Monetary Policy as a Confidence Game

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The Board Of Governors The Forever ZIRP

The Board Of Governors: Chair Janet Yellen, Vice-Chairman Stanley Fischer, Jerome H. Powell, Daniel K. Tarullo, Lael Brainard

Tomorrow the Federal Reserve (Fed) is expected to announce that they will raise interest rates for the first time in eight years. Dr. Janet Yellen, the Chair of the Board of Governors, studied at Yale under Prof. James Tobin, one of the most outstanding monetary theorists in history. She has had it drummed into her head that raising interest rates is contractionary and lowering rates is expansionary. The only explanation I can think of is signaling. By raising interest rates the Fed believes they can send a signal to markets about the Fed’s confidence in the economic recovery. In other words, the Fed is playing monetary policy as a confidence game.

Will it work? I’m skeptical that the Fed can even manage to raise the Federal Funds rate. For my reasoning, read on.

M1, M2, Reserves, Oh My

A few months back I wrote about the arcane topic of the relationship between monetary aggregates (M1, M2) and bank reserves. At the end of December 2014, excess reserves were about 95 percent of total reserves. The Federal Reserve (Fed) was holding $2.66 trillion in total reserves, but required reserves were $142 billion.

Most Fed-watchers believe the Fed will announce an interest rate increase at the conclusion of the current Federal Open Market Committee (FOMC) meeting tomorrow. The question I want to explore is how they will manage to accomplish that goal.

Background: Federal Funds, Reserves, and the Fed

Since about 1975 the Fed’s monetary policy target variable has been the Federal Funds rate.[1] There’s nothing mysterious about this interest rate. It is the rate banks charge each other for 24 hour lending and borrowing of bank reserves. The historic reason for these activities has been reserve requirements. Banks are required to hold a minimum percentage of their deposits as reserves. Reserves include vault cash and deposits at the Fed.[2] Vault cash is just currency held by the bank.[3] Deposits at the Fed are called bank reserves.

Again historically, when the Fed has wanted to raise the Federal Funds rate they engaged in an open-market sale of government securities. The result of this transaction is that the private sector ends up holding more securities and the Fed holds more deposits. Deposits held by the banking system have decreased. So have required reserves.[4] Banks will reduce their reserve holdings. And a lower quantity of reserves reduces supply in the Federal Funds market, pushing up interest rates. When the Fed wants to lower interest rates they engage in an open market purchase of government securities, increasing bank reserves.

The point of all this is that the Fed actually relies on the market mechanism – supply of and demand for reserves – to hit interest rate targets.

Brave New Monetary World

Today banks have $2.5 trillion in excess reserves. I sometimes marvel at the fact that there is any demand in the Federal Funds market at all. But there apparently is. The Fed will raise their target for the Federal Funds rate. That will induce … what? Banks will want to lend more of their excess reserves to other banks, but the higher interest rate will reduce quantity demanded. The outcome is unpredictable. But I will hazard a guess that the Fed will discover they can’t actually raise the Fed Funds rate.

I know there are some smart people on the Board of Governors. I have the highest respect for Dr. Stan Fischer. Some of his work was the inspiration for my Ph.D. dissertation. But honestly I am not sure they have thought this through.

There is one other possibility: they might raise the discount rate, the interest rate the Fed charges banks for borrowing from the Fed. That would be consistent with the hypothesis that all this is mainly propaganda.

Global Markets Matter

One factor overlooked by many people is the large disparity between U.S. interest rates and similar rates in other countries. I wrote about this recently and won’t repeat the story here. But I will say that markets expect a serious U.S. dollar depreciation over the next ten years. If that happens, the effect may well be to put downward pressure on U.S. interest rates. There is considerable uncertainty about this because of the role of expected future exchange rates in uncovered interest parity. I may do some research and add another note later this week.

The Fed as Proselytizer[5]

Any objective look at the U.S. economy will tell you that the best word to describe the current recovery is “troubled.” People continue to flee the labor force. That decrease in the number of people either employed or looking for work has mainly been caused by a decrease in the labor force, the sum of those two totals. The percentage of people with part-time jobs who would like a full-time job is reaching all-time highs. Inflation remains barely detectable. Indeed, just this morning I heard a not-very-bright observer comment that inflation has been low because of declining oil prices. You may recall that decades ago the Fed created the “core CPI” which excluded the “volatile” prices of food and energy. Apparently now that energy prices are falling, they have begun watching the overall CPI again. Which is, of course, nothing more than cherry-picking the economic indicator that most justifies what you plan to do anyway.

So why raise interest rates? Dr. Janet Yellen studied at Yale under Prof. James Tobin, one of the most outstanding monetary theorists in history. She has had it drummed into her head that raising interest rates is contractionary and lowering rates is expansionary. The only explanation I can think of is signaling. By raising interest rates the Fed believes they can send a signal to markets about the Fed’s confidence in the economic recovery. The Fed is playing a monetary policy confidence game.

Will it work? Tell you what – first let’s see what the FOMC actually announces. If they just raise the discount rate it’s pure public relations. If they announce a higher target for the Fed Funds rate, then we get to see if they can actually pull it off. Either way, the next week or so should be entertaining.

Update on M1, M2, and Bank Reserves

I know that both my faithful readers would be disappointed if I didn’t include some numbers in this treatise. But it doesn’t matter because nothing much has changed. At the end of November, 2015, total bank reserves were $2.66 trillion. Of that, $0.15 trillion are required reserves, leaving $2.15 trillion in excess reserves, 94.44% of the total. The only glimmer of good news is that totals have not changed much since the beginning of 2014. As always my methods are transparent. Click here to download the Excel workbook with the underlying figures and my calculations.

Conclusion

“May you live in interesting times.” When I was studying monetary theory in graduate school I never imagined this old Chinese curse would apply to the mundane field of monetary policy.

[1] The best-known exception to this general rule is from 1979-1981 when Paul Volcker changed the focus to the growth rate of the money supply. Mr. Volcker retains his hero status to many of us for knowing how to kill off inflation.

[2] Yes, I know it’s more complicated than this. For current purposes I only need a simple model.

[3] I have long believed that it’s called “vault cash” as a constant reminder to bankers about where they should keep currency. Put it in the vault. Don’t leave piles of Federal Reserve notes lying around on the counters. Sound banking practices are sometimes very simple.

[4] If you don’t like this story, try the case where the Fed sells securities directly to banks. The banks pay for those securities with reserves, reducing the quantity of reserves directly.

[5] Look it up.