In my last post, I argued that bank reserves, if they pay interest, are essentially a form of government debt. They’re issued by a different institution and have a different maturity than most government debt, but in their essential nature, they’re just a special case of government debt.
In that post, I was agnostic about whether bank reserves should be considered “money.” If bank reserves are government debt, then, to be consistent, we should either consider all government debt to be money or consider bank reserves to be something other than money. In particular, Ben Bernanke’s use of the phrase “printing money” is consistent if you consider all government debt to be money, in which case QE2 only exchanges zero-maturity money for high-maturity money whereas QE1 exchanges money for private sector assets. If you take the second option, however, then neither QE1 nor QE2 was “printing money.”
I want to explore that second option, which seems pretty reasonable in terms of the way I learned liquidity preference theory in school. In the simplest version of liquidity preference theory, money (1) pays no interest and (2) is controlled by policymakers. Obviously bank reserves no longer meet the first criterion, and bank deposits (as we learned painfully during the policy experiment of the early 1980’s) do not meet the second criterion. I’m increasingly coming to believe that the most reasonable definition of “money” is simply “cash” (negotiable central bank notes plus coins).
But the Fed does not attempt to control the supply of cash. Banks can withdraw reserves from the Fed, or deposit them, whenever they choose, and the Fed will normally compensate for aggregate net withdrawals or deposits by adjusting the total level of reserves to bring it back to where it was before the net withdrawals or deposits took place. Moreover, the amount of cash outstanding, as determined by the demand for cash, is not a significant factor in the setting of Fed policy. If “money” simply means cash, then the Fed’s “monetary policy” is unlimited accommodation. And moreover, nobody cares, or should care, about how this policy is going. For practical purposes, there is no such thing as monetary policy.
The Fed does do something active, and they call it monetary policy. But what is it really? The Fed does several things that usually come under the heading of monetary policy, but they can all be reasonably classified as something else. For one thing, it manages the level of bank reserves through open market operations. But this is really government finance policy, not monetary policy: it consists of substituting zero-maturity government debt (bank reserves) for higher maturity government debt (Treasury securities), or vice versa.
The Fed also sets the interest rate on reserves. This is also government finance policy. Suppose that, instead of auctioning off fixed quantities of securities, the Treasury were to sell as much as it could at a given interest rate and leave any excess cash in a vault. If we’re talking about, say, one-month T-bills, which have only slightly higher maturity than bank reserves, then the effect would be essentially the same as when the Fed sets the interest rate on reserves. (In particular, imagine that, starting from today’s near-zero interest rates, the Treasury were to start selling T-bills with a fixed 1% yield. That would be just like an increase on the interest rate on reserves, except that others besides banks could participate. That difference is really irrelevant except for the arbitrage opportunity provided to banks when the IOR rate exceeds the T-bill rate. If the IOR rate were to rise, banks – being in competition with one another for funds – would have an incentive to let others participate indirectly.)
Granted, this doesn’t work in reverse: the Treasury needs to borrow a certain minimum amount to finance its expenditures, so it can’t set an arbitrarily low interest rate. But it doesn’t work in reverse for bank reserves either. If the Fed sets the IOR rate far below the T-bill rate, it becomes irrelevant: banks will simply hold, for emergency purposes, a tiny amount of reserves over and above what is required, and the rest of their reserve assets they will hold as T-bills, which can easily be sold or repoed for federal funds if necessary.
The Fed also sets the reserve requirement, thereby compelling a demand for reserves, but this is not monetary policy either; it is regulatory policy. There is a regulation that requires banks to hold a certain quantity (set by the Fed) of zero-maturity government debt (reserves). There are other regulations that effectively require banks to hold certain quantities of more broadly defined safe assets to satisfy capital requirements. All these regulations create an increased demand for government debt; it’s only the maturity of the debt that is different. To the extent that such policies are used for macroeconomic demand management, they are essentially a form of taxation: the Fed can pay a lower rate of IOR than it otherwise would because it is compelling banks to hold reserves instead of using the money for profitable activities; it could achieve the same effect by raising IOR until those activities are no longer profitable (in risk-adjusted opportunity cost terms) and taxing the banks an amount equal to the difference in the interest they pay. To the extent that regulatory policy is used for macroeconomic demand management, it is just a form of fiscal policy.
Finally, the Fed lends (or purchases the assets from those who have lent) to the private sector, via its discount window, via various emergency programs in times of crisis, and in particular via QE1. But this isn’t monetary policy; it’s fiscal policy. It’s no different than what the TARP did: an exchange of government debt for private debt. Anything the Fed does through such programs could also be done by the Treasury, which could issue T-bills to obtain funding, and it would surely be considered fiscal policy. The Fed issues bank reserves instead of T-bills: a slight difference of maturity, not a fundamental difference of substance.
So there you have it: there is no such thing as monetary policy. There is “central bank directed stabilization policy,” and, for convenience, you can refer to that as monetary policy if you want. If so, recognize that you are using the term loosely, and let’s not get into arguments about whether some particular Fed action is “really” monetary policy. None of it is really monetary policy.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.