...once the supply of reserves is sufficient to drive the short-term riskless rate to zero..., there is no reason to expect further increases in the supply of reserves to increase aggregate demand any further... Once banks are no longer foregoing any otherwise available pecuniary return in order to hold reserves, there is no reason to believe that reserves continue to supply any liquidity services at the margin; and if they do not, the Modigliani-Miller reasoning applies once again to open market operations that increase the supply of reserves, just as in the model of Wallace.
-Michael Woodford, 2012.
On a whim, I wrote an email to Michael Woodford last week. Woodford, a macroeconomist at Colombia University, is the authour of Interest and Prices (pdf), an important contribution to modern monetary policy. I'll be the first to admit that I haven't been able to work my way through his book—too few words and too many equations. But I have read two excellent papers by him. The first is Monetary Policy Without Money, which I'll touch on in another post, and the second is a well-known paper that he presented at Jackson Hole in 2012 entitled Methods of Policy Accommodation at the Interest-Rate Lower Bound. If you're interested in monetary policy and you haven't read it yet, you really should.
My email, affixed below, had to do with the above quote from his second paper:
Dear Professor Woodford,Frequent readers will notice that my letter was just a summing up of my three recent posts on the convenience yield.* If you've already read those three posts and reached your quota, don't bother reading further, since much of what I'm going to write follows in that general theme.
I have read your paper Methods of Policy Accommodation at the Interest-Rate Lower Bound several times and it has taught me quite a bit.
In Section 3.1 (Effects of Targeted Asset Purchases in Theory), you point out that once the supply of reserves is sufficiently plentiful, banks no longer forgo a pecuniary return that would otherwise be provided by reserves (ie a marginal convenience yield). This is the point at which the overnight interest rate hits the lower bound, additional reserve additions are irrelevant, and the Modigliani-Miller result applies.
It seems to me that the overnight rate doesn't shadow the general convenience yield on reserves per se, but rather it shadows the 24-hour convenience yield on reserves. Just like there is a term structure to bonds, there is a term structure to the convenience yield on reserves. In addition to a 24-hour convenience yield, there is a 1 week, 1 month, 1 year yield, each point allowing us to construct a convenience yield curve.
Although the overnight yield may be zero, convenience yields further down the convenience yield curve may still positive. Banks hold reserves not only to enjoy their overnight convenience, but also to enjoy expected flows of future convenience. This would seem to imply that the present discounted value of future flows of convenience can be positive even when the overnight convenience yield is zero.
Which would indicate that even when we are at the lower bound for overnight rates, purchases are not necessarily subject to the Wallace irrelevance critique insofar as they specifically target positive yields further down the convenience yield curve. If purchases today can reduce convenience yields tomorrow, the present discounted value of future flows of convenience will be reduced. Overnight purchases won't suffice since they only target overnight convenience yields. Open-ended outright purchases might not work if there is no commitment to avoid unwinding these purchases in the future. Perhaps long term repo operations that target the distant end of the convenience yield will be most effective in avoiding the irrelevance criticism. Repos precommit a central bank to avoid unwinding at a future point in time, thereby reducing future convenience yields and, as a corollary, the present value of total convenience flows.
Does that make any sense? I am curious what your thoughts on this are.
Surprisingly, Woodford got back to me. I'm not going to publish his response, but in brief he doesn't think that there should be a convenience yield curve. Woodford told me that he thinks reserves are an overnight asset, not a long-term asset like, say, Treasury bills, and an overnight asset doesn't supply a convenience yield for longer than 24 hours.
I agree with Woodford that the convenience yield supplied by a short-lived asset is negligible. No one holds a stock of ripe avocados because they might serve as convenient medium of exchange 30 days from now.
But reserves aren't avocados. They are infinitely-lived instruments that can be perpetually held without the necessity of paying storage fees. This means that even when overnight yields have hit 0% (as indicated by an overnight fed funds rate of zero) reserves still supply current reserve-owners with a positively-valued marginal convenience yield over longer time frames than the 24-hour window. The implication of this is that although central banks may no longer be capable of manipulating the 24-hour convenience yield lower, they may be still be able to conduct targeted financial transactions, or balance-sheet policy, that change distant parts of the convenience yield curve. This gives a central bank plenty of traction at the zero lower bound. After all, a reduction in the future convenience flows thrown off by reserves will reduce the present value of all convenience flows. The expected return on reserves having been reduced, reserves will be spent away in the present and this will stimulate today's inflation and/or real activity.
QE—what Woodford refers to as balance sheet policy—is a fairly blunt tool when it comes to reducing distance convenience yields.** This is because a one-time expansion of the central bank's balance sheet can be easily reversed at a future point in time by sucking reserves back in. Financial markets may therefore view QE as fleeting. If so, distant convenience yields will not budge much and, as a result, inflation and real activity will remain unaffected.
Rather than engaging in crude QE when the overnight rate hits zero, a central bank might enter into a more focused form of balance sheet expansion. Five-year repos, for instance, may be sufficient to ensure that excess reserves stay in the system for an extended period of time. Even more effective would be a policy of entering into forward contracts with banks. These transactions would commit the central bank to purchasing assets at various points in the future, thereby ensuring a series of large balance sheets down the road.
For instance, if the Bank of Canada faced the ZLB and wanted to reduce the future convenience yield on reserves after, say, 2015, it could contract with commercial banks to purchase assets at various dates in 2016, 2017, and 2018. It would enter into as many of these forward contracts as necessary to guarantee today a sufficiently large supply of reserves tomorrow. Unlike crude QE, forward contracts are irreversible. The permanency of these transactions should be sufficient to reduce the future convenience yield on reserves, thereby diminishing their expected return in the present and stimulating current spending.
A policy of using forward contracts to reduce the distant convenience yield on reserves could be a substitute for Woodford's verbal forward guidance. Rather than specifying in words the future time path of interest rates, the central bank need only add a sufficient amount of forward contracts to its balance sheet in order to ensure that it hits its targets (an inflation target, a nominal GDP target, whatever). The upshot is that balance-sheet policy needn't die at the zero-lower bound. Concrete actions that guarantee to alter the size of a central bank's future balance sheets and convenience yields can be just as effective as Woodford's carefully crafted wording.
In any case, I'm not holding my breath for Woodford to get back to me on that, he's a busy guy.
*Interestingly, Woodford uses the term convenience yield in his paper, too.
** Miles Kimball has equated balance sheet policy at the ZLB to using a massive fan to move the economy.