Something I don’t understand: Endogenous Money, Forward Guidance, and QE Exit
Endogenous money has been used to represent several slightly different things. In this post I am referring to the way in which a central bank moves the short term interest rate by controlling the money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government bonds.
This means that for any non zero short term interest rate, given a set of real factors in the economy, there is only one possible size of the monetary base. If you control interest rates the base is endogenous. Once the short term interest rate hits zero, this relationship breaks down, and once can expand the monetary base without lowering the short term nominal interest rate. That is the situation in which we find ourselves.
Now, my question is, when we raise interest rates off the zero lower bound, surely we will reenter the regime of endogenous money, in which case surely it is impossible to raise rates without at least partially unwinding QE?
It might seem obvious that the Fed can put upwards pressure on the interest rates while holding the monetary base constant by selling long treasuries and buying short ones, but that is not the case. Provided there are a large amount of excess reserves, any attempt to raise the short term interest rate above the interest rate paid on excess reserves (IOER), will result in money moving out of reserves into the short term treasuries, they being essentially perfect substitutes as a risk free interest bearing form of money.
This brings me onto forwards guidance. Many people have said that forward guidance is largely pointless. I wish to point out here, that as the economy strengthens, and spending increases, the quantity of base money consisted with a given non zero interest rate increases. Thus, the date of the first rise in interest rate wholly determines how much of the QE base expansion is permanent and how much is temporary. It is widely known that temporary expansions in the base are not inflationary, this also tails nicely with the apparent decreasing effectiveness of QE. If forward guidance means you think you know the MB at the date of the first interest rate rise, QE over and above that will do little. The only question is, are we there yet? The reaction of the stock markets to the taper talk in may strongly suggests that they believe that the US economy is not yet strong enough to withstand a tightening of policy.
In conclusion….I don’t know if I really believe the argument set out above. It seems to me, when I look at the comparative GDP paths of US, UK and EZ, or 1990’s Japan vs 2013 Japan, that those countries which have done more QE have better GDP growth. Economies are to complicated to be able to guarantee that we always have a concrete transmission mechanism and 100% understanding of the consequences of policies. For all that, it does not seem obviously wrong, and it does trouble me, and suggest that th eexit from QE may be harder than some in central banking assume.