Friday, January 29, 2016

A monetary policy sound check

It's healthy to ask others for a sound check every now and then. I'm going to give a short description of how I see the monetary policy transmission process working, then readers can tell me how far off I am. Hopefully this sound check will bring some more rigour to my thought process.

Briefly, the story from start to end it goes like this...

1. A central bank reduces interest rates.

2. After a delay, consumer prices will be higher than they would have been without the rate cut.

Here's some more detail on how I get from 1 to 2.

A) In the first moment after the rate cut, banks find themselves earning a smaller return on balances held at the central bank than on competing short term/safe financial assets (like government bills and commercial paper). Central bank balances are overpriced, government bills and commercial paper are underpriced.

B) To maximize their profits, banks all try to sell their overpriced balances, driving the prices of government bills and commercial paper up and their expected returns down. The relative mispricing has been fixed; returns on central bank balances are once again equal to returns on other short-term/safe financial assets. What about other financial assets?

C) In the next moment the reaction spreads to the rest of the financial universe. Financial market participants (many of whom don't have an account at the central bank) observe that the returns on government bills and commercial paper in their portfolios have been reduced relative to returns on other financial assets. They try to sell their bills & paper and buy underpriced risky assets like stocks, gold, and bitcoin, driving the prices of these instruments higher and returns lower until the arbitrage window is closed.

D) Very quickly, these adjustments brings the expected returns on all financial assets into balance with each other. What about goods markets?

E) In the next moment the reaction spreads beyond financial markets. Investor begin to notice that the returns on the financial assets in their portfolios have suddenly become inferior to the return they can expect on consumer goods and services. Investors try to re-balance by selling their financial assets and buying underpriced consumer goods.

F) Unlike financial prices, goods prices may be slow to adjust. This means that the window for enjoying artificially underpriced consumer goods stays open for a period of time. With people flocking to enjoy free lunches, the quantity of consumer goods and services sold speeds up relative to the pace that would have prevailed without a rate cut. We get a boom.

G) At some point, shops increase prices and close the arbitrage window. We've now arrived at 2 and the story is complete.

You may notice that I didn't include bank lending in my sound check. That's because I'm not convinced that bank loans are vital to the monetary transmission process. That being said, we can introduce an optional step between F and G.

i) To take advantage of underpriced consumer goods, investors may take on bank debt in order to buy more goods than they might otherwise have afforded, so the quantity of debt increases.

But even if people choose not to take on additional debt, or for some reason the banks decide to hold back lending, the arbitrage process ignited by a rate cut will still play itself out with an increase in consumer prices being the final result. The key role banks play in the transmission process is at A & B, the effort to sell reserves for alternative safe assets, not at the i) level. And no matter how sick a bank is, it won't forgo arbitrage at the A & B level.

So the purpose of the Bank of Japan's recently-announced negative interest rate policy is not to make Japanese banks lend more. The point is to set off an arbitrage process out of Bank of Japan deposits and into goods & services through a series of other intervening assets, eventually leading to higher prices.


Previous posts on the transmission process:

Robin Hood Central Banking
Toying with the Monetary Transmission Mechanism


  1. Conventionally with the first two steps you'd think in terms of the cost to banks to borrow from the fed, but I suppose now that they're awash in excess reserves your steps A) and B) become more pertinent.

    C) is the portfolio re-balancing channel, but I don't think it's quite right to describe this process as arbitrage.

    E) makes little sense to me - "the return on consumer goods and services" doesn't mean much to me at all. A lower expected return on their savings might induce more consumption, but the portfolio re-balancing would only change the risk profile of their savings, it wouldn't necessarily lower the return.

    "You may notice that I didn't include bank lending in my sound check. That's because I'm not convinced that bank loans are vital to the monetary transmission process. "

    I find this view very strange, I would argue the lending channel is more dominant than portfolio re-balancing channel.

    "i) To take advantage of underpriced consumer goods, investors may take on bank debt in order to buy more goods than they might otherwise have afforded, so the quantity of debt increases."

    Why would that be the reason. You're missing the elephant in the room that debt is now cheaper, and debt servicing lost burdensome, which means less deleveraging and more leveraging.

    You also have a step after b) but concurrent with c), as non bank investors might adjust their risk profile from safer assets towards riskier assets, so too might banks adjust their balance sheets from government bonds/central bank balances towards business loans, mortgages and consumer loans/credit - by reducing their offered rate.

    1. Thanks for the soundcheck, good points.

      On E, a consumption good like a car or a plate provides a stream of consumption services over its lifetime. We can also think of a stock/ bond as yielding a flow of dividend or interest payments that purchase consumption services. In E, people have to make a choice on the margin between the most cost effective option to have in their portfolio.

      A cut to the central bank's interest rate sets up a disequilibrium ( muck like in C) whereby it is cheaper to acquire consumption services by directly buying consumer goods than investing in bonds and using interest to get those services. A rebalancing restores equilibrium.

      How do you see the monetary transmission process proceeding from the financial sector to the consumer goods sector?

  2. Assumes starting from equilibrium and the bank cuts for the hell of it, while more likely a yield inversion from a previous increase or fall in expectations or rise in uncertainty of risk sends money flooding into safe assets which the cut is trying to stem. G should be the bank raising rates anticipating inflation bringing the arbitrage to an end. Vitally necessary, no, but important, as the chief consumer investment good is housing, debt service lessening through adjustment/refinance, appreciation leading to more debt, and most appreciation is not counted toward inflation, slowing the inflationary response. The largest effect occurs through long rates even if short are changing.

    1. Thanks for the soundcheck. Yes, I sort of started in a vacuum without saying why the bank cut.

    2. There is also a deeper issue, that of the complexity of expectations. Does a cut increase expectations of a rise or of further cuts. Someone with full faith in the bank should believe and act in this way. Someone with less faith may believe the direction is right but the magnitude too small and anticipate further cuts leading them to defer. Someone with little faith may read this not as a response to the economy but commentary on it leading them to do the opposite. That degree of faith and those expectations can shift over time as well as with data and explanation, or be resistant in the face of them.

  3. Am I wrong in thinking that interest rates are not a choice variable for a central bank? The simpler story would be: CB targets a lower interest rate by making open market purchases. So higher prices and lower interest rates are both consequences of the addition of high-powered money to the financial system.

    Your story sounds more like the consequences of lowering the interest paid on reserves. But seeing as the Fed's only been doing that for less than a decade now, I'm not sure that's part of the standard complement of monetary policy levers. At least yet. Does the Bank of Japan target interest rates differently than the Fed?

    1. Thanks for the soundcheck. I agree that I could have started the story with a change in the quantity of money rather than an interest rate cut. In the Bank of Japan's case, it has created so many reserves via QE that the key lever under its control is the interest rate that it sets on central bank balances.

  4. That's not the standard story. The key thing is that there is much more business or investment debt than consumer debt. Especially if you count buying a house as an investment. The point of most debt is not to raise consumption but to raise investment, to allow purchase of equipment or infrastructure in order to get a return, to allow capital creation and allow growth of businesses.

    The profitability of investment projects is evaluated relative to alternative investments and interest rates. Lower real interest rates means more projects are worth doing compared to holding cash or safe bonds. More projects, means more demand for employees, more demand for equipment and more people being paid, labour scarcity also eventually raises wages and people being paid more are willing to pay more for things, therefore inflation.

    I suppose if real rates go negative enough holding long lasting durable consumer goods can become a relatively competitive investment (if storage is cheap enough) so there can be that direct consumer goods channel too.

    1. Thanks for the soundcheck.

      You agree that long lasting durable consumer goods can become a relatively competitive investment if real rates go negative enough. In equilibrium, shouldn't consumer goods ALWAYS be competitive? Shouldn't the direct consumer goods channel be perpetually open? Otherwise people are leaving dollars on the table.

      Good points in the first and second paragraph. I think you are assuming that the prices of equipment and infrastructure are sticky? If they adjust rapidly (like stocks/bonds) after a CB rate cut, then the profitability window for taking on loans to embark on projects quickly closes. That prevents the demand for employees from emerging and impedes the carry-through from the rate cut to final prices.

    2. Yes! If I interpret what you say properly, I think we agree. I think the price of equipment and infrastructure is sticky because the wages of those producing them are sticky.

      If central banks were doing their jobs properly, the savings vehicle of last resort should be stockpiling of consumer goods or raw materials. It should not be accumulation of excess reserves or excessive government debt which are just forms of coupons that don't actually carry value into the future on the aggregate. They are fictitious forms of savings unless they are invested properly.

      Now storage costs can be high, sometimes tens of percent of the value being stored per year. So in order for money to get out of the way of this type of investment, real rates might have to be very low. But between real rates stuck at -2% and the -10% or so rates that would make stockpiling worth doing, there are probably tons of good investment opportunities. Real rates will probably never need to go so low as to trigger widespread stockpiling unless we can predict an impeding global catastrophic economic decline.

      Still though, there might be some stockpiling that can be done somewhat efficiently. I always wondered if, a solution to recessions would be to get people that have spare space in their basements or closets to buy a couple years worth of household supplies.

      This might happen naturally if inflation goes high enough and people can see that they will have to pay more if they wait. Even at 2% inflation, buying things in advance might have a relatively good return for stockpilers especially if they buy in discounted bulk.

      I don't know how much it would help the economy since most stuff that can easily and cheaply be warehoused, can easily be shipped and is usually not made locally. But hey, we live in a global economy, maybe if it could be done on a global scale.

      The point of all of this is that to boost aggregate spending in an economy you don't have to reduce saving since some forms of spending are also forms of saving. That include all capital investments, inventory and stockpiles.

      It is the (I) in (Y) = (C) + (I)

  5. To my mind your steps are spot on and insightful.

    The only thing I would add is that if you are talking about the central bank reducing its overnight rate rather than interest on reserves, it helps things along by actually intervening in the market for safe assets by buying them for new money. I think that speeds up your step B.

    1. Thanks for the soundcheck! Good to hear someone doesn't think I've gone to far astray.

  6. OK, from a completely different perspective:
    A. Starting from equilibrium, the central bank cuts its lending rate.
    B. This reduces the central bank's assets while expanding its liabilities.
    C. The central bank's money now has less backing, which can (immediately) reduce the value of money, unless
    D. the central bank's assets were previously so large that, even with fewer assets, the central bank still has enough assets to back its money at par.

    1. What I'm really interested in is C; how do we get from an inferior return on money to higher prices? Do we need to go through banks?

  7. Sounds fine (for the interest rate version).

    Except you missed out the positive feedback loop from expectations of F and G. And in an open economy, we need the exchange rate channel as well.

  8. I think your description lacks the balance sheet effect, which is in my opinion the strongest force of a central bank interest rate reduction.

    The main idea is that the reduction of short term interest rates immediately improves the balance sheets of businesses which rely heavily on taking on short term loans, especially banks and merchants (who typically finance their inventories using short term loans).
    This balance sheet improvement leads to more investement projects of these businesses through lower costs of asymmetric informations (businesses with better balance sheets can have more "skin in the game" and can therefore get better financing conditions, i.e. long term debt or equity).

    The abitrage effect you are describing is in my opinion just a way to spread (or amplify) this balance sheet effect to even more households, for instance by improving the balance sheets of private households through higher housing prices.

    The abitrage effect alone can (in my opinion) not explain why even small interest rate reductions (in non zero-lower-point scenarios) can have huge inflation effects. The same is true for the very simplified "lower interest rates mean lower borrowing costs and therefore more borrowing" explanations.

    Also, I recommend reading this paper by Bernanke:

    1. Thanks anon, great points. Will give the link a read.

  9. Your steps A)and B) only describe the response of the commercial bank money market operation (which includes the reserve position and all short term wholesale assets and liabilities) to a change in the policy rate.

    You’ve qualified it partially later with reference to loans.

    But you’ve overlooked a very important response from the full commercial bank balance sheet.

    Which is the comprehensive transmission of the policy rate change to ADMINISTERED rates (retail and wholesale) throughout the commercial bank balance sheet – asset and liability sides. Too many moving parts to get into detail here. But this is very important. Retail flows and their potential interest rate sensitivity are huge.

    The distinction between market rates and administered rates is fundamental to banking and not to be overlooked.

    (And when you think about it, the central bank policy rate itself is an administered rate. It’s just that market intervention techniques are required at times to administer that rate – e.g. pre-QE Fed OMO.)

    1. In other words, the rhythm guitar player is MIA.

    2. Thanks for the soundcheck. Any thoughts on Gavyn Davies' article, where he says that:

      "This means that the full effects of lower interest rates will not be felt by the whole economy, because the rates paid on household and corporate bank deposits will remain positive. As a result, the expansionary effects of the monetary stimulus will be limited, compared to a “plain vanilla” cut in all policy rates."

      The tiered approach seems to nullify many of the flows & sensitivities that you mention.

    3. I was thinking of the positive rate situation. If that's referring to the Bank of Japan with tiered negative rates, that seems right.

  10. OK, you won't get a soundcheck from me. Trust me, you don't want one from me! (I'm sure it would be less than useless). I just want to know if you think this new negative IOR policy will work for Japan. A year from now will Japan be easily hitting their target inflation rates (or whatever targets they go for)?

    I know of a simple model that essentially says "No, it won't matter." Here's that model's predictions (with 2 sigma bands on either side) compared to the BoJ's projections. Here's the BoJ's projections on their own, and their source (in which the symbols are explained).

    1. Hi Tom, I don't know if the Bank of Japan will be easily hitting their inflation targets, but I do think that they will be closer to hitting them after having implemented negative rates than if they hadn't implemented them at all.

    2. Thanks JP. Let me ask you this: do you think NGDP growth rates and inflation rates are linked? Does there tend to be a functional relation between them? Also, do you think Okun's law tends to hold?

      If this new tool is still not adequate for Japan to hit its targets, what would you suspect would be the primary impediment?

    3. The primary impediment would be that it can only get down to -1% or so, when something like -2% might be necessary.

  11. Great post, it filled in key gaps in my understanding.

    Have you thought of releasing an e-book? You could write something similar to Tim Harford's The Undercover Economist Strikes Back) mixing money parables and quirky financial anecdotes.

  12. Japan has wage led demand regime with limited exposure to external demand.

    Effects of negative rates:

    1. Export Channel: Lower yen will have modest effects on demand, but they may hope to get something now the fed is off balance having just gone up, and before China devalues.

    2. Investment channel: As bond yield curves flatten completely corporates may fancy some more leverage. But will they invest with it? Also 3 works against this.

    3. Retail: negative rates are a cost to banks. This will most likely be passed on on the price of loans rather than negative rates on deposits. Reduces demand.

    4. Expectations: the new Keynesian Taylor rule game died in 2008. Negative rates simply signal further weakness to come. Reduces investment and demand.

    5. Fiscal. This is the real target, the politicians. Negative rates increase remittance to the fiscal arm. Will gov't spend the money? How big a deal is austerity in their political economy ?

    Conclusion. Transmission mechanism remains bust. Negative rates counter productive. Over to the politicians.

  13. Well, the Austrians emphasise the effect of money supply changes on the price of producer goods due to banks lending money to businesses. I see that Benoit brought this up. I'll build on that.

    If businesses see that consumer goods prices rise, won't that trigger an overproportionate demand and an overproportionate price increase of producer goods by businesses?

    If money is lent into the market instead of being produced, the amount of money available is disconnected from the amount of scarce resources available. The supply of input goods available for the producers (capital goods) is scarce, so they have to bid against each other. But in a debt-based monetary system they can, in theory, borrow as much money as they estimate the business plan profitability will be able to handle, based on to the interest rate they have to pay. So if they see consumer product prices rising and they think they can expand their businesses, the producer goods prices should rise overproportionately.

    If they are not rising, it can mean that some other factors are in play, for example commercial banks don't actually want to lend the money, or the businesses are no optimistic about being able to expand.