Re: Divorcing Money from Monetary Policy
newyorkfed.org
I believe an alternative read to your correspondent's (a major expansion of free bank reserves, a.k.a. inflation as far as the eye can see)is that the freed up reserves would be made available by the Fed at interest to lend to banks that can't make their reserve requirements. That would allow the Fed to gather reserves from banks--at no lost opportunity costs to the lending banks-- that have traded in toxic waste for Treasury paper in order to cure their balance sheet deficiencies. These banks are really only Potemkin banks, as they can't afford to lend in any case, being short capital. I.e., they really aren't banks anymore. But their "liquidity" could be siphoned back to the Fed to relend to other Potemkin banks. This all would be accomplished without an increase in liquidity in theory, as this would all amount to recycling the same funds over and over. Fed policy right now appears to be to prevent as many lines as possible from forming at insolvent banks. In the not very far run (as in maybe within 90 days or so), however, the default/foreclosure rates will force an expansion of liquidity in any event and this exercise will be futile.
The pertinent parts of the article are as follows:
"This article highlights the important similarities in the monetary policy implementation systems used by many central banks. In these systems, there is a tight link between money and monetary policy because the supply of reserve balances must be set precisely in order to implement the target interest rate. This link creates tensions with the central bank’s other objectives. For example, the intraday need for reserves for payment purposes is much higher than the overnight demand, which has led central banks to provide low-cost intraday loans of reserves to participants in their payments systems. This activity exposes the central bank to credit risk and may generate problems of moral hazard. The link also prevents central banks from increasing the supply of reserves to promote market liquidity in times of financial stress without compromising their monetary policy objectives. Furthermore, the link relies on banks facing an opportunity cost of holding reserves, which generates deadweight losses and hinders the efficient allocation of resources. If desired, the floor system could be modified in ways that encourage higher levels of activity in the overnight interbank market.
…
In this floor-system approach, interest is paid on reserve balances at the target interest rate. This policy allows the central bank to increase the supply of reserves, perhaps even significantly, without affecting the short-term interest rate.
[Conclusion, p.14]
Goodfriend (2002) takes a different view, proposing that the supply of reserve balances could be used to stabilize financial markets. The central bank could, for example, “increase bank reserves in response to a negative shock to broad liquidity in banking or securities markets or an increase in the external finance premium that elevated spreads in credit markets” (p. 4). More generally, he suggests that the supply of reserves could be set to provide the optimal quantity of broad liquidity services. It should be noted that there may be complementarity between payments policy and liquidity policy with respect to reserve balances; increasing the reserve supply to support broad liquidity can simultaneously reduce the use of daylight overdrafts, which might be particularly desirable during times of market turmoil. [p.11]
…
One concern is that a floor system would likely lead to a substantial reduction in activity in the overnight interbank market, as banks would have less need to target their reserve balance precisely on a daily basis. In particular, since banks with excess funds can earn the target rate by simply depositing them with the central bank, the incentive to lend these funds is lower than it is under the other approaches to implementation discussed above. Nevertheless, an interbank market would still be necessary, as institutions will occasionally find themselves short of funds. How difficult it would be for institutions to borrow at or near the target rate is an important open question. [p.12]
…
Since the new framework was introduced, the RBNZ [Reserve Bank of New Zealand] has implemented two changes. First, banks are now allowed to use a wider set of assets to raise cash from the central bank. In particular, a limited amount of AAA-rated paper is eligible. Second, a tiered system of remuneration was introduced in response to episodes in which the market interest rate rose substantially above the OCR. The RBNZ now estimates the quantity of reserves a bank needs for its payment activity and, based on this estimate, sets a limit on the quantity that will be remunerated at the OCR. Any reserves held in excess of that limit earn a rate 100 basis points below the OCR. This policy is designed to provide an incentive for banks to recirculate excess reserve positions and to prevent them from “hoarding” reserves. [p.13]
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However, the RBNZ uses FX swaps to increase the supply of reserves, and it found that the price in this market was moving against it; the more reserves the RBNZ created, the more costly it became to create those reserves. It is worth noting that this problem would not arise in a country with a large supply of government bonds or with a central bank that can issue its own interest-bearing liabilities. In such cases, increasing the supply of reserves need not be costly and could be an attractive alternative to a tiered system." [p.13][emphasis added] |
