Current Monetary Policy Crisis control and recovery (c) 2009-2017 Gary R. Evans. May be used only for non-profit educational use without permission of the author.
Qualifications to the story about how OMOs are used to increase credit/money and influence interest rates The previous discussions about how OMOs are used to increase reserves and thereby increase the amount of money and/or credit in the economy while also influencing interest rates is historically accurate and may at some future date be relevant again, but it is not a very relevant story after 2008. The mortgage meltdown financial crisis, which had its roots in the easymoney policies after the 2000 stock market crash, nearly destroyed the global economy in 2008 and the years that followed. The crisis provoked a policy reaction so extreme on its scale, scope, and duration that it will be very difficult to return to the old, managed anti-inflation iflti policies lii that tht dominated for decades. The new policies still use Open Market Operations! It is still really the The new policies still use Open Market Operations! It is still really the only tool in the toolbox. But the level of use is on a scale that would have been unimageinable in 2005.
Putting it in perspective: The S&P 500 stock index over the period in question 2,500 7/20/2015 2128.2828 2,000 3/24/2000 1524.4646 10/9/2007 1565.15 1,500 1,000 500 10/9/2002 776.76 3/9/2009 676.53 0
The original swarm of dedicated recovery programs since 2008...... with names like TARP1 (Troubled Asset Relief Program), TARP2, Maiden Lane LLC, TALF, TSLF, Term Auction facility, Operation Twist, and QE2 (Quantitative Easing), these dedicated programs have in summary done the following (blue represents largely l paid idback or discontinued): d) 1. Purchased more than $1 trillion in bad mortgages from the banks that issued them, giving them reserves. 2. Purchased around $450 billion in agency debt (like FNMA). 3. Purchased more than $600 billion in U.S. Treasury securities while promoting the sale of a much larger amount to banks and overseas trading partners. 4. Made loans to auto makers, AIG, and commercial paper and similar markets.
OMO Qualification: The FRS also bought mortgages g with Open Market Operations In September 2012, the FRS initiated a program called Quantitative Easing 3 (QE3), using OMOs to buy each month (1) $45 billion of U.S. Treasury securities and (2) $40 billion of residential mortgages. Memo: QE2 at its high point was buying $75 billion worth of U.S. Treasury Securities per month The mortgages had been owned by banks (mostly) and were held in the form of huge pools called Mortgage-backed Securities (MBS). Prior to QE3 the FRS has already taken some mortgages into their portfolio because of the failure of Lehman Brothers (these are listed as "Maiden Lane" assets in FRS statements). The FRS began to reduce the mortgage purchases in January 2014 and the program was discontinued in October 2014.
Qualified OMO: The starting gp point, with mortgages g added.. A Federal Reserve System L&E A All private banks ($billions) L&E $25 Govt Bills $10 Reserves $5 Mortgages $20 Equity $10 Reserves $100 Checkable deposits $60 Loans (ex mort) $10 Equity $20 Mortgages $20 Govt Bills (checkable deposits are money)
Qual 2: The result of two open market operations... A Federal Reserve System L&E A All private banks ($billions) L&E $25 Govt Bills $10 Reserves $28 $15 $5 Mortgages $20 Equity $7 $10 Reserves $100 Ch. Deposits $15 $60 Loans $10 Equity $20 Mortgages $18 $20 Govt Bills $17 the FRS bought $3 in Bills and $2 in Mortgages and paid g g g p for them with $5 in reserves. This created $5 in free reserves.
Consolidated Balance Sheet all Federal Reserve Banks April 5, 2017, millions of dollars Assets Liabilities U.S. Treasury Securities 2,464,454 1,493,478 Federal Reserve Notes Federal Agency Debt Securities 13,329 425,190 Reverse repurchase agreements Mortgage-backed Securities 1,769,122 2,508,349 Reserve deposits Gold and SDR certificates 16,237 82,953 U.S. Treasury General Account Premiums on securities held 154,248 5,177 Foreign official accounts Foreign currency assets 20,042-81,102 Other liabilities Other assets 37,202 4,434,045 Total Liabilities Total Assets 4,474,634 40,589 Capital Equity Source: Federal Reserve Statistical Release H.4.1 for date shown. Green: OMO lecture asset accounts Grey: OMO lecture reserves Some accounts here are consolidated or renamed to be consistent with labels used in the OMO lectures.
Adding mortgages to OMOs and monetizing the deficit (tbe) Change in Federal Reserve Holdings that Explain Increase in Reserves April 5, 2017 2006 Now Change U.S. Treasury Securitites 758,544 2,464,454 1,705,910 U.S. Agency Securities 0 13,329 13,329 Mortgages 0 1,769,122 1,769,122 TOTAL CHANGE 3,488,361 MEMO: Securities held for foreign official accounts: of which, Marketable US Treasury: 3,214,191 2,891,595 Source: Board of Governors of the Federal Reserve System, Factors Affecting Reserve Balances H.4.1, April 5, 2017, $ millions
Why QE3 (and European QE) worked... In the United States (not so much Europe), federal spending and a huge budget deficit increased the demand for funds, which would have increased rates (to r x ).. SF 1 r x r 1 SF 2 r 2 DF 2 0% DF 1... except that it was fully accomodated by an increase in the supply of funds due to historically huge open market operations, which had the net of pushing nominal interest rates to nearly zero.
Total Reserves of Depository Institutions (monthly, billions $, 1959 - August 2008) 70 60 Note the scale Explained in next slide. 50 40 30 20 10 Explained by a change in reserve requirements and a different method for calculating reserves. 0 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 Source: Board of Governors of the Federal Reserve Bank, H.3 Statistical Release
20 Excess Reserves of Depository Institutions 18 Note the scale 16 (monthly, billions $, 1959 - August 2008) 14 This was the celebrated 12 Greenspan act of salvation, saving the banking system 10 after the liquidity crisis provoked kdin part my the dotcom crash, but mostly the dt 8 6 panic trigger by 9/11. 4 2 0 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 Source: Board of Governors of the Federal Reserve Bank, H.3 Statistical Release
2,000 Total Reserves of Depository Institutions (monthly, billions $, 1959 March 2013) 1,800 1,600 1,400 Note the scale Note that we added 5 more years of data here. 1,200 FRS now pays an Hmmm... 1,000 outlandish 0.25% of these reserve deposits. 800 600 400 200 The old scale: 70 The celebrated Greenspan intervention 0 1959-01 1969-01 1979-01 1989-01 1999-01 2009-01 Source: Board of Governors of the Federal Reserve Bank, H.3 Statistical Release
1,800 Excess Reserves of Depository Institutions (monthly, billions $, 1959 March 2013) 1,600 1,400 1,200 QE1, QE2 and QE3 have "monetized the budget deficit. 1,000 800 600 400 200 The old scale: 20 The celebrated Greenspan salvation... saving us from catastrophe after the 2000 crash and 9/11. 0 1959-01 1969-01 1979-01 1989-01 1999-01 2009-01 Source: Board of Governors of the Federal Reserve Bank, H.3 Statistical Release
% Ratio of Excess Reserves to Total Reserves 120 (monthly Jan 2000 March 2013) All reserves are free reserves. 100 There is no effective cap on bank lending, and this cannot be used again in the near future (what are 80 they going to do, conduct $1.5 trillion in reverse OMOs). 60 40 20 0 2000 2003 2006 2009 2012
Excess Reserves (2015 calculation) In summer of 2013, the Fed database eliminated the statistical categories represented on the previous page (including reserves adjusted for changes in the reserve requirement) and replaced them with a mash of complicated arrays. This is your teacher s estimate of excess reserves in 2015. "Reserve balances maintained that exceed the top of the penalty-free band": $2.5747 Tr in March 2015.
Current FRS transitional goals: 1. Normalization 2. Reducing the inventory of FRS assets..
The FRS point of view... From the minutes of the March 14-15, 2017 FOMC meeting: In their discussion, policymakers reaffirmed the approach to balance sheet normalization articulated in the Committee s Policy Normalization Principles and Plans announced in September 2014. In particular, participants agreed that reductions in the Federal Reserve s securities holdings should be gradual and predictable, and accomplished primarily il by phasing out reinvestments t of principal i received from those holdings. Most participants expressed the view that changes in the target range for the federal funds rate should be the primary means for adjusting the stance of monetary policy when the federal funds rate was above its effective lower bound.
Plank 1: Normalization From the FOMC press release Sept. 17, 2014 The Committee also has agreed that it is appropriate at this time to provide additional information regarding its normalization plans. All FOMC participants but one agreed on the following key elements of the approach they intend to implement when it becomes appropriate to begin normalizing the stance of monetary policy: The Committee will determine the timing and pace of policy normalization--meaning steps to raise the federal funds rate and other short-term interest rates to more normal levels and to reduce the Federal Reserve's securities holdings--so as to promote its statutory mandate of maximum employment and price stability. When economic conditions and the economic outlook warrant a less accommodative monetary policy, the Committee will raise its target range for the federal funds rate. During normalization, the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the interest rate it pays on excess reserve balances. During normalization, the Federal Reserve intends to use an overnight reverse repurchase agreement facility and other supplementary tools as needed to help control the federal funds rate. The Committee will use an overnight reverse repurchase agreement facility only to the extent necessary and will phase it out when it is no longer needed to help control the federal funds rate. http://www.federalreserve.gov/newsevents/press/monetary/20140917c.htm
"Normalization" wants to raise these rates... Federal Funds Target Rates January 2000 -March 2017 Upper limit of 0.25 range 7.00 6.00 5.00 4.00 3.00 2.00 1.00 Currently at 0.75% - 1.00% 0.00
What if a stimulation is needed and rates are zero? In this scenario, the FRS wants to increase the scale or pace of open market operations, but the federal funds rate and are other short-term interest rates are already near zero!! SF... and this is why they want to raise rates! 0.25% 0% DF Is this a policy trap?? Do you go to negative rates? In 2016 this scenario is being undertaken in Japan and Europe and feared in Washington. This is why in 2016 the FRS wants to raise rates to closer to "normal" levels!
The great experiment. Will we be able to go back to normalization in 2017...?? Whichever perspective you want (from the previous lecture)... "Normalization" was promised in November 2014, yet the FFR was raised only twice before 2017! Now four are promised for 2017.
Remember?: The Effect of a Rise in United States Interest Rates $ price of /$ Exchange Rate S 1 The Supply of the rises (more demand for $) S 2 $1.45 Result: Weaker (and ) $1.25 D 2 D 1 Demand for the falls (U.S. investors keep their money here) Volume This is a forecast: The relative rise in U.S. interest rates causes a surge in demand for the dollar from both the pound and the euro, which has the potential to actually accelerate the already substantial devaluation of those two currencies. Can the FRS raise rates in the face of this? 2
Plank 2: Asset reduction (deleting excess reserves) Method: Difficulty: Timeframe: 1 Do not roll over maturing assets easy eternity 2 Accelerate reverse repos difficult long 3 Hard reverse OMOs impossible never Source: The Wall Street Journal, April 6, 2017.
One "solution" that will continue to be used...... monetizing Red Ink, which is to say, monetizing the U.S. Treasury budget deficit. Note: This overlaps into the next module about fiscal policy. Suffice to say for the moment that the estimated size of the current (2017) budget deficit of the U.S. government stands at approximately $560 billion.
The fiscal effects of budget deficits Our models tell us that budget deficits should stimulate the economy in the short run The potential for such stimulation to be inflationary depends upon the starting point (context). There can be substantial damaging long-run effects of enduring budget deficits.
The economic effect of deficits Loanable Funds model tells us that deficits can crowd out private borrowing This can be offset by "easy" FRS OMO policy Can also be offset by surge in supply of funds to markets during times of crisis or from foreign investors Therefore, deficits can be said to have a tendency to cause interest rates to rise r Due to rising budget deficits DF 2 DF 1
but OMOs can intervene to keep rates low... r SF 1 because of OMO e 1 e 2 SF 2 DF 2 This amounts to because of deficits monetizing the dfiit deficit DF 1 volume of credit
Monetizing the budget deficit... (how to pay unemployment benefits when you don t have the cash to do it) 1. Fund your budget deficit by selling U.S. Treasury bills, notes, and bonds. 2. If the private markets will not buy them, be willing to compete with ever-rising interest rates or 3. Have the Federal Reserve System conduct aggressive open market operations, sometimes indirectly, by having banks buy them first and then buying from banks. 4. The Federal Reserve System pays for the U.S. Treasury securities by making deposits in a dedicated tax and loan account on the Treasury s behalf bhlfat a private bank. 5. The Treasury is now free to spend that money on unemployment compensation or whatever else. This is the modern equivalent of printing money.
Memo: How the FRS buys U.S. Treasury Securities through FRS Primary Dealers U.S. Treasury Dutch Auction The FRS doesn't participate in Treasury Dutch Auctions. Instead they have primary dealers (see below) bid then acquire the securities later in an OMO. This is essentially how the deficit gets "monetized" if it is done on a large scale. In 2009, the FRS loaned money to the primary dealers below to do this. Primary Dealers Competitive Bids at Auction FRS buys Treasuries from Pi Primary Dealers in OMO
Assets Consolidated Balance Sheet all Federal Reserve Banks April 5, 2017, millions of dollars Liabilities This is the U.S. Treasury's checking account (also called a tax and loan account). U.S. Treasury Securities 2,464,454 1,493,478 Federal Reserve Notes Federal Agency Debt Securities 13,329 425,190 Reverse repurchase agreements Mortgage-backed Securities 1,769,122 2,508,349 Reserve deposits Gold and SDR certificates 16,237 82,953 U.S. Treasury General Account Premiums on securities held 154,248 5,177 Foreign official accounts Foreign currency assets 20,042-81,102 Other liabilities Other assets 37,202 4,434,045 Total Liabilities Total Assets 4,474,634 40,589 Capital Equity Source: Federal Reserve Statistical Release H.4.1 for date shown. Green: OMO lecture asset accounts Grey: OMO lecture reserves Some accounts here are consolidated or renamed to be consistent with labels used in the OMO lectures.
Final comment before we move into fiscal policy in 2017 We keep reading terms like "the FRS is printing money" and they are "monetizing the deficit" or "monetizing the crisis recovery." We now know that these are only metaphors. Once one insists upon a precise definition of money, and then measures whatever that happens to be, you realize that the wild fluctuations in "money" measures have nothing to do with what has happened recently or presently. To be precise, when we now use the term "monetizing" we really mean that they are creating copious amounts of net new credit, which implies higher levels of indebtedness, even (especially) when normalized against our national output as represented by national income or GDP. And when the Federal Reserve System is doing it, the credit is being created from nothing - erasing a number and writing a bigger number in its place. Is this undesirable? Only if it is done to excess. Has it been done to excess?
... is this going to... (continued) Controversy: Can we ever escape this cycle?? 2.6 2.4 New millennium i boom 2.2 2 1980s debt boom 1.8 1990s plateau 1.6 1.4 1.2 Post-war plateau 1 1965 1970 1975 1980 1985 1990 1995 2000 2005 My answer: No, never. This started in 1980. It is the modern source of our economic growth. And like a powerful drug, it gets less and less potent as time passes. We are addicted to debt.
The micro-market market we watch.. autos and this morning's Wall Street Journal
Controversy: Will the latent potential of all of these excess reserves eventually result in an inflationary explosion? Will that be desired at some point?? The inflation cannon is loaded, and it s a huge cannon with a big wad and a big ball. The question of the era: Is anything going to set it off???