No Monster At The ZLB, Just Supply

This is a syndicated repost courtesy of Alhambra Investments. To view original, click here. Reposted with permission.

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Before Chuck Yeager broke the sound barrier in his experimental Bell X-1 aircraft, it was long thought by many to be an extremely difficult challenge if not impossible altogether. Many test pilots spoke of a monster that lay beyond the speed of sound, one ready to destroy any human machine attempting to go faster. In fact, a year before Captain Yeager’s triumph, Geoffrey DeHavilland was killed when his DH-108 disintegrated near the barrier, with many witnesses on the ground reporting a sonic boom.

In economics, there remains today a similar constraint though one not nearly as useful in fact as well as in theory. Economists loathe the Zero Lower Bound (ZLB) mostly because it is a limitation on what they might do. Nominal interest rates can’t be negative (yet), so getting monetary policy into the Twilight Zone of the ZLB is an experiment in fantasy.

Not for lack of trying, of course. The Japanese have been struggling with nominality for decades now. Western central bankers have been well aware of the Bank of Japan’s inability to make much of it, but instead of reworking their theories they blamed the Japanese for poor execution. Now a decade after the global monetary panic, nobody wants to talk much about QE at all anymore.

The theory was relatively simple and plausible. To generate “stimulus” at the ZLB meant emphasizing real interest rates rather than nominals. Economics had moved already in that direction as a result of the 1970’s, where it was realized that there was often a large difference between them. Economic behavior was dictated by real interest rate experience.

To achieve negative real interest rates a central bank needs only to create positive inflation expectations. That’s it. Since, in the words of Ben Bernanke, it possesses the printing press it merely has to threaten to use it in order to push inflation expectations upward. People who believe that money printing is going to happen will act today in anticipation of that happening. Expectations for prices rise, real nominal rates fall, even at the ZLB, and the world benefits by “stimulus.”

The results are almost a self-fulfilling prophecy, where anticipation of higher inflation actually leads to higher inflation especially through wage growth.

I have (intentionally) omitted from the above paragraphs just one word that makes all the difference – credible. For a central bank to really manipulate inflation expectations, it has to credibly threaten to use the printing press. People have to believe that a central bank not only will do it, but can do it. If, however, the public begins to sense that these threats are empty because it was all a bluff, or because the printing press isn’t in the 21st century a settled concept, then the ZLB will be the least of the problems.

Economists in 2017 seemed puzzled by inflation. Central banks did all the “money printing”, yet there is no evidence anywhere in the real economy that it happened. Inflation rates early this year finally picked up to the 2% target range here as well as in Europe, but that had absolutely nothing to do with QE, bank reserves, or money printing. Instead, by the clear trajectory related to oil prices we know there wasn’t any of that at all. People have caught on, after four QE’s in the US and countless monetary programs on the other side of the Atlantic, to the fact that it wasn’t ever money printing no matter how officials and the media might refer to it.

Therefore, in the latter years especially, there hasn’t been any credible threat to pierce the ZLB and reduce real interest rates sufficiently negative on its own theoretical terms. Even in misperceiving what QE is and was, people are still closer to being correct about it than economists and central bankers. The Fed did something arcane, but we know it didn’t have any economic effect. At most, people believe stocks are up and bankers got rich (which is only partially true, banks are almost all still shrinking). Day to day economy, nothing changed.

Bank reserves are not money no matter how often the textbooks claim that they are. As I so often write, even the base money aggregates no longer tell us anything of use.

The volume of funds which might be shifted back and forth between the of the monetary statistics arose in connection with Euro-dollars; [Coombs] suspected that at least some part of the Euro-dollar-based money supply should be included in the U.S. money supply. More generally, he thought M1 was becoming increasingly obsolete as a monetary indicator. The Committee should be focusing more on M2, and it should be moving toward some new version of M3—especially because of the participation of nonbank thrift institutions in money transfer activities should be included in the U.S. money supply.

That was the FOMC discussing monetary statistics in December 1974, almost a half century ago. The issue in the 1970’s was money demand, meaning that economists forecast x amount of future demand for M1 and would find instead only a fraction. It wasn’t that money supply was low, this was the Great Inflation after all, instead the (global) economic system was using other means (eurodollars, repo, etc.) to achieve monetary outcomes (the graphic below belongs to my upcoming series on monetary evolution, Eurodollar University).

The solution offered to this money supply problem was the federal funds rate target. The Federal Reserve under Alan Greenspan began to believe that it was too difficult to define useful parameters on the supply side, shifting instead to an interest rate target to control money demand. By raising or lowering the federal funds rate, the FOMC really assumed it was greatly affecting the demand for money no matter in what form the private global market might supply it.

By this view, the ZLB becomes even more important if it should ever stray within reach. By effectively being removed from supply, should the Fed fail at the ZLB there would be nothing left for it to add (or subtract).

The issue, then, is bank reserves. We all know the Fed, as the ECB and BoJ, did something under various QE’s, but what? They bought bonds (or other assets) from primary dealers in exchange for increasing the deposit balance on those banks’ reserve accounts. The aggregate level of bank reserves rose, as did the obsolete M’s. For many people, perhaps most, that’s money printing. In reality, it wasn’t even close (below again from Eurodollar University).

On the monetary supply side, bank reserves are but one option in a wide variety of liability choices; and not even an important one. Therefore, a bank reserve is not itself money but a possible ingredient in it should whatever bank decide to use it in an economic or financial setting. The fact that banks are in the aggregate shrinking over the last decade totally overrides the increase in this one form of liability. Actual money supply is delivered by bank balance sheets, not by one part of them – the decay or erosion in the rest of the liability side overwhelmed and swallowed up the QE’s.

What good is trying to influence money demand under these conditions? Even if you believe that Alan Greenspan was effective during the Great “Moderation” (I don’t; he was fooling himself and everyone else), this is the one scenario that a money demand policy can’t possibly overcome. That’s why there was a crash in 2008, and further why when the Fed (or ECB) finally paid some attention to money supply (long after it was too late) it was if the QE’s never happened.

The result is a global inflation puzzle for central banks who long ago decided money supply wasn’t their mandate. The struggle at the ZLB actually shows that it was all along, and that central bankers were just fooling themselves into believing that they had it all under control with a single rate. There is no monster below nominal zero, just a bunch of clueless economists who really don’t know what they are doing.

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