No Exit

FOMC, Interest on excess reserves, negative interest rates, reverse repos, Stanley Fischer
World Economic Forum, "The Rise of Unconventional Monetary Policy, Fischer," CC BY 2.0

Fischer ThirdSartre famously wrote, "L'enfer, c'est les autres" (“Hell is other people").  In his recent speech, Fed Vice Chairman Stanley Fischer, assisted, as he says, by William English of the Board's staff, supplies an example of hell being the "other policy."

The last substantive paragraph of Fischer’s speech includes the following summary of current FOMC policy:

The Committee has indicated that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively.  But that statement leaves open the question of when we should begin to reduce the size of our balance sheet.  Because the tools I mentioned earlier — the payment of interest on reserve balances and the overnight reverse repurchase facility — can be used to raise the federal funds rate independent of the size of the balance sheet, we have the flexibility to adjust the size of our balance sheet at the appropriate time.  With the federal funds rate still quite low and expected to rise only gradually, I think there is some benefit to maintaining a larger balance sheet for a time.  Doing so should help support accommodative financial conditions and so reduce the downside risks to the economic outlook in the event of a future adverse shock to the economy.  Consistent with this view, the Committee has decided to continue to reinvest principal payments from its securities portfolio until normalization of the federal funds rate is well under way.  The decision about when to cease or begin phasing out reinvestment will depend on how economic and financial conditions and the economic outlook evolve.

From this statement one gathers a number of facts.  First, the Fed remains determined to stay on an interest rate-raising path, as circumstances allow.  The question here is, just what are the circumstances presently pointing to the desirability of further raising interest rates?

Second, the Fed plans to maintain its bloated Fed balance sheet, including reinvesting maturing asset balances, for the indefinite future, instead of looking hard for a chance to reduce it, as it has long promised to do.

Third, we're still going to pay increased interest rates on excess reserve balances (a subsidy) and maintain the raised rate on the already subsidized reverse repo transactions (principally for nonbanks).  One wonders what would happen in the market to those rates if the Fed allowed the balance sheet to shrink, even short of outright asset sales, by simply allowing maturing assets to roll off and stopping the implicit subsidy of reverse repos.  Has anyone on the Board's or FRBNY's staff done such a study?  If not, isn't the absence of such a study a hallmark of willful indifference to "data-driven policy"?  If such a study exists, shouldn't the transparent Fed release it so that we might see it?

Finally (a case of omission), Fischer’s speech says not a word, either in his summary or in the rest of his speech, about negative rates.  If the Fed (which created a generation's worth of new reserves in recent years) stopped intervening in the Federal funds market, one wonders where market rates would go.  I think they would go negative, at least briefly, before eventually recovering with normal economic activity.

A negative rates environment might be a powerful incentive to bankers, encouraged if need be by bank examiners and discount window officers, finally to restructure legacy (that is, pre-2009) debt at the household and firm level (the one very big thing that was done in the 1930s that was not done after 2008).  The payoffs for such restructuring would be resumption of natural economic growth as debt burdens are eased, with positive (but significantly lower than present) interest rates on the restructured debt.  In my tax practice, I still encounter too many households paying 8 or 9 percent interest on legacy mortgage, car loan, and student loan debt.  It won't do to say that credit scoring requires such outrageous spreads; credit scoring is rotten to the core, and bankers know it (or should know it).  The scores are low because the debt is not restructured.  Also, the insurance industry now sets rates using credit scoring; no one at the Fed appears to be concerned about this expansion of the use of credit scoring.  This bankers' and insurers' sword is not what was intended when credit scoring was invented as a shield for use in the banking industry in judging patterns of racial discrimination in mortgage lending in the 1980s and 1990s.  Congress and the Fed gave bankers a shield and they turned it into a sword.

In short, it looks as though the Fed is persuaded that economic growth will resume and increase once the prices of oil and other commodities stop falling.  If there is a historical or an econometric policy model supporting the Fed's current policy mix, I'd like to know what it is.  The data so far, and the Japanese experience since the 1990s, seem to suggest that maintenance of Fed-managed low interest rates to stimulate economic growth against a backdrop of elevated excess reserve levels tends, if anything, to depress economic activity.  (Japan finally took its official rates into negative territory last week, by the way.)  What Vice Chairman Fischer describes is but a procrustean attempt to make the Fed’s model fit the data.  One wonders what economy, shorn of its limbs, will emerge from the other side of the Fed’s latest, indefinite policy commitment.

I’m not suggesting that negative rates are a cure for all that ails us.  The Swiss experience indicates that negative rates merely stop the bleeding (in this case, adverse domestic economic effects of high foreign exchange value of the dollar), giving the patient a respite during which natural healing forces might take over.  In any case, Fed tolerance of temporarily negative rates cannot possibly have worse cumulative economic effects than the bloated balance sheet policy that actually has been followed, with no exit in sight.

  • Dan Thornton

    I agree with Walker
    Todd’s first three statements based on an excerpt Vice Chairman Stanley Fischer’s
    speech, but not his suggestion that negative interest rates might be
    beneficial. I have no doubt that they would give bankers an additional incentive
    to “restructure legacy debt,” but I would have thought that the extremely low
    interest rates that we’ve had in recent years would have been incentive enough.
    Moreover, the Fed can only achieve this by making the IOER negative. This would
    cause banks to make loans or other investments that yield positive returns.
    This would convert excess reserves into requirement reserves resulting in an
    explosion of the money supply because each dollar of required reserves supports
    about $11.5 in checkable deposits: Banks currently hold about $2.3 trillion in
    excess reserves. While I frequently suggested this option when I was an
    economist at the St. Louis Fed, I did so tongue-in-cheek, the idea being that
    it would create a massive inflation that would force the FOMC ineffective and
    ultimately damaging zero interest rate policy. I didn’t really want this
    outcome because inflation is terribly destructive and because experience has
    shown that once the inflationary process begins is tremendously difficult to

    • George Selgin

      "This would convert excess reserves into requirement reserves resulting in an
      explosion of the money supply because each dollar of required reserves supports
      about $11.5 in checkable deposits: Banks currently hold about $3.3 trillion in
      excess reserves. While I frequently suggested this option when I was an
      economist at the St. Louis Fed, I did so tongue-in-cheek, the idea being that
      it would create a massive inflation that would force the FOMC ineffective and
      ultimately damaging zero interest rate policy."

      But you assume, Dan, that the Fed would not be compelled to sell assets as the multiplier recovers, precisely so as to avoid the inflationary consequences to which you refer. That seems to me a wrong application of ceteris paribus reasoning. Surely those who would like to see a Fed policy geared toward a revival of the base-money multiplier all take for granted that such a revival would be accompanied by an offsetting reduction in the quantity of base money. Indeed, the fact that it would compel such a reduction, and corresponding return of the Fed to something like its former "footprint" on credit markets, is all the more reason, in my opinion, for favoring a policy of negative interest rates.

      • Walker Todd

        Well done, George. Walker Todd, Chagrin Falls, Ohio

      • W. Ferrell

        Ah. So the Fed could just sell a $trillion of the bonds they hold and not raise interest rates? In a country with total debt in the 360% GDP ballpark, that shouldn't cause a problem.

        • George Selgin

          W. Ferrell, the question is not whether the Fed should or shouldn't take steps to raise interest rates. It is whether the best way to raise rates, assuming the Fed is determined to pursue that course, is by lowering IOR and selling assets, or by trying to prop rates up by means of higher IOR and repos, as it did in December.

          In any event, the alternative policy does not have to be implemented in one fell swoop, as you seem to assume. By imagining that it is a question of all or nothing you make it (and me) seem more unreasonable than is the case.

      • Dan Thornton

        Well George, of course you'd be correct if anyone in the FOMC was paying the slightest attention to the monetary aggregates, or if inflation jumped to a high level abruptly and they made the connection between the rise in inflation and money growth. But, of course, hardly anyone on the FOMC pays any attention to money. More importantly, the person making policy certainly doesn't. Moreover, it is unlikely that inflation will shoot up like Old Faithful. It is more like that inflation will initially rise gradually and that policymakers would not get concerned until it reaches at least 4 to 6 percent. But, by then, it might be too late. Moreover, you are not considering the fact that (for reasons that they have not articulated much beyond Vice Chairman Fischer's statement that he believes "there is some benefit to maintaining a larger balance sheet for a time") the FOMC has been loath to reduce the size of the balance sheet.

  • Benjamin Cole

    Have to say I don't find the Fed's balance sheet to be bloated. Sometimes the balance sheet is larger, sometimes smaller. A good case can be made that the Fed should indicate that the current increase in the balance sheet is more or less permanent.

    I think I concur on interest on excess reserves. The IOER and reverse repurchase agreements seem to be industry subsidies in drag, cloaked as monetary policy.

    It may be time to consider QE as a conventional policy, to be conducted at moderate levels in perpetuity.

    The world is awash in capital, excess capacity, and weak demand. Perhaps we need a global summit of central banks who together say they will conduct aggressive QE programs until we begin to approach the capacity utilisation rates that we need.

    I am all for cutting down whatever structural impediments we can. You tell me when we can get rid of property zoning, occupational licensing, the USDA and rural subsidies, the national security budget, the Department of Commerce, extensive state and local regulations. And yes, the home mortgage interest tax deduction.

    It is plain that a central bank can always point at structural impediments and claim the problem rests in the fiscal-regulatory side, and not the central banking side.

    Given the robust growth we saw in the United States of the 1950s and 1960s, should we believe central bankers?

    • Joch C.

      You are going to confuse the ignoramus with you sarcasm, facts and logic.

      • George Selgin

        Which "ignoramus," Joch C.?

        • Joch C.

          I suppose it depends on how much of Benjamins comment is sarcastic and how much is sincere. He may be confused; I may be confused, not quite sure.

          In the larger picture, the ignorant I refer to is people who
          believe an alternative monetary future includes the Federal Reserve.