The following is an excellent excerpt from the book “AFTER THE MUSIC STOPPED: The Financial Crisis, The Response, and The Work Ahead” by Alan S. Blinder from Chapter 9 “The Attack on The Spreads” on page 243 and Chapter 11 “Watching a Sausage Being Made” on page 313 and I quote: “Unconventional Monetary Policy: A Quick Tour – Conventional monetary policy consists of raising or lowering the federal funds rate (a virtually riskless rate) in order to manage the state of aggregate demand. Normally, the Federal Reserve does this by selling or buying Treasury securities (which are riskless) in the open market. Anything else the central bank does, including any of a variety of quantitative easing policies, can be considered unconventional monetary policy. And the Federal Reserve has done plenty that’s unconventional since 2008.
When would a central bank resort to unconventional monetary policy? Mainly when its scope for conventional monetary policy is (or is nearly) exhausted; that is, when the policy interest rate gets close to zero. Unconventional monetary policy can be complicated, but its goals are simple. They might be (a) stimulating aggregate demand; (b) repairing the wounded financial system, and so restoring aggregate demand; or © combating a financial panic, and thereby limiting the damage to aggregate demand. Do you see a pattern there?
Since unconventional monetary policy is anything that is not conventional, it comes in a virtually infinite variety of shapes and sizes. Which ones did the Fed deploy and why? And which ones has the Fed resisted?
Make a Verbal Commitment – Perhaps the simplest unconventional monetary policy is making a verbal commitment to keep short-term interest rates low for a protracted period of time. Other than uttering a few words, the central bank doesn’t do a thing; the market does all the work for it. Remember the basic idea: By promising to hold the federal funds rate low for a long while, the Fed can push down intermediate- and longer-term interest rates because these longer rates reflect expectations of where the funds rate is headed in the future. For example, in September 2012, the Fed committed itself to maintaining a superlow federal funds rate “at least through mid-2015.” Just saying that pushed down longer-term interest rates.
Here’s a simple example of how such a policy works. Suppose the Fed wants to drive the two-year interest rate down to 1 percent. It may be able to accomplish that by pledging to hold the overnight interest rate (the federal funds rate) at 1 percent for at least two years. If the pledge is believed, an investment strategy of purchasing federal funds 730 days in a row would be expected to yield a 1 percent annualized return. That should also be the expected annualized return on a different investment strategy: buying a 2-year Treasury bond and holding it to maturity. In that way, verbal commitments by the Fed—as long as they are believed—can push down long- and medium-term interest rates.
The Fed employed such verbal commitments both during and after the crisis. As mentioned in the previous chapter, the FOMC promised to hold the federal funds rate in the 0-to-25-basis-points range “for some time” in December 2008, changing those words to “for an extended period” three months later. The FOMC then stuck with that phrase until August 2011, when it replaced the vague “extended period” language (how long was that?) with a more precise commitment to hold the current federal funds rate “at least through mid-2013.” That decision marked a major departure from previous Fed practice because it virtually tied the FOMC’s hands for nearly two years—a commitment that a number of FOMC members found objectionable. [Footnote: The vote was 7 in favor, 3 opposed. Such a wide split is highly unusual on the consensus-bound FOMC.] In September 2012, it stretched its commitment into mid-2015. All these cases had the same purpose: to push intermediate-term interest rates down.
Notice that a successful verbal commitment relies on two key ingredients: First, the Fed’s pledge must be believed. Second, the expectations theory of the term structure—which holds that long rates are averages of expected overnight rates—must be approximately true. That’s where the bad news comes in: Mountains of empirical evidence show that the expectations theory, though logical, works poorly in practice. It looks like a weak reed on which to stand. That said, it seemed to work pretty well in 2009, 2011, and 2012.
Raise the Inflation Target – A very different sort of unconventional monetary policy, suggested years ago by Paul Krugman for Japan and more recently Ken Rogoff (and Krugman again) for the United States, is to raise the central bank’s target inflation rate. The idea here is that real interest rates, not nominal interest rates, matter most for spending decisions. Since the real interest rate is the nominal interest rate minus the expected rate of inflation, higher expected inflation should lead to lower real interest rates.
Unlike other unconventional monetary policies, posting a higher central bank inflation to shift the whole structure to work on spreads at all. Rather, it is supposed to shift the whole structure of real interest rates down. Here’s a realistic example: Suppose the federal funds rate is stuck at zero and expected inflation is 2 percent, as is roughly true today. Then the real fed funds rate is minus 2 percent, and it can’t be pushed any lower because the nominal fed funds rate cannot drop below zero. But if the Fed could convince market participants to expect 4 percent inflation instead, the real rate would drop to minus 3 percent.
This makes sense in theory. But the idea gets nothing but Bronx cheers from actual central bankers, who are allergic to declaring their affection for higher inflation, even if the love affair is only temporary. Would markets believe it was temporary? Besides, it may be difficult for a central bank to deliver higher inflation when its economy is depressed. In fact, one reaction to Krugman’s suggestion for Japan back in 1998 was, How in the world can the Bank of Japan (BOJ) make a credible promise to create 4 percent inflation? In fact, it has been hard-pressed to achieve even 1 percent inflation. Neither the BOJ in 1999-2000 nor the Fed in 2011-2012 was receptive to the suggestion that it post a higher inflation target.
Reduce the Interest Rate Paid on Reserves – A third form of unconventional monetary policy is to reduce the interest rate that the Fed pays banks on their excess reserves—perhaps even to a negative number, which would amount to charging a fee for holding excess reserves. This option requires some explaining, starting with some vocabulary. (Sorry!)
Banks hold reserve balances—essentially, checking accounts—at the Fed. These checking accounts represent idle cash, which, these days, earn banks 25 basis points per annum. Some of this idle money sits there because the Fed requires banks to hold reserves equal to 10 percent of their customers’ transactions deposits. So, for example, when you deposit $1,000 into your checking account, the law forces your bank to add $100 to its reserve account at the Fed. Any reserves that banks hold above those legal requirements are called excess reserves, and in normal times banks keep excess reserves close to zero. But the period since Lehman Day has been anything but normal. Banks have built up a veritable mountain of excess reserves, as is clear from figure 9.3. It shows that excess reserves were negligible prior to the Lehman bankruptcy and then exploded.
Economics 101 students learn that additional bank reserves support a multiple expansion of the money supply, which in turn supports a multiple expansion of bank lending. Had that happened after September 2008, lending would have skyrocketed. But it didn’t. Instead, excess reserves just sat there rather than being put to work creating money and credit. And that’s where the idea of lowering the interest rate paid on excess reserves comes in. It stands to reason that if the Fed makes holding excess reserves less attractive, banks will hold fewer of them. That, in turn, should push some idle reserves out of banks, thereby creating more money and credit. Paying a lower interest rate on excess reserves wouldn’t directly lower spreads. But if the economy improves, spreads should fall across the board.
To date, the Federal Reserve has rejected this option. It offers two main reasons. (I can be definitive on this point because I have argued for this policy over and over with FOMC members, unsuccessfully so far.) One is their belief that lowering the interest rate on excess reserves is a weak policy instrument. Maybe so. But that’s not really an argument against it, because none of the Fed’s remaining weapons pack much punch, either. Besides, several fed spokesmen, from Chairman Bernanke on down, have repeatedly emphasized the importance of raising the interest rate on reserves as a tool for inducing banks to hang on to excess reserves. Why, then, isn’t lowering that interest rate an effective way to induce banks to shed them?
The second argument is that ending interest on reserves would decimate the money market mutual fund industry. Why? Because much of the money fleeing banks’ reserve accounts would be invested in the safest, most liquid assets available, such as T-bills, thereby driving their rates down to zero. Since it costs a few basis points to run a money market mutual fund, those funds and other similar arrangements might be put out of business if T-bill rates went to zero. This argument once sounded more cogent than it has since T-bill rates fell to essentially zero, anyway. Somehow, the money market funds have survived.”
Page 313 – “Derivatives and the Lincoln Bill – That’s not Abe, but Blanche . Blanche Lincoln was then a Democratic senator from Louisiana not known for Left-leaning views. However, she found herself in a serious primary fight with a challenger from the Left, the state’s lieutenant governor, Bill Halter. [Footnote: Lincoln successfully fended off Halter’s primary challenge but then lost her seat in the2010 election.] Lincoln also happened to be chair of the Senate Committee on Agriculture, which, you may recall, has jurisdiction over the CFTC [Commodity Futures Trading Commission] and thus over derivatives trading.
As the Dodd bill meandered its way through the Senate in April 2010, waiting for the agriculture committee to drop in its derivatives piece, Lincoln pulled off a major coup by persuading the committee, on a bipartisan vote, to force banks to spin off all their derivatives trading, proprietary or not. The Lincoln bill not only out-Volckered Volcker on trading, it even went some way toward resuscitating the separations imposed under Glass-Steagall.
Lincoln’s headline-grabbing achievement set off alarm bells at the White House, the Treasury, and the Fed—all of which swung into action to oppose the bill. Even Sheila Bair, the self-styled popular FDIC chair who often disagreed with Geithner and Summers, spoke out against the Lincoln bill—as did Volcker himself. Predictably, the banking industry declared that the bill’s passage would doom American capitalism yet again. In the end, however, much of Lincoln’s language survived to become Title VII of Dodd-Frank. Chris Dodd had no other choice; he needed the Republican votes in the conference committee. But banks were allowed to retain their derivatives trading in interest-rate and foreign-exchange swaps, the vast majority of the business. For bank lobbyists, it was an uncomfortably close call.
It Ain’t Over ‘Til It’s Over – The journey to Dodd-Frank took about thirteen months and resulted in a complicated 2,319-page financial reform law. Along the arduous road to passage, reformers had to fight off hordes of bank lobbyists—sometimes successfully, sometimes not. But, despite what you learned in “How a Bill Becomes a Law,” the battle was by no means over when President Obama signed Dodd-Frank into law on July 21, 2010. The lobbyists were channeling their inner Churchills: We shall fight them in the committees, we shall fight them on the floor, we shall fight them in the regulatory agencies and in the media, we shall never surrender.”
(THIS HAS BEEN A FASCINATING BOOK THAT I’VE BEEN READING FOR SOME TIME NOW AND SEN BLANCHE LINCOLN PRETTY WELL SUMMARIZED THE PROBLEM BUT NOTHING COMES EASY LIKE THE BIG BANK LOBBY AND WALL STREET SAID “WE’LL FIGHT THEM ALL THE WAY.” I DON’T BELIEVE IT’S FOR THE BENEFIT OF THE 99 PERCENT, WHO ARE GETTING EXPLOITED BY THE RICHEST 1 PERCENT, WHO ARE BILLIONAIRES AND GETTING RICHER EVERY YEAR. I’M GLAD TO SEE SEN BERNIE SANDERS IN THE DEMOCRATIC PRIMARY WITH HILLARY CLINTON. I BELIEVE THE ISSUES BEING DISCUSSED IN THIS BOOK HAVE A BETTER CHANCE OF BEING BROUGHT OUT IN THE OPEN AND TALKED ABOUT, PRESERVING THE MIDDLE CLASS, WHICH ARE PART OF THE 99 PERCENT.
LaVern Isely, Progressive, Independent, Overtaxed, Middle Class Taxpayer and Public Citizen and AARP Members