It has become quite common to describe U.S. monetary policy as very loose. But with core inflation at 1.4 per cent, that cannot be the case. In fact, at approximately -1 percent, the expected short-term real interest rate is probably higher than the rate that clears markets for goods and services at the economy's production frontier. Federal Reserve economists have estimated the latter to be around -4 percent.
The perception of expansionary monetary policy is in large part due to a widespread misunderstanding of the Federal Reserve's balance sheet. Contrary to what is often asserted, the size of the balance sheet has no direct implication for monetary policy - it's all about credit policy. Yet, according to FOMC minutes, even members of the Fed's policy making committee are worried about the inflationary impact of banks' ex-cess reserve balances. That might have been a legitimate concern if the Fed had not changed monetary implementation procedures last year. But it did.
Before the financial crises the Fed did not pay interest on bank's reserve balances. The Fed then had to be prepared to adjust a scarce amount of reserves in order to keep the federal funds rate at the policy target. However, since October 2008 the Fed has been paying interest on banks' reserves. This effectively decouples the overnight interest rate from the stock of reserve balances - a system that was pioneered by the Norwegian central bank in 1997. When the Fed wants to tighten monetary policy, all it has to do is to increase the interest rate on reserves. There is no need to shrink the balance sheet. Nor is it necessary to drain reserves by entering into reverse repur-chasing agreements with banks or by offering them term deposits.
One might argue that one of the stated objectives of the Fed's credit policies is to affect interest rates beyond the federal funds market, and that these initiatives, there-fore, have an impact on inflation in addition to the response from the federal funds rate. But empirical studies have not been able to identify a lasting impact on the yield curve from central bank debt management policies. One reason is that while the central bank is a monopoly in the market for reserve balances, it's just one fish in the sea of global credit markets. Also, absorbing credit, liquidity and term risk on the Fed's balance sheet does not change private sector risk preferences. So while large-scale purchases of assets might have an announcement effect on asset prices, as we saw when the Fed and the Bank of England launched their quantitative easing programs, their equilibrium effects are likely to be muted. Finally, while the Fed has shorted the maturity of the overall public debt, the Treasury has been busy increasing the maturity of its debt. What the Fed gives, so to speak, the Treasury takes away.
Only indirectly might the Fed's swollen balance sheet interfere with monetary policy. Borrowing 1.1 trillion dollars in overnight funds has enabled the Fed to pursue risky credit policies. So far this has been a lucrative business. But in a possible worst-case scenario the federal funds rate that is deemed necessary for inflation control might turn the Fed into a loss-making enterprise. Since the yield on the Fed's assets is about 4 percent, and since the Fed's overnight debt finances 50 percent of those assets, the central bank will have to ask Congress to cover its losses if the policy rate is hiked beyond 8 percent. That would be a reversal of roles. Last year the Fed handed the Treasury a hefty profit of 46.1 billion dollars.
Chinese authorities and other creditors have voiced concern about a possible mone-tization of U.S. public debt. But monetization is not inflationary if monetary policy, i.e. the overnight interest rate, is calibrated properly. In fact, reserve balances, as over-night debt, are just another part of the public sector's debt. Financing deficits by issu-ing overnight debt is in principle equivalent to paying for the public sector's expenses by emitting T-bills. Also, as assets for the private sector Treasury liabilities and reser-ve balances are almost perfect substitutes. The main difference is that while all mark-et participants can hold T-bills, only banks can hold reserve balances.
Instead of worrying about the Fed's balance sheet, inflation hawks should focus on the potential inflationary impact of rapidly deteriorating public finances. As everyone knows, if the U.S. net public debt is not to reach unsustainable levels, current Keyne-sian fiscal policies and future social democratic welfare state policies must lead to either cuts in other expenditures or a significantly higher tax burden as a proportion of GDP.
But what happens if Congress chooses an unsustainable path? Then the real value of public liabilities must fall in order to match the present value of expected real pri-mary surpluses. To the extent that the public sector is financed by non-nominal debt, the market value of public liabilities will fall, followed by an explicit default as debt comes to maturity. To the extent that the public sector is financed by nominal debt, as is mostly the case in the U.S., the real value of public liabilities will drop first, through a fall in the debt's market value and then through an upward shift in the price level. Of course, since prices are sticky, what we will see is a tumultuous and value-destroying increase in inflation. And, what matters here is not necessarily short run fiscal exces-ses - what might create sharply higher inflation now is a widespread perception of future fiscal irresponsibilities.
But isn't inflation control the prerogative of Fed policy? Not exclusively. While the Fed can nudge inflation up or down by adjusting the overnight interest rate, it is within the power of fiscal policy to determine the absolute price level that a given trend of in-flation runs through. Milton Friedman once said famously that inflation always and everywhere is a mone-tary phenomenon. That's not completely true. Garden variety inflation is an overnight interest rate phenomenon, exceptionally high inflation it is a fiscal phenomenon. Their common denominator is that inflation is always and every-where an expectational phenomenon.
Hoien is a portfolio manager with Skagen Funds in Stavanger, Norway and was on the executive board of the Norwegian central bank from 1998-2002.
Read Full Article »