Reserve Balances and the Fed’s Balance Sheet in the Future

An important part of the Fed’s normalization policy is to reduce its holdings of securities and thereby reserve balances—deposits of banks at the Fed—used to finance these holdings. As I argued when quantitative easing began in 2009, this reduction should be predictable and strategic.  That view was given some empirical support by the “taper tantrum” in 2013, when Ben Bernanke abruptly said in a congressional hearing that the Fed’s purchases of securities would taper in “the next few meetings.” In contrast, when the tapering later became more predictable, markets digested it easily.

The Addendum to the Policy Normalization Principles and Plans recently issued by the Fed conforms to this gradual and predictable approach. The Fed said it intends to reduce its holdings of Treasury and mortgage-backed securities by decreasing reinvestment of principal payments to the extent that they exceed gradually phased-in caps. As stated in the Addendum, the Fed “anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively. Gradually reducing the Federal Reserve’s securities holdings will result in a declining supply of reserve balances.”

The statement that the supply of reserve balances will decline in a gradual and predicable manner is welcome. But there is still the important question about what the Fed is aiming for. As explained in the Addendum, the “Committee currently anticipates reducing the quantity of reserve balances, over time, to a level appreciably below that seen in recent years but larger than before the financial crisis; the level will reflect the banking system’s demand for reserve balances and the Committee’s decisions about how to implement monetary policy most efficiently and effectively in the future. The Committee expects to learn more about the underlying demand for reserves during the process of balance sheet normalization.”

It is important that the Fed refers to reserve balances so much in this statement. There are two basic approaches to the question of what the Fed should aim for, and the level of reserve balances in the balance sheet is the key difference between them. One approach is for the Fed to aim at an eventual balance sheet and a corresponding level of reserve balances in which the interest rate is determined by the demand and supply of reserves—in other words, by market forces—rather than by an administered rate under interest on excess reserves. (To be sure, during the normalization or transition period with inherited high reserve balances, there is no choice but to use interest on excess reserves). Conceptually this means the Fed would eventually operate under a framework as it did in the two decades before crisis.  Most likely the level of reserve balances will be greater than the levels of 2007, but that will depend on liquidity regulations. The defining concept of this approach is a market determined interest rate.

I think the case can be made for such a framework. The assessment of Peter Fisher, who ran the trading desk at the New York Fed for many years, is that such a framework would work. At the recent monetary policy conference at the Hoover Institution, he said “we could get back and manage it with quantities; it’s not impossible. We could just re-engineer the system and go back to the way we were.”  I agree based on the time I spent in the markets for federal funds in those days watching how they operated and writing up an institutional description and model of how people traded in those markets. If we went back to that framework, there would not be any need for interest on excess reserves. If the Fed wanted to change the short term interest rate, it would just adjust the supply of reserves.  The amount of reserves would be set so that the supply and demand for reserves determine the interest rate.

The Fed could also provide liquidity support if it needed to do so in this framework. Recall the events of 9/11 when the devastating physical damage led the Fed to provide effective lender of last resort loans. So you can have that kind of liquidity support in such a regime.

If it wanted to, the Fed could operate with corridor system in this framework. There would be a lower-interest rate on deposits at the floor of the corridor, a higher-interest rate on borrowing at the ceiling of the corridor, and, most important, a market-determined interest rate above the floor and below the ceiling.

This approach creates an important connection between the Fed’s policy interest rate and the amount of reserves or money in the system. The Fed is responsible for reserves and money, and that connection is important to maintain. Without that connection, you raise the chances of the Fed being a multipurpose institution, which leads people to raise questions about its independence.  The Fed has already been involved in credit allocation with mortgage-backed securities purchases, and Charles Plosser argues it might do much more.

The second approach is a system where the quantity supplied of reserves remains well above the demand, and the interest rate is administered through interest on excess reserves as recently discussed along with other normalization issues by Fed Governor Powell.  The method is sometimes called a “floor” system, but the federal funds rate moves a bit below the floor, so it is not really a floor. In any case, the interest rate is not market determined.

Those who support the second approach argue that more reserves than the amount needed to determine the interest rate are needed for liquidity purposes. Some (see Todd Keister) argue that the payment system doesn’t function well with a smaller amount of reserves. In the past there were large daylight overdrafts. However, one could limit the size of the overdrafts, perhaps as a percentage of collateral. There also may be some regulatory changes that would reduce the demand for liquidity.

Some argue that with a large balance sheet the Fed could provide depository services to regular people, just like it provides depository services to banks, with advantages described by John Cochrane here in an earlier conference volume. The Treasury could provide that service without interfering with the Fed’s operations, however, or there may be other ways to provide the service without creating a disconnect between the interest rate and reserves.

Others argue that a permanently large balance sheet with large reserve balances would allow quantitative easing to be used regularly.  I don’t think quantitative easing has been that effective, and because there is uncertainty about its impact, it is hard to conduct a rules-based monetary policy with such interventions.  Moreover, the spreading of quantitative easing across the international monetary system adds turbulence to exchange rates and capital flows.

In sum, we should not only be thinking about how to reduce the size of the balance sheet in a predictable, strategic way. We should also be thinking about where reserve balances are going.  I think the first proposal described here makes sense. After the normalization, after the transition is finished, interest rates would again be determined by market forces.

Posted in Financial Crisis, Monetary Policy, Regulatory Policy

R-Star Wars

In a recent speech at the Economic Club of New York, Fed Governor Jay Powell stated that the endpoint of the Fed’s normalization process “will occur when our target reaches the long-run neutral rate of interest. Estimates of that rate are subject to significant uncertainty. The median estimate of its level by FOMC participants in March was 3 percent, more than a full percentage point below pre-crisis estimates.” The neutral rate of interest is commonly designated as R*. (Sometimes R* is stated in real terms, rather than nominal terms. With an inflation target of 2 percent, a real neutral rate would would be 1 percent according to the FOMC median of 3 percent nominal.)

Actually the estimated drop in R* is quite recent: the FOMC median nominal R* was 4 percent just 4 years ago, which illustrates the uncertainty. It’s a very important issue: If there has actually been a drop, then, as some argue, the Fed should be ready for another zero lower bound event with more quantitative easing or even a higher inflation target. If there has not been a drop, then the Fed’s normalization endpoint will likely be the type of policy used in the 1980s and 1990s.

To take a deep dive into the issue, the Hoover Institution and the Stanford Institute for Economic Policy Research held an R-STAR WARS debate between two of the world’s foremost experts on this question, with me as moderator. On one side was Volker Wieland of Goethe University of Frankfurt and the German Council of Economic Experts. On the other was John C. Williams of the Federal Reserve Bank of San Francisco and a member of the FOMC.  Williams argued that the neutral rate is now much lower than in the past. Volker Wieland argued that there has been no such decline. Each made a good case in my view, but you be the judge. Here is a video of the debate in three parts: Opening remarksQuestions from Taylor, and Questions from the audience.  At the least you will see why Powell says there is “significant uncertainty,” and perhaps that is the main takeaway for policymakers.

Posted in Monetary Policy

Principles of Economics 8.0: Lower Price and Better Format

I’m really excited about the 8th Edition (I should say Version 8.0) of my introductory economics text with Akila Weerapana because it comes from a new publisher, FlatWorld, and will be sold at a much more reasonable price—only 10% to 25%, depending on the order, of the price charged for the old edition.  In the past I told students to buy used copies because the price was so high, but no more: I got the publication rights back and found a new publisher, Flatworld. In addition to charging a reasonable price, Flatworld will also provide access to the book to wide audience with more flexible formats suited to the needs of students and teachers. The FlatWorld platform will allow us to update the book on a regular basis with minimal disruption. In addition to using the text in Stanford’s Econ 1 course next fall, I plan to use it in Stanford’s massive open online course (MOOC) Econ 1 when it again goes live this summer.

Principles of Macroeconomics v. 8.0 is already out, with Principles of Microeconomics v.8.0 and the full book Principles of Economics v. 8.0 out in the next few weeks.  Of course v. 8.0 has new facts and ideas as well as new features, but the goal of the book is still to present modern economics in a form that is intuitive, relevant, and memorable to students who have had no prior exposure to the subject. Akila and I both teach introductory economics— at Wellesley and Stanford—and we enjoy teaching greatly. We have endeavored to make the basic economic ideas as clear and understandable as possible.

The book starts out with the key idea that economics is about making purposeful choice with limited resources and about people interacting with other people as they make these choices. Most of those interactions occur in markets, and the book is mainly about markets, including labor markets, financial markets, capital markets, and international markets.  The micro part of the book shows why free competitive markets work well to improve people’s lives and how they have removed hundreds of millions from poverty around the world, with many more, we hope, to come.  The book shows how interference with free competitive markets due to monopolies or environmental spillovers can cause market failures, and looks at ways to remedy these failures including through the use of government.  The macro part of the book looks at monetary policy in all its modern forms and the effects of tax and fiscal policy. The book considers economic policy in theory and in practice and explains why government failure is also a problem in economics.

Posted in Uncategorized

Another Takeaway from the Trump Trip: Targeting Terrorist Financing

Many (see herehere, here, and here) are listing takeaways from President Trump’s trip abroad, such as the unusual pomp and circumstance in Saudi Arabia, the unprecedented non-stop flight from Riyadh to Jerusalem, the significance of the follow-up leg to Rome, and the interactions with NATO and the G7 countries.

A takeaway that has received far too little attention, in my view, is the announcement of an agreement between the United States, Saudi Arabia, and the rest of the Gulf Cooperation Council to set up a new effort to combat terrorist financing. It highlights the role that finance and economics can play in foreign policy and national security. In the speech in Saudi Arabia at the Arab Islamic American Summit, Trump announced “that the nations here today will be signing an agreement to prevent the financing of terrorism, called the Terrorist Financing Targeting Center—co-chaired by the United States and Saudi Arabia, and joined by every member of the Gulf Cooperation Council. It is another historic step in a day that will be long remembered.”

The aim is to cut off financial channels through which ISIS gets cash, to “strip them of their access to funds” whether from selling oil or receiving transfers of funds which are used to pay fighters and recruit reinforcements. It is an important part of the new accelerated strategy to defeat ISIS, as Secretary of Defense Mattis has explained. Later in the trip the US and the other G7 countries followed up in a communique that “we will refocus our efforts and take action to cut off sources and channels of terrorist financing and the financing of violent extremism,” and Trump mentioned it again in the final speech of the trip in Sicily.

That this is a highly visible joint effort demonstrates significant strength and resolve, especially with Saudi Arabia and the United States co-chairing and with the other members of the Gulf Cooperation Council–Bahrain, Kuwait, Oman, Qatar, United Arab Emirates—participating. The new agreement and center will include countries that could be doing more stop the flow of money to extremists. The action is similar to, but stronger and wider than, previous joint agreements, some going back to the months after 9/11. For example, the U.S. and Saudi Arabia jointly designated branches of the Saudi based charity, Al-Haramain, in Bosnia, Somalia, Pakistan, Indonesia, Kenya, and Tanzania in 2002 and 2004. At that time U.S. intelligence showed that these branches of Al-Haramain were diverting funds to Al-Qaeda and to Al-Qaeda affiliated terrorist groups, such as Jemaah Islamiyah, and were linked to bombings in Bali and in U.S. embassies in Nairobi and Dar Es Salaam.

The Treasury will play a key role in the new Center, and details are posted here along with the MOU on the Treasury web site.  Of course, the specific actions of the Center going forward are what will really matter, and Treasury’s job will be key, at least that is my experience from developing the initial international efforts to combat terrorist financing at the Treasury in the days and months after 9/11 as described here. That job will be in the hands of the incoming Under Secretary of the Treasury for Terrorism and Financial Intelligence.

Unfortunately, the confirmation of the nominee for that position, Sigal Mandelker, is now blocked. As Senator Ron Wyden tweeted “I’ve placed a hold on nominee for Under Secretary of Treasury for Terrorism & Financial Intelligence until Trump Admin produces Russia docs.” This hold obviously has an adverse effect on the new Center. It is important for the Senate to confirm Sigal Mandelker so that she and the United States can get going on implementing the new initiative.

Posted in Uncategorized

ECB Watching

Hundreds of financial market participants and news reporters showed up for the 18th annual “ECB and its Watchers” conference in Frankfurt last week. I was one of the speakers as I was at the first conference in 1999. It was a good day for talking about policy with candid questions and answers.  ECB President Mario Draghi led off with a review of current policy; I followed with a talk about asset purchase programs (my assigned topic), and for the rest of the day we listened to presentations and discussion of unconventional policy, structural reform, international coordination, and an enlightening debate between Volker Wieland and John Williams on the “neutral” real interest rate moderated by Sam Fleming of the FT.

The previous time I spoke at this event in 2014 I examined the implications of the Fed’s large-scale asset purchases from 2009 to 2014. I argued then that the purchases did not lower longer term rates except for possible signaling and temporary announcement effects, and I pointed to ten possible negative unintended consequences:

  • Distortion of price discovery in markets
  • Unresponsiveness of long-term rates to key events as in normal times.
  • Non-functioning of money markets
  • Risk of discouraging lending and investment
  • Uncertainty about unwinding
  • Too much risk-taking by risk-averse investors
  • Undermining of fiscal discipline
  • Public questioning of the need for central bank independence
  • Large re-distributive impacts
  • International contagion of policy as central banks followed each other

This time I examined the ECB’s asset purchase program, which expanded dramatically in 2014. I mentioned the same ten concerns (later the ECB’s Peter Praet noted they were monitoring these). But I also noted more of an impact on financial markets and possibly inflation than in the US. The graphs below show the expansion of ECB purchases and the accompanying change in the ECB inflation rate, though the latter may prove to be temporary.

There are also much more detailed studies of the ECB’s asset purchases, many of which find large exchange rate effects. Empirical work by Demertzis and Wolff in a June 2016 Bruegel Policy Contribution found a big effect on the euro exchange rate as did a January 2017 Bundesbank Monthly Report which went beyond announcement effects with dynamic regression estimates. A September 2016 ECB working paper by Andrade, Breckenfelder, De Fiore, Karadi, Tristani found effects on asset prices, though they focused on announcements; they then plugged these into a model to see the impact on lending, but, in my view, the model simulations still need to be checked for robustness.

The exchange rate effects raise international issues (per the tenth unintended consequence on the above list). To see this, trace the recent history of the asset purchase programs at the Bank of Japan and ECB. During the Fed’s asset purchase program, Prime Minister Shinzō Abe, when he was first running for office, complained about the strong yen, and, when he won, he appointed Haruhiko Kuroda, who then expanded asset purchases in 2013 which was accompanied by a depreciation of the yen as seen in the yen-dollar graph.

Soon after that Mario Draghi spoke about the strong euro at Jackson Hole in August 2014, the ECB’s asset purchase program began, and there was a large depreciation of the euro also shown in the euro-dollar graph.

These international developments along with improving conditions in the euro area indicate that it is time to consider a strategy for normalizing ECB policy in a clear, predictable way. Economics and the experience with normalization by the Fed suggest ways to do it gradually and strategically (including the taper tantrum experience of what not to do). The question of sequencing (reducing the size of purchases versus policy rate increases) is best approached by paying careful attention to the negative impacts listed above, as Mario Draghi suggested in his talk, and there are special considerations for a currency zone where some countries are performing differently than others.

It would be best if normalization were toward a rules-based monetary policy which has worked well in the past, as I explained in a presentation on interest rate rules at the 1999 ECB Watchers conference. Moreover, rules-based monetary policy at the ECB, the BOJ, and other central banks would help to create a much-needed rules-based international monetary system.

Posted in Monetary Policy

It’s Time to Pass the Financial Institutions Bankruptcy Act

Today the House Judiciary Subcommittee lead by Tom Marino held a hearing on the Financial Institution Bankruptcy Act (FIBA) which lays out in clear legislative language the “Chapter 14 type” reform proposals that Stanford’s Hoover Resolution Project have been working on since the financial crisis. Based on this hearing, which included top legal experts familiar with the bankruptcy code, including Bankruptcy Judge Mary Walrath, I am optimistic that the bill will become law soon.  The written testimony of all of the witnesses, including me, can be found here.

As I stated in my opening remarks at the hearing, FIBA, which adds a new Subchapter to Chapter 11, is an essential element of a pro-growth economic program.  The legislation makes failure feasible under clear rules without disruptive spillovers. It would

  • help prevent bailouts
  • diminish excessive risk-taking
  • remove uncertainty associated with an ad hoc bailout process
  • reduce the likelihood and severity of financial crises and thereby lead to stronger economic growth.

Chapter 11 has many benefits, including its basic reliance on the rule of law, but for large complex financial institutions it has shortcomings because it is likely to be too slow and cumbersome to deal with runs on failing financial institutions.

FIBA would also rely on the rule of law and strict priority rules of bankruptcy, but it would operate faster—over a weekend—leaving operating subsidiaries outside of bankruptcy entirely. It would do this by moving the original financial firm’s operations to a new bridge company that is not in bankruptcy.  This bridge company would be recapitalized by leaving behind long-term unsecured debt. It would thus let a failing financial firm go into bankruptcy in a predictable, rules-based manner without spillovers.

It is important to understand how a reformed bankruptcy code would resolve a large financial institution and in an important contribution Emily Kapur has done just that, examining how it would have worked in the case of Lehman.

FIBA would work better than Title II of the Dodd-Frank Act in which the FDIC would have to exercise considerable discretion and might wish to hold some creditors harmless in order to prevent spillovers.  The perverse incentive effects of such bailouts occur whether or not the extra payment comes from the Treasury, from a fund financed by financial institutions, or from smaller payments for other creditors.

Moreover, under Title II, a government agency, the FDIC, would make the decisions. In contrast, under bankruptcy reorganization, private parties, motivated and incentivized by profit and loss considerations, make key decisions about the direction of the new firm.

Another advantage of FIBA is that it would facilitate resolution planning under Dodd-Frank. Some of the resolution plans submitted by the large financial firms have been rejected by Fed and FDIC. With FIBA the plans would be feasible.

The issue of liquidity should be considered if FIBA were to replace Title II.  The new firm might need lender of last lender support. Section 13(3) of the Federal Reserve Act would be available in such circumstances.

International arrangements should also be considered if FIBA were to replace Title II.  For example, current European resolution authorities contemplate a parallel authority abroad. If Title II were repealed and there was no parallel authority in the U.S., then a way to cooperate internationally would have to be created.

In sum, reform of the bankruptcy law, such as FIBA, is essential for ending government bailouts and for creating a robust financial system supporting economic stability and growth.


Posted in Financial Crisis, Regulatory Policy

A New Hearing and, Possibly, a New Phase in Monetary Policy

Today’s hearing of the House Monetary Policy subcommittee—the first of the new Congress with the new chair Andy Barr from Kentucky—provided a good opportunity to discuss policy in light of new and different decisions by the Fed, new and different speeches by FOMC members, and of course a new Administration. I testified along with John Allison, Marvin Goodfriend, and Joshua Bivens. It was a good, candid hearing, which moved reform efforts forward.

Though it may seem like a long time ago, it is crucial to remember that it was back in 2003-2005 that the Fed departed from the policy of the previous two decades of good economic performance by holding the federal funds rate “too low for too long.”  Along with a breakdown in the regulatory process, this policy decision was a key factor leading to the financial crisis and the terribly high unemployment that followed.  It is telling in this regard that Josh Bivens, in his more positive assessment of recent monetary policy at the hearing, did not even discuss the possible role of policy leading up to the crisis and the large increase in unemployment.

After the panic in the fall of 2008, Fed policy moved sharply in an unconventional direction. The Fed purchased large amounts of U.S Treasury and mortgage backed securities, and it held its policy interest rate near zero when indicators used in the 1980s and 1990s suggested that higher rates were in order.  Much research shows that these post-panic policies were not effective.  Economic growth was consistently below the Fed’s forecasts with the policies, and was much weaker than in earlier U.S. recoveries from deep recessions.

One clear lesson from this historical experience is that the Fed should normalize policy and get back to the kind of policy that worked well in the past.

Here there is some progress in recent months, including in the FOMC decision this week. The Fed has shown more determination to normalize policy, and the whole term structure of interest rates has adjusted. With the federal funds rate still below appropriate levels, a key step is to raise it gradually and strategically going forward. In my view, reserve balances should also be reduced to the size where the interest rate is market determined rather than administered by the Fed’s setting the rate on excess reserves.  (I know there is some disagreement here and I consider the issues in my written testimony.)

A second lesson is that the FOMC should adopt and explain its monetary strategy, put the strategy in its “Statement on Longer Run Goals and Monetary Policy Strategy,” and then compare that strategy with existing monetary policy rules in a transparent way.  John Allison and Marvin Goodfriend supported this view. Marvin testified that “the Fed should include in the ‘Statement’ its intention to improve legislative oversight by presenting the FOMC’s independently chosen monetary policy decisions against a familiar Taylor-type reference rule for monetary policy.”

Here too there is some progress in recent months.  In a speech in January, Fed Chair Janet Yellen compared current monetary policy with the original Taylor rule, with a Taylor rule which is more reactive to the state of the economy, and with a Taylor rule with inertia.  Vice-Chair Stanley Fischer gave two follow-up speeches in February and March which take a similar approach, focusing on decisions made in 2011 and more recently, and comparing those decisions with the same three rules. All these speeches take policy in the direction of the kind of policy transparency that is called for in the Fed Oversight, Reform and Modernization Act (FORM).

The hearing was also a chance for members to emphasize that there is nothing in the FORM act that would require the Fed to follow a mechanical formula.  The Fed would simply choose its own strategy, and could change it or deviate from it if circumstances called for a change.

A third lesson involves the international monetary system. Unconventional monetary policies have spread internationally as the Bank of Japan, the European Central Bank, and other central banks adopted policies similar to that of the Fed.  Thus the international monetary system has deviated further from a sound rules-based monetary system, and the results have not been good. I have been arguing that normalization by the Fed would lead other central banks to move away from unconventional policies, and eventually normalize.

Here too there is some progress. As the Fed has showed a more determined effort to normalize, the ECB has changed the pace of its unconventional policies, and the BOJ is increasingly mentioning problems with its own quantitative easing. There is clearly an increased understanding of a change at other central, and perhaps a new phase internationally as well.

Posted in Monetary Policy