Arnold Kling  

Exchanging Nickels for Dimes?

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James Hamilton writes,


Suppose that the Federal Reserve were to sell off all its Treasury securities of less than one-year maturity, and use the proceeds to buy up all the longer term Treasury debt it could. For example, in December of 2006, this would have required selling off about $400 B in bills and notes or bonds with less than one year remaining, with which the Fed could have effectively retired all Treasury debt beyond 10 years....Yields on maturities longer than 2-1/2 years would fall, with those at the long end decreasing by up to 17 basis points. Yields on the shortest maturities would increase by almost as much.

I have not read the paper, but I have some methodological observations.

1. He really touts the statistical significance of the results, even though he acknowledges that the economic significance is pretty small.

2. It seems to me that the exercise he talks about, consisting of a $400 billion exchange of assets by the Fed, is probably well outside the normal historical range. I don't know about the techniques used here, but usually when you extrapolate an effect that has been observed within one range to something completely outside the range it is pretty unreliable.

In any case, this paper reminds me ofthis installment of the Macro Doubtbook, in which I discussed


the relationship between finance theory and macroeconomics. I think that relationship is an uneasy one.

"Portfolio balance theory" is contradicted by much theoretical and empirical work in finance. That is why Hamilton is excited that he and co-author Cynthia Wu have found any statistically significant results at all. But still, the results seem small to me. They are closer to what you would get if you thought of the Fed exchanging nickels for dimes than if you think of it as some all-powerful manipulator of interest rates.


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COMMENTS (7 to date)
jsalvati writes:

Indeed, I think one of the biggest lessons to come out of this episode will be that thinking of monetary policy in terms of a interest rates is confused.

honeyoak writes:

what concerns me about such an operation is that it increases the interest rate exposure of the central bank by a factor of 15 (or so depending on the average change of the portfolio's maturity). unless they hedge this (I am not sure that the capital markets could easily absorb such an amount of concentrated interest rate risk)any small change in the rates of interest (due to some exogenous shock lets say)would totally wipe out the central bank causing the taxpayer to make them whole. this could amount to a large loss. If rates rise from 2% per annum to 4% there could be a total loss of some 20% of the outstanding portfolio (i.e. $80 billion)and that is a conservative estimate.

Bob Murphy writes:

Could the Fed become insolvent? I mean, I suppose they have liabilities in an accounting sense, but if a bunch of banks want their reserves, doesn't the Fed just print them up (or have the Treasury do it)?

honeyoak writes:

They way I see it (and I was taught), is that a central bank is just like any other institution with a balance sheet. When the central bank prints money it is in essence issuing a zero coupon infinite duration bond on behalf of the sovereign. Should the central bank engage in investments that turn out to be worth less then originally thought, then there will be a mismatch between those liabilities and the assets that back them. This causes those liabilities to be discounted by the market as the output lost on the investment has to come from somewhere, it cant just disappear. this is a direct transfer from the holders of the central bank's liabilities to the investors who shorted the central bank's investments. Just like pre-bankruptcy GM couldn't issue debt to restore it to solvency (as the market was already discounting the wealth destruction that took place in the price of its debt and equity) a central bank cannot issue more currency to restore it to solvency. This will just causes more inflation then the discount that the market will already place on the high powered money(this usually happens in the FX market first before appearing on CPI). The central bank can either reduce the amount of its liabilities (by retiring money), or if monetary policy needs to be expansionary the treasury can issue (tax collecting) debt to the central bank(the bank of england has an official arrangement like this with HM Treasury over their QE induced purchase of guilts) . As to the commercial banks, as the wealth loss gets translated into the market for the central bank's liabilities,these banks have a large incentive to reduce their demand for reserves as to avoid any depreciation of their own capital. this is often why developing countries force commercial banks to hold certain amounts of liabilities, so that any mismanagement does not lead to large runs on the currency.

Mike Rulle writes:

I don't get what Hamilton is driving at. Is he suggesting a form of "carry trade" for the Fed is actually a good thing? What is the point? To hike short rates and lower long rates? Its all just zero sum in the financial system. It doesn't create quantitative easing as bills need to be rolled. Its strikes me as unecessary government manipulation. I have an idea. Why not sell 2 trillion of bonds and buy 40 trillion of S&P options on margin?

Mike Rulle writes:

I meant futures, but what the heck, they could buy some options too.

B.B. writes:

Hamilton is talking about once was called "Operation Twist" by the JFK crowd that sought to tilt the Tresury yield curve by swapping the quantities of debt along the curve. The Treasury could do this on its own; it doesn't need the Fed.

The expectations theory says no effect; the preferred habitat theory says some effect.

But none of this matters. QE is not about swapping debt. It is about the Fed buying, say, $1 trillion of long Treasuries with freshly created cash, currency or bank reserves. That could have a profound effect on bond yields and ultimately on aggregate demand. (Hello, Prof. Sumner.)

I see no downside to more QE right now. To say that more QE will cause inflation is to say that it will raise aggregate demand. But if the Fed is "pushing on a string," it can't raise aggregate demand. Both can't be true, unless you believe the aggregate supply curve is vertical at a 9.5% unemployment rate

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