Monetary Policy Questions

Some of these questions are probably best suited for any ph.d. economists out there, but I'm struggling a lot with the direction of U.S. monetary policy, and what the implications are for markets. I'm wondering about the interest rate that the Federal Reserve pays on deposits by banks, which currently stands at 25bps. Prior to the financial crisis, there was no such interest paid on reserves (excess or otherwise). Now banks can leave cash or Treasuries (more likely) on deposit at the Fed and receive a free 0.25% just out of the goodness of the Fed's heart. There are about $2.7T in bank reserves at the Fed, translating to $6.7 billion in annual subsidies from the Fed to the banks.

A few questions/observations:

1) What is the purpose of this? To the extent this was put in place in an effort to incentivize banks to carry larger capital buffers, hasn't that already been accomplished (Basel)? Why is it still in effect?

2) Can someone help me understand QE and the net impact on rates?

My understanding; the Fed has been buying virtually all of the new net debt created by the U.S. (along with ~60% of the mortgages) since QE started. So payments flow from Treasury to the Fed based on the prevailing interest rates on those treasuries/MBS. But banks also hold significantly more treasuries than they did pre-crisis. The Fed basically pays them a 25bps premium to hold these on reserve, so the interest rate banks are getting is actually 25bps higher than what the yield curve would suggest. So what is the actual market rate? You've got one player getting a premium to Treasury yields (banks), and another player getting just the treasury yields but they have an unlimited balance sheet so their cost of capital is effectively zero and it's all free money anyway... I'm so confused... Can we draw any inferences about what rates would be without the subsidy and with normal economics facing buyers and sellers of treasuries?

3) Do global market participants get that we are just monetizing the debt? Why is the dollar so strong? Is it just that other developed market currencies are being trashed even harder (e.g. Yen, Euro) and so the question is "relative to what". Maybe relative to the Yen the dollar is a pretty good currency, but relative to real assets it is piss poor??

4) Long term implications: sovereign credit bubble? what is the endgame there?

I'd be curious if others have spent time trying to understand any of this...

 

1) Part of intended purpose of IOER was to main sufficient control over short-term interest rates. As excess reserves grew, there was too much liquidity in the system, meaning short-term rates could free fall. In order to maintain some control over fed funds rate and other short-rates, IOER was introduced. IOER, however, did not put a floor on short-rates, since GSEs cannot leave funds at the Fed, they went into the FF market to earn some positive rate, gutting it in the process. Part of your funding intuition is mixed around. Reserves in part fund the Fed's QE program, as some of that excess liquidity goes right back to the Fed at 25 bps. Banks would also incur costs to the extent that this added capital creates an opportunity cost, moreover FDIC charges a fee on deposits to banks. 25 bps is an implicit fee paid by the Fed to the banks for holding onto excess reserves. That said, yes there is an IOER arbitrage, wherein banks accept deposits (and pay say 10 bps) to leave at Fed, making the spread, again there are real costs associated with this. When regulatory requirements become even more stringent heading closer to 2018, excess reserves will be even more costly - Fed hopes Foreign banks for whom IOER arb operations are large will continue to engage in this activity. Also the Fed seems to think adjusting IOER alone will suffice to move fed funds effective within range at time of liftoff, but I don't get where this notion comes from. Seems to me the Fed repo facility will have to do most of the heavy lifting. Short rates trade closer to GC (which can and has traded negative in the past 2 years), not IOER.

2) QE effect on rates is a huge and on-going topic (see Larry Summers paper yesterday written w/ a bunch of harvard dudes), will let someone else take first stab. Will mention however the picture some have in mind that on-set Fed bond purchases reduce yields in mechanical fashion is rather misleading: a look at past QE programs show this is not the case (or at least timing is an issue). Looking at IOER as a premium over the yield curve is also misleading - IOER is an interbank funding rate. Market makers in the rates business fund inventory and cover shorts through the treasury repo market, which is a distinct yet related short-term rate.

3) Wish I understood the FX market, will have to fix that at some point. Yes, policy divergence with the US approaching rate hikes while EU and Japan contemplate QE certainly has something to do with the stronger dollar. This is an extremely simplistic description and in general I don't view market phenomenon through an inflated perception of cause and effect (e.g. rationalizations of every move). Will just offer that deflationary trends in foreign countries and globalization is consistent with wrecking of purchasing power here in the States which is consistent with recent dis-inflationary trends in the U.S. which is consistent with collapse of inflation expectations which is consistent with tightening of financial conditions which is consistent with stronger $ and pulled forward expectations of rate hikes. Still too simplistic but certainly some events that could be occurring in conjunction.

 
Best Response

1) IOER is not a "subsidy" and neither is it an attempt to create an incentive for banks to hold more capital. Like the other poster says, it's an instrument of monetary policy. There are lots of uncertainties about how the liftoff is going to work with all these different rates, so hard to speculate about that.

2) What is "normal economics"? Is there even such thing? The impact of QE plus regulation had undoubtedly been to cause a very material shift of the yield curve downwards, but it's impossible to quantify the impact (some academics have tried).

3) Part of the attraction of USD is undoubtedly the case that it is the "best looking horse at the glue factory". However, there's also an element of things also genuinely improving in the US, which is difficult to claim about other places in the world. There's definitely very little substance to the idea that QE is monetizing debt, given the ever improving fiscal situation and the end of QE. Finally, a currency is not an asset, so comparing USD to "real assets" doesn't make a lot of sense.

4) Sovereign credit bubble? Maybe, but bubbles are always very hard to identify, except in hindsight... 10y treasuries yield 2.35%, while 10y JGB yields 50bps. Is one or both of those a bubble?

 
jankynoname:

1) What is the purpose of this? To the extent this was put in place in an effort to incentivize banks to carry larger capital buffers, hasn't that already been accomplished (Basel)? Why is it still in effect?

Traditional countercyclical monetary policy has always aimed to stimulate economic variables through the effective aggregate demand channel. Essentially, monetary expansions lead to lower interest rates (the cost of capital) and to higher revenues, in turn elevating corporate profits. The ultimate goal is to elevate investment and the demand for labor to a point that is consistent with NAIRU (non-accelerating inflation rate of unemployment) or, in other words, to alleviate excess capacity deemed to be the result of ‘cyclical pressures’ (as opposed to structural shifts caused by technological innovations or shifts in international comparative advantages or institutional frictions caused by minimum wages, unions etc).

It is important to note that traditional macroeconomics posts that there is a direct causal relationship between the demand for final consumer goods and for the demand for labor. It also does not distinguish between various types of investment. Investment is simply a homogenous fund that flows or permeates throughout the entire economy. I won’t spend too much detail going into this since it doesn’t address your primary concerns, but it is important to note that the capital goods required for automobile production, for example, cannot be easily and costlessly converted into capital goods required for natural gas excavation and production.

To get back to your original question, Bernanke’s primary concern was not to provide stimulus as much as it was to provide stability. Bernanke, as a student of the great depression, though I would argue a poor one, classified the financial crisis of 2007 as a liquidity crisis that would lead to a potential deflationary banking contagion (i.e., the introduction of the “systemically important” institution), similar to that of the Great Depression. Stimulus was a secondary concern that would manifest, not through the effective aggregate demand channel, but through the wealth effect, i.e., through higher asset valuations.

This leads us to the answer to your first question, namely why the FED is paying banks to sit on reserves. In part it has to do with bank capitalization rates, as you mentioned, but it is primarily the result of what I described above. The effective aggregate demand channel (what Keynesians refer to as the fiscal multiplier) coincides with higher monetary velocity leading to a “money multiplier” effect. As macroeconomic variables are stimulated, the rate at which money circulates through the economy is accelerated which, in turn, leads to a higher effective money supply.

Bernanke realized that if the money that he injected into the economy entered circulation, and was successful in stimulating the economy, that it would put upward pressure on prices and on interest rates (inflation). Instead, by paying the financial system to sit on the cash, he’s constricting velocity and therefore potential inflation while simultaneously elevating asset prices. The degree and extent to which he can (or could, I should say) pull this off is yet to be seen, but even with the wealth effect, the newly created money will enter circulation eventually.

jankynoname:

2) Can someone help me understand QE and the net impact on rates? My understanding; the Fed has been buying virtually all of the new net debt created by the U.S. (along with ~60% of the mortgages) since QE started. So payments flow from Treasury to the Fed based on the prevailing interest rates on those treasuries/MBS. But banks also hold significantly more treasuries than they did pre-crisis. The Fed basically pays them a 25bps premium to hold these on reserve, so the interest rate banks are getting is actually 25bps higher than what the yield curve would suggest. So what is the actual market rate? You've got one player getting a premium to Treasury yields (banks), and another player getting just the treasury yields but they have an unlimited balance sheet so their cost of capital is effectively zero and it's all free money anyway... I'm so confused... Can we draw any inferences about what rates would be without the subsidy and with normal economics facing buyers and sellers of treasuries?

Unfortunately we cannot estimate the true risk free rate under such circumstances. This is related to the point I made above. The risk free rate is a vital component in the cost of capital calculation, not just for banks, but for all valuations. Since most valuation practitioners have been trained to view yields on government securities as the “appropriate” risk free instrument, they continue to use artificially depressed yields as the proxy for the time value of money. This has the result of elevating valuations and transaction multiples leading to the “wealth effect.”

Essentially the economy’s ability to engage in rational economic calculation has been subdued. No one knows what the real cost of capital, for any stream of cash flows.

jankynoname:

3) Do global market participants get that we are just monetizing the debt? Why is the dollar so strong? Is it just that other developed market currencies are being trashed even harder (e.g. Yen, Euro) and so the question is "relative to what". Maybe relative to the Yen the dollar is a pretty good currency, but relative to real assets it is piss poor??

The U.S. dollar enjoys its status as the world reserve currency, i.e., the “vehicle currency.” All transactions, worldwide, are ultimately settled in dollars. When and Indian exchanges software for a German automobile, the transaction is Rupees  Dollars  Euros  Dollars. This requires that all nations keep large amounts of dollars in their reserves. This arbitrarily elevates the demand and therefore the value of the dollar which puts downward pressure on our current account (trade deficit) but elevates our capital account (investment inflows into the U.S.).

This is not the result of natural, macroeconomic phenomena. It is purely the condition of our distorted international monetary system that leads to worldwide imbalances, similar to the system that characterized the interwar gold standard pre Great Depression (where the artificially overvalued British Pound lead to international catastrophe).

In addition to this, the U.S. is not the only nation pursuing destructive and distortive monetary policy—it’s the approach of choice all over the world. Some argue, therefore, that the Dollar is the “least worst” currency.

jankynoname:

4) Long term implications: sovereign credit bubble? what is the endgame there?

A lot of Fixed Income buy-side institutions incorrectly assumed that the FED’s goal was to outright stimulate macroeconomic variables. They assumed that as the economy recovered, and as velocity picked up, that yields would also rise. Many of them have had short positions which have turned out to be highly unprofitable. This, again, is because the goal was not to directly stimulate but rather to stabilize, which has caused a lagged effect. At some point though, economics will take hold, the FED will lose control of inflation and interest rates, yields will rise and banks will find that, at a risk adjusted basis, it is more profitable lend rather than to hold (in turn increasing the amount of money that enters circulation and boosting velocity, i.e., the “money multiplier”).

The end game is higher yields, higher inflation and lower interest coverage ratios, not only for corporates that have been levering up, but also for governments that have taken on an unprecedented level of debt. In other words, bankruptcy.

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