Seth Carpenter paper

On Tue, Sep 28, 2010 at 12:36 PM, Eileen wrote:

Did Hell freeze over and I missed it??

Seth B. Carpenter and Selva Demiralp, recently posted a discussion paper on the Federal Reserve Board’s website, titled Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?

The authors note that bank reserves increased dramatically since the start of the financial crisis. Reserves are up a staggering 2,173% from $47.3bn on September 10, 2008, just before the financial crisis began, to $1.1tn now. Yet M2 is up only 11.4% since September 10, 2008, and bank loans are down $140.2bn. The textbook money multiplier model predicts that money growth and bank lending should have soared along with reserves, stimulating economic activity and boosting inflation. The Fed study concluded that “if the level of reserves is expected to have an impact on the economy, it seems unlikely that a standard multiplier story will explain the effect.”

That not only repudiates the textbook money multiplier model but also raises lots of questions about the goal of the Fed’s quantitative easing policies.


The Carpenter/Demiralp study quotes former Fed Vice Chairman Donald Kohn saying the following about the money multiplier in a March 24, 2010 speech: http://www.federalreserve.gov/newsevents/speech/kohn20100324a.htm

“The huge quantity of bank reserves that were created has been seen largely as a byproduct of the purchases that would be unlikely to have a significant independent effect on financial markets and the economy. This view is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of causation from reserves to the money supply to economic activity and inflation. . . . We will need to watch and study this channel carefully.”

Here are more shocking revelations from the study under review: “In the absence of a multiplier, open market operations, which simply change reserve balances, do not directly affect lending behavior at the aggregate level. Put differently, if the quantity of reserves is relevant for the transmission of monetary policy, a different mechanism must be found.

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38 Responses to Seth Carpenter paper

  1. room rental says:

    The point is that if the multiplier doesn’t exist then the QE wont work as the low interest rate in the paper is not guaranteed to work.

    Reply

  2. beowulf says:

    Well on p. 33 of 7IDF, Warren wrote:

    when the U.S. government does what’s called “borrowing money,” all it does is move funds from checking accounts at the Fed to savings accounts (Treasury securities) at the Fed. In fact, the entire $13 trillion national debt is nothing more than the economy’s total holdings of savings accounts at the Fed.

    Paying interest on reserves (authorized by the 2008 TARP bill) is, to extend Warren’s analogy, like paying interest on checking accounts. The new interest-bearing checking account is a chimera, it has qualities of both savings accounts and the old no interest checking account.

    Paying IOR allows the government to create money by spending without “borrowing”, there’s no need to execute a reserve drain (using Warren’s frame this would “add to the savings account”), when the IOR payments can drug the excess reserves to sleep (and Uncle Sam doesn’t add to the national debt).

    My mental image is that old Saturday Night Live fake ad for “Sleepytime Rat Control”, Phil Hartman points out, sure killing the rats would be the ideal solution, but putting the rats to sleep for 8 hours, that’s not bad.
    http://www.retrojunk.com/details_articles/816 (halfway down the page)

    At any rate, don’t think of that $1 trillion as money that isn’t been lent out, its $1 trillion that would otherwise be in the savings account if the checking account hadn’t started earning interest.

    Reply

  3. Tom Hickey says:

    Mat the whole quote makes it clear that a “not” was omitted:

    “In the absence of a multiplier, open market operations, which simply change reserve balances, do not directly affect lending behavior at the aggregate level. Put differently, if the quantity of reserves is [NOT] relevant for the transmission of monetary policy, a different mechanism must be found.

    Logic requires, “if the quantity of reserves is [NOT] relevant for the transmission of monetary policy, a different mechanism must be found.”

    Perhaps, subliminally, they just could not bring themselves to write that, because it crashes the whole system as viewed conventionally. In cognitive terms the money multiplier is the meme that underlies the conventions of monetary policy as practiced by the principle institution of the financial system. This is like a theologian in a theocracy declaring that God doesn’t exist.

    Reply

    Matt Franko Reply:

    Tom,
    Thanks yes that must be a typo corrected as you describe…it makes better sense that way.

    OTOH, maybe it was edited by their superiors to read that way, they couldnt admit it like you say…I thought it may have been like it was time for them to “talk to their doctor about Viagra”, but they keep blaming it on their technique :o)

    But this is progress nonetheless imo. JKH has often been of the opinion that Bernanke has been learning on the job, if Donald Kohn said what is quoted, I have to think Bernanke thinks about the same way. Maybe this is why they didnt go head long into another QE out of the last meeting, they know it doesnt work. Now if we could only get Ben B to directly inform Congress of this development in his next testimony…if only.

    Steve Leisman was on CNBC this AM with some leaks out of the Fed about what they were going to do at this point instead of the QE they did last time, it sounded like they were going to make purchases only to maintain a sort of rate ceiling (price not quantity?), but I didnt catch it all. Ill try to find the video link later and try to post it up at Mikes.

    Resp,

    Reply

    Ed Rombach Reply:

    Here’s a couple of video segments of my own on this topic. The frst is from Sep 21, and the second one was aired on Sep 29. Warren – Many thanks for providing me with much of the conceptual foundation.

    http://insider.thomsonreuters.com/link.html?ctype=groupchannel&chid=3&cid=145854&start=0&end=194&shareToken=MzpmYzU1NGNlNS0zNzc3LTQyMDEtYmUxNC04Zjk3MTEzNDQ3YTk%3D

    http://insider.thomsonreuters.com/link.html?ctype=groupchannel&chid=3&cid=148385&start=0&end=148&shareToken=MzpmNzU4NmY3NS0wY2VhLTQ4OGMtYWIxMC1kYjg1ODdiMzUyYzE%3D

    Reply

    JKH Reply:

    Tom, it may not be a typo, IMO.

    The quantity of reserves can be relevant for monetary policy – it’s just not relevant in the sense of the multiplier idea. E.g. it’s relevant under normal conditions (non-QE) when the Fed supplies reserves elastically at the Fed funds rate. And it’s relevant in the recent situation to the degree that the Fed’s balance sheet activity, with increased reserves as a by-product, has had some effect on credit spreads and the yield curve. I.e. it’s been a relevant tool for interest rates. But these things have nothing to do with the multiplier.

    The paper itself is yet another tragedy in a long list of papers. When are these people going to wake up and discover how double entry bookkeeping works when a bank makes a loan, and how the Fed itself always supplies required reserves with a lag?

    As Matt says, I suppose it’s useful that they’re at least raising the question – even if they are grappling with it with a “who’s on first” level of understanding. But this is an area where MMT should have been decisively helpful in promoting some hard facts on how the monetary system actually functions. Yet, I see little traction developing in mainstream for what should be pure, non-ideological comprehension in this regard.

    Reply

    Tom Hickey Reply:

    Thanks, JKH. Agree. Then the quote should be construed, “In the absence of a multiplier, open market operations, which simply change reserve balances, do not directly affect lending behavior at the aggregate level. Put differently, if the quantity of reserves is [to be understood as] relevant for the transmission of monetary policy, a different mechanism must be found [to explain it, i.e., relative to rate setting and influencing the yield curve].

    Reply

    JKH Reply:

    P.S.

    Zanon is correct, above.

    Reply

    jcmccutcheon Reply:

    What is the nature of Bank Capital?

    Reply

    JKH Reply:

    the nature?

    bank capital is a source of funding that’s designed to absorb first losses

    and as such it’s the balance sheet item that intersects critically with the income statement

    central bank reserves have neither of those characteristics

    capital is “tiered” according to sub-ordering of loss absorption; e.g. “tier 1″ is mostly common equity – compositional qualifications are being tightened up under Basel III

    the purpose of central bank reserves is to facilitate settlement of interbank payments

    and aggregate reserves are also used by the Fed for interest rate control

    central bank reserves are a commercial bank asset; capital is on the other side of the balance sheet, ranking below liabilities in terms of liquidation payout

    or did you mean something else by “nature”?

    BFG Reply:

    JKH, Warren anyone

    Matt and I were searching for the ECB Securities Market Program (SMP) last week to find which government debt the ECB were buying. So we found the following ECB Balance Sheet just after the programme started.

    The ECB/NCB purchases are located on the Asset side under item 7.1 Securities held for monetary policy purposes, they are also recorded alongside the covered bonds purchase programme. Due to this purchase the liability side of the balance sheet expands. But where is the liability side of this purchase? Is it 2.2 Deposit facility, located under Liabilities to euro area credit institutions related to monetary policy operations denominated in euro.

    The ECB conducts operations in order to re-absorb the liquidity injected through the SMP. An increase in any item on the asset side of the balance sheet is providing “liquidity” which is available to the banking system. An increase in any liability item other than L.2.1, by contrast, leads to an absorption of liquidity from the banking system.

    This is the Balance Sheet for the following week. The first week they purchased €16.3B. But I can’t seem to find them on the liability side, but the following week after the programme started the following appeared under 2.1 fixed term deposits you will see the deposits that were created when the debt was bought. Its a 1% fixed term deposit, do you think this is the corresponding liability to the purchase. It amounts to €16.5B, and every subsequent week it is tracking the bond purchase program. They have bought ~€61.7B to date. If it is used to drain the reserves that were created by the purchase why is there a delay of one week?

    Many thanks,

    BFG

    JKH Reply:

    BFG,

    I’m not familiar with it, but maybe some things to explore:

    – is there a lag between the point at which funds initially created by bond purchases are reflected immediately in the current account facility or the regular deposit facility, and the point at which those funds are subsequently switched over into the fixed deposit facility?

    – is there an auction schedule for the fixed deposit facility that creates such a lag?

    – also, maybe there is a settlement lag between purchase date for bonds and their cash settlement; i.e. are the bonds entered as assets on trade date, and the corresponding liability effect of the cash created on a later settlement date?

    These are just guesses on my part.

    Matt Franko Reply:

    BFG,

    It looks like from this schedule
    that they didnt do the -16.5B operation until May 19th and the BS was dated May 14th so that may be the delay. ie They bought by the 14th but didnt drain until the 19th.

    Resp,

    Ramanan Reply:

    BFG,

    The ECB says that it will issue debt certificates to withdraw the liquidity but it doesn’t actually do so. Doesn’t seem like.

    Instead, if it purchases 10b of government bonds in one week, it will lend 10b less to the banking sytem in the following week.

    Remember the institutional setup is an overdraft type and the the Eurosystem has a large claim on the banking system which gets renewed every week.

    jcmccutcheon Reply:

    Thought bank capital was assets minus liabilities. Looking for examples of bank capital? How do bank increase their capital?

    JKH Reply:

    Bank capital is assets minus liabilities, for the most part. Certain kinds of subordinated debt and other structured liabilities have also qualified as capital, within very strict limits. That’s being updated by Basel III. Don’t know the details.

    But you are basically right; the base case, with minor exceptions, is:

    bank capital = assets – liabilities = equity

    Most capital consists of common equity and preferred equity.

    Banks increase their capital through retained earnings or new issues of equity or qualifying debt.

    Banks can also improve their risk weighted capital ratios by managing down the risk of their assets.

    BFG Reply:

    JKH, Ramanan

    - is there a lag between the point at which funds initially created by bond purchases are reflected immediately in the current account facility or the regular deposit facility, and the point at which those funds are subsequently switched over into the fixed deposit facility?

    The purchases are so small relative to the normal functioning of the current account facility that it would be hard to find, but the following graph covers the 2.1 Current accounts (covering the minimum reserve system) and the 2.2 the Deposit Facility, they are in lock step with each other.

    - is there an auction schedule for the fixed deposit facility that creates such a lag?

    – also, maybe there is a settlement lag between purchase date for bonds and their cash settlement; i.e. are the bonds entered as assets on trade date, and the corresponding liability effect of the cash created on a later settlement date?

    You may be onto something here:

    Fine Tuning Operation

    As announced by the Governing Council on 10 May 2010, the ECB will conduct specific operations in order to re-absorb the liquidity injected through the Securities Markets Programme. In this regard, the ECB will carry out a quick tender on 28 September at 11.30 in order to collect one-week fixed-term deposits with settlement day on 29 September. A variable rate tender with a maximum bid rate of 1.00% will be applied and the ECB intends to absorb an amount of EUR 61.5 billion. The latter corresponds to the size of the Securities Markets Programme, taking into account transactions with settlement at or before Friday 24 September, rounded to the nearest half billion. As the settled SMP transactions last week were of a volume of EUR 134 million, it happens that the rounded settled amount – and the intended amount for absorption accordingly – remains unchanged at EUR 61.5 billion.

    If you look at the following graph of the Fixed-term Deposits , you will see there is a settlement of 1 week to re-absorb the liquidity injected through the SMP. So the ECB/NCB purchases the bonds but they are not settled till one week later through the 1% fixed term deposit is that correct?

    Matt,
    It looks like from this schedule that they didnt do the -16.5B operation until May 19th and the BS was dated May 14th so that may be the delay. ie They bought by the 14th but didnt drain until the 19th.

    They reported the operation on the 18th May for the pre-ceding week and they didn’t reabsorb it till the following week of the 25th May. That is one week after reporting the €16.3B purchase. They are not purchasing any real amounts of government debt and the quantity being purchased is so small that they are not going to make much of a difference to the yields, so what is the point?

    Thanks

    Ramanan Reply:

    BFG – what is the thing that you are trying to figure out ?

    http://www.ecb.int/press/pr/wfs/2010/html/fs100518.en.html has zero term deposits but http://sdw.ecb.europa.eu/reports.do?node=100000129 has 61b. Don’t know why there is a discrepancy.

    Also the point is of the operation is to prevent some governments from defaulting.

    The fixed term deposits are issued because people don’t like unsterilized operations. With so much excess of reserves, there is no need to issue the term deposits really.

    Matt Franko Reply:

    Here is the link at Mike’s where BFG was looking into the NCB balance sheets….the links are in the comments section.

    Resp,

    JKH Reply:

    “If you look at the following graph of the Fixed-term Deposits , you will see there is a settlement of 1 week to re-absorb the liquidity injected through the SMP. So the ECB/NCB purchases the bonds but they are not settled till one week later through the 1% fixed term deposit is that correct?”

    Almost, but not quite – is my guess.

    It looks like the bonds are settled with the usual securities settlement timing, with the related cash effect showing up right away in the current account and/or regular deposit facility categories. The dedicated fixed deposit facility then engages on schedule, with the effect that the amount of cash already injected by the bond operations is reallocated from the first two categories into the fixed deposit category.

    I think Ramanan is roughly right on the “sterilization” aspect. Sterilization across all three categories of cash effectively amounts to paying interest wherever it’s required in order to set the lower bound for the Euro policy target rate. There’s a bit of transparency theatrics in denoting this special fixed deposit category as the sterilization channel for the bond program. The term extension really isn’t that important to the objective, which is always interest rate control.

    This is all a guess on my part, but sounds OK?

    Ramanan Reply:

    oops messed up dates http://www.ecb.int/press/pr/wfs/2010/html/fs100928.en.html has 61b

    Reply

    Ramanan Reply:

    People just want sterilization to happen. As the name suggests, it is supposed to be done because there is a view that money will mutiply and it needs to be sterilized. In this case, the reserves in the system has been in excess for a long time, and there was no need to sterilize. In reality sterilization is just for targeting rates. Right now the target is 1.00% but the rates are anywhere from the floor – 0.25% to around 0.5%

    The ECB must have done this only because people demanded sterilization happen.

    BFG Reply:

    Ramanan,

    I was trying to figure out why the fixed-term deposits didn’t show up on the liability side till weeks after the purchase program. And to trace them back to the NCB BS to find out whose debt was being bought.

    The Irish 10yr yields are higher now than before the program started. The purchases are too small so I don’t think it’s going to prevent some governments from defaulting. Portugals and Belgiums yields are also on the rise now.

    Ramanan Reply:

    I see. That’s ok if there is a delay. The reserves level were anyway high so there was no need to absorb it fast. Plus the ECB wants to do the operations secretively and hence it is a bad strategy to absord that extra liquidity asap because people know the size of the operation.

    The ECB bought time when it started doing it. Plus since it was doing it secretively, it bet on the fact that the market participants will act on the news and start buying bonds themselves so that the ECB itself need not do the job. I think it will fight all attempts to bring down any government. It has created a situation in which market participants will not like to burn their fingers via a speculative attack.

    JKH Reply:

    repeat:

    “If you look at the following graph of the Fixed-term Deposits , you will see there is a settlement of 1 week to re-absorb the liquidity injected through the SMP. So the ECB/NCB purchases the bonds but they are not settled till one week later through the 1% fixed term deposit is that correct?”

    Almost, but not quite – is my guess.

    It looks like the bonds are settled with the usual securities settlement timing, with the related cash effect showing up right away in the current account and/or regular deposit facility categories. The dedicated fixed deposit facility then engages on schedule, with the effect that the amount of cash already injected by the bond operations is reallocated from the first two categories into the fixed deposit category.

    I think Ramanan is roughly right on the “sterilization” aspect. Sterilization across all three categories of cash effectively amounts to paying interest wherever it’s required in order to set the lower bound for the Euro policy target rate. There’s a bit of transparency theatrics in denoting this special fixed deposit category as the sterilization channel for the bond program. The term extension really isn’t that important to the objective, which is always interest rate control.

    This is all a guess on my part, but sounds OK?

    BFG Reply:

    Yes, that makes more sense. The cash had to show up immediately in the current account or regular deposit facility to balance the purchase on the asset side.

    Thanks

  4. Min says:

    “That not only repudiates the textbook money multiplier model but also raises lots of questions about the goal of the Fed’s quantitative easing policies.”

    I admit to being a little confused about the money multiplier model. Some time back Bill Mitchell on his blog derived the money multiplier. All that the math showed, of course, was that the multiplier is the limit on the money created, given the reserve requirements. For that limit to be achieved in practice, a number of other conditions would seem to be required — to a non-economist, anyway. ;) Also, a couple of years ago I found one the Web some historical money supply statistics for the U S. Not surprisingly, the actual money supply was nowhere near the limit. (Or perhaps I did not understand what I was looking at.) Empirically, it seems that money simply does not multiply to the max, even in normal times.

    Yet, judging from the comments, it sounds like the textbooks teach exactly that. Can that really be the case?

    Reply

    zanon Reply:

    Min:

    The textbooks teach the multiplier model as if reserves were capital.

    So, reserve requirement is 10x, so 1 $ deposit equals $10 in loan.

    This is nonsense of course.

    Capital requirement does work like this, so bank with 10% capital requirement can leverage up 10x (more or less).

    Reply

    Min Reply:

    Many thanks, Zanon. :)

    Reply

  5. Tom Hickey says:

    Put differently, if the quantity of reserves is relevant for the transmission of monetary policy, a different mechanism must be found.

    Right, it’s called “functional finance,” and it’s been around since Abba Lerner surfaced it in 1943.

    Reply

    JKH Reply:

    Right.

    And it’s also called “the banking system”.

    Judging from the academic methodology of the paper, looks like these two may have stumbled upon a scintilla of truth by blind luck.

    Reply

    Matt Franko Reply:

    Tom,

    I focused on that statement also..is it a typo do you think??

    If the mechanism of Open Market Operations wont “transmit” the correct reserves, what will? Are then reserves dependent on their point of origin? Some reserves are better than others? I dont get it?

    JKH?

    Resp,

    Reply

    JKH Reply:

    I didn’t focus on any statement actually.

    The only thing that matters in conventional policy is the ON rate. We all know how that works.

    And the only thing that matters in QE is the yield curve.

    Quantity of reserves where its relevant is always a means to an end – the end being rates – whether conventional or QE.

    Quantity of reserves has nothing to do with bank lending – not in any material way.

    Reply

    JKH Reply:

    P.S.

    It’s pretty tough to know how the transmission of monetary policy works if you don’t even know what the effect of monetary policy is.

    :)

    Reply

    beowulf Reply:

    It’s pretty tough to know how the transmission of monetary policy works if you don’t even know what the effect of monetary policy is.

    Oh, next you’re going to say the New Guinea cargo cults are wasting their time building airplanes out of straw. Don’t be so insensitive. :o)
    http://en.wikipedia.org/wiki/Cargo_cult#Pacific_cults_of_World_War_II

    While the Fed patiently waits in the jungle for the deities and ancestors to bring back the C-47s loaded with Coca Cola, its worth reading this 2007 paper by Wynne Godley and Marc Lavoie:
    Fiscal Policy in a Stock-flow Consistent (SFC) Model

    It follows from the model that if the fiscal stance is not set in the appropriate fashion—that is, at a well-defined level and growth rate—then full employment and low inflation will not be achieved in a sustainable way. We also show that fiscal policy on its own could achieve both full employment and a target rate of inflation…
    http://www.levyinstitute.org/publications/?docid=911

    JKH Reply:

    Milton Friedman = Prince Philip:

    http://en.wikipedia.org/wiki/Prince_Philip_Movement

    :)

    beowulf Reply:

    Heh heh, that’s funny Prince Phillip sent his (“His”?) cargo cult photographs, that’s a man who doesn’t forget his fan club.

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