demand management and liquidity preferences*

A confederacy of dorks by Steve Randy Waldman

Krugman and I can enjoy an ecstatic “kumbaya” on both of his questions (no visuals please!), if he is willing to define as a liquidity trap any circumstance in which the central bank pays interest on reserves at a level greater than or equal to its target interest rate.

I don't have a firm grasp on the terms of the debate but do sort of get the gist of what they're discussing. As the quote shows, important concepts are IOR (interest rates on reserves held by the Fed), OMO (open market operations) and liquidity trap.

What also caught my eye was Izabella Kaminska's notion of multiple liquidity preferences and how it relates to how Alan Blinder said he changed his textbook to reflect the importance of multiple interest rates. During the crisis, private interest rates shot up as credit markets froze, while government set rates dropped. Kaminska:

In short, the problem wasn’t insufficient liquidity, per se. It was too much liquidity in some quarters and not enough in others. 

The challenge for the Fed was how to equalise the distribution of liquidity in the system, without putting further pressure on an already stressed-out repo market, on the verge of taking the “risk-free” funding rate negative. 

Offering interest on excess reserves was seen as an effective solution. Not only would IOER ensure that all banks holding excess liquidity could now benefit from a stable and positive rate — thus suspending the panicky capital destruction process — it would allow the Fed to continue adding liquidity until all shortfalls were covered, and more importantly all fear of potential shortfalls was removed from the market. 

In short, IOER was the key factor that compressed the spread between the risk-free and risky rate. But not because the risky rate was being suppressed. Rather, because the risk-free rate was being propped up with the IOER floor. 

Going back to Waldman’s argument, it’s at this point that “base money” became fully substitutable with short-term US debt. But, we would add, interest-bearing reserves even became preferable in some cases. 

Nevertheless, the entire debate really relates to liquidity preferences. 

The way we would put it is that IOER skewed the usual preferences in play. It’s the key reason why the proportion of reserves to currency in “base money” suddenly skyrocketed. The situation would undoubtedly reverse quickly if IOER was ever to drop to zero (or negative territory), since an opportunity cost would immediately be associated with holding reserves over zero-yielding currency. 

In fact, we would go one step further and argue that IOER was the key factor that stopped private rates turning negative, and in so doing suspended a process that could otherwise have led to a money market fund breaking the buck or even stacks of physical banknotes being hoarded and vaulted all over the United States. 

In this way, we agree with Waldman that the moment IOER created a preference for excess reserves over short-term debt assets or cash, was the moment excess reserves became a new type of safe asset security in their own right. 

Excess reserves became the equivalent of state debt. But, very importantly, a state debt taken with the intention of never being spent, but rather for the purpose of creating safe assets instead.

Also what struck me was the notion that the Fed might want to keep the reserves as a tool, even though the Fed seems to be saying they will exit when they can. In fact they keep prematurely talking about an exit.


I'm a bit at sea in this fascinating discussion since I don't have a firm grasp of the terms of debate and the mechanics under discussion. What stuck out for me was the notion that the Fed might keep hold of reserves. As I recall, they forced the banks to give them reserves in the midst of the panic to calm things down (even though, counterintuitively it was a tightening move, taking money from banks which could have been used to add credit to the economy.) And via the IOR, they recapitalized the banks, helped them deleverage, and restored confidence. A TARP supplement. This was Geithner's point about stablizing the financial system being a stimulus. Now the financial system is relatively stable, the economy is slowly growing and the banks are just sitting on the reserves, not lending them out when they can just earn the interest without risk. Meanwhile the Fed is doing QE, buying $85 billion in MBS assets until the unemployment rate drops some.

So the question is the exit when the economy starts growing, inflation is rising and the Fed wants to hit the brakes. It lowers the interest rates on reserves? What if the banks pull all their reserves?

The thing is the inflationistas keep predicting runaway inflation and it doesn't happen. The more mainstreamers keep prediciting a pick up in growth and it doesn't materialize. Goldman Sachs chief economist Jan Hatzius is predicting 2.5 percent growth in 2013H2 and 3 percent in 2014, so we'll see what happens.

Another point by Waldman:

When the Fed sets interest rates, it alters demand for money and government debt as a unified aggregate. What keeps the Fed special under a floor system is an institutional difference. The Fed issues the debt it calls “reserves” at rates fixed by fiat, while Treasury rates float at auction. The Fed leads, then Treasury rates follow by arbitrage. The Fed is powerful by virtue of how it prices its debt, not because it is uniquely the supplier of base money.

which is preceded by:

I agree full stop that “the Federal Reserve has great power over aggregate demand except when market interest rates are near zero”, even in a floor system. But, as Nick Rowe correctly points out, the source of this power is the Fed’s ability to affect demand for, rather than the supply of, money. And not just for money! 

which I don't undestand. Nick Rowe:

Even if the central bank kept the supply of base money constant, by printing more to offset what gets lost down the back of the sofa, waving the wand to increase the percentage from 1% to 2% would reduce the demand for base money and cause people to try to spend it before the sofa got it. Waving the wand would make base money a hot potato.

This seems to be the fundamental point, as Kaminska says:

But there are other problems associated with unwinding such a huge position on the market, too. Especially if you view this as tantamount to either “spending” the money borrowed, or paying it off. 

Consequently Waldman’s argument is essentially: why bother if you don’t have to? Let the excess reserves, just like state debt, roll on:

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*Update: Wow Waldman links to this post. Better clean up my thinking and grammar! Here's the link to my complete genealogy on the discussion of a possible paradigm shift.