The Real Bills Doctrine

by: economist88

In the October 2013 FOMC Minutes there was an idea proposed to establish a facility to conduct unlimited open market operations. By having a standing purchase program of short-term Treasury notes, it would be a quantitative way to influence the expected path of short-term interest rates. Fed Chairman Bernanke mentioned this mechanism in his 2002 speech. At that time he proposed an interest rate ceiling by committing to unlimited purchases of 2-year or shorter Treasuries. The Minutes expressed reluctance to deploy such a tool. However the fact that it was discussed and several participants felt it was worthwhile to study, implies there is a serious consideration among FOMC members for such a facility. A tool like that could perhaps be used in a scenario when the US falls into a higher risk of deflation.

Exchanging money for short-term notes is what has been known as the 'Real Bills doctrine'. The original version of the doctrine (late 1800s) was the opposite of what is today known as the fiat currency system. The doctrine says when banks issue money backed by good collateral, inflation would not necessarily ensue. As long as the bills collateral was 'good security' (and at not more than 60-days maturity), there would be infinite capacity for money creation. Economists like Thomas Sargent disputed the real bills doctrine. In his view when government debt reaches a limit, the Federal Reserve would have no choice but to fully monetize all outstanding government liabilities. The exchange of money would be for 'bad' collateral when debt hits a limit. In that case the price of the collateral would fall. A short-term bond would turn inflationary as the excess money finds its way outside the system.

Thus far quantitative easing has not led to higher inflation-judged by the average 1.4% core PCE since 2009. Instead, the excess reserves remain stuck in "Yucca Mountain". Some argue this has been the problem. The reserves enticed consumption to be brought forward but because aggregate demand was not strong enough, real investment spending did not gather momentum. As a result the economy remains sluggish, which lead to a combination of low inflation and high asset prices. Rather than having an effect on the economy, quantitative easing reduced the term premium in bonds. In combination with central bank communication methods like forward guidance, expected short-term rates were lowered. There is distinction to be made what has an effect on what. The term premium affects investor behavior that seek returns further out on the yield curve. Influencing expected short maturity interest rates can have a greater impact on the real economy however. Fed research by Kiley (2012) for example provides evidence that a change in expected short-term rates entices short-term borrowing.

There is a view that quantitative easing policy should further distance term premium from expected short-term rates. Bernanke was specific on this point in a speech last November whereby he highlighted the Federal Reserve can significantly 'shape' expectations by providing more transparency on monetary policy objectives and plans to attain those objectives. The idea that quantitative easing may morph into a modern version of the Real Bills doctrine may not be that unrealistic. This doctrine could be an unlimited purchase program of 0-2yr notes while providing a floor on interest on excess reserves through the reverse repo facility. This could impact the shape of the yield curve materially by becoming steeper than what was the historically the norm.

The term premium is not a known variable to investors when they choose to hold long-maturity bonds instead of rolling over a strip of short-term securities. FOMC member Stein has argued that a steep yield curve is a tool that can mitigate financial stability risks. By communicating a slowdown in asset purchases the term premium adjusts which provides a disincentive to investors to take on more leverage. At the same time, forward guidance is becoming a stronger promise each time asset purchases are slowed down. It would create a trade-off between rolling short-term borrowing and investing. The October FOMC Minutes may set in motion a process where markets will face a short-term interest rate that is influenced differently than in the past. This different rate determined by market forces rather than policy would be the start of a careful exit of the extraordinary monetary policy from the last 5-years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here