Central banks, rabbits, printing presses and dead ends
The Wall Street Journal has an article about money and the printing presses. At the end it quotes Ben Bernanke for his ultimate belief in the printing press. Here. But should we join him in that belief?
Money supply continues to perform more or less normally. Monetary velocity has slowed but that in and of itself is not particularly odd.
What is most peculiar in an historic context, but totally understandable by today’s standards, is that the money multiplier no longer works. Under the old system we would see banks get fully ‘loaned out.’ That is, they would loan funds until the banking system’s excess reserves were negligible. But now the amounts of excess reserves in the system are vast. The Fed has pumped up its balance sheet and there are billions of billions of excess reserves that are not being lent. This is the ultimate example of what economists call pushing on a string. And it is now NORMAL- not a special case of sorts. So do the printing presses still work?
Banks do not lend funds because they now have strict capital requirements to make loans. Loans not only need to be funded with deposits but they to be backed by capital and the bank needs to pass stress tests imposed by the Fed based on what is on its balance sheet. Because of the capital requirement, banks are more careful about making loans. For one thing bankers will not engage in so called ‘riskless arbitrage’ and blow up their balance sheets as they once did. Bank loans are the way money is created. If banks make loans more slowly, then money creation itself will slow. Banks make loans under much more restrictive conditions these days. And bank loans have more competition these days, too, as banks are being paid returns on the excess reserves they own. Banks can hold excess reserves and earn the return on reserves nearly risk free. That raises the hurdle for risky lending as well.
Not all bank reserves become money supply in this model. They do not get turned into M2 assets/liabilities. And a wedge is created between the Fed’s balance sheet growth and the growth of conventional monetary assets held by the public. When Bernanke talks about the printing presses saying that they will have an eventual impact, it depends on what he means by ‘the printing press.’ Since the reserve channel is not functioning and that does not seem to be particularly temporary ‘the printing press’ is not bank reserve growth.
It is not clear how much monetary stimulus matters in this environment. QE worked by removing safe assets and forcing the public to acquire riskier assets. It pushed rates lower through asset purchases LSAP (large scale asset purchases) - at least for a while- there were at least announcement effects. And while some have said that QE has many of the same effects of a traditional Fed policy easing, those similarities appear to be fleeting and there are side effects from QE. If this were a drug, I’m not so sure that the FDA would so easily approve it. In short there is no one for one equivalent between QE and a cut in the Fed funds rate.
Negative rates of interest are being considered apparently in the U.S. (‘not off the table’ to use Yellen’s lexicon) and are being used in some countries. That distortive policy seems particularly dangerous. Central bankers are getting desperate and have done their best to try portraying some novel policies as analogs to tried and true conventional policies. This is just like in the financial crisis when the private sector employed derivatives that were poorly understood while they pretended they had been fully vetted and were well-behaved. I think markets are also coming to this point of view regarding central bank behavior especially since the BOJ implemented negative rates and got the opposite exchange rate reaction that it expected.
It is now clear that some of these novel policies are starting to show their quirks and how they are different rather than the same as traditional policy. And markets are frightened. Central banks seem to be overstepping the boundaries of their understanding. Are they going down the rabbit hole? Have they reached a dead end and have all the different ways that central banks have to run the printing presses stopped working?