The Rube Goldberg Fed, 1/29

Contractionary liquidity?

Viral V Acharya and Raghuram Rajan write,

It seems obvious that the liquid central bank reserves issued to finance central bank balance sheet expansion should, ceteris paribus, enhance the supply of liquidity, bringing down illiquidity premia in the market, and reducing the cost to firms of financing. Yet this view neglects three key private sector responses.

…Third, and perhaps most novel, in times of liquidity stress, healthy banks may see a valuable convenience yield to liquid reserves – for instance, as dry powder in case conditions worsen. Consequently, healthy banks may hoard liquidity and maintain unimpeachable balance sheets, in order to be perceived as safe and attract more deposit flows, rather than lending it out to stressed banks.

Their analysis is neither demonstrably correct nor easily debunked. What it shows, in my view, is that no one can predict with confidence the consequences of actions taken by the Fed in its Rube Goldberg incarnation.

My intuition is that if a Fed expansion raises the demand for liquidity by a lot, then such an expansion should not fuel bubbles in houses or in speculative assets. So if you think that the main thing that the Fed is doing is fueling a bubble, you don’t want to emphasize the theoretical possibilities raised by the authors of this paper.

In 2021, we saw a combination of two phenomena in financial markets. One is that the interest rate on safe securities was low. In fact, holders of U.S. Treasuries lost purchasing power at a faster rate than at any time since at least the early 1970s. The other phenomenon is that speculative assets, whether houses or Bitcoin or stocks, generally rose.

One relatively mainstream interpretation of this is that the Fed flooded the economy with money. Moreover, contrary to the theory in the paper, the expansion had the effect one might expect, lowering interest rates and raising asset prices.

I have a heterodox view. I think that the Fed is engaged in an opaque hodge-podge of balance sheet activity and regulation. We don’t know what the impacts are, and we will not know for a long time, if ever. But I don’t think that the Fed can control any interest rate that really matters.

I attribute the financial behavior in 2021 to the perceived wealth created by government deficits and speculative financial markets. When the government borrows a dollar and writes a check for a dollar (it doesn’t matter whether the check is a gift to a household or a purchase from a firm), both the lender and the check recipient now think they have assets worth a dollar. The lender holds a one-dollar IOU, and the check recipient holds a dollar. In short, government deficits are perceived as increasing wealth.

Some of the wealthier people are risk averse, so they put their wealth into government bonds. Other wealthier people are more willing to speculate, so they put their wealth into Bitcoin, Gamestop, NFTs, start-ups, or whatever.

So far, things are shaping up differently in 2022. The reality of inflation is starting to sink in, so risk averse investors are starting to look for some place other than government bonds to park their money. Interest rates are nudging up.

An increase in a long-term interest rate from 1.5 percent to 3 percent would be both too little and too much. It would be too little to yield a return above an inflation rate of more than 5 percent. But it would be too much for financial markets to bear, because it cuts the price of the bond by about 50 percent. (compare 1/.015 to 1/.03). Other long-term assets, such as stocks, can lose value by a comparable amount.

Note that, in contrast, an increase in the long-term rate from 9 percent to 10 percent would only reduce the price of a long-term bond by about 10 percent (compare 1/.09 to 1/.10). If you don’t follow the math/financial analysis, do a search for “bond price and interest rate formula”, and try to find calculations for long-term bonds (10 years or more).

In short, if interest rates rise anywhere close to the rate of inflation, many asset prices could collapse, which would erase a lot of perceived wealth and choke off the inflation. If interest rates stay low, perceived wealth will be chewed up by inflation. If they rise sharply, perceived wealth will collapse because of the higher interest rates.

Perhaps at a long-term interest rate of, say, 2.5 percent, the collapse in wealth is sufficient to bring inflation down to, say, 2 percent, but not cause a catastrophic recession. But this sort of soft-landing scenario is by no means assured.

If you are a mainstream economist, you see the Fed as being capable of engineering a path of interest rates that achieves a relatively benign outcome. If you are like me, you think that the really important long-term interest rates are out of the Fed’s control: the capital markets will set long-term interest rates, and that it turn will determine how hard or softly we land.