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Marcus Nunes sent me an interesting old post from Paul Krugman. Here’s Krugman in November 2008:

Nearly every forecast now says that, in the absence of strong policy action, real GDP will fall far below potential output in the near future. In normal times, that would be a reason to cut interest rates. But interest rates can’t be cut in any meaningful sense. Fiscal policy is the only game in town.

Those were the posts that had me pulling my hair out in 2008. Why wasn’t Krugman calling for monetary stimulus? One answer is that rates were already at zero, and hence could not be cut any lower. But there are lots of other ways to stimulate the economy. And even worse, rates weren’t yet at zero, the fed funds targets was 1.0% in November 2008. So I decided to follow the link in Krugman’s article, to see why he concluded that rates could be cut no further. And it led to this James Hamilton post:

There was yet another announcement from the Fed this week that caused my jaw to drop, though you’d think I’d be getting used to such surprises by now. The Fed announced on Tuesday that it will raise the interest rate it pays on both required reserves and excess reserves to the level of the target itself, currently 1.0%. My first reaction was, How in the world could that work? Why would any bank lend fed funds to another bank at a rate less than 1%, exposing itself to the associated overnight counterparty risk, when it could earn 1% on those same reserves risk free from the Fed just by holding on to them? It would seem paying 1% interest on reserves should set a floor on the fed funds rate, so that any fed funds actually lent between banks would have to offer a higher rate than the official “target.” But I’ve always been more persuaded by facts than by theories, and the effective fed funds rate reported for Thursday– the first day of the new regime– was 0.23%. So much for that theory. But what’s going on? The answer begins with the observation that the GSEs and some international institutions also have accounts with the Fed. But unlike regular banks, these institutions earn no interest on those reserves, so they would in principle have an incentive to lend out any unused end-of-day balances as long as they earn a positive interest rate. But that’s not a sufficient answer by itself, because there’s an incentive for any bank that is eligible to receive interest from the Fed on reserve balances to borrow those balances from the GSE at a rate less than 1%, get credited by the Fed with 1% for holding them, and profit from the difference. Why wouldn’t arbitrage by banks happy to get these overnight funds prevent the rate paid to the GSEs from falling below 1%? Wrightson ICAP (subscription required) proposes that part of the answer is the requirement by the FDIC that banks pay a fee to the FDIC of 75 basis points on fed funds borrowed in exchange for a guarantee from the FDIC that those unsecured loans will be repaid. If you have to pay such a fee to borrow, it’s not worth it to you to pay the GSE any more than 0.25% in an effort to arbitrage between borrowed fed funds and the interest paid by the Fed on excess reserves. Subtract a few more basis points for transactions and broker’s costs, and you get a floor for the fed funds rate somewhere below 25 basis points under the new system. Under this regime, the effective fed funds rate– a volume-weighted average of the rate associated with fed funds traded on a given day– would come in above the target if it is dominated by actual banks borrowing fed funds, and below target when dominated by GSE lending. In the latter case, the effective fed funds rate would seem to be a particularly meaningless statistic, reflecting nothing more than the institutional peculiarities just detailed. That means a couple of things for Fed watchers. First, fed funds futures contracts, which are based on the average effective rate rather than the target over a given month, are primarily an indicator of how these institutional factors play out– how much the effective rate differs from the target– and signal little or nothing about future prospects for the target. Second, the target itself has become largely irrelevant as an instrument of monetary policy, and discussions of “will the Fed cut further” and the “zero interest rate lower bound” are off the mark.

That seems to support Krugman’s argument. However in the remainder of the post Hamilton goes in a very different direction from Krugman:

There’s surely no benefit whatever to trying to achieve an even lower value for the effective fed funds rate. On the contrary, what we would really like to see at the moment is an increase in the short-term T-bill rate and traded fed funds rate, the current low rates being symptomatic of a greatly depressed economy, high risk premia, and prospect for deflation. What we need is some near-term inflation, for which the relevant instrument is not the fed funds rate but instead quantitative expansion of the Fed’s balance sheet. I continue to have concerns about implementing the latter in the form of expansion of excess reserves, which ballooned by another quarter trillion dollars in the week ended November 5. Instead, I would urge the Fed to be buying outstanding long-term U.S. Treasuries and short-term foreign securities outright in unsterilized purchases, with the goal of achieving an expansion of currency held by the public, depreciation of the currency, and arresting the commodity price declines. But the last thing we should expect to do us any good would be further cuts in the fed funds target.

I think this is exactly right. Once you’ve started paying IOR, what you need is not so much a bigger monetary base, but rather a bigger currency stock. Currency doesn’t earn interest. Hamilton was writing before I published my paper advocating negative IOR, so I wouldn’t have expected him to mention that out-of-the-box idea. Instead he points to the need for inflation, enacted by depreciating the currency and boosting commodity prices via QE. Krugman would counter that the Fed can’t change the price of assets like stocks, commodities and foreign exchange, because we are stuck at the zero bound. So let’s see who was right.

On December 16th, 2008, the Fed conducted a near perfect test of Krugman’s hypothesis. They cut the fed funds target (and the IOR) from 1.0% to 0.25%. Krugman would predict no effect, as the actual fed funds rate would stay around 0.25%. Recall that the Keynesian model says that what matters is the actual short term interest rate, not the target rate. In fact, the S&P500 rose by more than 5% on December 16th. Now I do realize that very few people share my faith in the EMH. And stocks did resume their downward trend over the next few months as new economic data showed the recession to be worse than expected. So let me also provide a mechanism for why the IOR cut mattered.

Unlike Keynesians, monetarists don’t believe the short term rate is the key mechanism for the transmission of monetary policy. Rather we look at things from a supply and demand for money perspective. Increases in the supply of money are inflationary, and increases in the demand for money are deflationary. The IOR program provides an excellent test of this hypothesis. A change in the IOR can change the demand for ERs, without necessarily changing the effective fed funds rate at all. We have four observations; the initial announcement of IOR on October 6, two subsequent increases in IOR in late October and early November 2008, and the big cut on December 16th, 2008. In all four cases stock prices moved strongly in response to the IOR announcement. The moves ranged from 3.85% to 6.1%, with an average change of over 5%. Those are relatively big daily changes. More importantly, all four changes were in the right direction; stocks fell sharply after the three increases in IOR, and rose sharply when IOR was cut. This is certainly not conclusive proof (four observations isn’t enough, and other things were going on at the time) but it’s four data points in support of the monetarist transmission mechanism.

If you pay people to hold on to ERs, there’ll be a greater demand for ERs. And when the demand for any good rises its value rises. But when the value of the medium of account rises, its nominal price cannot change, by assumption. Instead, the only way for the medium of account to become more valuable is for all other prices to fall. The Fed did a beautiful experiment in late 2008 by creating IOR—pity about the economy.

PS. Of course a much more powerful refutation of the liquidity trap view came from market reactions to QE1 and QE2.

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This entry was posted on May 30th, 2012 and is filed under Monetary Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



