Bottom line: The Fed’s excess reserves are not inflationary. As Greg Ip noted in 2009, "Reserves have not been a relevant constraint on bank lending for decades, if ever. Bank lending is constrained by customer demand and by capital." Forget about excess reserves. The Fed’s easing simply doesn’t have a lot of influence in a world of overleveraged households lacking in credit demand. And Fed communications of inflation and interest rate policy is not going to be a make-or-break policy tool. If we want to get the economy on the right track, we will need to focus on jobs.Read it at Credit Writedowns
What about all those excess reserves at the Fed?
by Edward Harrison
Please help me reconcile Harrison's take with Mike Whitney's take.
ReplyDeleteWhen banks have excess reserves, are they allowed to invest them in stocks or commodities ? If so, that would support Whitney's claim that QE gooses stocks and commodities.
But I don't know much about banking so I need some help here.
@ Dan
ReplyDeleteWhen tys are sold, the NFA are switched from non-zero maturity to zero maturity (bank reserves). If a bank exchanges tsys for reserves, its reserve "deposit account" at the Fed increases. If a hedge fund or other financial institution sells the tsys, its deposit account increases at its bank as do the reserves correspondingly in the banks reserve account at the Fed. In the first case, there is no corresponding bank liability against the reserve increase, since the bank was the owner of the tsys it exchanged. In the second case, the increase in bank reserve (bank asset) has a corresponding liability (increase in tsys seller's deposit account). In both cases, those liquidity funds can be used to purchase other assets. These funds can also be leveraged using margin. So QE can drive up asset prices, commodities now being treated as an investment vehicle, too.
QE brings the inter-bank interest rate down to near zero as it leads to system-wide excess reserves. Those individuals and companies that were previously invested in treasuries or just had cash in the bank might as a result decide to invest in riskier assets (as opposed to zero-risk Treasury bonds) in order to maintain a decent rate of return - especially if inflation is up. Low interest rates also make it possible for those with the means to borrow cheaply for speculative purposes.
ReplyDeleteWhen QE began oil and commodity prices were already rising so many people may have decided to go into those markets, thereby further fueling price rises. Such speculative behaviour exacerbates pre-existing supply-side inflationary pressures.
As such, the portfolio rebalancing brought about by QE and low interest rates may have contributed to inflation. There may also have been a 'wealth effect' felt by some as the result of rising equities, which may have led to a limited increase in spending (probably more or high end goods).
@ Anonymous
ReplyDelete'When QE began oil and commodity prices were already rising so many people may have decided to go into those markets, thereby further fueling price rises. Such speculative behaviour exacerbates pre-existing supply-side inflationary pressures."
I would say that QE is actually only a minor factor. QE doesn't force anything. People had greater indifference to holding tsys than not to decide to sell them. True, the low rates likely convinced them that there was greater opportunity elsewhere, even weighting for risk. And some were also likely concerned (erroneously) that the Fed's policy would be inflationary. So I would call QE a contributing factor rather than the cause.
As such, the portfolio rebalancing brought about by QE and low interest rates may have contributed to inflation. There may also have been a 'wealth effect' felt by some as the result of rising equities, which may have led to a limited increase in spending (probably more or high end goods).
It is possible that the increase in asset prices results in some inflation, since portfolio managers now consider commodities an asset class. It's rather certain, at least in my considered opinion, that speculation has led to higher commodity prices, which has gotten passed on to producers and consumers. But absent wage pressure, of which there is none at present, increases in PPI and CPI don't indicate inflation, which is a continuous rise in the price level. Prices rise due to increased demand and that sends a signal to produce more. Inflation doesn't kick in until capacity is reached at near full employment.
I would write increasing oil prices off mostly to demand due to speculation and increasing uncertainty in oil-producing centers like MENA that are key to maintaining adequate supply.
"Inflation doesn't kick in until capacity is reached at near full employment."
ReplyDeleteWhat about the recent increases in inflation to over 5%, along with high unemployment?
Stagflation?
UK: late 80s-early 90s, unemployment between 7% and 10.5% with inflation between 6% and 8.5%.
As well as all the other price rises nicely not counted by standard measurements.
OK, I think I get it.
ReplyDeleteLow interest rates and high liquidity (and misguided inflation expectations) may encourage investment in equities and commodities, driving those prices up.
But QE does not cause core inflation, since we still have massive excess capacity. Diminished interest income may even dampen the macro economy.
Nonetheless, the 1%, who are typically heavily invested in equities and commodities, see their wealth increase, while the 99% have to pay more at the gas pump and at the grocery store.
@ Dan
ReplyDeleteRight.
Dan, re: liquidity.
ReplyDeleteExcess reserves don't in themselves allow banks to do things they couldn't otherwise do. Banks only use reserves to settle among themselves and with the treasury and central bank. All they can do with reserves apart from using them in settlement is lend them to each other at the fedfunds rate or use them to buy government bonds. Reserves only leave the central bank system when they are withdrawn in the form of cash.
The important thing is the interest rate.
Banks can always obtain reserves if they need them, at the going fedfunds rate (or direct from the fed at the discount rate, which is a bit higher). Banks can also normally withdraw enough cash if customers want it as the fed will normally exchange cash for bank assets if need be.
If the interest rate is low, banks can potentially attract more borrowers as loans are cheaper.
QE pushes the fedfunds rate to zero as the Central Bank buys bonds with new reserves, leaving the banks with more reserves than they need to meet their reserve requirements. Beyond this point, additional purchases of bonds by the central bank push down bond yields at the long end of the yield curve, pushing the price of bonds up.
Companies and individuals who sold bonds to the fed during QE end up with credit in their bank accounts. However, they could have sold their bond quickly and easily at any time before QE anyway. Owning a bond does not 'hold back spending'. If you're a bond owner and you want to spend, you can sell your bond quickly without fuss, as the market is 'deep and highly liquid'.
However, low interest rates/ higher bond prices may lead to changing patterns of investment - people selling bonds may look for something else with a higher return. This may entail a higher tolerance of risk, though for most people this is unlikely, especially during a financial crisis. Many will go into 'safe havens' like gold, or be content to hold on to their dollars. Others move into the stockmarket, some into more speculative commodity markets.
QE does not increase the ability to spend as such but it can entail a shift in investment and could make borrowing easier (if banks weren't so risk averse).
While that is technically correct regarding liquidity-reserves, Anonymous, high liquidity does result in inflationary expectations that drives behavior in the direction of portfolio shifting toward perceived inflation hedges, like equities and commodities. This is the Bernanke put, and it is working so far to drive those asset prices higher than they would be otherwise, regardless of whether than is a causal transmission mechanism operative — which, of course there isn't.
ReplyDeleteI've been continually amazed at the Pavlovian response of financial markets to QE based on expectations with no factual basis. But the resulting "wealth effect" that the Fed was banking on never translated into anything else other than some higher prices of commodities being passed through.
Nor are lower rates necessarily stimulative, or higher rates contractionary, although if maintained long enough, conditions will change and they may eventually have an effect. But by themselves, they do not stimulate lending or borrowing when credit is tight, consumers tapped out, and investment prospects bleak, nor does raising rates immediately curtail the demand for credit when the economy is really humming and the prospects look good no matter the higher rate.
Interest rate setting works chiefly through the housing channel and there is a significant lag in its taking effect.
Sure low interest rates aren't going to stimulate anything in a 'balance sheet recession'. But much of the credit boom that led up to the crash was stimulated by low rates which made it easier to borrow and sustain debts, leading to higher asset prices esp real estate, entailing even more issuance of debt. High rates may not deter investors from borrowing if the economy is humming, but make borrowing and sustaining debt harder for the general population and for smaller businesses or highly indebted businesses. Higher rates can also encourage more saving vs spending (for most people, although those living off savings might spend more), and can cause the value of the currency to rise, reducing cost-push inflation.
ReplyDelete@ Anonymous
ReplyDeleteThis is a reason that monetary is ineffective and also unfair. Low rates benefit wealth first by driving up asset prices. This creates a "wealth effect" through unrealized "paper" gains, which then begins to affect prices. e.g., through commodities, which are also an asset class. As consumer prices rise, then wage pressure increases. Wage pressure sends a signal to the cb to raise rates to decrease investment and increase saving, which results in economic contraction and rising UE, the tool the cb uses to control inflation being the buffer stock of unemployed that decreases wage pressure.
I agree its unfair, I just don't agree that it doesn't 'work' to regulate inflation.
ReplyDeleteThe monetarists think that MMTers who deny that low interest rates can be stimulative and that high interest rates can be restrictive, are just bonkers.
Right and MMT'ers think that monetarists are just ignorant of monetary economics. Moreover, the effect of interest rates works chiefly through the housing channel with considerable lag, so it is relatively inefficient and ineffective as a tool for addressing inflation. In addition, monetarists don't bother to acknowledge the unintended consequences of monetary policy.
ReplyDelete