Friday, February 15, 2013

Frozen deposits as a Federal Reserve policy tool?


I've written before about Iranian monetary sanctions.  We can disagree on motives and targets, but monetary sanctions are undeniably a very powerful instrument. They work because in severing Iran from the global payments network, the sanctions degrade the liquidity of Iranian wealth. I'm going to borrow this idea and see if I can apply it to central bank monetary policy. Can a central bank like the Federal Reserve conduct monetary policy by manipulating the *expected liquidity* of the liabilities it issues? Can the Fed hit its inflation targets by sanctioning its own deposits or, put differently, by freezing and/or unfreezing them?

Let's say that the expected return from holding a Federal Reserve liability can be decomposed into 1. capital appreciation/depreciation (ie. inflation); 2. interest (either interest on reserves ["IOR"] or the federal funds rate), and 3."liquidity services".

Traditionally, an inflation-targeting central bank manipulates the interest rate portion of a dollar's return up or down in order to make inflation, the dollar's expected capital appreciation, rise or fall to its target. Here's what I'm curious about. What happens if the Federal Reserve holds the interest rate fixed but manipulates the "liquidity services" of Fed liabilities? Will this be sufficient to make inflation rise or fall to target?

All assets provide varying degrees of liquidity services, but the liquidity (or "moneyness") of central bank liabilities are supreme. In the US, deposits held at at the Fed can be used to make Fedwire payments. Fedwire is an interbank clearing and payment system hosted on the books of the Federal Reserve. Banks make payments in order to settle cheques, buy and sell securities, and make other large time-sensitive payments on behalf of clients. The average value per transfer over Fedwire is about $5 million. In 2011, $663 trillion in transactions were conducted via Fedwire. That's a lot of liquidity.

Let's say the Fed announces that going forward some not insignificant percentage of all deposits held at the Fed will be frozen for a period of time, say a month. While frozen, deposits will still earn IOR, but banks won't be able to sell them on Fedwire. The distribution of frozen deposits will be random. No bank knows if they will be afflicted or not. When, after a month, a deposit is unfrozen, some other random deposit in the system is frozen.

Just like monetary sanctions, the freezing of Fed deposits will have the effect of degrading their anticipated liquidity services. Banks who had previously been sure of the superior saleability of Fed deposits now face the possibility that they won't be able to utilize them should some unanticipated need arise. In response, banks will simultaneously try to rebalance their portfolio towards other liquid assets by selling some of the Fed deposits they hold. But the stock of outstanding Fed deposits is fixed. The only way for the system to equilibrate is for the price of all other assets to rise, or, put differently, for inflation to increase.

In this scenario, the Fed loosens policy (creates inflation) by either increasing the margin of deposits that are frozen or by lengthening the period for which they will be frozen. It tightens by unfreezing and shortening. Playing around with its liquidity-services tools allows the Fed to hit its inflation target.

Conversely, the Treasury tightens Iranian monetary policy by freezing Iranian deposits in the international payments system and loosens by increasing the ability of Iranian's to participate in the system. The Treasury's target is unrealistic—Iran must stop developing the bomb. A more realistic target would be Iranian NGDP.

Apart from serving as a mental exercise, using liquidity tools in monetary policy might be useful at the zero-lower bound. We know that the Fed can't set a negative interest rate at the ZLB because everyone will quickly convert Fed deposits into Fed cash in order to escape the penalty. The Fed therefore loses its ability to drive up inflation.* Miles Kimball's vision of a conversion penalty on cash withdrawals is one way to limit the dash for cash, thereby allowing central banks to set negative rates. A more extreme fix is to simply ban cash.

Because cash is a day-to-day feature of regular people's lives (well, criminals too), implementing cash penalties or bans might be a bit awkward. If instead we try to escape the ZLB by reducing the liquidity of Fed deposits and creating a bit of inflation, this shifts the burden of coping from the public to banks. Won't banks simply evade the sanctions by converting deposits into Federal Reserve cash? Unlikely, since they'd be forfeiting IOR and have to pay storage and transportation costs on cash.

*Market monetarists don't believe this and think large scale purchases can do the trick. I don't disagree.

11 comments:

  1. Assume a starting point of IOR=FF. If reserves are somehow penalized, then the Fed will have to raise IOR to maintain a constant FF. With IOR>FF, banks will be happy to hold the penalized reserves.

    "Won't banks simply evade the sanctions by converting deposits into Federal Reserve cash? Unlikely, since they'd be forfeiting IOR and have to pay storage and transportation costs on cash."

    They don't have a choice. They are obligated to convert if their customers demand currency, which they will if FF is much below 0%.

    To prevent this, a central bank could suspend conversion of reserves into currency, which would allow an arbitrarily negative FF. The supply of currency wouldn't necessarily be static, but additional currency would be sold at auction. I guess you could call this "banning cash", but it's really transforming bank notes into bearer bonds, which can also be used as a medium of exchange. Hand to hand transactions aren't blocked, just inconvenienced.

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    1. "Assume a starting point of IOR=FF. If reserves are somehow penalized, then the Fed will have to raise IOR to maintain a constant FF. With IOR>FF, banks will be happy to hold the penalized reserves."

      I'm imagining excess deposits and a very tight corridor. Say IOR is .25% while banks can borrow at the primary credit rate of 0.3%. What ever happens inbetween isn't the CB's concern. It keeps the corridor fixed and only freezes or unfreezes deposits.

      "They don't have a choice. They are obligated to convert if their customers demand currency, which they will if FF is much below 0%."

      The central bank keeps the channel at 0.25-0.35%. If it freezes, the total return on deposits declines while the interest portion of the return stays fixed. I'm not sure why bank customers would demand cash if interest rates stay fixed.

      Delete
  2. I think this sentence may be unintentionally reversed: "Conversely, the Treasury tightens Iranian monetary policy by freezing Iranian deposits in the international payments system and loosens by increasing the ability of Iranian's to participate in the system. "

    You probably meant to say that the Treasury loosens Iranian monetary policy by freezing Iranian deposits, and tightens by unfreezing.

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    1. Hi JP (always nice to meet a fellow JP)...

      I originally wrote that the Treasury loosens Iranian monetary policy by freezing Iranian deposits, but for some reason the analogy doesn't translate. It's the exact opposite. Still trying to figure out why.

      ....

      More comments later from me. Am on holiday till Monday evening.

      Delete
  3. I'm assuming random freezing can only "work" with a penalty or limit on currency withdrawals. If so, reducing the liquidity of demand deposits can have harmful effects: increased cash transactions, capital flight and a correspondingly low deposit-to-gdp ratio.

    In Argentina (which has suffered deposit freezes) for instance, "casas de cambio" facilitate the conversion of foreign bank deposits in domestic currency. When someone buys a house, they wire in funds from abroad, convert it to currency at the "casa", and show up at closing with a suitcase full of cash (hopefully accompanied by an armed guard). The infrastructure of deposit-avoidance makes velocity much more sensitive to policy, but not in a beneficial way.

    Would conversion penalties have harmful unintended consequences in the U.S.? To an economist like Kimball, the probability of that is not high enough for to merit a mention. The reason, presumably, is non-linearity and path dependence don't exist in his models. Unfortunately, they do in the real world.

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    1. Diego, I don't think random freezing of Federal Reserve deposits requires currency withdrawal limits. The freezes would only be temporary, after all, and would only apply to a portion of total Fed deposits.

      But yes, the last thing one wants is an Argentinean situation.

      I remember reading that when the corralito happened, people escaped it by purchasing dual-listed stocks. The above idea strikes me as having some similarities. Freezing Fed deposits encourages banks to move into other liquid assets like stocks, thereby bidding down the price of Fed money.

      Delete
  4. JP: if the elasticity of demand for gas is less than one, an increase in cars' mpg causes a reduction in the demand for gas. If the elasticity of demand for gas is greater than one, an increase in cars' mpg causes an increase in the demand for gas.

    I think there's something similar here. Whether freezing is a tightening or loosening of monetary policy depends on the elasticity of demand for money. (But my brain can't quite figure it out.)

    Good post. As always.

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    1. Thanks Nick,

      That's a good way of putting it. In this post I assume a demand for liquidity-in-general which presupposes high elasticity and substitutability among liquid assets. Just choose whichever form of liquidity is the cheapest. So any decline in the mpg, or effectiveness, of Fed liquidity causes a decrease in demand for deposits. Something like that.

      Delete
  5. this is quickly becoming my favorite blog... on the Iran tightening/loosening thing, doesn't it matter most from reserve currency status vs. pegged currency status of Iran? we are creating inflation there b/c of lack of dollars for USD based goods on a global scale, --> rial constrained weaker usd stronger --> inflation. can that work here? my suspicion is no, degradation of liquidity should create a demand elsewhere i think, the question where? and since there isn't a natural need for an external currency i also think it may actually be deflationary domestically.

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  6. Note to self... reading back on this, I don't think freezing deposits necessarily evades the ZLB. As the threat of freezing increases (and keeping IOR fixed at 0.25%) at some point banks will prefer 0% yielding cash to 0.25% reserves, despite the superior yield on reserves. All deposits will be at some point converted into cash since the latter isn't subject to immobilization.

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  7. The provide of forex wouldn't actually be fixed, but extra forex would be marketed at public auction. I think you could call this "banning cash", but it's really changing financial institution notices into wearer ties,
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