To virtually nobody's surprise, the ECB announced a 60 billion Euro a month asset purchase program. Queue the peanut gallery. 60 billion isn't enough. 60 billion is too much. Europe's economy is saved. Hyper-inflation is around the corner. The ECB is causing a bubble in stocks. The ECB is causing a bubble in bonds. The responses ran the gamut and pretty much aligned one-for-one with the political predilictions of the commentators. But perhaps some of the most confused people in the room were economists themselves. When the story hit the newswires, all the reporters called up their economist sources to give them one liners they could quote. There was lots of quotes about liquidity, money creation, and interest rates. But most of it was muddled and simply decreased the signal to noise ratio. The purpose of this essay to speak with authority and clarity on how QE actually affects the real economy.
QE Shifts Portfolio Preferences and Investment Behavior
People seems to have an infatuation with incomprehensibly large numbers so its not surprising that news sources like to use them a lot in headlines. The number 60 billion and 1.1 trillion littered the front pages of the financial press this morning. No doubt, editors secretly hoped that readers would see the headlines, imagine 1.1 trillion euros being pumped into the financial sector, and wonder how they could get a piece of the action. Sadly, this is not remotely close to how QE works. In fact, the ECB is not pumping any 'money' per se into the financial sector at all. Rather, it removing certain assets from the market place in an attempt to shift portfolio preferences. The idea is actually very simple. When the ECB (or the Fed or the Bank of Japan) purchases government bonds, it removes interest bearing assets from the market. This reduction in supply raises the price of bonds because investors are now forced to compete over fewer outlets to earn interest. The result is higher bond prices and lower yields. Inevitably, some investors who were satisfied earning some rate of interest which was available to them before QE happened are now disatisfied with current yields, and thus shift into riskier assets such as stocks or lower grade bonds. With more investors fighting over the same number of stocks, stock prices rise. The same is true for corporate debt all the way down the credit quality spectrum. Therefore, by lowering government bond yields, the central bank is able to affect the kind of investments that get made. Investments in riskier assets is stimulative to the real economy via a variety of factors. Namely, firms are now able to issue debt more cheaply, which makes expanding operations more attractive. The required returns for capital investments is now lower as well. For example, say a widget company is thinking about building a new factory and reckons it will earn a 10 percent return on its investment. If government bonds are yielding 10 percent risk free, you can bet the corporate treasurer of the widget company will advocate that the firm simply invest its retained earnings in government bonds. But if the government could lower the yield on its debt to say 4 percent, that factory may well get built, and thousands of jobs could be created. Some have also speculated that there is a 'wealth effect' whereby higher securities prices stimulate the consumption of other investors because they 'feel' richer.
QE is not about Liquidity
But wait a minute, don't interest rates fall beacuse the banks are now awash in 'free' money? No. TThe reserves created by QE are not an important part of the transmission mechanism. The banks are not able to lend more than they could before QE. This is because QE typically, though not necessarily, occurs when the short term interest rates are already at zero. The policy rate, or short rate, through which most modern central banks traditionally implement monetary policy is the effective price of reserves that banks must pay to meet the reserve requirement. And the central bank can only credibly implement monetary policy if it stands ready and willing to supply these reserves at the stipulated price. The cost of meeting this reserve requirment is the true constraint on bank lending. Bank credit is thus constrained by the price of reserves, not the quantity of reserves.
The failure of QE to spark a credit explosion in the United States should thus ultimately be the deathknell for the so called money multiplier model of money creation, as well as the so called loanable funds market. On loanable funds, reserves can never be 'used up' because banks lend by crediting the checking accounts of borrowers. When the newly created checking deposits are spent by the borrower, reserves are transferred from the borrower's bank account to the bank account of whoever the borrower purchased goods or services from. The total amount of reserves held by the banking sector is unchanged. The bank of the payee now invests those reserves at the policy rate. There is no limit to the number of time these reserves can be lent and re-lent. The so called 'loanable funds market' does not exist.
But what about the reserve requirment everybody learns about in Econ 101? Actually, most advanced economies have no practical reserve requirment. The US technically has a 10 percent reserve requirement, but that only needs to be met during the so called 'reserve matenence period,' which consists of a day or two every three weeks. The effective reserve requirment in the United States is really only 2 percent. Canada, Austrailia and New Zealand have formally abolished their reserve requirements. But even under a reserve requirement, banks can never 'use up' the reserves of the banking system. This is beacuse in modern times, the central bank is the sole issuer of bank reserves and can create them at will. Thus if lending ever picks up and the demand for reserves increases, again solely to meet a statutory reserve requirement, the central bank simply issues more reserves such that the price of reserves remains constant. In essence, the central bank allows the quantity of reserves to float, and fixes the price. Thus, even under a reserve requirement, the quantity of reserves is never a constraint on bank credit. The constraint is the price of reserves. Banks must find willing, credit worthy customers who will take loans at a high enough interest rate to cover the costs of meeting the reserve requirement. Reserves are thus analogs to tradeable pollution permits. There have value and a price only because they are required by the government to be obtained in order to engage in some economic activity.
The quantity of reserves in the banking system is irrelavent, but it is especially irelavent when the price of reserves is zero. Reserves are only necessary for meeting the imposed reserve requirement. Returning to the tradeable pollution permti analogy, suppose for second a cap and trade system was fully implemented in the United States and that carbon emission permits traded on open exchanges. Now consider the economic implications of a price of zero for emission permits. This would entail that all emittors already held the necessary permits to perform their economic activity of choice, and that there was no bidder for the permits, eg, no one new wanted to engage in economic activity which required carbon emssion. Now, say the economy is deeply depressed, and the government actually wants to encourage economic activity which results in carbon emission (Eg,factories, taxi cab fleets, ect.) Would issuing more permits result in more emissions? No. Again, even at a price of zero, nobody wants to emit more. Thus, the extra permits will simply go unused, sitting idle and in excess. A similar situation has been going on in the banking sectors of countries where QE has been implemented. The price of reserves was already zero. Thus, the demand for reserves was already met, and no bidder existed for reserves. Therefore, creating more reserves has no effect on credit creation. Banks could obtain reserves at a price of zero before QE, and can obtain reserves at zero after QE. QE created more reserves, but the banks are price constrained, not reserve constrained.
QE is never inflationary
Perhaps never is too strong a word. But nonetheless, QE is very unlikely to ever be inflationary. Again, we all learn PQ=MV in Economics 101. That is, the price level times the quantity of goods produced is equal to the money supply time velocity of money. The obsession of human beings with big numbers is rearing its ugly head again. Surely massive injections of reserves must lead to hyper-inflation. However, as we have discussed at length, the banks are not able to do anything after QE they could not do before QE.
Outside risks to inflation do exist if the private sector responds strongly to lower interest rates and the credit cycle quickly restarts. But recent experience has shown us that this is unlikely in a depressed economy. In the United States, bank lending did not begin to grow again until 2014, nearly six years after QE started and ironically the same year it ended. QE it seems does not lead to credit creation precisely because the quantity of reserves is not a constraint on the banking system.
A major source of the confusion is that before modern central banking, the quantity of reserves was a constraint on the banks. Under the gold standard, banks held reserves of gold against their note issues and created loans by printing notes and giving them to the borrower. (In an analogous fashion by which modern banks simply credit the checking accounts of borrowers, essentially issuing 'bank money' or M1) Since notes were backed by some fractional reserve of gold, gold reserves did act as a real constraint on credit creation. Thus, when credit was tight in the United Kingdom, the Bank of England would ironically raise the rate of interest paid on gold. This would attract gold from abroad, which would allow the banks to issue more notes and thus fund more loans. In contrast to today, central banks supply reserves at will, on demand, and at a stipulated price. Thus, the quantity of reserves is again never at issue, especially when the price of reserves is zero.
QE does not entail ZIRP
Mario Draghi was one for two at his press conference when talking about the transmission mechanism by which QE affects the real economy. He touched on the portfolio balance channel, but also mentioned the mysterious signalling channel by which QE reassures the banks that interest rates will remain at super low level for a long time, thus reducing the interest rate risk born by the banks. While any central bank is certainly free to pledge to keep rates low forever, QE does not tie the hands of central bankers when it comes to short term interest rates. This is because most central banks have the authority to pay interest on reserves. Therefore, nothing stops the Fed, the ECB, or the Bank of Japan, from simply buying up tons of long term assets financed with reserve creation, and then simply setting a price floor on reserves by paying interst on them. The result would be a flatter yield curve. The supply of long term assets would fall, reducing long term bond yields. At the same time, the short rate would stay constant because of rate of interest paid on reserves kept at the central bank.
A flatter yield curve may be a legitimate policy goal. In the 1960s, the monetary autorities in the United States wanted to increase short term interest rates but lower long term rates. The government had dual objectives. It wanted to raise short term interest rates to support the dollar, which had come under pressure because of the US balance of payments deficit. But it also wanted to stimulate long term investment. Thus, the US Treasury hatched a plan whereby it would issue more short term Treasury bills and fewer long term Treasury bonds. The result was an increase in short rates by about 10 basis points, but a sharp reduction in very long term rates (30 year) by about 47 basis points. As discussed in the previous post, funding the government with more bills and fewer bonds is the economic equivalent of QE. This early monetary experiment shows that QE does not entail ZIRP. In fact, QE even allows for an increase in short term interest rates!
Conclusion
We have explored QE and its various flavors in the context of the modern monetary system. I have shown that QE acts via a portfolio balance channel. I have also demonstrated that it does not increase liquidity in the financial sector nor does it represent 'free money' for the banks. I discussed why QE is very unlikely to be inflationary, though it is not impossible for QE to cause inflation. Finally, I used a historical example to show why QE does not entail a zero interest rate at the short end of the term structure.
In sum, the implementation of QE around the world has generated much hype, hysteria, and conspriracy theories and confuses even seasoned economists. While I cringe every time I hear an economist talk about how QE is important because it 'expands the money supply' I hope this essay will serve as useful guide to both expert and layman alike when they try to wrap their heads around the opaque world of unconventional monetary policy.
Thursday, January 22, 2015
Sunday, January 18, 2015
Commentary: Falling US Yields Do Not Portend Disaster
In 2014, the biggest economic story was the dramatic collapse of oil prices. But perhaps more surprising to both economists and bond traders has been the dramatic fall in US yields despite clear signaling from the Fed that rate hikes are coming in 2015. However, cutting edge research from the Bank for International Settlements suggests that the drop in long term yields in the US, and also notably in Australia and New Zealand is not a mystery at all. On the face of it, this research is simple in premise. Just like any other security or commodity, the price of long term assets (and thus yields) are driven by supply and demand, not a "stacking up" of shorter term interest rates. Thus, the dramatic fall in the supply of long term assets relative to demand, in most cases due to large scale asset purchases by central banks, explains the fall in yields even in the face of rising short rates.
Bernanke’s “Global Savings Glut”
In 2005, the future Fed Chairman Bernanke delivered highly influential lecture on bond yields which sought to explain the so-called “Greenspan Conundrum” whereby aggressive hikes in the Fed Funds Rate beginning in 2004 failed to increase long term bond yields (or mortgage rates). Bernanke believe that a global glut of dollar reserves from abroad, mainly the result of large US current account deficits, were being recycled back to the US as foreign investors piled into US Treasuries and Agency debt. While Bernanke made many insightful observations about why high savings rates abroad might contribute to low long term interest rates, he completely ignored the supply side of the equation. A glut of savers could equally be seen as a dearth of borrowers and/or long dated assets. A key factor missed by both the Treasury and the Federal Reserve was that the supply on long term investment outlets was falling rapidly, and this was the direct result of government policy. Beginning in 2002, the US Treasury department radically shifted course by issuing a large number of short term bills relative to longer term bonds. In 2006, right before the yield curve inverted, the average weighted maturity on US Treasury securities held by the public stood at a historic low of 43 months. The net supply of new long term Treasury bonds being supplied to the market was falling, and falling fast.
Fundamentally, what Bernanke failed to grasp was that there is and will always be a strong demand for long dated Treasury securities. Regulatory and institutional features are the main drivers of this highly price inelastic demand. In general, banks are required to hold zero capital against US Treasuries because they are correctly judged as risk free. Insurance companies, which have many long term liabilities and thus match them with long term assets, are required to hold large percentages of their portfolios’ in government bonds. Liquidity requirements also play a role. Large financial institutions are required to hold a certain amount of highly liquid assets, and the most liquid bond on the planet is the US Treasury.
Supply Effects Persist
Later, Dr. Bernanke would become Fed Chairman, and would exploit supply effects in the Treasury and Agency MBS markets to push down long term interest rates. The reserve creation brought on by the various rounds of QE was meaningless because the price of reserves was already zero. In contrast, QE removed long dated assets from the private marketplace. This is the economic equivalent of the Treasury funding itself with more bills rather than bonds. In sum, QE caused investors already starved for yield to compete for even fewer Treasury bonds, which bid down yields even further.
Something else happened in 2009. The deficit exploded because of collapsing tax receipts, and the US Treasury faced a humongous financing task. However, in what now is recognized to be a highly unproductive course, the Treasury decided to finance the deficit with mostly long term bonds rather than bills. This may or may not have been consistent with the Treasury’s mandate to achieve the lowest possible borrowing costs for the taxpayer. (A mandate that should be reconsidered) But there is no doubt that it was highly disruptive to the implementation of monetary policy. Just as the Fed’s was desperately trying to remove long dated assets from the market, the Treasury was boosting the supply of them. 2010 minutes of the Treasury Borrowing Advisory Committee reveal that the Treasury is loathe to acknowledge Fed actions when making borrowing decisions, viewing that as nothing more than another “large investor.” Strikingly, the supply effect was also noted yet dismissed,
At this point, a member asked about the impact of the Fed's potential quantitative easing (QE2), expected to be announced at the November 2010 FOMC meeting. The question arose regarding whether the Fed and the Treasury were working at cross purposes, given that Treasury is extending the average maturity of the portfolio while the Fed is expected to purchase longer-dated securities. The member noted that from an economic perspective, the Fed's purchase of longer-dated coupons via increasing reserves was economically equivalent to Treasury reducing longer-dated coupons and issuing more bills.
The same minutes even openly acknowledged that the Fed and Treasury are “independent institutions whose objectives may at times appear to come into conflict.” The Treasury's insistence on changing its funding strategy even when it disrupted the implementation of monetary policy calls for a re-examination of the Fed-Treasury relationship. Specifically, two institutions control the aggregate supply of US Treasuries, the Fed and the Treasury itself. And, if the supply of US Treasuries is major determinant of long term interest rates and thus a monetary policy variable, coordination, not independence or mutual ambivalence, is required to implement policy objectives.
Today's Environment
In October 2014, Fed purchases of Treasury bonds finally ended, but Treasury rates have kept falling. However, yet again a simple supply story can explain this drop. Indeed, in 2010 when the deficit peaked at 10 percent of GDP, net issuance of long term Treasuries topped out 1.2 trillion dollars. Net issuance in 2013 of Treasury notes was 644 billion dollars, while in 2014 this figure fell to 576 billion dollars, a drop of 70 billion. This dramatic reduction in net issuance is exclusively the result in the shrinking deficit, itself a product of the improving economy. Therefore, the Treasury began supplying less long dated Treasuries to the market precisely as the Fed has phased out its purchases of Treasury assets. The net economic result is that the private market is being supplid with less Treasuries, which causes the prices of these very securities to be bid up.
The fall in Treasury yields is not the bond market's way of pricing in disaster. Rather, it is simply a reflection of the sharp reduction in the supply of new Treasuries over the past few years. Should the Fed move to raise rates on the short end of the curve, the result will be a flattening of the term structure, not a parallel shift in long term rates. In fact, we already have a test case for this. The Reserve Bank of New Zealand hiked the overnight rate by 150 basis points in 2014, while at the same time public debt in New Zealand is very low. This created a scarcity of long dated NZD denominated assets, which many investors are required to hold for regulatory reasons. The result has been (unsurprisingly) an inversion of the NZD yield curve. Fixed income investors can rest easy. A shrinking deficit all but ensures a greater scarcity of Treasury notes and bonds. Flatter yield curve here we come.
Bernanke’s “Global Savings Glut”
In 2005, the future Fed Chairman Bernanke delivered highly influential lecture on bond yields which sought to explain the so-called “Greenspan Conundrum” whereby aggressive hikes in the Fed Funds Rate beginning in 2004 failed to increase long term bond yields (or mortgage rates). Bernanke believe that a global glut of dollar reserves from abroad, mainly the result of large US current account deficits, were being recycled back to the US as foreign investors piled into US Treasuries and Agency debt. While Bernanke made many insightful observations about why high savings rates abroad might contribute to low long term interest rates, he completely ignored the supply side of the equation. A glut of savers could equally be seen as a dearth of borrowers and/or long dated assets. A key factor missed by both the Treasury and the Federal Reserve was that the supply on long term investment outlets was falling rapidly, and this was the direct result of government policy. Beginning in 2002, the US Treasury department radically shifted course by issuing a large number of short term bills relative to longer term bonds. In 2006, right before the yield curve inverted, the average weighted maturity on US Treasury securities held by the public stood at a historic low of 43 months. The net supply of new long term Treasury bonds being supplied to the market was falling, and falling fast.
Fundamentally, what Bernanke failed to grasp was that there is and will always be a strong demand for long dated Treasury securities. Regulatory and institutional features are the main drivers of this highly price inelastic demand. In general, banks are required to hold zero capital against US Treasuries because they are correctly judged as risk free. Insurance companies, which have many long term liabilities and thus match them with long term assets, are required to hold large percentages of their portfolios’ in government bonds. Liquidity requirements also play a role. Large financial institutions are required to hold a certain amount of highly liquid assets, and the most liquid bond on the planet is the US Treasury.
Supply Effects Persist
Later, Dr. Bernanke would become Fed Chairman, and would exploit supply effects in the Treasury and Agency MBS markets to push down long term interest rates. The reserve creation brought on by the various rounds of QE was meaningless because the price of reserves was already zero. In contrast, QE removed long dated assets from the private marketplace. This is the economic equivalent of the Treasury funding itself with more bills rather than bonds. In sum, QE caused investors already starved for yield to compete for even fewer Treasury bonds, which bid down yields even further.
Something else happened in 2009. The deficit exploded because of collapsing tax receipts, and the US Treasury faced a humongous financing task. However, in what now is recognized to be a highly unproductive course, the Treasury decided to finance the deficit with mostly long term bonds rather than bills. This may or may not have been consistent with the Treasury’s mandate to achieve the lowest possible borrowing costs for the taxpayer. (A mandate that should be reconsidered) But there is no doubt that it was highly disruptive to the implementation of monetary policy. Just as the Fed’s was desperately trying to remove long dated assets from the market, the Treasury was boosting the supply of them. 2010 minutes of the Treasury Borrowing Advisory Committee reveal that the Treasury is loathe to acknowledge Fed actions when making borrowing decisions, viewing that as nothing more than another “large investor.” Strikingly, the supply effect was also noted yet dismissed,
At this point, a member asked about the impact of the Fed's potential quantitative easing (QE2), expected to be announced at the November 2010 FOMC meeting. The question arose regarding whether the Fed and the Treasury were working at cross purposes, given that Treasury is extending the average maturity of the portfolio while the Fed is expected to purchase longer-dated securities. The member noted that from an economic perspective, the Fed's purchase of longer-dated coupons via increasing reserves was economically equivalent to Treasury reducing longer-dated coupons and issuing more bills.
The same minutes even openly acknowledged that the Fed and Treasury are “independent institutions whose objectives may at times appear to come into conflict.” The Treasury's insistence on changing its funding strategy even when it disrupted the implementation of monetary policy calls for a re-examination of the Fed-Treasury relationship. Specifically, two institutions control the aggregate supply of US Treasuries, the Fed and the Treasury itself. And, if the supply of US Treasuries is major determinant of long term interest rates and thus a monetary policy variable, coordination, not independence or mutual ambivalence, is required to implement policy objectives.
Today's Environment
In October 2014, Fed purchases of Treasury bonds finally ended, but Treasury rates have kept falling. However, yet again a simple supply story can explain this drop. Indeed, in 2010 when the deficit peaked at 10 percent of GDP, net issuance of long term Treasuries topped out 1.2 trillion dollars. Net issuance in 2013 of Treasury notes was 644 billion dollars, while in 2014 this figure fell to 576 billion dollars, a drop of 70 billion. This dramatic reduction in net issuance is exclusively the result in the shrinking deficit, itself a product of the improving economy. Therefore, the Treasury began supplying less long dated Treasuries to the market precisely as the Fed has phased out its purchases of Treasury assets. The net economic result is that the private market is being supplid with less Treasuries, which causes the prices of these very securities to be bid up.
The fall in Treasury yields is not the bond market's way of pricing in disaster. Rather, it is simply a reflection of the sharp reduction in the supply of new Treasuries over the past few years. Should the Fed move to raise rates on the short end of the curve, the result will be a flattening of the term structure, not a parallel shift in long term rates. In fact, we already have a test case for this. The Reserve Bank of New Zealand hiked the overnight rate by 150 basis points in 2014, while at the same time public debt in New Zealand is very low. This created a scarcity of long dated NZD denominated assets, which many investors are required to hold for regulatory reasons. The result has been (unsurprisingly) an inversion of the NZD yield curve. Fixed income investors can rest easy. A shrinking deficit all but ensures a greater scarcity of Treasury notes and bonds. Flatter yield curve here we come.
Subscribe to:
Posts (Atom)