Wednesday, February 27, 2019

Quick note on Interest on reserves and inflation expectations

I've been working on the follow up book to Shut Out.  Some version of this graph will probably be in it.  It shows that the deep drops in equity values didn't come from the disastrous September 2008 Fed meeting after the Lehman Brothers failure.  They came during the period when the Fed began paying interest on reserves.

The story in a nutshell is that the Fed had the target interest rate pegged at 2%, which was far too high at the time.  In order to maintain the peg, they would have had to sell every Treasury on their balance sheet.  So, in order to suck cash out of the economy and maintain their interest rate target, first they asked the Treasury to issue T-bills and deposit the proceeds at the Fed, to fund emergency loans they were making to panic-stricken financial firms so they wouldn't be inflationary.  Basically, the Treasury was selling T-bills so the Fed wouldn't have to.  Then, when the Treasury had deposited hundreds of billions of dollars at the Fed and was balking at borrowing more, the Fed began paying interest on reserves, so they could effectively borrow directly from the banks.

Now, the point of this was because they were afraid of creating inflation when they made emergency loans.

In this graph, I also have the implied expected 5 year inflation rate, from TIPS markets.  For much of the time they were sucking credit from the banking system, 5 year expected inflation was negative 1%-2%.


  1. It strikes me that it was quite reasonable of the Fed to worry that creating hundreds of billions of dollars would lead to inflation. Reasonable. But totally wrong.

    How was the Fed to know? Maybe it should have checked the market signals at the time.

    The Fed's disregarding of market signals is so unfortunate. Hopefully this is improving under Powell. But, it would be so much better to formalize the incorporation of market signals into Fed policy. Like, perhaps with NGDP level targeting.

    The market is going to outperform Fed models every single time. Why not take advantage of it?

    1. Hear! Hear!

      As you know, the irony is that the best way to keep a smaller balance sheet is to raise inflation.

      It's interesting to think of counterfactuals here, isn't it? I mean, imagine if they had not sterilized their emergency loans. If that truly would have been inflationary, then by the time inflation had moved to, say, 4%, the crisis would likely have been averted, because nominal values on all that collapsing collateral would have been stabilized. Exactly where would the equilibrium have kicked in? Would a few billion unsterilized loans in the summer of 2007 have been the end of it?

  2. I understand what Ken Duda is saying, but he is far too kind. The teeth of a recession is not the time to worry about inflation.

    And if a central bank is going to worry about inflation, do what they Reserve Bank of Australia does. Have an inflation band of 2% to 3%.

    Australia has not had a recession in 30 years although it did have a couple minor stretches of 4% inflation.

    Really, is not some moderate inflation an easy price to pay to avoid recession?