Thursday, August 29, 2013

Forward Guidance – Who Are You Going to Believe, the Fed or Your Lying Eyes?

August 29, 2013

Forward Guidance – Who Are You Going to Believe, the Fed or Your Lying Eyes?

Recently, a commentary published by the Federal Reserve Bank of San Francisco, “How Stimulatory Are Large-Scale Asset Purchases?”, came to my attention. In this commentary, the co-authors,Vasco Cúrdia and Andrea Ferrero, state:

“The Federal Reserve’s large-scale purchases of long-term Treasury securities most likely provided a moderate boost to economic growth and inflation. Importantly, the effects appear to depend greatly on the Fed’s guidance that short-term interest rates would remain low for an extended period. Indeed, estimates from a macroeconomic model suggest that such interest rate forward guidance probably has greater effects than signals about the amount of assets purchased.”

Cúrdia and Ferrero (C&F), similar to so many of their mainstream brethren, believe that the degree of aggregate-demand stimulation emanating from Fed purchases of long-maturity securities depends on the degree of decline in yields on long-maturity securities resulting from these purchases. But C&F argue that Fed purchases of long-maturity securities alone sow the seeds of their own ineffectiveness in stimulating aggregate demand. According to C&F, any initial decline in yields on long-maturity securities will quickly be offset by a subsequent rise in yields as market participants revise their expectations for an earlier Fed-induced increase in the federal funds rate and/or a larger increase in the federal funds rate due to stronger growth in nominal demand resulting from the Fed’s purchases of longer-maturity securities. Got that? So, according to C&F, if Fed purchases of long-maturity securities are going to be more effective in stimulating aggregate demand, the Fed needs to provide forward guidance as to at a minimum, when it intends to begin lifting the federal funds rate.

Before I comment on “forward guidance” as a monetary policy tool, let me once again provide you with my explanation of how Fed purchases of securities, long- or short-maturity, it does not matter, stimulate aggregate spending. The Fed purchases a security from me. The funds that I receive from the Fed did not come from you or anyone else. The funds came from the Fed’s figurative printing press. These are net new immediately spendable funds in the economy. It is as if these funds were created out of thin air. I have three options with which to use these funds. Option One would be for me to spend these funds to purchase goods, services or assets, including financial assets. Option One directly increases nominal spending. Option Two would be for me to lend these funds to someone else. Most people borrow funds to spend them on something – a good, a service or an asset, including a financial asset. So, Option Two indirectly increases nominal spending. Option Three would be for me to simply hold these funds at my bank. If my bank is unable to use these funds to acquire any new earning assets, perhaps because of capital constraints, then Option Three would not result in any new nominal spending in the economy. Other than extreme risk aversion, it is difficult for me to rationalize persisting with Option Three for any length of time. Although yields may be gyrating all over the place for all kinds of reasons after the Fed engages in purchases of securities, to me the effect on nominal aggregate demand from Fed purchases of securities boils down to if Bernanke prints it, someone will spend it.
Alright, let’s get on to forward guidance. Suppose the economy has been dead in the water and the federal funds rate is fallen to zero. Under these conditions, the Fed states that it has no intention of lifting the federal funds rate in the coming x-number of months. This “forward guidance” with regard to the Fed’s target of the federal funds rate is quite credible. Why would anyone expect the Fed to raise the federal funds rate so long as the economy is “in irons” (hint – it is a sailing term)?

A few months pass and the economy remains moribund. In response, the Fed begins a program of securities purchases, with Options One and/or Two, as discussed above, being operative. That is, nominal spending begins to grow faster. At the same time, the Fed reiterates its statement that it has no intention of lifting the federal funds rate in the coming x-number of months. Is the Fed’s same forward guidance as credible now, after the implementation of its program of securities purchases and after tangible evidence of a pick-up in nominal spending? If it is to you, I have some bonds I want to sell you.

The Fed can provide all of the forward guidance it wants. But if its actual policy actions, in contrast to its words, and the incoming economic evidence suggest that a prudent monetary policy should run counter to the Fed’s forward guidance, who are you going to believe – the Fed or your lying eyes? After years of observing the behavior of financial markets, I bet that you are going to conclude that your eyes are not lying and that you will make portfolio adjustments accordingly. After you and other market participants have altered your portfolios in accordance with reality, the Fed will eventually will alter its guidance.

Paul L. Kasriel
Econtrarian, LLC


  1. Thanks again for the insightful commentary. Might it not be worthwhile to consider what the world would look like today in the absence of large scale asset purchases by the Fed? I think you can make the case that it actually wouldn't look very different than it does.

    The government has decided to fund a part of its spending by issuing bonds, so someone has to buy/hold them. For its own commercial reasons, the banking system has decided to reduce its exposure to risky assets (ie, private sector loans) and would like to own more riskless ones. From a bank's perspective, these days reserves and government bonds are near substitutes for one another since they pay similar rates of interest and are both riskless. The sum of bonds (mainly Treasuries plus implicitly guaranteed GSE paper) plus reserves has grown as a percent of banks' assets from 21% to 37% since the crisis. Although the banking system doesn't have any control over the level of reserves in the system, it does in fact control the total of reserves plus Treasuries.

    It seems that what at first glance appears to be QE is in fact just a reflection of the commercial decision by banks to hold more government bonds plus reserves. Banks are willingly funding the government directly by buying bonds, and indirectly by holding reserves backing the Fed's own stash of Treasuries. And depositors are funding the banks.

    So at the end of the day, the government spends, putting money in people's pockets, which they deposit, which the banks use to buy bonds or hold as excess reserves (which in turn fund the Fed's purchases of bonds), which leads to more government spending, etc. If there had been no QE then banks would hold fewer excess reserves and more Treasuries, and the picture would look pretty similar.

  2. Firstly, if the banking system does NOT have any control over the level of reserves in the banking system, as you correctly note -- only God can create a tree and only the Fed can create dollar reserves -- then how can the banking system have control over total reserves PLUS Treasuries? What if the banking system wanted to hold an amount of reserves AND Treasuries LESS than the amount of reserves created by the Fed. It could sell all of its Treasuries, but this would not extinguish any reserves in the banking system. So banks would still end up holding more reserves and Treasuries (zero amount) than I assumed they wanted to hold.

    "If there had been no QE then banks would hold fewer excess reserves and more Treasuries, and the picture would look pretty similar."

    The payment of interest on bank reserves complicates the issue. I would agree that there is little incentive for a bank to purchase a 2-year Treasury at 25 bp, which was the rate a couple of months ago, when it can earn 25 bp overnight on reserves held at the Fed. So, if there were no interest paid by the Fed on reserves, the banking system would likely hold more short-maturity Treasuries and Fewer EXCESS reserves and MORE Required reserves. The amount of TOTAL reserves would depend on what the Fed created.

    You also are correct that in the aftermath of the 2008 financial crisis, banks have desired to shed risky assets in favor of riskless ones, such as Treasuries and reserves. Why? Because of loan losses and higher regulatory capital ratios, banks did not have the capital to support the previous level of risk assets. The question is whether banks have the capital to increase their TOTAL assets at a "normal" rate of growth? Apparently not. From Jan. 1973 through Dec. 2008, the median year-over-year change in TOTAL commercial bank assets -- loans, securities and cash reserves -- was 8.13%. Starting in Jan. 2009 through Jul. 2013, this median year-over-year change in Total commercial bank assets has been 4.03%. Why has there been such a marked deceleration in the growth of Total commercial bank assets? I would submit because of capital constraints. The data suggest that while banks were preferring relatively more riskless assets, at the time they were constrained in increasing TOTAL asset growth at a "normal" rate.

    So, I would argue that the world would NOT look the same today in the absence of QE. Without the augmentation of "thin-air" credit from Fed QE activity, growth in TOTAL "thin-air" credit -- Fed credit and bank credit -- would have been considerably below "normal" and, as a result, growth in nominal spending would have been even weaker than it has been.

    Paul Kasriel

  3. "What if the banking system wanted to hold an amount of reserves AND Treasuries LESS than the amount of reserves created by the Fed? It could sell all of its Treasuries, but this would not extinguish any reserves in the banking system. So banks would still end up holding more reserves and Treasuries (zero amount) than I assumed they wanted to hold."

    Agreed in theory, but I don't think this describes the current environment. Despite the massive increase in excess reserves, banks have grown their securities portfolios considerably faster than their loan books since the crisis. Eventually, if and when the opportunity cost increases, banks might choose to hold fewer reserves plus Treasuries (or alternatively, grow their balance sheets faster), but we're still a long way from that happening, no?

    Furthermore, I'm not sure how slower than normal growth in bank balance sheets is evidence that QE has been effective (or vice versa, for that matter). I'm basically arguing that what asset growth there has been is a result of the combination of debt funded deficit spending and a compliant banking system, which can hold a virtually unlimited amount of Treasuries regardless of its capital levels. In the absence of this quiet "conspiracy", I agree that growth in nominal spending would have been weaker, but I don't see how this has anything to do with QE.

    To the extent that the Fed ends up holding assets that would have otherwise been held by the non-bank private sector, I suppose you could argue that purchasing power in the economy has been goosed. But even in this case I wonder whether Treasuries have sufficient "moneyness" to be treated as a substitute for cash---admittedly I'm out of my depth on this front.

    Thanks again for the great commentary---always food for thought!

    1. A couple of thoughts to hopefully add, not detract, from the conversation:

      *While banks cannot create reserves, they can destroy them through negative interest rates. I'm not saying this is happening (or will), but reserves can be destroyed which is a key reason for interest on reserves (IOR).

      *In a future state where the opportunity cost to hold reserves is higher than lending on reserves, banks will lend more but total reserves will remain the same and will just be passed amongst banks. As reserves are necessary, but not sufficient for lending, the opportunity cost will not affect the total amount of reserves in the system (at least from a bank's perspective).

      *Given this, I'm not sure I fully agree with the bolded statement "if Bernanke prints it, someone will spend it." I would agree if you include IOR as a type of purchase, but otherwise I would disagree as QE has not produced actual physical dollars but rather electronic reserves (there is a difference). This increases the traditional definition of money supply, but not actual money in the way most of us perceive money.

      *As a final thought, markets are always trying to gauge what the Fed will do and act ahead of this action. That being said, in the absence of any solid information the behavior of others becomes a seemingly valuable piece of information (simple evidence can naturally be found in financial markets as well as in real life; think of how people avoid an empty restaurant, assuming that if the food was good, it wouldn't be empty). The problem with this, of course, is that the information loop is circular and not built on any substantial information. I won't go so far as to say my lying eyes are incorrect, but I would caution what information the market is actually acting on.

      Overall, this is my first time to your blog; thank you for the commentary.

    2. This first reply is to the Gulliver's Travails Sept. 01 comment. Then I will reply to the Finn 0123 Sept. 04 comment.

      To Gulliver -- banks are not only subject to risk-based capital ratios but also to overall leverage capital ratios. As a percent of bank total assets or loans/securities, their acquisition of Treasury securities since the 2008 financial crisis has been significantly lower than in past economic recovery cycle phases. Why? Two possible explanations. Firstly, banks' leverage ratios may have constrained their purchases of Treasuries. Secondly, the interest rate paid by the Fed on reserves was equal to or above the yields on short-maturity Treasuries.

      Slower-than-normal growth in total bank assets has everything to do with the necessity for QE. If banks are not creating "normal" amounts of thin-air credit, then growth in nominal spending/transactions will also be weaker than normal. QE is a temporary substitute for thin-air credit that would have been created by the banking system under normal conditions. The key to understanding and evaluating the effectiveness of QE is to look at the behavior of the SUM of Fed credit AND bank credit (i.e., loans and securities). For example, if the Fed purchases securities from the banking system, ceteris paribus, Fed credit increases. If banks choose NOT to replace these securities with some other ones or with some loans, then bank credit falls by the same amount that Fed credit increased. In this case, the change in the SUM of Fed AND bank credit is zero. QE is ineffective. But, if banks do replace the securities sold to the Fed with some other ones and/or with some new loans, then there will have been a net change in the SUM of Fed AND bank credit equal to the dollar amount of securities purchased by the Fed.

      To Finn -- If the Fed penalized banks for holding EXCESS reserves by charging banks for them -- a negative interest rate on EXCESS reserves -- then banks would have a strong incentive to acquire securities and loans, which would result in an expansion in deposits and other liabilities of the banking system. To the extent that REQUIRED reserves increased because of the expansion in deposits, then EXCESS reserves would have, indeed, been reduced. TOTAL reserves, however, would not have changed. If the Fed charged banks for holding reserves of all categories, the only way banks could rid themselves of reserves would be for them to charge their depositors a penalty rate so as to induce depositors to redeem their deposits for currency.

      You are quite correct in stating that for a given amount of reserves created by the Fed, banks cannot reduce this total by acquiring earning assets (loans and securities). However, as I explained in the prior paragraph, if banks do acquire more earning assets and this increased REQUIRED reserves, then the composition of TOTAL reserves will be affected -- more REQUIRED reserves, fewer EXCESS reserves.

      "If Bernanke prints it, someone will spend it" is, admittedly, flip. There are two conditions that have to be met for this statement to hold. Firstly, the SUM of Fed credit AND bank credit must increase. Secondly, the nonbank public's demand to hold "money" must not increase by an amount equal to or greater than the amount of credit created by the Fed. In other words, the velocity of money needs to fall by less than the amount of funds created by the Fed.

      I am not very facile with analogies, but if the economy starts to boom and the Fed tells me it is not going to change its policy in response to this, I certainly hope that other market participants believe the Fed because I have some bonds I want to sell them at what will turn out to be inflated prices. As I recall, there was a fellow by the name of Soros who did not believe that the BOE would continue to defend the pound despite what the BOE said.

    3. Well, at the risk of flogging a supine equine, I will restate my position: In a world where competitive rates of interest are paid on excess reserves, the rate of growth of bank assets tells us nothing about the effectiveness of QE. If banks want to hold riskless assets and don't distinguish between obligations of the central bank (ie, reserves) and obligations of the government (ie, Treasuries), then QE is redundant. In such a case, bank balance sheets grow mechanically as a function of government deficit spending, whether or not the central bank intervenes. But your point about overall leverage constraints is well taken---I'll have to go and remind myself whether banks effectively have limitations on their holdings of Treasuries.

  4. Buying an asset, (real or financial) doesn't increase nominal spending. Thus, we need to distinguish between the spendable money supply (used in consumption or new productive investment) and the investible money supply (used to purchase existing assets). If bond purchases simply increase the investible money supply, then it will just raise asset prices, not increase nominal spending.

    1. Advant Guard, if I substituted "increased nominal transactions" for "increased nominal spending", would we be square?

      Paul Kasriel

  5. Since the Fed's securities purchases are made with institutional counterparties, not individuals, isn't the increased spending capacity limited to items that the institutions are able to purchase, i.e additional securities?

    If no securities purchases are made, the Fed purchase monies increase the institution's capital so more lending can occur.

    Do I have this right?