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This is basically nonsense. You are attributing way too much power to the central bank. Central banks follow the market:

The Fed follows:

The RBA follows:

And the BoC follows:

Scroll down to the table. Look at "Three month bankers' acceptances". Does anyone want to get the data series and make a graph?

"But if the threat is credible, it need never be carried out."

And how many times can the Fed do this before the market believes the threat will not be carried out?

Wait,"credible" is doing the work here. The Fed never has to carry out the threat, and the market always believes the threat will be carried out, because of credibility.

The Guvn'rs are gonna love it.

The Fed is far from credible, and it will not become credible any time soon.

The most credible central banker in the world may well be Trichet. How is that working out?

Richard Nixon's famous "madman" theory of negotiation would be another analogy that would work. If Bernanke wants Fed action to affect AD, he needs to act like he's crazy -- promise to personally print money and give it to beach bums if the QE doesn't work, start dressing flamboyently and appearing at casinos late at night sipping highballs. What he has been doing with every expansionary move is to say, "settle down, the Fed is vigilant and won't permit any inflation," which prevents the expansion from happening.

rpi: the market can anticipate the Bank of Canada's moves for the overnight rate. (Surveys usually get the Bank's next move right). So of course longer rates lead shorter rates. Simple expectations hypothesis.

bob: the threat is conditional: "*If* you don't do X, then I will do Y".

Min: what does the Fed want to happen? It doesn't say. What is it going to do if what it wants to happen doesn't happen? It doesn't say.

Will: That might help. Better yet though, simply define what he means by QE "working" (what's the target he's aiming for?) then announce he will do QE in unlimited quantities for an unlimited time until he hits that target. Even Chuck Norris doesn't go beating people up at random (I think).

How does the bond market fit in with this?

E.g. if there is a risk of higher inflation, you say that the central bank may end up not tightening - if its implicit threat to tighten stabilizes inflation expectations.

But the bond market normally responds negatively to incoming data that indicates actual inflation and inflation risk. In doing so, the bond market itself tightens actual monetary conditions and surely has an effect on inflation expectations by doing that.

So how do you separate the effect of the central bank Chuck Norris from the action of the bond market Alien in the overall result for the stabilization of inflation expectations?

(And the bond market is also supposed to reflect expectations for central bank monetary policy, among other things.)

I'll talk about the US Federal Reserve Bank because that's I think where this topic is geared. It often hints it wants a 1-3% target band but never commits to it explicitly as long-term policy. If inflation of 1-3% is their goal, it's hard to maintain credibility if it's having trouble fulfilling its first mandate right now, never mind its second. In other words the market is already signalling that either the Fed wants deflation or that it's powerless to stop it.

Let's say for argument's sake the Fed did promise to raise inflation to, say, 5% annualized for a period until UE drops to 5%. That would be a change in policy where they explicitly inflation target. The market may move the yield curve up such that medium rates are higher. Long rates would go up but one assumes that they would be lower than medium rates because the inflation rate would be brought down in the long run. But the overnight rate is set at zero and they promised to maintain it there for the next few years. We therefore have a situation of a very steep yield curve at the short end, and an inverted yield curve at the long end.

Or alternatively the market may be unimpressed with the Fed's ability to raise inflation because it thinks it's not credible or possible. What does the Fed do should its bluff be called?

JKH: Let's take an example. Suppose the CPI comes in higher than expected. That suggests the natural rate of interest is higher than people thought it was, at least temporarily (in other words, demand is stronger than people thought it would be, relative to supply). The bond market knows that the BoC will raise nominal interest rates to match the implied increase in the natural rate of interest. It also knows that the higher natural rate may persist for some time. So bond prices fall as yields rise.

Expected inflation is assumed to stay constant in the above story. In reality, since people know that the Bank is always a little behind the curve, due to data lags and decision lags and the Bank not wanting to bring inflation back too quickly, very short term expected inflation may rise. But 2-year ahead expected inflation should stay constant throughout.

jesse: The Fed has to make explicit what it will do until expectations move to where it wants them to move. Unlimited QE, for an unlimited duration. Keep on expanding by buying every asset that is traded. The Fed has very deep pockets.

Here's to hoping the Fed makes this commitment right away.

JKH, could you check my accounting on this post and comment?


Posted by: Too Much Fed | October 14, 2011 at 04:06 PM

Thanks in advance!

"If a central bank wants to keep expected inflation on target, it must threaten to reduce nominal and real interest rates if expected inflation falls below target, in order to make expected inflation rise. But suppose a central bank wants to increase its target rate of inflation. It announces that the new target is 3% inflation. If the central bank is credible, and expected inflation increases to 3%, the central bank must increase the nominal interest rate to prevent the real rate from falling."

1) What if price inflation goes up, but wages don't?

2) If for most products the amount demanded and the amount supplied are equal, should there be any price inflation? What if reduced supply is necessary for the price inflation?

"Thesis. We teach the monetary policy transmission mechanism like this: the central bank pulls a lever, and that lever pulls other levers, which eventually move the target variable in the direction the central bank wants to move."


Boston Fed President Eric Rosengren

"[E]even though residential investment is a small share of GDP (today only 2.2 percent), it is quite interest-sensitive – it can decline quite dramatically as interest rates rise, and expand quickly when interest rates are relatively low. So it has been a disproportionally important part of the monetary policy transmission mechanism."

What happens when policy is lower the central bank overnight interest rate, hope the people running the long bond market follow with lower interest rates, hope people go into currency denominated mortgage debt to increase the amount of medium of exchange and that no longer works?

"At the zero lower bound on nominal interest rates, the standard threat strategy cannot work. It is no longer credible for the central bank to threaten to cut nominal interest rates if expectations don't move to where it wants them to move. It has to threaten to do something else. Like start buying stuff. How much stuff? For how long? That answer is exactly the same as when we are talking about interest rates. As much as is needed for as long as is needed."

I'd rather concentrate on the something else besides buying stuff. Another thing is the "expectations" stuff. What if "expectations" and reality don't match, and it is the "expectations" stuff that is incorrect? It would be like telling someone many years ago the Earth revolves around the Sun.

What if the retirement market is "out of balance" because of medium of exchange problems?

"The Fed has to make explicit what it will do until expectations move to where it wants them to move"

The goal of this, according to the latest I've heard out of the Fed, is to increase inflation until unemployment drops. I see what the Fed is doing as temporary, even if the endgame, should velocity fail to pick up, is to own all assets. Personally I think it`s unlikely it will go that far.

And to be clear, if the Fed holds its overnight rate at zero but threatens/promises 5% inflation in the future, that looks like expropriation from savers and relief to debtors, so say my young eyes. Further, it seems if they start fiddling with the middle part of the curve that could actually increase, not decrease, consumption.

"If that threat is communicated clearly, and believed, the actual amount of QE needed will be negative."

You are assuming that everyone shares your economic theory that QE increases demand. In reality, some people believe in QE and some don't. If the believers don't make up a critical mass, then the CB will have to carry out the threat - and then the result will depend on whether the economic theory is actually correct.

To put it more generally - the potency of a policy intervention depends not only on its forcefulness, but also on the level of uncertainty regarding its efficacy.

Max: what you say is correct. But consider this:

Push it to the limit. First the Fed buys all the short Tbills, then all the long Tbills, then all the state bonds, then all the munis, then all the commercial bonds, then all the stocks, then all the farmland, then all the houses,.... At each point, people are swapping an asset that earns interest for one that does not. At some point, the Fed will have to bid up asset prices to persuade people to part with them, and the prices of the remaining interest-earning assets in private hands will be bid up the remaining stock dwindles, and as people see what's coming next. Some of those assets are reproducible. "Hey, I can hire the unemployed, build some assets, float a company, and the Fed will have to buy the shares at my price, because it's running out of things to buy!"

At what point in this process would you cry "Uncle!", and expect NGDP growth? At what point do you think the people around you would cry "Uncle!"? Remember, the last people to cry "Uncle!" are the suckers, who get hit by Chuck Norris's inflationary roundhouse, holding depreciating cash that pays no interest while the economy recovers. All the others wisely left the room early.

jesse: "I see what the Fed is doing as temporary, even if the endgame, should velocity fail to pick up, is to own all assets. Personally I think it`s unlikely it will go that far."

I think it's very unlikely to go anywhere near that far. Because people can see the endgame, and will want to get out of cash before the endgame, and before everyone else sees the endgame. Because real asset prices rise in the endgame, and rise when people anticipate the endgame.

Fed Statement: "Inflation is 3% instead of 2%. Right now. That's all." I like it.

Nick: "First the Fed buys all the short Tbills, then all the long Tbills, then all the state bonds..."

Whoa! Fed can't lend to the states. And they can't *buy* anything other than treasuries. All they can do is *lend* to particular systemically important actors with credit instruments (not stocks!) as collateral. It's all in the Federal Reserve Act.  Now if you want to amend the act, of course the sky is the limit. But then how about trying helicopter drops, one citizen at a time, before you go running around paying off all the rentiers (again).

Nick, I fear the Fed has too much Chuck Norris ability, too much inflation fighting credibility now. Look at the 10-year inflation forecast. They have barely budged--actually fallen slightly if anything--despite the large run up of the Fed's balance sheet. Thus, the bond market expects the Fed over the long-run to unwind this balance sheet expansion.

This creates two problems. First, the Fed is enamored with its inflation fighting reputation it doesn't want to lose it. Bernanke admitted this some time ago. Second, the Fed may be so good at Chuck Norrising the markets that if it decided to do something like a NGDP level targeting the markets might get a little confused. To use your analogy above, it is like Chuck Norris given the look and everyone knows it is time to leave the front exit (the Fed fuzzy inflation target). Now, Chuck wants everyone to leave the back exit (NGDP level target) and so the old look will not do. It has to be accompanied by a few kicks and punches.

Nick: Given that the Fed open market committee members disagree on what to do, can the Fed act like Chuck Norris? The real Chuck Norris didn't have multiple personalities.

K: fair point. But didn't I read somewhere recently that the Fed could buy municipal bonds? And couldn't the Fed and Treasury do it together (the Fed lends Treasury the money, and it buys stuff)?

The trouble with helicopter drops is that you want to threaten them, but also threaten to reverse them if the target variable overshoots the target, which it definitely will. And it's very hard to reverse them. Helicopter operations are much easier than vacuum cleaner operations. The Fed needs to threaten to move forwards, but actually move backwards once its threat becomes credible.

Jeremy: Yep. I think that's the underlying problem. BoC deputy governors all sing from the same songbook, like choirboys. Fed governors don't. That's the trouble when you don't have a monarchy.

David: Yep. It's like now Chuck Norris wants everyone to go *into* the room, for a change. But, as kindergarten teachers say, "Use your words!".

I think the apt analogy would be Chuck Norris strapping himself with a bomb, and telling everyone if nobody goes for the exits, then he will blow the whole place up. Everybody has to believe that Chuck Norris is willing to blow himself up if people do not follow his intent for them to take to the exits.

PS like the Chuck Norris analogy but we should remember he lost to Bruce Lee in Way of the Dragon.

"A credible central bank is a bit like Chuck Norris."

Very interesting. I did always think it was pretty cool how the BoC could move rates just by speaking.

Mind you, being like Chuck Norris isn't something peculiar to central banks. It's one of the benefits of being a very large fish in the economic system. A company with dominant market share can threaten to lower prices should a competitor choose to enter their market, and this implicit threat - as long as it is credible - prevents competitors from entering. So the dominant firm never has to actually drop prices. We may even see it doing the opposite of what they have threatened; increase prices so as to reap the benefits of their dominant market share.

^ That would happen particularly in markets where the size of the market only allows one firm of optimal size, right? One company ends up with the lowest possible cost, and could credibly undercut any entrant--so any new entrant would have to be prepared to fight a long, bloody battle to unseat the incumbent.

Nick: The Fed has fairly limited authority to purchase muni bonds with maturities under six months in certain murky circumstances. Bernanke has told Congress multiple times he sees this authority as very narrow and essentially inapplicable to large scale monetary operations. The legalities of the Fed and Treasury working together to the same effect are not simple without Congressional action, and the new cooperation-required-plus-legal-abyss reaction function implied by this also doesn't seem simple.

On a more theoretical note, it seems slightly contradictory to rightly focus on the import of the hidden bazooka, but then describe the effect of actually using the bazooka when required without respect to import of the still-hidden rest of the arsenal. That is, if the Fed confused everyone with a cross-eyed Chuck Norris look, and so had to start buying up every last asset to make its point, it still hasn't guaranteed itself credibility. Agents may very rationally predict that the Fed is not a good bet to follow up (or survive long enough to implement) its threat to own every non-money asset (even it had the authority). Or maybe agents believe in the Fed's power and resolve but become convinced that other agents expect the Fed to actually succeed in buying all assets without bidding them up, do resultant damage to the economy, and then have to find a way to immediately redistribute assets to the private sector. And money holdings will be a pretty handy candidate! So does the Fed have to promise to own all the assets and then redistribute them randomly? Is it really the Fed choosing a reaction function that somehow guarantees an equilibrium because everyone knows that it can get it done with its fists anyway, or is it more like the market and the Fed finding some kind of focal point amid the unavoidable possibility of multiple equilibria? After all, this movie is really about Chuck Norris threatening to beat the crap out of all of his individual cells.

Nick: "But didn't I read somewhere recently that the Fed could buy municipal bonds?"

I think they may be able to buy short dated muni commercial paper. But they are prevented by the new Federal Reserve Act from lending to insolvent borrowers so no real beta. 

"And couldn't the Fed and Treasury do it together"

Not obviously. Congress had to approve TARP. But maybe they could structure some kind of vehicle independently. I think the directors of the participating Feds would be extremely wary though, that they'd be structuring vehicles for the direct and only purpose of circumventing an act of congress. 

But if they can find a way to structure a vehicle to buy stocks or crappy corporate bonds or munis surely they could also fund a vehicle that gives cheap 30 yr loans to citizens.

You might be right that it would be easier to circumvent the law in order to give money to corporations than to citizens. But if we are going to use a crisis to undermine democratic institutions, shouldn't we at least try to do the right thing?

As far as undoing helicopter drops goes, the Fed could also take huge losses if it buys stocks. But sure, if the Fed gets heli drops it would be good if it had a vacuum cleaner too. A land tax would be ideal, but a sales tax would work great too.

Chuck Norris doesn't ask economists about the economy- Economists ask Chuck Norris.
I think the challenge is the credibility over time. Sure his threats were credible 25 years ago. Inflation was all over the map, the global financial market was relatively easily understood (at least in terms of financial instruments available to the symphony players) and Chuck was obviously one of the toughest guys around. Today, well Chuck is 71 and he hasn't carried out any threats in recent memory. He might still be strong but does he have the necessary will-power? Can he still deliver the goods? Maybe, maybe not. There are other Tough Guys (including some "buddies" that got knocked down and Chuck picked back up) and some may or may not be interested in what goes on. All of which contributes to a credibility issue.

Even if the Fed wanted to buy some asset not explicitly authorized by the Federal Reserve Act, these laws are very easy to get around these days.


Just incorporate a special purpose vehicle and lend to it via section 13 of the F.R. Act.

JP: Aha! You always know where to find the deep stuff on the rules.

K: "As far as undoing helicopter drops goes, the Fed could also take huge losses if it buys stocks. But sure, if the Fed gets heli drops it would be good if it had a vacuum cleaner too. A land tax would be ideal, but a sales tax would work great too."

1. If NGDP recovers, stocks will rise (in real terms, and moreso in nominal terms. Long bonds are the trickier one.

2. Using a helicopter followed by a tax vacuum cleaner creates all sorts of disincentive and/or distribution effects. Sure, asset purchases may have distributive effects too, but at least exchange is voluntary. Only the people who fail to heed Chuck's warning will get the roundhouse to their cash balances and Tbills.

"a tax vacuum cleaner creates all sorts of disincentive and/or distribution effects"

Land taxes don't create incentives. Consumption taxes impact incentives to consume which may be what you are looking for. None of this is ideal, but this debate is about making crappy patches for a lousy system. If we actually wanted to create a stable, fair and efficient system it wouldn't be that hard, but I don't think that's what we are talking about.

"Sure, asset purchases may have distributive effects too, but at least exchange is voluntary."

It's not the exchange that's wrong. It's the announcement of the intent to exchange. If the the Fed announces a $2Tn purchase of stocks and the stock market rallies by $1Tn then shareholders "voluntarily" accept a $1Tn gift from the Fed? If they announced they were going to buy houses in my neighbourhood I'd voluntarily accept the real-estate appreciation too.

Anyways, somehow I, and every other citizen, ended up guaranteeing bank deposits and apparently the liabilities the entire financial sector. I never volunteered for that. Personally I think we should all be free of each other and I am full of good proposals for how we can achieve that. But if we are handing out little bits of freedom, banks and institutional investors can get in line with the rest of us.


While you are right that the feds have a nice loophole letting them lend to literally a pizza parlor ("[...]section 13(3) of the Federal Reserve Act [...] permits the Federal Reserve Board, in unusual and exigent circumstances, to authorize Reserve Banks to extend credit to individuals, partnerships and corporations that are unable to obtain adequate credit accommodations"), still, lending is not buying -- the loans have to be repaid, and they were at least with two of the five SPVs, not sure about the Maiden Lanes status.

Exactly... those purchases would have been illegal, nothing in the Act permitted them. So the Fed created some dummy corporations to do the purchasing for them, then funded these corporations via perfectly legal 13.3 loans. So did the Fed buy? It can argue it didn't - the corporations did, and it just lent to them.

Who then owns or controls those SPVs?

K: "Land taxes don't create incentives."

Of course they do. You have an incentive to earn the money to pay the taxes.

Andrew F: They probably aren't corporations. When banks structure these things often they are trusts which means they don't have an "owner". They have a beneficiary (who is probably irrelevant) and an administrator who is appointed by whoever set up the trust, e.g. the NY Fed. Then they have debts and possibly contracts designed to mop up remaining cash (if any) at the end and pay it to somebody (e.g. the NY Fed). Often the person setting up the trust (NY Fed) can't be the beneficiary or the law might not recognize the trust as an independent arms length person. So sometimes a charity or some other party is designated as beneficiary but contracts ensure that they will never get a penny. That would not be an unusual way to do it, but I have no knowledge as to how the Fed did it in the past (PPIP, TALF, etc.).

The only relevant point is, the lawyers find a way.

Min: "Of course they do. You have an incentive to earn the money to pay the taxes."

If depends what you hold equal. Wealth being equal, a tax on unimproved land value doesn't impact incentives. Lets say you impose a tax equal to the risk free rate on the value of land. Then the sale value of the land drops to zero. If you don't compensate the owner for the loss, then they'll feel "incentivized" to get to work. But if you compensate them then they have money that can earn exactly the return needed to pay the land tax (until the land value changes). The existence of the land tax doesn't change the optimal use of the land (as everyone knows) and therefore doesn't change the owners incentives. With compensation it doesn't change their desire to work either.

Hold on, JP, the SPVs were mere conduits created for presumably liability avoidance purposes, but the feds lending was specifically targeted at concrete entities. Therefore, one cannot say that the SPVs *bought* impaired assets with funds lent by the feds. The feds lent through SPVs to say AIG, and AIG had/has to repay to the Feds, although through the Maiden Lanes.

It is not as if the feds lent to the shell companies that had total freedom to do anything they wanted with the borrowed funds. That would be truly remarkable.

However, that is not the case yet.


It is not altogether clear why the feds decided to set up SPVs in order to lend to the entities they deemed "important".

The usual purpose of setting up an SPV is credit enhancement through securitization, e.g. rather than issue corporate bonds rated BBB, the company may "sponsor" an SPV with assets having higher rating. Another consideration may be shielding SPV investors (those who buy securitized paper) from the sponsor bankruptcy, but that one has not been thouroughly tested in courts yet.

It does not appear that the Maiden Lane SPVs were set up for any of those purposes, so the reason may have been just to use the tools those folks are most familiar with, a kind of brokerage to manage funds flows, not really sure.

Excellent post. Much better than my metaphor of a shy guy at a party having to work much harder than an outgoing person. "Just do it."

Moi: "Of course they do. You have an incentive to earn the money to pay the taxes."

K: "If depends what you hold equal."

If it does, then you have violated the rational expectations of language usage. ;)


Joking aside, people generally regard tax as a loss, and regard losses in a different light from gains. They are generally more willing to work to avoid a loss of $X than to make a gain of $X, ceteris paribus. :)

"The feds lent through SPVs to say AIG, and AIG had/has to repay to the Feds, although through the Maiden Lanes."

The Maiden Lanes, CPFF, and TALF didn't lend, they bought assets outright (from AIG and others). AIG didn't have to pay back the Maiden Lanes; the issuers of the assets purchased by the Maiden Lanes had to pay them back. You can see here, for instance, a list of Maiden Land I debtors.


Some names on the list... Hilton, MBIA, Fannie etc.


I revisited the Lanes info I collected in 2009, and I believe you are quite right. The main(sole ?) purpose of establishing the shell LLCs was to circumvent the FRA prohibition on buying certain assets (e.g. RMBSs).

In my opinion, the feds overstepped the FRA boundaries by formally structuring the essentially prohibited asset purchases as loans. Most likely, given political will, the shell companies would *not* have stood the legality test in courts.

Now, the F-D act curtailed the 13(3) power somewhat, so at least theoretically it'll be 'impossible' to manufacture lane clones any more. See http://www.skadden.com/Cimages/siteFile/Skadden_Insights_Special_Edition_Dodd-Frank_Act1.pdf, Page 15.

In its fight against the flight into the Franc, the Swiss National Bank took two steps to lower the value of the currency vis a vis the Euro (and other currencies). The first step was to lower rates to near 0 in the hope that that would discourage foreign savers from pouring in. Absolutely nothing happened. The Franc neither moved up nor down beyond the scope of any normal daily fluctuations.

Then came the second step. Because the first didn't work, they announced that they would lower the value of the Franc against the Euro and keep it at max. Fr.1.20/Euro by promising to buy any amount of Euros in the market to achieve that goal. This worked immediately and has been spot on ever since.

Now, according to my reading of your post, both acts were 'Chuck Norris' moves (although I'm not sure that's true - I don't know how many bonds or Euros the SNB has had to buy to keep its promises). But, assuming for a moment that they were, the fact remains: only the second worked.

So my first question to you is, why?

My second question is, are both moves 'monetary' policy by your definition?

And my third question is:

You speak of equlibrium. To what extent must the anticipated goal (moving interest or exchange rates) be reflective of any real world number (whether measurable or not) to be (remain in) such an 'equilibrium'? Would it, say, be achievable in your opinion, for the SNB to maintain an exchange rate of Fr. 2.00* / Euro? Or 2.50*? That seems to be what the Chinese have been doing successfully for quite some time. How large is the band-width of possible equilibria and of what consequence, other than forcing central banks to apply common sense and fiat power, is it to their decision making?

* PPP with its Euro neighbors is said to be at around Fr.1.40 - 1.60/Euro

I should have said common sense or fiat power...

Oliver: interesting.

Both moves were monetary.

The standard answer to your second question is that a central bank can target any nominal variable (with $ in the units) at any level it chooses, but cannot target any real variable (without $ in the units). So it can target the nominal price of apples, or the nominal exchange rate.

Nick: At each point, people are swapping an asset that earns interest for one that does not.

You know that it is wrong but keep on saying this. Central bank can not purchase deposits at commercial banks and deposits at commercial banks do pay interest. Even demand deposits can pay interest.

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