Wednesday, October 9, 2013
Toying with the monetary transmission mechanism
Does it matter what the Fed buys? ...from whom? ...or how? I don't think so.
The Fed currently buys and sells government-issued and guaranteed securities from designated primary dealers. It does so publicly and transparently. In the case of QE, it announces ahead of time the quantities it will purchase. Prior to 2008, it announced that it would conduct enough purchases to drive the fed funds rate up or down by x%.*
But let's modify the monetary policy transmission mechanism a bit. Say that a few years from now the Fed decides to buy and sell bitcoin, bitcoin claims, and other cryptocoins instead of government securities. Rather than executing these trades through a select posse of firms, it'll transact broadly with Joe Public. And rather than announcing purchasing intentions, it will carry them out surreptitiously. Big as these changes may seem, altering the route won't impede the transmission of monetary policy. Whether it quietly buys bitcoin from the public or pre-announces government bond purchases with primary dealers, the Fed will still continue to keep a firm grip on the economy's price level.
There are a few ways for a hypothetical bitcoin transmission mechanism to work. Here's one way. Say the Fed wants to loosen policy and push prices up by, oh, 5%. Fed officials fan out across the US, looking for local bitcoin over-the-counter exchanges. Bitcoin OTC markets exist on street corners, in coffee shops, houses, cafés, public libraries, city parks, and bars. These informal OTC exchanges are where Joe Public congregates to truck and barter bitcoin. Once located, the Fed officials begins to write out cheques to OTC traders in exchange for bitcoin at the going market price. The Fed now has bitcoin on the asset side of its balance sheet. OTC traders have Fed cheques which they proceed to deposit at their local bank.**
So far the Fed's purchases haven't had an effect on the price level — neither the price of bitcoin nor the price of goods have budged. Note that even if Fed officials accidentally nudge bitcoin OTC prices up a bit through their buying, arbitrageurs will quickly counterbalance this by routing sales away from centralized bitcoin exchanges like Mt-Gox (assuming it still exists in a few years) to OTC markets, driving OTC prices back to their fundamental value.
The OTC traders' Fed cheques having been deposited in the banking system, banks proceed to load them into Brinks trucks for delivery to the local district Fed for clearing and settlement. During the clearing process, a large settlement imbalance in favor of private banks emerges, an imbalance that has arisen thanks to the Fed's cheque-writing campaign. The Fed settles its debts by crediting the reserve accounts of creditor banks with newly created deposits.
Only now is our bitcoin transmission mechanism poised to push prices higher. Banks collectively find themselves with an excess stock of reserves. But there is no place for this excess to go. Within the next few hours, banks will madly compete to get rid of their reserves. They'll do so by buying up financial assets like bonds, stocks, MBS, and bitcoin from other banks.*** As a result of their combined efforts, the prices of all these assets will quickly rise. Put differently, the purchasing power of reserves will fall. This decline will only stop when the purchasing power of reserves has fallen to a low enough level that they are once again willingly held by bankers. While this will happen very fast with financial asset prices, stickier prices like goods and labour will take longer to adjust upwards.
In a nutshell, that's how the Fed's bitcoin purchasing policy succeeds in increasing the price level. And if the Fed falls short of hitting its 5% growth target, it need only send out more officials to write more checks for more bitcoin until it hits its mark.
Let's make a few changes to our transmission mechanism. To streamline the process, the Fed decides to funnel purchases to a select number of bitcoin dealers rather than spraying them broadly. Should the Fed require it of them, these chosen dealers are required to quote the quantity of bitcoin they are willing to sell and at what price.
Does the decision to funnel purchases rather than spray them change anything? Not at all. Fed cheques are still deposited by bitcoin sellers at their banks and these checks are settled with reserves. Whether funneling or spraying, banks still end up with an excess reserve position which they will try to rectify by simultaneously buying up assets. The only resolution to this will be a quick rise in prices. A primary bitcoin dealer system, it would seem, is no different a transmission mechanism than our earlier broad Joe Public approach.
The Fed may even require that bitcoin dealers hold inventories of government bonds and submit bond quotes from time to time in addition to bitcoin quotes. Even if the Fed decides to purchase bonds rather than bitcoin, nothing about the transmission mechanism changes—Fed cheques still result in excess reserve positions at banks, and these can only be equalized by a rise in prices. But now we're back at our current system in which primary dealers sell bonds to the Fed.
The Fed may even start to publicly announce its intentions to make bitcoin purchases rather than surreptitiously writing checks. Anticipating that they will soon be inundated with excess reserves upon hearing the announcement, banks won't wait for the reserves to arrive before trying to offload them. Rather, they'll sell immediately. This will quickly push asset prices higher. Smart speculators and investors, anticipating that forward-looking bankers will quickly spend their reserves after the Fed announces its intention to buy bitcoin, will try to beat the bankers to the punch by purchasing assets the moment an announcement is made.
So when the Fed's purchasing intentions are announced, market prices adjust even before the Fed carries out the actual purchases. Without an announcement, however, the cheques must physically enter the economy and cause a reserve imbalance before prices begin to adjust, a process that will only start a day or two after and will proceed in a jagged manner.
The upshot of all this is that it doesn't matter what the Fed buys, nor from whom. Monetary policy works irrespective of the route. As for the "how", the Fed's decision to publicize their intention to make bitcoin purchases rather than quietly writing out cheques has the effect of dramatically speeding up what would otherwise be a circuitous transmission process.
* For simplicity, I'll be assuming a world in which the Fed doesn't pay interest on reserves.
** Even if OTC traders don't accept cheques, they'll accept bank notes, and the same analysis applies.
*** In addition to purchasing financial assets, banks will try to lend them away to other banks in the interbank market, receiving the overnight interest rate in return. This will cause the interbank lending rate to fall.