My Lesson in Monetary Policy

In a comment on my last post, Jon gave me another lesson on monetary policy and John Taylor's arguments about the crisis.

I have read other articles by Taylor on the crisis and continue to see money and credit confused, and an obstinate desire to claim that the federal funds rate was just fine, it was the rest of the economy that was wrong.

Jon claims that Taylor believes that his audience understands "loose" money in terms of the federal funds rate. If Taylor panders to his audience in that fashion, then, that makes him part of the problem.

Making monetary policy work when no one believes it will work is more difficult. Continuing to encourage the identification of monetary policy with a target for the federal funds rate, and so perpetuating the myth that with the federal funds rate set at a range of zero to .25 percent, monetary policy is "out of ammunition," is destructive.

Jon describes what the Fed did in the federal funds market as "liquifying" the market. I find the concept of liquifying a particular market a bit odd. My blender has a setting of liquify. Liquidation is sometimes a euphemism for assassinate.

Jon explains that Taylor believes that by selling its T-bill portfolio, the Fed reduced liquidity in the OTM market. I suppose that means the "over the counter" market. I am not sure who supposedly had little money in their checking accounts and how they were associated with what sort of over the counter trading.

I think I do understand what Jon reports is Taylor's view about federal funds and LIBOR. The Fed injected funds into the federal funds market, but those funds were not being relent by banks onto the LIBOR market. The federal funds rate fell, but the LIBOR rate remained high.

From Jon's last lesson on monetary policy, I took it that the Fed added funds to the economy by making secured overnight loans to primary security dealers (broker dealers.) But they were not lending those unsecured funds on the LIBOR market.

Here is some information from the British Bankers Association on LIBOR:

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The LIBOR rate is the interest rate a handful of large money center banks pay to borrow money. The British Bankers association selects them and then polls them on their borrowing costs. It isn't like there is some kind of exchange where funds are traded and the interest rates are reported. If we assume that these large money center banks have the best credit, then other banks and nonbank borrowers can be expected to pay more.

Note that it is an average rate and the BBA carefully discards the higher and lower rates. But what happens when most of the banks that the BBA's selection committee chose have similar problems at the same time? Instead of LIBOR communicating something about market interest rates, it is now communicating information about the financial problems of a handful of banks.

The Fed funds rate is the relevant overnight borrowing rate for most U.S. banks. During the crisis, there was a large volume of overnight lending at low rates. But, heaven forbid, many of the large money center banks had to pay higher interest rates than most banks (rather than lower rates, as is their birthright, of course,) because they had financed large portfolios of mortgage backed securities with short term funds. I suppose we can call their inability to sell the mortgage backed securities "the queen of spades" problem, that is, who knows which mortgage backed securities include mortgages that will default. And those banks ability to borrow no doubt changed with changing perceptions of whether and how they would be bailed out.

Taylor (and Jon) insist that these money center banks didn't have a liquidity problem. Well, if that means that their problem wasn't that the people that would otherwise lend to them wanted to hold money, and that there wasn't enough money for those potential lenders to hold, and so they were refusing to lend to those banks, then maybe. Creating more money may have resulted in more lending, but maybe none of it would have flowed through the money center banks.

On the other hand, I am sure there was a problem with liquidity in the U.S. economy. While the quantity of money rose, it rose by less than the demand to hold money, so nominal expenditure began to grow more slowly in the third quarter of 2008, and then dropped in the fourth quarter of 2008 and the first quarter of 2009. To this day it remains 9% below its long term trend because the quantity of money is less than what the demand to hold money would be if nominal expenditure were on its trend growth path.

And that is what the Federal Reserve needs to worry about, not the borrowing rates of a handful of money center banks. And claiming that the interbank lending rate is just fine--well, maybe. I think it is time to understand that interbank lending rates are beside the point.