Cash for bonds
By Scott Sumner
In a recent podcast, David Beckworth interviews David Andolfatto of the St. Louis Fed. At one point they were discussing an Andolfatto post that suggested inflation can be modeled by looking at the supply and demand for money. (A post criticized by Paul Krugman.) David Beckworth asked Andolfatto about comment left by someone called “Traditionalist”. Here is the comment:
I see that Krugman has linked to this post as an example of “immaculate inflation”. I frequently disagree with Krugman, but I do agree with him on this point, and it’s a useful way of summarizing my arguments above.
I also think it’s a more general point – a close analogue is discussion about the effects of monetary policy that ignores the role of the short-term nominal interest rate. A lot of monetarist-ish bloggers like to criticize mainstream macro’s focus on monetary policy via interest rates, arguing that interest rates are really just an epiphenomenon, a distraction from the main mechanism. But if you try to identify the mechanisms, the actual decisionmaking at the micro level, you realize that interest rates are absolutely crucial, and if anything *money* is the distraction.
The Fed has traditionally implemented monetary policy by intervening in an obscure market that virtually no households or firms participate in; this only influences real behavior because it affects much more important interest rates via expectations and arbitrage, and these interest rates matter for decisions. Meanwhile, the frictions associated with base money are trivial for most decisionmaking because it is almost costless to convert between base money and other assets (whether we’re using an ATM for paper currency or Fedwire with electronic reserves). Even if we cared about these frictions, the only way that the Fed’s policy can affect a household’s portfolio allocation to paper currency is indirectly, through interest rates (since again, the Fed does not engage directly with households); maybe you’ll withdraw fewer dollars from the ATM if the opportunity cost of foregoing interest is a bit higher.
You can’t escape the central role of interest rates as a summary of what matters for household decisions; toy models can obfuscate it, but it’s no accident that rates are central to most larger-scale models.
I’m one of those “monetarist-ish bloggers” who regards interest rates as just an epiphenomenon. And I strongly believe that not only can the analysis of monetary policy and inflation be done without the interest rate transmission mechanism, interest rates add nothing of value to the analysis.
I would take issue with how Traditionalist describes the way that monetary policy has traditionally been implemented:
The Fed has traditionally implemented monetary policy by intervening in an obscure market that virtually no households or firms participate in
This is inaccurate. Traditionally (i.e. before 2008) monetary policy was 98% the exchange of currency notes for bonds, and 2% the exchange of electronic reserves (aka “fed funds”) for bonds. Now it’s true that at the moment of the transaction, the bonds were always exchanged for fed funds. But that’s completely unimportant, as almost all of the extra fed funds were converted into currency within a few days. It would have made no substantive difference if the Fed had directly exchanged currency for bonds, as that’s the form taken by the new money within a few days.
Traditional monetary policy best thought of as the exchange of cash for bonds. Period, end of story.
Because the public is heavily involved in the currency market, they respond to currency injections by getting rid of any “excess currency balances”. An individual can do this by bringing the money to a bank. But for society as a whole, the only way to get rid of excess currency balances is by spending the money, until NGDP is driven up to a high enough level where those currency balances are once again desired for transactions and hoarding purposes.
Thus traditional monetary policy was all about injecting enough currency to create enough excess currency balances to make NGDP grow at about 5%/year (from 1990-2007).
Yes, the Fed had a short term fed funds rate target, but interest rates played no more role in the transmission process than does the price of raspberries.
PS. If you want to use interest rates in monetary analysis, you’d be better off using them as a factor helping to explain currency velocity. The currency stock rose faster than NGDP during 1984-2008 because currency velocity slowed. And currency velocity slowed because nominal interest rates were trending downwards, and nominal interest rates represent the opportunity cost of holding currency. As that opportunity cost declined, currency demand rose as a share of GDP. And currency demand as a share of GDP is the inverse of velocity.
But of course in this sort of model, low interest rates are contractionary, ceteris paribus. They boost the demand for currency.
PPS. The currency spike in 2000 represents precautionary injections before “Y2K”. The smaller spikes each year were to accommodate the Christmas shopping season.
PPPS. Some people insist that the currency stock is “demand determined”, as if in 2008 the people in Zimbabwe suddenly had a desire for trillions of dollars in currency. Yes, the currency stock is demand determined at a moment in time (say Christmas) if you are targeting something other than currency (such as interest rates, exchange rates, or M2), but that’s missing the point. Those targets get adjusted over time to hit various macroeconomic goals, by moving the currency stock away from where it would be if the targets were not being adjusted.
PS. I have a blog post at a new AEI symposium on how the US can best compete with China.