Krugman, Kaminska, and Waldman - InvestingChannel

November 24, 2024

Krugman, Kaminska, and Waldman

by TheMoneyIllusion0166

There is an interesting debate taking place over the issue of whether we are in a new world, where monetary injections will no longer create inflation via a sort of “hot potato effect.”  Instead, base money and short term debt would become almost perfect substitutes.  Here’s Izabella Kaminska:

In this way, we agree with Waldman that the moment IOER created a preference for excess reserves over short-term debt assets or cash, was the moment excess reserves became a new type of safe asset security in their own right.

Excess reserves became the equivalent of state debt. But, very importantly, a state debt taken with the intention of never being spent, but rather for the purpose of creating safe assets instead.

Fed exit

And herein lies the differentiation point. If and when the Fed decides to exit unconventional policy, it will be obliged to re-associate opportunity costs with excess reserves. As rates go up, the spread between between the Fed Fund rate and the rate on excess reserves will only widen.

At this point the huge amount of excess liquidity sitting on reserve would either end up chasing any positive-yielding safe security in town or flood directly into the real economy. And both scenarios carry risks. In the former scenario, the crowding out of safe assets could once again lead to repo rates falling well below the Fed Funds rate, rendering central bank rate-hiking policy useless. In the latter scenario, the economy could face the real risk of run-away inflation.

To counteract these effects, the central bank would need to drain excess liquidity more quickly than the liquidity can flow into either alternative option. But what took four years to dish out could take a little while to reabsorb.

But there are other problems associated with unwinding such a huge position on the market, too. Especially if you view this as tantamount to either “spending” the money borrowed, or paying it off.

Consequently Waldman’s argument is essentially: why bother if you don’t have to? Let the excess reserves, just like state debt, roll on:

“Why go to the trouble of unwinding the existing surfeit of base money, which might be disruptive, when doing so solves no pressing problem?”

And since not moving quickly enough poses too great a risk, the alternative would be committing to IOER as a long-term rate-steering alternative instead.

As Waldman sums up:

“If the Fed adopts the floor system permanently, then the Fed will always “sterilize” the impact of a perpetual excess of base money by paying its target interest rate on reserves. As Krugman says, this prevents reserves from being equivalent to currency and amounts to a form of government borrowing. So, we agree: under the floor system, there is little difference between base money and short-term debt, at any targeted interest rate! Printing money and issuing debt are distinct only when there is an opportunity cost to holding base money rather than debt. If Krugman wants to define the existence of such a cost as “non-liquidity trap conditions”, fine. But, if that’s the definition, I expect we’ll be in liquidity trap conditions for a very long time! By Krugman’s definition, a floor system is an eternal liquidity trap.”

Krugman, for now, remains unconvinced.

I sympathize with Krugman’s view, albeit probably for slightly different reasons.  In his newest post Waldman says Krugman misinterpreted his argument.  So perhaps they aren’t that far apart.  But I still have reservations about where Waldman is going with his argument:
1.  I’ve already shown that the zero lower bound on the stock of excess reserves means that large increases in the price level would require a larger monetary base, if only to boost the currency stock.  So the quantity of money still matters, even with IOER.
2.  Waldman suggests that the Fed is not indifferent to the size of the currency stock.  Kaminska points out that a large stock of ERs might be beneficial, especially during financial crises.  So let’s consider the case where the Fed prefers to have banks hold ERs equal to 5% of GDP, roughly the size of the currency stock during normal times.  This implies that the base will be about 10% of GDP.  Obviously in that case the size of NGDP would be determined in ordinary quantity theoretic fashion.  Every extra dollar of base money has a hot potato effect, and boosts NGDP by $10 in the long run.  You might wonder how this occurs, when banks can freely exchange unwanted ERs for short term T-bills.  The key is that the Fed will adjust the IOER as needed to keep the level of ERs close to 5% of GDP.  If that seems like cheating, consider that Waldman made a very similar argument; that any Treasury injection of currency would be sterilized by the Fed, in order to maintain their macroeconomic objectives:

But Waldman definitely does not at all believe that 2(b) and (3) are equivalent when the interest rate is positive. He’s not sure where he implied that, but he must have done, and is grateful for the opportunity to disimply it. An expansion of the currency unopposed either by offsetting asset sales or paying interest on reserves would have the simple effect of preventing the Fed from maintaining its target rate. That would mean the Fed could not use interest rate policy to manage inflation or NGDP.

But that is precisely why Krugman is a bit unhelpful when he concludes, “Short-term debt and currency are still not at all the same thing, and this is what matters.” It does not matter, once the Fed’s reaction function is taken into account. The Fed will do what it needs to do to retain control of its core macroeconomic lever. Its ability to pay interest on reserves means it has the power to offset a hypothetical issue of currency by the Treasury, regardless of its size. Krugman is right to argue that, above the zero bound, an “unsterilized” currency issue would be different from debt, that it would put downward pressure on interest rates and upward pressure on inflation. But that is precisely why it is inconceivable that the Fed would ever allow such a currency issue to go unsterilized! In a world where it is certain that the Fed will either pay IOR or sell assets in response, we can consider issuance of currency by the Treasury fully equivalent to issuing debt.

[BTW,  Scott Sumner is a bit puzzled as to why Waldman refers to himself in the third person.  :)]
3.  Waldman’s strongest case would be that the Fed wants banks to hold very large amounts of ERs, but doesn’t much care how large as a share of GDP.  In that case we can assume the Fed uses IOER to make sure the level of ERs adjusts passively to offset any shocks to currency supply or demand, keeping NGDP on target.
I don’t think anyone disputes that, over a fairly wide range of the money supply, IOER can be used as the exclusive central bank monetary policy tool, with changes in the quantity of base money having no immediate impact on the economy.  After all, the price level is simply the inverse of the value of base money.  Obviously the value of base money can be altered via changes in either base supply (OMOs) or demand (IOER).
But I find it unlikely that the Fed would become completely indifferent over the share of GDP held as ERs, at least when rates are positive.  So I expect they’ll continue to do monetary policy via both supply and demand techniques.  Most importantly, even if T-bills become almost perfect substitutes for ERs, it will not allow fiscal policy to impact the price level.  It’s inconceivable to me that the Fed would allow this to happen.  They’ll simply adjust the IOER (downward) until they have traction, until they can do whatever it takes to change the amount of currency in circulation, and hence the price level.  (Again, I’m assuming normal times with positive interest rates–I think the strongest Keynesian argument is that “normal” may become increasingly unusual during the 21st century.)
There is another issue that tends to (wrongly) get lumped in with this debate—does pre-2008 monetary policy involve changes in the base, or the fed funds target?  And in that case I’d argue strongly for the quantity of money approach, even though in the ultra-short run (prior to 2008) the Fed targeted the fed funds rate and the base was endogenous.  However over more extended periods of time the fed funds target was adjusted so that the base would grow at levels compatible with 2% inflation.  If and when the Fed shifts to IOER targeting, I’d expect this to continue—money will be endogenous in the ultra-short run, and endogenous over the long run.
Where things may differ is the medium run.  No question that IOER allows the Fed to keep the stock of base money endogenous for a much longer period of time than fed funds targeting alone.  That’s because under fed funds targeting with no IOER the level of excess reserves is generally close to zero (at positive interest rates).  In that case control of the currency stock is a necessary and sufficient condition for price level control, not just in the long run, but even in the medium run.  With positive IOER you now have a high level of ERs, and by adjusting the rate of return on ERs you can stabilize inflation without changing the monetary base for a fairly extended period of time.