A James Alexander post
I was involved in somewhat arcane Twitter exchange yesterday with Frances Coppola, after she retweeted Cullen Roche criticising a NYT article by Binyamin Applebaum. The piece was trying to explain the tricky technicalities of rate-raising given QE.
Somewhat ironically, I think Roche may have misunderstood the article but the Twitter exchange was based on a real issue. The sub-headline he objected to suggested Interest On Excess Reserves held by commercial banks at the Fed was “Paying Banks not To Lend”. Actually, the article was merely presenting the Fed’s view that they would have to raise IOER as they tightened monetary policy. A fairly uncontroversial notion even if the raise itself is highly debated.
Coppola, Roche and Market Monetarists are all sceptical about the need of the Fed to raise rates now. So, in that sense we are all on the same side. Where we differ, I think, is over the point of paying any IOER when you are also trying to do Quantitative Easing (QE). At the moment the Fed pays 25bps.
Well, I have read both now and I still don’t get it. What was the overarching point of QE except to ease monetary policy at or near the Zero Lower Bound? If at first it was technically to add to liquidity to prevent more banks going to the wall, by QE3 it was a substitute to moving interest rates nominally negative.
My question remains: Why pump new money into the economy only to incentivise banks to do nothing with it by paying IOER? Why pay any interest at all? What’s the point?
Scott Fulwiler at New Economic Perspectives in the first link just asserted:
“The Fed simply must set a price—it cannot do otherwise. Not setting a price of reserves when it attempts to expand the monetary base simply means setting the price of reserves at zero.”
Well, what’s wrong with setting the price at zero, especially if you are trying to ease monetary policy.
Paul Sheard, S&P Chief Economist in the second link had an answer, of sorts:
“It might be asked: if banks cannot lend the excess reserves that the central bank provides, what is the point of the central bank supplying them? The answer to that question is simply that QE does serve to ease financial conditions.”
That’s clear. I and everyone must have rather missed the point.
To be fair the subsequent text from Sheard indicated there might be some minor practical impact via having interest rates for lending lower than they otherwise would be, but that was it.
I certainly understood the creation of excess reserves being a function of the rising Fed balance sheet in the absence of any strong nominal growth. But there is no need to explain the bleedin’ obvious in such painful detail. People want to know why it isn’t working very well. Why have the Fed and the other central banks pumped up their balance sheets and seen so little, or rather, less inflation, and less growth that we all want.
Using the identity of MV=PY as a starting point, PY (aka Aggregate Demand or Nominal GDP) has not risen despite the rise in M because V has not really got going. In fact must have fallen. Why has V fallen? How can it be got going?
Surely, one way would be to stop incentivising the piling up of all these excess reserves? I understand the reserves are not crimping lending if there was more demand for loans, but they are crimping velocity. Stop paying IOER and the banks have less incentive to lock them away with the Fed. The banks could buy securities or other financial assets from the market and get the cash circulating. It may still come back, but they the banks will just have to try harder. And not have the Fed take away the hard work from them, don’t make it so easy to do nothing!
It’s as if the central banks gives us money to go and party, but then induces us not to with special offers on its alcohol-free liquor from its own store. How will that work out?
Of course, Market Monetarists suggest an even better way that may actually erase the need for QE at all – work with market expectations. This would end the other self-defeating central bank paradigm of Inflation Targeting set at 2% – a sort of endlessly dull low alcohol party. Japan found that the market’s fear of central bank tightening anytime a recovery threatened any sort of a move to their inflation targeted killed the recovery. The Fed seems to be entering the same trap.
My “no tightening now” friend Frances Coppola should not turn into an enemy on these two issues. it doesn’t seem like she’d have to make a great leap, and I just can’t see the obstacles. We both want prosperity. So, ending sterilisation of Excess Reserves and moving to Nominal GDP Level Targeting would help achieve our common goals.