"The Narrow Bank"

 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 repo market or the federal funds market. The fed funds rate, for instance, tended to always be 0.2% or 0.3% below the interest rate the Fed paid to depositors.

Why wasn't this gap being arbitraged? After all, if a bank can deposit funds at the Fed and earn 1.95% overnight, then by borrowing in the fed funds market at, say, 1.85%, and putting the proceeds in its Fed account, said bank can earn a risk free return 0.1%. The ensuing competition to profit from this arbitrage should drive the fed funds rate within a hairline of the rate paid by the Fed to depositors. But the massive 0.2-0.3% gap implied that this trade was not being made. 

McAndrews and his co-authors posited that the fed funds market was crippled by a lack of competition. Specifically, there seemed to be a limited number of credible borrowers willing & able to wade into the fed funds market to conduct the trade. This group of borrowers was too small to absorb the funds of all the institutions that were shopping around to lend in the fed funds market. For the most part these lenders did not qualify to get interest from the Fed and were confined to buying fed funds. Thus the small group of borrowers operating in this market exercised a degree of bargaining power over the lenders, allowing them to extract artificially low borrowing rates.

The idea behind the paper was to have the Fed fix these rate distortions by re-introducing competition among borrowers in overnight wholesale lending markets. In short, all those banks that were not considered sound enough to qualify as fed funds borrowers would be able to partner with the Fed to offer risk-free accounts. Specifically, these banks would be able to go to a wary lender and say, "hey, if you lend to us we'll keep your funds hived off from all of our other assets by just depositing them directly at the Fed."

To sanctify this promise, the Fed would create a new type of account, a segregated balance account, or SBA. Once a customer had deposited funds at the the borrowing bank, the bank would transfer these funds into an SBA at the Fed. If the borrowing bank went bust, the swarm of creditors pursuing the bank's assets would not be able to touch the funds locked into its Fed SBAs. The bank itself could not use the funds in an SBA for any other purpose than paying back its customer. By hiving off a wary customers' funds, a risky bank could emulate a Fed account and re-enter wholesale lending markets.

The interest that the bank earned on SBAs would be passed-through to its customer, less a small fee incurred by the bank for providing the service. So if the Fed was paying 1.95% on deposits, the bank might be able to offer 1.90%, thus keeping 0.05% for itself. And since borrowers in the fed funds market were only offering 1.75%, say, then lenders would would avoid them, preferring to invest their funds at banks that offered an SBA solution. To compete, a borrower in the fed funds market would have to offer at least 1.90% themselves. Thus the various wholesale interest rates would be in better alignment.

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Maybe upper level Fed officials took McAndrews aside and said, hey James, we're not going to implement this idea. And he thought to himself, but this is a good idea, why don't I run with it by setting up a private bank. I'm not sure, but whatever the case McAndrews quit the Fed and co-founded The Narrow Bank in what seems to be an effort to implement a market-provided version of SBAs.

TNB is a designed as a pure warehousing bank. It does not make loans to businesses or write mortgages. All it is designed to do is accept funds from depositors and pass these funds directly through to the Fed by redepositing them in its Fed master account. The Fed pays interest on these funds, which flow through TNB back to the original depositors, less a fee for TNB. Interestingly, TNB hasn't bothered to get insurance from the Federal Deposit Insurance Corporation (FDIC). The premiums it would have to pay would add extra costs to its lean business model. Any depositor who understands TNB's model wouldn't care much anyways if the deposits are uninsured, since a deposit at the Fed is perfectly safe.

In theory, TNB (and any potential copycat) should fix the competition problem that McAndrews and his coauthors alluded to in their Segregated Balance Accounts paper. Presumably all those lenders in the fed funds market that can't find suitably sound borrowers, and thus submit to being gouged by the only banks that qualify, will turn to TNB. After all, TNB is clean. Unlike regular banks, it doesn't partake in all of the traditional banking activities that make a bank risky, such as lending to consumers or businesses, or trading for their own accounts. TNB does one thing only, it acts as a portal to the Fed. Since TNB collects 1.95% from the Fed and has minimal costs, it should be able to pay interest of around 1.90% to its customers, who might otherwise get a paltry 1.75% from competing borrowers operating in the fed funds market. Thus the presence of TNB should remove, or at least minimize, some of the distortions in wholesale lending markets.   

But all is for nought. The Fed has refused to grant TNB a master account. John Cochrane has recently blogged about this as well as helpfully uploading the lawsuit that TNB has filed against the New York Fed. We don't know why Fed officials are dragging their heels, so all we can do is speculate. Cochrane has a few theories, including potential worries among Fed officials about controlling the size of its balance sheet.

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But even if TNB succeeds in its lawsuit, there is a larger threat. The gap the bank is trying to exploit is shrinking. Back in 2016 when McAndrews and his colleagues first embarked on the effort to build a new bank, the fed funds rate was typically 13 to 14 basis points below the rate offered by the Fed. Fourteen basis points was a lot of rope for TNB to work with. But this gap has since shrunk to just 4 basis points (see chart below). Possibly wholesale markets have become more competitive while the bank was being constructed, in which case there may no longer be much of a role for TNB to play. If TNB borrows at 1.91% and invests at 1.95%, that doesn't leave it much wiggle room to pay its fixed costs and salaries.

Even if the gap disappears, could TNB serve as more than just a conduit for engaging in arbitrage? Let's say that in the future rates have normalized. Banks now offer to lend at an overnight rate that is in-line, or even exceeds, the rate that the Fed pays to depositors. TNB no longer has a sweet deal to offer. Even then, large institutions who can't directly bank at the Fed may like the idea of keeping an account at TNB. Although they will earn slightly less then they otherwise would in competing overnight markets, the Fed is a risk-free place to park one's money, unlike say the fed funds market. These institutions could also invest in treasury bills. But even though a treasury bill would provide a higher return than parking funds at the Fed, there is always a risk that it cannot be immediately sold for its face value. Put differently, a treasury bill has duration risk. Funds held at the Fed via TNB have no duration risk. They can be withdrawn in a moment at par.

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How big might this demand be? Interestingly, TNB isn't the first of its kind. On Twitter, Karl Storvik informs me that an analog exists in Norway, the Safe Deposit Bank of Norway. SDBN is a self described "conduit" established in 2013 to provide ultra-high net worth individuals, asset managers or corporate treasurers a means to park funds at the Norges Bank, Norway's central bank.

According to the SDBN's website, its license prevents it from holding any other asset than Norges Bank deposits. The interest that the central bank pays on these deposits flow back to SDBN's customers, SDBN taking a fee for itself. This is basically TNB, Norwegian style. But as best I can tell, SDNB's function isn't to arbitrage small differences between the rate of interest that the Norges Bank pays and other overnight rates. It is trying to provide a product that is in and of itself useful to folks like high net worth individuals and corporations.

From a glance at its most recent balance sheet, I'd say that The Safe Deposit Bank of Norway hasn't been terribly successful. Sure, it is still in start-up phase, but as of the end of 2017 it had only NOK 53 million on deposit at the Norges Bank, or a piddling US$6.3 million. Assuming TNB gets Fed approval, one wonders if this wouldn't be its fate as well.

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Matt Levine has an interesting take on the whole thing. What if TNB were to allow regular folks like you and me to open an account? The overhead involved in serving a retail customer base would be higher than if TNB served a purely institutional clientele, notes Levine: "you’d need at least a website, a customer service department, ATM cards—but the opportunity is intriguing." But unlike a regular bank it wouldn't need to hire loan evaluators or absorb credit losses. So TNB might be able to provide many of the same payments capabilities as a regular bank (debit card payments, ACH payments, and wire transfers), but pass through a larger share of central bank interest payments to depositors.

If it went this route, TNB wouldn't be the first financial institution to operate as a narrow bank, i.e. to swear off lending in order to focus solely on satisfying the public's payments requirements. This is exactly what mobile money platforms like M-Pesa do. Mobile money providers accept incoming customer funds, park this money in trust at a bank, and issue 100%-backed liquid IOUs to the customer. These IOUs can be used to buy stuff at retailers or exchanged with other users on a person-to-person basis. Unfortunately, liquid deposits held in trust at the commercial bank don't yield much interest, so even if a mobile money operator wanted to flow some interest through to its customers it wouldn't have much to draw on.

The novelty introduced by a retail-facing TNB is that the customer's funds would be parked directly at the central bank instead of an intervening commercial bank. So central bank interest payments could flow straight to the narrow bank rather than being sucked up by an intermediary. And so it would be possible, in theory at least, for TNB to offer retail depositors not only a useful payments option but also a financially meaningful flow of interest.

That seems like a decent financial innovation, no? For instance, the Bank of Canada currently pays 1.25% to banks that have clearing accounts, while I make a meagre 0.15% on my no-fee chequing account. If a Canadian version of TNB could offer me a 1% interest rate on an absolutely-no-frills account with a debit card attached to it, I'd definitely consider it. If James McAndrews and TNB get rebuffed by the Fed, maybe they should come up here and try the Bank of Canada.

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P.S. By coincidence, I recently wrote about some of James McAndrews work on financial privacy at the Sound Money Project. And he commented on my Cato Unbound proposal to introduce taxed $500 and $1000 banknotes. Small world.

There's water everywhere, but John Taylor wants us all to be thirsty

"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 requirements could go to the fed funds market and buy them from banks who had excess reserves, the price they negotiated referred to as the fed funds rate.

I disagree with John Taylor. Resuscitating the fed funds market is not a good idea. The fed funds market is no longer used because the Federal Reserve has stuffed the market with so many reserves that banks no longer need to buy them from other banks to meet their requirements. But this cornucopia is a good thing. Any effort to bring back the fed funds market would ruin it.

Let's set up an analogy. Imagine a country called Waterland that gets tons of rain and has plenty of lakes and rivers. Since everyone has immediate access to water, there is no market for the stuff. The price of water is zero. Say that the government establishes control over the waterways and rainfall. It decides to limit the amount of water that is available to the citizens of Waterland. In response to this artificially-imposed scarcity, a market develops in which citizens buy and sell water among each other. 

Markets are great. They allow those with too little of something to trade with those who are good at conserving what they need, both sides improving their lot in life. But this particular market should never have existed in the first place. Water is plentiful in Waterland, and so it should be a free good, not a market-traded one. The entire apparatus that has been built around the exchanging of water—informed dealers, speculators, exchanges, warehouses, networks for transporting water to and from market, auditors and lawyers involved in verifying water transactions—represents a waste. By consuming resources in constructing and operating the market, other more important projects never see the light of day. If the absurd water scarcity were to be removed, the market for water would disappear, freeing up resources for more socially beneficial uses. 

Reserves, like water in the previous example, should by all rights be free. The only effort the Fed incurs in introducing a new unit of reserves into circulation is a keystroke or two. This means that the Fed can provide a bunch of new reserves, say by conducting open market operations, without incurring any costs whatsoever. As the Fed continues to mouse-click new reserves into existence, the demand that each individual bank has for reserves will eventually be satiated. Once that point is reached not a single bank will need to bid for the reserves of another bank, and so there will be no activity in the market for reserves. The fed funds market is effectively dead, as is currently the case.

Taylor wants to bring back the fed funds market. But this would mean putting an artificial constraint on the amount of reserves that the Fed supplies, much like Waterland's frivolous constraint on water. Banks, their satiation for reserves now being replaced by an artificial hunger, would suddenly be willing to pay a fee to other banks in order to get their hands on some reserves.

A whole fed funds trading apparatus would re-emerge. Traders would have to be hired and trained to to fill newly-formed fed funds desks. Bank resources would be diverted away from other valuable projects towards plotting the best way to time outgoing payments, the idea being to reduce the need to hold reserves in order to lend them out in the fed funds market. The Fed itself would have to rehire Peter Fisher to run its open market desk. All of this would be an expensive investment of time and money, diverting resources from other more socially beneficial activities.

In calling for a return to the days of an active fed funds market, it is as if Taylor were advocating for an artificial constraint to Waterland's supply of water, solely because he admired the market for water that emerged. Never mind that the whole water trading apparatus, though wonderfully efficient, represents a massive missallocation of resources. Given that I'm pretty sure Taylor would not want to kickstart a water market in a hypothetical Waterland, I don't understand why he is so keen to reboot the fed funds market.

Does the Fed lack the technical means to dive into negative rate waters?

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 deposits at the Fed. At deeply negative rates, this subsidy could get very large, turning the Fed's substantial profits into large losses. The result, a steady fall in its share capital, might undermine Fed independence and the credibility of monetary policy.**

Why these odd effects? As Nick Rowe says in this delightful post, in a world with negative interest rates everything old is new again, only it's a mirror image. And in a world of negative U.S. rates, the mirror image of the Fed's leaky floor is a sticky ceiling. And just like the leaky floor (more on this later) dragged the overnight rate down to 0% when IOR was positive, the sticky ceiling effectively pulls the overnight rates back up to 0% when IOR is negative. To see why this would happen, we need to take a quick tour of the legal and technical history behind IOR.

Until October 2008 the Fed was legally prohibited from paying interest to banks. Any bank manager who left reserves on deposit at the Fed earned 0%. This changed with the passage of the  Financial Services Regulatory Relief Act of 2006 which bolted Section 19(b)(12) onto the Federal Reserve Act allowing banks to "receive earnings to be paid by the Federal Reserve Bank." As a direct result of 19(b)(12), the Fed has been paying interest of 0.25% for a number of years, a rate that was recently increased to 0.5%.

Not only did Section 19(b)(12) provide the Fed with the ability to pay interest on reserves, it also gives it the technical means to pay negative rates on reserves. Now there is some controversy whether the wording in Section 19(b)(12) authorizes a negative rate; for instance, it mentions the paying of earnings to banks, not the payment of negative earnings:

World is cascading to - rates. Does Congress need to authorize Fed to "charge" IOR? ('06 law says "pay") @dandolfa @jp_koning @mileskimball

— Diego Espinosa (@dvespinosa) January 29, 2016

...and here is Stephen Williamson on the issue.

Ex-Fed official Narayana Kocherlakota points out that various members of the Fed Board of Governors, including William Dudley and Stanley Fischer, have already hinted at negative rates as a potential tool, the implication being that the Fed has high confidence in a certain interpretation of the Act that would legally justify the move, otherwise they would not have spoken. Don't forget that Fed general counsel Scott Alvarez will have to sign off on the question of legality. Alvarez is the one who allowed a truck to be driven through Section 13.3 during the credit crisis, legalizing the bailout of Bear Stearns and AIG via Maiden Lane.

Let's assume that there is no legal controversy and the Fed sets negative IOR of -0.25% tomorrow. That's where the Fed's real problems start. Because as I said at the outset, the overnight rate won't follow IOR down in lock-step, it may even stick to the 0% ceiling. On top of this is the aforementioned subsidy provided to those institutions that have access to interest-free deposits at the Fed, namely the government-sponsored entities Freddie Mac, Fannie Mae, and the Federal Home Loan Banks (I'll describe this subsidy later).

As I said at the outset, the sticky ceiling problem is the opposite of the well known leaky floor problem. Over the last few years the various U.S. overnight rates have traded below IOR. These leaks are odd since IOR is supposed to set a lower bound to the overnight rate. After all, why invest your funds at 0.05% overnight when you can get 0.25% at the Fed? We can blame the leakage on our three government-sponsored entities (GSEs): Freddie, Fannie, and the Federal Home Loan Banks. These GSEs are allowed to keep accounts at the Fed but are prohibited from collecting interest. Rather than earn nothing, the GSEs have been lending their reserves overnight to banks who have access to IOR. These banks have been engaging in arbitrage whereby they borrow GSE funds at 0.05%- 0.15% and invest them at 0.25%, a nice gig if you can get it.

From whence this prohibition on interest? 19(b)(12), the same bit of legalese that authorizes IOR, emphasizes that only "depository institutions" can receive interest, and since Freddie, Fannie, and the Federal Home Loan Banks are not depositories, they do not qualify (this article speculates why).

Which means that if the Fed is going to stretch Section 19 authority for payment of interest  to allow for the payment of negative interest rates, then the GSE prohibition on receiving positive interest means that they will likewise be exempt from paying negative interest.

The ultimate effect of all this is that if and when the Fed decides to brings IOR to -0.25%%, the overnight rate is going to do a flip—rather than trading below IOR it will start to trade above it. Why the inversion? In positive rate land the IOR exemption meant that it really sucked to be the GSEs. But in negative rate land it's great to be a GSE. When all other banks must endure a -0.25% penalty, an exemption from IOR becomes an asset, not a liability. Banks, sensing a way to improve their returns, will compete to purchase 0% shelter from the GSEs. Say they offer to lend funds to the GSEs in the overnight market at  -0.17%, an 8 basis point improvement to IOR of -0.25%. GSEs would be hard-pressed to not accept this gift. After all, they'd be borrowing at -0.17% in order to lend to the Fed at 0%, which means 17 basis points in risk free profit. Taken to the extreme, a profit-maximizing Fannie, Freddie, and the Federal Home Loan Banks will compete to borrow the entire $3.3 trillion in reserves held at the Fed, driving overnight rates back up towards 0%. No matter how deep the Fed brings IOR into negative territory, the overnight rate stays stuck at a shallow level thanks to the GSEs.

You may recognize that the sticky ceiling problem is just another (perhaps weaker) version of the good old zero-lower bound problem, but in the role of 0% cash as antagonist, 0% deposits held at Fannie, Freddie, and the Federal Home Loan Banks have been substituted.

Now it could be argued that GSE arbitrage will force the overnight rate within a hair of negative IOR. For instance, if  IOR is at -0.25%  the overnight rate might trade at -0.24%. If so, the problem is less about monetary policy impotence and more about the massive subsidy being granted to the GSEs. These institutions have a large incentive to hoover all the reserves held by non-GSEs in order to earn risk free returns. Rather than earning 0.25% on reserves held by banks, the Fed will get 0%. And since the Fed's profits--what economists call seigniorage--typically flows to the taxpayer via the Treasury, taxpayers would be subsidizing Fannie, Freddie, and the Federal Home Loan Banks to the tune of millions, a fiscal transfer lacking the appropriate Congressional approvals.*

If the GSEs take the free gift, this will have very real effects on the Fed's financial health.  With IOR at -0.25% the steady rolling-over the Fed's assets will result in a decline in their yields, maybe even negative returns. As the spread between the return on assets and cost of liabilities shrinks, the Fed's seigniorage will drop dramatically. In  normal times, a certain portion of this seigniorage goes to rebuilding any impairments to the Fed's capital base while the rest flows through the Treasury to the taxpayer, either in the form of reduced taxes or services. With a 0% loophole being offered to the GSEs, the Fed risks running permanent operating deficits which in turn will lead to a steady erosion in its capital base. If the equity writedowns gets too large this may reduce the Fed's credibility in the eyes of the market, thus reducing the effectiveness of monetary policy.**

The Fed will have to plug this hole if it doesn't want to find itself neutered and/or subsidizing the GSEs. Maybe Fed officials can cap the amount of reserves that the GSEs are allowed to borrow, or use moral suasion to get the GSEs to drop out of the market. Better yet, maybe Fed Chair Janet Yellen can ask Congress to change 19(b)(12) so that, like all other banks, GSEs get to receive IOR (and are forced to pay it). Alternatively, maybe the laws can be altered so that the GSEs are prevented from keeping deposits at the Fed to begin with.

The legal option is a good idea for two reasons. First, it means that negative IOR effectively sets the overnight rate, restoring the pass-through from negative rates into financial markets and the real economy. It also removes the subsidy to the GSEs and the potential for large hits to share capital. Secondly, it fixes the Fed's leaky floor problem at positive rates of IOR. The Fed has already set up an overnight reverse repo agreement (ON RRP) facility to borrow from those ineligible to receive IOR, the idea being to keep a sterner floor under overnight rates. But as Marvin Goodfriend writes, ON RRP

violates the minimal intervention principle of central banking by turning the Fed into a financial intermediary operating directly on a large scale beyond the banking system with the potential to distort short term credit allocation and enable disruptive flight-to-quality flows during periods of financial distress.

Far less obtrusive to fix the leak with a quick change to legislation than fully arming a new battle station.

In closing, if the Fed wants to go negative, it may have some technical details to worry about. Fed officials no doubt already know this. If they don't, the blame can be attributed to their all-out focus on so-called normalization. By throwing all their organizational capital into the creation of a mechanism for keeping rates on an upward trajectory (the ON RRP), the Fed has diverted resources and attention away from the design of a complementary mechanism necessary for a downward rate trajectory. In hindsight, perhaps the Fed should have been tasking half its lawyers, accountants, financial architects, and media personnel to the rate normalization project, and the other to the negative rate project. Time to play catch-up?

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Due to the difficulty of this subject matter, I've altered this post a few times since initially publishing it. The general idea has remained the same.

* In my original post, this paragraph didn't appear but was in the footnotes. I think it's important enough to bring up to the body of the text.
** Added on January 4.
*** Since originally posting this, I've softened my position on the sticky ceiling. I originally thought that the overnight rate would stay stuck at 0%, but I now feel it is likely to move closer to negative IOR. It would remain above IOR, however, so the idea of a sticky ceiling, while muted, is still relevant.

The convenience yield as epicentre of monetary policy implementation

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 little more than a reflection of the underlying convenience yield on reserves. Fed funds rates move only in the instant after the convenience yield has been modified. Nor are overnight rates the first to move in response to changes in the convenience yield. They are just one of an almost infinite number of market prices and rates to react in the moments after the convenience yield has been diminished or improved. We should stop thinking in terms of overnight-rate exceptionalism. Price changes radiate out from the convenience yield.

I've gone into much more detail on all these ideas in an earlier post. In this post I want to focus on one point I made earlier -- the fed funds rate can be a bad reflection of the underlying convenience yield. There are several reasons for this. First, in renting out reserves, banks are effectively replacing the central bank as their counterparty with another private bank. In normal times, banks make excellent counterparties. But during times of stress, rentors may require an extra amount of rent that has nothing to do with the usefulness or scarcity of reserves, but the riskiness of counterparties. A spike in the fed funds rate may have nothing to do with the underlying convenience yield, and everything to do with credit risk.

Secondly (and more importantly), the funds rate ceases to be a good indicator when it falls to zero. When this happens, there is a temptation to view monetary policy as spent. After all, it may seem that a central bank can't reduce the convenience yield below 0, which is to say that it can't push the fed funds rate into negative territory. We should resist this temptation. The current fed funds is an estimate of the 24-hour convenience yield on reserves. But agents hold reserves not only to enjoy their present convenience but to enjoy their expected future flows of convenience. So even if the market puts no value on the immediate 24 hour convenience yield, that isn't to say that the market doesn't value their convenience 1 week from hence, or 1 month, 1 year, or 1 decade.

Just like there is a term structure to government bill/bond rates, there is a term structure of the convenience yield on reserves. We can get an inkling of the term structure by looking at longer-term fed funds deals. In the term fed funds market, for instance, banks will rent reserves for up to one year. Federal funds futures give an indication of the expected convenience yield several years from now.

When the overnight convenience rate hits zero, central banks still have plenty of traction over the rest of the term structure. By attacking the convenience yield on reserves one year from now, for instance, a central bank hurts the discounted value of expected streams of convenience thrown off by reserves in the present. As a result, today's forward-looking agents will be nudged away from holding reserves, causing a rise in the price level. As long as there are portions of the convenience yield curve that are still positive, a central banker can do their job.

If thinking in terms of short term rates is misguided, so is a focus on base money. Once the short term convenience rate on reserves has hit zero, present changes in the quantity of base money will have little effect on convenience yields further down the curve. One way to reduce convenience yields five years hence would be to promise that the then-supply of base money will be sufficiently broad so as to ensure that the marginal deposit yields no convenience flows. But a central bank will only be able to affect future convenience yields if the market believes it will have the gumption to follow through on its promises.

Monetary policy at low convenience rates is all about making promises about future convenience yields and ensuring those promise are credible. Conventional monetary policy, on the other hand, is relatively simple -- all a central banker need do is manipulate the current convenience yield in order to have an effect on prices.

The fed funds rate was never the Fed's actual policy lever

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 position, although I'm not entirely in the same corner. I agree that the Fed's policy instrument was never the fed funds rate. But I'm going to go one further than the market monetarists and say that the Fed's real policy instrument prior to 2008 was always the non-pecuniary return on reserves.

What do I mean by non-pecuniary return? All assets are expected to provide a sufficient return to their holder. This expected return can be decomposed into a pecuniary and a non-pecuniary component. Financial assets, for instance, tend to provide only pecuniary returns. These come in the form of expected interest payments, dividends, and capital appreciation. Non financial assets like couches, books, and cutlery tend to provide only non-pecuniary returns. These non-pecuniary returns come in the form of future consumption (dated consumption claims), protection from uncertainty, status, etc. Complex assets like houses provide both pecuniary and non-pecuniary returns. We expect to enjoy the shelter provided by our house, and we simultaneously expect it to provide a capital gain when we sell it.

Note that another word for non-pecuniary return is convenience yield. I'll use the two interchangeably from here on in.

For the first time ever on Moneyness, an equation to help clear the waters:

Total expected return of an asset = expected non-pecuniary return + expected pecuniary return

In well-functioning markets, all assets provide the same total expected return. If some asset begins to throw off excess returns, people will buy it up till its price has risen to the point that the cost of acquiring that asset offsets its superior return. Vice versa with an asset that begins to throw off deficient returns.

Central bank reserves are like any other asset. They provide an expected return that can be decomposed into pecuniary and non-pecuniary components. Perhaps somewhat oddly for a financial asset, reserves have never provided a pecuniary return, at least not before 2008. This is because reserves failed to pay interest. (In fact, reserves have always provided a slightly negative pecuniary return. They are generally expected to fall in price, burdening holders with a negative capital gain).

Reserves, therefore, are only held because their non-pecuniary return, or convenience yield, is sufficiently large to compensate their owners for a lack of a pecuniary return. [From here on in, it goes without saying that I am talking about the pre-2008 Fed]. What is the nature of this yield? Reserves are the main instrument used for interbank payments and settlement. Should an emergency arise necessitating an immediate payment, a banker can always put his or her inventory of reserves to use. If a banker foregos holding an inventory of reserves, he or she will have to bear the risk of not being able to quickly obtain sufficient reserves for potential unforeseen payments requirements. Reserves are to a banker what a fire alarm is to a household— while neither provides an explicit pecuniary benefit, both assets provide their owners with ongoing protection from the uncertainty of future events. Bankers and households alike expect to "consume" this convenience over the life of the asset, earning the same total return they would on their other assets.

It is the convenience yield on reserves, and not the fed funds rate, that serves as the Fed's policy instrument. By manipulating the convenience yield—the non-pecuniary return provided by reserves—the Fed exercises monetary policy. When the Fed improves the convenience yield on reserves, reserves will provide a superior expected return relative to all other assets in an economy. Rational agents will bid the price of reserves up, and the price level down. When it hurts the convenience yield, reserves will provide an inferior expected return relative to all other assets in an economy. Rational agents will now cry the price of reserves down, and the price level up.

One way to alter the convenience yield on reserves is to change their quantity via open market operations. As the supply of reserves shrinks via open market sales, the marginal reserve provides an ever improving convenience yield. Rational agents will seek to earn an excess return on their portfolios by buying superior-yielding reserves and selling other assets. This causes a fall in the price level until reserves no longer provide superior returns. Conversely, as the supply of reserves is increased via open market purchases, the marginal reserve provides an ever shrinking convenience yield. Rational agents will try to rid themselves of inferior-yielding reserves, causing a decline in the price of reserves, the mirror image of which is a rise in the price level.

There's a second way to change the convenience yield on reserves. Keep the quantity fixed, but make reserves more convenient! Just like an auto manufacturer can improve the expected convenience yield of a car by adding more features—cup holders, AWD, safety air bags, inboard TV, you name it—the Fed can also improve the expected convenience yield on reserves by souping them up. One popular add-on has always been the required reserve stipulation. As a condition of participation in the payments system, a central bank may require member banks to hold a certain quantity of reserves contingent on the number of deposits that each member has issued to the public. Where before central bank reserves were valued primarily for their role in settlement, now reserves can also be held to fulfill the reserve requirement, enabling the bank to continue as a payments system member in good standing. Voilà, reserves are now doubly-convenient since they can perform two roles, not just one. Henceforth, any increase in reserve requirements improves the convenience yield on reserves and any decrease will hurt their convenience yield.

If the Fed's monetary policy instrument has always been the convenience yield on reserves and not short term interest rates, as is commonly supposed, why all the hoopla about the federal funds rate? Why do central banks talk so much about manipulating overnight interest rates?

The problem with doing monetary policy in terms of convenience yields is that convenience yields are not directly visible. We know that they exist, but we can't really see them. This leaves the Fed in a conundrum, because if it tries to communicate about monetary policy, it can only talk about raising or lowering the hidden convenience yield on reserves, but it can't go into any numeric depth on the issue.

But wait! There are indirect ways to measure convenience yields. One way is to ask people how much money they expect to earn if they forgo the convenience of some asset for a duration of time. The rent they expect to earn in compensation should "shadow" the convenience yield. The more convenient an asset becomes, the higher the rent the asset holder expects to be compensated with if they are to do without that asset for a period of time. The less convenient, the lower the rent.

The federal funds market is the rental market for reserves. Banks can either hold reserves and enjoy their convenience, or they can rent their reserves out to other banks, foregoing the convenience of reserves for a period of time but earning compensatory payments. These payments are the rental value of reserves, or the fed funds rate. The fed funds rate is driven by the convenience yield on reserves. So when reserves are made more convenient by the Fed, banks will expect to earn a higher fed funds rate as compensation from borrowers. When the fed funds rate falls, that means that reserves have been made less convenient.

So the fed funds market provides a numeric manifestation of the unobservable convenience yield on reserves. The Fed can use this manifestation as a stand-in for communicating with the public, describing monetary policy as-if it was directly manipulating the fed funds rate whereas in actuality the convenience yield is the Fed's true policy instrument. In the 1990s and 2000s, when the Fed announced changes in the fed funds rate target, it was doing nothing more than describing to the public how a change in the underlying convenience yield would appear to the superficial observer. As Nick Rowe says, interest rate targeting is not reality, its a way of framing reality.

The fed funds rate also serves the Fed's Open Market Committee as a useful sign post, or indicator, that provides information on the way to hitting its final price target. For each modification it makes in the convenience yield, the FOMC can measure how successful it has been by referring to how far the fed funds rate has moved in response. Alternatively, the FOMC can use the fed funds rate as a guide for stabilizing what would otherwise be an invisible and difficult to manage convenience yield. In general, the Fed has tried to keep the convenience yield on reserves flat for extended periods of time between meetings. Whenever the fed funds market blips up or down in the interim, the Fed can use these blips as indicators that it is not keeping the underlying convenience yield steady. Action, either OMOs or reserve requirement changes, will be used to bring the convenience yield on reserves back into its holding pattern.

But the key point here is that the federal funds rate is NOT doing the heavy lifting in monetary policy. The federal funds rate only responds passively to changes in the Fed's true policy instrument—the convenience yield on reserves. Fed-induced changes in the convenience yield create an instantaneous and simultaneous reaction in all markets, including the fed funds market, bond markets, stock markets, labour markets, goods markets, and commodity markets. The fed funds rate isn't the first price to react, nor is it the pivot around which the full network of other market rates move. That we use the fed funds market to measure the reaction of the economy to a change in the policy instrument rather than using, say, commodity markets, is merely for the sake of ease. The funds rate just happens to be the one that provides the most noise-free signal for how much the convenience yield has been manipulated.

...but not a perfect noise-free signal. The fed funds rate's ability to act at a good reflection of the underlying convenience yield comes to an end when it gets too low. Even as the Fed continues to reduce the convenience yield, the fed funds rate falls to 0% from where it refuses to budge, conveying the impression—an improper one—that the Fed's policy instrument is powerless. But further reductions in the convenience yield, and a higher price level, ARE still possible.

My point here is very similar to the one that Nick Rowe makes when he says that interest rates "go mute" at zero. This is an important point I never grasped intuitively till I began to think of Fed policy as the manipulation of convenience yields. The main difference between the two of us is that  Nick takes the "money" view, which looks at absolute quantities of money, while I take a "moneyness view", which means I'm interested in monetary convenience yields [on money vs. moneyness]. We arrive at the same final destination, though, albeit by different roads.

Plenty of things changed after October 2008. I suppose I could go into this in more detail, but this post is already too long. Suffice it to say that reserves ceased offering a present non-pecuniary return and began offering a pecuniary return. The latter is IOR (interest-on-reserves). The non-pecuniary return has shrunk because there is currently such a glut of reserves in the system that the marginal reserve no longer offers its owner a present convenience yield. All of these changes complicate the picture.

There's plenty more to say on all this stuff, but this post is heavy enough. Just keep in mind that thinking in terms of convenience yields and not the federal funds rate opens up a whole new world. The idea that the funds rate was ever the policy instrument should be confined to the trash bin. More later.

A rush for US paper dollars: the rejuvenation of the world's most popular brand

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 the demand for Canadian paper. As James Hamilton points out, this is no doubt due to the huge transactional demand for US dollars overseas. The emerging countries in which US paper is demanded often have high growth rates, and their requirement for transaction media is correspondingly elevated. Unlike greenbacks, Canadian loonies are only demanded in Canada. As a slow-growth country, we don't require rapidly expanding amounts of physical transactions media.

2. Zooming in on any given year (I've chosen 1997) the demand for Canadian paper is far more jagged than the demand for US paper. Why is this? My guess is that the demand for US paper is diffused across multiple nations with diverging business practices and cultures. The demand for Canadian paper, on the other hand, is tightly linked to specific Canadian customs, holiday seasons, and payroll scheduling practices. The overseas demand that smooths out and counterbalance the peculiarities of domestic US paper demand don't exist for loonies.

3. There are some neat patterns in the chart. No, not all cash is demanded by criminals. There's always a cash spike at Christmas/New Years, and if you look carefully you can see jumps in Canadian cash demand coincide with major holidays, including Thanksgiving and the September long weekend. As Lenin once said, give me data on your nation's money supply and I can tell you when its holidays are. And note the huge Y2K-inspired rush to hold paper. Cash is still the ultimate medium for coping with raw uncertainty.

4. US paper demand started to slacken relative to trend in the early 2000s. One might be tempted to blame technological advances or changes in US preferences over payment media for slowing demand. Cash is a dinosaur, right? But this can't be the case. Canadians benefit from the same technologies as the US, nor do payment preferences change when one moves from 50 miles south of the 49th parallel to 50 kilometres north of it. If technology or preferences had changes, then Canadian cash demand would have deteriorated too, but as the chart shows, it continued to rise on trend. The best explanation for the US dollar's divergence from its long term growth just as Canada hewed to its trend is that foreign demand for US paper began to decline.

It's a reasonable explanation. Around 2002, the value of the US dollar begin a long and steady deterioration against most of the world's currencies, in particular the euro. It's very probable that consumers of the US$ brand punished the brand owner, the Federal Reserve, by returning dollars enmasse to their source, thus reducing the supply of paper dollars (or at least reducing its rate of increase). As incontrovertible proof, I submit exhibit A—a 2007 video of Jay-Z flashing euros instead of dollars (skip to 0:51).

5. So it seems to me that from 2003-2008 there was a mini run on the Fed by overseas cash holders. What Jaz-Z doesn't show is the process by which US dollars would have refluxed back to the US. Euroization, or de-dollarization, goes like this. A foreigner goes to their local bank to trade US dollars for euros. The local bank, flush with dollars, puts this paper on a plane for redeposit at their US correspondent bank in New York. The New York bank, which now has too much vault cash, loads these dollars into a Brinks truck and sends them to the New York Fed. And the FRBNY shreds the notes up.

This mini run would have put downward pressure on the federal funds rate. Here's how. Having accumulated excess cash from overseas, US banks would have sent this cash to the Fed in return for reserves. But now these banks have excess reserves. Desperate to get rid of them, they all try to lend their reserves at once, driving the federal funds rate down. To ensure that the federal funds rate doesn't fall below target, the Fed would has to sell treasuries in order to suck in reserves, thereby reducing the oversupply in the federal funds market and keeping the fed funds fixed.

The lesson being, when folks like Jambo in Zimbabwe and Julio in Panama get distraught about the quality of their Ben Franklins, the effects of their unhappiness will be felt, with some delay, all the way back at the Fed's open market desk.

6. US paper demand has since rebounded. Paul Krugman posts a chart that shows a massive accumulation of US cash holdings relative to GDP beginning in 2008. But Krugman's chart overstates the effect by constricting his time frame. As my chart shows, the rate of growth in US paper has only returned to the trend it demonstrated in previous decades.

Krugman attributes this increase in dollar holdings to the fact that the US is in a liquidity trap. When rates are near zero, people have no problems holding zero-yielding cash. I'm not so sure about his explanation. Canada had incredibly low rates for a few years, yet as our chart shows, Canadian paper never budged from its trendline growth. The same goes for the Euro. Rates have been low there, but we haven't seen a flight into paper money. Because cash is inconvenient and bulky, rates have to go pretty far below zero before people flee to paper.

No, the more likely explanation for the rebound in the US paper outstanding is the rejuvenation of the US dollar brand. The ECB has had to deal with waves of negative publicity for the last few years. Given the alternatives, the world wants to hold Benjamins again. This seems to be borne out in the chart below, which shows the ratio of ECB-to-Fed banknotes in circulation.



The US dollar, it would seem, is back. Cash holdings are only one sign off a currency's hegemony. It would be telling if there's also been a rebound in the use of the dollar to denominate bonds and other debt instruments, as well as increased holdings of US dollar-denominated assets in the reserves of major central banks. The US's "exorbitant privilege", as Barry Eichengreen calls it, continues apace.

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Note: As I was writing this, I stumbled on a paper by Ruth Judson via James Hamilton called Crisis and Calm: Demand for U.S. Currency at Home and Abroad from the Fall of the Berlin Wall to 2011. And what do you know. She uses Canada as a foil for determining US cash demand, just like I did. I haven't read it yet, but am quite looking forward to doing so and am willing to yack about it in the comments.

On Lenin, read White & Schuler.

Frozen deposits as a Federal Reserve policy tool?

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 interest rate portion of a dollar's return up or down in order to make inflation, the dollar's expected capital appreciation, rise or fall to its target. Here's what I'm curious about. What happens if the Federal Reserve holds the interest rate fixed but manipulates the "liquidity services" of Fed liabilities? Will this be sufficient to make inflation rise or fall to target?

All assets provide varying degrees of liquidity services, but the liquidity (or "moneyness") of central bank liabilities are supreme. In the US, deposits held at at the Fed can be used to make Fedwire payments. Fedwire is an interbank clearing and payment system hosted on the books of the Federal Reserve. Banks make payments in order to settle cheques, buy and sell securities, and make other large time-sensitive payments on behalf of clients. The average value per transfer over Fedwire is about $5 million. In 2011, $663 trillion in transactions were conducted via Fedwire. That's a lot of liquidity.

Let's say the Fed announces that going forward some not insignificant percentage of all deposits held at the Fed will be frozen for a period of time, say a month. While frozen, deposits will still earn IOR, but banks won't be able to sell them on Fedwire. The distribution of frozen deposits will be random. No bank knows if they will be afflicted or not. When, after a month, a deposit is unfrozen, some other random deposit in the system is frozen.

Just like monetary sanctions, the freezing of Fed deposits will have the effect of degrading their anticipated liquidity services. Banks who had previously been sure of the superior saleability of Fed deposits now face the possibility that they won't be able to utilize them should some unanticipated need arise. In response, banks will simultaneously try to rebalance their portfolio towards other liquid assets by selling some of the Fed deposits they hold. But the stock of outstanding Fed deposits is fixed. The only way for the system to equilibrate is for the price of all other assets to rise, or, put differently, for inflation to increase.

In this scenario, the Fed loosens policy (creates inflation) by either increasing the margin of deposits that are frozen or by lengthening the period for which they will be frozen. It tightens by unfreezing and shortening. Playing around with its liquidity-services tools allows the Fed to hit its inflation target.

Conversely, the Treasury tightens Iranian monetary policy by freezing Iranian deposits in the international payments system and loosens by increasing the ability of Iranian's to participate in the system. The Treasury's target is unrealistic—Iran must stop developing the bomb. A more realistic target would be Iranian NGDP.

Apart from serving as a mental exercise, using liquidity tools in monetary policy might be useful at the zero-lower bound. We know that the Fed can't set a negative interest rate at the ZLB because everyone will quickly convert Fed deposits into Fed cash in order to escape the penalty. The Fed therefore loses its ability to drive up inflation.* Miles Kimball's vision of a conversion penalty on cash withdrawals is one way to limit the dash for cash, thereby allowing central banks to set negative rates. A more extreme fix is to simply ban cash.

Because cash is a day-to-day feature of regular people's lives (well, criminals too), implementing cash penalties or bans might be a bit awkward. If instead we try to escape the ZLB by reducing the liquidity of Fed deposits and creating a bit of inflation, this shifts the burden of coping from the public to banks. Won't banks simply evade the sanctions by converting deposits into Federal Reserve cash? Unlikely, since they'd be forfeiting IOR and have to pay storage and transportation costs on cash.

*Market monetarists don't believe this and think large scale purchases can do the trick. I don't disagree.

Zero percent interest rates forever

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 probably right that after some time passes, an artificially low federal funds rate will lead to a steady deflation.

Imagine that you're an investor who can hold either deposits at the central bank or units of some durable good. In order for these two assets to be willingly held by both you and your fellow investors, each must provide attractive returns. If one of these assets provides excess returns, arbitrage dictates that you'll all try to switch to that asset until those excess returns cease to exist.

A bank deposit's return can be decomposed into an interest component, expected capital appreciation (or depreciation), and a liquidity yield. Liquidity is a special benefit that a deposit provides since it more marketable than most assets. The durable good, assume it costs nothing to store, provides a return in the form of capital appreciation (or depreciation), but no interest and a liquidity yield that is so minimal that it may as well be nothing.

At the outset, the returns on the two assets are already equal. But the central bank suddenly lowers the interest component of the return it pays on deposits to nothing, catching the investment community by surprise. As an investor you're distraught. The deposit you held just prior to the announcement yielded, say, 5%, and now it yields just 0%. You'd like to sell it for the durable good, since the return on the durable good (which is composed, say, of expectations of 10% price appreciation) is superior. But investors holding the durable good won't sell to you, simply because the return they require on the 0% deposit must be similar to the return on the durable good they already own. And it isn't.

To convince them to accept your 0% deposit for their good, you must increase its return. You can do this by increasing the expected capital appreciation provided by the deposit. By marking down the current price of the deposit relative to its expected future price, you provide your trading partner with the necessary potential capital appreciation. Whoever buys the deposit can be sure that even though it yields an interest rate of 0%, it will provide a commensurate capital return of 5% or so.

In knocking down the market price of the deposit, you've caused immediate inflation. The purchasing power of money (the deposit) has fallen such that you can't buy as many durable goods with it as you could before. At the same time, you've cleared the stage for future expectations of deflation. That's because in low-balling the offer price for your deposit to attract buyers, you've increased the expected capital appreciation provided by the deposit. You've caused inflation in order to promise deflation.

Maybe the entire process happens immediately. But economists like to divide things into the short and long run. In the short run, all you'll see is inflation as the market gropes for a new and lower clearing price for deposits. At first, perhaps, most investors think that the central bank will only keep rates at 0% for a year and then set them back at their normal rate. But when the next year comes and the bank surprises the market by keeping those rates at zero, once again you'll have to rapidly lower the price of your deposit so as to provide potential deposit buyers with enough capital appreciation to compensate for the disappointing yield on deposits.

This yearly pattern of lowering the price you offer on your deposits continues until the market is no longer surprised by the central bank's intentions to keep rates at 0% for eternity. Only then will the inflation end. Deposits, which by now have been bid down to some terminally low level, will slowly and steadily appreciate. This is the "consistent deflation" that Kocherlakota describes.

There is one interesting caveat here. I started out the example by pointing out that one component of a deposit's return is its liquidity yield. Because the market puts a premium on liquid assets —a liquidity premium, so to say —deposits and other liquid assets can provide lower interest rates than not-so-liquid assets.

But if deposits (or any other money-like object) are constantly plunging in value, they cease to be attractive as medium of exchange. In general, people prefer to transact with relatively stable monies. Thus each time you mark down the deposit's value, its liquidity premium deteriorates as the market searches out for other assets that can serve as better mediums of exchange. With the decline in its liquidity yield, the overall return from holding deposits declines even further. This inferior return can only be compensated by a promise of more capital appreciation ie. yet another fall in today's market price relative to expected future prices. This process feeds on itself as the falling value of a liquid assets renders it less liquid which causes it to fall further in price. At some point, the deposit risks being demonetized.

What comes first? Will the deposits reach a terminally low price from which they commense their rise? Or will they become demonetised and valueless? What about the assets that back deposits... might these provide some lower limit for the price of a deposit, even if it pays 0% loses its entire liquidity premium? Fun questions, but I'll leave those for someone else.


Related blog posts:
Karl Smith here and here, and Andy Harless here.