The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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April 01, 2009

Snapping ropes and breaking bricks

James Hamilton of Econbrowser is concerned about the current state of monetary policy. On the blog, Jim writes:

"I would suggest first that the new Fed balance sheet represents a fundamental transformation of the role of the central bank. The whole idea behind open market operations is to make the process of creating new money completely separate from the decision of who receives any fiscal transfers. In a traditional open market operation, the Fed buys or sells an existing Treasury obligation for the same price anyone else would pay for the security. As a result, the operation itself does not involve any net transfer of wealth between the Fed and the private sector. The philosophy is that the Fed should base its decisions on economy-wide conditions, and leave it entirely up to the market or fiscal authorities to determine where those funds get allocated.

"The philosophy behind the pullulating new Fed facilities is precisely the opposite of that traditional concept. The whole purpose of these facilities is to redirect capital to specific perceived priorities. I am uncomfortable on a general level with the suggestion that unelected Fed officials are better able to make such decisions than private investors who put their own capital where they think it will earn the highest reward."

After I looked up "pullulating," I found much to agree with in Professor Hamilton's description—or at least I did up to that last sentence. I certainly share his discomfort with a presumption that "Fed officials are better able to make… decisions than private investors," but that doesn't quite capture my view—and I emphasize my view—of how nontraditional policy is supposed to work. My own description of what the "fundamental transformation" of central bank policy is all about appears, hot off of the virtual press, in the first quarter issue of EconSouth, the Atlanta Fed's regional economics publication:

"I have a simple way of thinking about how monetary policy works. Imagine a long rope. At one of end of the rope are short-term, relatively riskless interest rates. Farther along the rope are yields on longer-term but still relatively safe assets. Off at the other end of the rope are multiple tethers representing mortgage rates, corporate bond rates, and auto loan rates—the sorts of interest rates that drive decisions by businesses and consumers. In the textbook version of central banking, the monetary authority grabs the short end of this allegorical rope, where the federal funds rate resides, and gives it a snap. The motion ripples down and hopefully reaches longer-term U.S. Treasury rates, which then relay the action to other market interest rates, where the changes reverberate throughout the economy at large.

"That's the story in normal times, and over the past year and a half the Federal Open Market Committee (FOMC) has done a fair bit of rope-snapping. In August 2007 the FOMC set the federal funds rate target—the overnight rate on loans made between banks—at 5.25 percent. As of December 2008, the rate target was lowered to a very low range of 0–0.25 percent. As the committee noted then (and reiterated in January), 'weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.'

"These FOMC statements held another extremely important message: 'The focus of policy going forward will be to support the functioning of financial markets and stimulate the economy.' In a speech to the National Press Club on Feb. 18, Federal Reserve Chairman Ben Bernanke elaborated:"

'Extraordinary times call for extraordinary measures. Responding to the very difficult economic and financial challenges we face, the Federal Reserve has gone beyond traditional monetary policy making to develop new policy tools to address the dysfunctions in the nation's credit markets.'

"One way to view the effects of those credit market dysfunctions is to imagine that someone had placed a series of bricks at strategic points along the segment of rope connecting short-term interest rates to broader market rates. With these bricks in place, it is simply not enough for a central bank to keep snapping short-term interest rates: The bricks—dysfunctions in the markets—will keep the impulse from being transmitted to the interest rates that are directly connected to market outcomes. Thus, a new set of policy instruments is needed, instruments that allow the monetary authority to circumvent blockages in the monetary transmission mechanism."

The "policy instruments" I have in mind, of course, are the pullulating new facilities that have Jim Hamilton worried. But it is worth emphasizing that many of these facilities are motivated by "unusual and exigent circumstances," a point emphasized in the recent Treasury-Federal Reserve statement (which is discussed in some detail by Tim Duy):

"As long as unusual and exigent circumstances persist, the Federal Reserve will continue to use all its tools working closely and cooperatively with the Treasury and other agencies as needed to improve the functioning of credit markets, help prevent the failure of institutions that could cause systemic damage, and to foster the stabilization and repair of the financial system."

How long will those conditions persist? Returning to my EconSouth commentary:

"No set timetable exists, but one would presume that as long as the bricks of market dysfunction are lying around, the tools will be necessary. Eventually, of course, markets will heal, the bricks will crumble, and the stage will be set to a return to business as usual in monetary policy and the economy. The sooner the better, but in the meantime it's helpful to have the tools in hand to start cracking the bricks."

That's my story, and I'm sticking to it.

By David Altig, senior vice president and research director of the Atlanta Fed

April 1, 2009 in Federal Reserve and Monetary Policy , Financial System , Money Markets | Permalink


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The Fed has terrible judgment. Just look at the past several years, it ignored cheap money from overseas ramping up credit growth because inflation was low while asset inflation was going to the moon, when the you-know-what hit the fan in August 07 they all believed it would be contained to housing and business capex would pick up the slack, then they started cutting rates when the problem was not the cost of money but in open market operations (ask some people off-the-record about dudley's performance at that time), and then the sharp eases that gave china and the other dollar-linked nations a boost that inflated energy and food prices then raising U.S. inflation to the point where the FOMC was adamant in having the forwards price a fed funds hike by year-end 2008. this fed has been wrong and wrong-headed all along the way and now Bernanke and the Fed are viewed as stewards of the financial order in need of broader regulatory power? as my grandmother used to say -- Oy! econmkts.blogspot.com

Posted by: steven blitz | April 01, 2009 at 03:07 PM

I'm not an economist, but heck, it's never stopped me before, so here goes.

No one in the private economy is spending their buck, so you spend the government buck.

When banks leave the field of battle, the Fed and the Treasury step in and provide a minimal amount of lending/spending, thus limiting the near term damage to ordinary people of all sizes and stripes.

This all works a lot better if the Fed and Treasury don't have to pay any interest on their borrowing.

Yield curve gets an upward, healthier slope. Credit markets notice this.

Once the now chastened (and poorer) private money returns to the playing field, the Fed and the Treasury recall their money and lessen the sovereign debt.

Depression avoided. At least for now.

Posted by: Beezer | April 02, 2009 at 09:45 AM

I follow Prof Altig's logic, but disagree on the bricks. Are the bricks market related, or there because of fiscal and fed policy? Had the elected wonks let AIG and the rest go bankrupt, surely we would have seen a melt down in the market. However, all the intervention has created a different conundrum. We are still in a liquidity trap. Since the Fed action of last Wednesday, long term rates have seeped higher. Only active Fed action will keep those long term rates low, since expectations are driving them higher. The short end of the curve is complacent. It's hard to snap the rope when rates are zero.

Fiscal policy is dismal, since it is anti-growth, and highly inflationary. The rhetoric coming out of the Congressional chambers is not helpful either. The government has bred a climate of fear-and the savings rate has climbed significantly higher.

It brings me back to the bricks. I am convinced that all of the insolvent banks and counter parties should have been allowed to fail, or taken a lot of pain. The market would have unfrozen quicker (bankruptcy does that) and we would be hurt but recovering. Now we are limbo.

When we watch Washington instead of LaSalle and Wall Street, we are in trouble.

Posted by: jeff | April 02, 2009 at 10:28 PM

While the analogy makes sense, I do not believe it is the Fed's job to fix these 'bricks'. I could understand this in the case of panic, but we are beyond that. Liquidity in particular appears under control - large bid-ask spreads are natural in a recession on complex products that have not gone through a deep recession along with massive gov't interventions.

Higher long rates are not a problem, its actually a necessary condition for banks to generate attractive returns on new loans which could draw new private capital. If the fed wants cheap loans to consumers and businesses then the gov't will have to directly or indirectly provide all of the loans, with no expectations of willing private capital. If consumers and businesses can not afford high rates then much safer to use fiscal policy to soften the blow. Not least it encourages good behavior, not the over leveraged. Also If inflation sets in rates will presumably go up considerably, creating a recession far worse than what we have already.


Posted by: GB | April 05, 2009 at 01:10 AM

What is needed is for the Federal Reserve to think out of the box and seriously consider ways to enforce significantly negative short term interest rates.

In order to achieve that, it should not add numerous policy instruments but remove the one that blocks the system : cash banknotes (you know, the actual green paper thing !).
It is easier than one thinks : just consider the percentage of one's expense that one actually settles with paper cash : 5%,3% ? The US (and most of the industrial world actually) has already the "plastic" infrastructure in place. Volker is wrong about the ATM being the only innovation in finance since the 70's ! Ubiquitous retail electronic payment is a very significant one and is indeed a big difference between today and the 30's.
Roosevelt had to abolish (in practice) private ownership of gold to monetarily kick start the New Deal. The equivalent for Obama is to abolish paper cash. Once this is done (actually, once it is announced with a short deadline !), the Fed can get rates into negative territory. Reserves at the Fed would COST money to depositing banks, that would transmit this cost to deposit holders,that would impact the whole yield curve both on treasuries and corporates.

Bottom line : the Fed is back in the game with a full powered monetary policy. As a non-negligible side benefit, underground economy, especially the illegal one, finds it much more difficult to operate.

If it is so easy, why hasn't this been done in Japan ? Two reasons,the second being the most important :
- It would have sent the Yen to the bottom, raising the ire of the US at that time.
- The social groups that were the biggest holder of cash at the end of "The Bubble" in Japan were (and are still) at the same time the biggest "constituencies" of the LDP.

Posted by: Charles Monneron | April 05, 2009 at 10:05 PM

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