St. Louis Fed is seeing the Fisher Effect
The Federal Reserve Bank of St. Louis published an article that low nominal interest rates lead to low inflation… In essence they describe the Fisher effect about which I have been writing here on Angry Bear. There are many economists who do not accept the Fisher effect that low nominal interests lead to stable low inflation. These include Mark Thoma, Nick Rowe, Paul Krugman and David Beckworth.
What did the St. Louis Fed say in their article…
“Assistant Vice President and Economist Yi Wen and Research Associate Maria Arias, both of the Federal Reserve Bank of St. Louis, explain that, in a liquidity trap, investors choose to hoard the additional money resulting from an increase in the money supply rather than spend it because the opportunity cost of holding cash—the forgone earnings from interest—is zero when the nominal interest rate is zero. If this increase in money demand is proportional to the increase in the money supply, inflation will instead remain stable. If money demand increases more than proportionally to the increase in money supply, the price level falls.
In a paper last year, Wen argued that large-scale asset purchases by the Fed at the current pace could reduce the real interest rate by 2 percentage points, but would also put severe downward pressure on the inflation rate, among other effects. In The Regional Economist article, the authors argue that low inflation makes cash more attractive to investors, in turn making a liquidity trap easier to occur.
Wen and Arias wrote, “Therefore, the correct monetary policy during a liquidity trap is not to further increase the money supply or reduce the interest rate but to raise inflation expectations by raising the nominal interest rate. … Only when financial assets become more attractive than cash can the aggregate price level increase.”
Evidence and logic is growing for the Fisher effect.
The difficulty is this is all an expectations game. If the Fed lowers rates is it expecting lower inflation or trying to make investment more attractive and raise it. If the Fed raises rates is it expecting higher inflation or trying to prevent it. It not only matters what the Fed thinks but what everyone else thinks as well, for their beliefs will become their actions and will become self fulfilling. Even so, not everyone will have the same expectations. Some will believe the Fed is trying to do one thing and others the opposite. Some will believe the Fed is trying to do one thing, but doubt its effectiveness, or as in this case, expect it to result in the opposite. It is very possible to accept a contrary position, but just as possible to accept a doubly contrary position. We already know some don’t believe in this and their actions will tend to make this untrue. Overall the effect is to make the Fed less effective in its actions. Under fully divided beliefs, it would make the Fed irrelevant.
I have a post tomorrow that will explain it is not all an expectations game. There are other contributing factors.
If the Fed lowers rates, they are making investment more attractive, but you have to lower rates to get that effect. The problem is that the Fed hasn’t lowered rates for 5 years. The effect of that original lowering has worn off.
Sure, everyone has a different view, but in the aggregate there is an “average” view, which shows up in a stable low inflation rate.
I hope you explain if what if most believe the Fed is doing is wrong, why the economy is growing, unless it is not right or wrong but just different. I take growth to be a preponderance vote of confidence, even if limitedly so.
There is growth because there is still available effective demand. Growth will continue no matter what (within reason) until the natural end of the business cycle. The effective demand limit is the natural end of the business cycle. We have not quite reached the natural end but we are close.
Even if the Fed raised nominal rates, the economy would continue to grow if there is available effective demand. There are economic adjustments that have to happen, but they get made. It is only when the effective demand limit is reached, that a rise in nominal rates would trigger a recession… because there is no upside room for the adjustments.
It would be better to read the entire article at:
And to read the article linked to in it:
There was an interesting comment to the article by the Federal Reserve Bank of St Louis.
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“I’m confused. Data from the St. Louis Fed itself show fairly clearly that as of late 2013 almost all of the increase in the Monetary Base since late 2008 stayed parked in Excess Reserves at Depositary Institutions.
Doesn’t this mean that investors haven’t been able to get their hands anywhere near the funds this article presumes they are hoarding? Looks like the hoarders are the Depositary Institutions. Would not bank lending on a large scale have been required to release these funds from QE asset purchases into the circulating supply of money? And where is the evidence of that large scale bank lending, please?
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The link is to a FRED graph plotting the Monetary Base and Excess Reserves of Depository Institutions. It shows that Excess Reserves of Depository Institutions went up in step with increases in the Monetary Base.
It appears to me that ptboy’s point is that the FED has not actually been injecting money into the economy, it has only been raising the Excess Reserves in Depository Institutions. And surprise, surprise, it has had no effect.
Raising inflation expectations would be quite an achievement in this economic environment.
Raising deflation expectations would be a lot easier.
One of the reasons for the banks to hoard money is to protect themselves. There is a lot of money in derivatives for example. There needs to be larger reserves just to back that. So as the monetary base increased, the banks used a portion of that money to back financial contracts.
The question would be… did the increase in the monetary base generate more activity in the such markets as derivatives, which then generated a need for more bank reserves, which then allowed more derivatives and so on in a positive feedback loop?
“It appears to me that ptboy’s point is that the FED has not actually been injecting money into the economy, it has only been raising the Excess Reserves in Depository Institutions.”
There’s two sides to a balance sheet Jim.
Let me refer to the BOE’s recent paper on money creation:
In particular I want to refer to Figure 3 and the related text concerning the impact of QE on balance sheets.
What is interesting about this example is that it involves a non-bank (a pension fund). It shows that when a non-bank sells government debt to the central bank this creates a deposit. More generally, when a non-bank sells an asset to the central bank this increases the broad money supply.
Not shown is that if a commercial bank sells an asset to the central bank this has no necessary effect on the supply of broad money because it occurs entirely on the asset side of the commercial bank’s balance sheet. Thus QE must directly increase the broad money supply only if it does not involve purchasing assets from commercial banks.
The question is, as a practical matter, how much of QE involves purchases of assets from non-banks and how much of it involves purchases of assets from banks?
It stands to reason, if commercial banks in aggregate have increased their holdings of the kinds of assets that have been bought by central banks under QE, then the effect of QE must have been felt entirely in the form of increased deposits (or, of course, as currency in circulation), rather than as a reduction on the asset side of the commercial bank balance sheet of the kinds of assets bought by the central bank during QE.
So let’s look at the kinds of assets bought by Fed from mid-2008 to the present and see if commercial banks have increased or decreased their holdings of them.
The following figures all come from the Federal Reserve Flow of Funds (Table L.109).
The Fed started increasing its holdings of securities in September 2008, although QE1 was not officially announced until November 25. It concluded at the end of March 2010. From 2008Q2 to 2010Q1 depository institutions increased their holdings of Treasuries from $101 billion to $263 billion. They also increased their holdings of Agency Bonds and Agency MBS from $1,426 billion to $1,858 billion.
QE2 was hinted at by Bernanke at Jackson Hole in August 2010. It only involved the purchase of Treasury securities. It concluded at the end of June 2011. From 2010Q2 to 2011Q2 depository institutions increased their holdings of Treasuries from $261 billion to $270 billion.
QE3 was hinted at by Bernanke at Jackson Hole in August 2012. It is ongoing. From 2012Q2 to 2013Q4 depository institutions increased their holdings of Treasuries from $295 billion to $305 billion. They incrased their holdings of Agency Bonds and Agency MBS from $1,906 billion to $1,949 billion.
The only way that QE could not add to broad money supply is if the Fed purchased securities from depository institutions and depository institutions failed to replace these securities. Such purchases would only have added to reserve balances or to vault cash and not to deposits or to currency held by the public.
If depository institutions turned around and replaced any of the securities they sold to the Fed by buying more from non-banks, then this is effectively the same as if the Fed had purchased securities from non-banks in the first place, since such purchases would increase the amount of deposits or currency held by the public.
During each QE depository institutions have increased their holdings of the same kinds of securities that the Fed has bought, meaning that effectively 100% of the securities the Fed has bought have been bought from non-banks. Thus QE has directly increased the supply of broad money.
So the balance sheet activities of the Fed must have directly increased the broad money supply. The next step in this estimation process is to see how much deposits and reserve balances have increased.
Deposits (demand, savings and time) and Private Depository Institutions increased from $8,582.5 billion in 2008Q2 to $11,703.6 billion in 2013Q4, or by $3,121.1 billion. Reserve balances increased from $33.5 billion in 2008Q2 to $2,249.1 billion in 2013Q4, or by $2,215.6 billion.
Thus 71.0% of the increase in deposits is directly attributable to QE.
“One of the reasons for the banks to hoard money is to protect themselves. There is a lot of money in derivatives for example. There needs to be larger reserves just to back that. So as the monetary base increased, the banks used a portion of that money to back financial contracts.”
As usual this makes no sense. The net current credit exposure (NCCE) of financial derivatives held by US banks fell to $298 billion in the latest OCC report:
This is down sharply from the $800 billion level it reached at the end of 2008.
Excess reserves held by US banks have increased from less than $800 billion at the end of 2008 to nearly $1.9 trillion today. This has absolutely nothing to do with the financial derivatives market.
You say that net current credit exposure of US banks to derivatives was only %298 billion. Then why does this article put such large numbers on their exposure?
The article (May 13) points out aspects of risk and difficulty from derivatives.
The article talks about outsourcing some management of derivatives. I just got through watching the Hank Paulson movie on netflix and banks are quite sensitive to appearing solvent.
What is the general liquidity risk from the derivatives market? Even though banks may not be directly exposed so much in relation to the total derivatives market, how much are they indirectly exposed? And how indirectly or directly are the banks exposed to the fragility of credit markets abroad, like in China?
By the way, at the end of the Hank Paulson movie, he is still concerned that another crisis can take place because many flaws in the system have not been effectively fixed. Is there still a feeling that something bad could happen because there are still unregulated imbalances in the system?
Banks see potential problems in China and low inflation in Europe. Don’t you see that have reason for concern? Derivatives is just one part of the financial system. How fragile is the system in general? How confident can anyone really be? I would feel safer right now if I had some excess reserves, even though I am not directly exposed to derivatives, or China.
“Then why does this article put such large numbers on their exposure?”
Because big numbers sound really, really scary to some people.
Yes, the notional value of the global financial derivatives market reached $710 trillion at the end of 2013 (up from $683 trillion in mid-2008 or by 4.0%). But is this a reasonable measure of the risk exposure? Don’t be ridiculous.
The NCCE value of global financial derivatives (the net amount owed if all contracts were immediately liquidated) was only $3.6 trillion at the end of 2012 (“OTC Derivatives Market Analysis Year-End 2012”):
The share held by US banks was only $430 billion at that time, or 10.7%. And as I mentioned previously, this is now down to $298 billion.
The NCCE value of the global financial derivatives market is down sharply from its peak of $5.0 trillion at the end of 2008, or by 28%, four years previously.
The huge increase in reserve balances has absolutely nothing to do with the decline in the financial derivatives market.
You need to read the comments section of that article. The notional number is a measure of operational risk.
Mayra Rodriguez V. knows what she is talking about.
There are many unknown, unregulated aspects of derivatives which should require some protection by banks with some extra reserves, just for the sake of being unknowns.
It is not known where many derivatives are originated. And if there is a need to settle in court, there is a risk because countries have different rules.
There is still great financial risk in this world as total notional derivatives rise with their unknowns and as China recognized its unsustainable ways.
That is the point.
From the most recent OCC report page 13:
“Changes in notional amounts are generally reasonable reflections of business activity, and therefore can provide insight into potential revenue and operational issues. However, the notional amount of derivatives contracts does not provide a useful measure of either market or credit risks.”
Anyone claiming that notional value is useful as a measure of risk is quite simply a fraud.
When it comes to derivatives…
“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.” Donald Rumsfeld
It does not seem to me that you are aware of all the risks involved with derivatives… Think of the jurisdiction issue. Let’s take a hypothetical example. Let’s take some derivatives that were originated in Russian. What if there is a standoff politically, and those derivatives won’t be paid off?
Let’s take some derivatives originated in an emerging country that all of sudden has capital flight issues. They may stop the payoff of derivatives.
Also, one of the uses of derivatives is to avoid taxes. What will happen in the derivatives market if there is a coordinated global effort to raise taxes to curb inequality?
We might say there is only $3 trillion of credit risk, but that is still a lot and it is conditional upon institutional, political, legal and economic changes.
The future looks very controlled. Inflation slowly rising back to target. Nominal rates staying low. Expectations are anchored to this controlled view of the future. What if these plans are interrupted by a chaotic event?
There are unknown unknowns in derivatives, not to mention China. Just for that reason, there has to be some extra reserves to protect against an unforeseen unknown liquidity risk.