Monetary policy

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We Should Stop asking the ECB to carry the Eurozone on its Shoulders. It is time to Introduce New Tools for Debt Management

Published by Anonymous (not verified) on Tue, 28/06/2022 - 10:22pm in

In the past couple of years I have had a hard time to feed this blog with original content. I have therefore decided that I will post the English translation of pieces that I write for other outlets; sometimes (always??) the translation will be rough I will start, today, with an article published in the Italian daily Domani on the ECB own impossible trinity (growth, supply-side inflation, spreads).

The last few weeks have shown beyond any doubt how complicated the task of central banks has become. In normal times, inflationary pressures go hand-in-hand with an overheating of the economy caused by increases in spending (public or private, it matters little); therefore, restrictive policy simultaneously achieves the result of keeping price increases in check and cooling demand. But we do not live in normal times. In a world of increasing geopolitical risks and supply-side shocks (the pandemics, the disruption of supply chains, structural change related to the ecological and digital transition), the two objectives of growth and inflation become contradictory: central banks are forced into complicated balancing acts to try to reduce an inflation they have few tools to control, without causing a collapse in consumption and investment that would send the economy into recession.
Even in the United States, where at least some of inflation is due to the overheating of the economy, it is difficult to understand the logic of the recent acceleration in tightening: the risk that the Fed’s moves will cause a recession in the coming quarters is real. In the Eurozone the demand push is less pronounced; in addition, the ECB’s task is further complicated by the coexistence of a single monetary policy with the nineteen fiscal policies of member countries, and the resulting risk of financial instability and segmentation of sovereign debt markets. Thus, not only must the ECB decide how far it is willing to take the risk of sending the economy into recession to try to keep inflation in check; it must also be prepared to manage the consequences its actions have on spreads.

Certainly, the turmoil of the past few weeks is due to less than flawless communication, which has given markets the feeling of an ECB uncertain about what to do. Moreover, it is frankly astounding to discover, when markets are already in panic mood, that the ECB is thinking about an anti-spread shield; the shield should have been ready months ago, to be deployed as soon as the announcement of a turn toward a restrictive stance had created tensions in the markets, which were widely predictable. However, mistakes and delays cannot hide the fundamental problem: the ECB is now asked to perform its classical tasks of closing the inflation and the output gap while ensuring the stability of financial markets, in the face of a fiscal policy that always does too little and too late. Even with firmer leadership and greater cohesion within the governing council, the ECB could not carry the entire weight of the Eurozone on its shoulders; especially in turbulent times such as we are currently experiencing. The erratic communication, the feeling that the ECB is perpetually behind the curve, then, cannot be attributed to the clumsiness of Christine Lagarde or to conflicts between hawks and doves; the ECB is probably being asked to do the impossible.

How do we get out of this? First, in the fight against inflation, monetary policy needs to be assisted by industrial policies that remove bottlenecks and release some of the supply constraints Second, the risk of segmentation of sovereign debt markets needs to be reduced. For this, the EMU should move forward decisively with the creation of a central fiscal capacity. Replacing part of the member states’ debt with common borrowing would not only stabilize financial markets with a safe asset, but also mechanically reduce the segmentation of sovereign bond markets.
However, the complete normalization of monetary policy could only take place with a solution that unburdens the ECB of the goal of keeping spreads under control. While the stated intention of creating an anti-spread tool is commendable, it will probably keep interfering with the classical tasks of central banks. One (only seemingly radical) way out is to establish a European Debt Agency (EDA). This agency would form a diaphragm between the member countries, to which it would offer perpetual loans, and the markets, from which it seek financing issuing Eurobonds. The EDA would protect member countries from the irrationality of markets while ensuring, through appropriate modulation of interest installments on loans over time, that national governments remain fully accountable for their fiscal behaviour: less virtuous countries (e.g., that fail to comply with fiscal rules) would be called upon to pay higher interest. The debt mutualization so feared by the so-called frugal countries would therefore be avoided. This is only a seemingly radical solution because in the recent past it has become customary for European institutions (the ESM, SURE, even Next Generation EU) to borrow at preferential rates and then transfer those rates to member states, effectively acting as guarantors and intermediaries. The European Debt Agency would take this mechanism to its extreme consequences.
The establishment of the European Debt Agency would create a single European sovereign debt market, mimicking the operation of a federal system. This on the one hand would provide the markets with a safe asset and, as in the United States, reduce the risk of speculative attacks to virtually zero. On the other hand, it would free monetary policy from the task of having to keep spreads down. The ECB would be free to set interest rates and decide of the size of its balance sheets with in mind only a central bank’s own goals of keeping inflation low and supporting growth. This seems the only structural way out of the present difficulties.

How Could Oil Price and Policy Rate Hikes Affect the Near-Term Inflation Outlook?

Published by Anonymous (not verified) on Fri, 24/06/2022 - 7:36am in

Since the start of the year, oil prices have risen sharply owing to worsening expectations regarding global oil supply. We’ve also had an acceleration of inflation in the United States and the euro area, as well as a sharp steepening of the expected paths of policy rates in both economies. These factors, combined with the potential for a slowdown in growth, have made the inflation outlook quite uncertain. In this post, we combine the demand and supply oil price decomposition from the New York Fed’s Oil Price Dynamics Report with yield curve data to quantify the likely path of inflation in the United States and the euro area over the next twelve months. Based on our analysis, we anticipate that inflation will likely remain elevated through the second quarter of 2023, despite payback for the inflationary impact of current negative oil supply shocks during the second half of 2022 and the disinflationary effects of tighter monetary policy.

Recent Oil Price Developments

The statistical model underlying the New York Fed’s Oil Price Dynamics Report examines correlations between weekly oil price changes and a broad array of financial and oil production-related variables by means of a limited number of common factors. These are then interpreted as related to anticipated developments affecting supply and demand in the global oil market. In the chart below, we plot the cumulative change of the Brent crude oil price since the start of 2022 up to June 10, which is the end of estimation samples used in our forecast models later. The chart also depicts the corresponding expected demand and anticipated supply components of Brent crude price changes from the oil price decomposition model. This year’s oil price increases have mostly resulted from a sharp deterioration of anticipated global oil supply. Upward price pressure from adverse oil supply shocks, especially after the Ukraine Invasion during the week ending February 25, have pushed Brent crude up by about 63 percent year to date. Deteriorating global demand expectations have partially checked the upward price pressure stemming from anticipated strain on supply, especially over the most recent weeks.

Anticipated Oil Supply Pressures Have Contributed the Most to Rising Oil Prices in Recent Months

Sources: Authors’ calculations; Haver Analytics; Thomson Reuters; Bloomberg.

Central Bank Policy Rate Expectations

Financial market pricing throughout this year has been driven in large part by shifting expectations about major central banks’ policy rate paths. To get quantitative measures of these shifting expectations, we can use information from government bond yield curves in the United States and the euro area. Engstrom and Sharpe (2018) show that in the United States, a certain near-term forward spread moves in line with survey-based measures of the expected fed funds rate path over the next five quarters. Their near-term forward spread is defined as the eighteen-month-ahead forward rate of the three-month Treasury bill rate minus the current three-month Treasury bill rate, thus measuring the expected change in the short-term interest rate over the next year and a half. The chart below depicts these near-term forward spreads for the United States  and the euro area since the start of the year, constructed using zero-coupon yield curve estimates for the United States , from the Federal Reserve’s Board of Governors, and Germany, from the Bundesbank. This chart clearly shows that the two central banks’ predicted policy paths have steepened sharply, especially since March. It also shows that U.S. monetary policy is expected to be tighter than in the euro area over the next eighteen months.

Monetary Policy Expectations Have Increased This Year across Major Economies

Sources: Haver Analytics; Refinitiv; Deutsche Bundesbank; Federal Reserve Board.
Notes: Monetary policy expectation spreads are calculated by taking the difference between the 18 month forward 3 month interest rate and the 3 month interest rate for each economy. The euro area monetary policy expectation spread is derived from the German monetary policy expectation spread.

Inflation Forecast Distributions

We now want to leverage the information contained in the oil price decomposition, short-term interest rates, and near-term forward spreads to assess the likely path of inflation over the next twelve months. Both oil prices and policy path expectations can behave in a non-linear fashion, where periods of volatile changes are followed by low volatile change periods and vice versa. This might suggest that these variables are of varying importance for different parts of the inflation distribution—for example, tails versus the center. To allow for this, we use quantile regressions that can relate different slices of the inflation distribution separately to changes in oil price components, short-term interest rates, and policy rate expectations.

We use two sets of quantile regressions to be able to forecast inflation over the next year: the first one models the change in the first six months of the forecast horizon, and the second set models the inflation change over the subsequent six months. For the first six-month horizon, the inflation change quantile regressions use the six-month change in the short-term interest rate (representing policy rate changes over the past six months) as well as the demand and supply components of the current six-month change in Brent crude (with all three corrected for realized inflation over the past six months) plus lags of month-over-month changes in annual CPI inflation. Policy rate expectations are thus assumed to not matter over this first six-month horizon: expected policy rate path shifts will first affect financial conditions, which then start impacting real activity after some period and given price rigidities, then finally influence inflation with an additional lag. These policy rate path changes, however, could have an inflation impact for the second, subsequent six-month horizon. Hence, estimation of the inflation change quantile regressions for this second six-month horizon is therefore not only based on the two components of current six-month changes in oil prices, six-month changes in the short-term interest rates, and lagged monthly changes in annual inflation, but also on the current eighteen-month forward interest rate spread.

Once we estimate the inflation change quantile regressions for the tail and central parts of the distribution for the first and subsequent six-month horizons, we generate forecasts for the two horizons and add these up across the corresponding slices of the inflation distribution to get one-year-ahead forecasts mapped into twelve-month inflation levels. We then combine the forecasts across the different slices in a similar manner as in Adrian et al. (2019), and construct forecasted conditional twelve-month-ahead forecast distributions of CPI inflation.

In the chart below, we depict the conditional distribution of U.S. CPI inflation over the next twelve months on two dates: January 14 (incorporating the release of the December 2021 CPI, published on January 12) and June 10 (incorporating that week’s May 2022 CPI release). In January, the likeliest forecast for year-end 2022 U.S. inflation was around 5.8 percent year-over-year, but by May the likeliest forecast for mid-Q2 2023 U.S. inflation wound up around 6.5 percent. Clearly, the increase in U.S. CPI inflation since January, along with the string of adverse oil supply shocks over the period, did push up the likely path of U.S. inflation. Interestingly, the more recent inflation forecast distribution seems more skewed to the downside, suggesting that while the average inflation rates implied by the two distributions have shifted up, the May 2023 distribution suggests more downside risk than the one for December 2022.

One Year Out-of-Sample Forecast Density Indicates a Slowing in U.S. Inflation

Source: Authors’ calculations.
Notes: Circle markers indicate median of forecast density; diamond markers indicate mean of forecast density; vertical lines indicate realized inflation for December 2021 on January 12, 2022 (left) and for May 2022 on June 10, 2022 (right).

We conduct a similar exercise for the euro area with corresponding distributions shown in the next chart below. Compared to the United States, there is a much more dramatic shift in the distributions between the two dates, with the projected year-over-year euro area inflation rates shifting out significantly, rising from about 4.3 percent annually in December 2022 to more than 7 percent in May 2023. The May 2023 euro area inflation distribution also appears relatively more symmetrical than that of U.S. inflation: the probability of inflation being 5 percent or less from the euro area distribution is about 5 percent, whereas this probability is about 22 percent for the U.S. distribution.  

One Year Out-of-Sample Forecast for the Euro Area Has Increased in Recent Months

Sources: Authors’ calculations.
Notes: Circle markers indicate median of forecast density; diamond markers indicate mean of forecast density; vertical lines indicate realized inflation for December 2021 on January 1, 2022 (left) and for May 2022 on June 1, 2022 (right).

Counterfactual Inflation Forecast Distributions

What factors are the largest drivers of these near-term inflation outlooks—policy rate changes or the demand/supply components of oil price changes? To get insight into this question, we estimate a weekly model for the six-month short-term interest changes, the near-term forward spread and both demand and supply components of six-month oil price changes, where each of these four variables depends on lags of all series. Unexpected changes, or shocks, for each of the series are determined by using the residuals of this model. We then apply an ordering such that short-term interest rate changes and the near-term forward spread can affect oil price change components in the same week, but those interest rate series respond to the oil price series the following week. This ordering acknowledges the fact that the oil price decomposition used here relies heavily on the use of a wide range of financial market data. Based on this estimated structure, we can decompose the historical time series for each of the variables into independent parts related to current and past shocks to either policy rates, the expected global demand component of oil price changes, or anticipated oil supply. This, in combination with the estimated quantile regressions, allows us to construct counterfactual inflation forecast distributions that assume that the impact of one or more of these four shocks on the predictor variables are set to zero. Given that tighter monetary policy and oil supply shocks have been the dominant themes recently, we will look at counterfactual distributions where the predictor variables in the quantile regressions are entirely driven by one of these two channels.

The chart below presents the result of the counterfactual exercises for U.S. CPI inflation. The blue line represents our forecasted May 2023 inflation distribution, which we discussed earlier. The gold and red lines represent counterfactual distributions where we allow only, respectively, anticipated oil supply shocks and policy rate shocks to have impact on the explanatory variables in our quantile regressions. Tighter monetary policy alone is not enough to explain the projected deceleration of U.S. inflation over the year. In the quantile regressions for the second six-month part of the forecast horizon, adverse oil supply shocks have a negative inflationary impact. Hence, apart from more restrictive financial conditions owing to tighter monetary policy, there is an important role for disinflationary payback in the latter part of 2022 for the current inflationary consequences of recent adverse oil supply shocks, driving the downside risk to the forecast.

One Year U.S. Inflation Outlook Is Driven by More Restrictive Financial Conditions and Recent Oil Shocks

Source: Authors’ calculations.
Notes: Circle markers indicate median of forecast density; diamond markers indicate mean of forecast density; the vertical line indicates realized inflation for May 2022 on June 10, 2022.

A similar analysis for euro area inflation can be found in the chart below. As with the U.S., we notice here that when we only allow for the impact of adverse oil supply shocks within our predictive quantile regressions, a fair degree of the predicted slowing in euro area inflation comes from the reversal of current inflationary pressures owing to these shocks. Tighter monetary policy impacts the twelve-month euro area forecast distribution somewhat less than that of the United States , especially with regards to the left tail of the inflation forecast distributions. For the euro area monetary policy shocks only distribution, the probability for inflation to hit 5 percent or less is about 7 percent, and for its U.S. counterpart it is about 13 percent.

One Year Inflation Outlook for the Euro Area Is Affected Most by Recent Oil Shocks

Source: Authors’ calculations.
Notes: Circle markers indicate median of forecast density; diamond markers indicate mean of forecast density; the vertical line indicates realized inflation for May 2022 on June 1, 2022.

Conclusion

Recent oil price hikes and tighter financial conditions have dominated the news. We use approximations of the drivers behind these developments to quantify the twelve-month outlook for CPI inflation in the U.S. and the euro area. In both regions, inflation is projected to ease somewhat but will remain elevated by May 2023. The forecast distributions do indicate, however, a higher likelihood of a larger-than-expected easing of inflation in the United States compared to the euro area. The projected inflation easing in the United States is mainly driven by a reversal of the inflationary impact of recent oil supply shocks and monetary policy tightening, while in the euro area tighter monetary policy has a less prominent impact.

Jan Groen is an economic research advisor in the Federal Reserve Bank of New York’s Research and Statistics Group.

Adam Noble is a senior research analyst in the Bank’s Research and Statistics Group.

How to cite this post:
Jan J. J. Groen and Adam I. Noble, “How Could Oil Price and Policy Rate Hikes Affect the Near-Term Inflation Outlook?,” Federal Reserve Bank of New York Liberty Street Economics, June 24, 2022, https://libertystreeteconomics.newyorkfed.org/2022/06/how-could-oil-pric....

Disclaimer
The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).

How Is the Corporate Bond Market Responding to Financial Market Volatility?

Published by Anonymous (not verified) on Thu, 16/06/2022 - 6:53am in

The Russian invasion of Ukraine increased uncertainty around the world. Although most U.S. companies have limited direct exposure to Ukrainian and Russian trading partners, increased global uncertainty may still have an indirect effect on funding conditions through tightening financial conditions. In this post, we examine how conditions in the U.S. corporate bond market have evolved since the start of the year through the lens of the U.S. Corporate Bond Market Distress Index (CMDI).  As described in a previous Liberty Street Economics post, the index quantifies joint dislocations in the primary and secondary corporate bond markets and can thus serve as an early warning signal to detect financial market dysfunction. The index has risen sharply from historically low levels before the invasion of Ukraine, peaking on March 19, but appears to have stabilized around the median historical level.

CMDI Is a Unified Measure of Market Functioning

The CMDI combines information on various aspects of functioning of both the primary and secondary markets for U.S. corporate bonds into a single metric, as described in detail in our staff report. Ranging from 0 to 1, a higher level of CMDI corresponds with historically extreme levels of dislocation. The chart below plots the evolution of the CMDI since the start of the year, with event lines at February 24 (the start of the invasion of Ukraine) and March 16 (date of the March Federal Open Market Committee [FOMC] meeting at which the target range of the federal funds rate was raised for the first time since 2019). The CMDI started 2022 at historically low levels—below the fifth percentile—suggesting that conditions in both primary and secondary markets for corporate bonds were at historically accommodative levels. The chart shows that the rise in global uncertainty precipitated by the invasion of Ukraine corresponded to a rapid increase in the CMDI, which peaked at the sixty-first percentile in the week ending on March 19 but has subsequently retraced to the twenty-third percentile in the week ending on May 28.

The CMDI increased rapidly following invasion of Ukraine but has since stabilized

Source: Authors’ calculations from Mergent FISD, TRACE, Moody’s KMV, and ICE BAML indices.
Notes: CMDI is Corporate Bond Market Distress Index. The event line on February 24 corresponds to the start of the Russian invasion of Ukraine and the one for March 16 corresponds to the date of the March Federal Open Market Committee meeting.

In addition to examining how conditions have changed in the corporate bond market overall, we can also compare the differential changes in conditions for investment-grade bondsthat is, those rated Baa-/BBB- or above—and high-yield bonds. The next chart shows that market functioning deteriorated considerably more for investment-grade bonds, peaking at the seventy-fourth percentile in the week ending on March 19. While the increases in global uncertainty coincided with monetary policy tightening, the larger deterioration in market functioning for investment-grade bonds is suggestive that uncertainty may have played a bigger role than monetary policy in the evolution of functioning for the overall market. Market conditions for higher-rated corporate bonds are less sensitive to changes in monetary policy than those for high-yield bonds; for example, because the average maturity for high-yield bonds is shorter—increasing the probability that high-yield issuances will be refinanced at higher interest rates.

Market functioning deteriorated more rapidly for investment-grade bonds

Source: Authors’ calculations from Mergent FISD, TRACE, Moody’s KMV, and ICE BAML indices.
Notes: CMDI is Corporate Bond Market Distress Index. The event line on February 24 corresponds to the start of the Russian invasion of Ukraine and the one for March 16 corresponds to the date of the March Federal Open Market Committee meeting.

What Is Driving the Recent Movements in the CMDI?

To further understand what has been driving the recent changes in the CMDI, we turn to the contributions from the six underlying sub-indices—secondary market volume, secondary market liquidity, secondary market duration-matched spreads, secondary market default-adjusted spreads, primary market issuance, and the spread between primary and secondary market pricing—to the level of the CMDI-squared. The way the CMDI is constructed, the square of the index can be written as the sum of contributions from the individual sub-indices. The next chart shows that, although a slowdown in issuance was the most noticeable contributor to the level of the CMDI at the beginning of 2022, the deterioration following the February 24 invasion of Ukraine can be initially attributed to trading conditions in the secondary market, with a decline in average trade size and the buy-sell ratio and an increase in turnover. The peak in the week ending on March 19 coincided with a deterioration in the default-adjusted spread sub-index, suggesting greater risk compensation for bearing default risk, and a deterioration in the spread between primary and secondary market pricing, suggesting a reduced willingness by market participants to intermediate in the primary market for U.S. corporate debt.

Both primary and secondary market conditions drive changes in the CMDI

Source: Authors’ calculations from Mergent FISD, TRACE, Moody’s KMV, and ICE BAML indices.
Notes: This chart illustrates contributions from the six underlying sub-indices of the Corporate Bond Market Distress Index (CMDI)—secondary market volume, secondary market liquidity, secondary market duration-matched spreads, secondary market default-adjusted spreads, primary market issuance, and the spread between primary and secondary market pricing (PM-SM spread)—to the level of the CMDI-squared.

Overall, this chart highlights the wealth of information encoded in the CMDI. By combining information from both the primary and the secondary market, the CMDI is better able to capture the overall market functioning. Deteriorations in the CMDI are not driven by secondary market credit spreads or secondary market liquidity alone but rather reflect the balance of conditions in both the primary and the secondary market.

Monetary Policy Tightening and Corporate Bond Market Conditions

While we have focused so far on the potential impact of the rise of global uncertainty, the stance of monetary policy and market participants’ perceptions of the stance of monetary policy have also shifted during this period. The FOMC voted to increase the target range for the federal funds rate at the March 15-16 FOMC meeting and financial market participants anticipate ongoing rate increases over coming FOMC meetings (see here).  A natural question to ask in this context is how much of the changes in the CMDI can be attributed to monetary policy rather than global uncertainty. The charts above show that the functioning of investment-grade market deteriorated more rapidly than that of the high-yield market, and that the initial deteriorations in the overall index were primarily driven by measures of secondary market volume rather than spreads, both of which suggest that at least the initial deterioration of market functioning between February 19 and March 19 is unlikely to have been driven by monetary policy. An alternative approach to evaluating this question is to compare the recent evolution in the CMDI to the evolution in the CMDI over a comparable period preceding the December 15-16, 2015, FOMC meeting—the start of the previous tightening cycle. The next chart shows that the CMDI was actually declining ahead of the December 2015 FOMC meeting, providing further suggestive evidence that the anticipation of tighter monetary policy does not necessarily translate into an immediate deterioration of corporate bond market functioning.

The CMDI has not had an outsized reaction to monetary policy tightening

Source: Authors’ calculations from Mergent FISD, TRACE, Moody’s KMV, and ICE BAML indices.
Notes: This chart illustrates the recent evolution in the Corporate Bond Market Distress Index (CMDI) to the evolution in the CMDI over a comparable period preceding the December 2015 Federal Open Market Committee meeting.

All Quiet on the Corporate Bond Market Front?

Although the CMDI has retraced somewhat from its March 19 high, it remains noticeably above its average 2021 levels. In other words, while the corporate bond market continues to function at historically average levels, market functioning has deteriorated relative to the recent past. It is thus important to continue to monitor conditions in this market as both the geopolitical situation and the monetary policy tightening cycle evolve. As shown in the staff report, the CMDI often provides a more timely signal of rapidly deteriorating conditions than any of its individual underlying metrics or, indeed, other commonly used metrics of financial distress, such as the VIX.

Nina Boyarchenko is the head of Macrofinance Studies in the Federal Reserve Bank of New York’s Research and Statistics Group.

Richard K. Crump is a financial research advisor in the Bank’s Research and Statistics Group.

Anna Kovner is the director of Financial Stability Policy Research in the Bank’s Research and Statistics Group.

Or Shachar is a financial economist in the Bank’s Research and Statistics Group.

How to cite this post:
Nina Boyarchenko, Richard Crump, Anna Kovner, and Or Shachar, “How Is the Corporate Bond Market Responding to Financial Market Volatility?,” Federal Reserve Bank of New York Liberty Street Economics, June 1, 2022, https://libertystreeteconomics.newyorkfed.org/2022/06/how-is-the-corpora....

Disclaimer
The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).

MMT Banking Primer

Published by Anonymous (not verified) on Mon, 06/06/2022 - 1:28am in
by Jonathan Wilson

First published April 8, 2022, on the PMPE website (PDF).

Comments may be left via the form below or sent via email to GIMMS
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Modern Monetary Theory illustrates how governments control the use of currency, including the private banking system’s ability to create credit. Additionally, MMT’s framework argues that governments who want to encourage households to purchase consumer goods can focus on directly increasing those individuals’ deposit accounts at commercial banks—as manipulating reserve balances is inconsequential. In this short primer, we will explain the liabilities of the banking system and how the entities in the banking system interact as they hold and transfer liabilities between one another. Then, we will explain the implications this system has for the theory of state money and for monetary policy.

 

I.                   Transfers Within the Central Bank’s System

Let’s start with an elementary banking system model, which includes only the Central Bank, the Treasury, two commercial banks, and four customers (Figure 1). In the United States the Central Bank is called the Federal Reserve, but to avoid any confusion from non-American readers, we will only refer to it as the Central Bank or the CB. In this model, the commercial banks and the Treasury each have a reserve account at the CB with a balance of $500,000, and each of the customers has an account at their respective commercial bank with $100,000 on deposit. The Treasury’s account at the CB is also known as the Treasury General Account.

 

Elementary banking system model, which includes only the Central Bank, the Treasury, two commercial banks and four customersFigure 1

 

By debiting and crediting account balances, the CB accounts for transactions between the commercial banks and the Treasury, as well as between the two commercial banks. The CB manages the ledger that records the reserve balances held by the Treasury and commercial banks, and it adjusts that ledger by crediting and debiting accounts when it receives notice that one of the entities wishes to transfer reserve balances to one of the other entities. To be clear, changing the ledger is itself the transfer. Reserve balances are representative numbers; there is no physical object that either party needs to ship to the other when transferring reserves. For example, when a commercial bank pays taxes, fines, and fees to the Treasury, or when it purchases goods or services (such as stamps or electricity) from other government agencies, the CB debits the commercial bank’s reserve account balance and credits the Treasury General Account. Similarly, when the Treasury buys assets from commercial banks, the CB debits the Treasury General Account and credits the commercial bank’s reserve account. When one commercial bank buys assets (such as securities or real estate) from the other commercial bank, the CB debits the purchasing commercial bank’s account and credits the selling commercial bank’s account.

In the charts below, observe what happens when Bank 1 buys a $25,000 asset from Bank 2 (Figure 2), then makes a $75,000 payment to the Treasury (Figure 3).

 

Bank 1 buys $25,000 asset from Bank 2. As described in the text.Figure 2

 

Bank 1 pays $75,000 to TreasuryFigure 3

 

In the first transfer, Bank 1 notified the CB that it was transferring $25,000 of reserve balances to Bank 2. The CB then debited Bank 1’s reserve account balance by $25,000 and credited Bank 2’s reserve account balance by $25,000. In the second transfer, Bank 1 notified the CB that it was transferring $75,000 of reserve balances to the Treasury. Then the CB debited Bank 1’s account by $75,000 and credited the Treasury General Account by $75,000.

 

II.                Money Is a Liability

While reserve balances are simply numbers, both the Central Bank and the Treasury, as parts of the national government, are legally required to accept them in payment. Reserve balances are assets of the depositor and a liability for the bank, which, for the purpose of this primer, means a credit that the issuer or its affiliate accepts in exchange for extinguishing a tax liability or any other payment due to the issuer. In the case of reserve balances, the issuer is the CB, and the Treasury is its affiliate, so both the CB and the Treasury accept reserve balances in payment. For example, the CB deletes reserve balances from its ledger when commercial banks buy physical notes and coins from the CB or pay fines imposed by the CB. Similarly, the Treasury is legally required to accept reserve balances (which courts have described as being “functionally equivalent” to cash)[1] in exchange for forgiving fines and tax liabilities and for specified goods and services that several statutes require some government agencies to sell. For example, 39 USC 403 obligates the United States Postal Service to provide postal services and to sell stamps at “fair and reasonable rates and fees” (39 USC 403); 16 USC Chapters 12 through 12H collectively require the Secretary of the Army and the Secretary of Energy to operate hydropower facilities and sell the electricity “at the lowest possible rates” (§ 825s); and 38 U.S. Code §§ 7301 and 7302 require the Veterans Administration to deliver healthcare to Veterans who tender the required copay under 38 CFR § 17.36. The U.S. is not unique in this regard. For example, Bahamian[2] law and Chinese[3] law both require the maintenance of an electricity corporation that sells power at reasonable prices. Because commercial banks need reserve balances to pay government fines, to extinguish their tax liabilities and to make other payments to the Treasury, they are willing to sell goods and services in exchange for these necessary reserve balances when making payments within the banking system—not only to the national government but also among each other.

Similarly to how reserve account balances are assets that measure claims that commercial banks have against the national government, the units of account in individual bank accounts, which are usually called deposits, are likewise the depositor’s assets that measure the claims that account holders have against banks. If someone has a $100 bank deposit, they have a $100 asset, and the bank has a $100 liability (a redeemable credit) outstanding. A bank can directly redeem its deposits (debit the depositor’s account) by giving the customer cash that the bank purchases from the CB or by selling financial assets to the customer, such as certificates of deposit, bonds, or any other asset that it holds. A bank can also redeem deposits by transferring them to a recipient’s account at the same bank. It does this simply by debiting the account of the transferor and crediting the account of that recipient. Or, if the recipient’s account is at another bank, reserves can be transferred to the reserve account of the recipient’s bank, and the recipient’s bank will credit the recipient’s account at his bank. When depositors at commercial banks make payments to the Treasury, the Fed debits the commercial bank’s reserve account and credits the Treasury’s Fed account, while the commercial bank debits its depositor’s account.

Payments between individuals who have accounts at the same bank occur by debiting and crediting deposit accounts. Recall that customers A and B have accounts at Bank 1 and customers C and D have accounts at Bank 2. If A makes a payment to B, Bank 1 debits A’s account and credits B’s account.

Payments by customers to the Treasury and to customers of other banks are slightly more complicated. Because individuals don’t have reserve accounts and you cannot literally transfer an entry on a ledger to someplace outside the ledger, these types of payments are processed by multilateral agreements to increase and decrease liabilities. When a customer at Chase Bank makes a payment to a customer at HSBC, what literally happens is the Chase Bank customer asks Chase Bank to convince HSBC to give the HSBC customer a deposit. Then, to compensate HSBC for its increase in liabilities, Chase transfers reserves to HSBC. Then, to compensate Chase for its loss of assets, the Chase customer agrees to surrender some of their deposits to Chase. In other words, the payor is giving up their claim against their bank to induce the recipient’s bank to issue a liability to the recipient, with several intermediate steps.

If an individual makes a payment to the government, the bank debits the customer’s account and requests the CB to transfer reserves from the commercial bank’s account into the Treasury General Account. If A, a Bank 1 customer, makes a payment to C, a Bank 2 customer, Bank 1 debits A’s account, Bank 2 credits C’s account, and both banks request the CB to debit Bank 1’s reserve account and credit Bank 2’s reserve account. Bank 1 transfers reserves to Bank 2 to offset Bank 2’s new liability: C’s deposit. C now has the right to request cash or payment from Bank 2, and transferring reserve balances to Bank 2 ensures Bank 2 can comply with C’s requests. Like payments between A and B, payments between C and D settle without transferring reserves because they have deposit accounts at the same bank. In the charts below, observe what happens when A makes a $20,000 payment to B, then B makes a $50,000 payment to C.

 

Intital state before transfers begin. Treasury has $575,000 reserve balance, Commercial bank 1 has $400,000 reserve balance, Commercial bank 2 has $525,000 reserve balance and customers A & B (Bank 1) and C & D (Bank 2) each have balances of $100,000 in their deposit accounts.Figure 4

 

Customer A of Bank 1 pays $20,000 to Customer B of Bank 1. Therefore, Customer A then has a balance of $80,000 and Customer B has a balance of $120,000. All other balances reamain as in the initial state (Figure 4)Figure 5

 

 

Customer B (Bank 1) pays $50,000 to Customer C (Bank 2). Therefore, Customer B now has a deposit account balance of $70,000, Bank 1 has a reserve balance of $350,000, Bank 2 has a reserve balance of $575,000 and Customer C has a deposit balance of $150,000.Figure 6

 

In the first transfer, Bank 1 merely debits A’s deposit account by $20,000 and credits B’s deposit account by $20,000. In the second transfer, B tells Bank 1 that it wants to pay C. Bank 1 tells Bank 2 to increase C’s deposit account by $50,000, and to compensate Bank 2 for increasing Bank 2’s liabilities, Bank 1 tells the CB that it wants to pay Bank 2, so the CB debits Bank 1’s reserve balance account by $50,000 and credits Bank 2’s reserve balance account by $50,000. To compensate Bank 1 for the loss of its reserve balances, Customer B agrees to surrender some of its liabilities against Bank 1, so Bank 1 debits B’s deposit account by $50,000. When executing the transfer from B to C, usually the debiting and crediting of deposit accounts occurs instantly, and the debiting and crediting of Bank 1 and Bank 2’s reserve balance accounts occurs later, by some time set by the CB. Regardless of the actual time of execution, the legal requirement to complete the reserve balance transfer comes into existence the moment Bank 2 agrees to credit C’s deposit account.

It is very important for banks to manage the amount of liabilities depositors hold against them. Because banks are regulated entities, they are required to record and account for each transaction they make, including all deposits they issue. Every time a bank issues a deposit, whether it issues a loan, it pays its employees for their labor, buys some asset from one of its customers, or makes a charitable donation, this action is recorded as an expense that the bank must account for when recording its retained earnings, which has significant regulatory impact which we will discuss later. When banks extend loans, they offer deposits in exchange for a written agreement, or “note,”[4] promising to give the bank more financial assets—cash, reserves, debt relief, deposits at another bank, etc. In this sense, when banks lend, they sell deposits in exchange for notes promising payment with interest. From an accounting perspective, the difference between a bank buying the labor of its CEO with a $1 million bonus and buying a note from (making a loan to) a customer for $1 million is that the note is an asset that offsets the increased liability represented by the additional deposit. When the bank gives the CEO the $1 million bonus, it must record this transaction as a $1 million reduction in its retained earnings, but when the bank makes the $1 million loan, its retained earnings remain the same and will increase when the borrower pays interest.

 

III.             Regulations Affecting Banks

Now that you know what bank liabilities are and why they issue them to customers in exchange for value, the next step is learning what regulations limit banks’ ability to issue loans, accept deposits, and clear payments without penalty: capital adequacy ratio requirements and liquidity coverage ratio requirements. These regulations in their current configuration, which most countries use in some form, were developed by the Basel III Committee in 2009.

 

A.                Capital Adequacy Ratio Requirements

Capital adequacy ratio requirements mandate that a bank keep, based on a percentage of its assets, a certain amount of money that meets specific qualifications. Collectively called “capital,” this money consists of proceeds from sales of their equity, retained earnings from asset sales, and interest collected on loans. For clarity, “capital” in most contexts refers to the value of the obligation to pay shareholders upon a liquidity event, but in the regulatory context, it is an accounting[5] residual that refers to the funds paid in exchange for those shares, and the funds themselves can be thought of as a subset of the bank’s assets. Money that is encumbered—specifically, money that banks borrow and must repay—does not count towards a bank’s capital. The money that comprises the regulatory capital is held in the form of reserve balances, deposits at other banks, and cash. For clarity, everything of value that the bank holds is one of its assets. However, only assets that the bank obtains from certain sources count towards its capital. Borrowed funds do not count towards a bank’s regulatory capital; proceeds from sales of equity, retained earnings from sales of assets, and interest income do count towards a bank’s regulatory capital.

Capital adequacy ratio requirements exist in two forms. One compares a bank’s capital to its overall assets, and the second compares a bank’s capital to a risk-weighted subset of its assets. When calculating risk-weighted asset numbers, banks must multiply the value of each asset by a risk weight percentage assigned by regulation. For example, the regulations assign a 100% risk weight to deposits at financial institutions, corporate stock and unsecured loans; a 50% risk weight to residential mortgages; and a 20% risk weight to bonds issued by States. Most importantly, reserve balances, cash, and bonds issued by the national government have a risk weight of 0%, meaning they do not count towards the total. Note that certain funds, such as proceeds from the sale of the bank’s equity which is held at a correspondent account at another commercial bank, can count both towards a bank’s capital and towards its risk-weighted assets, meaning that a capital-deficient bank can approach satisfying the capital adequacy ratio by solely accumulating deposits at other banks but will likely need at least some cash, bonds, or reserve balances to fully satisfy the capital adequacy ratio requirement. Because cash, bonds, and reserve balances carry this zero-risk weight, banks will always have demand for them.

To illustrate, consider a bank that owns (i) $100 in corporate stock, liabilities against other financial institutions, and unsecured loans; (ii) $250 in residential mortgages; (iii) $400 in State bonds; and (iv) $1000 in cash, reserve balances, and US Treasury bonds. Such a bank would have a risk-weighted asset total of $225 (see Table 1 below). The regulations instruct banks to maintain a total capital ratio of 8%, meaning our hypothetical bank would need to have $18 in capital.

 

Asset
Value
Risk Weight
Risk-weighted Value

Liabilities against other financial institutions, corporate stock, and unsecured loans
$100
100%
$100

Residential mortgages
$250
50%
$125

State bonds
$400
20%
$80

Cash, reserve balances, US Treasury Bonds
$1000
0%
$0

Total
$1,750

$225

Table 1

 

B.                 Liquidity Coverage Ratio

The liquidity coverage ratio requires banks to keep a certain amount of a specified type of liquid asset called a high quality liquid asset (“HQLA”) based on a percentage of their liabilities. HQLAs consist of reserve balances, assets issued or guaranteed by national governments, and qualified stocks and bonds. The regulations require banks maintain a level of HQLAs at 1:1 ratio with the sum of various percentages of the bank’s liabilities, called the Net Cashflow Amount. The actual regulation[6] that defines total net cashflow amount has too many sub-parts to discuss in this primer, but to get a general understanding of how it works, know that total net cashflow amount includes 3% of insured customer deposits, 10% of uninsured customer deposits, and 10% of the amount of money the bank has committed to originate retail mortgages in the last 30 days. For example, if a bank has $1,000 in insured deposits, $2,000 in uninsured deposits, and has originated $5,000 in retail mortgages in the last 30 days, its net cashflow amount is $730 (see Table 2 below).

 

Liability
Value
Multiple
Net Cashflow Amount

Insured Deposits
$1,000
3%
$30

Uninsured Deposits
$2,000
10%
$200

Retail Mortgages Originated in Last 30 days
$5,000
10%
$500

Total
$8,000

$730

Table 2

 

Similarly, the regulators take a complex series of steps to calculate[7] the HQLA amount, but this primer will use a simplified description. The regulations define two types of liquid asset. Level 1 includes reserve balances and securities issued by the US Treasury or other national governments; Level 2 (split into 2A and 2B) includes securities sponsored or guaranteed by government enterprises other than the US Treasury, corporate debt, Russel 1000 stock, and municipal bonds. To calculate a bank’s HQLA amount, take the amount of its Level 1 assets and add an amount of its Level 2 assets equal to at most 2/3rds of its Level 1 assets. For example, if a bank has $9 in Level 1 assets and $3 in Level 2 assets, its HQLA amount equals $12, and if a bank has $9 in Level assets and $6 in Level 2 assets, its HQLA amount equals $15. However, if a bank has $9 in Level 1 assets and $500,000 in Level 2 assets, its HQLA amount still equals $15 (because the Level 2 assets are only allowed to contribute $6 to the HQLA amount, as $6 is 2/3rds of $9), and if a bank has $0 in Level 1 assets and $500,000 in Level 2 assets, its HQLA amount equals $0. Consequently, banks must maintain at least some Level 1 assets to avoid civil penalties. See the Table 3 below, and for a spreadsheet that you can play with to simulate how different liquid asset amounts affect the HQLA amount, click here.

 

Bank
Level 1 Assets
Level 1 Contribution to HQLA Amount
Level 2 Assets
Level 2 Contribution to HQLA Amount (max of Level 2 Assets and ⅔ of Level 1 Assets)
HQLA Amount

A
$9
$9
$3
$3
$12

B
$9
$9
$6
$6
$15

C
$9
$9
$500,000
$6
$15

D
$0
$0
$500,000
$0
$0

Table 3

 

Banks must maintain an HQLA to Net Cashflow Ratio of 1:1, but please note that the regulations do not require banks to acquire HQLAs before issuing deposits, nor do they require banks to acquire capital before acquiring assets. However, they do influence banks’ activity; empirical studies of banks show that banks that approach the limits of the capital and liquidity guidelines will temporarily[8] reduce lending[9] until they can obtain additional capital or liquidity. In very extreme circumstances, they may alter their lending standards[10] to favor safer, more liquid loans.

 

IV.             What Happens When Banks Run Low on Liquidity?

If a commercial bank runs low on liquidity, it can still process payments by using mechanisms at the Central Bank and by borrowing from other commercial banks.

 

A.                Central Bank Mechanisms: The Overdraft Facility and the Discount Window

Adherence to the capital ratio requirements and liquidity coverage ratio requirements grants banks free access to two mechanisms at the Central Bank that provide them with flexibility to process more transactions—the overdraft facility and the discount window. The overdraft facility allows banks to have negative balances in their reserve accounts at the CB up to an amount called the net debit cap. The size of a bank’s net debit cap depends on how well it follows the capitalization and liquidity requirements, but the cap can be zero for struggling banks. A bank that makes a payment in excess of its net debit cap can still use the overdraft facility but must pay a penalty and risks being shut down by regulators if it continues to exceed its net debit cap. Banks which use the overdraft facility must obtain reserves to bring their balance back to zero by the end of the day. For example, If Bank A has a reserve balance of $500, but needs to make a $700 payment to the Treasury, the CB will credit the Treasury General Account by $500 and debit Bank A’s reserve account by $500, resulting in Bank A’s reserve account measuring negative $200. Bank A must then pay the CB $200.

The discount window allows commercial banks to borrow reserves directly from the CB, which serves as a lender of last resort when banks cannot borrow reserves from each other. Maintaining access to both of these processes allows banks to maintain their operations without penalty, even when running low on capital and liquidity. The CB imposes various rules that deter unlimited use of the discount window, including the requirement to pledge collateral and restrictions on how borrowed funds may be used. Additionally, the amount banks can borrow is limited by their regulatory capital.

 

B.                 Interbank Lending

One of the ways banks can eliminate negative balances from overdrafts is to borrow reserves from one another. Banks that lend reserves charge interest on these loans, and the number of total reserves existing among all banks determines the rate of interest. When there is an abundance of reserves in the system, banks charge a lower rate of interest to lend to one another, but they will always charge more than the passive rate of interest that the CB pays on reserves. If a bank receives 2% interest on reserves from the CB, it would never make sense to charge only 1% in interest when lending to another bank because it could simply do nothing and receive more. When reserves are plentiful, banks also compete with each other for loan customers by offering lower rates, which reduces the average overall interest rate.

Similarly, debiting reserves raises interest rates by making reserves more scarce, although banks will almost never charge more than the CB charges to use the discount window. A bank which can borrow from the CB at 1% interest would never pay 2% interest to borrow from another commercial bank. In this sense, the interest paid on reserves and the discount window form a corridor system[11] that places upper and lower bounds on the interbank lending rate. That being said, if there were a system-wide shortage causing liquidity issues and banks begin to exceed their net debit caps, rates would likely have no ceiling.

 

V.             Shadow banks, Eurodollar banks, and Payments

Until now, we have exclusively discussed banks which have accounts at the Central Bank. But some financial institutions, called shadow banks, provide banking services denominated in a given currency despite existing outside the direct supervision of the ordinary financial laws and regulations of the country originating that currency. For example, Eurodollar banks, defined as banks outside the United States that issue dollar-denominated liabilities, represent one type of shadow bank. Because shadow banks do not have accounts with the nation’s CB, Eurodollar banks and other shadow banks must hold deposits with an entity that does have an account at the CB in order to finalize payments to the Treasury.

Consider a hypothetical individual who does business in both the United States and Italy. She has $20,000 in a dollar-denominated account with Intesa Sanpaolo, an Italian bank, and needs to make a $5,000 payment to satisfy a fine imposed by an agency of the United States national government. To make an international payment like this one, commercial banks have correspondent accounts with banks in the country of the recipient. Suppose Intesa Sanpaolo has a $100,000 correspondent account at Wells Fargo in the United States and Wells Fargo and the Treasury each have $500,000 in their reserve balance accounts (Figure 7). First, Intesa Sanpaolo debits the business owner’s dollar account by $5,000, leaving $15,000. Next, Intesa Sanpaolo requests that Wells Fargo process a payment to the Treasury General Account. Wells Fargo then debits Intesa Sanpaolo’s account at Wells Fargo by $5,000, leaving a balance of $95,000, and finally, Wells Fargo requests that the CB debit its account at the CB by $5,000 and credit the Treasury General account by $5,000. Wells Fargo’s reserve balance account now holds $495,000; the Treasury General account now holds $505,000; and the payment settles.

 

Balances before international transfer. Details in text.Figure 7

 

Balances after international transfer. Details in text.Figure 8

 

Similarly, if someone wants to make a payment from an account at a shadow bank to an account at a commercial bank that is a part of the CB system, generally the shadow bank must have an account with a CB member-bank that has adequate reserves, access to the overdraft facility, or is willing to pay a penalty for an overdraft. CB member-banks can accept deposits at other banks in lieu of payment in reserves, but regulations limit such interbank liabilities unless the bank issuing the deposit is another CB member-bank that meets certain capital adequacy requirements. In other words, shadow banks can issue liabilities denominated in the national currency, but they must rely on CB member-banks to process many types of payments. Most importantly, shadow banks always ultimately rely on CB member-banks to process payments to the government.

 

VI.             Implications

The structural and legal aspects of the banking and shadow banking systems discussed above have important consequences for two areas of economics discussed by MMT: chartalism and monetary policy.

 

A.                Implications for Chartalism

The theory of chartalism claims that the government, through its agents which include the commercial banking system, can attempt to provision itself by demanding as payment an asset that only it can create (monopolized currency). Critics of chartalism assert that it must not actually be the case that governments have monopolized currencies because (1) commercial banks (particularly Eurodollar banks) can issue as many deposits denominated in the  government’s unit of account as they want, in a number that exceeds the total amount of the state’s base money (reserves, reserve bank notes, and coins) created by the government; (2) the Central Bank will always satisfy the need for reserves by allowing an automatic overdraft; and (3) the Treasury debits the TGA when it spends and is usually not allowed an overdraft.

Regarding the first criticism, to my knowledge, people who make it almost never explicitly state what immediate practical consequences they think stem from the difference in size between reserves and deposits; no one ever states exactly what the government cannot do because—and only because—of this fact. But as far as we can tell, the insinuation seems to be that if the government imposes a tax that the private sector does not want to pay, commercial banks can simply either (1) issue deposits to the Treasury and declare the tax paid, avoiding any punishment for non-payment; or (2) use the overdraft facility or the discount window to pay the Treasury without attempting to obtain reserves. Readers of this primer will recognize that the structure of the banking system and the requirements imposed by banking regulations make this criticism unconvincing. The Treasury does not accept payments from banks in the form of commercial bank deposits; to clear a payment to the Treasury, you must credit the Treasury General Account with reserve balances. Only CB member banks in good standing can do this; shadow banks and Eurodollar banks cannot.

The ability to create a bank deposit is relatively inconsequential; what matters is the ability to clear payments. In order for a shadowbank deposit to affect the value of the government’s currency in that currency’s country of origin, it must be able to redistribute real resources in that country. Because various regulations in every country essentially require citizens to have domestic bank accounts (as opposed to exclusively using offshore banks), shadow banks have very limited ability to affect the real economy without relying on correspondent accounts at CB member banks.

Regarding the second criticism (that the Central Bank will always satisfy the need for reserves by allowing an automatic overdraft), it is true that the CB always grants an automatic overdraft to prevent the payment system from breaking down, but this does not mean that commercial banks can spend as much as they want without penalty or that reserve balances are a pure residual with no impact on economic activity. Using the overdraft facility is not free; banks must post collateral to use the overdraft facility or the discount window, and Banks that use the overdraft facility must obtain reserve balances to clear the overdraft. The only way to get reserve balances to clear this overdraft is to borrow or purchase them from another entity with a reserve balance account or to sell assets directly to the CB, which only sells reserve balances for assets it deems eligible. Commercial banks cannot simply will infinite amounts of reserve balances into existence, just as bank customers cannot will money into their checking accounts, and if a bank fails to repay its discount window loans or clear its overdrafts, regulators will dissolve the bank. This means that commercial banks always need an income in base money and will always accept base money in payment, or else they will rely on correspondent accounts with a bank that does have such income.

Although there is a continuous need by banks to obtain net reserves to clear payments without penalty, banks can sometimes postpone this process. For example, in the US, commercial banks facilitating tax payments can use a Treasury Tax and Loan Account (TT&L), which is an account where tax payments are temporarily held. However, this does not eliminate the need to transfer reserve balances because the balances in TT&Ls are debited with a corresponding reserve transfer within 48 hours of being deposited. Additionally, banks who use TT&Ls must post collateral at the Fed equal to 100% of the balance of their TT&L. If crediting a TT&L were “payment” in a meaningful sense, no collateral would be required. Consequently, it is misleading and unhelpful to characterize use of a TT&L as “paying taxes in deposits then settling with reserves”. A more legally and operationally accurate description is that the taxpayer surrenders deposits to his or her commercial bank in exchange for the bank’s promise to transfer reserves on the taxpayer’s behalf to the Treasury, and the TT&L is simply an accounting of the collective payments to the Treasury that the commercial bank has committed to paying. The payments, however, are not actually complete until the reserve transfer. The only reason TT&Ls exist is for logistical convenience; it is more efficient for a commercial bank to keep a running tally of all the reserves it needs to transfer to the Treasury and make one big transfer at the end of the day than it is to make thousands of small transfers throughout the course of the day. The existence of TT&Ls does not negate the fact that banks need income in base money.

After pointing out why banks need to obtain the state’s base money, critics of MMT usually claim that this “sounds like the money multiplier theory and not the endogenous money theory”[12] (emphasis added). Careful readers will notice that this argument does not rebut any empirical claims but merely invokes a label, which it misapplies. The money multiplier is the specific claim that banks need to get reserves first before they can issue deposits and that banks will only issue as many deposits as their current supply of reserves allows. As described by the Federal Reserve[13], the money multiplier claim is that:

“the amount of money (deposits) banks ‘create’ is a fraction of the reserve requirement ratio set by the Fed. For example, if a bank subject to a 10 percent reserve requirement lent an additional $100 of funds, $1,000 (or 100 × 1/0.10) in total would ultimately be added to the money supply. In this case, reserves in the banking system would create 10 times as many deposits.”

The money multiplier is not the claim made by MMT; MMT’s claim as stated in this primer is as follows: “Banks need income in government liabilities to clear overdrafts, repay discount window loans, and meet other regulatory requirements and will always accept units of the monetary base or government bonds in payment. Because taxpayers as bank customers rely on banks to settle most payments to the government, assets which are denominated in the government’s unit of account–which banks must use–will always have value to taxpayers.”

With regards to the third criticism (that the Treasury debits the TGA when it spends and is usually not allowed an overdraft), while it is true that the Treasury must spend from the Treasury General Account, the Treasury has several means to bypass this self-imposed funding constraint[14] and credit the Treasury General Account with any number it chooses. It can mint coins, issue tax anticipation bills, credit TT&Ls, and coordinate with the CB to perform indirect monetary financing. Critics of MMT have claimed that the Treasury can only spend without taxing or borrowing if the CB cooperates, but we emphasize here that only one of the four methods that the Treasury uses to bypass self-imposed funding constraints relies on cooperation with the Central Bank. Therefore, any money that the Treasury “has” in the Treasury General Account is an administrative accounting residual, not a reflection of accumulated wealth or any meaningful limit on its ability to spend. Any time the Treasury declines to use these bypass methods, it is making a political decision, not observing a legal requirement. In contrast, commercial banks have no ability to simply bypass the need to obtain reserves to clear overdrafts and repay discount window loans.

Moreover, before commercial banks can purchase bonds from the Treasury or pay taxes and clear any associated overdrafts or discount window loans, the reserves used in those transactions must first be created by the government and transferred to the commercial banks, either (i) when the CB lends to the commercial banks; (ii) when the CB purchases assets from the commercial banks; or (iii) when the Treasury spends. Once enough reserve balances are in the system for it to run, the government, through some combination of actions by the CB and the Treasury, must continue to give reserve balances back to commercial banks. If the CB halted all open market operations and if the Treasury stopped spending (or even merely ran a surplus), commercial banks could not indefinitely continue settling tax payments. In that scenario, in which the government permanently commits to no longer add net reserve balances to the banking system but continues taxing the private sector, rates would rise, regulatory capital would fall, and every single commercial bank would eventually fail. Consequently, the system as currently designed requires the government to continue giving base money to the private sector, which is why MMT states that the government is the monopoly issuer of the asset it demands from the private sector in payment.[15]

 

B.                 Implications for Monetary Policy

Just as the banking system’s structure colors our understanding of chartalism, it also provides three important insights into why monetary stimulus has limited impact on spending. When the government wants to increase spending by private individuals, it needs private individuals to gain and then spend bank deposits. Some economists believe the government can encourage commercial banks to issue more bank deposits to their customers merely by having the CB issue more reserve balances by purchasing assets from commercial banks. However, commercial banks do not issue deposits free of charge even when they have additional reserve balances; they issue deposits in order to buy assets, labor, and promissory notes (to earn interest income). A shortage of bank deposits does not indicate a need for more reserve balances; it reflects a lack of creditworthy borrowers who desire to sell promissory notes and a lack of wealthy individuals who want to sell their assets to banks. For this reason, the first insight is that if the government wants to stimulate private spending, it can do so most effectively by directly increasing deposits held by individuals, rather than by merely increasing bank reserves and hoping that banks will extend deposits to individuals.

If the Treasury conducts fiscal policy by directly increasing deposit accounts and transferring corresponding reserve balances to the commercial banks, then it can stimulate individual spending. For example, in order to directly increase your deposit account at First Republic Bank, the Treasury can offer to send First Republic Bank reserve balances on the condition that First Republic Bank increases your deposits by the same amount. This is what the Treasury did by providing stimulus checks during the Covid-19 pandemic; when it sent out the final stimulus checks in March, deposits and reserve balances at commercial banks increased, and personal consumption expenditures immediately rose by 4.2%[16] that month.

The second insight is that the private sector can continue to spend, even if the government issues bonds and engages in deficit spending. Some economists believe that selling bonds “crowds out” private-sector spending by draining the reserve balances that the private sector needs to clear payments. This theory fails to note that swapping reserve balances for bonds replaces those reserve balances with a high quality liquid asset that can be used as collateral to obtain additional reserve balances—therefore, the bank’s liquidity coverage ratio and ability to clear payments remain unchanged. No private sector spending has been crowded out. Private sector spending is only crowded out when the CB deliberately raises rates, which is a political choice that most MMTers find empirically misguided.[17]

Finally, the third insight is that we should not expect monetary policy—specifically, the CB exchanging government bonds for reserve balances—to significantly affect the relative price level. Conventional economic theory states that if reserves become scarce and the interest rate rises, banks will issue fewer loans, leading to less spending. This narrative omits the fact that banks are primarily restrained not by reserves directly but by capital and liquidity requirements; they will always lend if they think borrowers can repay. Granted, the interest rate has some impact on this profitability analysis, but it is not dispositive.[18] If every agent in the economy receives more money in interest payments because rates have risen, this additional income may allow for greater spending in some circumstances: If more people spend money, investments may become more profitable, which may at least partially offset the fact that the person running the investment must pay higher interest expenses to their bank. If this offset occurs, then increasing interest rates may not deter lending. Additionally, even if raising rates deters some lending, it may not deter purchasing in a proportional amount. Businesses can finance their investments through debt, equity, or retained earnings. If the cost of debt rises, businesses may make the same purchases for their investments by financing them with less debt and more equity and retained earnings. If they are unable to rebalance their financing profile this way, they may simply pass the increased cost of financing onto customers, elevating the relative price level.

 

VII.             Conclusion

Banks have a great deal of freedom, but are forced to operate within the confines of a strict regulatory framework, where they rely on actions by the government’s Central Bank to maintain stability and liquidity. The government, therefore, is not an exterior appendage that latches on to a pre-existing financial system. Rather, the financial system emerges from the government’s institutional structures. Because of this relationship, the government has a duty to its constituents to ensure that the financial system works to their benefit. This goal can only be achieved through a proper understanding of how this legal structure impacts economic incentives. With luck, this primer has shed some light on how the banking system actually operates and how various policies affect it, and we hope that readers are better equipped to evaluate proposals to reform it.

 

References:

 

[1] United States ex rel. Kraus v. Wells Fargo & Co., 943 F.3d 588, 602 https://www.leagle.com/decision/infco20191121105

[2] Electricity Act, 1956 https://laws.bahamas.gov.bs/cms/images/LEGISLATION/PRINCIPAL/1956/1956-0017/ElectricityAct_1.pdf

[3] Electric Power Law of the People’s Republic of China, 1996 http://www.asianlii.org/cn/legis/cen/laws/eplotproc429/

[4] Not to be confused with a “banknote”, a note or promissory note is usually colloquially called a loan contract. When someone buys a loan contract or a note, they are buying the right to payment from the person identified as the “issuer” of the note or the person identified as the “borrower” in the loan contract.

[5] Bragg, Steven. Equity capital definition, accessed 5/6/22 at https://www.accountingtools.com/articles/what-is-equity-capital.html

[6] 12 CFR § 249.32 – Outflow amounts. Accessed 5/6/22 at https://www.law.cornell.edu/cfr/text/12/249.32#a

[7] 12 CFR § 249.21 – High-quality liquid asset amount. Accessed 5/6/22 at https://www.law.cornell.edu/cfr/text/12/249.21

[8] Eickmeier, S., Kolb, B., and Prieto, E., Tighter bank capital requirements do not reduce lending long term. Accessed 5/6/22 at https://www.bundesbank.de/en/publications/research/research-brief/2018-22-bank-capital-requirements-lending-765338

[9] Bridges, J., Gregory, D., Nielsen, M., Pezzini, S., Radia, A. and Spaltro, M. 2014. The impact of capital requirements on bank lending. Accessed 5/6/22 at https://voxeu.org/article/impact-capital-requirements-bank-lending

[10] Roberts, D., Sarkar, A., and Shachar, O. 2018 (revised 2022). The Costs and Benefits of Liquidity Regulations. Accessed 5/6/22 at https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr852.pdf

[11] Levey, S., 2017. Buffer Stocks: A Simpler Diagram. Accessed 5/6/22 at https://slevey087.medium.com/buffer-stocks-a-simpler-diagram-a462e9ea5359

[12] Etzrodt, C., 2018. Modern Sovereign Money—Part II: A Synthesis of the Chicago Plan, Sovereign Money, and the Modern Money Theory. Open Journal of Social Sciences Vol 6 no 9 pp 116-135. https://www.scirp.org/journal/paperinformation.aspx?paperid=87125#return166

[13] Ihrig, J., Weinbach, G.C., and Wolla, S. A. 2021. Teaching the Linkage Between Banks and the Fed: R.I.P. Money Multiplier. https://research.stlouisfed.org/publications/page1-econ/2021/09/17/teaching-the-linkage-between-banks-and-the-fed-r-i-p-money-multiplier

[14] Tymoigne, É., 2014. Modern Money Theory and Interrelations between the Treasury and the Central Bank: The Case of the United States. Levy Economics Institute of Bard College Working Paper no. 788. https://www.levyinstitute.org/pubs/wp_788.pdf

[15] Even if you reject the MMT claim that the Central Bank (whose leadership is appointed by the government and is legally required to remit all of its profits to the Treasury) is a part of the government and insist that the Central Bank is somehow a private agent, the system as currently designed only works because the government’s regulations deem that the Central Bank’s reserve balances are legal tender, carrying a zero-risk weight and serving as a level-1 liquid asset.

[16] Lisa, A. 18 November 2021. The Effects of Stimulus Checks on the Economy. Accessed 5/6/22 at https://www.msn.com/en-us/money/savingandinvesting/the-effects-of-stimulus-checks-on-the-economy/ar-AAQSo3p

[17] Wilson, J. 2022. How MMT Differs from Mainstream Macroeconomics: Steady-State Interest Rate Dynamics. Accessed 5/6/22 at https://www.pmpecon.com/post/how-mmt-differs-from-mainstream-macroeconomics-steady-state-interest-rate-dynamics

[18] Wilson, J. 2022. Can Tinkering with Interest Rates Solve All Inflation? Accessed 5/6/22 at https://www.pmpecon.com/post/can-tinkering-with-interest-rates-solve-all-inflation

 

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The post MMT Banking Primer appeared first on The Gower Initiative for Modern Money Studies.

Sell Your Stocks and Enjoy the Slide

Published by Anonymous (not verified) on Fri, 27/05/2022 - 2:37am in
by Brian Czech

I’m sorry if you’re one of the 145 million Americans invested in the stock market, but I actually find it gratifying to see the market sliding. Why shouldn’t I? As a steady stater, I’m firmly against GDP growth in the 21st century. A perpetually growing stock market presupposes a perpetually growing economy. If the market has to decline along with GDP, I’m all for it.

Conversely, it’s safe to say that anyone hoping for an ever-growing stock market is no steady stater. They’re not on the side of people and planet; not really. They’re on the side of their short-term selves, and maybe their immediate families, but not the rest of us, and not the grandkids.

A serious steady stater would probably possess no stocks whatsoever. Yes, arguments get made for “green stocks” such as wind or hydrogen, but ultimately the steady state economy means a stabilized size of economy, whether it’s run on wind, hydrogen, or cow power. If you have disposable income, you can surely think of some steady-state expenditures that don’t reek of pro-growth hypocrisy. Better yet, you can save!

What’s in a Stock Market?

Robert Reich holding a finger up at a podium.

Robert Reich: “Repeat after me, the stock market is not the economy.”
Except it kind of is. (CC BY 2.0, ATIS547)

As Robert Reich would have us repeat, “The stock market is not the economy.” He avers that jobs, wages, and general standards of living have little connection to the market. In terms of its ownership, too, the stock market is hardly representative of the citizenry. While 145 million Americans—56 percent of adults—seems like a lot of investors, most of the “investment” is in the form of retirement accounts containing mutual funds. Only about 14 percent of American families actually invest directly in individual stocks. And, the wealthiest 10 percent own more than 80 percent of the shares.

Shareholding is skewed even more than the general distribution of wealth (including real estate), and far more than the distribution of income. So, Reich’s point is well taken. If the economy is supposed to reflect society at large—rich, poor, and middle-class—then the stock market is not the economy.

On the other hand, let’s not get carried away with nostalgia for Reich or our own wishful thinking. If we’re concerned about people and planet, we have to think twice about the relationship between the stock market and the economy. We’d be way wrong to rationalize, for example, “OK, if the stock market is not the economy, I can invest in it without worrying about my ecological footprint. Limits to growth might apply to the economy, but not to the stock market, which is after all just a measure of expectations, not economic activity per se.”

While the stock market may not be the economy, it certainly represents a lot of our economic activity. Consider the 30 stocks comprising the Dow Jones Industrial Average, the long-serving index of the New York Stock Exchange:

Dow-Jones Component
Sector (vernacular)
NAICS Best-Fitting Sector*

3M
Chemicals
Manufacturing

American Express
Financial services
Finance and Insurance

Amgen
Pharmaceutical
Manufacturing

Apple
Information
Information

Boeing
Aircraft
Manufacturing

Caterpillar
Heavy Equipment
Manufacturing

Chevron
Energy
Mining, Quarrying, and Oil and Gas Extraction

Cisco Systems
Technology
Manufacturing

Coca-Cola
Beverage
Manufacturing

Disney
Entertainment
Information

Dow
Chemicals
Manufacturing

Goldman Sachs
Banking
Finance and Insurance

Home Depot
Retail
Retail Trade

Honeywell
Equipment
Manufacturing

IBM
Technology
Information

Intelligent
Technology
Manufacturing

Johnson & Johnson
Pharmaceutical
Manufacturing

JP Morgan Chase
Banking
Finance and Insurance

McDonalds
Food services
Accommodation and Food Services

Merck
Pharmaceutical
Manufacturing

Microsoft
Information
Information

Nike
Footwear
Manufacturing

Proctor & Gamble
Personal care (products)
Wholesale Trade

Salesforce
Software
Information

Travelers
Insurance
Finance and Insurance

UnitedHealth
Health Insurance
Finance and Insurance

Verizon
Telecommunications
Information

Visa
Financial services
Finance and Insurance

Walgreens
Retail
Retail Trade

Walmart
Retail
Retail Trade

*NAICS is the North America Industry Classification System, maintained by the U.S. Census Bureau.

 

 

 

 

 

 

Taken one by one or in the aggregate, does anything look sustainable about this who’s who of Wall Street? If anything, it’s a conglomerate with a glaring and growing ecological footprint, with Caterpillar bulldozing the way for the rest of these bellwether corporations. Yet when we study the list, we also find something glaring in its absence.

The absence should be glaring for steady staters, at least, if not for Robert Reich (a progressive but nevertheless neoclassical economist). Can you spot it?

Here’s a hint: How are any of the 30 CEOs, their boards, and their strategists going to eat, and thus continue their plundering growthmanship? Yes, McDonalds is in their midst, but once that last McDouble comes off the McGriddle, they’re in McTrouble, and more than McLittle. They’ve got no farmers, fishers, or growers to keep food on the table!

In this non-Reichian sense, then, the stock market is profoundly not the economy. The real economy starts with agriculture—agriculture and extraction, but most notably agriculture—before anyone goes to work at Apple, Amgen, or American Express. The real economy starts, succeeds, and persists only with enough agricultural surplus to free the people for a division of labor, allowing for the existence of IBM, 3M, and McDonald’s itself. Without that agricultural surplus, the entire economy collapses; real and monetary sectors alike.

So, if we think of “the stock market” as the Dow, it most certainly is not the economy. It’s not the economy for the “Reich reason” (not representing the American public) and it’s not the economy for the structural reason (lacking an agricultural and extractive base). But hang on; there’s more to the story. The verdict isn’t quite in yet on how closely the stock market resembles, reflects, or represents the real economy.

The Dow is Not the Stock Market

The Dow is not “the” stock market, but rather a stock market index. It’s the leading index, but not the only index. Unless you’re comatose, you can’t get through a week in the USA without hearing about the Nasdaq and S&P 500, too. The Nasdaq represents the technology sector especially, while the S&P 500 is supposed to represent the stock market at large.

The New York Stock Exchange Trading Floor

All that time and attention spent on mind-numbing, money-grubbing minutiae.

Thank goodness we don’t have to hear about the rest of the approximately 5,000 indices. We have almost as many indices in the USA as there are publicly traded stocks, perhaps even more if we leave out the OTC equities (that is, stocks traded purely over the counter and not via stock exchange).

Globally there are well over 3 million stock indexes, or 70 times the number of publicly traded companies! I’ll opine about the proliferation of such indexes below, but only after we settle this matter of the stock market representing (or not) the real economy.

If we took all the publicly traded corporations in the world—roughly 43,000—and assembled them like pieces of an ecological puzzle, they’d start looking more like the real global economy; that is, the triangular economy building upon the agricultural and extractive sectors at the base. Similarly at the national level, we could use the Wilshire 5000 for a fuller picture of the U.S. economy than we get from the Dow, Nasdaq, or S&P 500. We have agricultural and extractive sectors at the base, heavy manufacturing sectors in the middle, and light manufacturing at the top, with service sectors intertwined throughout, serving the agricultural, extractive, and manufacturing industries in addition to household consumers.

Reich’s particular point about the representation of citizens would still stand, because while Del Monte, Perdue, and Cargill might be there, pumping out the produce and poultry like insults at a political rally, not a single family farm would be in sight, or in mind. Nevertheless, the full suite of NAICS sectors would be represented. In that sense, we might hearken back to another Clintonian confidant, James Carville, and say of the stock market, “It’s the economy, stupid.”

Which brings us back to the incompatibility of stock market investment and serious steady statesmanship.

What Happens When You Purchase Stock

When you purchase stock through an initial public offering, you’re either helping yet another corporation take root, or an existing one expand its operations. It’s that simple. That might have been fine in the early 20th century, but by now, any addition to the bloated economy is like feeding Fat Albert French fries. It’s not healthy—literally—for people or planet.

While the effect isn’t as direct, you encourage the corporation to expand its operations when you purchase “seasoned” (non-initial) shares at the stock exchange, too. Corporations view their share price as a barometer for when to initiate more capital outlay. On the ground, that means more factory floor, offices, utilities, energy consumption, and pollution. Less green space, quietude, biodiversity, resources, clean air, climate stability…all the things we need most at this point in history.

Please don’t cop a plea with the lukewarm alibi, “I’ll do good with my money by investing in sustainable industries.” Steady staters know that sustainability is first and foremost about the size of the economy. The hydrogen French fries may not be as fattening, but Fat Albert needs less fries, period.

Furthermore, the economy grows as an integrated whole, and so does the stock market. If you’re helping one sector, you’re essentially helping them all. You may not be assisting every business competitor when you purchase a particular stock, but you are helping to expand a sector, and therefore the economy at large.

Every stock purchase is an opportunity cost, too. Think of all the bona fide good that could have been done with the trillion dollars poured into stock markets in 2021. Things like infrastructure repair, debt relief, healthcare coverage, and education. It almost makes you want higher taxes—especially capital gains taxes. That’s assuming our elected politicians have meritorious priorities. And there you go: meritorious political campaigns could have been supported instead of more pipelines, power plants, and parking lots.

Stock Market Indices Are Social Indicators, Too

In 1975, global market capitalization (the market value of publicly traded shares) comprised roughly 27 percent of global GDP. It first exceeded GDP in 1999, and by 2020 was 135 percent of GDP, or almost $94 trillion. In the USA alone it was nearly $41 trillion; well over double the American GDP. What does that tell us about American priorities?

Two adults happily sliding down a double playground slide.

Sell your stocks and enjoy the slide! (CC BY-NC-SA 2.0, blanchardjeremy)

Revisiting the proliferation of stock indices and funds, one gets the impression that just about any combination or permutation of stocks could constitute this or that “index,” with more of them arising by the business day. Many if not most of these indices double as investment vehicles in their own right, scarcely distinguishable from mutual funds and exchange-traded funds (ETFs). These “index funds” can only be purchased outside of trading hours though, so in today’s hyperactive markets, ETFs have become all the rage, as they can be traded throughout the day. In the first quarter of 2022, 73 more were added to the New York Stock Exchange alone (one of 60 stock exchanges in the world).

This proliferation of funds, indices, and market cap speaks to the salesmanship and ambition of financial operators, brokerage firms, and (most likely) second comings of Bernie Madoff. It’s also an embarrassment for Homo sapiens, with so many of its members occupying their precious time on such mind-numbing money-grubbing.

Don’t we have better things to do with our time and money than analyzing the markets to death and trying to suck even more money out of an inflated market and money supply?

If you own stock, why not sell it now? Use it to help an ailing loved one, or even an ailing stranger. Boost the campaign of a steady stater. Put it in a trust fund for your kids’ tuition. Protect some land, help Ukraine, and put some smiles on poor kids’ faces. Who knows the benefits you might impart?

One thing is certain: When you sell your stocks, you’ll be helping us all—people and planet—with desperately needed degrowth toward a steady state economy. Then you can stop worrying about the Dow, the Nasdaq, and the rest of the 5,000 boring indices.

Brian Czech, Executive Director of CASSEBrian Czech is the executive director of CASSE.

The post Sell Your Stocks and Enjoy the Slide appeared first on Center for the Advancement of the Steady State Economy.

More than words: Bank of England publications and market prices

Published by Anonymous (not verified) on Tue, 17/05/2022 - 6:00pm in

Timothy Munday

How easy is it to understand this sentence you are currently reading? How easy it is to understand this sentence that has dependency arcs that are longer that make it more difficult to read? How about if my writing is magniloquent? Or what if I use normal words? Writing style matters for how easy it is to read text. This post asks if writing style can influence how long markets take to digest Bank of England monetary policy information. I find that Bank of England publications that summarise their content in the first sentence, and use less unexpected vocabulary, are associated with a faster time for swap markets to reach a new equilibrium price following the publication release.

The Monetary Policy Report (MPR), Minutes and other publications have material effects on asset prices (Hansen, McMahon and Tong (2019). But these moves in asset prices may take hours (or days) to materialise. The November 2021 MPR was 56 pages long. That publication was released simultaneously with the Minutes, which was 15 pages long. Subsequently, there was an hour long Q&A, the text of which was 14 pages long when transcribed. In other words, markets received a deluge of information. That information will only be fully reflected in asset prices when market participants have had time to read and digest the publications.

A discussion of what the Bank of England’s Monetary Policy Committee (MPC) chooses to say in these documents is well above this author’s pay grade. It is the result of a long process of deliberation by the MPC and staff. The content of that discussion, the outcome of the MPC’s decision, and the reasons behind it, are taken as fixed.

How the MPC chooses to communicate is a different issue (and indeed has been discussed on this blog before). This post asks if writing style can influence how long markets take to digest Bank of England monetary policy information. In other words, if the Bank of England writes more clearly, does that lead to a faster time for market prices to move to a new equilibrium?

Measuring post-publication market dynamics

How long market participants take to digest the Bank of England information is calculated by measuring the time it takes market prices of the 2 year sterling Overnight Index Swap (OIS) rate to stop moving following the publication(s).

Technically, I define a new equilibrium price to have been reached when the total change in price over an hour is statistically indistinguishable from zero.

I consider the release of the MPR (and any concurrent publications such as the Minutes) that occurred from 2009, when OIS data becomes available, to the end of 2019, when the available textual data ends.

Chart 1 shows how long it takes after each MPR (and Q&A) for the OIS market to settle.

Chart 1: Time for 2 year sterling OIS market to reach a new equilibrium following an Monetary Policy Report release

The joy of text

Clear writing has many aspects. The small sample means I can only test a few hypotheses as to what kind of writing is associated with quicker market reactions.

Luckily, previous work can act as a guide to what might be important. In an empirical exercise, Munday and Brookes (2021) find several aspects of central bank text to be significant for whether a communication is reported on in newspapers. These aspects of writing seem to matter because they make the text more readable.

The aspects of readability I consider in this post are:

  • Average word prevalence. This measures how well known the words are in the publications. It is measured using the dataset of Brysbaert, Mandera, McCormick, and Keuleers (2019).
  • Contextual expectancy score. This measures how expected (or unexpected) a word is given its context. This is measured using Spacey’s word vector engine.
  • Dependency arc length. Dependency arcs map the relationships between words that readers must manage whilst reading a sentence. When reading a sentence, we process each word incrementally over time. Sentence structures that hamper this process make reading more difficult. Munday and Brookes (2021) find that long dependency arcs are related to reduced news coverage of Bank communication.
  • Headlining score. This is a measure of to what extent the first sentence of a document summaries its contents. It is measured by the doc2vec similarity (Le and Mikolov (2014) of the first sentence and the rest of the document.
  • Number of sentences. This measures how long the Bank of England’s text is.

I run a standard OLS regression of the length of time the market takes to reach a new equilibrium against the textual features outlined above.

The regression also includes controls for whether a monetary policy decision occurred on the day of the publication(s), and on the initial (30 minute) market surprise on the release of the Monetary Policy Report. Both of these are plausibly related to the time it takes for the market to reach a new equilibrium price, because they capture the Bank’s immediate monetary policy decision. I condition on them in order to focus on the communication component of the Bank’s information release.

Results

Chart 2 shows the coefficients of the estimated regression. Each bar shows, all else equal, the association between one standard deviation increase in a feature, and the time the market takes (in seconds) to move to a new equilibrium. The black bars represent 95% confidence intervals. This regression is not without issues (discussed below), so these results should be interpreted as associations, rather than causal relationships.

There are two features that are significant at the 5% level and two at the 10% level.

Documents with higher contextual expectancy, first lines that summarise the entire document, words that are more prevalent, and are published on days without a monetary policy decision are associated with a shorter time for the market to reach a new equilibrium.

The length of dependency arcs, the initial market reaction, and, interestingly, the length of the document, do not display any association with the time taken for the market to digest the Bank’s information.

Chart 2: Effect on time to new equilibrium of writing style (regression coefficients with confidence intervals)

Without wanting to over-interpret these results, it does seem like particular aspects of writing style are important for market understanding.

Discussion

The above analysis comes with several caveats, and so our results should be read in with them in mind.

Only correlations between some (handpicked) textual features and how long it takes for the market to settle have been presented. And, of course, correlation doesn’t imply causation. Indeed, there are plausible omitted variables: one could argue that if the Bank of England has a more complicated message to convey, it must write in a more complicated style.

Furthermore, the estimates of how long it takes the market to digest communication are simple, and influenced by news releases that occur after the publications (although these should only add noise to the estimates, not bias them).

Finally, the small sample does mean that the regression lacks power. Coefficients that just dip under a 5% or 10% significant level should not be over-interpreted.

These caveats notwithstanding this is initial evidence that writing style matters, adding to the existing body of work on this topic from the Bank of England (Haldane and McMahon (2018); Bholat et al (2018). Of course content matters, and the Bank of England’s message is of paramount concern when drafting communication. But, at the margin, when that message’s substance has been formed, the style it is presented in can help the market to understand it quicker.

Timothy Munday worked in the Bank’s External Engagement Division in Monetary Analysis when he authored this post.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Reblog – No, MMT Didn’t Wreck Sri Lanka

Published by Anonymous (not verified) on Sun, 15/05/2022 - 8:37pm in

Debunking Bloomberg with Fadhel Kaboub

Written by Stephanie Kelton

Originally published on Stephanie Kelton’s “The Lens” on 29th April 2022.

Two poor men sitting on a trolley on a street of closed shops. Petta, Colombo, Sri LankaImage by Harshabad on Pixabay

Last week, Bloomberg touted an opinion piece (written by one of its regular columnists) claiming that “Sri Lanka was the first country in the world to try MMT” and that “the experiment has brought the country to ruin.” A few days later, The Washington Post republished the article. So it garnered a fair bit of attention. Unfortunately, the essay offers little insight into what’s really gone wrong in Sri Lanka. But, hey, editors and writers have discovered that MMT drives clicks, so there’s no dearth of efforts to shoehorn MMT into almost anything.

A number of people sent me the link and asked me to respond. I sat down to do just that, but then I remembered that MMT economist Fadhel Kaboub talks about Sri Lanka in some of his presentations and that he’s been studying the country for years.

Fadhel is an Associate Professor of Economics at Denison University and President of the Global Institute for Sustainable Prosperity. He brings deeper knowledge of the Sri Lankan economy and the policy decisions that have paved the way for their current predicament. So I reached out to invite him to respond to Mihir Sharma’s main claims about the so-called MMT experiment in Sri Lanka.

Sharma’s big claim is that “two cherished heterodox theories…became official policy in Sri Lanka and, within two years, they brought the country to the brink of default and ruin.” The government has halted payments of its foreign debt and warned that it may default. Import prices are surging. It’s hard for people to buy food and fuel. There are periodic blackouts and rationing. Inflation is close to 19 per cent and the central bank has recently doubled interest rates. Sharma acknowledges that there are ’structural factors’ at play, and he concedes that the pandemic hammered the nation’s tourism sector while the Russian invasion of Ukraine made everything worse. But he argues that “the deeper problem” is that the ruling elite “turned Sri Lanka’s policymaking over to cranks.” One of the heterodox theories that is supposedly responsible for the crisis is MMT.[1] What follows is a lightly-edited transcript of my Q&A with Professor Kaboub.

KELTON: Sharma claims that “Sri Lanka is the first country in the world to reference MMT officially as a justification for money printing.” He blames former central bank governor, Weligamage Don Lakshman, for listening to monetary cranks who convinced him that “nobody needs to worry about debt sustainability” as long as you “increase the proportion of domestic debt [relative to debt denominated in foreign currency].” Is there anything in MMT that says that as long as you “increase the proportion of domestic debt” you can “print money” without worrying about debt sustainability or inflation?

KABOUB: When I first read the statement of Sri Lanka’s Central Bank governor, Mr Weligamage Don Lakshman, back in 2020, it was very clear to me that he does not understand the basic MMT insights. He was under the impression that what matters in terms of monetary sovereignty is the proportion of foreign currency debt relative to domestic currency debt and that there was no need to rethink the foundation of the economic development model that his country has used since the late 1970s. Governor Lakshman focused on the proportion of debt but never questioned what the external debt was fueling, and never articulated how a higher proportion of domestic debt was going to build economic resilience in Sri Lanka.

MMT economists have been very clear all along that a country’s fiscal spending capacity is constrained by the risk of inflation, which is determined by the level of productive capacity (availability of real resources, productivity, skills, logistics, supply chains, etc.) and the level of abusive market power enjoyed by key players in the economy (cartels, exclusive import license holders, shell companies, cross-border traffickers, speculators, corrupt government procurement systems, etc.). Therefore, increasing a country’s fiscal policy space must be done via strategic investments to boost productive capacity and regulation of abusive market power. Sri Lanka’s economic policy choices (pre-pandemic and Russia-Ukraine war) do not even come close to what MMT economists would have suggested.

As I will explain below, Sri Lanka has three structural economic weaknesses that were systematically reinforced via mainstream economic policies: 1.) lack of food sovereignty, 2.) lack of energy sovereignty, and 3.) low value-added exports. These deficiencies imply that accelerating the country’s economic engines leads to more pressure on its external balance, a weaker exchange rate, higher inflationary pressures (especially food/fuel/medicine and basic necessities), and, as a result, it leads to the classic trap of external debt.

Here is how it all started. Sri Lanka, like many countries in the Global South, began the liberalization of its economy in 1977, and adopted a classic IMF-style economic development model based on exports, foreign direct investment (FDI), tourism, and remittances. This development model remained tamed during the civil war (1983-2009), but it was fully unleashed in 2009, and that is when external debt began to skyrocket, going from $16 billion in 2008 to nearly $56 billion in 2019. The value of the Sri Lankan rupee dropped from 114 to 178 LCU/USD. Thanks to a massive increase in government subsidies and transfers reaching more than 30 per cent of government spending in recent years, Sri Lanka struggled to keep inflation below 5 per cent. Yet, economists celebrated Sri Lanka’s great achievements with an average growth rate exceeding 5 per cent in the decade after the civil war, and a real per capita GDP growth putting the country officially in the upper-middle-income economy category. Sri Lanka was following the mainstream economic development model like a good student. In the decade starting in 2009, exports grew from $9.3 to $19.1 billion, tourism quintupled from 0.5 to 2.5 million visitors annually, FDI inflows quadrupled by 2018 to a record $1.6 billion, and remittances doubled to nearly $7 billion annually. These are the four engines of Sri Lanka’s economic growth, but they are also the engines driving the country deeper into the structural traps of food and energy dependency, and specialization in low value-added exports.

Here is how these engines constitute a trap. An increase in tourism induces more food and energy imports. An increase in remittances means more brain drain. An increase in low value-added exports induces more imports of capital, intermediate goods, fuel etc.; and an increase in low value-added FDI does the same plus the repatriation of profits out of Sri Lanka. On a global scale, these neocolonial economic traps have suctioned $152 trillion from the Global South since 1960.

KELTON: Sharma argues that it was the “printing of money” that caused inflation to hit record highs. He cites the rate of growth of the Sri Lankan money supply and concludes that inflation hit record highs because the central bank expanded the money supply by 42 per cent from December 2019 to August 2021. Why isn’t this a critique of MMT, and how do you think about the current inflationary pressures?

KABOUB: Sharma is wrong on two fronts here. First, he is assuming that the central bank actually controls the money supply, when in fact the money supply is an endogenous variable determined by the private sector (consumers, business, and banks). The central bank simply accommodates the needs of the market in order to keep short-term interest rates at a stable target, otherwise it will cause all kinds of instability across financial markets. Second, Sharma is assuming that inflation is caused by an increase in the money supply, when in reality, Sri Lanka’s inflation, like many developing countries, imports its inflation via food and energy imports. The higher the pressure on the external balance, the weaker the exchange rate, the higher the inflation pressure from imported goods. Sri Lanka struggled with these pressures for a decade, and managed to muddle through by accumulating more external debt, which quickly became unbearable after the pandemic (loss of tourism, remittances, FDI, and export revenues) and the massive increase in global food and energy prices after the Russian invasion of Ukraine.

The solutions to Sri Lanka’s inflation problems are not in the hands of its central bank. Raising interest rates in Sri Lanka will not end the war in Ukraine, or end the pandemic-induced global supply chain disruptions. The most effective anti-inflation tools fall under fiscal policy. It is the parliament, and the various ministries and commissions that can design strategic investments to boost productive capacity, and have the legal authority to update and enforce antitrust laws. In fact, raising interest rates can often fuel inflation (and inequality) because it is the equivalent of an income subsidy to bond holders, and a tax on actual investors who might be discouraged from increasing productive capacity

KELTON: Sharma appears to know that he has offered a faulty representation of MMT. He anticipates some of the counterpoints that I suspect you and I would both raise. He writes, “proponents of MMT will likely say that this was not real MMT, or that Sri Lanka is not a sovereign country as long as it has any foreign debt.” You have been studying Sri Lanka for a few years now. What, if anything, have policymakers done that suggest that they have been running any kind of “MMT experiment” over the last two years?

KABOUB: Well, this is where Sharma nails it! As I explained above, Sri Lanka’s economic policies don’t even come close to anything informed by MMT insights. Sri Lanka’s government ignored its structural weaknesses, didn’t invest in food/energy and strategic domestic productive capacity, didn’t tax/regulate abusive market power, has a corrupt political system dominated by a single family, and when it was backed into a corner after the pandemic, it doubled down on bad economic decision by claiming that agricultural fertilizers are unhealthy (when they really didn’t have the foreign exchange reserves to pay for the imports), so they destroyed agricultural output, especially rice, in the middle of global food crisis. If the Sri Lankan government was serious about investing in healthy food or a healthy economy, it would have put forward an actual food sovereignty strategy centred on native seeds, it would have discouraged intensive monoculture farming, it would have invested in regenerative farming to undo decades of damage to the soil, and it would have supported farmers to increase yields with well-defined medium and long term strategies. Clearly, this “organic farming” experiment was sloppy at best, but it should not overshadow the fact that the roots of the agricultural vulnerability have been decades in the making.

KELTON: Sharma chides the government for shunning the advice of “mainstream economists” and for “refusing to even consult the IMF.” Let’s assume he’s right about the central bank and other policymakers turning away from mainstream economists and institutions like the IMF. What kind of advice has the IMF given to Sri Lanka in the past, and what kind of economic development strategies would you recommend if officials called on you to advise them?

KABOUB: Sri Lanka has been following the IMF instruction manual for decades. It has received 16 loans from the IMF since the 1960s, and it is currently negotiating another one. Since 1996, Sri Lanka has never been away from the IMF’s negotiating table for more than 3 or 4 years at a time. Despite the political rhetoric of the Sri Lankan government over the last couple of years, the current Sri Lankan administration has abided by the IMF’s terms and conditions of the $1.5 billion Extended Fund Facility (that’s the 16th loan disbursed between 2016-2020). So maybe the Sri Lankan government has come to realize that the IMF instruction manual is actually harmful. The problem is that they don’t fully understand why, and they certainly haven’t identified an alternative strategy to escape from this trap.

In terms of policy advice, Sri Lanka needs emergency assistance with immediate shipments of food, fuel, medicine, and basic necessities. Sri Lanka needs debt relief rather than debt restructuring. For example, UNDP has recently recommended negotiating debt-for-nature swaps. There are other debt swap mechanisms such as debt-for-development, debt-for-equity, and debt-buy backs. The Sri Lankan central bank should be negotiating FX swap line agreements with the central banks of its major trading partners in order to stabilize the value of its currency.

Sri Lanka should also access the IMF’s newly created $45 billion Resilience and Sustainability Trust (RTS), which, unlike other IMF facilities, is actually a program that funds strategic investments to build resilience and promote sustainability. Sri Lanka would qualify for up to $1.4 billion of concessional loans with substantial grace periods. However, to qualify for RTS funds, Sri Lanka must first have an existing agreement with the IMF. It needs to enter these negotiations with its own strategic vision in order to escape the IMF’s austerity and external debt trap.

The IMF wants countries to establish an economic policy framework that leads to external debt sustainability, but its track record has been a miserable failure. Sri Lanka needs to convince the IMF and other lenders and strategic partners, that it can only escape this external debt trap if it tackles the problem at its source — e.g. by investing strategically in food sovereignty (with an actual long-term strategy rather than half-baked organic farming wishful thinking), investing in renewable energy capacity (energy efficiency, public transportation, etc.), investing in education and vocational training in order to climb up the value chain in the manufacturing sector, and becoming more selective in its support for export industries and FDI projects. In other words, ending the race to the bottom policies, and building resilience to external shocks.

These strategic investments must be coupled with an actual democratization of the political as well as the economic system. The government needs to crack down on corruption, cartels, abusive price setters, and entities that enjoy exclusive economic power and have every incentive to object to the strategic investments listed above.

The sad part of this story is that Sri Lanka is only one of many countries in the Global South facing the same structural traps, struggling with unbearable external debt, soaring food and energy prices, shortages, and rising social and political tensions.

 

[1] The other has to do with a shift toward organic farming that has apparently fueled a precipitous drop in crop yields, farming incomes, and export revenues.

 

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The post Reblog – No, MMT Didn’t Wreck Sri Lanka appeared first on The Gower Initiative for Modern Money Studies.

Otmar Issing Is Still Living in His Monetary Fantasy World

Published by Anonymous (not verified) on Sat, 23/04/2022 - 3:13am in

Otmar Issing can look back on a long and consequential central banking career. Even in his retirement he is still living the part, evaluating whether his successors at the European Central Bank are pursuing stability-oriented monetary policies to his liking. His most recent critique (“‘Living in a fantasy’: euro’s founding father rebukes ECB over inflation response” https://www.ft.com/content/145b6795-2d21-48c6-984b-4b05d121ba16) shows him on the wrong side of events and debates about sound monetary policy, again.

Mr. Issing spent an eight-year stint at the Bundesbank as chief economist of Germany’s legendary central bank and retired guardian of European monetary affairs. Misled by M3 overshots that were the result of the Buba’s own rate hikes inverting the yield curve, Buba kept on hiking until it crashed newly unified Germany, and the ERM too. Recession-caused fiscal troubles then saw Mr. Issing’s Buba cheerleading pressures for fiscal austerity. These involved hikes in indirect taxes and administered prices that were distorting headline inflation upwards and delaying Buba easing (see https://www.levyinstitute.org/publications/on-the-burdenr-of-german-unification). The ensuing malaise in Europe was so pronounced that it almost prevented Mr. Issing from becoming a founding father of the euro.

But the euro got lucky, courtesy of a last-minute push from America’s dot-com boom. And so Mr. Issing got his chance as the ECB’s influential first chief economist. Unfortunately, lessons from Germany’s debacle ten years earlier were not learned. The newly formed euro monetary union repeated the blunder of pairing fiscal austerity with growth-unfriendly monetary policy, resulting in stagnation and inflation stubbornly above two percent due to austerity-inspired hikes in indirect taxes and administered prices distorting headline inflation (https://www.levyinstitute.org/publications/assessing-the-ecbs-performance-since-the-global-slowdown and https://ideas.repec.org/p/imk/studie/01-2006.html).  Germany itself was supercharging austerity and wage repression and turned into “the sick man of the euro”. (see Bibow 2005 “Germany in crisis – The unification challenge, macroeconomic policy shocks and traditions, and EMU”, International Review of Applied Economics, 19(1): 29-50. And https://www.levyinstitute.org/publications/bad-for-euroland-worse-for-germany)

Not all members were stuck in stagdeflation though as financial liberalization fired up bubbles elsewhere in the euro area. (see https://www.levyinstitute.org/publications/how-the-maastricht-regime-fosters-divergence-as-well-as-fragility) Nonetheless, Mr. Issing’s previously held doubts about the optimality of Europe’s monetary union were dissolving. So convinced of the optimality of the ECB’s guardianship, he declared in 2005 that: “Today, in light of the evidence gathered so far in the euro area, I am more confident in saying: ‘One size does fit all!’” (see https://www.ecb.europa.eu/press/key/date/2005/html/sp050520.en.html). He retired from the ECB just in time to be no longer in charge when the euro’s apparent success story unraveled. But his immediate successors made sure to stick with the stability-oriented wisdom they had been taught by Mr. Issing, so that the euro area got stuck in the doldrums for years (https://www.levyinstitute.org/publications/germany-and-the-euroland-crisis).

It was only with the arrival of the Draghi team that enlightenment finally reached the ECB. Today, the ECB, still trying to steer a flawed monetary union that is lacking fiscal union, is confronted with unprecedented challenges in the form of a pandemic and the Ukraine war. Given Mr. Issing’s track record, they should take encouragement from his latest critique – they may actually be doing something right. A monetary policy mindset that always and everywhere sees provoking recession as a matter of precaution is unlikely to yield optimal monetary policies outside of Mr. Issing’s fantasy world.

It is telling that Mr. Issing uses his recent interview with the FT as an opportunity to invent yet another fantasy. Attacking the ECB for failing to start normalizing monetary policy a long time ago, Issing is reported to have asserted that: “The prospect for a ‘stagflationary’ situation of rising inflation and slowing growth is ‘the worst combination’ for a central bank, said Issing, who contrasted monetary policymakers’ responses to the two oil shocks of the 1970s. ‘The Bundesbank tried to control inflation and the consequence was moderate inflation and a mild recession,’ said Issing, who joined the German central bank in 1990. But ‘the Fed waited too long’ and the US had ‘double-digit inflation and a deep, deep recession.’”

It is of course true that inflation in the U.S. reached double digits in the 1970s and the U.S. suffered a double-dip recession in the early 1980s. Employment reached its trough at the end of 1982, 2.4 percent below the previous peak in early 1980. It was only in September 1983 that employment exceeded its pre-recession peak. Where Mr. Issing takes a deep dive into his “stability-oriented” dreamland is in asserting that (West) Germany only experienced a “mild recession” in the early 1980s. For in 1983 employment in (West) Germany was still 2.7 precent below its previous peak in 1980. It took until 1987 for (West) Germany’s employment to finally exceed its pre-recession peak. Of course, Mr. Issing would blame (West) Germany’s poor employment record despite allegedly only suffering a “mild recession” on “structural problems” and a lack of fiscal austerity. Because in Mr. Issing’s fantasy world – courtesy of the money neutrality postulate – “stability-oriented” monetary policy cannot possibly be responsible for anything else but price stability.

I am reminded here of the late Milton Friedman, the arch-monetarist, who refuted Mr. Issing for his comfort-seeking fancies about the relevance of monetary neutrality propositions for central bankers (see https://onlinelibrary.wiley.com/doi/abs/10.1111/1467-8454.00169), stating: “Neutrality propositions give little if any guide to effective central bank behaviour under such circumstances. Perhaps they offer comfort to central bankers by implying that all mistakes will average out in that mythical long run in which Keynes assured us ‘we are all dead’.” (see https://digitalcollections.hoover.org/objects/57393)

Central bankers, too, even the worst ones, deserve retirement before they are dead.

Otmar Issing Is Still Living in His Monetary Fantasy World

Published by Anonymous (not verified) on Sat, 23/04/2022 - 3:13am in

Otmar Issing can look back on a long and consequential central banking career. Even in his retirement he is still living the part, evaluating whether his successors at the European Central Bank are pursuing stability-oriented monetary policies to his liking. His most recent critique (“‘Living in a fantasy’: euro’s founding father rebukes ECB over inflation response” https://www.ft.com/content/145b6795-2d21-48c6-984b-4b05d121ba16) shows him on the wrong side of events and debates about sound monetary policy, again.

Mr. Issing spent an eight-year stint at the Bundesbank as chief economist of Germany’s legendary central bank and retired guardian of European monetary affairs. Misled by M3 overshots that were the result of the Buba’s own rate hikes inverting the yield curve, Buba kept on hiking until it crashed newly unified Germany, and the ERM too. Recession-caused fiscal troubles then saw Mr. Issing’s Buba cheerleading pressures for fiscal austerity. These involved hikes in indirect taxes and administered prices that were distorting headline inflation upwards and delaying Buba easing (see https://www.levyinstitute.org/publications/on-the-burdenr-of-german-unification). The ensuing malaise in Europe was so pronounced that it almost prevented Mr. Issing from becoming a founding father of the euro.

But the euro got lucky, courtesy of a last-minute push from America’s dot-com boom. And so Mr. Issing got his chance as the ECB’s influential first chief economist. Unfortunately, lessons from Germany’s debacle ten years earlier were not learned. The newly formed euro monetary union repeated the blunder of pairing fiscal austerity with growth-unfriendly monetary policy, resulting in stagnation and inflation stubbornly above two percent due to austerity-inspired hikes in indirect taxes and administered prices distorting headline inflation (https://www.levyinstitute.org/publications/assessing-the-ecbs-performance-since-the-global-slowdown and https://ideas.repec.org/p/imk/studie/01-2006.html).  Germany itself was supercharging austerity and wage repression and turned into “the sick man of the euro”. (see Bibow 2005 “Germany in crisis – The unification challenge, macroeconomic policy shocks and traditions, and EMU”, International Review of Applied Economics, 19(1): 29-50. And https://www.levyinstitute.org/publications/bad-for-euroland-worse-for-germany)

Not all members were stuck in stagdeflation though as financial liberalization fired up bubbles elsewhere in the euro area. (see https://www.levyinstitute.org/publications/how-the-maastricht-regime-fosters-divergence-as-well-as-fragility) Nonetheless, Mr. Issing’s previously held doubts about the optimality of Europe’s monetary union were dissolving. So convinced of the optimality of the ECB’s guardianship, he declared in 2005 that: “Today, in light of the evidence gathered so far in the euro area, I am more confident in saying: ‘One size does fit all!’” (see https://www.ecb.europa.eu/press/key/date/2005/html/sp050520.en.html). He retired from the ECB just in time to be no longer in charge when the euro’s apparent success story unraveled. But his immediate successors made sure to stick with the stability-oriented wisdom they had been taught by Mr. Issing, so that the euro area got stuck in the doldrums for years (https://www.levyinstitute.org/publications/germany-and-the-euroland-crisis).

It was only with the arrival of the Draghi team that enlightenment finally reached the ECB. Today, the ECB, still trying to steer a flawed monetary union that is lacking fiscal union, is confronted with unprecedented challenges in the form of a pandemic and the Ukraine war. Given Mr. Issing’s track record, they should take encouragement from his latest critique – they may actually be doing something right. A monetary policy mindset that always and everywhere sees provoking recession as a matter of precaution is unlikely to yield optimal monetary policies outside of Mr. Issing’s fantasy world.

It is telling that Mr. Issing uses his recent interview with the FT as an opportunity to invent yet another fantasy. Attacking the ECB for failing to start normalizing monetary policy a long time ago, Issing is reported to have asserted that: “The prospect for a ‘stagflationary’ situation of rising inflation and slowing growth is ‘the worst combination’ for a central bank, said Issing, who contrasted monetary policymakers’ responses to the two oil shocks of the 1970s. ‘The Bundesbank tried to control inflation and the consequence was moderate inflation and a mild recession,’ said Issing, who joined the German central bank in 1990. But ‘the Fed waited too long’ and the US had ‘double-digit inflation and a deep, deep recession.’”

It is of course true that inflation in the U.S. reached double digits in the 1970s and the U.S. suffered a double-dip recession in the early 1980s. Employment reached its trough at the end of 1982, 2.4 percent below the previous peak in early 1980. It was only in September 1983 that employment exceeded its pre-recession peak. Where Mr. Issing takes a deep dive into his “stability-oriented” dreamland is in asserting that (West) Germany only experienced a “mild recession” in the early 1980s. For in 1983 employment in (West) Germany was still 2.7 precent below its previous peak in 1980. It took until 1987 for (West) Germany’s employment to finally exceed its pre-recession peak. Of course, Mr. Issing would blame (West) Germany’s poor employment record despite allegedly only suffering a “mild recession” on “structural problems” and a lack of fiscal austerity. Because in Mr. Issing’s fantasy world – courtesy of the money neutrality postulate – “stability-oriented” monetary policy cannot possibly be responsible for anything else but price stability.

I am reminded here of the late Milton Friedman, the arch-monetarist, who refuted Mr. Issing for his comfort-seeking fancies about the relevance of monetary neutrality propositions for central bankers (see https://onlinelibrary.wiley.com/doi/abs/10.1111/1467-8454.00169), stating: “Neutrality propositions give little if any guide to effective central bank behaviour under such circumstances. Perhaps they offer comfort to central bankers by implying that all mistakes will average out in that mythical long run in which Keynes assured us ‘we are all dead’.” (see https://digitalcollections.hoover.org/objects/57393)

Central bankers, too, even the worst ones, deserve retirement before they are dead.

The Fed’s Balance Sheet Runoff and the ON RRP Facility

Published by Anonymous (not verified) on Thu, 14/04/2022 - 2:20am in

 Finance and banking concept. Euro coins and us dollar banknote close-up. Abstract image of Financial system with selective focus, toned, double exposure.

A 2017 Liberty Street Economics post described the balance sheet effects of the Federal Open Market Committee’s decision to cease reinvestments of maturing securities—that is, the mechanics of the Federal Reserve’s balance sheet “runoff.” At the time, the overnight reverse repo (ON RRP) facility was fairly small (less than $200 billion for most of July 2017) and was not mentioned in the post for the sake of simplicity. Today, by contrast, take-up at the ON RRP facility is much larger (over $1.5 trillion for most of 2022). In this post, we update the earlier analysis and describe how the presence of the ON RRP facility affects the mechanics of the balance sheet runoff.

Simplified Balance Sheets

In the exhibit below, we describe simplified balance sheets for the Fed, the Treasury, banks, and money market funds (MMFs). We only show the balance sheet items that are essential for understanding the mechanics related to the Fed’s actions. In a follow-up post, we consider the role of levered nonbank financial institutions and households.

  • On the Fed’s balance sheet, the asset side contains Treasury securities; on the liability side, there are reserves held by banks, cash balances held by the Treasury in its “checking account” at the Fed (the Treasury General Account, or TGA), and ON RRP balances held by MMFs.
  • On the Treasury’s balance sheet, the asset side contains balances in the TGA; on the liability side, there are Treasury securities.
  • On banks’ balance sheet, the asset side contains Treasury securities and reserves held at the Fed; on the liability side, there are deposits held by MMFs (for example, transaction deposits as well as overnight and term deposits placed in wholesale funding markets).
  • On MMFs’ balance sheet, the asset side contains Treasury securities, deposits at banks, and investments in the ON RRP facility; on the liability side, there are MMF shares held by households. In contrast to banks and the Treasury, MMFs cannot hold balances in a Fed account; however, MMFs have access to the ON RRP facility (MMFs with ON RRP access accounted for approximately 80 percent of MMF assets under management at the end of 2021).

 Federal Reserve, Treasury, Banks and MMFs with two columns representing assets and liabilities.

We start by showing what happens when Treasury securities held by the Fed mature, the Fed doesn’t reinvest the proceeds of the maturing securities, and the Treasury does not issue new securities. In this case, depicted in the next exhibit, the Treasury pays the Fed with cash from the TGA as the securities mature. The Fed holds fewer assets (its holdings of Treasury securities decrease) and has fewer liabilities (cash held by the Treasury at the Fed decreases), so the size of its balance sheet decreases.

 Federal Reserve, Treasury, Banks and MMFs with two columns representing assets and liabilities.

For the remainder of the post, we assume that when $1 worth of Treasury securities held by the Fed matures, the Treasury issues $1 worth of new securities, so the size of the Treasury’s balance sheet remains unchanged. To make things simple, we assume that new securities are issued at the same time as old securities mature.

Banks Purchase Newly Issued Securities

We now consider what happens when newly issued Treasury securities are purchased by banks (see exhibit below).

Two transactions occur simultaneously:

  • As in the previous exhibit, the Treasury repays the Fed for the maturing securities, which reduces the TGA balance and the Treasury securities held by the Fed by the same amount. In all subsequent exhibits in this post, the sequence of transactions includes this step of the Treasury repaying the Fed. In the interest of simplicity, we won’t mention this step again.
  • Banks purchase the new securities issued by the Treasury, with banks transferring balances to the Treasury in exchange for the securities. As banks transfer money to the Treasury, the TGA balance goes back to its original level.

At the end of this process, the size of the Fed’s balance sheet has decreased with a reduction of Treasury securities on the asset side and reserves on the liability side; the Treasury’s balance sheet is unchanged; and the size of banks’ balance sheet is the same but the composition of assets is different (higher holdings of Treasury securities and lower reserves).

 Federal Reserve, Treasury, Banks and MMFs with two columns representing assets and liabilities.

MMFs Purchase Newly Issued Securities

We next consider what happens when newly issued Treasury securities are purchased by MMFs. MMFs can fund their purchases by withdrawing deposits at banks, reducing their investments in the ON RRP facility, or a combination of the two. The next exhibit shows what happens if MMFs use both deposits and ON RRP investments to purchase Treasury securities.

Several transactions occur simultaneously:

  • MMFs buy new securities from the Treasury, which holds the proceeds at the Fed, returning the TGA balance to its level before the Treasury securities held by the Fed matured.
  • MMFs’ deposits at banks decrease as MMFs use them to purchase a portion of the Treasury securities. Banks facilitate the purchase, transferring reserve balances to the TGA while debiting the accounts that MMFs have at the banks.
  • MMFs reduce their investments in the ON RRP facility to fund the purchase of the remainder of the Treasury securities. ON RRP balances decline and the TGA balance increases by an equal amount.

Banks’ balance sheet shrinks, with lower deposits on the liability side, and lower reserves on the asset side. The size of MMFs’ balance sheet is unchanged, but its composition on the asset side has changed: the increase in Treasury securities holdings is offset by a decrease in deposits held at banks and investments in the ON RRP facility.

Since MMFs can only buy newly issued Treasury securities if they are Treasury bills or floating rate notes, only when these securities are issued in large amounts will MMFs be able to absorb a large fraction of the Fed’s balance sheet reduction. Moreover, the extent to which MMFs are willing to buy Treasury securities depends on how the rates on these securities compare to the rates paid on alternative assets such as bank deposits and ON RRP investments. Finally, since a large fraction of the MMF industry—namely government funds—cannot invest in bank deposits, it is likely that a large proportion of purchases of Treasury securities by MMFs would be financed through reduced investments in the ON RRP facility.

 Federal Reserve, Treasury, Banks and MMFs with two columns representing assets and liabilities.

Banks and MMFs Purchase Newly Issued Securities

Finally, we illustrate the case where some of the new Treasury securities are purchased by banks and some by MMFs. The next exhibit shows what happens when banks and MMFs each purchase half of the new issuance, and MMFs purchase the securities by drawing down a combination of deposits at banks and investments in the ON RRP facility. The description of the transactions corresponding to the exhibit is similar to the ones described above and left as an exercise for the reader.

 Federal Reserve, Treasury, Banks and MMFs with two columns representing assets and liabilities.

Conclusions

In this post, we updated an earlier post illustrating the balance sheet mechanics of a runoff in the Fed’s holdings of Treasury securities to illustrate the effect of the ON RRP facility. In all cases, the Fed’s balance sheet decreases as the Fed doesn’t reinvest the proceeds of its maturing Treasury securities. On the liability side of the Fed’s balance sheet, the decrease may stem from either a reduction of reserves held by banks or a reduction in ON RRP take-up or a combination of both. Similar mechanics occur when agency mortgage-backed securities mature and banks purchase the newly issued securities, as was noted in this Liberty Street Economics post. As the exhibits in this post show, the runoff of the Fed’s security holdings has potential implications for the balance sheets of a range of financial market participants.

Marco Cipriani

Marco Cipriani is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

James Clouse is a deputy director in the Division of Monetary Affairs at the Board of Governors of the Federal Reserve System.

Lorie Logan

Lorie Logan is an executive vice president in the Federal Reserve Bank of New York’s Markets Group.

Antoine Martin

Antoine Martin is a senior vice president in the Bank’s Research and Statistics Group.

Will Riordan

Will Riordan is an assistant vice president in the Bank’s Markets Group.

How to cite this post:
Marco Cipriani, James Clouse, Lorie Logan, Antoine Martin, and Will Riordan, “The Fed’s Balance Sheet Runoff and the ON RRP Facility,” Federal Reserve Bank of New York Liberty Street Economics, April 11, 2022, https://libertystreeteconomics.newyorkfed.org/2022/04/the-feds-balance-s....


Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

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