Monetary base endogeneity and new procedures of asset-based North American monetary systems

Marc Lavoie

University of Ottawa

Purpose of the presentation

To give support to the horizontalist view of endogenous money by looking at the current operational procedures followed by central banks, more specifically the Canadian and American central banks

My hypotheses

Central banks conduct operations essentially as they used to, in accordance with the horizontalist viewpoint;

The procedures of some central banks are more transparent (than they were and than those of other central banks), so the horizontalist story is more obvious: Canada, Australia, Sweden

The procedures of other central banks are less transparent; but when interpreted in light of horizontalism, we can see that their operational logic is identical to that of the more transparent central banks (FED).

How is the New consensus (new neoclassical synthesis) linked to post-Keynesian theory ?

Post-Keynesians There is an interest

rate reaction function because it cannot be otherwise. Money supply targeting is impossible in principle and in practice.

New Consensus There is an interest

rate reaction function because interest rate targeting is more successful to dampen shocks to money demand than money supply targeting.

Two different justifications for the currrent interest rate procedures ?

Post-Keynesians Based on a

microeconomic justification

Tied to the clearing and settlement system

Linked to the day-by-day, hour-per-hour, operations of central banks

New Consensus Based on the 1970 Poole

article A macroeconomic

justification If the IS curve were the most

unstable, use monetary targeting

The LM curve is unstable (money demand is unstable), use interest rates targets

Poole 1970Interest rate

OutputA

IS

LM

MT IT

LM

A = IT MT

IS

Investment is unstable:Use monetary targeting MTLess variability in output

Demand for money is unstable:Use interest rate targetingNo variability in output

ITIT

Authors who support the microeconomic explanation

Several central bank economists Bindseil 2004 ECB, Clinton 1991 BofC,

Lombra 1974 and Whitesell 2003 Fed Some post-Keynesian authors

Eichner 1985, Wray 1998 and neo-chartalists Institutionalists

Fullwiler 2003 et 2006

Outline

Bank of Canada procedures Federal Reserve procedures Conclusions

Current features for all central banks Explicit interest rate targeting No or very little attention paid to monetary

aggregates Central bank reaction functions All this is reflected in the New Consensus model,

where the LM curve has vanished IS curve Phillips curve Interest setting function

Bank of Canada

Inflation targeting Interest rate setting (target overnight rate) Zero reserve requirements No discount window restrictions (with collateral) Net clearing house settlement system Settlements in real time Tunnel (corridor, channel) system: symetric lending and

deposit rates by central bank Perfect certainty of each bank position Perfect certainty of central bank position

Federal Reserve Board

No official inflation targeting Interest rate setting (target federal funds rate) Reserve requirements over an averaging period Gross settlement system Not all settlements in real time No tunnel system: Penalty rate on overnight

deficit, and zero rate on held reserves Uncertainty of each bank position Uncertainty of central bank position (float)

Canada: historic sum-up

1982: monetary targeting officially abandonned, after 7 years 1987: first discussion paper regarding the dismissal of compulsory

reserves 1991: no limit on central bank overdrafts 1991: official inflation targets 1994: zero reserves implemented 1994: channel system implemented 1995: Design of electronic large-value transfer system (LVTS) 1995: Last outright open market operation (only repos afterwards) 1999: Implementation of LVTS

Bank of Canada The Bank sets a target overnight rate (8 announcements per year).

This is comparable to the Bank of England's two-week «repo rate», or to the American fed funds target.

Commercial banks demand zero settlement balances (deposits at the central bank) every day (unless there is a crisis)

The Bank targets zero settlement balances, by neutralizing any public sector outflow or inflow (cf. new chartalists, Wray, Mosler, etc.)

To do so, the Bank transfers (auctions) government deposits The Bank engages in repos or reverse repos (buyback operations)

when it is unhappy about the overnight rate. Buyback operations are also neutralized at the end of the day. Quantitative monetary policy is purely « defensive ». Cash (banknotes) is provided to banks on demand (purely

endogenous)

Bank of Sweden: overdraft system, but same logic « Lending to the banking system currently comprises a

significant part of the Riksbank’s assets…. Stage 1 involves a forecast of … how much liquidity

needs to be supplied or absorbed for the banks to be able to avoid using the deposit and lending facilities during the coming week …. Stage 3 involves executing open market operations to parry the daily fluctuations in the banking system’s current payments so the banking system will not need to utilise the facilities » Mitlind and Vesterlund, Bank of Sweden Economic Review,

2001

Settlementbalances

Overnight rate

0 + (surplus)- (overdraft)

Target rate TR

Bank rate = TR+25pts

Rate on positive balances = TR-25pts

The Bank of Canada channel system

Target and actual overnight rate

The Bank of Canada hits the target rate (say 2.50) exactly almost every day: 2.50, 2.51, 2.49 ….

The demand for settlement balances is always exactly equal to the supply (both zero in net terms); the actual rate of interest ought to be near the mid-point of the corridor, and this where the target rate is, acting as an additional anchor

If there was some uncertainty about settlement balances, it would be easy to miss the target rate (Cf Whitesell 2003)

0 Settlement balances

Target rate

Lending rate

Deposit rateDemand for balances

S’ S

And this is why there would need to be reserve averaging in the United States, even with a tunnel (Cf Whitesell 2003)

Reserves

Expected Fed funds rate

Lending rate

Deposit rateDemand for reserves

SS’

Uncertainty and reserve averaging

With uncertainty and reserve averaging, in a tunnel system, there is a flat portion to the demand for reserves curve, at the expected federal funds rate. So as long as the expected fed rate is equal to the target fed rate, it is relatively easy for the Fed to achieve its target.

The crucial thing however becomes the expected federal funds rate

Without the tunnel, things are more complicated, but nowadays the Fed has a publicly announced target Federal funds rate that acts as the anchor for the expected rate.

Problems with no tunnel and a not so credible target: central bank needs to be very precise in its daily forecast of reserves demand

Reserves

Expected Fed funds rate

Lending rate

Deposit rate

Demand for reserves

SS’

TargetFed rate

Quantity of reserves

Market federal funds rate

Target rate

Pedagogical representation of the American monetary system: (Cecchetti, 2005)Horizontalism in banking and money textbooks

Reserve supply

Reserve demand

The Fed acts no differently than an overdraft economy central bank

“The Fed’s purchases or sales of government securities are intended primarily to offset the flows into or out of the domestic monetary-financial system” (Eichner, 1987, p. 849).

“Fed actions with regards to quantities of reserves are necessarily defensive. The only discretion the Fed has is in interest rate determination” Wray (1998, p. 115).

And it was always so!

“The primary objective of the Desk’s open market operations has never been to ‘increase/decrease reserves to provide for expansion/contraction of the money supply’ but rather to maintain the integrity of the payments system through provision of sufficient quantities of Fed balances such that the targeted funds rate is achieved” Fullwiler (2003, p. 869).

Cf Poole in 1982, JMCB

«The old procedures [before 1979-1982] are best characterized as an adjustable federal funds rate peg system ….The new system [1979-1982] is qualitatively similar to the old ….The vast bulk of speculation about Fed intentions by money market participants concerns Fed attitudes toward interest rates…. The issue is always one of when and how hard the Fed will push rates ….»

But what about other interest rates, like the prime rate? Does it follow the federal funds rate? Shown here is the spread between the Prime Rate and the Federal Funds Rate (Atesoglu, 2005)

1.2

1.6

2.0

2.4

2.8

3.2

3.6

1988 1990 1992 1994 1996 1998 2000

SP

Interest rate spreads In Canada, banks set the prime lending

rate at exactly 175 basis points above the target overnight rate.

Overnight rate

Treasury Bills rate

Prime rate

0

1

2

3

4

5

6

7

8

2000 2001 2002 2003 2004 2005 2006 2007

Time of Year

Pe

rc

en

t

But things are different with the long rate….

Overnight rate

10-year government bond

yield

0

1

2

3

4

5

6

7

2000 2001 2002 2003 2004 2005 2006 2007

Time of Year

Pe

rce

nt

Conclusion

The behaviour of the Fed is no different from that of the Bank of Canada

The monetary base is fully endogenous in both cases

Central banks do their best to supply the amount of liquidity required by the financial system at the target rate of interest

This is just more obvious in the more transparent cases of Canada and Sweden