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Monetary Policy in Disarray

John A. TatomNetworks Financial Institute

Indiana State University

Reforming Finance: Balancing Domestic and International Agendas

June 7, 2012

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Monetary Policy in Disarray• Monetary policy became more difficult to characterize since 2006

because of the new credit policy, focused on private sector credit.• The policy relied on commercial banking strategy, instead of

central banking strategy.• Examples are: selling Treasury assets, paying subsidies to banks

for holding reserves and attracting a new class of Treasury debt sterilized in Fed deposits.

• Policy broke the tight link that had existed between Fed credit and its effective monetary base.

• Despite an exit strategy, the discretionary powers remain in place.

• The paper also reviews Fed claims that it has followed Friedman’s monetary policy framework.

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Highlights• Since 2006, the Fed’s credit policy relied on traditional

commercial banking strategies.• Commercial bankers expand assets by selling other

assets or attracting new liabilities. • Focus on credit obscured recessionary moves in the real

federal funds rate and monetary base. • The Fed caused, deepened and lengthened the

recession, and weakened the recovery. • Open market operations could more safely and cheaply

have increased money and credit. • The Fed has subsidized banks, and took on

unnecessary interest rate and credit risk.

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Outline

• Intro• Interest rate policy• Monetary base and excess reserves• Credit policy

– Cost of excess reserves– Commercial banking strategies– QEI and QEII

• Conclusion

The Fed Exported its Balance Sheet Policy

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Interest rate policyThe Real Federal Funds Rate Sometimes Shows Different Signals

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Monetary Policy in Disarray

• Monetary base and excess reserves– The Fed, monetary base and credit– Financing nontraditional assets– Monetary base and recession and recovery

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Money and monetary base

• Conventional model:M = [(1 + c)/(c + p + e)] MB = [(1 + c)/(c + p)] MBAwhere M = money(M1);MB = monetary base; D = depositsc = currency ratio = currency/depositsp = required reserve ratio = req. res./deposite = excess reserve ratioMBA = MB – e D

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Fed credit and the monetary base

• Total Fed credit (TC), including that created via banks, equals M in this model.

• So money and Fed credit cannot be changed independently.

• A credit view of Fed policy has to posit that Fed private credit is more powerful in affecting spending than other credit (Treasury securities).

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Fed private credit

• Let Fed private credit (PC) = RBC – TS, where RBC is Reserve Bank Credit and TS is Treasury securities.

• Then PC = [M/(1 + c)] (p + c + e + o) – TS, Where o = Other Fed liabilities/Deposits• Besides M, Fed PC can be raised by

raising e, o, or reducing TS

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New sources of Fed private credit

• Boost excess reserves (e) by paying interest on it

• Boost other liabilities (o)--new Treasury deposits held at Fed obtained by new security sales, ultimately to public.

• Reduce Treasury securities held outright• None of these affect M or TC

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The Fed, monetary base and excess reserves

• Until 2007, monetary base tightly connected to Fed credit, monetary aggregates and then spending (GDP)

• Since then, not so. The Fed intentionally broke links in pursuit of credit policy and nontraditional balance sheet policies.

• Fed aimed to expand credit without expanding monetary aggregates, especially non-bank private sector credit.

• Three key tactics: pay interest on reserves to boost excess reserves, coordinate new Treasury debt sterilized at Fed, reduce traditional assets.

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Sources of Financing for Nontraditional Assets

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Nontraditional Funding of Non-Treasury Assets(August 2007 to June 2011)

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Paying interest on reserves

• See Keister, Martin and McAndrews (2008) for explanation of Fed thinking on this, “Divorcing Money from Monetary Policy.”

• Follows Milton Friedman (1959)? Yes/But– Uses a subsidy rate, not risk free rate.

• Authorized in 2006 to begin in 2011. In July 2008, Fed obtained authority to begin this early. Aimed at lowering SWEEPs.

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Cost of excess reserves to support credit policy

• Rate set at 25 basis points. • January 2009 to June 2011, cost of

subsidy (over 3-month T-bill rate) is $3.3 billion.

• Based on first half of 2011, $2.3 billion per year. 97.5 percent due to excess reserves.

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Monetary Base Growth leads GDP

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The broken link between the monetary base and FR credit

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Monetary Base Adjusted

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Central vs. commercial bank tactics

• Central banks expand money and credit by buying assets with newly printed money.

• Commercial banks fund new assets by increasing liabilities or reducing other assets.

• Fed imposed unnecessary commercial constraints on their stimulus and focused on direct lending to the private sector instead of safe expansion of credit.

• Similar to depression era focus on lending to banks and reluctance to use OMO.

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Exit strategy• Treasury securities increased slightly 3/2009 – 9/2009,

then flat for one year. Exit begins in 9/2010, back to 50% in 3/2011.

• August 2011: Agency and MBS: $1 trillion(agencies-- $10 million, 2002 – 12/2003, then zero until 9/2008. MBS not held until 1/2009, despite explicit guarantee)

$50 billion of portfolio holdings (junk) $11.7 billion of ABS• Fed’s Treasury assets are longer term (50% >10 years;

90% > 5 years, than earlier. (interest rate risk)• Still large amounts of credit and interest rate risk.

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Depression parallel• Major criticism of the Fed during the Great

Depression was that it acted more like a commercial bank than a central bank.

• Epstein and Ferguson (1984): Fed responded to pressures from large commercial banks to keep interest rates up by not conducting OMO.

• The Fed appeared to be inadequately aware of the ability to boost its liabilities by acquiring assets and the benefits from such actions.

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Crudest parallel: Treasury Supplementary Financing Program

• Began 9/17/2008, the Treasury sold marketable securities, the proceeds from which they promised to leave on deposit at the Fed. Officially, the purpose of the deposits at the Fed was to drain reserves that had been created by new credit facilities.

• Or expand the balance sheet and finance private sector credit (like a commercial bank)?

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Test the alternative views• Fed view: Treasury deposits should be

negatively correlated with bank reserves. • Commercial bank view: Treasury deposits

positively correlated with RBC.• Correlations, 132 weeks from 9/24/2008 to

3/30/2011, for weekly changes:Treasury suppl. Deposits—reserves: -0.03Treasury deposits—RBC: 0.55Treasury deposits—non-tradit. Assets: 0.56

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Alternative policy (OMO)• Over 42 months from peak in 12/2007 to

6/2011, Fed could have increased MBA by 7 percent per year by buying $225 bn of Treasury securities, instead of actual $107.6 billion.

• RBC and total assets of Fed would have risen only $224.6 billion, instead of $1.9 trillion!

• Fed is more interested in leveraging up its balance sheet.

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Did the Fed follow Milton Friedman?

• Ed Nelson (2011). “Friedman’s Monetary Economics in Practice,” BOG Finance and Economics Discussion Series WP 2011-26, April.

• 5 key elements—broadening of deposit insurance to reduce systemic risk, recapitalization of commercial banks, extension of discount lending to financial system at rates below those before crisis, adjust Treasury security holdings to lower interest rates, payment of interest on reserves.

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Did they? • broadening of deposit insurance to reduce systemic risk

Not Fed (FDIC), Not broadening (?)• recapitalization of commercial banks

Not recap (preferred); forced sale; repaid ASAP• extension of discount lending to financial system at rates below

those before crisisFriedman opposed discount lending to banks and to other firms even more

• adjust Treasury security holdings to lower interest ratesFed reduced Treasury securities drastically 7/2007 to 2/2009(!)

• payment of interest on reservesnot at a subsidy rate—opportunity cost (risk-free overnight T-

bill rate), not FF rate; efficiency argument; not on excess reserves(?)

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Conclusions• Fed caused the recession, its depth, and the financial

crisis by tight liquidity policy; it weakened and delayed the recovery.

• The Fed’s credit policy was a huge mistake: exposed the Fed to substantial credit and interest rate risk; confused the public on its intentions and objectives, masked tight money.

• The authority to lend should be removed (not limited)• The Fed should return to a rule based, fixed penalty

discount rate.• The Fed should pay interest on required reserves at the

T-bill rate and zero for excess reserves. •

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Thank you!

For more information, questions, or comments, please feel free to contact me:

jtatom@earthlink.net