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.