A Few Things The Fed Has Done Right

by: John Cochrane

WSJ Oped, here.

As Federal Reserve officials lay the groundwork for raising interest rates, they are doing a few things right. They need a little cheering, and a bit more courage of their convictions ...

I like the large balance sheet and market interest on reserves. I just want them to be permanent, not additional tools for Fed discretionary policy.

I'll post the whole thing in 30 days.

The Oped builds on a new paper, Monetary Policy with Interest on Reserves, and on Toward a Run-Free Financial System. In the latter, I advance the idea that the Fed and Treasury should first offer interest-paying money, and then stamp out private substitutes, just as the US first offered banknotes and then stamped out run-prone substitutes in the 19th century. Interest on reserves, a big balance sheet, and opening reserves to all are a first step.

There are some big unknowns which I don't touch on in the Oped. (That's what the cryptic last paragraph refers to.) Will the Fed really be able to control interest rates just by raising the rate on reserves? And while also controlling the size of the balance sheet? Will interest rates thus controlled have the expected effect on the economy? The first paper spends a lot of time on the latter question.

It's not so obvious the Fed can control interest rates and the balance sheet. If the Fed said, tomorrow, interest rates shall be 5%, and started paying 5% on reserves, would Treasurys, mortgages, credit cards, bank deposits, etc. all really rise 5 percentage points instantly? If you pay your nanny $50 per hour, will all nannies suddenly get $50 per hour?

If the Fed said "5%, come and get it, give us your Treasurys and we will give you 5% reserves'' it would be clearer. But then the Fed would lose control of the balance sheet, and would likely expand -- a lot -- a reversal of the usual sign for a tightening.

Now, there is an arbitrage argument that the Fed can raise rates while keeping the balance sheet unchanged: Banks try to steal each others' depositors by offering more interest on deposits. Then Treasury holders try to hold bank deposits. I read the reverse repo program as a lack of faith that banks are anywhere near that competitive any more. In the reverse repo program, if a non-bank financial institution gets reserves, bank-held reserves and bank deposits have to go down dollar for dollar, a little noticed consequence and incentive to competitive behavior.

But then the question goes to another level. If Treasury rates rise 5%, and expected inflation doesn't jump 5% in neo-Fisherian delight, capital would flow in from abroad.

To see it more clearly, suppose the Treasury said "ok, the Fed wants rates to be 5%. So rather than auction debt, we'll set the price. 5%, how much do you want?'' The answer would be "a lot!'' But the end result is no different.

It's easy to set a price if you let quantities adjust. It's a lot harder if you also want to control the quantity.

My bet: The Fed will seem fine to be in control of loudly-telegraphed 0.25% bp rises, as open-mouth operations rather than actual open market operations seemed to provoke previous rate hikes. They will never try 5% overnight and we find out if they really control interest rates.