No(ah) More Excess Reserves

Noah Smith has a far better critique of Feldstein's attempt to link excess reserves with the inflationary dog that didn't bark. It's a bit late in the day and believe me, it's not an admission of guilt. Rather, you could view it as a sort of I-know-why-this-hasn't-happened-somebody-gamed-the-system sort of article.

But Smith's approach is simple. Treat the IOER (Interest on Excess Reserves) as the 'safe asset'. If it's less than the T-bill rate then the latter is the safe asset. Thus,

"The IROR is 0.25%. The T-bill rate is just over 0%. This means that the difference in the expected real rate of return between a world with an IROR and a world without an IROR is about 0.25%. In a world without an IROR, banks lend to any risky project with an expected real rate of return of S. In a world with an IROR, banks lend to any risky project with an expected real rate of return of S + 0.25%"

What he means in terms of Feldstein's claim, is that the band between a project's real rate of return and the +0.25% IOER has a lot of activity (projects to lend for) - R<project<R+0.25%

Basically it is, as Feldstein tries to assert, this that is holding back the excess reserves. If that spread disappeared and the 'safe asset rate' decreased by 0.25% (IOER), the reserves would flood the economy like chimera and inflation would finally bite, forget bark.

So where does the answer lie?

"The answer must lie elsewhere; it must be the case that either S is very high, or there are very few projects with decent expected rates of return, or maybe some sort of institutional constraint on the speed with which banks can ramp up lending. But that little 0.25% IROR can't be what's holding the economy back."

It's true, and it makes sense both on the surface as well as with a bit more thought. Otherwise, the moment the Fed cuts the IOER (stops paying interest on excess reserves), all hell will break loose. I'm pretty sure that's not happening.

And of course, it never hurts to look at Japan.

World Economic Outlook Update (July)

The July WEO update doesn't really say much. Well, on second thought, it doesn't say much that wasn't already known. Perhaps a bit more could have been said on the recent rise in treasury yields and the resulting constraints being faced by EM economies but all in all, the outlook seems muted and there seem to be very few notes of optimism.

A few more points:

- Weakening commodity prices

- Tail-risk mitigation including no more US debt ceiling drama and euro-backstop action on the do-what-it-takes front.

- The forecasts assume that recent volatility and associated rises in yield reflect a sort of one-off repricing of risk due to a protracted EM growth outlook slowdown and taper-talk in the US. This also comes with the warning of additional portfolio shifts and further rises in yields (USTs) that exacerbate capital outflows from EMs and diminish the growth outlook even more.

- For advanced economies, the priority remains near-term growth accompanied by credible medium-term fiscal consolidation (yep!). It cites low inflation and sizeable slack while advocating for continued monetary stimulus and mix of regulatory and macroprudential policy. Of course, clear communication continues to be an integral factor in mitigating volatility.

- For the euro-area, another push towards a full(er) banking union and policies to reduce fragmentation, lift demand and reform product and labor markets.

- Lastly, it stresses cyclical vulnerability in EMs - that sudden capital flow reversals have amplified trade-off risks. Lower than expected potential output has lead to higher fiscal constraints and while monetary easing can still function as the first line of defense, real rates are already low enough and outflows putting depreciation pressure on exchange rates are likely to constrain further easing.

- And there's a footnote (almost like a post-script) on sustainable consumption rebalancing for China and investment for Germany.

On a September Taper

Over at Tim Duy's Fed Watch, there's a marked consensus on the tapering taper talk of a few weeks ago. The point to be stressed here is not the Fed's reaction function but the market's. The blur between QE and interest rates is what caused and perhaps is still causing global jitters and flow reversals and even if the Fed realized that it jumped the gun, or that it needed to appear like it didn't jump the gun, the focus now should be on actual policy.

With the state of the labour market in mind (as it should be because essentially QE was a safety net to provide some semblance of a 'bottom' for the economy'), Duy says that three scenarios look probable

From BAML:

1) The economy converges to the labor data and the Fed starts to steadily move toward a September exit
2) The Fed thinks that reduced downside risks warrant a one-off taper (September) but then move to a wait-and-watch approach for broad-based improvement
3) The Fed plays the wait-and-watch game and doesn't move until December

Option 2 is the relative enigma here but according to Duy, "as we approach the September meeting, weak economic data will be considered less important for the outcome of that meeting relative to subsequent meetings. Barring a substantial negative turn in the data, the Fed will cut the pace of asset purchases in September, but a softer data flow may reduce the magnitude of the cut and the pace of subsequent tapering."

The problem, as evidenced by the recent reaction of the markets, is that a one-off taper followed by a pause doesn't seem to be entirely in the Fed's interest. The easiest path is a calendar path and therefore, it's possible that they start trimming their asset purchases by $15-20 billion per meeting till it hits zero by the end of the year.

Either way, it's important that the Fed convinces the markets of the distinction between QE and the path of short-term rates as policy tools - exactly how they differ in use and function. Most importantly, although it should seem more obvious than it is - a reduction in asset purchases does not and should not signal the end of the ZIRP.

What it does end up signalling, unfortunately, is an around-the-corner-possibility, which then leads to an invariable jumping of the gun. And that's why a September taper seems more and more likely. 

On Reserves, Excess Reserves and Yes, Inflation

Martin Feldstein has long since (make that loongg!) been warning of inflationary doomsday scenarios. Perhaps not to the tune of Meltzer but significantly nonetheless. Meltzer, as Krugman loves to recall has repeatedly stated his opinions such as: 

"Besides, no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation. When will it come? Surely not right away..."
Of course, you could nitpick right away. The US budget deficit as compared to an EZ budget deficit, the rapid growth of money supply is not relatively not very rapid at all. And currency devaluation? Currency devaluation??

But Feldstein backs the excess reserves argument once again over in a piece at Project Syndicate. While the warnings are less dire, they're still present. And it brought to mind the Keister/McAndrews paper back in 2009 on excess reserves. 

Now to be sure, you can't argue with the logic on the surface. If the money multiplier had a temporary demise and the Fed is paying interest on the excess reserves (the IOER has long since been 0.25%), then those parked reserves might see the day of light soon. After all, rapid monetary growth is the best harbinger of inflation!

This is what's happened over the past 10 years as far as inflation and the monetary base and M2 are concerned. All have been indexed to the start for a clearer comparison:

And this is what the money growth actually looks like on a monthly and year on year basis:

Lastly, the level of excess reserves is, in fact, unprecedented:

So when Feldstein states, "When businesses and households eventually increase their demand for loans, commercial banks that have adequate capital can meet that demand with new lending without running into the limits that might otherwise result from inadequate reserves. The resulting growth of spending by businesses and households might be welcome at first, but it could soon become a source of unwanted inflation," does he have a point?

What about the Fed? Feldstein has little faith - "The Fed could, in principle, limit inflationary lending by raising the interest rate on excess reserves or by using open-market operations to increase the short-term federal funds interest rate. But the Fed may hesitate to act, or may act with insufficient force, owing to its dual mandate to focus on employment as well as price stability."

You see, you can't forget a few things. For starters, the fractional reserve banking system operates on the premise of a money multiplier. So the idea of excess reserves contradicts the existence of a multiplier. It works like this: 

increase in bank reserves -> increase in broad money (lending/deposits) -> expansion of deposits raises reserve requirements. 

Clearly this has not occurred. And this is where the IOER (interest on excess reserves) checks in. Any bank holding excess reserves should seek to lend at a positive rate and this lending, in turn should decrease the short-term rate. 

From Keiseter/McAndrews, this: 

"leads to a small increase in reserve requirements, as described in the previous section. Because the increase in required reserves is small, however, the supply of excess reserves remains large. The process then repeats itself...until one of two things happens. It could continue until there are no more excess reserves,...In this case, the money multiplier is fully operational. However, the process will stop before this happens if the short-term interest rate reaches zero. When the market interest rate is zero, banks no longer face an opportunity cost of holding reserves and, hence, no longer have an incentive to lend out their excess reserves. At this point, the multiplier process halts."

But the Fed does pay interest on these excess reserves, so the multiplier process stops far sooner. Instead of continuing till the market interest rate is 0, it continues till this rate reaches the rate paid by the central bank on reserves. So if the central bank pays interest on excess reserves at its target interest rate, the multiplier ceases to exist. 

As for the looming inflationary risks lurking deep within, they hold in a traditional framework - where the Fed influences interest rates by changing the quantity of reserves. But if it's paying interest?

With no interest being paid, as demand for loans pick up etc. etc., the central bank must remove the excess reserves to arrest or check this multiplicative process. Only by removing these reserves can the CB check banks' willingness to lend and cause a rise in short-term rates.

But with interest being paid, the link between the quantity of reserves and willingness to lend breaks. It allows the CB to be independent, (in a way), of the level of reserves. 

Which is not to say that the point or the process is moot. It's not. But to suggest, weakly as Feldstein does, that the Fed may act hesitatingly or insufficiently because of its dual mandate is not correct.

At some point, trade-offs between labor market conditions and price levels may emerge. But that's an argument for another occasion. 

External Scenario Update: India

Courtesy Alex Etra, some updates on the external scenario over in India:

"Total external debt rose to 390 billion at March-end (21% of GDP), up from 376 billion in December and 345 billion in March 2012. Of particular concern is the rising share of short-term debt at residual maturity (44% of total) which comprises both short-term debt and long-term debt maturing in the next year. Combining the 172 billion in short-term debt at residual maturity and the expected CAD of about 100 billion provides a starker picture of the external financing requirement facing India over the next year (~13% of GDP)"

Furthermore,

"With 57% of total external debt denominated in dollars (~89 billion) and previous estimates that about 50% of companies’ foreign borrowing is unhedged, the 10% depreciation of INR over the last month will further add to the rollover risk this year"

There's pressure. The Fed's played it a bit wrong this time and shifts in flows have become a bit messy. As usual, while external scenarios don't factor into Fedspeak and Fedthought, that's where the major consequences are seen.

And I think the RBI's hands seem more tied than before. Any possible room has certainly got smaller and the transmission mechanism, in any case doesn't work too well (e.g: 100 bps of rate cuts in 2012-13 leading to 30 bps in bank lending rates?), not to forget that real deposit rates have been in negative territory for over a year approximately. Moreover, corporate and bank balance sheets are far from healthy and if anything at all, understated in terms of risk.

And you know what's worse? 
It's an election year.