Friday, September 23, 2011

Hendrikson on Operation Twist

Josh Hendrikson responded to my post giving conditional approval to "Operation Twist."
He agreed with my basic argument, but claimed that it wouldn't have much effect. He claims:

Now suppose that the Federal Reserve sells $X of T-bills uses the proceeds to buy $X of long term bonds. In doing so, the price of T-bills fall and the yield correspondingly rises. However, this generates an arbitrage opportunity for banks, which will use excess reserves (now paying a lower rate of interest than T-bills) to buy T-bills. They will continue to do this until the price of T-bills is bid up such that the yield on T-bills is equal to the interest rate on reserves. The degree to which the new reserves created by the sale of T-bills are used to purchase T-bills will be determined by the price elasticity of demand.

The transmission of monetary policy works through changes in relative asset prices. The relative price effect generated by this policy is minuscule. One can always argue that the sale of T-bills increase the supply of short-term safe assets by $X, but the only effect is a pure arbitrage opportunity that ultimately changes the distribution of T-bills and reserves, but leaves the total relatively unchanged.

I don't think this is correct.

The Fed sells the T-bills, increasing their supply. Banks use their existing excess reserves to purchase some or all of the T-bills the Fed just sold. This does not decease the amount of excess reserves in the banking system, but simply shifts the reserves from the banks buying the T-bills to the banks whose customers sold the T-bills. The total of T-bills, including those held by the banks, and reserve balances held by banks, is still higher.

Looking at the money holdings of the nonbanking public, if the Fed sold a T-bill to an individual, his or her money holdings, (checking account balance) are decreased. That individual has substituted money, perhaps FDIC insured money, for T-bills. If a bank then buys the T-bills from that person (arbitraging as above,) that person again has the money instead of the T-bill. There has been no increase in the quantity of money plus T-bills held by the nonbanking public. The nonbanking public has the exact same amount of money and no more T-bills than before.

But this, of course, ignores the purchase of the long term bonds by the Fed. The sellers of those bonds have additional money balances. And so, in this scenario, the amount of checkable deposits held by the nonbanking public expands. The amount of reserve balances held by the banking system is unchanged. And the banks have more T-bills.

If it was a bank that purchased the T-bills from the Fed initially, then the Fed would decrease its reserve balance and that bank has just substituted T-bills for reserve balances. But again, the Fed is buying long term government bonds.

If the Fed purchases the long term bonds from a bank, then that bank has additional reserves, perhaps additional excess reserves. If the Fed purchases from someone other than a bank, that person has an added balance in a checkable deposit (rather than a long term government bond) and his or her bank has increased reserves, perhaps more excess reserves.

However, if a bank responds to this scenario by selling a long term government bonds (perhaps because the yields have fallen,) then checkable deposits held by the nonbanking public return to their initial value. The problem isn't that banks might purchase the T-bills that the Fed sells, either directly or indirectly. The problem is that banks might sell long term government bonds that they already own.

This is the notion that banks reduce their private financial intermediation in a way that offsets the Fed's increased financial intermediation. Really it amounts to the notion that long term government bonds are also perfect substitutes for money.

However, I agree with Hendrickson's conclusion. Operation Twist is not enough. It is really wrongheaded.
The biggest problem with current Federal Reserve policy is that it lacks any coherent direction or policy goal. Expectations matter. (Read Woodford, for heaven’s sake! This is supposed to be mainstream monetary theory.) For Fed policy to be successful, they need to outline an explicit goal for policy in the form of a target for nominal income and the price level and commit to using the tools at their disposal to achieve that goal. Random announcements of specific quantities of asset purchases provide no guidance and will not be effective. Temporary monetary injections are not successful for much the same reason that temporary tax cuts are not successful (see Weil, “Is Money Net Wealth?”, 1991). Without a coherent goal or strategy, monetary policy with all its fits and starts will continue to fail.

Very well said. Look at today's Wall Street Journal headlines, "Markets Swoon on Recession Fears" and then, "Global Distress Rises Over Government, Central Bank Futility." Exactly.

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