Does Monetary Policy Have a Future?

bank lending, dual mandate, FOMC, interest on reserves, unconventional monetary policy
By Francesco Crippa (modified) CC BY 2.0: https://www.flickr.com/photos/8791553@N03/7967670670

fedcontrolsI have chosen a provocative title, but it is fully justified. Fed officials are flying on autopilot, but the controls don’t work anymore, or at least not reliably. Fed watchers are largely clueless. The investment community and the economy may be collateral damage.

Let me begin by briefly reviewing the recent past. All through last year, Fed officials were signaling they would begin a program of rate increases. At first, there were going to be 8 increases of one quarter point. As the year progressed, the first increase faded into the future. Finally, in December 2015, the Fed finally hiked its new interest-rate targets by 25 basis points. In my opinion, the FOMC did so largely to keep its credibility.

At the time, I wrote that “the chief effect of Wednesday’s action and accompanying statement is to once again increase uncertainty in financial markets” (O’Driscoll 2015). I became convinced that, promises to the contrary notwithstanding, the Fed would not raise interest rates again before December 2016. Instead, policymakers would dither all year. I forecast the earliest rate hike would be in December 2016. Note, I did not predict the Fed would actually raise rates this December, just that they would not do so before. I think I have been vindicated.

The reasons for Fed inaction were both political and economic, and they reinforced each other. On the political front, most Fed watchers naively ignored that 2016 was a presidential election year. Yes, the FOMC has raised interest rates in election years. But I felt there would be significant pressure on the Fed no to do so this year, and, frankly, I felt the Fed has become more politicized over the years. So, political considerations argued against a rate hike.

I turn next to economic considerations. The conventional economic case for increasing short-term interest rates was really quite weak. Neither of the two Fed mandates provided much justification. Early on, some Fed officials forecast that inflation would rise as the economy neared full employment. Yet the inflation rate remained stubbornly below the two-percent target. Next, Fed officials suggested the economy was approaching full employment. With or without inflation, they argued, the FOMC needed to start raising interest rates.

In fact, this recovery has been weak by any standard measure. It is a long recovery, but a weak one. That is true whether measured by output growth or employment growth. The contention that we are at or near full employment ignored labor-market realities. The Civilian Labor Force Participation Rate has been in free fall since the Great Recession. It has only recently shown an uptick. For men, the picture is even more dismal. The participation rate is near an all-time low. It is a largely unnoticed crisis, which Nicholas Eberstadt (2016) has chronicled. He estimated that there is a “male jobs deficit” of 10 million. The economy is not close to any reasonable concept of full employment. There was no employment justification for raising short-term interest rates.

I have come to the conclusion that the stated reasons for raising rates are not the real reasons, at least not for some Fed officials. They are constrained to Humphrey-Hawkins criteria (inflation and unemployment). But there is concern over the compressed margins for banks and money-market mutual funds. For banks, spread between borrowing rates and lending rates are compressed. For money funds, yields on eligible assets are very low, and it is difficult to pay a positive return to shareholders after costs. Can you imagine Fed Chair Yellen or New York Fed President Dudley saying we need to raise interest rates to make banking more profitable?

There are also international considerations. By now, central bankers are beginning to see the folly of negative interest rates. For the ECB to get rates just back to zero, however, U.S. rates must move higher into positive territory. Then, too, there are the EU’s banking problems. The cost of bailing out European banks could be monumental. A little extra economic growth from a weaker Euro would help finance that cost. Can you imagine if Fed officials said we need to raise U.S. interest rates to bail out the Germans?

There are good reasons for raising rates. They have been too low for too long. Capital is being misallocated all over the place as a result. Instead of stimulating investment in the real economy, low interest rates have fueled stock buybacks, M&A, and financial engineering more generally. The financial sector has grown at the expense of real economic activity. Asset bubbles have been created. The Fed’s policy of buying MBSs (Mortgage-Backed Securities) has channeled credit into housing. If these considerations were paramount, however, interest rates should have been higher long ago.

Some might say that, if I am correct, the Fed is in an impossible position. The economy is too weak to raise interest rates, but asset bubbles necessitate higher rates. That would be true if current monetary policy were stimulating the economy. In fact, unconventional monetary policy has been contractionary. To repeat, the policy of very low interest rates has been contractionary, not expansionary. The Fed has been dampening economic growth.

As already noted, very low interest rates have compressed bank’s margins. One can see that in the relatively flat yield curve. The point is even more compelling if one factors in risk. Lending is a risky activity. A bank must expect to earn a positive risk-adjusted rate of return. Right now it can earn 50bp risk free on reserves on deposit at the Fed. Moreover, those reserves satisfy the mandated liquidity balances of Dodd-Frank. Speaking of Dodd-Frank, its restrictions on risk-taking greatly reinforce the effects of the Fed’s low interest rate policies. Bank lending is discouraged. That has had an especially large impact on small business lending. Small businesses are the job creators for the economy. That is another reason why employment growth has been weak.

In a forthcoming article in the Cato Journal, Professor Charles Calomiris of Columbia University has estimated that the value to a bank of acquiring a deposit is approaching zero. Banks are actually turning deposits away. That implies, of course, that the value of all those branch networks is approaching zero since they are basically deposit-gathering facilities. The traditional business of banking may not be a viable model under current monetary and regulatory policies (Calomiris 2017).

To recapitulate, higher interest rates might actually spur economic growth. And they would be good antidotes to asset bubbles. What, then, are the prospects for higher interest rates?

The Federal Reserve’s unconventional monetary policy has robbed it of the ability to influence interest rates as it has in the past. That is particularly true for raising interest rates. The necessary linkages in monetary policy have been broken, or at least damaged.

In the past (pre-2008), how did the Fed raise interest rates? It sold short-term government bonds, Treasury bills. That pushed up the interest rates on bills and put upward pressure on other short-term interest rates. Banks, attracted to higher returns, competed for federal funds to lend. That drove up the fed funds rate, which restrained lending. The fed funds market was a choke point.

All these linkages are gone.

The Fed has zero Treasury bills on its balance sheet, so it has no short-term assets to sell. The policy of large-scale asset purchases — QE — flooded banks with reserves. Banks do not need to borrow reserves; reserves are abundant. The fed funds market, greatly shrunk in size, now mainly consists of transactions between GSEs — chiefly Federal Home Loan Banks — and a few banks, mainly foreign.

So what did the Fed do in December 2015 to increase short-term interest rates? It increased the interest rate paid on reserves from 25bp to 50bp. And it posted a rate of 25bp for reverse repos at the New York Fed. It then set a target range of 25-50bp for the fed funds rate. Did it hit that fed funds target? Yes, about in the middle of the range. Did it matter? Not really, for the reasons just mentioned. The availability and pricing of fed funds no longer constrains most banks. Moreover, the goal was surely to raise market interest rates. The opposite occurred. I quote former Cleveland Fed president, Jerry Jordan, on point: “Yields of market-determined interest rates subsequently fell and remain below the levels that prevailed before the increase in administered rates” (Jordan 2016: 26).

The Fed is now largely engaged in a futile exercise to control the economy. The massive expansion of its balance sheet flooded banks with excess reserves. “Operation Twist” robbed it of short-term assets. Its influence over short-term, market interest rates is attenuated at best. Nor does it seem able to control the money supply, though that is a more complicated issue (Jordan 2016).

What financial markets have feared the most, they in reality dare not hope for. The Federal Reserve is not positioned to raise short-term, market interest rates. If the feared spike in inflation materializes, the Fed is not positioned to contain it. Markets are expecting or fearing the Fed will do things it can no longer do. The misalignment between market expectations and Fed capabilities is very dangerous, and I fear it will not end well. Not an out-of-control central bank, but a not-in-control central bank is the problem markets must confront. The Fed is not positioned to control inflation when and if that becomes a problem.

___________

This post is a revised version of a speech given to the CFA Society of Nevada, October 27, 2016.

References

Calomiris, Charles W. (2017) "The Microeconomic Perils of Monetary Policy Experiments." Forthcoming in Cato Journal, Winter 2017, based on remarks delivered at the Shadow Open Market Committee's Fall 2016 Meeting.

Eberstadt, N. (2016) “The Idle Army: America’s Unworking Men.” Wall Street Journal (October 2).

Jordan, J. (2016)  “Rethinking the Monetary Transmission Mechanism.”  Paper prepared for the Cato Monetary Conference, November 2016.

O’Driscoll, Jr., G. P. (2015) “The Fed’s Uncertain Leap Forward.” Wall Street Journal (December 17): A19.

  • joebhed

    Thanks, Gerry.
    But another thorough and correct postulation of the obvious does little to advance any critical analysis of the problem's causality, and alternative solutions NEEDed, even if not available.
    Pity the Fed.
    They have a mandate to achieve the full employment without inflation national economy, through management of money and credit aggregates, but with zero effective tools to advance the latter policy prescription. How to manage the M&C aggregates?
    Pushing on the interest rate string will not achieve management of M&C aggregates in a debt-stiltified economy.
    Cannot be done. That's the point.
    Put the public (?) policy support more directly on the money supply lever rather than the money-cost lever, and anything is achievable. Let the money-cost settle out in the market of a non-scarcity in money.
    Here's EXACTLY how it can be done.
    https://www.congress.gov/bill/112th-congress/house-bill/2990/text
    Your thoughts appreciated.
    For the Money System Common.

    • M. Camp

      "To create a full employment economy", which is the stated goal of your law, is always within the capabilities of central planners (at the Fed, in this case) if they are given enough economic power. That is if enough economic decisions are taken out of the hands of those whose property and labor are being exchanged, and given to the planners, then they can create a full employment economy, by whatever arbitrary definition they choose to invent*. If at first they fail, they can either redefine the term, or more likely, demand more power be taken from the people and given to them.
      Even given the strictest possible definition, of every citizen having a job, it has been done in several central planning economies in the past or present (the NEP of Stalin, Mao's China; today, N. Korea).

      But is it good economic policy?

      *Central planners can't create any other kind of definition than an arbitrary one, since an objective definition would depend on market prices and free choices, for example about how each potential labor supplier prefers to spend his time…staying in his present job? accepting a different job? taking a break? thinking about the future? getting a better education or training? doing volunteer work? etc.). And unfortunately, central planning destroys that information, and has absolutely no technical means to replace it. In an idealized "free economy", there is objectively (not arbitrarily, according to a lawmaker's or bureaucrat's drafted text) ALWAYS full employment; in a real, relatively free society, there is ALWAYS an imperfect, but pragmatically optimal, approximation of full employment.)

  • Ray Lopez

    Very good article but only if you believe in money non-neutrality, short term. In fact, the evidence shows (Bernanke et al 2002 FAVAR paper, an econometrics analysis) that short term, money is largely neutral, with Fed policy shocks having only a 3.2% to 13.2% effect on real variables, statistically significant but rather small. Hence the author's "Capital is being misallocated all over the place as a result [of low interest rates]" is hyperbole. Interest rates are low because demand is low.

    • http://miltonchurchill.com/ Milton Churchill

      Interest rates are not low because demand is low, though that is part of it. Interest rates are low because demand is low relative to supply. The Feds asset purchases vastly increased the supply of money available for loans to a point, referenced in the article, where it may no longer make sense for banks to pursue additional deposits. It should also no longer make sense for their customers to maintain bank deposit accounts, but that is another story.

      And, of course capital is being misallocated. The whole process is somewhat reflexive. A plethora of government loan guarantees, and implicit and explicit guarantees from the Fed and Congress, have virtually eliminated risk on loans. This, combined with interest rates having been low for so long, projects and larger consumer purchases are pulled forward. Rates of return across the board are driven to zero when the risk and cost of time are pegged in real terms, essentially, to zero. Here it is; while initially the natural rate of interest was much higher in nominal and relative terms compared to Fed-manipulated money/loan "market" rates, say 8 years ago, today, I believe the natural rate has, indeed, caught down to the money rate of interest. So, calls for a raising of interest rates now is much much too late. The Fed and other central banks have lost control. The current phase is just the beginning of declining profitability towards zero, declining asset prices, and a vacuum economic activity that will make the Great Recession look quite mild in comparison.

      • Ray Lopez

        Again, your narrative, while good, assumes money is not neutral short term. A more fundamental reason for low interest rates is not the Fed but that demand is low due to (1) lack of animal spirits, or, (2) we're in a post-scarcity economy where it does not pay to invest in anything, Google "Great Stagnation" on this second theme (I don't buy it, but this argument is not without merit). Put another way: is it really true that Japan's central bank "sets the JP Yen/ US Dollar exchange rate"? Probably not. At the time the Plaza Accord was signed in Sep. 1985, the dollar was already appreciating vs the yen. Central banks can 'lean into the wind' or 'zig where the market zags' but they have very little market power to change nominal variables and there's very little real effect from these nominal changes, George Soros proved that, as well as academic studies such as: "Baxter and Stockman (1989), who examine the time series behaviour of a number of key macroeconomic aggregates for forty-nine countries over the post-war period. Although they detect evidence of higher real exchange rate variability under flexible exchange rates than under pegged nominal exchange rate regimes, Baxter and Stockman find no systematic differences in the behaviour of the macroeconomic aggregates under alternative exchange rate arrangements. Again, this suggests that there are speculative forces at work in the foreign exchange market which are not reflected in the usual menu of macroeconomic fundamentals" (Sarno, The Economics of Exchange Rates (2003)). But hey, I believe in the confidence fairy so I do believe that "presidents make a difference" (FDR's fireside chats did help calm the USA in 1933/34) and "Keep Calm and Carry On" is good advice.

    • Spencer Hall

      "that short term, money is largely neutral"
      —————
      I am the Alpha and the Omega. I cracked the economic code in July 1979. Nothing's changed in 100 + years. I should be awarded the Nobel Prize in economics. My discovery should be classified as "top secret" by the CIA.

      BuB should be in prison. He has no idea how to define and measure money's impact, as he admitted in his book. My 2016 forecast has now come true.

  • Jerry O'Driscoll

    You focused on a small piece of the argument. The post's main argument is about the long-run inefficacy of monetary policy.

    Bernanke believed in and practiced credit allocation. That is why he purchased all those MBSs.

  • B Cole

    Seems to me money-financed fiscal programs would work, aka helicopter drops.

    A FICA tax holiday, and print the money and dump it into the Social Security and Medicare funds.

    The only people receiving a tax cut would be those who work or employ.

  • Jerry O'Driscoll

    Ray, kindly reread my post, as the main argument

    in no way depends on the neutrality of money. That topic remains highly contentious, and was certiainly not settled by one study by Bernanke (who, as I indicated, did not in practice believe in the neutrality of money).

    Ray, you also need to check your facts. Real, gross private investment has grown very rapidly since the cyclical bottom in 2009.

    Temporary tax cuts have only transitory effects. Taxpayers save temporary tax cuts. Milton Friedman demonstrated that with his permanent income theory.

  • Spencer Hall

    "The fed funds market was a choke point"
    ——————-
    No, that was the device bankers used to satisfy reserve requirements, or be compliant. Accommodation was automatic when pressure was at the top of the policy target (i.e., whenever the banker's and their borrowers saw an advantage to lend/invest). The money supply can never be managed by any attempt to control the cost of credit.

  • Spencer Hall

    "As already noted, very low interest rates have compressed bank’s margins"
    ——————
    And that is your and everyone else's error. NIMs don't apply to the CB system. Banks un-necessarily pay for the deposits that they already own. And that's because everyone doesn't know money from mud pie. The elimination of Reg. Q ceilings for the CBs was a political conspiracy. As a system, banks don't fund their loans and investments with savings.

  • Spencer Hall

    The way to raise rates is to get the CBs out of the savings business. Then you offset the increase in money velocity by selling off SOMA securities. The upshot is that the commercial banks, the non-banks, and saver holders all receive higher rates of returns. R-gDp then expands conterminously.

    .

  • Spencer Hall

    "Nor does it seem able to control the money supply"

    ——————

    To expand M1, the FOMC simply has to couch its instructions for FRB-NY"s "trading desk" in terms of reserves available for private non-bank deposits, RPD, or 1972 FOMC directives (as described by Paul Meek, "Open Market Operations", Federal Reserve Bank of New York, May 1973

    I.e., unless the desk trades directly with non-bank counterparties or non-bank dealers or thru their clearing agent, there's no need to buy securities and credit the reserve deposit account of the bank handling the trade.

    In fact, it used to be that: “repurchase agreements are not extended to member banks which act as dealers; these banks can borrow directly from their Reserve Bank”

  • Andrew_FL

    You seriously think Fed officials are worried about margin compression? What, are they reading Julien Noizet?

    Because if so, that would actually be very good news indeed.

    • Andrew_FL

      "In fact, this recovery has been weak by any standard measure. It is a
      long recovery, but a weak one. That is true whether measured by output
      growth or employment growth. The contention that we are at or near full
      employment ignored labor-market realities. The Civilian Labor Force
      Participation Rate has been in free fall since the Great Recession. It
      has only recently shown an uptick. For men, the picture is even more
      dismal. The participation rate is near an all-time low. It is a largely
      unnoticed crisis, which Nicholas Eberstadt (2016)
      has chronicled. He estimated that there is a “male jobs deficit” of 10
      million. The economy is not close to any reasonable concept of full
      employment. There was no employment justification for raising short-term interest rates."

      This paragraph operates under the implicit assumption that the problem with the LFPR can be addressed through demand side policy. But after this much time that seems extremely unlikely, and far more like that the "natural" percentage of the population which is employable is lower now, and this represents a real, supply problem, that must be addressed with reforms unrelated to monetary policy, and only indirectly related to fiscal policy.

  • Spencer Hall

    Future? Nothing's changed in over 100 years.

    "Our second figure, therefore, plots an adjusted measure of monetary base growth suggested by John Tatom, which subtracts excess reserves"

    seekingalpha.com/article/4020426-feds-unrequited-romance-phillips-curve
    ———————–

    http://www.indstate.edu/business/sites/business.indstate.edu/files/Docs/2011-WP-21b_Tatom.pdf

    The author should be referencing me, not John A. Tatom’s August 2011; revised September 2011; revised February 2013 “U.S. Monetary Policy in Disarray”

    That’s how I called the bottom in the GR and stock market in March 2009.

    See one of my posts:

    http://www.newsneconomics.com/2009/03/real-money-supply-surging-in-some.html

    Tatom’s and Milton Frideman’s monetary base has never been a base for the expansion of new money and credit, and thus the associated money multiplier is wrong too. .

    – Michel de Nostredame (the greatest market and economic timer in history)

  • Seth

    I understand and agree with your conclusion that the Fed may have lost its ability to control the money supply via manipulating the Fed Funds rate. However, if it wanted to reduce the money supply in order to "fight" inflation, couldn't it sell down its balance sheet? To be sure, this would result in the Fed raising LONG rates, not short ones (since after Operation Twist it only owns a boat load of long bonds), but it would still, nonetheless, reduce the amount of money in circulation and most certainly reduce long-dated borrowing activity. If this reasoning is correct, then isn't the Fed still able to fight inflation since CB's (allegedly) do so by manipulating the money supply? (To say nothing about popping the asset bubble and those consequences.)

    • http://www.talkmarkets.com/content/global-markets/larry-summers-100-dollar-bill-ban-and-westfalia-lost?post=86090&uid=4798 Gary Anderson

      Long rates can't go up much. As Rick Rieder said, there is a cap on long bond yields, due to the monumental demand for long bonds (mostly as collateral). Bonds are the new gold. So if the Fed stopped the long bond demand, the banks and counterparties would likely collapse.

      The only guy who agrees with me about long bond demand is Edward Lambert, economist of note. Most other guys sort of ignore the subject. New Normal.

  • http://www.talkmarkets.com/content/global-markets/larry-summers-100-dollar-bill-ban-and-westfalia-lost?post=86090&uid=4798 Gary Anderson

    Nice article. There would be more lending if banks could make a better profit. But raising rates may not work since the demand for long bonds, as Rick Rieder has said, IS MONUMENTAL (because of their use as collateral in the derivatives markets. So, they really need to let the banks loan a bit of the reserves, if they want more people to participate. Only thing is, the banks have behaved so badly towards main street that they won't bite on loans unless they get a better deal.