Tuesday, January 15, 2013

The Waldman-Krugman-Sumner Debate: It's the IOER Path

Are we headed toward a brave new world of perpetual liquidity traps? Steven Randy Waldman says yes. He believes the Fed will continue operating in a zero lower bound-like environment going forward, even after the economy has recovered and interest rates return to more normal levels:
What I am fairly sure won’t happen, even if interest rates are positive, is that “cash and government debt will no longer be perfect substitutes.” Cash and (short-term) government debt will continue to be near-perfect substitutes because, I expect, the Fed will continue to pay interest on reserves very close to the Federal Funds rate... Printing money will always be exactly as inflationary as issuing short-term debt, because short-term government debt and reserves at the Fed will always be near-perfect substitutes. In the relevant sense, we will always be at the zero lower bound...In this brave new world, there is no Fed-created “hot potato”, no commodity the quantity of which is determined by the Fed that private holders seek to shed in order to escape an opportunity cost. It is incoherent to speak, as the market monetarists often do, of “demand for base money” as distinct from “demand for short-term government debt”...
Waldman's statement generated swift responses from Paul Krugman and Scott Sumner who disagree. They argue that currency and short-term debt will continue to be different even with the continuation of the Fed's interest payment on excess reserves (IOER). Both sides are making, I believe, reasonable claims but are assuming different future paths for the IOER. This difference is key to reconciling their views. 

Here is why. First, the IOER is not truly new. Although the IOER was introduced in late 2008, we implicitly  had the IOER all along, it was just 0% in the past. The key development was not its explicit introduction, but its taking on a positive value that was by most accounts above the equilibrium (or "natural") interest rate on other short-term safe assets (i.e. treasury bills). By late 2008, the U.S. economy was free falling and along with it went the equilibrium treasury bill rate. The Fed, in its infinite wisdom, decided to keep the IOER above the falling treasury bill rate and thus further increase the already elevated demand for bank reserves. In other words, the explicit introduction of the IOER mattered because it effectively tightened monetary policy. Going forward, the IOER will again matter based on where the Fed moves it relative to the equilibrium treasury bill interest rate. This is because the current and expected path of this spread will determine the stance of monetary policy. And what happens to this spread will also determine whether bank reserves do or do not remain perfect substitutes for treasury bills.

For example, assume the Fed does not sterilize the monetary base and keeps the IOER at 0.25% as treasury bill yields increase in response to the improving economy. Banks (and their creditors) now have a incentive to invest in treasury bills and other higher yielding assets, triggering a cycle of portfolio rebalancings (i.e. the "hot potato" effect). At the same time, the demand for financial intermediation increases owing to the improved economic outlook. Banks respond to this increased demand by creating more loans. As part of the recovery, the transactions demand for money will also increase and some of it will take the form of increased demand for currency. The unsterilized monetary base will therefore change composition toward more currency. This means there still can be a difference among the demands for currency, bank reserves, and treasury bills in our brave new world.

The key to this particular scenario, though, is that the IOER remains below the equilibrium treasury bill interest rate. The opposite outcome will unfold if the former rises above the latter. Steve Randy Waldman's scenario of no Fed-created hot potato effect and no difference between the monetary base and treasuries can also be true if the Fed manages to keep IOER equal to the equilibrium treasury bill yield. The key, then, to reconciling the Waldman-Krugman-Sumner debate is understanding where each commentator assumes the IOER will be relative to the treasury bill natural interest rate.  The table below summarizes the different scenarios: 

Now what  if we had a truly cashless society?  Scott Sumner argues that even in this scenario there can still be a Fed-created hot potato effect:
Now let’s suppose we have a cashless economy, just interest-bearing reserves. The base is one trillion dollars and NGDP is $20 trillion.  People prefer to hold base money equal to 5% of NGDP.  Now the Fed wants to double NGDP, to $40 trillion.  How do they do this?  They could adjust the quantity of base money.  But let’s rule that out.  We’ll have them adjust the demand for base money by changing the IOR.  So let’s say they cut IOR until the public prefers to hold reserves equal to 2.5% of NGDP.  If the stock of reserves is unchanged, there will be an excess supply of reserves at the new IOR.  The hot potato effect will take over, and raise prices and output until NGDP has doubled.  Then we will be in equilibrium again.  So the hot potato effect refers to changes in both the supply and the demand for base money.  There is nothing particularly “monetarist” about the hot potato effect.
Although Sumner does not explicitly state it, here again the key is where the IOER will be relative to the equilibrium treasury bill interest rate. The table below summarizes the cashless scenarios: 

Of course, all of this discussion is premised on the Fed continuing to use a short-term interest rates as its operating instrument (technically, its intermediate target). If, on the other hand, the Fed started targeting, say, a NGDP growth path and used the monetary base as its operating instrument, this entire discussion would be moot. But that is not the world we live in, so until that time keep your eyes on the IOER-treasury yield gap.

Update: Josh Hendrickson emails me the following discussion:
I think that what people are missing is the dynamic path of adjustment.  Let's suppose that we live in a world where the Fed conducts policy using IOER.  You are correct that if they lower the IOER, this should push banks to reduce their reserve holdings by buying Treasuries and other assets whose relative rates of return have risen to the point that they now make sense to own given IOER.  This should indeed lead to a corresponding change in the composition of portfolios and spending.  This is the dynamic adjustment path.  This adjustment continues until relative rates of return adjust. Thus, one would think that the yield on T-bills would adjust such that banks are indifferent between bank reserves and T-bills.  Waldman seems to think that we instantaneously move from one equilibrium to the next and that it is the reduction in interest rates that is all that matters.  In other words, what Waldman is really arguing is that with IOER, we are in a New Keynesian fantasy world where the central bank pins down the interest rate and everything adjusts correspondingly.  I remain unconvinced that the interest rate is sufficient to pin down equilibrium.  But more importantly, I am convinced that monetary policy works through more than one transmission mechanism.  If it only works through the interest rate, then monetary policy is always and everywhere (not just at the ZLB) pretty weak in the context of countercyclical policy.
Update II: The real authority on this issue is none of us bloggers, but Peter Ireland of Boston College. He has the foremost paper on this issue.


  1. Great post. I think this explains it exactly.

    I favor having IOR lower than the T-bill rate and letting it float.

    1. I concur but am wondering how much of spread between the two is appropriate.

  2. IOR was the means through which the Fed, in 2008, "saved" the financial system while "screwing" the real economy (by effectively tightening MP) so that inflation would remain (below) target.

    1. Yes, I was alluding to that above when I mentioned the Fed in its infinite wisdom decided to keep the the IOER above the tbill yield. The figure linked to there is amazing.

  3. Very clearly explained, or as clearly as it could be given the technical nature of the topic.

  4. How can there be no hot potato effect? The hot potato effect, as you point out, is about portfolio rebalancing. Even if Fed-issued financial instruments look and feel like Treasury-issued financial instruments, this doesn't mitigate people's willingness to rebalance their portfolios away from one or the other the moment expected returns on them diverge.

    1. JP Koning, see my update written by Josh Hendrickson. I think he is getting at the same point as you.

  5. David Beckworth:

    "The Fed, in its infinite wisdom, decided to keep the IOER above the falling treasury bill rate and thus further increase the already elevated demand for bank reserves. In other words, the explicit introduction of the IOER mattered because it effectively tightened monetary policy."

    Oh it was an incredibly wise move indeed by the Fed...if you realize the Fed is a banker's institution BEFORE it is a "help the public" institution of course.

    Ensuring that the most politically connected, large banks stay afloat during the worst financial calamity, even if crushing deflation ruins the little guys, is priority number one, and all other priorities are rescinded.

    Why do monetarists, many of whom are more or less well intentioned, cordial, and intelligent, so often make the mistake of assuming that the Fed cares about the same things as the monetarists do? The Federal Reserve Act was WRITTEN by bankers who wanted the power of the state to protect them during times of financial panics. The Fed was not created to help the general population. Sure, it was communicated that way, but that's how all special privilege laws and regulations are passed. They need to be translated into "public good" concepts.

    [Sidenote: This reminds me, as Obama makes his gun control announcement with children standing in the background, I recall this: "The state must declare the child to be the most precious treasure of the people. As long as the government is perceived as working for the benefit of the children, the people will happily endure almost any curtailment of liberty and almost any deprivation. " - Mein Kampf.]

    Anyway, imagine if the Federal Reserve Act was communicated truthfully, and the Congress and bankers communicated it thusly: "This Act is to benefit us bankers during times of panics, and the gains we acquire will make us relatively wealthier compared to the rest of the population. In fact, the Fed may just "forget" about the little guys"

    That would never have gotten passed, at least at that time, not sure about today.

    1. Tim Geitner's role as head of NY Fed in bailing out AIG's creditors--those banks who sat on his New York Fed board--100 cents on the dollar certainly does not help their case here.

  6. I read this post many times, and I agree with it.

    But---at the risk of being a scold---it raises but does not answer questions, such as:

    Okay, how do we get out of zero bound?
    What will it take, and for how long?
    Who will be responsible for getting us out of zero bound?
    Will the public know who is responsible?

    Japan tried QE from 2001-6, and got rave reviews from John Taylor, who gushed that it was a success. Then the BoJ stopped QE, and they sank back into zero-bound perm-gloom.

    Okay. So maybe we need 10 years of QE, hot and heavy. No? Well, five was working, but was not long enough for Japan. So maybe 10 years is the right number for the USA. I see no one saying this. I see people saying (praying?) that Fed guidance will work.

    Okay. What does 10 years of QE mean for the national debt? For the Fed's role as a revenue generator for the Treasury?

    Can an independent Fed show the flexibility needed to undertake this new direction? Or, is it too hidebound.

    I sometimes think this is a Volckerian moment: But we need a Volcker for QE this time around.

    I am a Market Monetarist, but I think me fellow MM'ers are not thinking forward, nor being really honest with the magnitude of policy that is needed, and also don't want to admit to the amount of monetizing the debt that will go on, as monetaizing debt is a cardinal sin.

    But hell's bells, if five years of QE in Japan was working, but just wasn't enough....

  7. I'm trying to think about how this works.

    In normal times (when banks just hold enough reserves to meet legal minimum or to meet their customers withdrawals) then an introduction of even a low level of IOR will slightly reduce the costs of keeping these reserves and they will keep more, no matter what the T-bill rate is.

    Maintaining both an IOR and an overnight rate will then give the fed more options in hitting its targets and allow it to get banks to increase reserves (by increasing IOR) when it is worried about liquidity.

    However we are not in normal times and banks hold huge amount of reserves(way more than is needed for legal minimum or to meet their customers withdrawals). IOR will be equal to T-bill rate until those excess reserves have drained because bank arbitrage will ensure that this is the case. The fed will have to raise IOR to prevent too much t-bill buying that would cause inflation.

    As the economy recovers there will upwards pressure on T-bill rate and IOR will have to rise to match it. Unless the fed can find another way of draining reserves it will have to have high IOR for years to come if it is to avoid the inflationary effects of the reserves being activated.

    I'm struggling to see what the effects of high and rising interest payments from the fed to banks will be.

  8. David,

    What do you currently have as your "required reading" for your Money and Banking course?

  9. [...] David Beckworth, Peter Dorman, Nick Rowe and Stephen Williamson (see here, here, and here) also share their thoughts. [...]

  10. @Ron: In normal times (when banks just hold enough reserves to meet legal minimum or to meet their customers withdrawals)

    Since WW II "normal times" has been a post-war / baby booming series of economic cycles, without the baby boomers retiring.

    Those "normal times" are gone, for the rest of our lives.

    No sustainable monetary policy is going to successfully stimulate the kind of US growth we saw in the 60 years after 1945.

    Further, the heavier hands of greater regulation and higher taxes, as well as the culture against making money/ creating wealth, means less wealth will be created.

    There should have been some IOER before 2006 to reduce the house price peak, and certainly none after 2008 when the economy needed more lending by banks to those willing to work on new productive ideas.

    The key metrics, mostly not followed, are how many loans are applied for, how many are granted, and what is the total amount of new net borrowing by profit-oriented firms.

    Money is "tight" if there is little new net borrowing, whether it's because the banks don't lend or because the new entrepreneurs are asking.

    But as other policies are tried and fail to promote growth, NGDP targeting will be tried, and is likely to produce some growth, as well as, after a 12-24 month lag, more inflation. With the new normal of 1-2% growth being seen as sustainably good, that will raise the rate of interest above the Zero bound.

  11. And now the Bank of Japan is targeting 2% inflation -- getting closer to NGDP targeting. I suspect it will work.