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.

EM sell-offs and more Taper Talk

In a few days, we'll have the latest BOP numbers that according to an RGE note will show a narrowing of the Indian CAD. It cites, "seasonal effects, moderating crude and gold prices (particularly towards the end of the quarter) and lower gold imports following a hike in import duties in January".

The problem is that the tapering talk is nowhere near consensus and there's a whole lot of clearing (corrective pricing?) happening in most Emerging market economies. Any BOP numbers on the wrong side of the estimates are likely to increase downward pressure on the INR in lieu of persistent external financing gaps.

But that's a general scenario that has been enhanced by recent actions by the Federal Reserve. And while in general, a depreciating currency provides a bit of relief to the current account of an economy, India has a lot more to worry about in terms of its imports. From RGE,

"Looking specifically at crude imports is instructive. Already the INR price of a barrel of Indian crude is back above 6000 while losses per liter of diesel (i.e. the government subsidy) have inched back up to 6.31 (from roughly 4.5 a month or so ago). Between January and end-May India imported roughly 541 million barrels of crude and petroleum (~USD 83 billion). Over the same period Brent prices dropped by about 10% and INR depreciated by 6%. 
 In fact in April INR strengthened as capital inflows were robust and the market saw the commodity selloff as INR positive given the latter’s expected impact on the CAD. But that hope turned out to be short lived. Since then INR has fallen another 5% while Brent has stabilized thus reversing the previously expected positive impact on the CAD.
Aside from widening the CAD the higher INR price of crude will raise the subsidy bill (in spite of recent upward revisions to administered prices) and/or raise imported inflation if higher international prices are passed through to domestic consumers via more diesel hikes. This will exacerbate the tension between fiscal commitments to contain subsidies and politically unpopular (and inflationary) price hikes ahead of elections."

It's not pretty. Global sentiment has significantly adverse affects and there are strong headwinds that are waiting to provide more problems through higher deficits and more inflationary pressure. And India stands out economically among all the EMs, in the worst macro-way possible.



And in terms of the big picture? At least, the EM sell-offs have led to a slight unwinding of carry trades and corrective pricing; and while the lessons of '97 have been learnt, vulnerabilities continue to exist in the form of sizeable CADs. slowing growth and stickily high inflation. But this is just the beginning and as US real yields inch upward, there are EM economies with some monetary policy room to ease a bit or at least not tighten.

What the sell-off is undeniably doing on the surface, is making EM local currency debt attractive where inflation is less of a concern. Statistical research on EM LCY debt in the past decade shows a significant shift in the behavior of LCY debt post the Global Financial Crisis. Whereas domestic monetary policy (expectedly) is observed to be a significant determinant of yields before the crisis, the significance of treasury yields and other global factors is far more pronounced over the past few years leading to a sort of temporary "safe-asset-syndrome" for EM debt.

As another RGE note categorically states,

"On a structural basis, EM growth prospects and external balance sheets have worsened as export growth has stalled. Government balance sheets mostly look strong, even if there isn't a lot of stimulus capacity/willingness, but its the corporate balance sheets that may suffer the most from the combined slowdown in growth and higher financing costs (either actual or effective). Those high inflation/low growth countries will be most exposed to rising financing costs, which could undermine growth prospects further, holding back any reacceleration"

A round-up analysis in the FT has differing opinions on whether this is a "mini-bust" that will be handled easily or just a mild tremor and a harbinger of a bigger quake. We may not see as much "original sin" anymore but that doesn't mean that conventional macro-vulnerabilities have vanished into thin air. In all likelihood, they've been replaced by different combinations of variables spurred on by the accommodating global monetary regimes of the past few years. 

And now that tapering talk has begun (never mind that there is no sign of short-term rates increasing or a favourable US employment picture), the downward pressure on bond prices in EM economies will increase. Accompanied by detrimental volatility in the markets, there will be lots of investor jitters before anything else.

As for some of the EM central banks, they might find a need to tighten monetary policy (or keep it tight) when it is perhaps the last thing desired, but something completely required.

Taper Talk

James Hamilton has a post on all the tapering talk and the accompanying rise in yields. Mainly, he emphasizes that it's not as if the purchases had no effect. The markets know of QE(x) before it is announced and implemented. Rather,

"One of the reasons that everyone expected QE2 was that we could all see for ourselves that the economy remained weak. Part of what persuaded the Fed to move, and what persuaded everybody else that the Fed was going to move, was a very weak labor market and signs of disinflation. But these same factors would also tend to depress interest rates even if the Fed didn't buy a single bond. Some of the drop in rates in the fall of 2010 was likely caused by anticipation of QE2, but some was also due to a very weak economy."

Essentially, the effect of what is expected of future short term rates also holds current long term rates. Ultimately,

"When it does announce tapering, the Fed will try to reiterate that the rise in short-term rates will still not come until much later. But just as QE3 added emphasis to the declaration of a commitment to an extended period of low interest rates on the way down, ending QE3 will tend to detract from that message as we start to look at the path back up.

And just as a weak economy was the primary reason the Fed embarked on QE3, a strengthening economy will be the primary reason the Fed ends it. And if the economy is strengthening, interest rates will be headed up, regardless of whether the Fed keeps buying bonds or not. It's worth emphasizing that the recent rise in interest rates has been a global phenomenon, not just something seen in the United States."

Some kind of __flation

Even if inflation is the dog that never barked, there's no harm in asking whether it's still a dangerous dog and might it bark and perhaps bite at some point in the future?

Martin Wolf has a piece from a few days ago which sadly ends with a safe and logical answer amid talk of public debt levels and central bank balance sheet expansion. If i tell you it starts with a 'g', you'll guess it in a second.

Nevertheless, Wolf does have a few important points to make. Firstly is the point about a US Republican warning of hyperinflation three years ago (Okay that's not an important point but it would be fun guessing who if the sample size wasn't so large!)

But the point about the money multiplier (or the lack of it), is important. Because common sense initially makes you wonder upon observing the explosive growth in the base contrasted with the growth of broad money - that is the link between the reserves of commercial banks held at the central bank and their lending to the public. An assumption that banks will eventually lend more (future monetary expansion) is almost unfounded.

This is where the bank's own solvency comes into question. If, as Wolf states, equity capital of a bank is a far more significant determinant of its lending ability than its reserves...and furthermore, the excess reserves are controlled by the Fed, then a lowering of excess reserves can be accomplished by simply raising reserve requirements (the IOER) or selling government debt to the public.

What's more important from the inflationary standpoint, is not the indicator of the behaviour of excess reserves but the impact that inflation has upon debt. Enter redistribution issues and the generational balance queries.

Thus, under some fairly basic assumptions, the strategy of 'growing out of the debt' seems plausible. At the same time, the threats don't seem to be receding - that a sharp contraction in real growth would have a negative impact on house prices, unemployment, price levels in general and make every government balance sheet far worse off. The low interest rate offsetting could be mitigated and one has to look no further than Japan to observe this.

Ultra-low interest rates simply cannot protect an economy against stagnation, deflationary pressure and adverse fiscal deficits among other things.

The JGB Paradox

Are the rising yields in JGBs a sign of an incipient expected real economic recovery? Are they a sign of the market being ahead of Abenomics? And what about the paradox, that on the one hand the massive bond-buying BoJ is seeing bond prices fall instead of rise, should they be concerned about the impact this has on their debt servicing costs?

On the one hand, the rational-investor-Kyle-Bass approach makes a bit of sense. If the BoJ is trying to drive up inflation to 2% (and erode the value of JGBs), this would imply the success (somewhat) of Abenomics and the selling of JGBs to buy foreign bonds/equities.

But this is similar to Richard Koo's balance sheet approach to doomsday. It's the same end but different means really. Once inflationary expectations pick up, the BoJ will essentially lose control of any ability to control a rise in yields. And then you can let your imagination run...loss of faith...beginning of the end...(insert apocalypse now scenario here).

It's pretty obvious that there's a time variant issue here. That economic recovery is relatively a more long-term implication than the volatility in interest rates. The reaction of the markets is immediate and often ahead of policy action. But if investors start selling, are they anticipating success or failure? And if long-term rate rises precede signs of real economic recovery, will lenders choke off borrowing and bring the whole experiment to an end?

Abe himself, is not one to discount the worrying impact of short-term volatility and rises in borrowing costs. In parliament, he said that, "sharp increases in long-term interest rates could have a grave impact on the economy and the government's fiscal conditions".

But perhaps Abe should not be overly worried at the moment. After all, the BoJ is the BoJ - a central bank with more in its arsenal.

And this sort of runs contrary to what Nick Rowe says over at Worthwhile Canadian Initiative. He claims that it's not just what you buy, but what you buy it with; and his example is paying for taxi medallions with newly produced bicycles. Thus, an increase in the stock of money in circulation (we have to be careful here!), will have an effect on the demand for bonds (by raising the expected future price level thus reducing the demand).

But the key here (and the paradox too!) is that if you're flooding the monetary base and forcing yields down in the hope that inflation expectations will pick up and spark a real recovery...and this will cause "a rise in investment, fall in savings..." and if you intend for all this to happen and will gladly accept the consequence of rising yields then are you really trying to force yields down in the first place? And if yields rise (we've come full circle here), has your policy succeeded or failed?

Rowe says that the easiest way to think about this (and he's mostly right) is that it's a battle to push bond yields down but a war for economic traction and recovery. Thus, if you win the war, you'll lose the battle and essentially, you'd want to lose that battle.

Because this we do know, that when and if the Japanese economy recovers from its deflationary trap and stagnant growth, nothing much can (and perhaps should) be done about an accompanying shift in the yield equilibrium. In that sense, the more any attempt is made, the higher it might rise. And if there's a real economic recovery (Not just expectations of it)? Then a new equilibrium might be the point at which the BoJ stops restraining yields.

So throw Econ 101 out of the window, which tells us that the more you buy of something, the higher its price goes. The expectations of Japanese and foreign investors could be different. As Noah Smith points out, JGB investors are largely Japanese which most equity flows have been driven by foreign funds. And in this sort of a Keynesian set-up, a rapid interest rate rise perhaps could only be explained by a multiple equilibria theory where "Abenomics kicks the economy out of its bad equilibrium very abruptly, and the economy is shocked back to a sustainably higher rate of nominal growth".

Thus, according to Smith, "Japan's only hope is to cause the kind of recovery where interest rates stay very low for a very long time". But he says this with the debt ratio in mind, assuming rationally that sharp rises in borrowing costs would have unwanted consequences on the fiscal position. From Rowe's point of view, this prolonged-low-rate environment will prove impossible by the design of its theory.

Lest we forget though, that instead of rises in nominal rates, the reason for the rise in nominal rates will impact the function of real interest rates. And if things seem to be working and Japan really kicks itself out of its deflationary liquidity trap then real rates will go down irrespective (barring a vigilante attack I suppose) and the real value of existing debt stock will be eroded even though debt-servicing costs rise.

In that sense, Koo is right but he's just a bit wrong too. With balance sheet constraints, budget deficits and NOT monetary policy moves are the solution but this ignores the fact that even in a balance-sheet scenario, there will be creditors who respond to lower real rates.

Once again, the key here is the time boundary. Volatility may not be something to be over-worried about and  neither is the paradox. And therefore, betting on Abenomics to end up as a failure is definitely not the right move to make at the moment. 

Politically Correct or Woefully Ignorant?

Question: I have two questions. The first one is: do you see any risk of deflation in some countries in the euro area?

The second question is, yesterday, the IMF issued another mea culpa with regard to the austerity measures which were imposed on Greece. I wondered if the ECB also had some mea culpa to offer.

Draghi: Well, not really.

First, on deflation: ... we do not see it. In addition, some of these changes I hinted at are actually changes in relative prices, so they are positive. They show that there is real adjustment taking place, which can be seen in the export levels, which have gone up in some of the stressed countries.

On your second point, on the issue of mea culpa, no, I do not think we do; in fact, one good thing, as far as I understand, about this IMF paper is that the ECB is not being criticised. So, that is one thing. There has been a statement by the European Commission this morning which responds to this IMF paper. It makes several points and I do not want to go back over these points. I would not to say something different. Looking at the present situation, Greece has undertaken an extraordinary adjustment process. There is ownership of this adjustment by the government and we have to acknowledge the progress that this country has made. If we think back to a few years ago, it would have been unthinkable. Of course, if this paper by the IMF – which I have not read – decides to offer mea culpa and identifies the reasons for mistakes that have been made and other things, we will certainly have to take them into account in the future. However, often this mea culpa is in fact, as I will call it, a mistake of historical projection, i.e. you tend to judge the past by today’s standards. We cannot forget that four or five years ago, when the discussions about the adjustment in Greece were taking place, the climate was, in general, much worse. There was a fear of contagion there and very high volatility. That is, in a sense, where the fragmentation of the euro area really started. So, it is always very hard to pass ex post judgement on what happened four years ago. Having said that, rather than looking backwards, why do we not look forward and take stock of the extraordinary progress made and the positive path that has been taken?

Question: You talked about dramatism a few minutes ago and I am afraid I will be a little bit dramatic now because I am from a country that has an unemployment rate of 27%, which is a number of a great depression, a fiscal policy that is contractionary and a monetary policy in Spain and also in other countries that is also contractionary because credit is not available to small and medium-sized companies. Are you telling the Spanish, Portuguese, Irish or even Italian people that the ECB can’t do anything else with inflation actually lower than 2%?

Draghi: Well, I am not sure I get the point, but I think I get it. 

First, the fact that inflation is low is not, by itself, bad; with low inflation, you can buy more stuff. 

Second, we don’t see deflation and that is what we have to fear. We don’t see that yet. 

Third, fiscal consolidation is and remains unavoidable. It should be clear I think to everybody that you cannot have growth with endless debt creation. Sooner or later, you are going to be punished and the whole thing stops and that’s exactly what happened after the financial crisis in many countries. 

Fourth, are there ways to make fiscal consolidation growth-friendly? The answer is yes. Fiscal consolidation in most countries has taken the shape of increasing taxes and there are many reasons for that. Often this was done in an emergency situation or unfortunately because the easiest thing to do is to raise taxes. Now that is not growth-friendly and it is not growth-friendly because it happens in parts of the world where taxes are already very, very high. So what would be a better way? A better way would be the difficult way, namely to reduce unproductive government expenditure and reduce taxes together. But once you have done that – and in a sense I hinted at this before – you also have to ask yourself why these countries were not competitive. Why did they have to rely for growth in the good times, or “fairyland” times, on the protected sectors that were shielded from international competition? And then you ask yourself what should these countries change to become more competitive? And then what adjustments are needed in order to achieve this objective? The encouraging thing is that we see that most countries, if not all of them, are in this process, which of course is very painful, and I don’t think I miss one opportunity to make sure that you all know how aware of this we all are in the ECB.