Muddled Monetary Policy and Negative Money Multipliers

A deviation from the textbook to a complex world of shadow banking and collateral chains

An effective monetary regime requires a functioning concrete mechanism. For as much as Nick Rowe discusses nonlinear chains of causality or the chuck Norris expectations model of monetary policy, the concerns of those of the concrete steppes cannot be totally ignored. A recent Voxeu paper by Manmohan Singh and Peter Stella provides a cautionary tale for those who want to leap off the concrete steppes without a closer look. What's the problem? A potential monetary policy negative money multiplier.


In the traditional Econ 101 explanation of monetary policy, the federal reserve expands the money supply by buying treasuries, thereby expanding the monetary base. Banks use that cash by lending it to businesses that subsequently invest the money. This spending makes its way back to the banks via deposits, thereby adding to the stock of demand deposits and the money supply. A fraction of the deposits, as determined by the reserve ratio, is held in reserve by the banks; the rest is lent out again. This is one of the marvels of fractional reserve banking:The "money" that the fed creates in its open market purchases multiplies itself throughout the money supply through this lending/re-lending process.

Singh and Stella emphasize a different channel of money multiplication: collateral chains. Their fundamental argument is that, in a world of shadow banking, repos, and financial derivatives, a lot of credit creation takes place by pledging the same collateral over and over again, a process otherwise known as rehypothecation. High quality collateral, "safe assets", serves the role deposits serve in the textbook explanation of monetary policy. Safe assets, instead of being deposited like cash, are used over and over again by different firms to obtain financing, thereby expanding the "shadow money supply". Banks who were burned in the past want to limit their loans and try to deleverage. But in this process, banks shorten the collateral chains, make credit less available, and contract the shadow money supply. Central banks can compound the problem by reducing the supply of safe collateral by purchasing the assets in open market operations. As a result, traditional purchases of US treasuries become contractionary. While they may increase the base, they prevent collateral chains from forming and facilitating more credit creation. The cash that financial institutions get from open market operations can't be rehypothecated, and therefore fails to expand credit supplies. Instead, collateral chains contract and this "shadowy" money supply grows more limited. So yes, the Fed can raise prices to any level by printing money. But no, rehypothecation and collateral chains prevent quantitative easing from being fully effective.

Collateralization also brings up the possibility that the Fed could ease not by Quantitative Easing, but rather by Qualitative Easing. Instead of buying up collateral and replacing it with uncollateralizable cash, the Fed could buy up risker assets (mortgage backed securities again?) and replace them with safer treasuries. While it may not expand the size of the Fed's balance sheet, it would help with the collateral chains and expand credit. Fiscal policy then gains new traction, as increases in government debt can 

1) Increase available collateral, thereby directly expanding credit

2) Limit the contractionary effect of the Fed's buying of collateral

An interesting corollary of this is that if fiscal policy becomes more effective, the Federal Reserves interest rate forward guidance becomes more powerful. As I've written before, the interest rate guidance would lose its indeterminancy, and change from Delphian to Odyssean. Low interest rates no longer represent low expectations for NGDP, rather they represent a committment to a temporary period of faster than trend NGDP growth. Interest rates aren't low because of low NGDP, but rather in spite of it.

Meanwhile, David Beckworth's NGDP targeting - safe assets story becomes murkier. David argues that, in a world of stable NGDP growth, private sector safe asset creation goes up significantly. So if the Fed commits to a stable NGDP growth path, the collateral chain problem goes away as there's enough private sector safe assets for rehypothecation. But if the NGDP growth path is uncertain, Quantitative Easing won't help. While the initial treasury purchases may marginally increase lending, the credit contraction from collateral chains may cause the policy to be net contractionary. However, the story is still not that simple. Much like currency depreciation in a small economy, there exists a sufficiently large change that would boost growth. Quantitative Easing would only have an effect once it has collapsed collateral chains to their minimum. After that point "printing money and buying assets" would undoubtedly raise NGDP. This leads to a peculiar result when we take Nick Rowe's concepts of nonlinear causality and expectations into account. If the scale of the initial asset purchases is perceived as credible enough to shape future NGDP expectations, even though initial purchases would shorten collateral chains, the supply of collateral would expand as the private sector created more safe assets. 

A major problem with this scenario is that the market response function becomes highly nonlinear. With no policy action the market contracts. With some policy action the market contracts further. Only with outsize policy action are private agents convinced of a stable future NGDP target, and do collateral chains continue to expand. In this situation, it would be hard for a central banker to tell how many asset purchases "would be enough". Consequently, a credible NGDP target becomes even more important. First, it facilitates private safe asset creation. Second, it assures the market that the Fed won't end up in the middle where collateral chains contract and monetary expansion fails to raise output or prices. This is a critical argument in favor of NGDP targeting in an increasingly complex world. In spite of all of the complications in modern finance and banking, stable nominal expectations can help smooth those problems over and maintain the processes of safe asset creation.

Another lesson we can learn from the debt rehypothecation/shadow money supply story is that nominal GDP targeting has a critical role to play in limiting the negative growth effects of financial regulation. If debt chains serve a function to expand the shadow money supply, then banning debt in a move to a more Black Swan free society can have severe monetary effects, significantly hampering growth. But if the central bank targets nominal GDP (ideally through a mechanism not as bank or debt-centric as treasury purchases), this would help ease in the structural adjustments to build macroeconomic resilience.

Monetary policy is muddled, adjustments are painful, but stable expectations can help. While Singh and Stella's story may not be perfectly applicable now, it is an interesting example of the peculiar nexus of modern finance and modern monetary policy. These uncertainties will only get worse in the future, so it's even more important to find a credible, robust, stable regime now.

Correlations Across Time - NGDP and Bond Yield Edition

There's a lot of interest in using futures to help determine expectations: TIPS spreads are used to forecast expected inflation, 10-year bond yields are used to forecast expected NGDP growth, and in Scott Sumner's market monetarist nirvana the central bank would use NGDP futures to help forecast NGDP growth exactly.  The central bank would then only worry about that one expectation, vastly simplifying monetary policy.

In this post, I want to focus in on the NGDP growth and bond-yield correlation.  David Beckworth offers pretty convincing evidence that bond yields are highly correlated with NGDP growth forecasts:

Forecasting can be a bit inaccurate, so Lars Christensen  has a very nice graph showing how the 10 year bond yield has been tightly coupled with the year to year growth in NGDP in any given year.

But how do these correlations or trends change throughout time?  From the FRED data, I computed foward looking NGDP growth in 10-year windows from the second quarter of 1964 to the first quarter of 2002.  I then computed the correlation between actual NGDP growth and the bond yield in 10 year windows for each date, with 19 quarters of the window before the given date and 20 quarters of the window after the given date.  With the correlation, I also computed the OLS regression slope for the regression of bond yield as the explanatory variable and NGDP growth as the response variable.  It turns out that the NGDP growth and  the bond yield have had a very tight correlation in recent windows, but that this was not always the case.



On the graph in the second half of the 1970's (which would have been the correlations between the data from 1970 to 1985 on the NGDP growth from 1980 to 1995), we can see that there is actually a negative correlation between the bond yield and NGDP growth.  This likely could have been the result of tightening by the Federal Reserve in the 1980's in response to the oil shocks.  As a result, NGDP was pushed down against expectations, thereby creating a negative correlation.  The correlation is stronger in recent times, as the 1997 data point includes data from 2012, but still the correlation is not as strong as the one Beckworth and others find for forecasters.

Another interesting point to note in recent times is that although the correlation between NGDP growth and bond yield has been fairly high, , the OLS coefficient is rather low.  Bond yield does predict NGDP growth, but not in a one-to-one relationship.  In the most recent window, a 1% increase in bond yield predicted a 0.47% increase in NGDP growth.  What's interesting about the OLS coefficient that the correlation hides is that the OLS coefficient has been increasing in recent history.  I'm still not quite sure what that means, but I feel it should have important implications for the safe assets hypothesis and expectations of future economic growth.