Chris Hanes is coming from SUNY-Binghampton to give an economic history seminar on Monday:
Posted by DeLong at April 29, 2004 09:39 AM | TrackBack | | Other weblogs commenting on this postChristoper Hanes (2004), "The Rise of Open-Mouth Operations and the Disappearance of the 'Borrowing Function' in the United States": Since the late 1980s the Federal Reserve has implemented monetary policy much as it did in the 1970s, choosing a "target" or "intended" value for the overnight federal funds rate and manipulating the Fed's tools--open-market operations, regulations governing banks' reserve balances, and the terms of bank borrowing from the Fed--to keep the market overnight rate centered on the target. The "liquidity effect" of changes in reserve supply is often described as the most important of the Fed's techniques.... Hamilton (1997)... concludes that "the liquidity effect is real: additional reserves lower the interest rate. This effect allows the Federal Reserve to target the federal funds rate on a daily basis."
In recent years, however, the Fed... appears to steer overnight interest rates through an "announcement effect" of "open-mouth operations": "when the FOMC publicly announces changes in the funds rate target, the market reacts very quickly and sometimes without anny immediate open market purchases or sales by the Trading Desk to alter the supply of Fed balances" (Taylor, 2001, p. 33). The other side of the coin is the "vanishing liquidity effect": on a monthly frequency, a relation between short-term interest rates and reserve supply innovations is apparent in data from the 1970s, but hard to find in data from the 1980s and 1990s....
For some circumstances, the mechanism underlying open-mouth operations is well understood... where banks are required to hold minimum reserve balances averaged over a multi-day maintenance period... reserve demand depends on the level of overnight rates expected to prevail later in the period. Any resrve-supply adjustments needed to support a change in the target can be postponed to the maintenance eriod's final days. Another type of announcement effect... reserve demand should depend on the cost to a bank that allows its... reserve account balance to fall below... required minimum.... A desired change in the target overnight rate can be effected by a suitable change in the discount rate with no change in the quantity of reserves supplied through open-market operations....
Neither of these mechanisms can account for the appearance of open-mouth operations in the U.S....
I argue that the appearance of open-mouth operations and the disappearance of the borrowing function... were both consequences of... restrictions on the frequency of a bank's discount borrowing and prohibitions on "continuous" borrowing.... These policies practically eliminated any relation between a target overnight rate or the discount rate, on the one hand, and large banks' reserve demand or discount borrowing on the other. Only small banks displayed the relations between interest rates and reserve quantities assumed by conventional models of interest-rate control. In the 1970s small banks' behavior was still an important determinant of variations in total discount borrowing and reserve demand. By the late 1980s, however, small banks had become unimportant in this respect. Thus the borrowing function disappeared... reserve-supply adjustments were no longer needed to enforce changes in the target overnight rate....
It's SUNY-Binghamton...no "p".
Posted by: George Zachar on April 29, 2004 10:24 AM"I argue that the appearance of open-mouth operations and the disappearance of the borrowing function... were both consequences of... restrictions on the frequency of a bank's discount borrowing and prohibitions on "continuous" borrowing"
How? Is he suggesting banks were forced to "securitize" their loan portfolios to minimize required reserves?
I think you're wrong Brad. It's a meta-credit effect, the credit of credit. If the effective 'credit rating' of a lending institution is high enough - a measurement of its liquidity and asset to book value which is a rating of the credit worthiness of its financial evaluations and loans - then it would be natural for a market mechanism to grant a very high meta-credit rating a very high discount.
In the limit where the meta-credit rating approaches a very large ratio to the asset / liquidity ratios of lending institutions and market mover purchasers then you have an approach to an almost complete risk discount - e.g. the most powerful and stable central bank in the world.
In that scenario, the market is going to be moved entirely by the expectation of the cash and capital flows of that market dominant institution. Hence the saying, "don't fight the Fed." Were that expectation of absolute correlations to weaken, uncertainty to increase, and therefore effective risk in trusting in the Federal Reserves pronouncements to increase then the market discount would be erased and you would have to see substantial market movement from Fed intervention in order to see a subsequent yield curve capitulation.
It's really about risk discounts in credit worthiness evaluation. If people believe that you will follow through on your word, no matter what, your word becomes a source of credit itself and can exert financial leverage in any given market situation.
Posted by: Oldman on April 29, 2004 10:44 AMSince the fed started providing market info on fed funds target the supply of reserves has been much more stable than it was previously. Prior to 1987 reserves were extremely volatile -- both rising and falling. But after 1987
saw free reserves expand when fed eased, but they did not contract when the fed tightened as they had prior to 1987.
Exceptions were when the fed withdrew liquidity injection provided after long-term capital crises and after 9/11.
I have long though the reason for change in behavior is that markets no longer had to search for equilibrium. When market did not know
correct interest rate they had to search for equilibrium so the fed had to sharply contract reserve supply to achieve equilibrium. It was a
cob-web function. When markets knew correct rate it moved to it in a frictionless manner, so fed did not have to contract reserve supply to acheive equilibrium.-- think of it as shifting supply and demand curves around the correct price(interest rate).
However, free reserves has been a great leading-concurrent indicator of stock market PE as far back as the data goes. If you use free reserves data as the measure of fed policy it suggest
fed policy stability in the 1990s was also a
major reason for expansion of stock market PE
in the 1990s.
It also implies that the fed withdrawing masive reserve injection after 9/11 caused policy to be much tigher in 2002 than they thought. Interestingly, this explain the fall in the stock market pe and bear market in 2002. The 2002 bear market was extremely unusual. 2002 was the first year of an economic recovery. As a matter of fact it was the 41st economic recovery since NBER has compiled the data going back to almost the civil war. But it was the first and only first year of a recovery that the stock market fell. The free reserves data implies that the reason the stock market fell in 2002 was that the withdrawal of the massive post 9/11 reserve injection caused te fed to be tighter than fed funds implied.
One of the current debates in economics is why is the econ more stable in recent years than historically -- one reason justifing higher PE than historic norm. This history of change in free reserves pattens implies that it might be partially an unintended consequence of the fed
telling markets what the funds target its.
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