Wednesday, July 25, 2012

Nick Rowe — How many monetary transmission mechanisms are there?

Read it at Worthwhile Canadian Initiative
How many monetary transmission mechanisms are there?
by Nick Rowe

The ever-resourceful Nick invites us to think about monetary transmission mechanisms, and he suggests that there may be many.
You want concrete steps? I will give you a million different flights of concrete steps.
For example, like Lars Christensen, lets talk about the monetary transmission mechanism where the central bank adjusts the stock price index, rather than a short term nominal interest rate. No zero lower bound problem there.
In case no one has noticed, the Fed is already fixing the stock price index through QE. Indeed, a Fed official admitted that asset prices are higher than they would be otherwise, and it is clear that this is policy objective to increase the "wealth effect." Markets have already priced in QE3 to a degree, and if it is not forthcoming, then eventually this expectation will be discounted.


STF said...

Raising equities by actually buying them would be fiscal policy, since the pvt sector gets a net financial asset=capital gain. So, yes, that would enable deleveraging in the non-govt sector, but it's far less efficient than just providing income to people that would actually spend, not to mention potential asset price bubbles. If you want more GDP, then create GDP; creating asset price bubbles to get more GDP indirectly has its consequences, as we should have figured out by now.

Nick Rowe said...

STF (Scott?): If raising equity (prices) by actually buying them would be fiscal policy, then raising gold (prices) by actually buying gold would also be fiscal policy. Even more so, since gold is (in part) a newly-produced good, and gold production is included in GDP.

If buying equities, and gold, counts as fiscal policy, why isn't buying bonds, or buying IOUs from commercial banks, also fiscal policy?

" If you want more GDP, then create GDP..."

That's exactly what we want the Fed to do. And it should tells us exactly how much (N)GDP it is going to create! ;-)

Tom: "Indeed, a Fed official admitted that asset prices are higher than they would be otherwise,..."

I wonder what he meant by "otherwise"?

Thanks for the link!

STF said...

"If buying equities, and gold, counts as fiscal policy, why isn't buying bonds, or buying IOUs from commercial banks, also fiscal policy?"

To the degree that there is a capital gain to the pvt sector on a net basis, then buying anything is fiscal policy (that is, the part that creates a capital gain). Our view is that this is a highly indirect and inefficient way to create GDP, akin to tax cuts for primary dealers with the hope that they'll spend more.

Tom Hickey said...

Nick: Tom: "Indeed, a Fed official admitted that asset prices are higher than they would be otherwise,..."

I wonder what he meant by "otherwise"?

Absent QE.

Brian Sack, FRBNY:
The effect of asset purchases on the economy remains a point of ongoing debate, with some uncertainty about the channels through which such purchases operate and the magnitude of those effects. My own perspective is aligned with the view expressed by Chairman Bernanke in Jackson Hole—that the effects arise primarily through a portfolio balance channel.2 Under that view, our asset holdings keep longer-term interest rates lower than otherwise by reducing the aggregate amount of risk that the private markets have to bear. In particular, by purchasing longer-term securities, the Federal Reserve removes duration risk from the market, which should help to reduce the term premium that investors demand for holding longer-term securities. That effect should in turn boost other asset prices, as those investors displaced by the Fed’s purchases would likely seek to hold alternative types of securities.
Some research studies have estimated that the effects of the earlier expansion of our securities holdings by just over $1.5 trillion lowered longer-term Treasury yields by about 50 basis points through this portfolio balance channel.3 These effects on Treasury yields appear to have been transmitted into lower rates on private credit instruments and higher asset prices more broadly....
Some observers have argued that balance sheet changes, even if they influence longer-term interest rates, will not affect the economy because the transmission mechanism is broken. This point is overstated in my view. It is true that certain aspects of the transmission mechanism are clogged because of the credit constraints facing some households and businesses, and it is true that monetary policy cannot directly target those parties that are the most constrained. Nevertheless, balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be. It seems highly unlikely that the economy is completely insensitive to borrowing costs and wealth, or to other changes in broad financial conditions.

Managing the Federal Reserve's Balance Sheet -October 4, 2010

Here's Henry Blodget on it:

Look! Ben Bernanke's Keeping Asset Prices Higher Than They Otherwise Would Be!
Henry Blodget

and J. Saft:

Fed is banking on phony wealth effect

Nick Rowe said...

STF: OK. The monetary base, in normal times, in normal countries (e.g. Canada) is around 5% of annual GDP. And commercial bank money is both an asset and a liability. So, to a first order approximation, if all the money is a country disappeared by magic, and at the same time we discovered a new oil field worth about the same 5% of GDP, there would be no effect on net wealth. Or spending. And the country could continue along fine, maybe using barter?

If monetary policy is so irrelevant, and only fiscal policy matters, how come the Bank of Canada has managed to keep inflation almost exactly at its 2% target for 20 years, despite massive changes in fiscal policy that were mostly aimed at bringing the debt/GDP ratio down, not at keeping inflation on target?

Nick Rowe said...

Tom: thanks. But that's a bit like the Fed saying that is has kept asset prices higher than they would have been if it had let the economy disappear into the black hole of a deflationary spiral. True, but not a very useful comparison.

Tom Hickey said...

But it is an example of monetary transmission, isn't it? QE flattened the yield curve and reduced borrowing rates, promoting portfolio migration into riskier asset with more leverage available less expensively.

I don't think that the Fed was thinking so much of asset prices other than housing, though. If the Fed had not propped up housing with monetary policy, the US could have spiralled into a black hole of deflationary depression if bank assets collapsed.

Bill Black argues that this was a piece of an overall plan to preserve the status quo in the financial sector rather than follow the law and put insolvent entities into resolution. He argues that not only was this the legal solution required, but also the socially equitable one and economically the most effective and efficient one. Black holds that the govt put advanced an either/or black[white rationale, which was not actually true, since not only where there other solutions but also better ones. It just wasn't just save the TBTF's or suffer from liquidationism at all, as experts in banking like himself knew at the time.

Nick Rowe said...

Tom: Maybe there are 3 questions:

1. What assets does the Fed actually buy and sell?

2. What price does the Fed say it is moving up and down as an instrument, in order to hit its ultimate target?

3. What's the ultimate nominal target the Fed says it wants to hold constant?

If I stood right back and asked "which particular group of asset holders is overall Fed policy designed to benefit (in the last 4 years)?" the only answer I can come up with is "those who hold 30 year Tbills".

Tom Hickey said...

That's the direct effect, Nick, but not the aim of monetary policy. It's an indirect effect of pursuing policy with a particular policy tool (QE).

Same can be said of paying IOR. The recipients of the interest payment (banks) are the direct beneficiaries, but paying IOR is a policy tool that aims beyond this. If the Fed wants to expand its balance sheet using QE, the the increase in reservess would drive the overnight rate to zero, which the Fed doesn't choose. So it pays IOR as the floor rate instead. I.e. the Fed sets price (FFR with IOR = FFR) and lets quantity (of rb) float.

The transmission of the lower interest rate is not in increased lending when the private sector prefers to save but rather through the housing channel chiefly and the portfolio channel secondarily.

In any case, there is no money multiplier. The so-called money multiplier is not an ex ante causal transmission mechanism but an ex post accounting residual.

Anonymous said...

It seems to me that the conventional monetary/fiscal distinction is crude, and often creates a great deal of confusion. Here are some ideas toward a better taxonomy:

First, there is an institutional or legal distinction to be made between central bank policy, on the one hand, and legislative policy on the other. That is, what actions can the central bank take under prevailing institutional and legal arrangements? What actions can the the central bank not take, and must be left to the political branches? Are there types of policies that both branches are permitted to take?

Second, some economic policies involve monetary transactions of some kind - i.e. either outright transfers, or taxes, or purchases of goods or services, or sales of goods or services, or purchases or sales of financial assets. Others involve regulatory moves, not transactions. Some regulatory moves might be made by the central bank; some by the legislature.

Third, both transactional and regulatory policies can be distinguished according to the economic sector directly affected, rather than focusing on the branch of government involved. As a first pass, we can distinguish among the household sector, the (non-financial) business sector and the financial sector.

So far, it looks like we have 12 possible kinds of policies.

1. Central bank; transactional; financial.
2. Central bank; transactional; business.
3. Central bank; transactional; household.
4. Central bank; regulatory; financial.
5. Central bank; regulatory; business.
6. Central bank; regulatory; household.
7. Legislative; transactional; financial.
8. Legislative; transactional; business.
9. Legislative; transactional; household.
10. Legislative; regulatory; financial.
11. Legislative; regulatory; business.
12. Legislative; regulatory; household.


Tom Hickey said...

1. What assets does the Fed actually buy and sell?

What assets can the Fed legally deal in? Gold and tsys under normal conditions. The Fed buys and sells gold to influence the fx rate by increasing and decreasing USD in the fx market, and the Fed also buys and sells tys using OMO to hits its target rate.

The Fed has emergency powers but they are not unlimited. The Fed has limited legal capacity to affect non-govt net financial assets, which is fiscal and the prerogative of Congress.

2. What price does the Fed say it is moving up and down as an instrument, in order to hit its ultimate target?

The Fed announces its target rate as either zero or non-zero. In the case of non-zero, the quantity of reserves is irrelevant. If the Fed wants to set a target rate above zero, then it must either conduct OMO to keep the quantity of rb sufficient to prevent the overnight rate falling below its target rate in the overnight market, or else pay IOR and let rb quantity float.

The Fed can also use POMO to influence the yield curve as in QE or by setting the price (yield) and standing ready to purchase all quantity offered at that level.

3. What's the ultimate nominal target the Fed says it wants to hold constant?

The Fed has announced its nominal target as 2% nominal inflation rate.

There's a lot of talk about the Fed doing other things, but a lot of it overlooks the constraints that the Fed operates under, and many of the proposals involving fiscal would require Congressional approval.

For example, in 2009 an act of Congress granted the Fed the power to pay interest on reserves. This approval was needed because IOR increases bank capital and amount of non-govt NFA, this is fiscal even tho there is no corresponding Tsy liability incurred| .

Anonymous said...

Now it seems to me that monetarists have a preference for doing everything via policies of types 1 and 4. That is, these are the direct policy channels they prefer to use. They also sometimes claim that these direct policy actions can generate effects that turn those policies into types 2,3,5, and 7. But that's where a lot of the debate lies, with critics of monetarism sometimes arguing that the causal links the monetarists explicitly and implicitly posit linking 1 and 4 to 2,3,5 and 6 are tenuous at best, and sometimes non-existent. Monetarists sometimes counter with arguments about the "concrete steppes", simultaneous causation, etc.

As a result their criticisms, the critics of monetarism argue that we should instead focus more attention on the direct implementation of policies of types 7 through 12.

Of course, one thing I left out of my taxonomy is any discussion of the goal of the policy. Goals include such things as price level changes or maintenance; RGDP changes or maintenance; NGDP changes or maintenance; interest rate changes or maintenance; employment changes or maintenance; structural economic change or maintenance, etc.

I also left out the fact that, due to present institutional arrangements, some central bank policies are directly targeted not at a sub-sector of the private sector, but at another branch of government. The central bank can act in ways designed to impact the treasury; the legislature can act in ways designed to impact the central bank, etc. (Note that in the US at least, the central bank can not act upon the legislature.)

Since I tend to believe monetarists seriously misdescribe or overestimate the causal channels leading from types 1 and 4 to 2, 3, 5 and 6, own preference is for a lot more policy actions of types 8 and 9. Basically, we need the legislature to do a lot more spending and transferring of resources directly to and among households and non-financial businesses.

Nick Rowe said...

Tom: 1,2,3. Yes, your answers are a *description* of current Fed policy. That is what the Fed *says* it is doing. And that policy is clearly failing. We need different answers to at least some of those 3 questions. We need to escape that straitjacket.

Dan: in a monetary exchange economy, (almost) every transaction involves money. That doesn't make it monetary policy. If we want to ask whether or not it's monetary policy, we need to stop looking at what is bought with the money, and start looking at whether the transaction creates money.

Matt Franko said...

From Nick:

"2. What price does the Fed say it is moving up and down as an instrument, in order to hit its ultimate target?

3. What's the ultimate nominal target the Fed says it wants to hold constant?"

To Point 2: imo they dont say any of this. To them it is about QUANTITY not price; hence QUANTITATIVE easing;

Point 3: They dont have a nominal target.

If you read this New York Times article here:


Each morning Mr. Frost and his team face a formidable task: they must try to buy Treasuries at the best possible price from the savviest bond traders in the business.

The smallest miscalculation, a few one-hundredths of a percentage point here or there, could unsettle the markets and cost taxpayers dearly. It could also embolden critics at home and abroad who say QE2 represents a dangerous expansion of the Fed’s role in the markets.

We are looking to get the best price we can for the taxpayer,” said Mr. Frost, a buttoned-down 34-year-old in a striped suit and rimless glasses.

The NY Fed's desk actually reveals here that their actual operations desk seeks LOWER PRICES on the bonds they buy "for the taxpayer"..... which LOWERS BOND PRICES AND RAISES RATES. The termination of this moron-fest aka QE2 was the act that allowed the now infamous "who's gonna buy them now rally" to ensue immediately following the end of the so-called QE2...

So Mr Sack is not on the same page as Mr Frost seems.... Sack wants the bond prices to go up, and Frost want the prices to go down... I think Frost is the one who was/is really in the drivers seat.

It is a fact that rates actually fall when the Fed is OUT of the market with these asset purchase programs.

The left hand does not know what the right hand is doing.... but they apparently can make it sound like they do.


Anonymous said...

Nick, the point of my comment was to suggest that we should stop asking the unclear question "Is it monetary policy?" and introduce a somewhat more exact taxonomy along the lines I suggested.

Many different kinds of policies can result directly or indirectly in money (of one kind or another) being created or destroyed. I'm not sure how much really depends on the quantities of money in existence. But to the extent things do depend on that question, there are different ways of doing it.

One of the big classical debates is over whether direct central bank adjustments to MB have a predictable impact on M2, right? If the answer is no, then even people who think policy should target M2 might choose a mechanism that operates outside the central bank.

Anyway, I was under the impression that even among monetarists, there are few economists these days who recommend direct targeting of the quantity of money - of any form.