Monday, April 13, 2009

There is No Free Lunch in Central Banking

Many observers, including myself, have questioned whether the Fed has the will to reverse the expansion of its balance sheet--the projected $2 trillion plus increase in the monetary base--once the economy starts recovering. While this monetary expansion is necessary now, a failure to reverse it in the future could lead to 1970s-type inflationary pressures. To do so, though, requires a large contraction of the monetary base--whose expansion has largely taken the form of a buildup in banks' excess reserves--which could knock the economic recovery down just as it is getting started. John Taylor, among others, is not convinced the Fed will be able to make such a politically unpopular move.

Via Mark Thoma, we now learn that Susan Woodward and Bob Hall believe this concern is misplaced. They argue in an almost upbeat manner that there is a "simple and effective answer" to this dilemma:
The Fed should raise the rate its pays on reserves as needed to control economic activity and inflation. It is unnecessary for the Fed to cut its reserves to low levels once the economy approaches normal conditions. Rather, it only needs to raise the reserve interest rate to a point sufficiently close to market rates to make banks willing to hold excess reserves.
While this approach may be simple, I am not so sure that it is effective since it implies a potentially large fiscal cost. As the economy recovers, market interest rates will go up and necessitate that the rate the Fed pays on excess reserves also goes up. Given the large stock of excess reserves, the interest payment could turn large. How would the Fed pay for it? The Fed could keep more of its seigniorage, but that would mean less revenue for the federal government. This would be, then, another implicit fiscal cost where banks would be funded by taxpayers.

Once the economy begins to recover I see four potential paths the Fed could take with regards to the large buildup of excess reserves:

  1. The Fed could do nothing and allow the inflationary pressures to emerge.
  2. The Fed could reverse the buildup of excess reserves and in the process stall the economic recovery.
  3. The Fed could pay even higher rates on the excess reserves and potentially incur large fiscal costs.
  4. The Fed could pray for super-robust economic growth that would allow the economy to quickly grow (i.e. increase real money demand) into the money supply. This would be the cure all solution--no need to reign in the buildup of excess reserves and no need to worry about inflation.

Number (4) is pipe dream. I suspect some combination of numbers (1) and (2) will be the likely outcome. Note that if the Fed pulls a Paul Volker and focuses solely on number (2) it would not only stall the economic recovery but may also incur some fiscal costs. This is because the Fed could have a negative equity position on its balance sheet by that time--interest rates will eventually go up and, in turn, push down the prices on securities currently held by the Fed--that would require it to either borrow securities from the Treasury or issue its own debt in order to reign in the expanded monetary base. The bottom line is there are no easy options ahead for the Fed once the recovery begins.

Update: Michael S. Derby also considers these issues.

Update II: Scott Sumner addresses some of the concerns in this post.


  1. I suspect that most QE proponents assume 4) without making it explicit. I believe they see a world in which "automatic stabilizers" (depleted inventories, pent-up durables demand) kick in and create robust growth. The more steep the recession, the more depressed the levels of these "stabilizers", the quicker the reversion to the mean. So basically, they believe the Fed not only can withdraw liquidity when growth resumes; they believe the Fed will WANT to do so because it will keep the non-inflationary recovery alive. They ignore the effect of leverage on the economy, or the need to reduce debt levels and asset prices in order to make future projects have attractive risk-adjusted returns. Debt is the central issue facing our economy, and they don't even mention it.

    One other point: the payment of interest on reserves may have an impact on velocity as well as the direct fiscal cost. The goal of paying interest is to keep reserves "parked" at the Feds. What is the optimal level of excess reserves given optimal M1 or M2 growth rates? What spread between Fed Funds and reserve interest will create that level? How sensitive is the level to the absolute level of the Fed Funds rate? Of course, no one knows the answers to these questions, so QE enthusiasts pretend the questions don't matter.

    Paying interest on reserves merely makes the money supply the permanent target of monetary policy. We don't know much about using that target.

  2. It is the consumer who will suffer, not rich Fed personnel. Once again, consumers get no seat at the decision making table. That is why they always lose.

  3. You think QE proponents assume 4? I think they assume something like 2. The idea of QE is that you increase the money supply, depending on how you measure that, by orders of magnitude; nobody is so sanguine as to think that real GDP is going to grow at 1000% annualized for several quarters in a row to sop that up.

    I think 3) could be a valuable piece of it; I expect 2) to be the biggest piece of the response, but 1) to be bigger than I'd like. 4 will be an absolute rounding error.

  4. David Pearson--interesting point on the Fed effectivly targeting a quantity by paying interest on excess reserves. Monetarism could make a comeback afterall.

  5. The Fed only needs to announce a particular target for the price LEVEL, which allows for all the inflation up to this point, but implies a slowing inflation rate.

  6. I'm glad you're trying to get ahead of things & worry about inflation, but at the moment, i see deflation everywhere. Incredible amounts of supply, nonexistent demand. The only way i can see inflation, even in the mid to long term, is in a few concentrated areas, like maybe oil and/or commodities. But a large run-up in across-the-board consumer prices? It seems highly improbable. We have yet to even feel the effects of the deleveraging of the financial system, which is a de facto decrease in liquidity.

  7. Anonymous #3:

    Yes, I am looking ahead but also recognize the need for the Fed to stabilize nominal spending now and avoid a deflationary collapse. You can see my concerns about the collapse in nominal spending and my endorsements of the current Fed policies here and here on this blog.

    The Fed is in a tough position. Ben Bernanke and the rest of the Fed have their work cut out for him.

  8. To me, the most striking part of the article was the authors' stating the Fed paying a positive interest rate on reserves currently is "inexplicable."

    I agree, although I've seen it argued elsewhere that the point was to give the Fed to ability to expand its balance sheet buy buing agencies, mbs, etc. The Fed creates money, it's recycled back to the Fed by banks rather than lent out, and the Fed uses it to buy more assets.

    Is that explanation incorrect, or did the authors just miss it?