Who Cares About the Fed Funds? We All Do.
Economists all over the place are up in arms over a recent NY Times blog piece by Casey Mulligan which essentially says that monetary policy stinks and has no impact on the economy. Mulligan says:
“New research confirms that the Federal Reserve’s monetary policy has little effect on a number of financial markets, let alone the wider economy. Politicians, and a few economists, have been imploring the Federal Reserve to help the economy grow before November. But the effects of monetary policy on the wider economy are small.”
That didn’t go over so well, with, oh, just about every economist who writes a prominent website these days. Brad Delong says:
“This is really embarrassing, New York Times: really, really embarrassing.
The first joke comes in Casey Mulligan’s first paragraph: the Fed does not lend money to banks on an overnight basis at the Federal Funds Rate. The Fed lends money to banks at an interest rate called the Discount Rate. The Federal Funds rate is the rate at which banks lend their Federal Funds–the deposits they have at the Federal Reserve–to each other. That’s why it is called the Federal Funds rate.”
Paul Krugman says:
“Mulligan tries to refute people like, well, me, who say that the zero lower bound makes the case for fiscal policy. My argument is that when you’re up against the ZLB (OK, it’s more a minus 0.1 percent bound, but no significant difference), conventional monetary policy is ineffective, so you need other tools.
And Mulligan’s answer is that this is foolish, because monetary policy is nevereffective. Huh?”
Scott Sumner says:
“Let’s start with the fact that everyone who works in the financial markets thinks this is nonsense. Of course they also think the EMH is nonsense, and it’s true . . . er . . . truish. But this time they are right. Here’s the market response to the Fed’s unexpectedly large rate cut of January 3, 2001:
(insert chart that I am too lazy to upload with crazy market reaction to FOMC decision).
Since I have an opinion and all I figure I might as well chime in as well to express my displeasure with extreme statements – given my loathing of extreme position taking!
1) Monetary policy has the potential to be incredibly powerful - even in a balance sheet recession (or a liquidity trap or a excess money demand environment depending your choice of economic approach). The Federal Reserve has a bottomless supply of reserves that it can tap to enact policy. If they wanted to pin the entire treasury curve at 0% they could. That’s right, if they wanted to QE every government bond out of the secondary market they would inform the NY Fed to say:
“Dear Bond Markets, we are going to be purchasing all US government debt at a rate of 0%. We would like to invite you to this profit losing party. But in the interest of full disclosure (Ron Paul is on our ass like white on rice!) we would like to inform you that we have endless supply of reserves and should you try to drive the rates higher your chances of success are approximately 0%. Good day and we hope to see you there!”
The rates on government bonds would drop to 0%. Probably without the Fed even having to implement a trade….
I am feeling particularly lazy right now so I am not going to run a data analysis on the correlation between government bonds and the 30 year mortgage, but here’s the correlation in chart form and a basic generalization to clarify my thinking. I think we can all agree that the Fed setting rates at 0% at the 30 year t-bond would trickle through to the 30 year mortgage rate in a way that would drive the cost of financing a home purchase (the US consumer’s largest asset and 73% of all debt outstanding) to a very low rate (yes, even lower than today’s very low rates).
There are other options for the Fed at this juncture, but I cherry pick that one just for ease of argument given the size of the mortgage market, its impact on the consumer and the extremeness of the policy. I think it’s beyond silly to argue that the $19 trillion in household real estate assets would not be impacted by this dramatic change or that it wouldn’t filter through the economy and other debt products in various ways. Through refinancings and the added affordability of housing I venture to argue that this would at least have SOME impact on the economy. Some of the economists mentioned above have even told me via email that they fear this might cause hyperinflation. I wouldn’t go that far, but it would certainly increase the demand for debt since it would nearly transform long-term credit into a perfect substitute for cash. I think that goes without saying. And at the end of the day, that’s how monetary policy works. By increasing or decreasing the demand for what Monetary Realism calls “inside money” or bank money.
2) Banking is a business of spreads. Banks lend at a spread over a benchmark wholesale funding cost. When the benchmark rate declines banks are then able to maintain a spread while inducing demand via lower rates. This is why you see a strong correlation between rates like the FFR and the 30 year mortgage (see chart below). Banking is ultimately a demand driven business. Loans don’t fly out the doors of banks as the money multiplier leads us to believe. So when a bank can maintain this spread and still induce stronger demand they’re driven by a strong profit motive to make loans at lower rates. In this regard, the Fed has always played a powerful role in the economy. Since most of the money in the economy is “inside money” (or bank money) it’s rather obvious that changing the cost of this money has an impact and can, at times, have an enormous effect. To claim otherwise is to misunderstand the fact that “inside money” is THE prominent form of money in the economy.
Conclusion – monetary policy has been very weak in the current environment for several reasons. The primary reason is due to a lack of demand for debt. Consumers are saddled with excessive debt so demand for “inside money” has been abnormally weak in recent years. This is perfectly normal following a credit driven bubble. And since monetary policy primarily works through altering the cost of “inside money” it’s not surprising that the actions of the Fed have appeared rather ineffective in recent years. But this unusual environment should not be taken to mean that the Fed has zero options or that monetary policy is never effective. To do so would be a vast misunderstanding of the basics of banking and the way our monetary system works. Monetary policy might be a blunt instrument at times, but let’s not make extreme comments that sound ideological or take the uniqueness of today’s environment to make sweeping generalizations.
Lastly, as I like to say, banks are the oil in the “machine” that is the monetary system. The Fed can alter the banking system in powerful ways. As the recent LIBOR scandal showed, central banks are always in the business of using banks to manipulate interest rates (that’s how they implement policy). In the USA, the Primary Dealers are the Fed’s agents for policy implementation. That’s just how it is. In recent years I have preferred other, more direct policy tools (primarily because I thought monetary policy would prove ineffective because of a lack of demand for credit), but I think it’s an exaggeration to claim “the Federal Reserve’s monetary policy has little effect on a number of financial markets, let alone the wider economy.” This doesn’t mean the Fed’s policies have a direct correlation with consumer spending or can magically transform the economy into something the Fed wants it to be, but let’s not be extreme in our conversation here. The Fed’s an incredibly powerful entity. My brief and incomplete analysis doesn’t prove that overwhelmingly, but market participants understand this. After all, “don’t fight the Fed” isn’t plastered all over Wall Street trading floors just for the fun of having slogans to read.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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38 Comments
If you understand MR this just all seems obvious. But thanks for continually hammering the message home. It needs to be reinforced far and wide.
You say monetary policy primarily works through the credit markets. If we have excessive debt then why would we want a policy that exacerbates this?
Yes, one of the main reasons why monetary policy has been a secondary option for me.
“[...] would drive the cost of financing a home purchase [...] to a very low rate (yes, even lower than today’s very low rates).”
Initially yes. But if thanks to ‘optically’ low credit costs the demand rises, the house prices will rise. Which in turn means, the sums to be financed go up, thus increasing the credit costs. So the next housing bubble is fueled. Or am I mistaken here?
Could cause another housing bubble….I am not saying this is an optimal approach, just saying that it has an impact which could be substantial.
1. Probably as well the supply-side of debt has an issue. Why would in one part of the (larger) market people pay a lot extra (compared to more ‘normal’ situations) for safe debt and at other parts (say mortgage market) they would not take that point into consideration.
2. Difficult to see if all these tools work as well with large dips (as now) as with relative minor dips as usual. A lot of assumptions/constants (often assumed constants) might get under pressure as well. We only have very limited empiric evidence on the larger dips, basically only some examples (and often in very different situations, the outside world has become much more important and subsequently what happens there as all issues now look to have an effect on others (makes very difficult formulas).
3. At the end of the day it is the question if the end (result) justified the means. Combined with the fact that a lot of the risks are not absolute and difficult to quantify with a reasonable amount of accuracy. Like will we get inflation? Of course we will but how much?
Of course it will work (as you indicate), but how much?
As said we have some examples but not really proper empiric evidence. Basically we know just too little.
Cullen, nice piece.
Question: if the Fed flattened the entire yield curve down to zero percent, are you saying that by refinancing existing debt at a much lower rate, the private sector then would have more disposable income to spend and therefore add to aggregate demand?
or (and?)
Are you saying that the private sector would take on more debt (inside money) because rates are so low?
Also, would you say that the private sector doesn’t have enough ‘credit-worthy- borrowers so banks are hesitant to make loans, or that borrowers are still to overleveraged to be interested in incurring more debt? My guess is that it’s a combination of both. Do you think one is more prominant than the other? Or are they basically the same thing said two different ways?
Cheers.
Nice point, JK. Saying that reducing mortgage payments will improve the economy ignores the fact that the interest paid is income to someone! Since it seems (to me) that the Fed flow of funds tables show that US households have more interest-paying assets than total debt, doesn’t a lower interest rate mean that in the aggregate, the national income will be decreased by lower interest rates?
There are many other areas where ZIRP feeds back negatively–like public pensions. Because states and municipalities are receiving less yield on their investments, they need to raise contributions, which will be paid for by either reducing spending (employment) or by raising taxes and fees–both of which reduce effective household income. Endowments have less money to spend because of lower rates. The stimulus provided by the federal government via interest payments on government debt has shrunk.
The bottom line is this: since US households in the aggregate have far more interest paying assets than debt, low interest rates hurt the national income. I can understand the argument that an interest rate cut can stimulate new demand if it is assumed to be temporary, but a prolonged spell of low rates has a chilling effect on the economy.
BB has the example of Japan staring at him in the face, but refuses to acknowledge it.
It’s what economist call “financial repression” (FR). Someone has to take the loss when $assets < $loans. But as you mention there are cases where some FR techniques don't work, e.g. inflating away liabilities doesn't work if those liabilities are indexed to inflation. Pinning the LT/mortgage rates is the "rate fixing" model of FR … works/ed in Japan, China and various Latin American countries.
Flattening the curve would help those who need it – households. So it’d ultimately be a bit of both….I think the demand for credit is low and banks have tightened up lending standards so a bit of both, but ultimately, lending is a function of demand more so than supply. Banks are in the business of making loans and they do so without restriction from reserve balances so the supply is always “there” if creditworthy borrowers walk in the door.
What if demand for credit is being driven by something other than the level of interest rates? In that scenario, all the easing in the world won’t do a thing to stimulate the economy. If a restaurant has trouble selling cokes for $2 a piece and then suddenly drops the price to $0.20 and still can’t sell any cokes, do you honestly believe dropping the price down to $0.10 or even $0.01 is going to make a difference?
There are lots of things that go into demand for credit. But incremental changes make a difference. It might not change the world in a balance sheet recession, but it certainly helps to, say, reduce a households borrowing costs a few hundred bucks a month. Again, we’re talking about a suboptimal policy in my opinion.
Cullen,
An above commentor mentioned that even if low rates help borrowers, they negatively affect the income stream of savers. Is there any way to determine which has a greater impact in the aggregate?
If policy were prudent we’d run larger budget deficits to offset the lost income effect. As I mentioned before, you can have your cake and eat it too here. But you need to combine low rates with higher deficits. That way, savers don’t lose the income AND we get the benefit of lower credit costs. As it stands, we’re beginning to run into an environment where the credit strains have been reduced, demand for debt is SLOWLY picking up, but the deficit is falling. So you’re starting to see the national income slow. We need to get back to that 10% budget deficit and we need to do it yesterday.
The Fed is stuck. Lowering rates has not spurred economic activity and you can make a case that its policies are setting up long-term negative implications.
The Fed is trying to recapitalize the banks, which it can’t say out loud, because the public would revolt, but even so, by doing so it now owns gigantic sums of useless debt.
Also, as the Fed’s main job has become financing government spending, we are stuck with low rates forever, because any rise in interest rates would just require more borrowing to pay the higher interest.
I realize the trading community loves the Fed because it can make asset prices rise and fall and you can get in and out of positions based on Fed action, but little of that makes the real economy better.
Loan demand is down due to lack of demand for everything except reality tv. Can’t we just end that fad.
There still is loan demand out there. Some anecdotal observations, at the community bank level they are pretty much not allowed to do a vast majority of real estate loans, no biggie. But they are putting caps on the amounts of loans you are allowed to do as a per cent of your capital. So if you do x amount manufacturing loans, you can’t exceed 150% or so of capital. Same goes for a commercial real estate and other loan types. Also, the loan to value has been drastically cut. 30-50% loan to value of collateral is pretty much what regulators will allow. So, loan demand is down but it could be higher than what is currently reflected.
I think we should define the meaning of “works” here. Monetary policy can “work” in that it induces more private credit creation and gets the economy going via interest rate sensitive channels (mostly housing and some business lending). Unfortunately, credit grows faster than income which makes this an unsustainable policy stance. It always ends in the popping of a private debt bubble (1929, 2007). This is why we need fiscal deficits to constantly provide demand without the need for excessive private credit creation, especially given the trade deficit that causes demand leakages.
Another powerful effect of the deficit is the additional financial assets which help the private sector heal balance sheets.
Yes agreed. Helps both the numerator and denominator in debt/assets and debt/income ratios for the private sector.
annother one giving me fits in the last 24 hours.
When the Fed buys Treasury securites that is monitary stimulus.
When the Govenrment runs a deficit that is fiscal stimulus.
But, when the goverment runs a deficit, the Treasury sells securities to finance the deficit.
Fiscal stimulus if monitarily contractionary.
When the fed buys securities they are swapping tbonds for reserves, no change in net financial assets. When the govt runs a fiscal deficit they are recycling cash, but also adding a net financial assets through bond issuance (that is, cash goes from one party to another AND a bond is issued to the person who bought the bond). Totally different things. One really helps (deficit), the other doesn’t do much if anything.
When the Fed buys securities, they are swapping bonds for reserves. The bond acts as an asset, and the reserves acts as liquid money available for trading our output. Bonds, or M3 type money shrink the money supply if the supply is considered liquid. Consider, if all money converted to bonds, then the economy would freeze up. So, it is not really an asset swap. It is a trade of two items, where each item behaves differently in the money system context.
When the economy needs liquid assets, it makes sense to provide those. QE was the matching of new money from the FED to match new bonds issued from the Treasury. The effect was more M1 in the economy, which allowed more demand and goes on to pay down the inside money, decrementing the ledger at private banks.
If currency users issue a bond, it simply contracts the liquid money supply. It is better to think of the needs of the money supply.
Reserves are not “available for trading our output”. They are deposits at the Fed. Adding reserves in exchange for bonds makes no difference on liquidity or net financial assets and has only a meager impact on the actual economy….
If the Fed really wanted to stimulate the economy, it should raise rates. Monetary policy is backwards.
That would hurt the demand for credit even though it might be more stimulative to household balance sheets. Better policy, imo, is keeping rates low and providing more fiscal. Then you get the best of both worlds.
Do you think that there is a lack of demand for credit? I think that there is a lack of supply. Banks are sitting on piles of exess reserves. They have tightened in their underwriting standards and are fighting thier auditors and their regulators to be allowed to do what they always used to do.
A steeper curve / wider spreads would give banks more incentive to lend.
It’s both to some degree. Lending standards have been tightened and demand for credit has dried up. But ultimately, banks are in the business of making loans and if there creditworthy customers walking in their doors then they make loans to them. There is no such thing as banks lending reserves so supply is not the issue. It’s a lack of creditworthy demand.
IMO, monetary policy is only as much effective as it helps to increase or decrease aggregate demand, and this is difficult to predict.
Thinking of monetary policy, I associate it with a funny saying we, the Bulgarians, have about the white wine:
“There is only one song written about white wine and it starts like this: White wine, white wine, why aren’t you red?”
The debate over whether monetary policy impacts agg demand is silly to me. It’s mostly ideological. For instance, most of the money in our economy is inside money, bank money. So what would happen if the Fed made loans to the pvt sector at 0% essentially creating inside money directly available to the pvt sector for no cost? What would happen? Would that impact agg demand. You bet your ass it would. It might be reckless, but viewing the extreme scenario like the above clearly shows that there’s an impact. It’s just a matter of marginal changes given environment, policy specifics, etc.
I’m not the world’s defender of monetary policy (especially in a BSR), but I think MMT’s position to essentially eliminate monetary policy is silly and that they’re using the BSR to make a point very similar to Mulligan. It’s not a very reasonable position, imo.
I think monetary policy (where should the fed funds rate be set) is a political question. Let savers and borrowers, all of them voters as well, decide it.
The Fed makes loans only to member banks under strict rules (like for instance automatic loans when overdrafts occur). Member banks can’t spend reserves (internal money) therefore boosting aggregate demand.
The Fed can only switch treasuries and reserves back and forth which are already available net financial assets, accumulated by federal deficits in the past. I don’t know if the Fed is allowed to buy gold or foreign currencies, which would be equal to government spending?
The Federal Reserve Act, which gives the Fed power over monetary policy, was specifically designed to skirt politics and give control of monetary policy to an entity that was neither part of the govt nor part of the private sector. Of course, the Fed is closely tied to both, but that still doesn’t take away from the fact that the reason for the Fed’s existence grew in large part out of the necessity to have an entity that can take swift politically independent actions. It’s not the perfect scenario for policy and I am not saying that it’s the best solution in the world, but it’s certainly a good tool to have have in the bag rather than relying on the buffoons in Congress to get it all done. I think the last 4 years prove that Congress can’t control the economy through policy changes and “working together”. They’re a hopeless bunch who can’t be convinced to work together until it’s too late. I think the MMT idea of setting rates at 0% and relying on tax changes to change the temperature of the economy is well intentioned, but 100% unrealistic. The Fed, while imperfect, at least has some policy tools that can be enacted without political wrangling and politics. Personally, I wish Bernanke would be more aggressive and do some fiscal via the Fed. But that’s a whole different story.
I don’t understand why you are afraid of politics?
You either believe in democracy or not.
Governments R Us, don’t you think.
Governments are only as good as we, the voters, are.
I’m not afraid of politics. I just understand politicians. And I understand that a policy agenda designed around eliminating monetary policy is a non-starter. There’s just no point even having that discussion. I think you guys have some really excellent ideas. But you’re way ahead of yourselves here. You can’t jam through the policies of MMT when the world isn’t even close to adopting your operational view of the world. You’ve put the cart before the horse. Of course we’re getting back into the reason MRists departed from MMT to begin with and I don’t want to stoke that fire, but I really think MMT’s biggest problem is misunderstanding this. If you guys want to advance your policy ideas you need to first do a better job of getting the world to be “in paradigm”. I fear that MMT is becoming more politicized as time goes on though. I guess that’s good in one sense – you’re owning your “inherently progressive” approach. But it risks derailing the whole thing. I am not sure how you all should proceed (and I think the founders are seeing this bind to some degree), but I wish you luck because an MMT world would be a better one than the one in which we live (even though I don’t fully agree with the approach)….
If the Fed made loans directly to the private sector at 0 percent?
Your belief in the power of the Fed to do all manner of radical things without consequences is staggering.
If the Fed made zero percent directly to the private sector we would all get as much of that as possible, knowing that to pay it back we would just borrow more money from the Fed at zero percent. Or just never pay it back. I mean, the assumption behind MMR is that federabl debt never has to be paid back, so why not get as much of it as you can.
Politically, you’d have a free-for-all deciding who got the free money and who didn’t.
And it would be inflationary, of course.
I said it would be irresponsible. See the other comments. I was making a point, not a recommendation.
Cullen,
You are certainly right that a central bank willing to buy sufficiently large quantities of longer-maturity bonds could reduce long rates arbitrarily low. But this is quite different from the question at hand, which is the effectiveness of monetary policy as conducted up until now.
One should also note that policy conducted at the long end will involve potentially very large capital losses for the central bank if long rates eventually return to a higher level, as presumably they will. There will also be large losses for any remaining private holders of long bonds, which means that to achieve a very ow rate the central bank may have to buy up essentially the entire stock of long bonds, i.e. take over from the banking system the function of financing housing and capital goods. This, I think you’d agree, is a substantial departure from what we normally think of as monetary policy.
Worth noting that Keynes discussed this possibility at length, mainly in the Treatise on Money. He called this “policy a outrance” and it was his conclusion that it was practically and politically infeasible that shifted his attention to fiscal policy. Very reasonably, I think. At the point where “monetary policy” involves both large losses for the central bank, and a central role for the central bank in allocating funds among investment projects, you are doing fiscal policy in all but name.
Hi JW,
I enjoyed your piece by the way so thanks for that. I agree that what I am discussing is a substantial change from what the Fed normally partakes in. But I disagree that it’s outside the definition of monetary policy. Suppressing long rates via OMO’s is really just the same type of transaction that occurs at the short end in achieving the FFR. It might be unusual to target the 30 year for instance, but that doesn’t make it something outside of the realm of monetary policy. It’s still using reserves to achieve a target rate. And mind you, I am not discsussing “sufficiently large quantities”. I am referring to monetary policy at the long end just as they achieve it at the short end. Meaning, unlimited quantities in defense of a rate. Monetary policy is about price, not quantity. In order for QE to be effective the Fed must target price. They haven’t done that and I think that’s a big reason why it has failed. I don’t call this fiscal because I don’t buy the monetization argument. That implies there is a lack of demand for govt debt. Now, if the Fed were to engage in buying munis or corporate debt then I think we might be on the same page. That’s the Fed doing fiscal. And it’s not only a powerful policy but likely undermining the power of the Congress, ie the power of the purse. But it’s within the realm of the laws as they stand today….
Cullen
All valid points. But I am suggesting that to get the rates that matter — rates on private long-maturity debt — down sufficiently to restore full employment, the Fed might *have* to start buying stuff other than Treasuries (as well as the entire stock of long Treasuries). This will be rue if, as Keynes believed, there is a floor on rates below which private investors are absolutely unwilling to hold long bonds. You have to be *very* confident that rates will remain low for a *very* long time before you will buy a 30 year bond with a yield of 1 percent.
More generally, I think you may be simplifying the way that “normal” monetary policy works. I think people greatly underestimate how important binding reserve requirements were in allowing the Fed to move rates with quantitatively modest transactions.