The Central Bank and the Yield Curve

In a recent post it was noted that the central bank could dictate longer interest rates if this were deemed appropriate. This deserves brief elaboration. The relevance of the observation is not that it would necessarily be a desirable policy, but rather that in a modern monetary system – one in which the government is the monopoly issuer of its own flexible exchange-rate fiat currency – ultimately interest rates are at the discretion of the central bank. The government chooses the form of debt it issues and the central bank can control the interest rates applying to that debt. It follows that the government’s risk of facing “unsustainable” interest obligations, in the orthodox sense of causing runaway inflation, is eliminated barring deliberately self-destructive policy.

When modern monetary theorists say that the central bank could dictate all interest rates, including longer ones – see, for example, Bill Mitchell’s Who is in charge? – they mean that the central bank could use a price rule rather than a quantity rule. This is what it currently does with the short-term interest target. The central bank could say it will stand ready to buy or sell whatever amount of debt of particular maturity is necessary to maintain its target for that interest rate, just as it stands ready to maintain its target short-term rate. Since the consolidated government sector (including fiscal and monetary authorities) faces no financial constraint, the central bank has the capacity to do this.

But this is not to suggest that such an approach is necessary, or even desirable, when it comes to longer interest rates. The important point is that, ultimately, interest rates have a monetary/political determination, not a real determination, and are at the discretion of the central bank. I discuss this point further in Interest, Money and Crisis, but see especially Scott Fullwiler’s Interest Rates and Fiscal Sustainability.

The observation that interest determination is a matter of political economy is a critical one. Some orthodox economists attempt to show that ongoing government net spending creates an excessive interest obligation that, when paid, gives rise to runaway inflation by causing demand to outstrip the capacity of the economy to respond. This fear subsides once it is understood that interest rates are at the discretion of the central bank.

In practice, it is not necessary to dictate longer rates. The Treasury and central bank, working in tandem, can instead do one of two things:

1. Stop issuing debt and just pay the target rate on reserves; or

2. Only issue short-term debt so that short-term rates are the only relevant ones for fiscal “sustainability” in the orthodox sense.

Since the central bank controls the short-term rate, and even more easily can control the rate paid on reserves, the interest obligation on public debt is directly controllable. Provided this approach is taken, it won’t matter from the perspective of the government’s debt obligation whether longer rates are allowed to be influenced by markets through inflationary expectations and arbitrage. Further, as long as fiscal policy is pursued with an eye to both strong employment outcomes and price stability, there will be little reason to fear steep increases in longer rates due to expectations of rapid future inflation.

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196 thoughts on “The Central Bank and the Yield Curve

  1. Because the Fed wants to control the price. Think about a currency peg. It’s the same principle.

  2. I don’t understand why the Fed wanting to control the price is significant. As long as the Fed controls the price, my bond is as good as money.

  3. We can talk about these operational details, but the bottom line is that in order for purchasing power to be constrained you’ve got to show that individual people who want to spend can’t or don’t do so because they hold bonds.

  4. “I said before, this is all too “cosmic” for me.”

    Dude, whatever it is, it’s definitely not cosmic.

    I suggest you worry less about money, which is just a load of numbers on a spreadsheet, and worry more about what those numbers represent. Unfortunately, Neo Chartalism / MMT gets this all wrong. They are known as “nominalists” for a reason.

    “I realize that there is some correspondence between nominal and real”

    I think you may be misunderstanding what the terms mean. But let’s just ignore them for a moment. We know that in any period the government is consuming goods and services produced by the economy. These goods and services are the economy’s income. Some of this income is taken outright as taxes by the government, and some is borrowed.

    “What atoms are put back when the govt repays the bonds?”

    Some of the income taken as taxes is returned to the private sector. In the case with no growth, this means that the government “earns” a quantity of output as taxes in excess of its consumption and returns the difference to its creditors.

    “Much easier to think about it in nominal terms – actual dollars changing hands.”

    It seems to me that this makes it more complicated than it needs to me. Just focus on the actual processes of production, exchange and consumption. Forget about the dollars for a moment.

    “Additional objection comes from the fact that a large part of government spending – transfer payments, subsidies etc – is not about consuming resources, as we agreed.”

    In those cases, the government is not consuming, but the recipient of the transfer is.

    “Imagine an extreme case where all of govt spending is like that. Then the whole idea of repaying atoms to the private sector stops making sense.”

    I can’t see that it makes much difference. The recipients of the transfers consume resources, which the economy has produced and the government redistributed. Some of these are taxed and some are borrowed. The borrowed resources need to be replaced in the future.

    “I guess that when the debt is paid back, then this corresponds to the opposite effect – namely depriving the public of all these potential government services.”

    Yes, but if the economy is growing we will have higher wealth and the government will find it easier to pay off these debts.

    “But once we start thinking in these abstract terms, we’re losing almost any connection actual monetary phenomena we’re talking about.”

    In the main, these are social phenomena. Money is a sideshow.

  5. We know that in any period the government is consuming goods and services produced by the economy. These goods and services are the economy’s income. Some of this income is taken outright as taxes by the government, and some is borrowed.
    […]
    Some of the income taken as taxes is returned to the private sector. In the case with no growth, this means that the government “earns” a quantity of output as taxes in excess of its consumption and returns the difference to its creditors.
    Just focus on the actual processes of production, exchange and consumption. Forget about the dollars for a moment.
    […]
    In the main, these are social phenomena. Money is a sideshow.

    Maybe. But what I contend is that focusing on actual processes and using the proxies of bond issuance you are liable to create confusion and reach false conclusions. If you only treat money as a sideshow, then why even talk about monetary transfers? You see yourself that when you are trying to convince us that no bonds is inflationary in nominal terms it seems to be hard. One reason could be we’re stupid and don’t understand your argument. Another is that your argument, while being correct, is not presented well. And, finally, it could be that in your switching between real and nominal you are actually confusing things and your argument is wrong. I say, for the purposes of this discussion, stick to tangible things like money changing hands, not on abstract notions of atoms changing hands. When you are saying things like “In the case with no growth, this means that the government “earns” a quantity of output as taxes in excess of its consumption and returns the difference to its creditors” I am not even sure what it means.
    Maybe you’re used to think of these things in these terms – they are the mental shortcuts you developed for yourself. Now imagine you need to convince a Warren Mosler voter that the no-bonds proposal is inflationary. Good luck talking like that.
    That said, back to the question why the government could not use only taxes – instead of bonds – to ultimately post-fund its spending. It issues no bonds, it simply spends and whatever doesn’t pay for itself in increased taxes due to increased output will be paid by proactive taxation. The advantage is that interest payments stop being part of government spending and this money can be put to productive use.

  6. Unfortunately, Neo Chartalism / MMT gets this all wrong. They are known as “nominalists” for a reason.

    This is basically a difference between paradigms. For example, in epistemology, there are several major paradigms,  realism, idealism, nominalism, and within these categories there several subcategories. Just about everyone holds some version of one of these as intuitive true. However, there are no agreed-upon overarching criteria for deciding which is superior, or which may be untenable. The world can be seen (structured) from any of these vantages.

    Paradigms are different ways of “seeing the world,” i.e., modeling the particualr reference points that are given or selected. There can be more than one way of viewing, and it is possible that each way could be equally useful, or useful for different purposes. Judging among different paradigms requires agreement over criteria for evaluating them.

    Paradigms are explanations, and there are different criteria for evaluating explanations. In those areas claiming to be scientific, predictive power is the confirmation of genuine explanatory power. Here the more comprehensive explanation generally wins, cet. par.

    Otherwise, the criteria are formal (logic, consistency and coherence) or aesthetic (simple, elegant). For example, major inconsistencies is a disqualifier. Ockham’s razor is another.

  7. “If you only treat money as a sideshow, then why even talk about monetary transfers?”

    I am talking about transfers of income, not money.

    “You see yourself that when you are trying to convince us that no bonds is inflationary in nominal terms it seems to be hard.”

    Not sure what you mean by “nominal” here, or what it would mean for something to inflationary “in nominal terms” (as opposed to real terms?). One way to compute real income is to measure the value of output over a period at constant prices. Nominal income is the value of the output at current prices. One measure of inflation is known as the GDP deflator and is nominal GDP divided by real GDP. When I say that no-bonds will be inflationary I mean that it will cause this ratio to be greater than 1.

    I know that Tom wrote in his comment that the term “inflation” is ambiguous, but really it is not. It is the growth rate of the price level.

    “One reason could be we’re stupid and don’t understand your argument. Another is that your argument, while being correct, is not presented well. And, finally, it could be that in your switching between real and nominal you are actually confusing things and your argument is wrong.”

    Hypothetically, anything is possible, so why worry about it?

    “I say, for the purposes of this discussion, stick to tangible things like money changing hands, not on abstract notions of atoms changing hands.”

    But we’re not interested in the money for its own sake; we’re interested in the actual transactions, the exchange of goods and services that the exchange of money accompanies. Imagine a simplified economy as a giant circuit. On one side are households and on the other, firms. Firms “rent” labour services from households and pay them a money income. Households buy the output produced by firms and pay them with their newly acquired dollars. Production and consumption flows in one direction round the circuit, and the dollars flow in the other.

    “When you are saying things like “In the case with no growth, this means that the government “earns” a quantity of output as taxes in excess of its consumption and returns the difference to its creditors” I am not even sure what it means.”

    It means that if the government borrows some money in one period, it is going to have to put it back the next. Because it took the money and spent it on goods, there were fewer goods to consume. When it returns the money, there must be more goods to consume. Thus it needs to lower consumption or raise taxes. Let’s say that the economy produces 10 units of output for $10. The government consumes 1 unit of output, paid for by borrowing $1. In the next period, it returns the $1, say by printing it. If it consumes the same amount of output, then value of the money has changed. However, note that even if the government does not consume, there will only be 10 units of output against the $11. So it needs to tax the private sector by $1. If you just ignore the flows of money, then what happen is that the government borrowed 1 unit of output in the first period, and then taxed 1 unit of output in the second period in order to repay whoever it was who deferred consumption originally.

    “That said, back to the question why the government could not use only taxes – instead of bonds – to ultimately post-fund its spending.”

    What do you mean by post-fund its spending with taxes?

  8. I know that Tom wrote in his comment that the term “inflation” is ambiguous, but really it is not. It is the growth rate of the price level.

    And you know how to measure that?

  9. vimothy,

    “I think you may be misunderstanding what the terms mean. But let’s just ignore them for a moment. We know that in any period the government is consuming goods and services produced by the economy. These goods and services are the economy’s income. Some of this income is taken outright as taxes by the government, and some is borrowed. ”

    You have a funny way of looking at things. You’re intentionally mixing up real and nominal here. You can’t even talk about MMT until you separate real from nominal.

    BTW, the government doesn’t consume any goods or services until it spends. And it doesn’t need any income in order to spend if there is demand for it’s currency.

    I think the issue is that you believe your understanding is deeper than everyone else’s somehow, but really you just have a confused understanding of what MMT says. Until you can articulate your criticism of MMT in a way that is understandable, if not compelling, I’m going to continue to believe that. Economics is not the only field that requires mathematical understanding.

  10. “BTW, the government doesn’t consume any goods or services until it spends.”

    Exactly.

    The classical mathematics presented on this thread always start half way round the spending cycle. It requires that money is exogenous and that there is ‘something to borrow’ in nominal terms because it cannot (or more likely doesn’t want to) explain how you can start from zero.

    It is that period zero insight that shows that a currency issuer is fundamentally different in its capacity from a currency user. The classical economic approach is like somebody in physics saying that nothing interesting happened in the universe before the atoms formed – let’s just assume they were there all along.

    “In fact, Aristotle dismissed the atomic idea as worthless. People considered Aristotle’s opinions very important and if Aristotle thought the atomic idea had no merit, then most other people thought the same also. (Primates have great mimicking ability.)” http://www.nobeliefs.com/atom.htm

  11. “And you know how to measure that?”

    Well, I must know at least one way, because I described it. I agree that the problem is non-trivial though.

  12. “You have a funny way of looking at things. You’re intentionally mixing up real and nominal here. ”

    I’m intentionally focusing on quantities, not prices, so that the distinction between real and nominal is not important.

    “You can’t even talk about MMT until you separate real from nominal.”

    It’s not me who thinks that by increasing the nominal value of income, real GDP can be made to increase.

    “BTW, the government doesn’t consume any goods or services until it spends. And it doesn’t need any income in order to spend if there is demand for it’s currency.”

    Income is output. Everyone knows that the government can print more money if it chooses to. It cannot print more output. If the economy’s real income is zero, real govt consumption will be zero too.

    “I think the issue is that you believe your understanding is deeper than everyone else’s somehow, but really you just have a confused understanding of what MMT says.”

    Fair enough, but I don’t recognise that at all. It seems to me that you guys think that your understanding is deeper than everyone else’s, which is why you’re so instantly dismissive of the mainstream. I don’t think that I’ve written anything particularly “deep”–what we’ve discussed is quite basic (if maybe slightly tricky conceptually).

    “Until you can articulate your criticism of MMT in a way that is understandable, if not compelling, I’m going to continue to believe that.”

    That’s okay too–I’m not trying to convert anybody. But look: if you don’t understand the mainstream view, how can you be sure that it’s wrong?

    “Economics is not the only field that requires mathematical understanding.”

    What does that have to do with anything?

  13. “Basically effective demand in excess of productive capacity. There are two key reasons for this occurring…”

    I think this was a nice comment. Do others agree with what Tom wrote?

  14. Hmmm Interesting comment Vimothy.

    Because you described ‘it’ you know how to measure ‘it’.

    So what price level are you referring to?

    I’d like to suggest that there is no single price level to be measured which is why different people see inflation in so many different places.

    I’d additionally like to suggest that an increased quality of life costs us all more….as it should. We have to pay more, in real terms, for quality. What many of us complain about being inflation is actually paying more for a better quality of life.

  15. Because you described ‘it’ you know how to measure ‘it’.

    Because we can describe it conceptually, we can design instruments to measure it empirically.

    “I’d like to suggest that there is no single price level to be measured which is why different people see inflation in so many different places.”

    Different groups of people faces different rates of inflation. It also makes sense to think of the expected or average rate of inflation faced by everyone in the economy.

    “What many of us complain about being inflation is actually paying more for a better quality of life.

    We want to be able to distinguish between changes in relative prices (real prices) and changes in the overall level of prices (nominal changes). By definition, inflation is paying more for the same quality of life.

  16. vimothy: Well, I must know at least one way, because I described it. I agree that the problem is non-trivial though.

    There are many ways to measure inflation, and that is one reason the meaning of “inflation” is ambiguous. If there is a standard, it is the official government statistics. But all government do not agree on this, and even within a single country parameters shift over time, so that comparing inflation rates over some periods is comparing apples to oranges.

    Inflation has a precise definition in economics in terms of a general rise in prices but it is very difficult to get agreement on how to measure this. So we have a definition but no agreed-upon way to apply it in context. This results in ambiguity.

    I am coming at this not so much from the side of economics but from the side of trading. Traders need to know about the current and anticipated price volatility, and they also know that indexes are not only not the final word, but also that they can be misleading. Moreover, the data on which indexes are based are not current. Current for traders means “now.”

    Traders realize that no one actually knows the current rate of inflation, velocity and acceleration, with any degree of precision due to complexity. Traders also suspect government statistics and pay for independent analysis like John Williams’ Shadow Government Statistics — Analysis Behind and Beyond Government Economic Reporting. So traders tend to look to interest rates and yields to determine what the market itself is saying about inflationary expectations. since there are different ways of approaching this, there is disagreement. There is a big kerfuffle among traders now as to whether the trend in the US is inflationary or deflationary, and there are major analysts on opposite sides of not only the debate but also the trade.

    The other reason that the term is ambiguous is that people use “inflation” rather indiscriminately to mean price appreciation. Especially because of the latter use, “inflation” is not only ambiguous but confusing.

    In addition, “inflation” has taken on a pejorative connotation that is often marshaled in both theoretical and policy arguments, whereas it is simply a technical economic term that purports to be objective in the scientific sense of divorced from subjectivity.

    But I agree that the issue concerning price stability/volatility is determining the relation between the nominal and the real. The principal focus here should be determining changes in real wages in that changes in real wages determine shifts in living standard. This is also difficult to measure with any degree of precision.

    For example, in a recovery after a recession prices may begin to rise generally before wages catch up, and while economists and politicians are proclaiming recovery and growth, ordinary people see their standard of living falling. This is a political problem, and one we are witnessing now.

  17. vimothy,

    Forgive me for quoting a previous article from this site, but given your comments on the article I’m quoting below and your comments in this discussion, I can only assume you didn’t actually read this:

    “A Comment on MMT Internet Discussions

    There is one particular straw man that is repeatedly erected by critics of MMT. I’m sure most foot soldiers reading this will have noticed it. It is one that I find especially grating. The best (i.e. most irritating) phrase I’ve seen to encapsulate the nuances of this particular straw man is the refrain:

    MMT claims we can print prosperity.

    The phrase “print prosperity” is shorthand for the common message board accusation that MMT ignores real resources and gets bamboozled by money as if it is magic. The accusation is very common. The term “print prosperity” was coined, to the best of my knowledge, by a Math Professor, no less, who happens to be keen on the kind of “fiscal conservatism” advocated by the Concord Coalition.

    I consider it a perverse injustice that, in online discussions, MMT sympathizers are frequently reproached for imagining that “we can print prosperity” when in fact it is us who constantly stress as a fundamental point that the only true constraints are resource based, not financial or monetary in nature. We are the ones insisting that if we have the resources, we can put them to use. It is the neoclassical orthodoxy and others who try to make out that we can’t use resources, even if they are available, because of some magical, mysterious monetary or financial constraint. Just who is it that believes in magic here?

    MMT shows clearly that if we have the resources, money is no obstacle to a government that issues its own flexible exchange-rate fiat currency. It is not saying that creating money magically creates goods and services. It is saying that it is nonsense – superstitious nonsense – to think affordability for such a government could be about money rather than resources.

    Obviously, anyone is entitled to disagree with the MMT position. But they are not entitled purposefully to misrepresent MMT as suggesting that it is oblivious to real resource constraints when it is alternative theories that attempt to obfuscate matters by conjuring up fictitious “financial constraints” (e.g. the neoclassical “government budget constraint” framework).”

  18. “That said, back to the question why the government could not use only taxes – instead of bonds – to ultimately post-fund its spending.”

    What do you mean by post-fund its spending with taxes?

    What I said in the next sentense: “It issues no bonds, it simply spends and whatever doesn’t pay for itself in increased taxes due to increased output will be paid by proactive taxation.” In other word, keep injecting money till you get demand pull inflation (which corresponds, according to MMT, to saturated desire for holding of NFAs by the non-govt sector) in which case you either reduce spending or increase taxation.

  19. “Are we agreeing here? As I tried to make clear in my comments over at heteconomist, people first decide to save, then choose a particular vehicle of saving. So, interest paid on bonds can only shift their savings to or from bonds, not between bonds and consumption. So, the price of, say, real estate may go up, but the price of computers would not, just as an example!”

    Peter, if you are interested in the answer to this question, and our host doesn’t mind, I’l answer it here. Think of all the assumptions you’re making in the course of this comment. We need to pay careful attention to them.

    You’re saying that for a given amount of income, people want to save X. Some portion of that X is going to be made up of govt debt. Say that govt buys all that paper back and replaces it with base money. Now people still want to save the same amount, because their income is the same. However, they’re only going to be indifferent between assets if their expected return is equivalent (subject to some conditions), so in order for the private sector to hold the same amount of savings as base money, the expected return on other assets has to come down to equal the expected return on base money. This implies falling interest rates and asset price inflation.

    In order to get this result we had to hold savings desires constant. However, in reality they are not constant. If you lower the return to savings, at the margin you are increasing the opportunity cost of saving, and so we would expect individual consumers to substitute out of saving into current consumption to some degree (implying that saving is an increasing function of the interest rate).

    So both effects–static and dynamic–are inflationary. Remember, we’ve held constant income, so no one has more purchasing power or wealth initially. We’ve just made them more liquid, and lowered the cost of consuming today vs the cost of consuming in the future.

  20. “I am saying it is unrelated to return on saving in the form of govt bonds”

    But you already agreed that asset prices were going to go up, which is equivalent to saying that yields / interest rates are going to come down. If asset prices rise, the return to saving falls.

    Think of it this way. The public holds outstanding govt debt. Say govt buys back this debt so that the whole debt is held by the private sector as base money. In order for the private sector to hold this level of base money, the return on other assets must fall. Yes? That’s why the Fed is paying interest on excess reserves at present. You want the private sector to regard bills and base money as perfect substitutes and so you need them to deliver the same return. Otherwise, the private sector will not want to hold that level of base money, and your condition for it not causing inflation is that they will. And since the private sector can’t get rid of the excess base, just swap it around, thi will cause yields on other assets to go down / prices go up.

  21. @vimothy these scenarios sound like one-time price appreciations, not inflation

  22. “If you lower the return to savings, at the margin you are increasing the opportunity cost of saving, and so we would expect individual consumers to substitute out of saving into current consumption to some degree (implying that saving is an increasing function of the interest rate).”

    this doesn’t seem like a relevant margin.

    you seem skeptical that the private sector would provide satisfactory savings vehicles to accommodate the aggregate desire to save. why?

  23. Vimothy, I think I made it clear long ago (fromt he beginning of this thread) that there will be asset price inflation – you explain it your way, which is correct, but I see it following easier from the fact that saving desires (in the absence of govt bonds) would have to be channeled into other savings vehicles (~assets), so, the price of those will go up. Hence my comment that I can see real estate prices go up. Are we finally agreeing on this point?
    Now, this is asset inflation which is a different creature from consumption items inflation, in my understanding. I could be wrong. You say:
    If you lower the return to savings, at the margin you are increasing the opportunity cost of saving, and so we would expect individual consumers to substitute out of saving into current consumption to some degree
    Now I believe this “some degree” is very small. I don’t see people moving consumption forward because it is not in human nature. You won’t start eating more or buying more electronic etc just because the rate in your savings account fell. To be clear, bu consumption items I don’t mean things like durable non-depreciating things which can be seen as investment. So, maybe the price of art and antiques will go up as well, but not electronics, food, gasoline, what have you. I don’t believe in “bringing consumption forward” in this respect, similar to that Winterspeak post about inflation expectations.
    And to whatever small degree of consumption would be brought forward – again, the question remain, why any of this cannot be dealt with functional finance and without any bonds? I think that question of mine is still left unanswered.

  24. vimothy,

    There is an assumption you are making that saving preferences are based solely on return. That’s a highly debatable assumption especially at the short end of the curve.

    Most of the money at the short end is in treasuries due to risk tolerance and not return. If the short treasuries were not available the vast majority of those investors would hold cash even at zero return.

  25. If the govt bought back the national debt with new base, would pension fund managers do with their new deposits? what would banks do with their excess reserves?

  26. Pension funds and banks don’t have to sell bonds unless they want to. The Fed would have to meet their indifference level, and they would switch the funds to the another opportunity at that level.

  27. Vimothy, what would they do? Buy food at the supermarkets? Buy electronics? Buy cars?
    They would buy munis and state bonds and corporate bonds and whatever else will be stamped with enough letters A so that they can sleep happy at night.

  28. Tom: but this is a thought experiment where we try to see how inflationary replacing the national debt with base money would be. Just assume they do. It’s your imagination.

    Peter: Yes, they’d buy other assets–near equivalents for whatever they were holding. So those prices go up/yields go down. But the private sector can’t get rid of the excess cash on its own–it needs the government to remove it. So it passes it around amongst itself until…?

  29. Why would it be inflationary at all. Interest paid on tsys will no longer be injected. That is deflationary rather than inflationary.

    For inflation, there has to be a transmission from reserves to spending. Where is the transmission from reserves to consumption? As Warren says, if there are no bonds, the Chinese can just hold reserves if they want to sell stuff to the US but not buy US stuff. Banks can just hold reserves. too, unless they prefer something else, like corporates or munis.

    What about the cash in deposit accounts? Mostly in pension funds. Pension funds are unlikely to want to hold cash instead of something that pays better, and their preference will be determined by what is available and their risk appetite. I would expect increased competition for corporates and munis, etc.

    You apparently think that an increase in base money (reserves and cash) is going to result in a spending spree, instead of another from of saving. There is no reason to believe that banks and pension funds are going to do anything differently than they are doing now. They will just have to do it without the luxury of a government subsidy for a default-free parking place.

    What is likely to happen is that interest rates will fall as corporates, munis, etc. are bid up. That encourages investment (residential RE is part of investment). With no bonds and zero FFR, se could see the prime rate fall to ~3% on an extended basis. That reduces rent and rent-seeking, and low rates were not inflationary in the fifties.

  30. @vimothy

    to be clear, we are talking about a scenario with no IOR, correct? looks like that’s the scenario tom’s addressing, as well.

    “But the private sector can’t get rid of the excess cash on its own–it needs the government to remove it. So it passes it around amongst itself until…?”

    this is the process where the rates fall to zero?

    i have a specific question about the makeup of ‘reserves’: they are a combination of the reserve *balances* kept at the fed, and of ‘reservable’ vault cash, correct? or do i have my definitions mixed up?

  31. The monetary base is notes and coins held by public, notes and coins held by banks and reserve balances held at the Fed. The Fed can determine the total supply of base money, and the private sector then determines how it is held.

  32. “to be clear, we are talking about a scenario with no IOR, correct?”

    Yep

  33. Leaving government spending as bank reserves is likely to cause some additional spending on consumable or investment items – which increases activity and therefore taxation.

    Therefore leaving the ‘deficit’ (not the national debt) as base money does two things

    – increases private spending by some undetermined amount which should increase taxation.
    – decreases government spending due to the reduction of interest payments.

    Therefore by definition not issuing bonds increases the tax take and reduces government spending – which means the deficit will be lower than it otherwise would be.

    So arguing for bonds is arguing for higher government spending and a higher government deficit.

  34. Neil, if people have the same level of nominal income, and for the same nominal deficit, you think that increasing the nominal stock of money they hold is going to reduce real government borrowing…?

  35. vimothy said @12:44am, “if the govt bought back the national debt with new base…” and @3:01am: “But the private sector can’t get rid of the excess cash on its own.”

    While the private sector can’t get rid of the monetary BASE on its own, I believe the private sector can get ride of extra BROAD MONEY if it wants, and that’s what counts. I did a post on this late last year:

    http://www.thoughtofferings.com/2010/10/how-loanbond-choice-helps-private.html

    I suspect that after large scale QE (or similar ways of government buying back the debt), bank loans get crowded out by other forms of lending, thus shrinking the money supply independently of changes in the overall level of borrowing. Ramanan seemed to think this was consistent with theory of circuitists like Marc Lavoie. I would be glad to hear if anyone finds flaws in the analysis. If true, there might be little effect even on interest rates over the medium term.

    That said, I don’t know how fast this process operates in the real world, and I do have slightly more concern than most MMTers over the potential financial market instability that can (in some situations, but not always?) be amplified by negative real interest rates. But my concern could be misplaced if the effect I described in the post above is true and is powerful enough.

    Sorry if I missed other relevant comments on this thread, I’ve only read a small portion of them but hadn’t noticed this angle covered.

  36. hbl: I asked Marc Lavoie about QE WRT the BoE’s APF programme in the UK, and (IIRC) he seemed to think that the new broad money created by the bond purchases mostly went on paying down existing debt, so that QE was allowing private sector to effectively refinance at lower rates (broad money grew by less than the value of the APF programme). I don’t know if you’re familiar with the term “reflux”…?

    The Bank’s own lit suggests that it deliberately targeted the non-bank credit channel, reducing the cost of non-bank corporate funding.

    “If true, there might be little effect even on interest rates over the medium term.”

    I’m not sure if I follow you here. If so, why do leading MMTers like Scott think that the use of an interest on reserves policy allows the govt to expand the base without necessarily lowering rates? How can QE make non-bank borrowing cheaper if it doesn’t lower rates?

  37. vimothy,

    Interesting that you asked Lavoie about this topic directly! If the question was framed as “why isn’t the broad money supply increasing given all this QE?”, then his answer makes perfect sense. There are lots of things going on at any given time, and deleveraging that involves paying back of bank loans could reduce the money supply faster than QE increases it.

    If you framed the question differently and that was still his answer, then perhaps his answer is not consistent with what I have postulated (i.e., I could be wrong). But it still seems logical to me unless someone shows me the flaws in the logic.

    My comment on little effect on interest rates even over the medium term was something I mentioned in that post, plus above Tom Hickey said “What is likely to happen is that interest rates will fall as corporates, munis, etc. are bid up.” I was suggesting that if the private sector can “shake off” that excess broad money supply, then there is no reason for debt prices to be influenced [beyond short term technicals] by supply and demand… i.e., prices can remain anchored to some collective assessment of fundamentals (credit risk, inflation risk, interest rate risk, etc).

    “why do leading MMTers like Scott think that the use of an interest on reserves policy allows the govt to expand the base without necessarily lowering rates?”

    Sorry to be ambiguous, I was discussing longer term rates, not the short end of the curve.

    “How can QE make non-bank borrowing cheaper if it doesn’t lower rates?”

    I don’t think it does either of those things. I’m claiming it might not have much impact on interest rates of treasuries or anything else. (Warren has explicitly stated he doesn’t think QE as practiced impacts interest rates other than via minor technicals, and I agree).

  38. “Neil, if people have the same level of nominal income, and for the same nominal deficit, you think that increasing the nominal stock of money they hold is going to reduce real government borrowing…?”

    Sorry I lose you when you start talking jibberish. Can you try expressing yourself without jargon.

  39. hbl: I’m an avid reader of Marc Lavoie’s research on monetary policy, actually, so I was interested in his take on UK QE. I can’t remember how I framed the question exactly, but it was something like that, yes. How come the broad supply money expanded by only X amount given that QE should have expanded it directly by 6X (since it involves buying assets from non-banks)? I forget the exact wording and figures/ratio.

    Also suggests, absent QE >> broad money supply growth would have been negative.

    “I was suggesting that if the private sector can “shake off” that excess broad money supply, then there is no reason for debt prices to be influenced [beyond short term technicals] by supply and demand… ”

    Right, but base money stays in the system until the govt/CB drains it out.

    If people still want to “save” the same amount, they won’t want to hold cash, they’ll want to hold assets that earn a return, & this implies that they will want to trade their new broad money for higher yield instruments >>> asset prices rise / rates fall. E.g. see charts at end of this paper:

    http://www.bankofengland.co.uk/publications/speeches/2009/speech405.pdf

    “Sorry to be ambiguous, I was discussing longer term rates, not the short end of the curve.”

    But both Warren has said that he thinks the expectations hypothesis explains the term structure and that it gives the govt power to set long rates. Since long rates are just the average of expected short rates (under EH), logically this implies that if short rates fall, long rates fall as well.

    “I don’t think it does either of those things”

    Have a look at the charts in Bean’s paper. What you write looks pretty weird to me though. What does affect the price of assets, then, if not people buying and selling them?

  40. Er okay Neil.

    Nominal: current market prices
    Real: constant prices
    Deficit: difference between spending and taxation
    Stock of (base) money: notes and coins held by public, notes and coins held by banks and reserve balances held at the CB
    Govt borrowing: public debt: sum of previous deficits

  41. “Right, but base money stays in the system until the govt/CB drains it out.”

    Yes but your original question pertained to “what would investors do” and they only interact directly with broad money, not base money.

    “Since long rates are just the average of expected short rates (under EH), logically this implies that if short rates fall, long rates fall as well.”

    I mostly agree, though how big the impact on long rates is depends on how long investors expect those short term rates to stay low.

    “Have a look at the charts in Bean’s paper.”

    I did but I’m not sure which you are most focused on. And anyway, I’m not sure what conclusions I would draw given how many factors in an economy are influencing asset prices at any given time.

    “What does affect the price of assets, then, if not people buying and selling them?”

    I worded it poorly… I’m saying prices of assets are about price-sensitive supply and demand, not price-blind supply and demand. If the money supply goes up I don’t think it automatically generates an equivalent increase in price-insensitive demand for a given asset class.

    If three investors each have four quarters and I have a dollar bill for sale, and you suddenly give them each an extra quarter before the bidding starts, odds are none of them are going to bid $1.25 in quarters for that dollar bill. Debt assets don’t have as unambiguous a value as that silly example, but hopefully it illustrates where I’m coming from.

    The key observation in my post I linked to, whether you agree or not, is that I think the private sector via the very portfolio shifts you suggest they will want to make has at least partial ability to choose investments such that any unwanted broad money “disappears” at a macro level.

  42. vimothy,

    Still don’t see what you’re trying to say – primarily because you are using ‘real’ in that inflation mode again whereas around here we use ‘real’ for physical things. That’s confusing, so you’ll have to translate what you’re saying into terms I can understand.

    My point was that removing bonds seems that it will reduce the government deficit as it will increase taxation and reduce spending.

    Can we get that resolved first. Is that the case?

  43. Vimothy:
    Peter: Yes, they’d buy other assets–near equivalents for whatever they were holding. So those prices go up/yields go down. But the private sector can’t get rid of the excess cash on its own–it needs the government to remove it. So it passes it around amongst itself until…?

    Until nothing. In this game of musical chairs the last person left with the dollar bill just shrugs and puts it in his pocket.

  44. Seems to me that Warren’s comment under this thread is saying what I’ve been trying to say this whole discussion:

    the questions posed in these comments like ‘if someone gets his tsy secs exchanged for reserve balances, will he spend them’ can be said to miss the point.
    anyone can sell tsy secs at any time and spend the proceeds.
    The fed isn’t needed for that.
    The only thing that changes when the Fed looks to buy is that the Fed becomes an ‘additional’ buyer and presumably rates are that much lower, just as they’d be if any buyer came into any market.
    So the relevant question is whether any particular term structure of rates/mix of nfa is working to increase or decrease savings desires.
    And whether the interest income effects, presumed to work in the opposite direction, are stronger or weaker forces.

    And from Sergei in the same place:

    However the claim about bond vs. reserves/deposits needs additional qualifications to be either right or wrong. MMT makes such additional qualifications by saying that sellers of bonds are indifferent savers and therefore do not spend their deposits in the real economy. This message is very clear and repeated very often. It is obviously impossible to prove this claim but in general it *can* be accepted. There will be certain spill-overs at the margin and I am sure MMTers understand them but they rather choose to ignore. It might be one of those cases where MMT would probably benefit from a bit softer stance providing a bit broader explanations of all important qualifications involved. There are no 100% laws in economics and everything depends.

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