Central banks in chaotic times Marc Lavoie

Central banks in chaotic timesMarc Lavoie The subprime crisis, monetary policy implementation, and changes in monetary theory

Motivation • The financial crisis has forced central bankers to modify their procedures. • It has created a communication problem, forcing them to explicitly reject some elements of textbook monetary theory. • It also has some implications for heterodox (post-Keynesian) monetary theory. • As a case study, I look at the Federal Reserve.

Outline • Some preliminaries on monetary theory and central bank operations. • Changes in operating procedures of the Fed since August 2007. • Implications of the new procedures for PK theory • Implications for textbook monetary theory and the Public Relations problem of central banks today.

Preliminaries I: mainstream (textbook) monetary theory • The central bank controls the amount of bank reserves or high powered money • To make loans, commercial banks need excess reserves at the central bank. • Excess reserves lead to the creation of money deposits, through a money multiplier story. • Excess reserves lead to an excess supply of money, which leads to price inflation. Click View then Header and Footer to change this text

Preliminaries 2: The post-Keynesian view of money creation • Banks look for credit-worthy borrowers first. • Then they try to find the reserves they need. • Loans make deposits, deposits make reserves • Reserves are demand-determined: Central banks provide the reserves needed by the system, at the rate of interest of their choice (the target rate). • The money supply is demand-determined • The money multiplier is an accounting identity • It plays no behavioural role. • It must be banned from all textbooks. Click View then Header and Footer to change this text

The timeline Click View then Header and Footer to change this text

Source: Keister, Martin, McAndrews (2009) Click View then Header and Footer to change this text

The timeline at the Fed I • Financial pressures started in mid-August 2007. • Real financial pressures started at the end of December 2007. The Fed is forced to make use of its lending facilities, providing loans (liquidity) to banks. • The expansionary effects of the central bank loans are neutralized by open market operations. • Until 12 September 2008, the Fed is able to move the federal funds rate next to the FMOC target interest rate (2%). • It is able to do so because the neutralizing operations of the Fed keep reserves at their approximate required level.

The balance sheet of the Fed until 18 September 2008 Click View then Header and Footer to change this text

Initially, the Fed keeps the supply of reserves in line with the demand for reserves, and the expected fed funds rate is the target rate Supply of reserves Lending rate Expected Fed funds rate Target Fed funds rate Demand for reserves Reserves Deposit rate 0%

Standard deviation of discrepancy between effective and target fed funds rate Click View then Header and Footer to change this text

Timeline at the Fed II • On 15 September 2008, the Lehman Brothers investment bank declares chapter 11 bankruptcy (a buyer could not be found and Paulson/Bernanke declined to nationalize it). • The interbank market freezes: banks don’t lend to each other. • Most banks in a long position at the clearing house prefer to keep their excess funds as deposits at the Fed. • Banks in a short position at the clearing house are forced to borrow at the Fed.

Timeline at the Fed II (bis) • From then on, the Fed is unable to achieve its target (fed funds rate is at first too high, then too low) • From 19 September 2008, the Fed decides to inject huge amounts of liquidities (provide huge lending facilities to the banks (and AIG)), without conducting compensating open market operations. • This is when the balance sheet of the Fed starts exploding. Click View then Header and Footer to change this text

Timeline at the Fed II: Balance sheet explosion • At first, the Fed asks the Treasury to issue securities, sold to the banks and dealers, and to deposit the proceeds in its account at the Fed, thus partially neutralizing the reserve-creating effect of granting advances to banks. • But within a few weeks this is abandoned, as the Treasury approached its legal debt limit ($10.62 trillion) defined by Congress (now $14.29 trillion, to be reached on 16 May 2011 !). • The Fed then gives up on its attempt to neutralize the reserve-creating effect of granting advances to banks. Click View then Header and Footer to change this text

The balance sheet of the Fed starting on 19 September 2008 Click View then Header and Footer to change this text

Fed loses control of the federal funds rate: too high, then too low S S’ S’’ Lending rate Fed funds rate 15-16 Sept. Target rate Demand for reserves Fed funds rate Deposit rate = 0 Reserves

Timeline at the Fed III:Trying to regain control of fed funds rate • On 6 October 2008, the Fed gets the authority to pay interest rates on (excess) reserves, thus setting up a corridor system, with a ceiling (the discount rate) and a floor (the interest rate on reserves). • Despite this, the Fed does not regain control of the federal funds rate, with a target at 1.50% and fed funds rate hovering between 0.67% and 1.04%.

This is what should have happened with the corridor system: the fed funds rate should be at least equal to the deposit rate S S’’ S’ Lending rate Target Fed funds rate Demand for reserves Deposit rate Rate of interest on reserves Reserves

Timeline at the Fed IV • On 6 November 2008, the interest rate on all reserves at the Fed is set as the target fed funds rate (1%). • Despite this, the fed funds rate hovers between 0.10% and 0.62%, getting ever lower. • Finally, on 17 December 2008, the Fed announces a target between 0 and 0.25%, with a rate on reserves at 0.25%, and actual fed funds rate in 2009 (and still now) is between 0.10 and 0.24%.

The floor system: this is what should have happened with the target rate set at the deposit rate, and with a large amount of reserves : the fed funds rate is exactly equal to the deposit rate S S’ Lending rate Demand for reserves Target rate and Deposit rate 1% Reserves

Why doesn’t the fed funds rate stay at the bottom of the corridor? • Not all participants (GSEs: Freddie Mac, Fannie Mae) to the fed funds market are eligible to receive interest on their reserve balances. • There are also foreign institutions that hold balances at the Fed that don’t get interest on reserves. • They may thus lack bargaining power and being forced to lend their surplus funds at a rate below the floor.

Implications for PK monetarytheory

The Decoupling Principle • With the corridor system, achieving a higher target overnight rate did not require any change in reserves. • With the target interest rate set at the floor of the corridor, central banks (FED, BOC) can now set the target rate at the level of their choice and simultaneously set the amount of reserves at the level of their choice. There is no relationship anymore between reserves and overnight rates. • This is the decoupling principle (Borio and Disyatat 2009) • Central banks can have an interest rate policy divorced from a supply-of-reserves policy.

The floor system • The floor system was recommended by Woodford (2000, p. 255), Goodfriend (2002, p. 3), Ennis and Keister (2008), and in more detail by Keister et al. (2008). • It was also advocated by the post-Keynesian/Institutionalist Scott Fullwiler (2005) • The floor system was adopted in New Zealand and Norway, before the crisis! Click View then Header and Footer to change this text

Implications for PK theory • On a day-to-day basis, the supply of reserves is vertical (as represented here). • A standard assertion of PK theory was that the supply of reserves is demand-determined, at the target overnight rate (the supply of reserves is said to be horizontal). • With the target overnight rate set at the floor of the corridor, this is no longer true. • The supply of reserves can exceed the demand for reserves. The central bank can maintain excess reserves (as long as banks don’t wish to pay back central bank advances).

A point of controversy • Some PK or NK authors believe that paying interest on excess reserves leads to more credit rationing and less economic activity (Palley 2010, Pollin 2010,Stiglitz 2010). • Their argument is that the opportunity cost of holding reserves is reduced when interest is paid on reserves. This would induce banks to make less loans to firms or households. • They propose to remove interest on reserves, and even to tax excess reserves, so as to induce banks to make more loans. Click View then Header and Footer to change this text

PK controversy • These authors don’t seem to realize that, as pointed out by Fullwiler (2005), “banks cannot use reserve balances for anything other than settling payments or meeting reserve requirements; reserve balances do not fund additional lending”. • Their argument is that other post-Keynesians don’t understand microeconomics and overly rely on macro laws (such as above). • Each individual bank will try to get rid of excess reserves by making new loans and hence new deposits. Thus compulsory reserves will rise, and hence excess reserves will decrease. • Their beliefs, ultimately, must be based on some implicit version of the money multiplier story, and on the belief that banks make a choice between loans to NFI and reserves. • The Fullwiler-Lavoie answer is that taxing reserves will only lead to a reduction in the federal funds rate, as the alternative, holding reserves, now has a lower rate of return. The choice is between holding reserves or lending reserves to other banks. Click View then Header and Footer to change this text

Support for PK position by Bank of England deputy governor • “The level of commercial banks’ reserves in aggregate is determined by the way we have funded the asset purchases, not by the commercial banks’ own decisions. The size of banks’ reserves cannot, as is frequently claimed, be a sign that they are “sitting on them”. No matter how rapidly or how slowly the economy is growing, or how fast or slow the money is circulating, the aggregate amount of reserves will be exactly the same. So it should be clear that the quantity of central bank reserves held by the commercial banks is useless as an indicator of the effectiveness of Quantitative Easing” (Bean 2009). Click View then Header and Footer to change this text

Quantitative easing ? • It is sometimes said that the Fed was pursuing quantitative easing (QE1), with the Fed providing excess reserves in the hope that banks would then make more loans to the private sector. • The analysis here shows that the Fed instead was pursuing credit easing, taking illiquid assets out of the market. The creation of excess reserves was simply the consequence of these credit easing operations. Click View then Header and Footer to change this text

Credit easing, not quantitative easing • “It is important to keep in mind that the excess reserves in our example were not created with the goal of lowering interest rates or increasing bank lending significantly relative to pre-crisis levels. Rather these reserves were created as a by-product of policies designed to mitigate the effects of a disruption in financial markets. In fact, the central bank paid interest on reserves to prevent the increase in reserves from driving market interest rates below the level it deemed appropriate given macroeconomic conditions”. (Keister and McAndrews 2009) Click View then Header and Footer to change this text

QE2 • Quantitative easing operates through an attempt to lower interest rates on assets that go beyond short-term government securities. • Instead of announcing the purchases of given amounts of securities and hoping this will have the forecasted effect on interest rates, shouldn’t the monetary authorities announce that they will purchase any given amount of government securities at a pre-announced price, thus setting the long-term interest rate on government securities? (Fullwiler and Wray 2010) • What is the risk of such a policy: will the central bank be forced to purchase huge amounts of government securities? • And if so, with a floor system, what is the problem? Click View then Header and Footer to change this text

Implications for central banks and mainStreamTheory

The problem of central banks today • Standard theory says that reserves create money, and money creates price inflation. • So if there are large excess reserves, this should lead to excess money supply or at least overly low interest rates, and hence inflation now or in the near future. • But the decoupling principle shows there is no relation between reserves and interest rates, and hence no relation with prices. • « There is a concern that markets may at some point, possibly based on the ‘wrong model’, become excessively concerned about the potential inflationary implications of these policies » (Bordo and Disyatat, BIS, p. 22). • This means that the ‘market’ has the ‘wrong’ model. • Gone are models of rational expectations within a single ‘correct’ model of the macroeconomy!

Central bank communications • There is a big effort by central bankers in the US to convince financial experts that the correct monetary theory has changed: excess reserves do not lead to inflation. • As said by William Dudley (2009, p. 1), the President and CEO of the New York Fed, “it is not the case that our expanded balance sheet will inevitably prove inflationary. It is important that this critical issue be well understood” • Keister and McAndrews, NYFRB (2008, 2009) claim that no inflationary pressures can arise when the target fed funds rate is the deposit rate. • The reason given is that banks have no opportunity cost in holding these reserves, and hence will not try to use them by lending them. • They reluctantly give some credibility to the multiplier story, but only when there is no floor system.

My critique to Keister (January 2009) • “You seem to imply that the textbook multiplier still applies when reserves earn no interest. I think that this is a misleading statement. It implies that there is a bunch of agents out there, waiting for banks to provide them with loans, but that they are being credit rationed because banks don’t have access to free reserves. ...Rather what happens when excess reserves are being provided with no remuneration of reserves is that the fed funds rate drops down, as banks with surplus reserves despair to find banks with insufficient reserves, having no alternative but a zero rate. The drop in the fed funds rate may induce banks to lower their lending rates, and hence induce new borrowers to ask for loans or bigger loans, but it really has nothing to do with the standard multiplier story. If there is no change in the lending rate, new creditworthy borrowers just won’t show up. There is never any money multiplier effect.”

Keister (NYFR) in personnal communication, January 2010 • “I agree with you on the money multiplier, but I would state things in a slightly different way....I understand your comment to be that this mechanism is not the ‘money multiplier’ as commonly described. We decided to be more generous to the textbooks and say that this mechanism must be what they had in mind, even if they left out the part about interest rates to simplify things for the students. Importantly, I think we agree on the point that discussions of the money multiplier have done more harm than good in terms of helping people understand what is going on.”

Implications for fiscal policy • If reserves can be remunerated at a rate of interest which is not far from that of Treasury bills, why bother selling T-bills to private markets when running a federal government deficit? • The T-bills can be sold directly to the central bank, thus creating bank reserves when the government spends. • The deficit can be financed by forcing banks to hold more reserves. • Banks should be indifferent between holding central bank reserves and Treasury bills (if rates of return are close to each other). Click View then Header and Footer to change this text

Conclusion • The global financial crisis may have one good result: it may succeed in getting rid of the false and misleading money multiplier story, which ironically, was given strong support by Keynes (1930).

Central banks in chaotic times Marc Lavoie