Challenging MMT / MR notions of the Central Bank's "Announcement Effect"

As a sidebar to the recent monetary policy and money creation debate, I have been debating JKH, over at MR, on the nitty gritty details of what the central bank can do to hit new target interbank rates. (We largely agree on the broader issues.) I'm using this post as a venue to lay out my position more clearly, with the aid of graphs. Apologies to those who haven't been following, if this seems like it comes out of nowhere. EDIT: For those who relate to the U.S., we're specifically debating this issue outside of a "floor" system, which is the situation in the U.S. currently. So think something like pre-2008 U.S., as one example. I discuss the issue more generally than the Fed in the U.S., though.

As I interpret JKH (and Scott Fullwiler, associated with MMT), altering reserve quantities can only be used to defend a new target rate, not to offensively set a new one. From their viewpoint, rates move due to an "announcement effect," whereby the central bank's announcement of a new target rate is enough to move the rate without the need for any other action, all else equal. Already, JKH has clarified that he believes the announcement effect must incorporate a change in corridor rates for it to move rates, all else equal. This I agree with, but I don't consider this to be a "pure announcement effect," in which it's only the central bank's words, rather than its actions, that matter. (I'd also add that the movement of the corridor may still not be enough to hit the new target. Depending on the corridor rates and probability of banks ending short or long reserves, quantity changes might be required as well, or more theoretically, a reserve requirement change.)

More generally, my aim is to show them that altering reserve quantities can most certainly be used to offensively achieve a new target rate. Admittedly, I am employing the assumptions that Bindseil and Woodford use in their most basic monetary policy implementation models - but I view these as plenty rigorous for our purposes.

Suppose we start with the following scenario. The central bank’s target rate is 2.5%. The ceiling and floor rates are 3% and 2%, respectively. There is a 50/50 probability that the market will end short or long reserves assuming the quantity of reserves available in the market is exactly equal to the quantity of required reserves. Thus, the central bank sets the quantity of reserves equal to required reserves to achieve their target rate. 

FIGURE 1

Now suppose that the central bank announces that their new target interbank rate is 2.25%. They announce that they will not be changing the ceiling or floor rates. Holding everything else constant, if the market believes that the central bank will enforce their new target rate, then it must anticipate a movement of the supply curve to the point where a 2.25% market rate would be a profit-maximizing (or cost-minimizing) outcome for the market.

FIGURE 2

If these are the expectations, the market rate should move to the new target rate prior to the central bank actually shifting the supply curve. However, the market will still expect the central bank to follow through on its implied promise of a shift in the supply curve. If and when the central bank shifts the supply curve, this will not cause the interbank rate to overshoot the target (contrary to my interpretation of JKH's and MMT'ers past assertions). 

Suppose instead that the central bank announces that their new target interbank rate is 2.25%, but that they will be changing the ceiling and floor rates to 2.75% and 1.75%, respectively. Upon this news, the demand curve should shift downward. In this case, I agree with JKH comments on the automatic shifting of the demand curve. Continuing to assume a 50/50 probability that banks end the reserve maintenance period short or long at the current quantity of reserves S*, then the shifting of the demand curve alone will yield the new target rate, without requiring any change in the quantity of reserves.

FIGURE 3

In this case, if the central bank were to also inject reserves, then the interbank rate would fall lower than target. The degree to which it would overshoot would depend on how many reserves the central bank injects. But contrary to what I’ve seen in the MMT/MR blogosphere, it would not necessarily fall to the new floor of 1.75%.

In conclusion, if all along, JKH, Fullwiler, et al. had this last case in mind, we would be in agreement. But that was never made clear, in my opinion. Furthermore, the other case, involving a shift in quantity of reserves, is just as fundamentally sound. Understanding both cases allows one to see that monetary policy implementation can be a matter of rates and/or quantity.

APPENDIX A: Changing Reserve Requirements

From a previous interbank rate of 2.5%, suppose that the central bank announces that their new target interbank rate is 2.25%. They do not change the ceiling or floors nor the quantity of reserves. Instead, they lower the reserve requirement. This should cause a leftward shift in the demand curve. In other words, given a fixed quantity of reserves, a lower reserve requirement means that banks will be less likely to end the reserve maintenance period short. As such, the interbank rate should drop below 2.5%.

FIGURE 4

Continuing to assume a symmetric probability distribution (50/50 short/long) around the quantity of required reserves, the central bank could have maintained the 2.5% interest rate if they lowered the actual quantity of reserves to the new quantity of required reserves by conducting an OMO. In our example, the central bank does not do that since they want a lower interbank rate.

APPENDIX B: Interbank Rate Targeting with Fixed Target-Ceiling Spread

Added in from comments: Assume a system similar to the U.S. pre-2008, where there is a fixed spread between the target rate and the ceiling – say it’s 2%. This means that as the target interbank rate changes, its distance from the floor will change, whereas its distance from the ceiling will remain fixed. We might call this an 'asymmetric' channel, in contrast to the 'symmetric' channel of Figure 3 above.

Assume a symmetric probability distribution of anticipated liquidity shocks and, just as a starting point, that the current quantity of reserves in the market is the quantity of required reserves. That means if the target rate is 3%, the ceiling is 5%, and the floor 0%, the interbank rate should be 2.5% (5%*.5 +0%*.5). Therefore the central bank is missing its target. To move the interbank rate up to 3%, the CB is going to have to remove a quantity of reserves so that it becomes more likely the banking system will end the reserve maintenance period short. In particular, there needs to be a 60% chance of this occurring (3% = 5%*.6 + 0%*.4). See Figure 5.

FIGURE 5

Then say the CB changes its target to 2%, which means the ceiling will be 4% (see Figure 6). Now, assuming the same symmetric probability distribution of liquidity shocks, the Fed needs to inject reserves back into the system until the quantity of reserves is the quantity of required reserves (2% = 4%*.5 + 0%*.5). Otherwise, the new rate will be 2.4% (4%*.6 + 0%*.4). In this case, changing the ceiling/floor rates was simply not enough to hit the target. The central bank needed to also change the quantity of reserves, even controlling for any changes in reserve distributions or any other market abnormalities. This is most certainly a liquidity effect. I am not denying that the rate will move to 2% upon announcement, but the central bank still needs to lower the ceiling and reduce the quantity of reserves to maintain the rate as well as its credibility. At least as far as this model goes.

FIGURE 6

Money Creation, the Bank of England, and Nick Rowe

The Bank of England's recent explanation of the money creation process has predictably led to another blogosphere debate regarding how this stuff 'really works.' The BoE clearly supports the typical Post-Keynesian view, with Nick Rowe leading the monetarist charge against it.

Attempting to reconcile Nick Rowe's view with the BoE's provides a good opportunity to use some of the central banking vocabulary I discussed a couple months ago. That is, we must be specific about how the operational target, which is under the purview of monetary policy implementation, links up with the intermediate and final targets, which are under the purview of monetary policy strategy. It also provides a good opportunity to review the various ways in which central banks implement monetary policy (AKA the rates vs. quantity debate).

Nick vigorously rejects the idea that the central bank sits idly by, supplying reserves to banks as demanded in order to keep the interbank rate (the operational target) fixed. He insists that if the inflation rate (the final target) departs from the aims of monetary policy strategy, then the central bank will change the interbank rate. If I understand him correctly, he believes that this means the central bank must resist supplying whatever quantity of reserves banks demand:

"No! Have these guys never heard of inflation targeting? The BoE does not sit idly by, happily “supplying” whatever is demanded at a fixed rate of interest. If banks decide to lend more, and this increases spending and pushes inflation up above target, the BoE will raise that rate of interest, precisely because the BoE cannot keep inflation on target if it simply lets reserves be “supplied on demand” at a fixed rate of interest.

They have an ant’s eye-view of the economy. They really need to step back and see the big picture. Any increased demand for reserves that is a result of actions that would lead to inflation rising above target will be met with a refusal to supply *any* additional reserves. The BoE will raise the rate of interest to make the supply curve of reserves perfectly inelastic in that case." (emphasis mine)

He's definitely correct in that there are intermediate/final targets (the inflation rate in this case) that guide the setting of the operational target (the interbank rate). But in concurrence with JKH, I don't think what the BoE has written contradicts this. Furthermore, as I currently understand Nick Rowe, I think he is wrong in believing that the BoE must toggle with the quantity of reserves in order to achieve the interest rate consistent with their inflation target.

As I've been heavily detailing in my monetary policy implementation series, whether we use Bindseil-ian or Woodford-ian models, central banks can achieve their target interest rate through any combination of quantities and rates. EDIT: Also, we should all speak more precisely: there is no "one quantity of reserves" that banks demand. There is a demand curve that has some elasticity to it, and the elasticity depends in large part on banks' uncertainty that they will end the reserve maintenance period short or long reserves.

To illustrate how the central bank can address Nick Rowe's concerns, I left the following response on JKH's post. Most of the individual pieces of my reply have been beaten like a dead horse on the blogosphere, although I'm not sure I've seen the operational and strategic elements of monetary policy tied together in a dynamic fashion.

"Nick, I’m going to expound upon your broader view of what the CB does, which is correct, but argue that you’re still focusing too singularly on quantity of reserves. To simplify matters, I’m going to assume the central bank targets a fixed price level, rather than growth rate in prices.

Suppose to attain the price level the CB desires, they decide the target rate needs to be 1.5%. This will lead to a level of bank lending activity consistent with their price level target. Once in equilibrium, the CB maintains the target rate by setting the floor rate (IOR) at 1% and the ceiling rate is 2%. Let’s say the reserve demand curve flattens out to 2% at 100 reserves and flattens to 1% at 200 reserves. Assume that setting reserves at 150 achieves the 1.5% interest rate. Let’s say this also corresponds to a level of deposits and loans around ~1500, where the reserve requirement ratio is 10% (thus 150 reserves).

Now say all the sudden the price level increases beyond the central bank’s target. Say the central bank thinks that if deposits/loans were brought down to 1000, then they would achieve their price level target again. Assume they think that if the interest rate is at 2%, then loans/deposits will decline from 1500 to 1000. So how can the CB achieve this?

In the short-run, assume that reserve demand won’t change very much because it takes a while for the economy to respond to the new interest rate of 2% (meaning loans/deposits stays around 1500, so demand for reserves stays around 150). In this case, the CB can simply change the floor and ceiling to 1.5% and 2.5% respectively, to hit its target of 2%. Of course, since this doesn’t impact demand for loans in the short run, it might not have much of an impact on inflation.

But say in the medium to long-run, the higher rate of 2% finally starts to dampen lending. Say loans/deposits declines to 1000, such that reserve demand centers around 100. Since there are 150 reserves in circulation, that means there will be an increasing number of excess reserves that will send rates towards the current floor of 1.5%. That’s a problem though, because the CB needs to maintain the 2% rate to maintain equilibrium. So how can it do this?

It has several choices. It can leave sufficient excess reserves in the system and set the floor rate to 2%. In this case, it can achieve its rate of 2% without changing the quantity of reserves. Alternatively, it can keep the corridor at 1.5%-2.5% but soak up some reserves to keep the rate at 2% (maybe the new corridor flattens at 50 and 150 reserves, so soaking up 50 reserves to leave 100 reserves in the system hits the rate of 2%). Another alternative is to increase the reserve requirement ratio from 10% to 15%: assuming the same probability density function of banks ending the reserve maintenance period short or long, then the CB can leave the corridor at 1.5%-2.5% AND leave the quantity of reserves the same to achieve an interest rate of 2%. The idea is that 15% of 1000 is 150, and that is the quantity of reserves the banking system already has."

Note, for sake of argument, I'm simply going along with the assumption that the central bank can effectively tame inflation by raising rates.

Anyways, the takeaways are:

A) Yes – the central bank sets rates based on their price target. I'm in agreement with Nick here.

B) No – the central bank does not necessarily have to change the quantity of reserves to keep the price level where it wants it. I disagree with Nick here. It could change the quantity of reserves, but it could instead only change rates. Or it could only change reserve requirements without changing rates or quantities. Or it could change some combination of both rates and quantities (see here). There are lots of possibilities!

The more fundamental point is that if inflation is connected to the quantity of bank lending, then we need to consider what bank lending is a function of. Bank lending is a function of what JKH said in his post: “mostly of capital and pricing of risk.” The central bank ultimately affects this by changing the interest rate, and changing the interest rate may or may not involve changing the quantity of reserves.

But It's Not Always Like a Helicopter Drop...

One of the lingering questions I have regarding the interbank rate models I've reviewed concerns whether or not they need to address the issue of how exactly reserves enter the interbank market. The models I reviewed so far seem to assume that there is essentially a "helicopter drop" of reserves into the banking system. At least Woodford's model appears that way. Consider that model's cost function of refinancing with reserves: C(s_j) = is_j – i_BE_j[min(s_j+ ε_j,0)] – i_DE_j[max(s_j+ ε_j,0)]. Reserves can only be borrowed or lent at the interbank rate, i, during the interbank market session. There is no repurchase agreement (repo) rate to be found, for example.

In a sense, this is somewhat accurate if all open market operations (OMOs) are conducted with non-bank dealers. In this scenario, banks passively accept reserves when non-bank dealers trade their bonds to the Treasury for deposits. But even then, one has to wonder whether the repo rate at which those transactions occur, or the prevailing repo rate in general, affects the interbank rate in some way. Secondly, to my knowledge, not all OMOs in the U.S. are conducted with non-bank dealers. I'd be curious if a reader knew the ratio of bank vs. non-bank OMO purchase volumes (I'm sure this varies across countries).

Hopefully, I can figure out answers to these questions, as they seem essential to acquiring a rigorous understanding of the linkages of funding rates within the economy. I believe Bindseil touches on this in his book, which I'll continue digging through, among other sources.

P.S. I'm using the term "helicopter drop" in a slightly different way it's typically used, which is in the context of (unconventional) monetary policy stimulus. Here, I'm simply considering the mechanisms by which reserves usually enter the banking system - that is, not against the backdrop of unconventional monetary policy ideas.

Michael Woodford's Individual Liquidity Shock Model of the Interbank Rate

Summary

This post gives a more complete explanation of the individual shock model introduced here. Bindseil gives a somewhat incomplete treatment of it in his book, given that he prefers the aggregate liquidity management model for its relative simplicity and so devotes most of his attention to it. In my own search for a more detailed explanation of the individual shock model, I found this 2007 paper from Bindseil, which reviews a more detailed individual shock model from Michael Woodford’s 2001 Jackson Hole paper, Monetary Policy in the Information Economy. This post explains that model and the math behind it in more detail than can be found in those papers.

Table of Contents - Monetary Policy Implementation Series

(AKA, quite possibly becoming the internet's most epic guide to monetary policy implementation)

This post is a table of contents for my series on monetary policy implementation, which is so far a summary of Ulrich Bindseil’s book. I ultimately plan to use this as a launching pad into contemporary debates on monetary policy and banking. First, though, I want to establish a solid grounding in the fundamentals.

1. Monetary Policy Terminology
2. How the Central Bank Targets Interest Rates
• Understanding the Central Bank’s Balance Sheet
• The Aggregate Liquidity Management Model
• Implications for the Central Bank’s Ability to Steer the Interbank Rate
• Appendix for Mathematical Explanation
• The Individual Shock Model of Liquidity Management
• Michael Woodford's Individual Shock Model
• Appendix for Mathematical Explanation

I realize this a lot of material, so I think I'll try to condense it even more at some point. However, if you're really interested in understanding how this stuff works, it's worth going through.

(Also, some of these posts were written several weeks or months back. I've re-dated them so that they all appear in order here).

Monetary Policy Implementation vs. Monetary Policy Strategy: Design Features of Monetary Policy, with Application to the Debate Regarding NGDP Targeting

Introduction

I was (re)introduced to monetary policy operations when I came across the work of Scott Fullwiler a couple of years ago. Reading his papers, it soon became apparent to me that there were some serious discrepancies between what I was taught about monetary policy in college and how Fullwiler explains it is actually implemented by real-world central banks. This was odd and distressing to me. Could it really be true that mainstream monetary policy theory was this divorced from reality? At this point in my research, the answer seems to be “yes” and “no.” Ulrich Bindseil’s book, which I discussed in a previous post, supports this notion. Bindseil is the Deputy Director General of Market Operations at the European Central Bank.

Building a Model of Monetary Policy Implementation – The Central Bank's Balance Sheet

Overview

I’m now getting into the nitty gritty of Bindseil’s book on monetary policy implementation ("MPI" - my abbreviation), which is to say the part where we start to develop a mathematical view of MPI. The math in this post is limited to basic balance sheet accounting and algebra, but we’re working our way towards a more rigorous view. Again, as a reminder, this is a summary of Bindseil's book, infused and modified with my own interpretation and explanations.