Bond Economics: Random Observations

My writing plans were disturbed (bike got a flat tire…), and so I am stuck with a placeholder article. I had been working on a section for my banking manuscript, but I want to look it over before posting a draft.

North American Monetary Policy Developments

The Bank of Canada (BoC) cut the target for the overnight rate to 4.75% on June 5th. They feel that policy is restrictive, and they stated that “our confidence that inflation will continue to move closer to the 2% target has increased over recent months.”

Although I have been dovish about Canadian (as well as others) rates relative to the commentary produced by the inflation nutters, one makes money by taking positions versus market pricing. It is unclear to me that the prospect of a few tactical rate cuts are enough to justify the current level of yields. People might want to point to negative risk premia, but that is just an over-educated way of saying that bonds are expensive. It is entirely possible that yields will trade sideways while investors wait for the next recession, but the negative carry on offer is not that attractive. 

Turning to the United States, I liked this scary-looking (for bond bears) chart of the durable goods (“commodities”) component of the (urban) Consumer Price Index. We are returning to the usual experience in the United States since the mid-1990s: goods are a source of deflationary pressure, while services are what is driving up core inflation rates. Of course, the Fed does not target durable goods prices alone, so we cannot ignore services. Rather, the point is that we are returning to a “typical” cycle that will look closer to recent decades’ experience.

I was writing this during the Fed press conference, and only got a few snippets. I have never worried too much about reading the details of Fed thinking – their thinking will change over the time horizons that are relevant for anything other than the shortest maturities. Although the Fed could follow the BoC and do a tactical cut, I still would expect resistance to such a move. It might create too much hype in over-excited markets that love to over-extrapolate Fed moves. The Treasury curve is already trading through the Fed Funds rate — if the Fed wants to help out private borrowing (like mortgages), market pricing is already doing that.

FT Reserve Tiering Article

I quickly read through this article “What to say when you’re asked your view on Bank of England reserve tiering.” To summarise, there has been a mini-controversy about paying interest on reserves (deposits of private banks held at the Bank of England). The article contains a good history of the situation in the U.K. My comments here overlap what is in the article, but I am putting my spin on the topic (repeating earlier rants).

The article indirectly shows the advantages of the MMT approach to government finance versus incorrect ones: we need to look at the real resources associated with government spending, and not just dollar (OK, pound sterling) amounts. Government interest spending is not buying the government anything, or achieving any social objectives via transfer payments, it is just a payment to liability holders. We then need to ask — why are these payments made in the first place?

The justification is straightforward, although it makes some people unhappy. In order for the central bank to have an interest rate policy, it has to pay interest on reserves that are greatly in excess of the amount required by regulation (and possibly convention). A banking system can support non-zero interest rates if there are is a small amount of excess reserves, but beyond a certain point, arbitrage will drive overnight market rates to the rate paid on reserves. So if neoclassical central bankers want to micromanage the economy with interest rates as well as be crypto-Monetarists and fool around with Quantitative Easing, they have to pay interest on (excess) reserves. If you want to stop paying interest on reserves, you need to get neoclassical central bankers to stop being neoclassicals.

In a modern financial system, the correct amount of excess reserves to hold is zero. You use money and interbank markets to hit your target balance with the payments system. Using reserves is something a 19th century banker might do, but that was then, and this is now.

You can try to mop up excess reserves by increasing reserve requirements. This is just a tax on the banking system — you are forcing banks to hold reserves that pay 0% and accomplishing almost nothing useful. Only someone who has read economists’ analyses of banking would say that required reserves help bank liquidity — the banks are forced to hold the reserves, so they cannot use them to meet liquidity needs. Yes, the required reserves will drop in response to deposit outflows — but reserve accounting lags means that this drop will be far too slow to stop a run. It does force the bank to hold instruments with no credit risk — reducing the cost of a bailout — but the costs of a bank bailout are mainly due to the disruption of economic activity. The bank having a small amount of safe assets is not going to significantly change the real cost of a bank failure to the government.

Taxing the banks — often the only part of the financial system that is properly regulated — and not non-banks might have worked as a “financial repression” tool in the highly-regulated post-WWII decades, but is just turbo-charging the movement to shadow banking in the current environment. Once again, if you do not want the government to pay interest, just tell the central bankers to stop raising interest rates. If you want them to hike rates, you are just encountering the consequences of your own actions.