to fight the pressure of the carry trade unwind; however, they can still _buy_ offshore, such as Citi buying up a Chinese asset in recent months. This is where much of private big capital is likely to go if left on its own. And just TRY figuring the money supply, since deregulation has proliferated 'shadowbucks' which don't really fall properly on any existing index but spend the same in the capital markets and speculative casino. The abject failure of the Fed and other central banks to maintain any perspective on shadowbucks renders the 'theory' behind quantitative easing moot: they don't really know what mountain they are trying to push, how big it is, or _where_ it is. So they are trying to push the mountain the see and know. If the mountain is bigger than you are, it becomes the fulcrum and YOU get pushed; in effect, the currency goes *whoosh* by that metaphor. Quantitative easing will most likely blow sidewise.

I found your contentions on M3-M1 ratios interesting, FairEconomist. I agree with you that the single greatest central bank mistake at present is the crash dive in rates: this has trapped the money, and destroyed what few conventional tools the Fed has. The best move by far would be to raise policy rates 1.5-2% while pursuing fiscal stimulus. To this point, we have been deflating shadow-M3 and real M3, which isn't deflation given the bubble conditions. Spillovers to employment and the real economy are unavoidable, though, and we now see demand destruction which is very much deflationary: there is little choice but to stimulate. I have no real problem with the Guvmint just spending in those circumstances, _so long as it avoids the money center players_ who are broken, speculating, and burning up cash faster than they steal it from the public. Spending has to go into the real economy if it is going to be demand-stimulative, I'm with you on that. Which is why we should be taxing the plutocrats to begin paying for bailing the banking system, while paying out to the public to support incomes and demand. The way we are _not_ doing this kind of stimulus is to nationalize some of the failed banks, and then (since they are government backed, and hence quasi-public conduits) using them to buy CP and make normal business loans, both of which big financials are doing less of now on their own account in the liquidity trap. That is, as well as printing money and giving it away, we could actually use some of the banks to, hrrumph, LEND. Which the government is poorly placed to do on its own. We are trapped by ideology, here, too. 'Private capital' is supposed to lend real, but it isn't; therefore, we are trapped. NOT. Take some of that private capital by the scruff and frog-march it into the service of the real economy, not to make stupid loans at losses but basic loans at basic profit.

And Flow5, you are certainly right that quarterly summations are stoopid, and that lags are far more substantive in assessing the state of capital. I would listen to a case for monetary flow lags being invariant, but few things in nature or systems are invariant, so off hand I doubt it. However, the range of lags might be stable enough over time that it could be simulated as invariant. Then too, we are dealing with factors here—nominal GDP &etc.—which are imprecise, so the precision of their forecast, mathematical or otherwise, will leave something to be desired; I suspect that you know that. And monetary aggregates really do matter in their absolute volumes and velocity, but these issues only come into play in long-tail/far from 'normal' equilibrium conditions—but there, they REALLLLY do. Those concerns aside, though, I would be far more interested to see public financial policy made on rate-of-change considerations, since as you suggest these are the numbers which really count, short-term in 'normal' conditions. And I'm with you, it is impossible to miss things like bubbles if you look at roc factors. There is more substance in your comments than I've had time to chew over. Stick around, why dontcha, and put more of that perspective in play hereabouts (small bits, though).

Anonymous says:

November 24, 2008 at 8:00 pm

not having read all comments but seems most (all?) assume money – whatever form – to be determinant — might be worth questioning such a fetish while recalling that over a sufficient period, stimulus negates itself, transforms from mitigating to undermining. So, what have decades of crisis management provided the world besides…rolling crisis.

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