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