Sunday, January 15, 2017

If the Fed was so aggressive, why didn't we have inflation?


 In a recent podcast with Robert Hall, Russ Roberts asks:
"If the Fed was so aggressive, why didn't we have inflation? And does that mean that Milton Friedman and others were wrong?"
It's a good question. Because I find monetary policy confusing, I want to try answering Russ's question with an analogy to an example that doesn't involve money.

Say there are two types of gold rings, those with diamonds and those without. The price of gold rings with diamonds exceeds the price of rings without diamonds by a wedge that equals the price of the diamond.

A technology emerges that can create diamonds at zero cost. The supply of diamonds will rapidly grow until they become like water; while boasting desirable qualities, a diamond will sell for $0. When this happens the price of gold rings with diamonds will equal the price of gold rings without.

Using this analogy, we can understand why—despite having been so aggressive—the Fed didn't create inflation. Treasury debt and Fed debt are alike in that they are both government liabilities. However, Fed debt comes with an extra cherry on top; it can be spent anywhere. Government debt... not so liquid. This mobility is a valuable commodity and people will (typically) pay a premium to own it. So we might say that Treasury debt is very much like our plain gold band, and Fed debt is like a gold band with a diamond attached to it.

When the Fed expands aggressively, it does so through open market operations, or by spending its own Fed debt to acquire Treasury debt. What effect do these operations have?

Let's look at how open market operations would work in the ring market. A ring producer that has developed a technology to create diamonds at zero cost begins to "spend" new gold bands (with diamonds) into the economy by purchasing gold bands (without diamonds). The number of gold bands in the economy will stay constant (x gold is being swapped for x gold). But the quantity of diamonds in the economy increases. On the margin, diamonds are becoming less valuable, and so the price of gold bands with diamonds falls. We get inflation in the price of gold bands with diamonds.

However, this inflation will eventually come to a stop. Once the price of diamonds has fallen to its lower bound of zero, the price of rings with diamonds will equal the price of a rings without. Subsequent spending by our ring producer of new gold bands with diamonds into the economy will have no effect—all that is happening is a swap of a gold band for a gold band, and a swap of like-for- like has no macroeconomic effect.

And that's why the Fed's aggressiveness (QEI-III) has had little effect on prices. Once the Fed has conducted enough open market operations, the useful commodity attached to Fed debt that we call mobility—much like the diamond in our previous example—becomes so prevalent that on the margin it is worth zero. At this point, Fed debt loses its uniqueness and is exactly the same as Treasury debt. All subsequent purchases are irrelevant because the Fed is simply switching like-for-like. Thus the Fed, like our ring producer, has lost the ability to create inflation via open market operations.

26 comments:

  1. The classical response to this argument is that it implies a free lunch. The Fed can simply monetize outstanding debt and prices will act as if the transactions were simply like-for-like.

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    1. Hi A.

      "The Fed can simply monetize outstanding debt and prices will act as if the transactions were simply like-for-like."

      But that's exactly what the Fed did--monetize debt--and prices did nothing.

      I'm not entirely sure what you imply by free lunch. As the Fed monetized debt via the various QEs, the Treasury no longer had to pay as much interest to the public. But at the same time the Fed had to pay much more. Since both are government agencies, it's a wash, or close to it.

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  2. "I find monetary policy confusing". No, no. You aren't confused. It's the advocates of conventional monetary policy who are confused - or perhaps I should say "who should be confined to the mad-house"...:-)

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    1. Hi Ralph,

      By conventional monetary policy, to you mean those who advocated for QE? I only ask because my piece is quite conventional, someone like Michael Woodford--the man behind mainstream macro--would agree with it.

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  3. If the Fed was so aggressive, why didn't we have inflation?

    This question cannot be answered by leaving out the commercial banking sector, i.e. by solely focusing on the Fed.
    As is well known money supply can grow either by an expanding fed balance sheet (that's what happened), or by an expanding commercial bank sector bs (much less clear whether there was growth), or both. Over the last 30+ years it has mainly been commercial banks expanding, that has caused prices to rise.
    As a consequence, the commercial banks are much more important than the fed, i.e. their balance sheet is much larger
    Conclusion:
    If the Fed expands, but the commercial banking sector shrinks or merely stays the same, the effect on money supply are muted at best and you do not get much consumer price (as opposed to asset price) growth
    It is the interaction between monetary polic and commercial bank behavior which needs to be understood (Eurodollar, risk models etc.) to anwer the question. The Fed balance sheet is just one part of a commplicated puzzle...

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    1. Hi Viennacapitalist,

      "As is well known money supply can grow either by an expanding fed balance sheet (that's what happened), or by an expanding commercial bank sector bs (much less clear whether there was growth), or both"

      Yes.

      "As a consequence, the commercial banks are much more important than the fed, i.e. their balance sheet is much larger. Conclusion: If the Fed expands, but the commercial banking sector shrinks or merely stays the same, the effect on money supply are muted at best and you do not get much consumer price (as opposed to asset price) growth."

      No, that doesn't follow. The best read on this is Nick Rowe and his distinction between alpha and beta banks.

      http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/03/alpha-banks-beta-banks-fixed-exchange-rates-market-shares-and-the-money-multiplier.html
      http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/12/alpha-beta-and-gold.html
      ... and elsewhere.

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    2. Thank you for the links. The alpha/beta distinction is useful.
      I did not intend to say that the commercial banks are always more important by virtue of their large balance sheets, just in this particular instance.
      The Fed is obvioulsy a very important player, i.e. the alpha bank.
      I just meant in order to explain the overall effect (inflation yes or no) understanding the behavior of the commercial banks is more important. For, had commercial banks expanded as the Fed wanted them to, the CPI path would have been up. But they did not, i.e. they were willing to loose market share, to put it in Nick Rowe's terms.

      And it is exactly this dynamic of commercial banks contracting and willingly yielding market share (compared to the Fed) that needs to be understood, in order to explain the CPI movement.
      This is what I mean when I say commercial bank behavior is more important to the story. By this I do not mean to say that they are the alpha, just that collectively the betas have a larger effect upon the outcome...

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    3. "I just meant in order to explain the overall effect (inflation yes or no) understanding the behavior of the commercial banks is more important. "

      I think you missed the point of Nick's post. As the alpha bank, a central bank can always counterbalance/offset whatever the beta commercial banks are doing. If the central bank isn't hitting its target, that's because it has *chosen* to miss--and not because beta banks are preventing it. Zimbabwe's commercial banking sector was incredibly sick... yet the central bank was able to create hyperinflation.

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    4. "If the central bank isn't hitting its target, that's because it has *chosen* to miss--and not because beta banks are preventing it"
      There is a misunderstanding. I did not say that the Beta banks are (literally) preventing the Fed, just that the Beta bank dynamic has dominated the actions of the alpha Fed in this cycle (for various reasons). With dominated I do not mean formal domination (like in alpha vs. beta), but with respect to the influence on the ultimate outcome (CPI inflation). This is not the same.
      I think I understand Rowe’s point quite well, it’s just that I disagree with the term "voluntary", as it implies there are no endogenous dynamics affecting the alpha’s decision making, i.e. the alpha can choose its target irrespective of circumstances.
      In my view, the Fed did not voluntarily "choose to miss", after all they did not reach their target (which, btw., they have never changed along the way something that needs to be done, if you voluntarily refuse from pursuing an action presumably leading to your stated goal).
      To reach their target would have involved fully counterbalancing the actions of the commercial banks. (These banks, just to make it clear, did not deliberately sabotage the fed, but had their own microeconomic reasons from behaving the way they did.)
      So why did the Fed not do it?
      The Fed is/was prevented by the facts on the ground (institutional, political, economic and most important limited knowledge). The fed was not hindered by the likes of JP Morgan and Goldman Sachs (Betas), but by the very real prospect of nasty unintended consequences popping up along the way, and by its (very) limited understanding of the situation (just like when Bernanke said that subprime was contained).
      For instance – and it would be interesting to hear your view on this – it is questionable IMHO whether the Fed even has the power in theory (let alone practice) to go "full Zimbabwe" given the high degree of division of labour in the US economy (not the case in Zimbabwe, which mostly consists of subsistence farmers, I suppose).
      For this reason, Zimbabwe, like Argentina (no subsistence farming, but very low financialization and the US dollar as de-facto currency) can stand 20 Percent inflation and for some time - I doubt the US economy could for long (supply chains, taxes, degree of financialization etc.). The degree of specialization nowadays and the debt levels are way higher than it was even in the 70ies, the last time US had double digit inflation. Before long, a lot of people would see their lives disrupted dramatically, leading to real social unrest. I believe there is a chance the US economy would fall apart even before we reach the 20 percent in such a case (I am not saying they will not try it though).
      The fed is not omnipotent and it cannot do whatever it wants. Much like an alpha Gorilla, albeit powerful, cannot learn to speak English, but has to rely on crude signals when leading its group.

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    5. "For instance – and it would be interesting to hear your view on this – it is questionable IMHO whether the Fed even has the power in theory (let alone practice) to go "full Zimbabwe" given"

      To create significant inflation, the Fed would have to drop rates deep into negative territory. The existence of cash removes this option. In theory, there are ways to get around the cash restraint, but in practice there are all sorts of legal and cultural reasons that might prevent a work-around.

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  4. Nice analogy - diamond easing, so to speak.

    But here's a bit of irony for you:

    There's an old bond trader's battle cry relevant to the returns from a multi-decade bull market. Perhaps you're familiar with it:

    "Buy bonds. Wear diamonds."

    :)

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    1. Hi JKH.

      That's funny, I was taught a similar phrase: "Buy gold. Wear diamond." But I started out at a firm full of gold bugs who didn't like bonds.

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  5. Money demand is a function of seigniorage - interest on bonds minus interest on money. The fact that seigniorage went to zero (or negative) explains how the Fed could expand the money supply without creating inflationary pressure.

    (The next question is why seigniorage went to zero. At least in part, this was an intentional plan. The Fed started paying interest on reserves which enabled it to cut seigniorage).

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    1. Hi Max, I don't follow. Do you mean to say that seigniorage causes inflation?

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    2. No. Seigniorage causes central bank profits.

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    3. You're being a bit too cryptic for me. How is money demand a function of seigniorage?

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  6. Actually, JP, bank reserves are assets.

    Banks had leveraged heavily through several cycles - lending heavily in all segments of the economy, while funding short in similarly leveraged and hypothecated markets.

    Deflationary debt /leverage was everywhere. When the shock hit, assets dropped and liabilities soared. Fed QE plugged negative shareholder equity with bank reserves.

    The fed recapitalized the banking system. That's all. The debt deflation was offset by a senior equity like capital injection.

    So we muddle along with massive central bank balance sheet, deleveraging banks, and a leveraging treasury. Net debt GDP unchanged since 2008.

    This would have been very different with a currency QE injection into nominal GDP - would have seen debt inflated away.

    As it is, how can we stop these massive reserves from being called into the nominal economy? Go cashless. No currency deliverable, just like no gold deliverable. Keep the reserves locked up on balance sheets offset by bank leverage.

    Reserves, QE, are only about banks. Currency is about the nominal economy.

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    1. "The fed recapitalized the banking system. That's all."

      No it didn't. All it did was swap one item on the asset side of a commercial bank's balance sheet with another thing.

      A recapitalization would have involved the liability side of the commercial banking balance sheet, ie banks issuing new equity to the Fed, and that didn't happen.

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    2. ...which should have happened in any normal world, but this is fed-world. In fed-world, banks can leverage up even when they are shareholder equity negative, ie bankrupt or terminally illiquid, borrow assets, deliver assets to fed and receive permanent assets on collective balance sheets. Or are you arguing that the fed intervention with its balance sheet in 2008-2009 did not strengthen the banking system?

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  7. You are confusing QE with OMO . The proposed mechanics of QE come into affect AFTER the phoenomenum of satuurating the market with a commodity , primary base, has ALLREADY taken place, via OMO. It is not the purpose of QE to increase the level of commerce by increasing primary Base.

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    1. How does QE increase the level of commerce?

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    2. Well its supposed to work by removing safe assets from the market to reduce the funding rates for less safe borrowers, also to encourage spending and investing by investors by increasing the market price of the assets that they hold, also, by buying assets from investors to encourage them to re-invest the cash in new assets to regain interest holding assets.

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    3. Also by removing private assets from commercial banks and replacing them with CB reserves its propsed to inrease the risk weighted capital calculation of commerecial banks, and thus allow them to take on more risks and lend more. Hence the name "Quantative" easing. ie to reduce the retail interst rate by quantity of money rather than the interbank interst rate.

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    4. Fair enough. But does that change the validity of the diamond ring parable as response to Russ's question? I don't think so.

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  8. The Fisher Effect (being repackaged by John Cochrane) is my explanation.

    The currency component of M1 has constantly expanded since the 1950s with the growing size of the economy. However, when interest rates were cut to 0 a new greater slope occurs. I maybe siting correlation and not causation and the confidence fairy but when the FED cuts rates to 0 it freaks people out about the end of the world and they hoard cash. Hoarding cash is cash that leaves the system causing a contraction in money supply. The FED may have increased cash at banks through QE (which is a swap program not monetization) and reserves but when consumers are hoarding they have no loan demand.

    The FED shot itself in the foot by freaking everyone out. I believe if they had showed some confidence and raised interest rates slowly but earlier animal spirits would have returned.

    This is why I think releasing FED minutes and forward guidance and transparency has backfired.

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    1. Yep, so-called neo-fisherism is one explanation for why the Fed can't create inflation.

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