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Friday, October 29, 2010

Cash down a rat hole.


ArmChairEconomist said...

Could you please help my understanding regarding one thing related to the current crisis?

A) The Fed has engaged in a large and unprecedented expansion of their balance sheet, and is expected to engage in QE2 soon. Presumably the Fed has done so to induce bank lending.

B) Additionally, the Fed has engaged in another unprecedented move of paying interest on bank reserves. Presumably this is to avoid a massive proportionate expansion in various monetary aggregates (M1, M2, etc) and thus, inflation.

To me, it seems as if moves A) & B) by the Fed in effect counteract one another: increase MB via QE to induce lending while simultaneously paying interest on reserves which will reduce lending.

What am i missing?

Randall Parker said...

Hi Armie: I do not think you are missing anything as these two do indeed work in opposite directions. But let me offer some observations. 1) The QE seems to me to be much larger in its impact than what the interest on reserves is. I view the interest on reserves as a tool that could be used if needed when a recovery commences to stop a sudden flight of reserves into money. The downside there is the political reaction to the Fed paying banks billions for idle balances if the rate were raised from its current low level. 2) If $1.5 trillion wasn't enough to get banks lending, then how much is enough? I don't necessarily view QEII to promote bank lending. I view QEII two ways. First, if you recall the graph on my blog from October 22, our price level is mimicking the Japanese experience and we cannot permit that to happen. Deflation must be avoided and fought root and branch. QEII is an attempt to generate some mild inflation and get the inflation rate to stay in the positive range about 2% or so. This would be a good thing and also would lower real interest rates for a time. Indeed I think the TIPS spread has already jumped a bit. So I have never bought the "liquidity trap" argument. 3) I have heard James Hamilton discuss estimates he has made that suggest a $400 billion purchase of 10 year Treasuries by the Fed would lower the 10 year rate by 14 basis points. That does not seem like a lot to me. So I think the Fed is doing whatever they can right now and not worrying about excessive inflation given all the excess capacity in the economy. I worry that there will be another commodity bubble with the new cash and that once you let the inflation genie out of the bottle, can you really control inflation as precisely as they seem to suggest or is this hubris? Allan Meltzer thinks it is hubris and is convinced we are going back to "that 70s show." I worry he is right and fear the Fed has done all they can, except if there were to be another crisis period. I am more of the opinion that our problems are fiscally related and those are political and have no solution in sight.

ArmChairEconomist said...

Thanks for the thorough reply professor. And that explanation makes sense.

You claim that you "don't necessarily view QEII to promote bank lending". However, isn't an increase in bank lending required for QEII to "generate some mild inflation and get the inflation rate to stay in the positive range about 2% or so"?

Randall Parker said...

Hi Armie: Yes bank lending would be the most direct route. But remember anything a bank does with excess reserves other than lend them to other banks will create more money as reserves will then be converted into deposits and/or currency.