With impending rules changes coming this October, the money market industry is back in the news. Beginning October 16, funds which invest in corporate and municipal debt will be required to float their share values. These funds will also be allowed to charge redemption fees and halt withdrawals in times of low market liquidity. Funds which only invest securities issued by the Federal Government or its agencies will be exempted from these changes, and will continue to keep a fixed $1.00 share price.
Several interesting developments have occurred in the market place. Short term dollar funding rates have risen in anticipation of a stampede out of non-government funds after the October 16th drop dead date. Several large funds have converted to government only funds to avoid being subject to the rules changes. This has upped the demand for short term Treasurys, which the Federal Government has somewhat accommodated by increasing its bill issuances.
Perhaps most interesting is that the very existence of money market mutual funds basically debunks a commonly held notion that deficit spending financed with debt is less inflationary than deficit spending financed with money creation. The MMMFs finance their investments in T-bills by issuing shares which can be redeemed for money at any time. Checks can be written against MMMF accounts. Some funds have debit cards. Many funds are FDIC insured. In other words, shares in MMMFs are perfect substitutes for bank deposits or money.
The very idea that government debt issuance requires some economic agents to delay consumption to finance the government's deficit is proven false. The private financial sector, through the magic of maturity transformation, converts Treasury securities back into money-like instruments which can be spent to purchase houses, cars, or cheeseburgers. Finally, if the MMMFs ever faced a mass of withdrawals, the Fed could and would supply the liquidity necessary to meet these redemptions through open market purchases. In other words, the Fed would remove Treasurys from the market place and supply the cash the public was demanding. If these redemptions were due to an increase in nominal spending, then inflation would occur. However, if the withdrawals came because shareholders doubted the soundness of certain funds' investments, as was the case in 2008, inflation would not take hold because there would be no corresponding increase in nominal spending.
Therefore, a preemptive buyback of short term government debt financed by printing money would be largely innocuous. Lacking investment outlets, the government MMMFs would wind down and return their shareholder's money. For their part, shareholders would likely invest in bank deposits, which are also a cash substitute. Rather than holding a money like spendable IOU issued by an MMMF, they would hold a spendable IOU issued by a bank. Crucially, the nominal spending power of the private sector would remain unchanged and hence no inflation would occur.
In sum, money and banking matter when it comes to the national debt. Trying to understand the economic significance of the national debt by just adding up numbers or targeting magic debt-to-gdp ratios will only take some very large numbers out of context, and cause you see all kinds of crises that aren't really there.
Monday, August 29, 2016
Monday, August 15, 2016
Commentary: Interest rates are low because of government policy
John Williams, president of the San Fransisco Fed has made news today by sharing some controversial views on interest rates. Williams is concerned that low long term interest rates gives monetary policy less room to maneuver during recessions. Williams advocates raising the Fed's inflation target, and for more proactive fiscal policy.
The press's coverage of Williams' comments has been confused over what he means by 'interest rate.' Within Fed and monetary policy circles, the idea of a 'natural rate of interest,' a central bank policy rate rate which allows for full employment but does not result in above target inflation still holds much sway. This is distinct from market rates of interest which are allowed to float freely, such as the ten year Treasury note yield.
Operationally of course, there is nothing 'natural' about any central bank policy rate, because the monetary authority either remunerates reserve balances to set an interest rate floor, or actively drains and adds liquidity to the financial sector via open market operations to hit rate targets. A central bank could also abandon interest rate targets altogether and supply a fixed amount of reserve balances. This would allow short term rates to be determined by market forces. The Fed did this from 1979 until 1982.
When thinking about the idea of a 'natural policy rate of interest' it is important to remember how policy rates affect the real economy. The cost (accounting or opportunity) for a bank to fund a loan is the geometric average of the central bank policy rates over the life of the loan. Banks, which must make a profit for shareholders, will charge borrowers a fixed rate of interest which exceeds the expected average policy rate. A cut in the policy rate today, or the signalling of rate cuts to come in the near future will reduce the expected average rate. This represents a cost savings for the banks, and if lending markets are competitive, results in lower rates for bank loans. All else being equal, lower interest rates results in more credit creation, a larger money supply, and a higher price level.
The rub is that the above story is predicated on a public which is willing and able to borrow. Williams' claims that the natural rate of interest has fallen because of an aging population. In other words, since older people borrow less often, even lower rates of interest would be required to induce public to take bank loans and transmit monetary policy across the economy. In other words, the Fed can set policy rates well below historical averages without causing inflation because of a secular decline in the demand for credit.
Press coverage has unfortunately largely conflated the 'natural policy rate of interest' and its potential decline with the sharp fall in government bond yields. The back up in yields of US Treasurys over the past year is the result of government policy. The four rate hikes that the market was expecting in 2016 and the Fed was signalling last year have not and will not materialize. At the same time, the US Treasury has significantly boosted the issuance of securities with tenors less than two years. This is has increased the supply of short term bills relative to long term bonds, and has helped flatten the yield curve. Of course, nothing stops the US Treasury from issuing more long term debt. This would require higher bond yields in order for the bond market to clear, resulting in higher lending rates across the entire economy.
In sum, the government still controls interest rates, and rates are lower today because of government policy. What a prudent path for policy might be in the future, or what is the 'natural policy rate' is an interesting question and Williams has contributed to the economic discourse just by sparking a debate.
The press's coverage of Williams' comments has been confused over what he means by 'interest rate.' Within Fed and monetary policy circles, the idea of a 'natural rate of interest,' a central bank policy rate rate which allows for full employment but does not result in above target inflation still holds much sway. This is distinct from market rates of interest which are allowed to float freely, such as the ten year Treasury note yield.
Operationally of course, there is nothing 'natural' about any central bank policy rate, because the monetary authority either remunerates reserve balances to set an interest rate floor, or actively drains and adds liquidity to the financial sector via open market operations to hit rate targets. A central bank could also abandon interest rate targets altogether and supply a fixed amount of reserve balances. This would allow short term rates to be determined by market forces. The Fed did this from 1979 until 1982.
When thinking about the idea of a 'natural policy rate of interest' it is important to remember how policy rates affect the real economy. The cost (accounting or opportunity) for a bank to fund a loan is the geometric average of the central bank policy rates over the life of the loan. Banks, which must make a profit for shareholders, will charge borrowers a fixed rate of interest which exceeds the expected average policy rate. A cut in the policy rate today, or the signalling of rate cuts to come in the near future will reduce the expected average rate. This represents a cost savings for the banks, and if lending markets are competitive, results in lower rates for bank loans. All else being equal, lower interest rates results in more credit creation, a larger money supply, and a higher price level.
The rub is that the above story is predicated on a public which is willing and able to borrow. Williams' claims that the natural rate of interest has fallen because of an aging population. In other words, since older people borrow less often, even lower rates of interest would be required to induce public to take bank loans and transmit monetary policy across the economy. In other words, the Fed can set policy rates well below historical averages without causing inflation because of a secular decline in the demand for credit.
Press coverage has unfortunately largely conflated the 'natural policy rate of interest' and its potential decline with the sharp fall in government bond yields. The back up in yields of US Treasurys over the past year is the result of government policy. The four rate hikes that the market was expecting in 2016 and the Fed was signalling last year have not and will not materialize. At the same time, the US Treasury has significantly boosted the issuance of securities with tenors less than two years. This is has increased the supply of short term bills relative to long term bonds, and has helped flatten the yield curve. Of course, nothing stops the US Treasury from issuing more long term debt. This would require higher bond yields in order for the bond market to clear, resulting in higher lending rates across the entire economy.
In sum, the government still controls interest rates, and rates are lower today because of government policy. What a prudent path for policy might be in the future, or what is the 'natural policy rate' is an interesting question and Williams has contributed to the economic discourse just by sparking a debate.
Tuesday, August 2, 2016
Commentary: What Could be Done Tomorrow to Create Millions of Jobs
Presidential campaigns are all about big promises and laying out bold agendas and Hillary Clinton's plan to invest 275 billion dollars in infrastructure will certainly create some jobs in the short term and boost overall productivity in the long term. However, even the Obama administration admitted a few years after the passing the Recovery Act that finding and overseeing worthwhile projects was challenging. I applaud Secretary Clinton's desire to enhance the long term economic fundamentals of the United States. However, big projects will take years to be implemented, and gains in productivity will trickle in over decades.
At the same time, economic indicators point to an overall shortfall in aggregate demand. Inflation continues to undershoot the Fed's two percent target. Although core PCE inflation registered a 2.3 percent increased on an annualized basis in June, that number was largely driven by a record increase in rents in urban cities. Indeed, in May rents rose at double the pace of other prices, helping to support the broader increase seen in the PCE price index.
Second quarter GDP came in below expected at 1.2 percent annualized growth, while first quarter growth was revised down to 0.8 percent. While the trade deficit has narrowed a bit this year, adding to growth, it is likely to widen as weakness abroad suppresses demand for US exports. This is likely to further reduce growth. Sadly, the United States, despite its slow growth, is one of the few bright spots in the global economy. Europe and Japan are mired in stagnation. Indeed, when you're the prettiest horse at the glue factory, its foolish to expect foreign spending to solve your aggregate demand shortfall.
To counteract the global slowdown, the United States should indefinitely suspend the collection of payroll taxes on the first 30 thousand dollars of income. Unlike direct government spending on infrastructure, this policy could be enacted immediately and would put close to 1500 dollars a year in the pockets of millions of American families. To be clear, this proposal should not be 'paid for.' With state and local governments retrenching, (and last quarter Federal government spending fell as well) the US government must step in to fill the demand shortfall by increasing the budget deficit.
The economy needs a jolt. Something easy to implement, non-controversial in Congress, and will have an immediate effect in shoring up aggregate demand. A tax cut for working Americans who would very likely spend their larger paychecks would greatly support growth in the coming quarters.
At the same time, economic indicators point to an overall shortfall in aggregate demand. Inflation continues to undershoot the Fed's two percent target. Although core PCE inflation registered a 2.3 percent increased on an annualized basis in June, that number was largely driven by a record increase in rents in urban cities. Indeed, in May rents rose at double the pace of other prices, helping to support the broader increase seen in the PCE price index.
Second quarter GDP came in below expected at 1.2 percent annualized growth, while first quarter growth was revised down to 0.8 percent. While the trade deficit has narrowed a bit this year, adding to growth, it is likely to widen as weakness abroad suppresses demand for US exports. This is likely to further reduce growth. Sadly, the United States, despite its slow growth, is one of the few bright spots in the global economy. Europe and Japan are mired in stagnation. Indeed, when you're the prettiest horse at the glue factory, its foolish to expect foreign spending to solve your aggregate demand shortfall.
To counteract the global slowdown, the United States should indefinitely suspend the collection of payroll taxes on the first 30 thousand dollars of income. Unlike direct government spending on infrastructure, this policy could be enacted immediately and would put close to 1500 dollars a year in the pockets of millions of American families. To be clear, this proposal should not be 'paid for.' With state and local governments retrenching, (and last quarter Federal government spending fell as well) the US government must step in to fill the demand shortfall by increasing the budget deficit.
The economy needs a jolt. Something easy to implement, non-controversial in Congress, and will have an immediate effect in shoring up aggregate demand. A tax cut for working Americans who would very likely spend their larger paychecks would greatly support growth in the coming quarters.
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