Typography

 A strange new bank called TNB, or The Narrow Bank , recently applied to get a clearing account at the Federal Reserve Bank of New York, only to be refused. Funny enough, TNB is run by the New York Fed's former director of research James McAndrews, who left in 2016 in order to get the bank up and running. McAndrews and TNB are now suing the New York Fed. There's a backstory to all of this kerfuffle. While still employed by the New York Fed, McAndrews coauthored a paper in 2015 entitled Segregated Balance Accounts . The paper proposed a solution to the following problem. Interest rates in wholesale lending markets were refusing to align with each other. Wholesale markets are the sorts of markets which neither you nor I have access to but are reserved for large institutions. For some reason, banks that kept interest-bearing overnight accounts at the Fed were not passing the rate they earned on these accounts to other overnight lending markets in which they were active, say the r...

"Water water everywhere, and not a drop to drink" - Rime of the Ancient Mariner (Gustave Doré woodcut) In a recent paper , John Taylor rhapsodizes about bringing back the good ol' federal funds market: I think the case can be made for such a framework. Peter Fisher ran the trading desk at the New York Fed for many years, and knows well how these markets work. His assessment is that such a framework would work, saying “we could get back and manage it with quantities; it’s not impossible. We could just re-engineer the system and go back to the way we were.” I spent time in the markets for federal funds watching how they operated in those days, and I wrote up an institutional description of how good experienced people traded in these markets, and I developed a model showing how the market worked. The fed funds market is currently moribund , but just a few years ago it was buzzing with activity. Banks that didn't have enough reserves at the end of the day to meet requirem...

The Federal Reserve may be in a bit of a bind. With the Bank of Japan reducing rates to -0.1%, many commentators are calling on the Fed to reverse its policy of rate normalization and follow Japan into negative territory.  The problem is this. Thanks to the rules laid out in the Federal Reserve Act, the Fed may lack the technical means to dive into negative rate waters. Let me restate this in different terms. If the Federal Reserve were to reduce the rate at which it pays interest on reserves (IOR) to -0.25% or so, the overnight rate may not follow very far. Monetary policy is useless, or at least less effective than it would otherwise be. Not only would monetary policy lose some of its potency when IOR falls below 0%, but an unapproved fiscal transfer from the Fed to another set of government institutions could occur. This is because negative IOR has the potential to provide a large subsidy to a narrow range of governments sponsored-entities that are allowed to keep 0%-yielding depos...

Let's not get carried away by the idea that central banks set overnight interest rates. Central banks exercise direct control over the economy by pushing down on one shiny red button, the convenience yield on reserves . By modifying the convenience yield, a central banker nudges agents to either flee from reserves or flock to them. This causes a change in the purchasing power of reserves, the mirror image of which is the general price level. So how do overnight interest rates like the fed funds rate figure into the picture? Reserves are scarce and convenient, so agents will only part with them if they are compensated with an adequate amount of "rent". The higher the marginal convenience of reserves, the more rent they require. The market in which reserves are rented out for very short periods of time, usually 24 hours, is referred to as the overnight market. By conceptualizing monetary policy this way, it immediately becomes apparent that overnight interest rates are litt...

The lever on which a central bank pushes or pulls in order to keep its target variable (say inflation) on track is commonly referred to as the central bank's policy instrument . The policy instrument is the variable that is under the direct control of a central banker. The classic story is that the pre-2008 Fed conducted monetary policy via its policy instrument of choice—the federal funds rate. By pushing the fed funds lever up or down, the Fed could change the entire spectrum of market interest rates. I think this is wrong. The fed funds rate was never the Fed's actual policy instrument. Now this isn't a novel claim. Market monetarists tend to say the same thing. According to folks like Nick Rowe, the quantity of money has always been the Fed's true policy instrument. The fed funds rate was little more than a useful shortcut (a communications device ) adopted by the Fed to convey to the public what it intended to do. I'm sympathetic to the market monetarist's ...

Here are Paul Krugman and James Hamilton on the renewed demand for dollar bills. So what's behind the soaring demand for US paper dollars? A simple strategy for getting a grasp on US data is to compare it to the equivalent in Canada. Comparisons between Canada and the US serve as ideal natural experiments since both of us have similar customs and geographies. By controlling for a whole range of possible factors we can tease out the defining ones. The chart below shows the demand for Canadian paper dollars and US paper dollars over time. To make visual comparison easier, I've normalized the two series so we start at 10 in 1984. On top of each series I've overlayed an exponential trendline based on the 1984-2006 period. I've zoomed in on 1997 for no other reason than to provide a higher resolution image of the typical shape of cash demand over a year. Some interesting observations: 1. Not a huge surprise, but the demand for US paper has been accelerating far faster than...

I've written before about Iranian monetary sanctions .  We can disagree on motives and targets, but monetary sanctions are undeniably a very powerful instrument. They work because in severing Iran from the global payments network, the sanctions degrade the liquidity of Iranian wealth. I'm going to borrow this idea and see if I can apply it to central bank monetary policy. Can a central bank like the Federal Reserve conduct monetary policy by manipulating the *expected liquidity* of the liabilities it issues? Can the Fed hit its inflation targets by sanctioning its own deposits or, put differently, by freezing and/or unfreezing them? Let's say that the expected return from holding a Federal Reserve liability can be decomposed into 1. capital appreciation/depreciation (ie. inflation); 2. interest (either interest on reserves ["IOR"] or the federal funds rate), and 3."liquidity services". Traditionally, an inflation-targeting central bank manipulates the ...

Noah Smith asks what would happen if the Fed kept interest rates at zero forever. Specifically: Suppose that the Fed targets only one interest rate, a short-term nominal interest rate, and that its only tool is Open Market Operations (it cannot provide any "forward guidance" or communicate with the public at all). Suppose that at date T, the Fed decides to keep the interest rate at zero in perpetuity, and remains unwaveringly committed to this decision for all time > T. He asks this because Nayarana Kocherlakota, head of the Minneapolis Fed, once said , somewhat counter-intuitively, that over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. This seems odd at first blush because we've been conditioned to assume that low interest rates lead to inflation, not deflation. I'm going to try and give an answer that financial types will understand. The spoiler is... over the short term we'd have inflation, but Kocherlakota is prob...