James Hamilton Calls for Quantitative Monetary Easing
He writes:
Econbrowser: The new, improved fed funds market: Yet another week of institutional changes that render all those nice macroeconomic texts and professors' lecture notes obsolete. The interest rate at which banks lend their Federal Reserve deposits to one another overnight is known as the fed funds rate. For the last 20 years, U.S. monetary policy has been primarily implemented by setting a target for this interest rate.... The Fed announced on Tuesday that it will raise the interest rate it pays on both required reserves and excess reserves to the level of the target itself, currently 1.0%.
My first reaction was, How in the world could that work? Why would any bank lend fed funds to another bank at a rate less than 1%, exposing itself to the associated overnight counterparty risk, when it could earn 1% on those same reserves risk free from the Fed just by holding on to them?... [T]he effective fed funds rate reported for Thursday-- the first day of the new regime-- was 0.23%. So much for that theory. But what's going on?... [T]he GSEs and some international institutions also have accounts with the Fed. But unlike regular banks, these institutions earn no interest on those reserves.... [T]he FDIC that banks pay a fee to the FDIC of 75 basis points on fed funds borrowed in exchange for a guarantee from the FDIC that those unsecured loans will be repaid.... [Y]ou get a floor for the fed funds rate somewhere below 25 basis points under the new system....
This means a couple of things for Fed watchers. First, fed funds futures contracts... are primarily an indicator of how these institutional factors play out... signal little or nothing about future prospects for the target. Second, the target itself has become largely irrelevant.... There's surely no benefit whatever to trying to achieve an even lower value for the effective fed funds rate....
What we need is some near-term inflation, for which the relevant instrument is not the fed funds rate but instead quantitative expansion of the Fed's balance sheet. I continue to have concerns about implementing the latter in the form of expansion of excess reserves, which ballooned by another quarter trillion dollars in the week ended November 5. Instead, I would urge the Fed to be buying outstanding long-term U.S. Treasuries and short-term foreign securities outright in unsterilized purchases, with the goal of achieving an expansion of currency held by the public, depreciation of the currency, and arresting the commodity price declines...
