Wednesday, April 15, 2009

Disturbing quote of the day

Mankiw links to a VOX re-print of an article by Hall & Woodward about Fed policy. Their main point is that future inflation shouldn't be a concern because the the Fed can raise the interest rate it pays on banks' excess reserves, encouraging banks to hold more reserves. This is a new Fed policy tool that they implemented while I was in the middle of teaching about the theory in Money & Banking last semester. I posted here about it at the time.

The article contains this quote (italics the authors'):
Raising the reserve interest rate is a contractionary measure. A higher interest rate on reserves makes banks more likely to hold reserves rather than increasing lending. The Fed’s decision to raise the reserve rate from zero to 75 basis points just as the economy entered a sharp contraction in activity is utterly inexplicable. Fortunately, the Fed lowered the reserve rate subsequently, but the continuation of a positive reserve rate in today’s economy is equally inexplicable.

It's nice to see experts saying something is "inexplicable," as I had no way to explain it to students last year. When a bright student asked "So, we read in the papers (and a Fed press release last year) that the Fed is upset because banks aren't lending, yet we see here that the Fed is paying them not to lend? How can that be?" Inexplicable.

Other economists were saying that it was explained by the Fed wanting to basically recycle created money back to the Fed to fund the purchase of risky assets the Fed was buying-- agency securities, MBS, commercial paper, etc. Despite all of his recently candid speeches, I don't think Bernanke has ever said anything meaningful about it.

Note: I disagree with the authors' conclusion that the Fed can unwind all of this inflationary risk tidily. If this were all taking place in a vacuum, I'd agree. But because of the balooning federal deficit (expected to balloon more in the near future with entitlement spending increases) foreign investors have expressed some hesitancy about purchasing U.S. Treasuries. China is currently slowing its purchase of U.S. assets. If investors aren't willing to buy the Treasuries, then the Fed will have to buy them... and it is currently purchasing Treasury notes instead of just Treasury bills which is rare. Arguing that the Fed can do this all they want, keeping long-term interest rates low, and keeping the massive lake of the cash dammed up by paying increasingly higher rates on reserves to banks just doesn't sound right to me. It's like a free lunch.

I wrote that last sentence before I saw Beckworth's post on the same subject: There is no free lunch in central banking.

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