Manmohan Singh is chief economist at the International Monetary Fund. Opinions below are his own, not those of the International Monetary Fund or its Executive Council.
Two recent Federal Reserve papers argue that balance sheet decline (or shrinkage of asset holdings) equates to tightening.
A Federal Reserve Paper by Edmund Crowley and others He says $ 2.5 trillion of the Fed’s balance sheet liquidation would be roughly equal to 0.50 percentage points of tightening, or 20 basis points per trillion dollars. Meanwhile, Stefania D’Amico and Tim Seda of the Chicago Federal Reserve are analyzing 10-year U.S. Treasury data to arrive at an estimate of 25 basis points per trillion dollars.
Remember that according to the previous timeline, it would take about two years to break up $ 1 trillion. As of September this year, the faster pace of relaxation ($ 95 billion a month in U.S. treasuries and mortgage-backed securities) will take about a year.
Similar research has been done by the IMF (published in the journal CATO) where we show that a trillion-dollar change in promised guarantees could shift short-term interest rates by up to 20 basis points. Intuitively, long-term bonds in repo / second / broker / derivatives markets can be cut / diced for very short periods of time. Intuitively, more floor treasury (or similar good collateral such as MBS or German securities) in the market space means more collateral is available, and better market performance (i.e. better “reverse” monetary policy transmission).
In other words, if you reuse the collateral factor, the effective supply of collateral going to the market is more than the nominal amount that the Fed settles. Thus, the $ 1 trillion liquidation applied in the two Fed notes will mean more than $ 1 trillion (ie a 20-25 basis point sharpening for every $ 1-2 trillion break, assuming the term of the liberalized collateral is approx. $ 2 for the time being, being, As my previous post about silk speed explained to me). Such parity for interest rate tightening is marginal at best, especially if it takes a very long time to resolve a trillion (1-2 years plus).
Intuition can be seen from the lens of money. Many textbooks still use the traditional language of the IS-LM model to describe the relationship between interest rates and economic output. Here, the IS curve represents investment and savings. The LM curve represents the liquidity demand and money supply. This represents the point at which equilibrium in the production and money markets intersects.
We have (illustratively) learned that across the IS / LM curves the LM transformations are parallel:
But LM can be crucial, as the role of collateral in money markets is often overlooked in macroeconomics:
Technical explanation: The LM curve is usually derived from the equation M = f (Y, r), where the demand for money is a function of production (Y) and standard interest rates (r). The latter is assumed to be sufficient to determine the entire return curve, including all money market rates and risk rewards. However, the role of collateral markets (c) in the transfer of monetary policy is ignored. C is also down (r) and metric for money.
In the “old” framework, any internal shift in the IS curve due to economic contraction can be neutralized, shifting the LM curve outward and lowering rates (even to negative levels) so that they are at the same level of output as before. . This IS-LM framework indicates that, through quantitative easing, the LM curve shifts to the right (money is pumped into the economy), but ignores the good guarantees (and money) taken out of the economy by quantitative easing.
In the “new” IS-LM model, changes in monetary policy may not always lead to a parallel shift in the LM curve; Here, the LM curve can rotate and intersect the IS curve at different points depending on the slope. Some research suggests that QE may initially increase production, but may have a diminishing effect as QE increases in scale. The new IS-LM model supports these findings. The red dots show the change in output relative to the slope of the new LM curve after the “money” taken as collateral by the central banks is held back by central banks. By way of illustration, excessive quantitative easing may produce less than the initial starting point before the crisis. Similarly, a little QT does not take us back to our starting point.
When policymakers set a rate through balance sheet policies, they should recognize the trade-off between money lost (or acquired) through the purchase (or settlement) of collateral during quantitative easing (or QT). Cross-border portfolio shifts (e.g., U.S. Treasuries) could reduce or even reverse the impact of consistently larger quantitative easing interventions on asset prices, as shown in a paper by John Ginakoplos and Haupin Wang. Similarly, the marginal QT will not do much for a ‘T’. The “new” LM curve factorizes the role of collateral in money markets and adds a new ripple to the monetary policy framework.