Thursday, January 1, 2015
Cashing up the system
David Beckworth had a very interesting pair of posts outlining how QE would only have had a meaningful effect on the economy if the associated monetary base growth was permanent.
One addendum I'd add on the topic is that even permanent expansions of the monetary base can have no effect on the economy. The best example of this is the "cashing up" of the Reserve Bank of New Zealand (RBNZ) in 2006, an event that doesn't get the attention that it deserves in monetary lore.
Banks typically hold deposit balances at their central bank in order clear payments with other banks. Because New Zealand's clearing and settlement system was suffering signs of stress in the mid-2000s including delayed payments, hoarding of collateral, and increased use of the RBNZ standing lending facilities, the RBNZ decided to 'flood' the system with balances to make things more fluid. This involved conducting open market purchases that bloated the monetary base (comprised of currency plus deposits) from around NZ$6 billion in mid-2006 to just under NZ$14 billion by December of that year. See chart below.
(Note that the RBNZ's problems began far before the credit crisis and were due entirely to the peculiar structure of the clearing system, not New Zealand's economy.)
This 'cashing up' of New Zealand's monetary system was fast, large, and permanent, so New Zealand should have experienced extremely high inflation, right? Actually, New Zealand's inflation rate was very reasonable and even declined a bit that year.
Why is that? As long as central banks are allowed to provide interest payments to depositors, permanent increases in the monetary base needn't have much of an effect on the economy. Like most modern central banks, the RBNZ pays interest to commercial banks that keep balances on deposit at the central bank. So even if a central banker permanently amps up the supply of balances, banks will not all simultaneously try to offload this excess supply and hyperinflation does not follow. This is because the deposit rate 'carrot' that is dangled in front of banks helps offset their urge to get rid of the excess. In fact, even as it was cashing-up the system the RBNZ increased its deposit rate by 5 basis points five times between July and October 2006 for a total increase of 25 basis points, a slight tightening of monetary policy. This brought the return on central bank balances to a level competitive with other assets like government treasury bills. Instead of panicking as the monetary base permanently exploded by 150%, New Zealand's banks shrugged and calmly accepted the new balances.
When central banks don't pay interest on deposits then a permanent increase in the base will typically have a large effect on the economy. Without an interest rate carrot to make deposits competitive with other assets, banks that are faced with large excess balances will race to get rid of them, causing a large spike in the price level. With the U.S. Federal Reserve only earning the legal right to pay interest in 2008, there are now no major central banks (to my knowledge) that lack their own deposit rate carrot. And all of them set that rate to be roughly competitive with the rate on other short term assets like treasury bills, specifically a few basis points below the rate on competing assets.
Just to make sure I've made my point, with the deposit rate on central bank balances being (almost) competitive with other assets, a permanent doubling in the supply of money will only cause significant inflation when combined with a large cut to the deposit rate. Keep that rate unchanged and the same doubling will only have a marginal effect on the economy. A doubling in the supply of money would actually be deflationary if combined with a large enough rise in the central bank's deposit rate. In short, central bank decisions about the deposit rate can override whatever permanent changes are made to the money supply.
Beckworth makes the case that the Federal Reserve's quantitative easing was never more than a temporary measure, and therefore had no meaningful effects on the economy. I agree with him that QE didn't have much of an effect, but not necessarily because it was temporary. Let's say that QE was not a temporary phenomenon but rather more akin to a permanent New Zealand-style 'cashing up' of the system. If so, would QE's effects on the economy have been more marked? Given the precedent set by New Zealand in 2006, I don't think so. Throughout the Fed's three QEs, the rate offered on Fed balances (generally referred to as interest on reserves, or IOR) was very competitive with the rate on other government-issued short term assets, and therefore banks would have been unlikely to feel any need to rid themselves of their rapidly growing pool of balances. So while I agree with Beckworth that the Fed's 'dirty little secret' is that QE was muted from the start, I don't think that this powerlessness necessarily hinges on QE being temporary—after all, permanent increases can fall on deaf ears, depending on the level at which the central bank's deposit rate is set. New Zealand is living proof of this.
PS. This isn't a gotcha post. Beckworth has mentioned this stuff before.
PPS. I'm not sure whether he'll agree with the following, though. Take the RBNZ again. It's 2006 and the Bank is paying a competitive rate on central bank balances. When it cashes up the system, the RBNZ simultaneously announces a regime change; it will now target 4-6% inflation rather than 1-3% inflation. It also says that the permanent increase in the supply of balances (and subsequent increases if necessary) will be sufficient to ensure this target is reached. The threat of a lower deposit rate will not be used to enforce the target, the rate being left unchanged. Will the RBNZ manage to hit its new target? I say no. Despite a regime change and a commitment to permanent open market operations, the Bank won't succeed in doubling inflation. This is because the unchanged deposit rate will be set too high, interfering with the RBNZ's ability to carry out its promise.
Review of the Reserve Bank of New Zealand's Liquidity Management Operations - A consultation paper, March 2006 [link]
Doubling Your Base and Surviving. Anderson, Gascon, Liu [link]
RBNZ 2007 Annual Report [Link]
...and on a totally unrelated note, Happy New Year!
These were my top five visited posts in 2014, as measured by Google.
2. Draghi's fake zero-lower bound and those pesky €500 notes
3. Is the value premium a liquidity premium?
4. Gilded Cage
5. Gresham's law and credit cards
Fedcoin, which I think the internet overrated, got picked up by Ycombinator, while Draghi's fake zero-lower bound and Is the value premium a liquidity premium (both much better than Fedcoin) were tweeted by Joe Weisenthal, spreader of ideas extraordinaire. Gilded Cage demonstrates the fact that people tend to prefer posts that attack individuals or groups of people and, finally, Gresham's law and credit cards is just plain awesome ;)
Two of my favorite posts that went pretty much under the radar screen were Fear of Liquidity and Liquidity Everywhere. Ignoring the fact that these titles sound like adverts for diapers, do give them a read.
Thanks to all you who comment on this blog. It's always fun to read your thoughts, they get me thinking about the next post.