An analysis of the federal reserve's policies over the last century

• Autores: David Pavon Prado
• Directores de la Tesis: Carlos Santiago Caballero (dir. tes.)
• Lectura: En la Universidad Carlos III de Madrid ( España ) en 2019
• Idioma: español
• Tribunal Calificador de la Tesis: Albrecht Ritschl (presid.), María del Pilar Nogués Marco (secret.), Mark Carlson (voc.)
• Programa de doctorado: Programa de Doctorado en Historia Económica por la Universidad Carlos III de Madrid y la Universidad de Barcelona
• Materias:
  • Ciencias económicas
    • Teoría económica
      • Teoría monetaria
• Enlaces
  • Tesis en acceso abierto en: e-Archivo
• Resumen

  • The Federal Reserve’ creation dates from the year 1914, after the Congress approved the Federal Reserve Act on December 23, 1913. It was designed with the main purpose of solving the significant fluctuations in market interest rates caused by the seasonal demand for currency, which mostly depended on the financing of crop harvest and the severity and frequency of banking crisis, as the previous thirty years had witnessed five of them. Those targets are far from the maximum employment, stable prices, and moderate long-term interest rates that have been determining monetary policy for the last decades. That change is synonym of having overcome those past obstacles and of the evolution in the field of monetary policy. However, banking, financial and debt crises, bubbles, market crashes, recessions, high inflation levels or even deflation, have been the recurrent episodes during the last decades. The lack of ability to prevent these phenomena proves that our knowledge about monetary policy is still scarce, and even, some of the already established and accepted knowledge may be erroneous. Thereby, this study was born with the intention of re-examining the Federal Reserve’s history, what implies its policies and their consequences on the American economy, relearning from the lessons provided, and subsequently, to discover missing or misunderstood mechanisms operating between monetary policy and the real economy.

    Thus, Chapter 1 reviews the narrative of the Federal Reserve’s history from the end of the World War I to 2007, just before the Great Recession, but skipping the 1940s, mainly because of the World War II and to make it consistent with the periods analysed in Chapter 2. The narrative covers the main events happening within the Fed regarding the learning process of its members about monetary policy and their reactions to economic and political episodes. After reviewing how the Fed used its instruments in the process of achieving their targets, not only some insight is acquired regarding the possible factors conditioning the American economy’s performance, but also that review leads to questioning whether researchers have been measuring monetary policy stance correctly. While it can be a recklessness to direct the attention to what should be considered as settled bases, one must be aware that if the measuring of monetary policy were erroneous, the error would be transmitted to the results. Consequently, the comprehension of the mechanisms whereby monetary policy is able to reach the economy would be poorly recognized and would disable the possibility and necessity of unveiling the common patterns that can help us in foreseeing and preventing undesired episodes as those previously commented, as policy advice will be based on false premises. Subsequently, the lessons learned will be translated into bad policies.

    This questioning appeared once I observed the common procedure to measure monetary policy stance used in the literature, in contrast with the knowledge acquired in the review of the Federal Reserve’s history. Thus, Chapter 2 explains how that common procedure is erroneous and a new approach is proposed. The standard procedure used intermediate targets such as short-term rates or reserves measures, although mainly the federal funds rate (Christiano, Eichenbaum and Evans (1998), Boivin and Giannone (2006), Primicery (2005)…) as Fed’s instruments. However, this approach entails a conceptual and a measuring problem. Conceptually, short-term rates or reserves measures are not Fed’s instruments but intermediate target. The actual Fed’s instruments are, mainly, the discount rate and open market operations. This leads us to the second problem. The use of intermediate targets to measure monetary policy stance introduce bias into the models. To understand this statement, the money market must be conceptualized as two submarkets. In the first submarket the Fed is the supply side and the banking sector the demand side. In the second submarket, the banking sector switches to the supply side, the other agents of the economy being the demand side. The Federal Reserve through the discount rate and open market operations sets the price and the amount of money in this first submarket, depending on its intermediate target. Taking the federal funds rate as example (although the same argument applies to reserves measures or other intermediate targets), when the Federal Reserve uses its instruments, it has an impact on the federal funds rate according to the level targeted. However, the federal funds rate also depends on how banks are pricing their reserves. That pricing is conditioned on the demand for loans, forecasts regarding growth, inflation, risks, Fed’s policies and so on. When the Fed is targeting a specific federal funds rate, to maintain it equal at two different periods, it will have to use its instruments differently to achieve such target, because, as already said, it depends also on banks pricing decisions. Thus, the different amount and price at which reserves are provided for the different periods, despite keeping the federal funds rate at the same rate, will have a different impact on the real economy. The reason is that banks set their loans rate, mainly conditioned on the cost of money to them, namely, the cost of the reserves. As the Fed provided them at different prices, but maintaining equal the federal funds rate, the impact on the loans rate will be different, and that different impact will be converted into a higher or lower demand for money, output growth and inflation.

    Thus, using the federal funds rate or other intermediate target to measure monetary policy stance, what should suppose the measurement of only the supply side of the first submarket, also captures the demand side of the first submarket. Therefore, the results will not only measure monetary policy stance, but also the banking sector’s decisions. This argument was born from the fact that during the last century, when the spread between the short-term rate of reference and the discount rate was positive, borrowing at the discount window increased, signaling that banks were taking advantage of the arbitrage opportunities by borrowing cheaper reserves at the discount widow. The relatively cheaper cost of those reserves could have enabled banks to increase the loans rates less than the Fed raised short-term rates. That is, when, wittingly or unwittingly, the Fed raised short-term rates, its impact on the loans rate was below the ratio 1:1 (as banks obtained cheaper reserves at the discount window), triggering an insufficient restrain of credit, and consequently, higher inflation, as the results confirm. In relation to this, Chapter 2 also unveils that the price puzzle, whereby increases in interest rates are accompanied by higher inflation (Barth and Ramey (2001), Boivin and Giannoni (2003), Bernanke, Boivin and Eliasz (2005), Uhlig (2005) and Hanson (2006), among many others), is non-existent. That puzzle is a consequence of bad policies that allowed positive spreads between the federal funds rate and the discount rate. Thus, the lesson learned in this chapter is that monetary policy stance has been measured erroneously. To solve that, a new procedure is developed using actual Fed’s instruments and the spread between short-term rates and the discount rate. According to the results, this chapter shows that monetary policy was almost useless during the interwar period, that the Fed used its instruments differently after the mid-1960s and that the banking sector was likely to have changed its behavior around 1990. It also hints that monetary policy seems to be transmitted through prices and not through quantities.

    Encouraged by the hypothesis that banks set their loans rate depending on the cost at which they obtain reserves and the possible banking sector’s behavior change around 1990, Chapter 3 focuses on the study of that potential channel whereby monetary policy can be transmitted to the real economy, and where the banking sector as transmitter of monetary policy, can modify Fed’s policies. While some authors debated whether monetary policies were transmitted through the “money channel” (Bernanke and Blinder (1992), Kashyap, Stein and Wilcox (1993)) or the “lending channel” (Ramey (1993), Oliner and Rudebusch (1995, 1996), Romer and Romer (1990)), the premise for both channels is based on the fact that banks need deposits to lend. Thus, when the Fed removes those reserves or avoids their rise, banks either increase the loans rate (money channel) or reduce the amount of lending (lending channel). However, authors such as Moore (1983), Bindseil (2004) or Jakab and Kumhof (2015) presented strong arguments against that premise and claimed that banks are not in need of deposits to lend as the deposit multiplier theory suggests. The reality is that banks lend as long as it is profitable and their solvency is not in danger, and just later, the required reserves are obtained. Therefore, causality runs from loans to reserves and not the other way around. Also, they argue that the demand for loans (money) is endogenous. “The ability of central banks to control the rate of growth of monetary aggregates therefore hinges on their ability to control the rate of growth of bank lending, rather than the monetary base” (Moore (1983), p. 544). Further: “The assumption…is that banks set the prime rate and then attempt to meet the loan demand that results” (p.545). Thus, once this misunderstanding is overcome and taking into account Chapter 2, I elaborate what I have named the “reserves-cost” theory. It claims that given the Fed sets short-term rates, wittingly or unwittingly, by providing reserves and using the discount rate, the only way whereby it can have an impact on the real economy is by influencing the reserves cost directly, and indirectly, with the impact of this cost on the loans rate. Therefore, while the spread between the federal funds rate and the discount rate is closed, it is more likely that the Fed has total control of monetary policy. Otherwise, the banking sector will modify those policies and the impact on the real economy will be different. The reason is that those positive spreads will cause that the federal funds rate has an impact ratio below 1:1 on the loans rate, which will depend on banks decisions, conditioned on the cost of their reserves. As banks can obtain nonborrowed and borrowed reserves from different sources, the cheapest one will determine the evolution of the loans rate, and consequently, the demand for credit.

    Once this theory is completely understood, I decide to drop the Fed’s instruments from the model, unlike in Chapter 2, for the reason implicit in the new theory. That is, to measure monetary policy stance, as policies have its impact on the economy through their influence on the reserves cost, it is sufficient to capture the price at which reserves are available in the money market. Thus, the spread used in Chapter 2, namely, the difference between the federal funds rate and the discount rate, is also used in this case as measure of monetary policy stance. In addition, a new variable is created to capture how the banking sector responds to those policies. This variable measures the spread between the prime loans rate and the federal funds rate. When this spread is smaller, it signals that banks are obtaining cheaper reserves at the discount window than those available at the short-term rates in the money market. Consequently, the loans rate evolves differently in relation to the federal funds rate, what implies the ratification of the assumption taken in Chapter 2, namely, the impact of the federal funds rate on the loans rate is below the ratio 1:1. This phenomenon produces an insufficient restrain in lending, causing higher inflation. The results confirm the new “reserves-cost” theory and therefore, a new mechanism discovered. It implies that the banking sector is able to modify Fed’s policies and that when positive spreads are allowed, the Federal Reserve lose, partially or totally, its power to drive the path of the economy. The understanding of this mechanism teaches us that to avoid episodes as the Great Inflation, besides setting a short-term rate target high enough to restrain the demand for credit, the spread between the federal funds rate and the discount rate must be closed. The “reserves-cost” theory may be also the explanation for Great Moderation (and the Great Inflation). The reason is that this episode coincides with the period when banks set a constant spread between the loans rate and the federal funds rate, being the largest of the period under analysis, unlike during the Great Inflation when the spread was smaller (or even negative) and more volatile. Thus, the stability or instability of this spread seems to be transmitted to the economy as the volatilities seen for the spread, coincide with those seen for output and inflation for the Great Inflation and the Great Moderation. At the same time, the amplitude of the spread seems responsible for the inflation levels.

    However, the “reserves-cost” theory, as exposed in Chapter 3, leaves one case without explanation. While for most of the period under analysis in that chapter excess reserves were scarce and banks decisions on the loans rate were based on the interest rate at each period, after the mid-1980s banks began to accumulate excess reserves. For this scenario, from the “reserves-cost” theory can be deduced that the cost of past reserves may also have an impact on the current loans rate. If it were the case, it would mean that the theory was incomplete, because it was able to explain how banks react to Fed’s policies only when current interest rates are taken into account. Consequently, Chapter 4 undertakes the completion of the “reserves-cost” theory. Further, the renewed theory is proposed as the explanation for the accumulation of reserves. While the literature has suggested low interest rates (Frost (1991), Bindseil, Camba-Mendez, Hirsch and Weller (2006), Dwyer (2010)), risk, uncertainty, (Goodhart (2010), Ashcraft, McAndrews and Skeie (2011), Chang, Contessi and Francis (2014)) or low demand for loans (Bindseil (2004) and Todd (2013)) as the most important factors determining the accumulation of excess reserves, I argue that the accumulation or use of excess reserves is explained also by the cost at which reserves are obtained.

    When banks accumulate reserves, if the cost at which reserves can be obtained at a particular period is below the cost of the reserves held, as profit maximization agents, banks will prefer to obtain reserves at current rates to maximize profits by obtaining the largest margin between the loans rate and the cost paid for the reserves required for loans. On the contrary, if reserves costs are above the price at which they can be found at that moment, banks will prefer to use their reserves. For the former scenario, banks will decide to accumulate excess reserves, while for the later, they will use those already held. Thus, the “reserves-cost” theory is revamped as follow: The only way whereby the Federal Reserve can have an impact on the real economy is through the manipulation of the cost at which banks obtain reserves. This cost will steer the loans rate, which is the actual rate that the real economy endures. If the level of excess reserves is scarce, just modifying the federal funds rate (or other the short-term rate of reference) and the discount rate will have a direct impact on the cost of reserves held by banks, as long as the spread between these rates is closed. In that case, the movements of those rates are likely to be reflected one to one into the loans rate. If the excess reserves levels are significantly above the levels of required reserves and precautionary factors, the impact of interest rates aforementioned on the loans rate will be proportionally diluted to the quantity hoarded, and more aggressive policies and longer time will be necessary to drive the real economy through the desired path. The reason is that banks’ decisions about the loans rate will make it to evolve differently in relation to short-term rates given the reserves cost. Consequently, there will be three hands behind the steering wheel of monetary policy. That is, past Fed’s policies, banks’ decisions and present Fed’s policies.

    To evaluate this new theory a new variable is created. This variable measures the average cost of the reserves held by the banking sector at every period. It is used along with the short-term rate of the money market, so that the spread between both variables indicates whether banks hold reserves with a cost above or below short-term rates. When the spread is positive, it will indicate that banks are holding reserves more expensive that the ones available in the market. Hence, they will obtain new reserves at current rates, accumulating even more, as they can maximize profits using the new reserves and lending at the loans rate of that period. It will also imply that banks will increase the loans rate in relation to short-term rates, in order to decrease the probabilities of incurring in loses in case they had to use their expensive reserves. On the contrary, when the spread is negative, it signals that banks hold cheaper reserves than current rates. Therefore, accumulated reserves will be used to maximize profits and the loans rates will be raised less in relation short-term rate increases, as there is no risk of using reserves with a cost above the loans rate. In addition, a relatively lower loans rate will increase loans demand and therefore, profits. The results confirms that when the cost of excess reserves is above the current short-term rate, banks accumulate more reserves and increase the loans rate in relation to the short-term rate. Thereby, this chapter is the final response to the ambitions that originated this study, as by finding an error in how to measuring monetary policy stance, the mechanism whereby Federal Reserve’s policies have an impact on the real economy was unveiled, adding to the needed knowledge to manage monetary policy. The chapter ends by describing the different scenarios that the Fed has to face depending on the amount and price of reserves holds by the banking sector, the spreads between the reserves costs and short-term rate, and the impact ratio of that short-term rate on the loans rate. The possession of that knowledge supposes the first step to prevent the harmful episodes commented at the beginning.