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Posts Tagged ‘Monetary Policy’

Yesterday, the Federal Reserve confirmed that it would end new purchases of Treasury bonds and mortgage-backed securities (MBS)—what’s known as quantitative easing—in October. In response, the media are heralding the end of the Fed’s stimulus:

“Fed Stimulus is Really Going to End and Nobody Cares,” says the Wall Street Journal.

“Federal Reserve Plans to End Stimulus in October,” reports the BBC.

This is utterly wrong.

What the Fed is about to do is stop increasing the amount of stimulus it provides. For the mathematically inclined, it’s the first derivative of stimulus that is going to zero, not stimulus itself. For the analogy-inclined, it’s as though the Fed had announced (in more normal times) that it would stop cutting interest rates. New stimulus is ending, not the stimulus that’s already in place.

The Federal Reserve has piled up more than $4 trillion in long-term Treasuries and MBS, thus forcing investors to move into other assets. There’s great debate about how much stimulus that provides. But whatever it is, it will persist after the Fed stops adding to its holdings.

P.S. I have just espoused what is known as the “stock” view of quantitative easing, i.e., that it’s the stock of assets owned by the Fed that matters. A competing “flow” view holds that it’s the pace of purchases that matters. If there’s any good evidence for the “flow” view, I’d love to see it. It may be that both matter. In that case, my point still stands: the Fed will still be providing stimulus through the stock effect.

P.P.S. I wrote about this last year during the tapering debate. In the lingo of that post, the Fed is moving from quantitative easing to quantitative accommodation. To actually eliminate the stimulus, the Fed would have to move on to quantitative tightening.

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A tribute to Ben Bernanke, sung to the tune of Rudolph the Red-Nosed Reindeer. University of Chicago professor Anil Kashyap unveiled this Friday at economists’ big annual conference.

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James Bullard, head of the St. Louis Federal Reserve Bank, gave a nice presentation on “The Tapering Debate” today. See the whole thing here.

One question he considers is whether the Fed balance sheet is getting scarily big. It’s certainly large by U.S. historical standards — the only time is was bigger, relative to the size of the economy, was in the 1940s.

By current international standards, however, the Fed balance sheet isn’t an outlier. In fact, Japan, Europe, and the United Kingdom all have larger central bank balance sheets, relative to their economies, than we do (FRB = Federal Reserve Bank):

Bullard

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The Fed believes the stimulus from quantitative easing depends on the stock of Treasuries and mortgage-backed securities that it owns, not on the flow of its purchases. If that view is correct, the future tapering of Fed purchases won’t be monetary tightening, it will a slowing pace of monetary easing (click for larger chart):

Tapering is not tightening

The chart shows a hypothetical trajectory for the Fed’s bond and MBS holdings. Under the stock view, that trajectory will go through three stages, paralleling those of traditional interest rate policy:

  • Quantitative easing: The Fed expands its balance sheet by buying Treasuries and MBS. Current pace: $85 billion each month.
  • Quantitative accommodation: The Fed maintains its balance sheet; it buys new assets to replace older ones as they mature.
  • Quantitative tightening: The Fed contracts its balance sheet by allowing assets to mature without replacement or, more aggressively, by selling them.

In this view, tapering is the final stage of quantitative easing. The Fed buys assets during tapering, but at a slower tempo. Tapering is not tightening.

That view is clear, logical, and elegant. But it utterly fails to explain why financial markets went haywire last week when Ben Bernanke and company talked about tapering.

One reason is investor expectations. The Fed has been trying to stimulate the economy not only through QE, but also by telling investors to expect easing in the future. Such forward guidance can be a powerful lever for monetary policy.

Tapering is tightening

Last week, investors learned that QE might end sooner than they expected. In the stock view with expectations, that is monetary tightening. As illustrated in the second chart, future Fed policy would be tighter than financial markets had previously thought.*

This view likely explains some of the market reaction to recent Fed statements. But it’s hard to reconcile the magnitude of the movements. Suppose markets expected tapering to begin in January and now think September more likely. All else equal, that four-month difference implies a $340 billion reduction in the Fed’s ultimate portfolio. That’s something, but could that alone explain the sharp market response?

My sense it that something else must be going on as well. Some candidates include:

  • Perhaps the flow of Fed purchases matters, not just the stock. This view appears much more common among traders than Fed economists. If anyone has a reference for a good articulation of this view, I’d love to see it. The flow shouldn’t matter in normal times—was the Fed tightening when the flow of purchases was essentially zero for decades before the recent crisis?—but these are hardly normal times. Perhaps the flow matters when you are at the zero lower bound?
  • Perhaps world financial markets expected a much longer period of QE and are highly geared to Fed policy. If I am reading it correctly, that’s the view of Vince Foster who discusses the unwinding of the carry trade (ht Tyler Cowen)

* This definition of tightening compares the new expected trajectory of Fed holdings to prior expectations. Such comparisons are relative; in principle, one could equally say that the Fed announcement indicated that future policy would be less loose, not that it would be tighter. But for most purposes, it seems simpler just to say that future policy has gotten tighter. The same semantic issue exists in fiscal policy. If Medicare spending is scheduled to grow $35 billion next year, what do we call a proposal under which spending increases $30 billion? We usually call that a $5 billion spending cut since it’s a decline relative to an accepted baseline. But we should remember that Medicare spending is growing. The same seems true with early tapering. Tightening seems the cleanest description for most purposes, even though in absolute terms it is slower easing.

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Ezra Klein reports an official statement from Anthony Coley, a Treasury spokesperson, killing the platinum coin strategy:

“Neither the Treasury Department nor the Federal Reserve believes that the law can or should be used to facilitate the production of platinum coins for the purpose of avoiding an increase in the debt limit.”

So R.I.P. platinum coins of  unusual size.

The administration has previously ruled out another oft-discussed debt-limit safety valve, overriding the limit based on the 14th amendment. So “Plan B” discussions will now move to two other alternatives that have been bandied about: prioritizing payments or, as Ed Kleinbard suggested the other day, issuing scrip like California did a couple years ago. Of course, issuing scrip *is* prioritizing payments, but with the added feature (or complication) of a written, transferable IOU.

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Policy wonks are debating whether a trillion-dollar platinum coin would be a clever or insane way for President Obama to play hardball with Republicans in the upcoming debt limit battle. Here’s what you should know about this crazy-sounding idea:

1.     A legal loophole gives the Treasury Secretary apparently unlimited authority to mint platinum coins.

Treasury is forbidden from printing money to cover government deficits. Treasury must issue debt, while the Federal Reserve independently controls our nation’s monetary printing press.

That is exactly as it should be. But there is an arcane exception for platinum coins. To serve coin collectors, Treasury can issue platinum coins of any denomination. That creates an intriguing loophole: Treasury could bypass the collector market and mint a trillion-dollar platinum coin. By depositing it at the Federal Reserve, Treasury could keep paying bills after we’ve fully exhausted our borrowing limit.

2.     Most observers think this is a terrible idea, but the legal arguments against it are weak at best.

A who’s who of commentators has already objected to the coin on legal, economic, political, and image grounds (see, for example, John Carney, Matt Cooper, Tyler Cowen, Kevin Drum, Jim Hamilton, Heidi Moore, and Felix Salmon). I’m no lawyer, but the legal arguments seem wholly unconvincing. The language of the statute is clear, and in any case, the executive branch gets away with expansive actions in extreme times. During the financial crisis, for example, Treasury aggressively interpreted its authorities in order to bail out GM and Chrysler and to backstop money market funds. If default became a real possibility, the same expansiveness could easily justify a platinum coin.

3.     The economic arguments against the coin are stronger but manageable.

There’s a good reason that Treasury is forbidden from printing money to pay our debts: inflation. Many economies have been ruined when profligate governments turned to printing money. But minting the platinum coin needn’t mean monetizing our debt. The Federal Reserve has ample ability to offset any inflationary impact by selling some of the trillions in Treasury securities it already owns. As long as the Fed does its job, inflation would not be a risk.

4.     The best arguments against the platinum coin involve image and politics.

Minting a trillion-dollar coin sounds like the plot of a Simpsons episode or an Austin Powers sequel. It lacks dignity. And despite modern cynicism, that means something.

It would also be premature. President Obama and the Republican and Democratic members of Congress have roughly two months to strike a debt limit deal. There is no reason to short-circuit that process, as painful as it may be, with preemptive currency minting as the now-famous #MintTheCoin petition to the White House suggests.

5.     Nonetheless the platinum coin strategy might be better than the alternatives if we reach the brink of default.

Analysts have considered a range of other options for avoiding default, including prioritizing payments, asserting the debt limit is unconstitutional, and temporarily selling the gold in Fort Knox. All raise severe practical, legal, and image problems.

In this ugly group, the platinum coin looks relatively shiny. In particular, it would be much less provocative than President Obama asserting the debt limit is unconstitutional. That nuclear option would create a political crisis, while a platinum coin could be a constructive bargaining chip. As Josh Barro notes, President Obama could offer to close the platinum coin loophole as part of a deal to raise or eliminate the debt ceiling.

6.     If necessary, Treasury should mint smaller platinum coins, not a trillion-dollar one.

A trillion-dollar coin is eye-catching and ridiculous. That’s why it’s filled the punditry void left by the fiscal cliff. But a single coin makes no policy sense. No federal transactions occur in trillion-dollar increments.

Among the largest transactions are Treasury bond auctions, which today raise about $25 billion at a time. If necessary, Treasury could issue individual $25 billion coins, each in lieu of a needed bond auction. Still ridiculous, to be sure, but less so as it would calibrate coin issuance to immediate financing needs.

Steve Randy Waldman suggests as even more granular approach: issuing coins denominated in millions not billions. Such “small” denominations would be even less ridiculous and could potentially be used in transactions with private firms, not just Fed deposits.

Of course, the best path would be a bipartisan agreement to increase the debt limit, address spending cuts, and strengthen our fiscal future, all settled before the precipice. If we reach the brink, however, minting million- or billion-dollar platinum coins would be better than default.

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