More on Unconventional Open Market Operations

Miles Kimball may have been the first New Monetarist (actually, if you read the paper, he may have been the first New-Keynesian; he's basically outlining the basic NK model in 1995). Fortunately for us, Miles wants to blog, which is guaranteed to increase the average quality of discourse in the medium. From a dismal low, you might say, but progress is progress.

Miles has taken the trouble to write at length in reply to my comments on one of his posts, so I'm encouraged to carry on the discussion.

For some background on liquidity traps, quantitative easing (QE) and what it can and cannot do, you can browse my archive, or read these particular pieces:

1. QE irrelevance.
2. An example.
3. Liquidity traps.

To understand QE, we need to know the difference between a channel system and a floor system. A good example of a channel system is the central banking framework within which the Bank of Canada works. The Bank sets a deposit rate (the interest rate on reserve accounts) and a higher rate at which it lends to financial institutions, and targets an overnight rate that lies between those two rates (i.e. the target rate lies in the "channel"). In a channel system, as long as the overnight rate lies within the channel, open market operations matter - purchases or sales of assets by the central bank will move the overnight rate.

Prior to the financial crisis, the Fed worked within what was essentially a channel system. The interest rate on reserves (IROR) was zero, excess reserves were essentially zero overnight, and the overnight fed funds rate fell between zero and the discount rate (there are some complications involving what the "fed funds rate" is, and how lending at the discount window takes place, but ignore that for now). Pre-financial crisis, if the Fed bought or sold assets (T-bills, long Treasuries, whatever), that would move the fed funds rate.

A floor system is different. Under such a system, the central bank sets an interest rate on reserves and a central bank lending rate, and plans to have a positive supply of reserves in the system overnight. As a result, the overnight rate must be equal to the IROR, by arbitrage. An open market operation in short-term government debt in a floor system will have no effect, at the margin, as the central bank is simply swapping one interest-bearing short-term asset for another. The instrument of monetary policy in a floor system is the IROR, which determines short-term nominal interest rates.

Currently, the Fed operates under a floor system. The supply of excess reserves is enormous, and the IROR determines short-term interest rates. There are some weird features of the system, such as the fact that the GSEs receive no interest on their reserve accounts, and there is some lack of arbitrage which results in a fed funds rate less than the IROR, but I think those weird features are irrelevant to how monetary policy works.

Under a floor system, we are effectively in a perpetual liquidity trap. Conventional open market operations in short-term government debt do not matter, whether the IROR is 5%, 0.25%, 10%, or zero. But, not to worry, the central bank can always change the IROR except, of course, when it hits the zero lower bound (neglecting the possibility of taxation of reserve balances, which is another issue altogether).

My irrelevance argument goes one step further. First, we have to understand why open market operations move the overnight rate in a channel system. An open market purchase of T-bills under a channel system essentially involves the transformation by the central bank of T-bills into currency. Remember that, in a channel system, overnight reserve balances are zero. The increase in outside money has to show up somewhere, so currency outstanding has to increase. Private financial intermediaries cannot convert T-bills into currency, as they are not permitted (either explicitly or implicitly in the US) to issue currency. That's why monetary policy matters in a channel system - central bank intervention works by varying the quantity of liquidity transformation.

But what happens if, for example, the central bank purchases long Treasury bonds under a floor system? The Fed issues reserves, and purchases Treasury bonds, thus transforming T-bonds into overnight reserves. Does that do anything? Why should it? A private financial institution can create a special purpose vehicle (SPV) whose only function is to hold T-bonds as assets, and finance that portfolio by rolling over overnight repos. The SPV performs exactly the same asset transformation as the central bank is performing when it purchases T-bonds. Imagine, for example, that there is an SPV that sells T-bonds to the Fed, and suppose that the overnight repos of the SPV were held by a financial institution with a reserve account. Suppose further that this financial institution increases its reserve account balance by exactly the amount of the reduction in its repo holdings after the Fed purchases the T bonds. Clearly, the financial institution does not care whether the T-bonds that back its overnight assets are held by the Fed or the SPV. Nothing changes.

This is just a more elaborate liquidity trap. Under a floor system, the only instrument the central bank has is the IROR. Asset purchases - of whatever - are irrelevant. Under current circumstances, this means that, as long as the Fed does not change the IROR, the inflation rate is passive. Changes in the price level are determined by the demand and supply of liquid assets - the whole array of that stuff, i.e. currency, reserves, interest-bearing government debt of all maturities, liquid asset-backed securities. The Fed can only change the composition of the total stock of liquid assets under a floor system, and so it can't change the price level without changing the IROR. What will move the price level, as long as the IROR is fixed? First, if the private sector creates more liquid assets that compete with reserves, that will increase the price level, and we will get more inflation. That is what I was worried about a while back. Not right now. If it looks unlikely that the private sector will be creating more liquid assets, and if the demand for US-dollar-denominated liquid assets rises, the price level falls and we get less inflation. That's our problem now. Of course there's nothing the Fed can do about that, as the IROR does not have far to go to reach zero.

Some specific comments in reply to Miles's post:

1. Miles argues that, even if we have some doubts about QE, why not try it? At worst it's irrelevant, so no big deal. The problem is that the Fed wants to believe it works, otherwise it looks silly, given the massive QE operations that it has engaged in. Various economists in the Fed system have been falling all over themselves to justify the actions of their superiors, and smart people like Miles are buying the arguments. The Fed has now convinced itself that QE works. In particular, the Fed thinks it works both ways. Thus, if we ultimately see what we think is too much inflation (a more remote possibility at the moment, obviously), the Fed will think it can control it through asset sales. It certainly can, but the sales only start to bite at the point where excess reserves get very close to zero.

2. Miles isn't sure exactly what friction makes QE work, but he seems confident that the friction is small, and so QE must be carried out on a very large scale in order to do much. In fact, as he says:

Balance sheet monetary policy can powerfully stimulate the economy if the Fed does enough.

That seems inconsistent with the rest of the argument. Suddenly we go from statements about how little we know to confident predictions about what we can accomplish if only we do "enough." You have to be more specific about the "enough" to give that content.