Presentation on “Do Central Banks Control the Price Level?”

A few weeks ago, I was invited to speak on “Do Central Banks Control the Price Level?” by the Forum for Macroeconomics and Macroeconomic Policies (FMM) at their annual conference. The panel also included Frances Coppola and Scott Fullwiler.

My presentation is here and you can find video of the session here. I went last, starting at 56 minutes.


Is the Fed Going to Go Bust?

While the Federal Reserve’s quantitative easing program has not yet caused an increase in inflation, many are concerned that the money creation due to QE will provoke serious problems at some point.  So when leading economist Robert E. Hall of Stanford releases a paper (co-authored with Columbia‘s Ricardo Reis) focusing on the “risks to solvency” facing the Fed then many people are going to pay attention.  This is particularly so when the paper includes scenarios in which the Fed loses control of the price level and “the central bank would likely be dissolved and a new currency introduced.”

So is the Fed going to go bust and be dissolved? Will the dollar have to be replaced? Let’s start with a spoiler alert.  In the end, Hall and Reis conclude the possibility of a doomsday scenario for the Fed is “remote”.  Still, given the nature of controversies about the Fed, the extreme scenarios cited in the paper are likely to become part of public debate on the Fed’s future. In this post, I argue that even the “remote possibility” scenarios put forward by Hall and Reis rely on a range of counter-factual assumptions.

A Potential Problem?

Hall and Reis’s concerns can be summarised as follows.  Because the Fed now holds very large amounts of long-dated low-interest-rate bonds, future increases in interest rates may reduce the value of these assets. They describe a scenario in which the Fed reaches a point where its assets don’t generate sufficient income to cover its costs.

In particular, Hall and Reis are concerned about the Fed’s ability to pay interest on the reserve accounts that banks hold with it. Payments made to Fed ultimately arrive via deductions from various reserve accounts that institutions such as private banks or the Treasury hold with it while interest paid on reserves to banks takes the form of additions to the relevant bank reserve accounts.

Given this structure, if the interest payments made to the Fed don’t cover the interest payments it makes on reserves, then the total stock of reserves will increase. Hall and Reis express a concern that this process of additional money creation stemming from such an increase in the stock of reserves would result in higher inflation. (Exactly how this gets so bad that the currency ends up being dissolved is a little unclear to me.)

So it turns out that Hall and Reis are not actually concerned about the Fed going bust in the usual sense of being unable to meet its obligations. Rather they express a concern the Fed might only be able to meet its obligations by creating a quantity of money that generates high inflation.  Alternatively, they discuss a scenario in which the Fed keeps the interest rate on reserves low to restrict the growth in total reserves but this low interest rate results in a loss of control of the price level.

After crunching some numbers, Hall and Reis finally assure worried readers that their scenario in which the Fed loses control of inflation isn’t a likely event.  However, this still leaves some room for doubt that there may be some more extreme set of losses than those contemplated in the paper that could result in a doomsday scenario.

A Problem that Simply Isn’t a Problem

In fact, the doomsday scenario outlined by Hall and Reis simply doesn’t make any sense and it doesn’t require crunching of numbers to dismiss it.

The scenario revolves around the problems caused by payment of interest on reserves.  However, it’s worth noting that, far from being a time-honored tool for controlling interest rates, the Fed only began paying interest on reserves in 2008 and had little difficulty controlling interest rates prior to the introduction of this policy.

As explained in this paper, the principle argument for paying interest on reserves is that it acts as a floor on money market interest rates and so reduces day-to-day volatility.  However, when central banks pay interest on reserves or a deposit facility, this interest rate is rarely the one used to set the target for short-term private sector borrowing rates.

For example, the ECB has a deposit facility that pays interest to banks, an emergency marginal lending facility for overnight borrowing and a weekly refinancing operation in which it lends money to banks. It is the refinancing rate that usually dictates average money market interest rates with the deposit facility rate acting as a lower floor.  So, in general, there are few grounds for the idea that setting a low interest rate for remuneration of reserves (or indeed a zero rate) will lead to the Fed losing control of inflation.

Still, with banks currently flooded with reserves, one could argue that it might be difficult over the next few years to raise the federal funds rate without hiking the interest rate paid on reserves. So one could still ask whether concerns about income shortfalls could lead to the Fed having to abandon paying interest on reserves and the operational efficiency gains that come with it. This is extremely unlikely.

Firstly, the Fed holds large amounts of assets that are set against currency “liabilities” which in practice pay no interest.  So it could incur losses on the rest of its operations and still make a profit. Moreover, there is no operational need for the Fed’s stock of assets to exceed its stock of notional liabilities.

Secondly, the Fed holds long-term assets and short-term liabilities and yield curves generally slope upwards.  So, on average, the Fed is going to make profits even without the assets backing currency notes.  It could thus go through a period of making losses and simply offset these losses with later profits that are partly retained rather than handed over to the US Treasury.

Hall and Reis note in their paper that this latter option of smoothing out profits and losses by varying dividends to the Treasury may not be possible if the Treasury decided to prevent the Fed from accumulating too much profit income without handing it over to the rest of the US government.  Here I can only say that any future world in which the Treasury is allowed to bully the Fed into providing it with more income would indeed be one in which price stability is endangered but only because the Fed will have lost its independence, not because of QE-related losses on assets.

The US economy has many real problems for people to focus on. Economists can help by focusing on those problems rather than fairy stories about the Fed going bust and the dollar being abandoned.