What Would Stein Do? - Monetary Policy and Financial Regulation

Should monetary policy play a role in financial regulation? Although Federal Reserve Board Governor Jeremy Stein argued in a recent speech that it does, monetary policy wonks such as Scott Sumner have not taken Jeremy's suggestions well. While I am sympathetic to both narratives, I feel that they miss the boat on what monetary policy as financial stability regulation would look like. When reading supporters such as MCK or opponents such as Ryan Avent, Matt Yglesias, and Scott Sumner, I find that the debate is focused on the short term interest rate response to financial risks. However, the focus on only the short term interest rate and its relationship with financial regulation is incredibly narrow and ignores important research on alternative monetary policy tools.

It may be useful to review the positions of the involved parties. According to M.C.K, monetary policy needs to be conducted with an eye to financial stability for two key reasons. First, extended periods of low interest rates encourage excessive lending. This causes bubbles to grow and results in large macroeconomic effects once they pop. Therefore monetary policy should be conducted to pop bubbles before they become major economic threats. Second, monetary policy is more effective than specific microprudential regulations such as inspecting bank balance sheets because financial innovation can allow banks to hide much of their conduct. Because all firms face the same set of interest rates, monetary policy has a better chance of "getting in the cracks" of financial markets and better protecting the system. Thus because monetary policy has wide reaching effects, it should be an important part of any financial regulation toolkit.

On the other side, some more Monetarist authors such as Scott Sumner or Matt Yglesias argue that using the short term interest rate as a regulatory tool is misguided because what matters most are macroeconomic variables such as nominal GDP or employment. Because monetary policy is such a blunt instrument, raising interest rates to pop a financial bubble is akin to fumigating an entire house to get rid of one patch of mold. The instrument is out of proportion with the threat. If the central bank stabilizes nominal GDP  the impact of financial crises on aggregate demand should be minimal. Moreover, it's not even certain if central banks can accurately identify bubbles. Even though the U.S. housing bubble seems obvious now, it's not exactly clear that policy makers could have identified it in real time. Therefore using monetary policy to pop bubbles is unlikely to be very effective and would result in substantial collateral damage.

Were the Fed to use monetary policy as a financial regulatory tool, the dilemma would be that one instrument, the short term interest rate, cannot simultaneously stabilize nominal GDP and the financial sector. One cannot address two problems with one tool. Fortunately, Stein has been working on an alternative policy regime to solve this problem. Once his alternative is considered, we can see how monetary policy and financial regulation can more effectively be integrated.

Stein's core proposal is that the central bank can be both a financial regulator through a combination of strict reserve requirements and paying interest on reserves. In Stein's model, the central bank can guide nominal variables through a kind of Taylor Rule for the short term interest rate while affecting the financial sector by manipulating the spread between interest on reserves and the short term interest rate.

To understand the logic behind Stein's proposal, we need to understand why the financial sector can be so unstable. Stein argues an important cause is an excess of short term debt. In particular, excessive short term debt raises the probability of fire sales, and the risk of a fire sale creates social costs that banks cannot internalize. Because reserves are required for short term debt issuance, a tax on reserves helps to constrain short term debt creation. In this way, a reserve tax helps internalize the costs of certain financial frictions, and therefore is an important tool for macroprudential regulation.

Stein proposes to implement such a reserves tax by first subjecting short term debt to stringent reserve requirements and then by varying the gap between the short term interest rate and the interest rate paid on reserves. To see why the gap between the short term interest rate and the interest on reserves is a tax on short term debt, recall the relationship between reserves and debt issuance. In a world of reserve requirements, the bank must hold a certain amount of reserves in order to issue the new debt.  Had the bank been able to lend those reserves out, they would have earned interest equal to the short term rate. This is the gross tax on reserves. But because the bank is also compensated with interest on reserves, the net reserves tax (heretofore known as the 'reserves tax') is the difference between the short term rate and the interest on reserves.

Under this framework, although both the short term rate and the interest on reserves are nominal variables, the spread between them is a real variable that serves to penalize issuance of short term debt. The pre-crisis policy of not paying interest on reserves meant that the short term rate was the entirety of the reserve tax. Therefore any desired increase in the reserve tax required the Fed to raise short term rates one-to-one. However, if the central bank were to pay interest on reserves, it can hold the short term rate constant while increasing the reserve tax.

In other words, policymakers can regulate debt maturities without deviating from existing interest rate rules. By increasing the gap between the interest paid on reserves and the short term interest rate, the central bank can penalize the issuance of short term debt without having to raise short term rates. In doing so, the central bank can try to stabilize nominal GDP while reducing short term debt fragilities. The central bank can engage in macro-prudential regulation while also staying faithful to its price stability and employment objectives.

No doubt, there are some problems with such an approach. The most obvious one is the case in which the required reserves tax is higher than the interest rate required to maintain price stability. In this case, since the interest rate cannot be lower than the rate on reserves, satisfying one mandate would necessarily ignore the other. To avoid this problem, the central bank could raise reserve requirements on short term debt. The intuition behind this is that for each additional dollar of short term debt, the bank would need more reserves. As a result, the effect of the reserves tax would be magnified, thereby lowering the optimal reserves tax below the necessary short term rate.

Another concern is that raising the reserve requirement could substantially disrupt the functioning of banks. Because banks have become used to certain reserve ratios, they would have a hard time adapting to higher reserve requirements, thereby reducing the money supply and causing more uncertainty. I see three ways central banks could mitigate this. First, they could announce the change in reserve requirements ahead of time and allow banks to more smoothly transition into the new regime. Second, the reserve requirement could be raised when there is a large supply of excess reserves, such as right now. Third, if nominal GDP slows down substantially, the Fed could engage in other "unconventional" actions such as Quantitative Easing to inject assets into the system. Moreover, raising reserve requirements as a part of deploying a new macroprudential framework may make certain Basel III requirements obsolete. In particular, the Basel III proposal of defining a stable funding ratio to limit short term debt issuance may become unnecessary when the Fed can control such a ratio with much more precision through a reserves tax. By making other reserves regulation obsolete, a new policy regime with interest on reserves could actually ease the regulatory burden on banks.

Neil Irwin, in his post on Stein, likened raising interest rates and popping bubbles to fumigating an entire house to get rid of one patch of mold. However, Stein's policy proposal would not be so dramatic. It would be more like a dehumidifier, addressing the risks of mold while still allowing people to live in the house.

Thus the debate over whether the short term rate should be used to moderate credit cycles seems a bit silly in the context of what Stein's papers have been suggesting. It is almost as if in all the arguments over what Stein said, people have forgotten to look at what he has written in the past. The alternative approach with interest on reserves and stricter reserve requirements can coexist with the price-employment mandate. In addition, such a strategy provides monetary authorities more tools to interact with the very large financial sector. In this way, the effective integration of financial regulation and monetary policy should improve macroeconomic stability, not worsen it.

Market Monetarism and Finance

As market monetarism starts to become more mainstream, I have started to take some time to think about what yet has to be done to develop this new brand of monetary theory. One issue that recurs in my thoughts is that market monetarism needs to help develop a richer understanding of financial dynamics.

One of the strongest justifications is that a richer understanding of financial linkages would help untangle the dynamics of monetary policy under different regimes. Scott Sumner argues that monetary policy works not with long and variable lags, but rather long and variable leads. Because agents are forward looking, expectations of future nominal GDP significantly affect current economic activity. The strongest evidence for this comes from the financial markets. For the United States, Marcus Nunes has done quite a bit of work charting the immediate effects of monetary policy hints on inflation expectations:

We also see similar evidence in the international arena, whether Japanese, Swiss, Hong Kong, or American.

However, the chart is incomplete. Past studies do suggest that the effect of interest rate cuts are not felt until several months after the initial policy declaration. While there may be identification issues with those studies, they do open up the possibility that monetary policy does not act as quickly as market monetarists would hope. In this context, a hybrid approach may be more accurate. While monetary policy leads the financial sector, it is likely that monetary policy lags in other "real" sectors, such as manufacturing.

This synthesis of both monetary and financial dynamics is especially important given Lars Christensen's argument that "there is probably no better indicator for the monetary policy stance than market prices." We know from the financial literature that certain phenomena, such as excess volatility, seem to defy the typical market monetarist use of the efficient market and rational expectations hypotheses. This is not to say policy would be better guided by the arbitrary decisions of central bankers, but rather that a move to market based signals needs to be grounded on better a theoretical and empirical understanding of how monetary policy and financial signals lead other parts the real economy.

As an example of this, we can take a look at the relationship between TIPS inflation expectations and PCE inflation. For those who don't know, the TIPS spread is the interest rate differential between the 5 year inflation protected treasury and the regular 5 year treasury, and therefore is a measure of what investors expect inflation to be over a five year time horizon.

Under the rational expectations hypothesis, expected future inflation should be a reasonable estimate of actual future inflation. By the efficient market hypothesis, these expectations should then be expressed in the 5 year TIPS spread. However, for the years during which we actually have data on how the 5 year TIPS compared against the actual inflation rate, performance is quite poor:

This evidence suggests that even market forecasts can be unreliable. While they can sometimes be a good indicator of future performance, in other times they can be unacceptably wrong. In the above example, the relationship between the TIPS forecast and actual inflation was so wrong that it was negative. While such data points may be washed out in the long run, the 5 years of flawed predictive capacity that it would have given should give any policy maker pause.

However, the TIPS spread is actually quite a good predictor of contemporaneous inflation. Below I plotted each month's PCE inflation rate with that month's average TIPS spread, and find that the linear prediction (red points) does a good job of measuring current month inflation:

This suggests that while we may not be able to use market signals to predict with precision, market signals do carry significant information content. Instead of waiting for each month's CPI report with bated breath, we could simply consider the financial data that is always available to us. This resembles my conclusion from looking at forecaster data. Given that we have reasonably accurate forecast, monetary policy should target those forecasts. When bad forecasts come in, central bankers can signal that they are ready to ease monetary conditions if the bad conditions materialize themselves. The trick here is to make sure that the information hiding in market prices can make its way into policy, and a better understanding of the relationship between finance and macro is an important step in that direction.