Liftoff Levers

I read the minutes of the January FOMC meeting. (I was preparing for an interview with WSJ's Mary Kissel) There is a lot more interesting here, and a lot more important, than just when will the Fed raise rates.

Mainstream media missed the interesting debate on "liftoff tools." Maybe the minute the Fed starts talking about "ON RRP" (overnight reverse repurchase agreements) people go to sleep.

Background

Here's the issue.  Can the Fed raise rates? In the old days there were $50 billion of reserves that did not pay interest. The Fed raised rates, so the story goes, by reducing the supply of reserves. Banks needed reserves in proportion to deposits, so they offered higher rates to borrow reserves.

Now, there are about $3 trillion of reserves, far more than banks need, and reserves pay interest. They are investments, equivalent to short-term Treasuries. If the Fed reduce their quantity by anything less than about $2,950 trillion, banks won't start paying or demanding higher interest.  And the Fed is not planning to reduce the supply of reserves at all. It's going to leave them outstanding and pay higher interest on reserves.

But why should that rise transfer to other rates? Suppose you decide that the minimum wage is too low, so you pay your gardener $50 per hour. Your gardener is happy. But that won't raise wages at McDonalds and Walmart to $50. This is what the Fed is worried about -- that it might end up paying interest to banks, but other interest rates don't follow.


In my analysis of this issue, it will work, gardener story aside ("Monetary Policy with Interest on Reserves." Ungated here). Banks should compete for deposits, driving up deposit rates. And deposits should compete with money market funds and Treasuries, driving up those rates. More deeply, central banks already seemed to raise rates more by "open mouth operations" than by actually buying and selling things. They say rates should go up 25 bp, rates rise. That experience is likely to continue.

But "compete" and "banks" don't necessarily sit well in the same sentence anymore, and just why open-mouth operations worked so well is a bit of a mystery. In the past there was some sort of credible threat to do something if rates did not go up.

So you can see why the Fed is worried. What if the Fed announces the long-awaited interest rate rise, the Fed starts paying banks 50 bp on reserves and.. nothing happens. Deposit rates stay at zero, treasury rates stay at zero. Congress notices "the Fed paying big banks billions of dollars to sit on money and not lend it out to needy businesses and households." Mostly foreign big banks by the way. Nightmare scenario for the Fed.

Enter ON RRP. It's a natural idea. If the Fed raises interest on reserves, and banks just eat the profits, then the Fed can counter by offering reserves to other investors. A money market fund, say, earning 0 on treasury bills, would jump at the chance to earn 50 bp on reserves. In turn, as more money funds do this, dumping treasuries, Treasury rates must rise. A rush of depositors to the money market funds forces banks to raise deposit rates and then lending rates.

This is, in a nutshell the ON RRP idea. I'm a big fan.  I think a large balance sheet open to all is a great thing for financial stability, opening up narrow banking. (More in "Toward a run free financial system.")

You can see why big banks might not be fans. If they can pay 0 for deposits and earn 50bp in reserves, why undermine the profits with competition?

You can also see from my story, that if the ON RRP facility is important for transmitting higher interest on reserves to other assets, the Fed might need to do a lot of it. A lot. We're trying to raise the interest on Treasuries, Agencies, commercial paper, etc. etc. etc. by having money market funds attempt to sell those and hold reserves. They might buy a lot of reserves before rates are equalized.

The total quantity of reserves need not change, and won't if the Fed does no open market operations. But the money market funds will get bank depositors to send them reserves, pay higher interest, and park those reserves at the Fed. Basically the ON RRP will facilitate a big shift of reserves and deposits to money market funds -- if the banks don't raise deposit rates pronto. But that shift could be huge. Did I mention that banks might not like this?

This is Big Stuff for monetary policy. Whether the overnight rate inches up 25 bp in summer or fall is angels dancing on heads of pins. The shift to an interest rate target on a huge balance sheet is a night and day change. And it had better work.

The FOMC minutes

With that background, maybe the whole section on "liftoff tools" makes more sense. So, the Fed opens up reserves to one and all, and stands ready to take trillions. What's the problem?

A couple of participants expressed continued concerns about the potential risks to financial stability associated with a large ON RRP facility and the possible effect of such a facility on patterns of financial intermediation.

I don't get this at all. I gather the story is something like, if interest paying reserves are available, then funds might in a new crisis want to dump all their assets and move to interest paying reserves. But they can just as well dump assets and buy cash or treasuries too. The existence of interest paying reserves open to non-bank institutions just makes very little difference.

It seems to me exactly the opposite. Every dollar invested in interest-paying reserves at the Fed is a dollar not invested in run-prone, financial-crisis-prone, overnight private lending, like the overnight paper Lehman was using at 30:1 leverage the night before it failed. More ON RRP means more financial stability.

If anyone knows a coherent explanation of how offering the most perfect narrow banking in the world (interest paying reserves backed by Treasuries) is bad for financial stability, I'd like to hear it. Are there speeches or papers by the "participants" I don't know about?

You can see the nervousness all over the discussion

Moreover, some participants were concerned that a decision to allow a temporary increase in the maximum size of the ON RRP facility could be viewed by market participants as a signal that a large ON RRP facility would be maintained for a longer period than those participants deemed appropriate.

OK, maybe as an emergency tool to help "liftoff," but they want a promise it ends soon.

While acknowledging these concerns, many participants believed that a temporarily elevated cap on the ON RRP operations at a time when the Committee saw conditions as appropriate to begin normalization would likely pose limited risks; another participant judged that an ON RRP program was, in any case, unlikely to materially increase the risks to financial stability. Some participants noted that a relatively high cap could be established and then reduced fairly soon after the initial policy firming if it was determined that it was not needed, and that such a reduction could help underscore the Committee's intent to use such a facility only to the extent necessary. A number of participants emphasized that the Committee should develop plans to ensure that such a facility is temporary and that it can be phased out once it is no longer needed to help control the federal funds rate.

You can see a big fundamental argument here, and the natural compromises such an argument leads to. OK, just this time. But promise it's limited. Impose a cap.

Alas, this is a lot like promising ahead of time that you won't send ground troops to a war.  Just what happens when, the Fed raises interest on reserves to 50 bp., deposits and treasuries don't budge overnight RRP demand hits the cap immediately. And now what, ladies and gentlemen? "Well, we wanted to raise rates, but we hit a self-imposed cap, so I guess that's it for now?"

You will not lower the oceans with an eyedropper. Pegging prices with a cap on quantities is a dangerous affair. Ask the Swiss National Bank.  If Mario Draghi had said "we'll do what it takes to save Greece and Italy, up to a cap" do you think it would have worked?

Here you see a huge divide, unlike anything involving the path of rates. (Members seem to pretty much agree on the rules of that game, just differing in their assessment of inflation vs. output dangers.)

The committee goes on to Term RRP, i.e. letting money market funds invest in interest-paying reserves but only for fixed time periods, like a CD.  I presume they hope that  might equalize rates without "financial stability concerns." But again, I can't figure out what these "financial stability" concerns are, so it's hard to evaluate. But you can see it again as a compromise.

Bottom line, if a bit repetitive. What are the "financial stability" concerns? Or are they really "bank profitability" concerns? Or are they "unwarranted Congressional attention" concerns? (If you think "the Fed is paying banks not to lend" is bad, wait until "the Fed is paying money market funds not to invest" hits the airwaves.)

A few other thoughts. 

Reading the report,  I was unaware how much foreign currency intervention the Fed does. I'm interested in knowledgeable commentary.

On the whole when-do-we-raise-rates thing, the Fed is clearly in a bit of a pickle.  We all know that stable expectations, transparency, etc. are good things, and that the Fed should not induce volatility by adding uncertainty about interest rate movements. So, Ben Bernanke started an admirable effort to give "forward guidance" about what the Fed would do. As the time to raise rates comes nearer, the Yellen Fed has sensibly wanted to telegraph "data-dependent" decisions. Even John Taylor would cheer at that, as "data dependent" is the heart of the Taylor Rule.

But the Fed also wanted to maintain its "flexibility." And without a Rule, "data dependent" looks to markets a lot like "whim-dependent." Without a rule, the "data" can be "we changed our mind."

So bit by bit, good intention by good intention, the Fed finds itself back in the corner that markets are parsing tiny differences in phrasing -- will She say that soon she might moderate "patience" to "tolerance?" FOMC members are arguing it out in speeches, and the Fed ends up creating more volatility than reducing it.

Source: Torsten Slok

I'm soon going to be nostalgic for the zero bound. It had a great advantage -- everyone knew exactly what interest rates were going to be!  The neo-Fisherite prediction of gently declining inflation was bearing out.

Mary Kissel asked me if I thought raising rates now is a good idea, so the Fed has some room to lower them later. I fumbled a bit, with an analogy that it's like wearing tight shoes because it feels good to take them off.

It's a good and deep question, asked by many, and I see that sort of opinion from many Fed-watchers: Raise now so we have room to stimulate if something goes wrong.

That view embodies a nonlinear or state-dependent idea of how monetary policy works. "Stimulus" is not just the level of the rate, but the rate relative to recent history. So, a zero rate in the crisis of 2018 is more effective if it has been preceded by tightening than if not. It's certainly possible, if rates push around some slow-moving state variable. If someone holds this view and can name the state variable I'd like to hear it.

Mary also asked if I thought the Fed was "politicized" when I opined they were worried about Congressional attention above and beyond economic issues. I fumbled a bit. A perfectly a-political agency would be nuts not to consider how its actions might or might not attract attention from Congress.  And that's how it should be in a democracy. Congress should pay more attention to many agencies, both sides respecting the trade of independence for limited powers. In this case, I agree that Congress may misunderstand perfectly good ideas -- paying interest on reserves, that the interest comes from Treasuries so is a wash to the taxpayer -- but that raises the onus on the Fed to explain these simple concepts so Congress and the rest of us understand what they're up to. Eschewing good economic policy because one worries Congress can't understand it is a bad way to run things.

A last thought: If the US's main economic problem, and financial markets' main shock,  is whether the overnight federal funds rates rises by 0.25 percentage point, in the context of a slowly improving real economy and very low inflation,  there to sit another 6 months to a year, this will be great news. The world is blowing up, Russia is invading Ukraine, Greece could go under, bond markets could go haywire. Look to the variance, not the mean. How the Fed will react to a big shock is far more important than what they will do in a perpetually quiet world. There will be more shocks!

Update: More (if you can stand it) in a second post, here.