Tuesday, August 11, 2015

Monetary Policy: Part 6 - Getting from Here to There

In 1980 establishing monetary policy based on the strong form of monetary theory described in the previous posts would have been a relatively trivial matter, both operationally and politically. In fact, without the advent of NOW accounts in late 1980 that might have actually happened. I was at the Tennessee Consolidated Retirement System until mid-1979 and from my position as Bond Portfolio Manager I had excellent access to the writings and thinking of most of the prominent Wall Street economists at that time.

One of them, H. Erich Heineman of Morgan Stanley in particular, had started to home in on the concept of Effective Reserves by the time I left Tennessee. Had NOW accounts not been authorized, I suspect that he, or one of his fellow economists, would have discerned the relationship I described in previous posts. I know he suspected it, but the advent of NOW accounts destroyed the operating environment in which the strong form of monetary theory operates.

A Brief Summary of the Desired End Point

1. Demand accounts need to be the only accounts for settling day-to-day transactions and must not bear interest. That ensures their minimization by users.

2. Savings accounts must carry at least a modest interest rate of 2% or so. That ensures that they will be preferred over leaving unused funds in checking accounts. The Fed can easily manage fed funds so that short rates stay above a 2% floor. (Note: While this point will be controversial, the Fed managed to put the fed funds rate exactly where they wanted it year after year for over four decades.)

3. Bank reserves must not bear interest. That ensures their minimization by the banking system.

4. The Fed should then adopt the strong form of monetary theory and begin to supply a consistent level of total reserves to the banking system, letting interest rates go where they will, even on fed funds.

5. Congress should restrict the Fed's mandate to one, and only one, purpose, that being to maintain a steady price level, neither deflationary nor inflationary. They should have no mandate for seeking to manage economic growth whatsoever.

So, How to Get from Here to There?

The toughest part will be forcing the Fed to take either a tremendous loss on their current portfolio of long maturity debt or to pay what will likely be on the order of $100 billion a year to banks out of their operating earnings. This will be necessary because for the strong form of monetary theory to be implemented around $2.5 trillion of Excess Reserves currently in the system have to somehow be either removed or neutralized.

Removing them permanently will require the Fed to sell well over $2.5 trillion of their long maturities. Why "well over"? Because as soon as the market realizes that's the way it's going to go, the long end of the market will take a huge beating and the Fed will be selling its portfolio at a significant loss, on the order of hundreds of billions of dollars as explained in an earlier post.

Neutralizing that amount of excess reserves without liquidating the Fed's portfolio will require the Fed to pay the banks to sit on the excess reserves rather than circulating them, for if the fed funds interest rate rises above the 1/4% they're now being paid, they will circulate them. This might partly explain the Fed's relatively recent interest in a long-term repurchase agreement facility, incidentally. If they did a one-year reverse repo with the banking system today at, say, 2%, they'd lock in their cost of neutralizing them at only $50 billion for the year. Of course, they'd have to take a similar action a year later at the rate prevalent at the time, whether that be 2% or 6%.

This is all doable, by the way, although the likelihood of the current Fed doing it would be about zero even if they suddenly bought into the strong form of monetary theory. It's just too big a hit, regardless what direction they go, so they'll either muddle along for another decade or so or be forced to take action by a change in the laws under which they operate.

Question: What About Seasonal Needs for the Money Supply?

The Fed has always operated on the assumption that the economy needs an increase in the money supply around the holiday season and has obliged by providing the reserves needed to support that increase. But what if they didn't?

Two things would happen. First, interest rates on short term funds would rise around the holidays, both on short-term savings balances and particularly on fed funds, for there would indeed be pressure to round up demand balances to pay for the increased economic activity. However, the second thing that would happen is that savers would come to expect higher interest rates during the holidays and would concentrate the lending of their money on those periods. Thus, higher rates would make more funds available. The effect on demand balances is simply that they would circulate more rapidly during holidays, rather than increasing as they traditionally did.

This takes some thinking through to understand how it will work out. For example, what if too many people tried to convert savings accounts to demand accounts? The fixed level of reserves supplied by the Fed wouldn't support the increase so, again,  what would happen? Everyone's reserve requirement would go up, but the reserves wouldn't be provided, so the fed funds rate would increase, perhaps by several percent. But that would also cause interest rates on short-term savings deposits to rise, thereby pulling money back into savings from demand accounts.

Perhaps a case could be made for giving the Fed some seasonal flexibility, but it would be interesting to first see what would happen if they didn't have it. For as the QE's have shown, if you give a bureaucracy some flexibility, they will use it to the utmost.

A Note to Congress: Is This Really What You Authorized?

A decent case could be made that the Fed of the middle decades of the 20th Century already had too much power to influence events. They really could, if they wanted, implement policy in a way that would influence elections. Maybe they even did that once or twice. Who knows?

But the Fed of the past decade has taken actions never, ever, anticipated in the law authorizing its existence. The entire purpose of the three QE's, for example, was to directly influence rates at the long end of the debt markets. In doing so their actions also had a direct bearing on stock prices, commercial real estate prices, art prices, home prices, etc., all while driving savings rates to nearly zero for every retiree in the country who had been relying upon a CD portfolio for income. Did Congress ever intend to delegate such power? Ever?

Not only that, but during this time of exceptionally low interest rates, the U.S. Treasury has made a concerted effort to extend the maturity of the U.S. public debt. That action has been entirely contravened by the Fed as it purchased those same maturities and placed them back in government hands, i.e., their own portfolio. Thus all of the Treasury's efforts have been in vain and the taxpayers will foot the bill should rates eventually rise, for it is the taxpayers that will be on the hook for the eventual losses the Fed is forced to take to restore some measure of normalcy to monetary policy.

Conclusion to Monetary Policy, Parts 1 - 6

The original purpose of OnTrack Economics was to set forth The Strong Form of Monetary Theory where people might eventually find it. If you've examined earlier posts, prior to this latest burst, you'll probably have come across my earlier 2001 paper, A Monograph on Monetary Policy, explaining the theory, and much of the content of these recent posts, all in one place. What the paper didn't anticipate, however, is the off-the-rails policies pursued by the Fed for the past several years. These recent posts explain the policy again, but also address the issue of how to restore the original Fed operating environment for without that step, the strong form can't be implemented.

Also, if you do read the paper, written in 2001, note that at the end it described Japan's deflationary dilemma at the time, prescribes a way out, but also warns that following in their footsteps by allowing rates to fall to near zero could lead to a similar decade of performance here in this country. For those not fortunate enough to see their asset portfolios increase, the last decade feels very much like that as they continue to endure falling real incomes year after year.

We can do better.

A Closing Note: I suspect that this will be the end of this burst of posts unless someone takes note of the material here and wants to explore it in more detail. Should that happen, I'd be more than willing to flesh out the ideas put forth here, as well as attempt to counter the inevitable objections.


Anonymous said...

Very well written Mr Everson. I came to your blog via The Money Illusion. I find your conclusions logical and thoughtful.

Chuck E.

Rod Everson said...

Thanks Chuck. Now I just wish you were an employee of the Federal Reserve....

And I apologize for the several-hour delay in posting your comment, but I'm still wary of opening my site up to unmoderated comments, not because of the ability it gives me to not display criticisms, but because of the inevitable spam, and other undesirable behavior.