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Monday, September 24, 2012

Fed Watch: Gramm and Taylor Don't Get It

Tim Duy:

Gramm and Taylor Don't Get It, by Tim Duy: As a general rule, I stay clear of the Wall Street Journal editorial pages. I'll be honest - I just don't have the emotional energy for it anymore. But Brad DeLong forced it on all of us this weekend, drawing attention to another anti-QE article, this time penned by Phil Gramm and John Taylor.

DeLong gets to the heart of the problem. Gramm and Taylor don't seem to realize that the stock of Treasuries is the same regardless of who owns them. What GT see as higher future interest rates would simply be higher current interest rates if the Fed was not temporarily substituting some cash for bonds. DeLong summarizes:

So why are Taylor and Gramm arguing that returning interest rates in 2016 and after to what they would have been anyway is a cost to QE III? It's a zero. It's not a change. It simply does not compute.

Yet there is still room to build upon DeLong's critique. GT get off to a bad start:

That kind of monetary expansion would normally be a harbinger of inflation. However, with banks holding excess reserves rather than lending them out—and with velocity (the rate at which money turns over generating national income) at a 50-year low and falling—the inflation rate has stayed close to the Fed's 2% target..

While the Fed considered its previous rounds of easing—QE1, QE2 and Operation Twist—the argument was consistently made that the cost of such actions was low because inflation was nowhere on the horizon. The same argument is now being made as the central bank contemplates QE3 during the Federal Open Market Committee meetings on Wednesday and Thursday.

Inflation is not, however, the only cost of these unconventional monetary interventions.

Notice that they admit that inflation has remained under control, yet then proceed to claim that inflation is a cost of QE. How can inflation be both under control and a cost? It can't, of course; GT just can't admit that inflation is not a problem even after actually admitted that fact. GT continue:

As investors try to predict the timing and effect of Fed policy on financial markets and the economy, monetary policy adds to the climate of economic uncertainty and stasis already caused by current fiscal policy.

QE3 actually reduces the uncertainty about monetary policy. Rather than defining QE by arbitrary amounts and end dates, we now have a steady flow of QE tied only to improving economics conditions in the context of price stability. No more uncertainty that the Fed will pull policy support regardless of the state of the economy. More:

Since September 2008, the Fed has acquired $1.16 trillion of government securities—in fiscal year 2011 (Oct. 1, 2010-Sept. 30, 2011), the central bank bought 77% of all the additional debt issued by the Treasury. Aside from the monetary impact of these debt purchases, the Fed allowed the federal government to borrow a trillion dollars without raising the external debt of the Treasury and without having to pay net interest on that portion of the debt, since the central bank rebated the interest payments to the Treasury.

So GT do not consider the Treasury debt held by the Fed as real debt because...why? Apparently because all of the Fed's profit need to be returned to the Treasury at the end of the year. That doesn't mean it isn't real debt, issued to cover deficit spending and issued without the expectation of outright monetiziation. Moreover, private investors see the Fed's holdings as part of the aggregate Treasury debt and will set their price expectations accordingly. GT continue:

When the Fed must, in Chairman Ben Bernanke's words, begin "removing liquidity," by selling bonds, the external debt of the federal government will rise and the Treasury will then have to pay interest on that debt to the public. Selling a trillion dollars of Treasury bonds on the market—at the same time the government is running trillion-dollar annual deficits—will drive up interest rates, crowd out private-sector borrowers and impede the recovery.

This just makes my head hurt. If the Fed needs to sell their portfolio into the market, this will be because interest rates are already rising. Let's take this slowly: Currently, interest rates are at very low levels. If the economy improves, there will be upward pressure on interest rates. Yes, interest rates will rise, and supposedly "impede the recovery." Yes, this will have an impact on growth, but that is exactly what you might expect if the LM curve slopes upward (if the IS curve increases, both output and interest rates rise). And yes, the Fed will likely follow rising long term interest rates by reversing the current situation.

This should be absolutely, 100%, not a controversial subject because, surprise, surprise, the Fed reverses their policy stance in every expansion. That is a feature of monetary policy, not a defect.

Moreover, assuming the economy is operating near potential, the Fed would not be crowding out the private sector; they would only be controlling inflation. Only the fiscal authority can crowd out the private sector by not engaging in counter-cyclical policy. And if the fiscal authority does indeed not control deficit spending as needed, it would be the Fed's job to compensate to the best of their abilities.

GT continue:

In addition, Operation Twist, by shortening the average maturity date of externally held debt, will require the Treasury to borrow more money sooner when the economy recovers and interest rates start to rise. This too will drive up interest costs and the deficit.

The issue here, I think, is that the Fed is swapping out short-dated assets that they normally would have rolled over when the assets matured (assuming they wanted to hold the balance sheet constant). Thus, the Treasury needs to increase its debt issuance to the public compensate in the near term. But guess what? First, if the Fed didn't hold the debt in the first place, then the public would hold the debt with the same consequences for the Treasury at maturation. Second, the US Treasury is wisely extending the maturity of its debt; see Jim Hamilton here. Extending the maturity will help reduce the pressure to refinance short term debt and lock in low longer term interest rates. Moreover, the Treasury has time time to implement these changes; interest rates are not skyrocketing overnight.

GT make similar errors with mortgage rates:

The same problems will occur as the Fed begins to sell its holdings of mortgage-backed securities to reduce the monetary base. When the Fed bought these securities, it may have marginally reduced mortgage interest rates. Selling them during a real recovery will likely cause mortgage rates to rise.

Yes, once again in a real recovery mortgage rates will rise. Just as in the past. And guess what happens if they don't rise - then you might in fact get that inflation the authors so fear. Again, rising rates are a feature, not a defect. GT, inexplicably, continue:

Proponents of QE3 argue that while the Fed's balance sheet must be reduced at some future time, it has the tools to minimize the impact on interest rates by slowing down the pace of the sales. But the Fed's ability to act has already been compromised by its pledge to maintain low interest rates through 2014. Having to time open-market sales to minimize interest-rate increases will further limit the Fed's ability to preserve price stability.

Once again, with emphasis, it is not a commitment. Believe me, many of us would like to see a commitment to be irresponsible. This isn't it. It is a conditional forecast; if economic activity exceeds current projections, the Fed will tighten policy sooner than currently anticipated. Finally:

The Fed could raise the interest rate that it pays banks on reserves they hold in lieu of reducing its balance sheet. Where would the money come from? It has to come out of the money the Fed is currently paying the Treasury, driving up the federal budget deficit. How will taxpayers feel about subsidizing banks not to lend them money?

Yes, the profits from monetary policy accrue to the US Treasury. Yes, profits are currently unusually high. Yes, if interest rates, and along with them policy, normalizes, then those profits will fall. Will this drive up the budget deficit? Consider the bigger picture. If the economy is accelerates such that there is upward pressure on interest rates, then the deficit will be eased by the activation of automatic spending and revenue stabilizers. In other words, we will have a choice - the Fed can hold the economy down now by withdrawing monetary stimulus, which will in turn widen the deficit, or foster stronger activity which will lower the deficit in the future. The Fed's profits are of third or fourth or fifth order importance in this process.

Bottom Line: If the US economy was not operating at the zero bound, the Federal Reserve would react to improving economic conditions and tighten policy by selling Treasury securities in the process of targeting a higher Federal Funds rates. John Taylor should know this. Now, with quantitative easing, if economic conditions improve, the Fed will tighten policy by...yes, the same thing, selling Treasury securities. In either case, the Fed will only do this if interest rates are already responding to stronger activity. In this light, the Fed isn't really doing anything new. I don't think you should fear the Fed having to withdraw the stimulus. Indeed, I think you should really fear the opposite - that the economy does not lift off the zero bound before the next recession hits. If that happens, we will all be wishing the Fed had done more, and sooner.

    Posted by on Monday, September 24, 2012 at 12:15 AM in Economics, Fed Watch, Monetary Policy | Permalink  Comments (32)


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