Monetary policy must find the path for the greatest economic growth with low inflation and moderate long-term interest rates. This framework suggests the excess supply of bank reserves causes the natural rate to go 0%, quantitative easing protects against deflation and once deflation is no longer a problem, the Central Bank can unwind its balance sheet with a yield curve anchored at 0%. This enables the Central Bank to normalize its balance sheet to prepare for the next financial crisis without causing a taper tantrum.
Without central bank intervention, when the supply of cash is greater than demand, commercial banks compete to lend out their excess reserves causing the interest rate to fall to 0%. When cash trades near 0%, a small move in monetary policy has a huge impact, and at 0%, a near-infinite amount of capital can be created. When the supply of cash is greater than demand, this lack of demand keeps inflationary pressures at a minimum, as was the case in the Great Depression when inflation never went above 2%. When central banks allow interest rates on cash to naturally trade at 0%, this cheap capital stimulates the economy until demand picks up again and interest rates naturally rise.
Contents
Introduction
For the first time since the Great Depression, the supply of cash is greater than demand. To deal with the excess bank reserves the global central banks chose opposite strategies for monetary policy and this white paper was written to outline a third strategy, the only strategy with the mathematics to support it. The Federal Reserve chose with congressional approval, to pay interest on the excess bank reserves, currently at $15 billion per year, from the interest it receives on its $4 trillion balance sheet, to put a floor on interest rates in the name of normalization. The Bank of Japan and European Central Bank chose to charge interest on excess bank reserves to penalize banks for holding cash causing negative interest rates.
When there is an over supply of excess bank reserves, why do the central banks want to move interest rates on cash when they are naturally at 0%? Have the central banks not yet replaced their old domestic economic models or have they implemented policy, where the means justify the end results? Either way, monetary policy must be grounded in the mathematics and the laws of behavior for interest rates or run the risk of harming the economy or even worse creating asset bubbles.
The global monetary policy outlined in this paper is supported by the economic models discussed below ruled by the behavior of interest rates and excess bank reserves and the mathematics to graph it. When excess bank reserves are greater than 0, currently at $2 trillion, commercial banks compete to lend out their excess cash and the interest rate paid for cash naturally goes to 0%. The downward pressure on interest rates continues until excess bank reserves are used up and are in a supply and demand equilibrium at 0, less than $3 billion. Excess bank reserves can never go below 0 because commercial banks by law must meet their minimum regulatory reserve requirements. If reserves are needed, the bank must entice other banks to lend them cash and if excess bank reserves are near 0 this demand drives interest rates higher. This equilibrium of excess bank reserves at 0 establishes the level of interest rates based on current demand for cash and inflationary expectations. In this equilibrium, the central banks are most effective at influencing interest rates without the need of a large balance sheet.
In sum, the global monetary policy outlined in this paper would let the interest rate paid on cash naturally be 0% and would wait until demand for excess bank reserves are in equilibrium with supply to naturally drive interest rates higher. By waiting until excess bank reserves are at an equilibrium of 0 enables the economy to benefit from cheap capital until demand and inflation picks up again. The only tightening that would be done in the name of normalization, and to widen the yield curve to further support the banking system, is the unwinding of the central bank's balance sheet after a quantitative easing to be prepared for the next financial crisis.
Central banks embody the trust and stability for the banking system and the local currency. They are battling deflation coming from global competition for good jobs, increased productivity from technology and the lack of demand for capital. They are challenged by fiscal policy that has been running historic deficits to maintain entitlement programs without the adequate tax revenue to finance them and must find the path for the greatest economic growth with low inflation and moderate long-term interest rates.
The isolated domestic economic models created in the 19th and 20th century are no longer relevant in a competitive global marketplace. In a global economy, full employment is no longer inflationary, as there is always someone willing to do the job cheaper but rather it is the demand for capital that reflects inflationary expectations. In 2009, for the first time in modern history, we have witnessed how interest rates for cash naturally go to 0%, when the supply of cash is greater than the demand, and we have witnessed the nonlinear impact of a change in interest rates off of 0%.
Before 2009, the laws of behavior for interest rates have always been experienced from one side. The supply of excess bank reserves have always been in an equilibrium with demand at 0 and interest rates have always been greater than 0%, typically above 3%. The old economic models have caused the central banks to believe the impact of monetary policy is linear, full employment is inflationary and negative interest rates are not deflationary. They have ignored the Natural Equilibrium of Interest Rates and how it relates to excess bank reserves and the Federal Reserve believes in a so-called "neutral" rate without the mathematics to calculate it. All believe in quantitative easing but none have the strategy to unwind it, other let it mature one day far into the future. This white paper does outline the strategy for unwinding quantitative easing by letting short term interest rates naturally go to 0% and selling off the balance sheet causing the yield curve to widen further supporting the banking system and consumer credit.
After 2009, we experienced both sides of the equilibrium so now we can mathematically model the behavior of interest rates and the impact of monetary policy. We can show, when the supply of bank reserves is greater than demand the interest rate paid naturally goes to 0%, and a small move in interest rates at near 0% has a huge impact and negative interest rates are deflationary. The Natural Equilibrium of Interest Rates models the rate paid for cash given the supply and demand of excess bank reserves. This enables the central banks to know where interest rates would naturally be without intervention. The Impact of Monetary Policy models the impact of a change in interest rates and this enables the central banks to quantify the impact of either a tightening or an easing.
In the limit function for Interest Rates, X is the supply of excess bank reserves and Y is interest rates. The top half of the Interest Rates limit function, where supply is greater than demand for excess bank reserves is 0 because banks compete to lend out their excess reserves driving interest rates to 0% and banks would never pay interest on reserves to lend them out so they would never go negative. This has been the experience since 2009, until the central banks artificially manipulated the interest rate on excess bank reserves where the Fed paid interest on reserves to raise rates and the BOJ and ECB charged interest on reserves to drive rates negative. Therefore without central bank manipulation interest rates on excess bank reserves would naturally be 0%. The bottom half of the Interest Rates limit function experienced prior to 2009, where demand is greater supply, so when x is negative f(x) multiplied by -x results in a positive y where y is positive interest rates. Prior to 2009, interest rates have always been positive when demand was greater than supply and excess bank reserves were 0.
The limit function for excess bank reserves is straightforward in that the outcome is a function of bank regulations where X represents supply vs demand and Y represents excess bank reserves. The top half of the limit function for excess bank reserves is when supply is greater than demand so when X > 0 f(x) = x, the quantity of excess supply of bank reserves. The bottom half of the function is by law kept at 0 because when demand is greater than supply, banks must borrow reserves to meet their minimum requirements causing excess bank reserves to never go negative. In fact, when you look at the actual graph of excess bank reserves since 1960, they have been at 0 until 2009.
interest rates ≥ 0% when excess bank reserves = 0
Central banks are battling deflation coming from global competition for good jobs, increased productivity from technology and the lack of demand for capital. The graph to the right shows US productivity growth and median family income over the past 65 years. The chart suggests that US productivity will continue while US wages remain weak. The chart also shows wages decoupling from productivity in the early 80s, when the US economy opened up globally, starting with Japan and the auto industry. In effect since the early 80s, the US worker has been forced to compete against lower global wages.
The empirical evidence demonstrates globalization is deflationary, even in the face of a weakening currency.
The advanced economies in Asia, Europe and the Americas are faced with deflationary pressures and have governments with historically high debt.
In short, the only stimulative capital available to these economies is from their central banks.
Near-zero monetary policy provides the tools and the impact needed to stimulate these diverse economies while maintaining control over inflation.
Leading up to 1980, US inflation grew and interest rates rose as the price of oil grew 10 fold as the purchasing power of US consumers rose. The rising purchasing power of the US consumer came from women joining the workforce and the securitization of the mortgage market. During this period, this rising purchasing power competed for limited domestic products that drove inflation and interest rates to historic highs. Interest rates peaked in the early 80’s as the US economy began to open up globally. The period from 1984 to 2007 was driven by globalization, the increase in worker productivity and the refinancing of the mortgage market as interest rates went down to historic lows.
Since the Federal Reserve had never tightened when the Fed Funds rate was at 0%, and there was no empirical evidence to suggest otherwise, the Federal Reserve expected the impact of their monetary policy to be linear, much like the times when the Fed Funds rate was higher. The equation above demonstrates the Federal Reserve was right to expect the effects of monetary policy to be linear, but only if the Fed Funds rate was above 3%. By contrast, when the Fed Funds rate are near-zero, the impact of monetary policy is nonlinear and the effect of a 25 basis point tightening is quite substantial.
Early January 2016, the global financial markets gave us the empirical evidence that the impact of monetary policy is nonlinear. There were three forces putting pressure on global asset prices, the first was the US Federal Reserve tightening, the second was weakening oil prices and third was the People’s Bank of China weakening their currency. In the first two weeks in January, all asset classes sold off very quickly and the Dow Jones Industrial average lost over 2000 points and 11% of its value. The speed and intensity of the global market sell-off in early January in all asset classes was due to forced selling of investments made with leveraged capital.
For the government and the country, the ideal situation is for all its citizens to be productive, healthy and educated. The triad of governmental policy responsible for productivity are fiscal, monetary and regulatory which are charged with economic growth for the country. Monetary policy is charged with maximizing employment, stabilizing prices, and moderating long-term interest rates. Maximum employment in a global economy is far greater than what is currently being achieved as the historically low participation rate would suggest. In the past, employment in an isolated domestic ecomomy was a finite resource and demand for capital was always greater than supply. Excess bank reserves were in a supply and demand equilibrium of 0 and there was always a concern for inflation. However, when everyone is competing for a good job globally and the supply is greater than demand for capital, the central banks should be concerned about deflation. While the supply of excess bank reserves is greater than demand, short-term interest rates will naturally be at 0% and long-term interest can be kept low with the yield curve anchored at 0%.
The challenge for monetary policy is fiscal policy has been running historic deficits to maintain entitlement programs without the adequate tax revenue to finance them. Historic high deficits are unsustainable so the government must find ways to make it citizens more productive to generate more tax revenue. Monetary policy must find the path for the greatest economic growth with 2% inflation and moderate long-term interest rates.
Current Federal Reserve Policy
The Federal Reserve Act of 1913 was passed to create a government bank able to provide capital to the private banking system during a time of crisis. The Federal Reserve employed quantitative easing during the financial crisis to provide liquidity and be the buyer of last resort. During this period the Federal Reserve's balance sheet grew to over $4 trillion with 35% of the US debt past 5 years with no discussion of unwinding to prepare for the next crisis.
After the Fed raised interest rates in December of 2015, many on the Federal Open Market Committee (FOMC) believed that the Fed would tighten another 4 times in 2016. These FOMC members would have been right, if current interest rates were at 3%. These FOMC members still believe the Impact of Monetary Policy is linear and do not recognize their 25bp tightening at 0% was equivalent to 5 tightenings of 25bp, if current interest rates were at 3%. Some of the FOMC members still refer to economist and domestic economic models from the 19th and 20th century. The old domestic models saw employment as a finite resource so as the economy reached full employment inflationary pressures increased, as referred by economist as the Phillips Curve. What these domestic model do not recognize is the infinite resource of employment in a global economy. Consequently, many on the FOMC are concerned about full employment and believe interest rates should be higher to combat future inflation.
After the financial crisis, the FOMC became very aware they did not have the tools to raise short term interest rates without a large balance sheet because for the first time ever excess bank reserves was no longer in an equilibrium at 0 but in fact over $2 trillion. The Federal Reserve sought congressional approval to use the interest it receives on its $4 trillion balance sheet to pay interest on the $2 trillion of excess bank reserves to raise short interest rates. Every 0.25% is $5 billion a year in interest with $2 trillion in excess bank reserves. If the Fed did not have such a large balance sheet from the last quantitative easing, the Fed could not afford to pay interest on the excess bank reserves and short term interest rates would naturally be at 0%. The arrogance of bankers is to believe they have control over the markets rather than recognizing markets are a force of nature that have their own laws of behavior.
Current Federal Reserve policy has been rooted in old domestic economic models that predict inflation with full employment. The media has perpetuated the idea the Federal Reserve is artificially holding interest rates down when in fact they are holding them up. The Federal Reserve currently raises rates by paying interest on the excess bank reserves from interest it receives on its $4 trillion balance sheet. By using the Fed balance sheet to raise rates, the Federal Reserve runs the risk of slowing the US economy down by causing interest rates to be higher than they naturally would be and underminding the Trump administration's fiscal policy.
It should be noted, if the Fed chooses not to unwind their balance sheet, they will not have "unlimited" capital for the next financial crisis to stabilize the markets.
When the supply of excess bank reserves is greater than demand the Natural Equilibrium of Interest Rates causes fed funds to settle at 0%. The Federal Reserve can not affect this equilibrium unless it pays interest or charges interest on excess bank reserves. Congress gave the Federal Reserve the authority to use its balance sheet to pay interest on excess bank reserves. What the Federal Reserve has done is create artificial demand for bank reserves to drive fed funds to 0.25% - 0.50% in the name of normalization. Because the Impact of Monetary Policy is non-linear near 0%, any artificial tightening slows down the economy prematurely. The Natural Equilibrium of Interest Rates will cause fed funds to naturally settle at 0% until demand picks up and the supply of excess bank reserves approaches 0 again. Once in a supply and demand equilibrium of 0 for excess bank reserves, the interest rates paid will reflect the demand for cash and inflationary expectations.
The Impact of Monetary Policy is quantified as the delta change in interest rates divided by interest rates (ΔIR/IR) which is non-linear and a vertical asymptote at 0% so a small move in interest rates when rates are near-zero has a large impact. In short, the impact of a 5 basis point move near-zero is equivalent to a 25 basis point move when interest rates are at 1.25% and two times more impactful than when interest rates are at 3%. This enables the Federal Reserve to micro-adjust monetary policy, and at 0%, the Federal Reserve is most effective at supporting the U.S. economy when there is an over supply of excess bank reserves. Not until there is an equilibrium again at 0 between supply and demand for excess bank reserves will we see inflationary pressures. Once excess bank reserves are at 0, the natural equilibrium of interest rates will cause fed funds to rise to compensate for inflation.
Quantitative Monetary Policy enables central banks to have "unlimited capital" at their disposal but any quantitative capital added to the central bank's balance sheet must be removed in a timely manner to be prepared for the next crisis. When the central bank begins quantitative tightening short term rates are naturally at 0% and at the end of quantitative easing the sale of bonds widens the yield curve which further supports the banking system. The wider the yield curve gets the greater the profits are for the banks as they borrow short term to lend long term. Not until excess bank reserves are at a supply and demand equilbrium of 0 will we see short term rates rise as the natural equilibrium drives interest rates higher as demand increases pricing in the implied inflation rate.
