Does The Fed Believe In Fiscal Fairy Dust?

by: Scott Sumner

Some posts almost write themselves. A number of commenters sent me a WSJ story by Jon Hilsenrath, which is worth a half dozen posts:

Federal Reserve officials are considering a new type of bond-buying program designed to subdue worries about future inflation if they decide to take new steps to boost the economy in the months ahead.

Under the new approach, the Fed would print new money to buy long-term mortgage or Treasury bonds but effectively tie up that money by borrowing it back for short periods at low rates. The aim of such an approach would be to relieve anxieties that money printing could fuel inflation later, a fear widely expressed by critics of the Fed’s previous efforts to aid the recovery.

This reminds me of the “magical AD” theory that you see kicked around so much in popular discussion. It works this way:

  1. Monetary stimulus creates inflation, and hence is bad.
  2. Fiscal austerity reduces real growth, and hence is bad.

You see these ideas discussed quite frequently in the British press. In theory, both monetary and fiscal stimulus directly impact AD, and the effects on prices and output depend on the slope of the short run aggregate supply curve. But the “magical theory” of AD says that demand-side policymakers can get whatever P/Y split they prefer, by using a special “magic dust” which they sprinkle over the economy. Then when the Fed buys long term bonds to reduce interest rates and boost growth, the magic dust prevents any inflationary impact.

You might wonder how this magic dust is supposed to work:

The Fed’s approach to a bond buying program matters a lot to many investors. More money printing could push commodities and stock prices higher, or send the dollar lower, if it sparks a perception among investors that inflation is moving higher, said Michael Feroli, an economist with J.P Morgan Chase. However, if the Fed chooses a course aimed at restraining inflation expectations, the impact on those markets might be more muted.

Fed officials have used different types of bond-buying programs since 2008. In each case the aim has been to drive down long-term interest rates to spur investment and spending by businesses and households. In case they decide to act again, they’re exploring three different approaches, according to people familiar with the matter. Those approaches are:

First, they could use the method they used aggressively from 2008 into 2011, in which the Fed effectively printed money and used it to purchase Treasury securities and mortgage debt. The Fed has already acquired more than $2.3 trillion of securities in several rounds of purchases using this approach, widely known as “quantitative easing,” or QE.

Second, the Fed could reprise a program launched last year in which it is selling short-term Treasury securities and using the proceeds to buy long-term bonds. This $400 billion program, known as “Operation Twist,” allows the Fed to buy bonds without creating new money.

Third, in the new novel approach, the Fed could print money to buy long-term bonds, but restrict how investors and banks use that money by employing new market tools they have designed to better manage cash sloshing around in the financial system. This is known as “sterilized” QE.

The Fed’s objective under any of these programs would be to reduce the holdings of long-term securities in the hands of investors and banks. The Fed believes that reducing the amount of long-term bonds in the hands of investors drives down long-term interest rates, encourages more risk-taking, and thus spurs spending and investment by households and businesses.

The differences between the three approaches involve where the money comes from and where it ends up. The Fed hasn’t literally print more money, but it has electronically credited the accounts of banks and investors with new money when it purchased their bonds under quantitative easing. The Fed has pumped more than $1.6 trillion in new money into the financial system this way, and has also rejiggered it existing holdings, as part of its bond-buying efforts.

Many Fed officials believe strongly the bank reserves it has created as part of this money creation aren’t an inflation threat. But they are acutely aware of a popular perception, also held by a few inside the Fed itself, that the money the Fed has created could cause an inflation problem down the road. An approach that limits the amount of new money flowing into the system—through another Operation Twist or a sterilized operation—could help them manage that perception.

Where does one even begin? The Fed’s already been sterilizing 100% of all monetary injections since October 2008; sterilization is certainly not a new program. So what’s really going on here? Despite the mocking tone of this post the Fed isn’t stupid, so there must be an explanation. I’m not sure what the explanation is, but I’ll take a wild guess:

  1. There are two types of inflation expectations; those of the unwashed masses, and those held by sophisticated investors with lots of money on the line.
  2. The naive masses think there’s a direct correlation between the size of the monetary base and inflation. They also think inflation is bad, as they believe in the magical theory of AD. They believe some types of increased AD (produced by something like quotas on Chinese imports) create jobs, and other types (say printing money) create inflation. The Fed doesn’t want to frighten this group by doing something that would produce scary stories about “printing money.”
  3. The sophisticated observers understand what’s really going on. They understand that higher inflation expectations are good for the economy right now. And if they expect more inflation, it will drive up asset prices and trigger more AD, more growth.

In my view the real problem here is that the sophisticated investors are even smarter than the Fed. They don’t believe in magic dust, nor do they believe that lower long term nominal interest rates are an indication that higher inflation is on the way. They don’t buy into the Fed’s basically Keynesian worldview, and hence the policy is not likely to succeed unless . . . and this is where things get really tricky, unless it succeeds in convincing the sophisticated observers that the lower long term rates are a coded signal that the Fed intends to allow faster than expected growth in currency in circulation once we exit the zero rate bound.

In other words, Fed policy might “work” but for the wrong reason. How would we know it’s working? One sign is if they are not successful in reducing long term rates as much as they’d hoped.

I said there was enough here for a half dozen posts. Consider this:

Fed officials in New York and at the board in Washington are considering the costs and benefits of the different approaches. They have been pleased with the results of Operation Twist. But they would face some practical limits if they wanted to repeat it.

Louis Crandall, a money-market analyst with Wrightson ICAP LLC, estimates the Fed would have only about $200 billion of short-term securities left to work with in the second half of the year if it decides to repeat the Operation Twist program as currently designed. The current program ends June 30.

The third approach has some benefits the other options don’t have. Unlike Operation Twist, the size of the program wouldn’t be constrained by the Fed’s own holdings of short-term Treasurys. This approach would also give officials an opportunity to try out some of their new tools to see how they work on a large scale.

To a casual reader, this might sound like it’s a program to overcome the fact that the Fed is “out of ammunition.” In fact, just the opposite is true. This quotation refers to a low stock of government debt held by the Fed. However, being “out of ammunition” actually means there is a low stock of public debt not held by the Fed. This says the Fed has lots of unused ammunition, they simply don’t want to use it; they don’t want a larger monetary base.

Moreover, the program could be conducted with financial institutions other than banks, like money-market funds, increasing the Fed’s flexibility in managing reserves. The reverse-repo program was designed to include money-market funds and these institutions don’t participate directly with the Fed in other operations.

Yes! Can we please completely separate monetary policy from the banking system? I get tired of commenters trying to bait me into talking about the banking system, when in fact the banking system doesn’t actually play an important role in monetary policy. It’s all about currency in circulation. It would make more sense to treat those interest-bearing ERs as government debt, not “high powered money.” Money is only “high-powered” when it earns no interest. And sometimes (as in Japan prior to 2008 when they began IOR) not even then.

Here’s the conclusion:

Still there are potential drawbacks. Reverse repos could push short-term interest rates—now near zero—higher than the Fed wants them to go. Moreover, the Fed has described the reverse-repo program as a tool to use when it wants to tighten credit. Using it in combination with a bond-buying program meant to ease credit could “send a lot of conflicting signals” to the markets, Mr. Feroli said.

The Fed’s an expert on mixed messages. The most famous example occurred in October 2008, when they adopted an avowedly contractionary policy in the midst of the mother of all financial crises, and the biggest fall in NGDP since 1938. I am referring, of course, to the infamous interest on reserves program, their first attempt at sterilizing monetary injections. This recent proposal is merely some accounting trickery to make the base look smaller, there’s no meaningful difference between interest bearing ERs and these short term repos.

HT: Michael Darda, Clare Zempel, Tommy Dorsett, John Hall