I likely won't be the first to post, since I didn't write this before hand.

I'm involved in the Collegiate Fed Challenge competition, where teams from universities go to Fed branches and deliver FOMC reports, which gives an analysis of the current economic situation and offers advice on how to proceed. My team just won at the Baltimore branch this Friday and will be advancing to compete at the Richmond Fed on the 15th. If we win there, we go back to DC to compete against the winners from the Boston, New York, Cleveland, Chicago and Philadelphia Fed branches (the others are just too far away to be bothered).

So, in our analysis we highlight that the key problem is low demand from consumers for loans (hence a low supply of quality loans) and an unwillingness by banks to loan money (hence why 95% of reserves in the Fed are excess reserves). The way we choose to address these two issues is through inflation. Since the Fed doesn't have the power anymore to influence inflation through OMOs or the Fed Funds rate, we choose to target market expectations of inflation.

Our recommendations are as follows:
Do not taper LSAP 3 (known by the public as QE 3), but continue on for at least 6 more months (FOMC forecasts are for 18-24 month horizon). When you do choose to taper, do not give forward guidance on the decision and prioritize reducing the amount of treasuries purchased over MBS
Change the inflation target from an asymmetric target (up to 2.5%) to a symmetric target (1.5%-2.5%). Putting a lower bound on it will change short-term inflation expectations in the market, and the market will push rates up to reflect this, causing inflation.
Change how interest is paid on excess reserves. Right now they are paid at the Fed Funds Rate, but we suggest to change it to 35 basis points below the Fed Funds rate, making effective interest payments on excess reserves -27 basis points. This negative interest rate will encourage banks to increase lending in the interbank market, to the real economy or increase purchases of Treasuries.

Now, the Fed officers we presented too were intrigued by this idea, but had questions regarding the following:
What if the market doesn't react to the change in inflation targeting?
Why are banks holding these reserves?
Which banks are holding these reserves?
Why choose to decrease Treasury purchases first over MBS?

I'm just starting to research this stuff a bit deeper, but would like your thoughts on it.
Cheers.

42

Brilliant and insightful commentary as always red. Though I appreciate you bumping it up.

Goldfinger - what a well presented argument.

I agree with not giving forward guidance when tapering is commenced. Would you make a policy statement now that no forward guidance will be issued or will you just start tapering when ready. You are aware, of course, that either option will lead to a swift stock-market decline. I'm not saying that should stop you doing it, but it might be wise to point out the downside of tapering (forward guidance or not) and then go on to say that it still has to be done.

Not sure about making inflation a range.

Like negative overnight interest rate.

The bit I don't like is your assessment of the problem. Low demand from consumers. Think about this from the the real world prospective. Say I need a new sofa. I have two choice, buy one now on credit or save up and buy one. He responsible thing to do is save up and buy one. Buying one on credit increases the cost and puts me at risk of defaulting if my circumstances change. A death in the family, new baby, job loss, divorce, illness, etc. trying to reduce the cost of the loan only reduces the risks, it doesn't remove them.

This applies to most consumables where the value depreciates.

One could argue that buying items on credit which either generate an income or are likely to experience capital growth is an acceptable risk to take, but this kind of assets purchase for example house to rent out, could lead to assets bubbles and we all know where that leads us.

In short I'd redefine the problem slightly, look at the types of loans you wish to encourage - business loans for example - and then target your 'solution' more towards solving that problem. Hope that helps.

@Maniac - thanks for the well-thought response. I'll respond to your points properly in the morning with some links to graphs, because data backs up a lot of what you're saying. We just can't think of a better idea :)

Very interesting proposal, goldfinger. Your recommendations look to me to be in line with what the dovish consensus is these days -- push out the tapering calendar, symmetric inflation targeting, no more IOER.

The criticism you probably get is that household deleveraging makes the main transmission mechanism of MBS purchases unlikely to work, because households simply won't borrow more. I think you need to respond to with some analysis of the residential and commerical mortgage and mortgage-refi markets. I haven't done much work on the US housing market so I'm not sure what the data says, but mortgage rates have been rising for the last 6 months or so IIRC.

But when asked why you taper treasuries over MBS, you have a neat little story. The FOMC already believes that the portfolio rebalancing mechanism mainly works through the size of the Fed's balance sheet, not the size of monthly flows - and the yield curve is already very compressed, so you can argue (as Bernanke did) that simply maintaining a large portfolio of treasuries will continue to reduce long rates and ease through the term premium. And then you can speak to tangible benefits from additional MBS purchases to the housing sector, where there is more policy space to increase consumption and investment in the short-term.

What's the value added of your inflation range to the Fed's current forward guidance on interest rates? Seems like all you're adding is that you don't want inflation to fall below 1.5%, but the last FOMC statement already highlighted that persistently low inflation is a risk, and they've been saying they'll let inflation get as high as 2.5% for over a year now. IMO, the market probably doesn't react to this -- inflation expectations are simply too well-anchored. The Phillips curve is pretty steep, even in the short run now.

And presumably banks are simply holding onto excess reserves because IOER is greater than their cost of funds... eliminating IOER may or may not induce greater lending from banks with the lowest cost of funds. The Fed's current belief seems to be that large increases in excess reserves are a consequence of LSAPs and do not impede its effectiveness, so you might have an uphill battle there.

You might want to add in something about the Fed's new fixed-rate, full-allotment, overnight reverse repo facility (which I think is still being tested). Like IOER, that is another tool the Fed can potentially use to have more direct control over short rates, which seems to be your goal there. Not everyone is convinced that reducing IOER would have the effects you think it does, so it's worth adding in other mechanisms to directly affect short rate, and the new facility is about as cutting edge as it gets.

@ goldfinger:

Very interesting. I do have a question:

"the key problem is low demand from consumers for loans (hence a low supply of quality loans) and an unwillingness by banks to loan money"

On what evidence is the first part of that statement based? The situation in the US may be very different from the UK, and I'm not an expert on the US economy, but I know that here in the UK, there is a reasonable level of demand for loans, especially from small businesses, but the banks have become so risk-averse that they are refusing to lend (which you do also note is part of the US's problem).

I am not a big fan of the no-forward-guidance-on-taper part. Lack of forward guidance could lead to precautionary behaviour in the markets to the risk that tapering may happen any day. It may be better to condition it to unemployment, or at least commit to a certain amount of years during which tapering will not occur.

also seems to me like 1.5%-2.5% is too low. at the moment 2.5% is probably interpreted as an exact target rather than an upper bound. I would go for 2-3% at least.

Before I say anything, I should mention that I am a 2nd year econ undergrad and after this term I will have 2 econ credits (of which 1.5 is micro econ), so my knowledge of economics is dwarfed by that of others here, so take my thoughts with a grain of salt.

I agree with anlari here. If one of the problems you are citing is unwillingness by banks to loan, no forward guidance would only serve to increase their reluctance.

If the FED is trying to increase current inflation (which you are), forward guidance is necessary.

The other point I want to mention is that the main thing I have taken from recent history is that good monetary policy can't bailout bad fiscal policy (Bernenke has taken the most aggressive monetary policy ever seen, and despite that this has been the second slowest recovery in history). Massive reform is needed in government before the FED should try anything too drastic. As long as there is risk of default by the US, and deadlock preventing anything from getting done on capital hill.

Both Canada and Japan have tried negative interest rates on excess reserves in the past, and it hasn't worked: The market remained tight despite a -54 bp here in Canada in 2012, coincidentally twice as high as your recommendation. I think you should keep that in mind.

Well. to be honest monetary policy is not nearly as aggressive as it could be. If QE was focused on buying less liquid assets, it would be a lot more effective. So would nominal GDP targeting. Hell, if Fed really wanted to, it could undertake a monetary financed fiscal stimulus.

The problem is that we are not quite sure what happens after we get out of the liquidity trap under these options, and just plain fiscal stimulus would probably be safer than any of them (although it's not going to happen..).

In any case, I didn't mention any of these more radical measures because it just wouldn't fly with Fed officials at the moment due to the above risks, and well, the fact that the situation is not desperate enough to try them.

I think rate cuts on excess reserves always help, but I do not think that there is a magical line when you cross zero (and it is probably no longer effective when the real rate hits zero, since they can just hold cash, but I think goldfinger was talking about the nominal rate), so a few basis points is probably insufficient to get the US out of the liquidity trap.

What may work better is forward guidance, but that is in turn undermined by deflation bias (see the Eggertsson paper on this). It is not easy for the Fed to commit not to taper early, and the last move made it worse if nothing else. So I think the best move may be a very strong signal that it won't occur. Saying there won't be forward guidance will probably make it worse.

Wait so anlari, as you saying lowering the interest rate on excess reserves is a good idea or a bad idea?

I am saying it is just like a small interest rate cut. Good but not enough

Also I confused myself earlier - taking them below zero nominal should have no effect..

Well, I find it really unfortunate that I can't get links to the graphs that we made for the presentation. So whatever links I have will be only a partial view of the matter.

So, on to address some of this excellent commentary

First, jamiet brought up the question "Why target consumer loan demand?"

For several reasons. First off, the real problem isn't loan demand, but rather low inflation, low GDP growth and high unemployment. Now the Fed can't directly address any of these at the moment, so it must rely on transmission effects of what it can do. What it can do is effect interest rates. Now, if you look at this chart:

http://research.stlouisfed.org/fred2/series/PNFI

You'll see that business lending has come back to pre-recession levels. However,

http://research.stlouisfed.org/fred2/series/PRFI

Shows that residential investment has a long way to recover. Part of this is because most of the housing stock is used homes rather than new housing starts. Right now you have companies such as Berkshire Hathaway sitting on $40 billion in cash and other banks sitting on $2.3 trillion in excess reserves because the business lending market is nearly tapped out. Thus, any lending growth should come through residential lending or other forms of consumer debt. Also, you have the most recent Senior Loan Officer's Report indicating that demand for consumer loans is increasing faster than banks are willing to supply credit. So, we target two things in our recommendations - make it more expensive for banks to not loan money and make it less expensive for consumers to get debt.

http://www.federalreserve.gov/boarddocs/snloansurvey/201308/default.htm

And a large problem is, as Maniac was saying - people don't want to take out loans. They'd rather pay in cash. Banks are reporting lower demands for housing loans as more people pay in cash (or more in cash). There's also this graph

http://research.stlouisfed.org/fred2/series/TDSP

Which shows debt payments as a proportion to disposable income are decreasing (even though disposable income is rising). Along with this is consumer debt as a proportion of GDP, which is also falling. So combined this shows that debt payments are decreasing due to a lower amount of consumers taking out loans rather than a lot of people paying off their debt.

As for the interest rates - 5 year inflation expectations are 1.76% (given by the spread between 5 year treasuries and 5 year inflation adjusted treasuries) and current inflation is 1.2%. So, by changing the target we hope to have an increase of at least .3% inflation, if not more. I'm worried about increasing the range to 2-3% because the market doesn't expect inflation to get into that range and honestly I don't think the Fed can budge inflation if it tried.

But transmission mechanisms are our biggest worry right now. Because it's not guaranteed that the market will increase its inflation expectations, or that banks will lend out their reserves with the change in IOER, or whether increased inflation will lead to consumers getting more loans. Its just that the Fed has done so much and exhausted so many options that there's no certainty in how the market will react.

For example, LSAPs have zero effect on interest rates right now. Check out table 1 in Krishnamurthy and Vissing-Jorgenson, "The Ins and Outs of LSAPs" and you'll see how little they help now compared to LSAP 1 or LSAP 2. The problem is that we can't taper since a taper would put deflationary pressures on the economy.

In regards to forward guidance, if you look at the yield on 10 year treasuries, they've jumped ever since Bernanke mentioned tapering in June. Just the mention of a taper caused them to jump as if the taper had actually happened. Rather than suffer the consequences of these higher real rates before you want to taper (by giving forward guidance) why not gain the (balance sheet) benefits of a reduction in purchases at the same time as taking the hit of higher interest rates.

I wouldn't tell the market we aren't giving them forward guidance though, as that would cause too much volatility. When we do taper we expect a stock market dip, but we aren't too concerned with that.

Also, I wasn't aware of Canada and Japan trying negative interest rates. I thought Denmark was the only country to have negative nominal interest rates.

Also @ anlari - I think if we suggested monetary financed fiscal stimulus we would get thrown out haha. The credibility of the US and the Fed, as well as the independence of the Fed would all be called into doubt. And if there's one thing these people are insistent on, it's the independence of the Fed from government decisions (and not choosing winners and losers in the markets). But they're certainly knashing their teeth over the government deficit falling so quickly.

But the purpose of the negative nominal interest rates wouldn't be to move all the money out of the Fed, or get us out of the liquidity trap. It would just be to move a fraction of the $2.3 trillion out of the Fed. Even if 10% came out, that's $230 billion. Banks can't hold that much cash, so they would hold it in Treasuries, depressing real interest rates.

the keynesian hegemonic paradigm is the source of the problem
you will never convince the elites that the elites are the problem
the only solution is to end the corrupt monstrous institutions the elites use to maintain their oligarchic grip upon us
go to the presentation with a bomb and destroy the elites

No, can't do that. They had pretty tight security there.

Goldfinger:

I agree monetary fiscal stimulus is not the right thing to talk about :P It's not controversial that the government's budgetary stance goes into the Fed's response function, as long as it is Fed's response function and not the government ordering it around though.

About moving cash out - banks would probably buy Treasury bonds until those hit zero as well, and then start building storage areas for the cahs. You can push back on the Treasuries by issuing more of that, but we go back to the monetary-fiscal stimulus direction again. Other than that, I don't see a major effect.

Lack of forward guidance on tapering is not so bad if you don't mention it.. but I think giving forward guidance of NOT TAPERING can help quite a bit - this is essentially the opposite of what Bernanke did with the surprise taper, and it worked (in the opposite direction) at that point.

Raising the inflation target to 2-3% would help in that direction. Yes, Fed can't increase inflation at the moment, but what matters in the long-term interest rate, and having a slightly higher target would suggest you would wait a bit more before tapering/raising rates in the future, which reduces long-term rates. This is essentially the same as the forward guidance argument, but with a bit more credibility for Fed.

Hi, just a goober from the University of Chicago, fourth year econ noob. I have no stake in our school's FMOC dealio, and I don't know how old this thread is, but I'd like to throw in a word if I may. The time inconsistency problem shows that if people are rational and aren't having a dumb, they will expect inflation based on various stuffs including your QE3. In a game theoretical model, the CB has an incentive to deviate from a steady targeted inflation rate, and if you gave them Feds a range of inflations to target, it would only put markets more at unease. They'd be more likely to misperceive lowering targeted inflation as tapering, and you'd get more sads and volatility than if you had a fixed targeted inflation rate. Just a quick two cents.

Thanks miles. I'm just a fourth year econ student at a crappy school, so I'll take advice from someone coming from UChicago :)

The thing is though we're trying to raise targeted inflation rates rather than lower them. The current upper bound is 2.5% All we're doing is putting a lower bound on it in our suggestions.

If that is the policy, just make it clear that you are keeping at a fixed inflation target level for inflation, but that you will not reveal the exact rate you are targeting, and that /you will not deviate from that level/. It'll keep markets guessing a little bit about your policy so you do have room to deviate within the range if absolutely necessary, and hopefully build credibility to your image.

http://www.philadelphiafed.org/publications/speeches/plosser/2007/03-06-07_ny-assoc-bus-econ.cfm