Tuesday, November 12, 2013

Monetary Policy in the age of QE

The first comment on this post by Tyler Cowen is interesting:

Doug November 12, 2013 at 3:19 pm
The irony of the past five years is that while central banks have been trying to flood the markets with cheap capital, banking regulators have been significantly tightening the regulatory cost of capital for almost all activities. The two are operating at complete cross-purposes. Interest rates may be zero, but capital charges have become so high that banks can’t do any lending regardless.

The effect of this might be that monetary policy will be less transparent, more fitful, more pro-cyclical, and more subconscious.

I have been preparing for the approaching maturation of the business cycle by considering the Fed's management of their balance sheet, Fed Funds rate, and interest on reserves (IOR).  But, this adds an extra wrinkle to the issue.  Cash is not a constraint, by a long-shot.  What if a sort of unnoticed, pro-cyclical bias creeps into the subtle tactical decisions of bank regulators.  From a monetary policy point of view, operating in a sort of continuous function of interest rate policy, we might hope that the Fed would raise the Fed Funds rate and pull IOR up along with it in order to induce banks to hold onto reserves until the Fed can unwind its Treasury holdings.

But, what if banks have potential credit opportunities now that represent fair value several percentage points above the market rate, but they are currently being held back by capital scarcity and regulatory constraints.  If these constraints are lifted, credit creation could ramp up faster than the Fed can manage it.

I would expect forward interest rates stemming from FOMC policy to be pretty stable, and probably low, but I wonder if this sort of regulatory risk is where an inflation shock scenario could come from.


  1. '...central banks have been trying to flood the markets with cheap capital....'

    Which isn't even wrong. Money growth isn't (necessarily) capital growth. It could go almost 100% to consumption spending.