Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Wednesday, March 1, 2017

A reply to Lawrence White

People are generally not accustomed to the idea of a central bank altering the maturity structure of outstanding government debt in a manner that might confer a financial benefit to the government (and by extension, to the citizens it represents). The purpose of my previous post was to make people aware of this possibility, using the recent experience of the Federal Reserve's quantitative easing (QE) program as an example.

The gist of my story went something like this. Suppose that the Fed makes a one-time purchase of a 10-year treasury bond yielding a risk-free 2.5% annual nominal coupon. Suppose that the purchase is financed by "printing" reserves. (Note, this asset purchase and method of finance describes the basic nature of QE). Suppose further that the interest paid on reserves remains below 2.5% for the duration of the bond. Then the Fed makes a profit off the rate of return differential in each of the 10 years it holds the bond on its books. If I understand my critics correctly, none would dispute the financial benefit associated with this Fed intervention as far as the public purse is concerned; at least, as long as it is somehow known ex ante that the short rate will remain below the long rate in the manner assumed.

One objection to this story asks why the Fed is needed to convert a 10-year bond into a lower-cost short-term instrument when the Treasury itself could have just issued a short-term debt instrument to begin with. That's a good question. I'm not sure what factors determine the Treasury's choice over the maturity structure of its debt. The key question to ask is whether the structure chosen is optimal from a social standpoint. The benefit associated with the Fed intervention I described in my post assumes that it is not. What justifies this assumption? No one really challenged me on this. Another objection relates to the optics of the enterprise from a political perspective. Even if the intervention makes sense from an economic perspective, paying interest on reserves held by big banks with the effect of reducing Fed remittances to the Treasury just looks bad (even though it's equivalent to the Treasury paying those big banks for holding treasury debt).

The main objection to my post seems to rest on the claim that I have ignored "duration risk." Let me quote directly from Lawrence White, who was kind enough to take the time to critque my post:
When the Fed borrows short from the banks to lend long to the Treasury, it does not do so costlessly. Duration transformation carries a risk of capital loss, also known as duration risk. Suppose the yield curve shifts up, both short and long interest rates rising together. The Fed will experience a decline in present value of its assets that will swamp the smaller decline in the present value of its liabilities. Such an event is not unknown: in 1979-81 it rendered insolvent about two-thirds of US thrift institutions, who were financing 30-year fixed-rate mortgages with 1- and 2-year deposits. In cash-flow terms, such an event would mean that the Fed would quickly have to start paying higher interest rates to borrow, while its asset portfolio continues to pay low yields and roll over much more slowly. The Fed’s annual net transfer to the Treasury might even go negative. Smaller or negative transfers from the Fed to the Treasury would mean a sudden jump in the present value of the public’s ordinary tax liabilities. Net interest income from playing the yield curve is not a free lunch.
To assess the merit of this critique, let's consider the following thought experiment. First, imagine that there is no central bank (End the Fed wins). Next, imagine that the Treasury wants to borrow money. One option is to issue the 2.5% 10-year bond described above. But another option would be to issue very short-term treasury debt, rolling it over for 10 years. If the Treasury behaved in this manner, it would in effect be replicating the Fed intervention I described above. There would be obvious cost savings to the government and taxpayer, at least, assuming that short rates remained below 2.5%. So what could possibly go wrong?

Well, the risk is that the short-term rate might rise and stay on average over 2.5% for the next 10 years. In that event, which is certainly a risk to consider, the Treasury will have made a loss relative to locking in its debt at the long-term rate of 2.5%. But from the perspective of the taxpayer, it matters not one iota whether this prospective loss is incurred because of the Treasury action or an equivalent action on the part of a Fed QE program.

So, if the point is that financing short-term at low rates entails risk relative to financing long-term at high rates, then I agree. The question, however, is not whether QE exposes the taxpayer to duration risk. Of course it does. The same would be true if the Treasury was to shorten the average duration of its debt on its own. Whether the Fed or Treasury performs this operation is immaterial (from an economic perspective, not necessarily from a political perspective). The fundamental question then is whether government debt is structured optimally to begin with. To the extent that the fiscal authority relies too heavily on long-term debt, then some QE on the part of the Fed could have the public finance benefit I described in my post.

Does the Treasury rely too heavily on long-term debt? I honestly do not know. Those who warn against the Fed shortening duration must implicitly assume that Treasury debt-structure is optimal. Maybe they're right. But as the following figure shows, the spread between long and short rates is usually (though not always) positive.

If this pattern could be relied on to hold in the future, then the question to ask of a QE program is not whether it entails duration risk (it does). Rather, the question is whether the endeavor constitutes a positive net-present-value project.  The data above suggests that it may very well be. This is not the same as claiming there's a "free lunch." The Fed has saved the government over $80 billion a year over the past seven years. That's about $600 billion in cost savings--money that the government would have had to secure through other means to service its debt. It was fluke, the critics will say. An ex ante gamble that pays off ex post is not a justification. Sure. But billions in remittances, year after year, one fluke after another?

Let me briefly address a few other points made by Larry. In the quoted passage above, he warns that the Fed is exposed to suffering a capital loss on its assets should market interest rates rise, that this has happened to private banks in the past with dire consequences, that the result may be lower (possibly negative) remittances to the Treasury.

I think these concerns are overstated. Warning against the prospect of having to reduce remittances is not an economic argument against exploiting a profit opportunity (although, one could make the case on political grounds).

Yes, if the market price of bonds fell, the market value of Fed assets would decline. Should this be a concern? U.S. treasury bonds are nominally risk-free and the Fed normally holds its assets to maturity. Larry's reference to the plight of U.S. thrift institutions is not, in my view, relevant to the issue at hand. Because Fed liabilities are money (essentially equity shares accepted by all as a payment instrument), the Fed cannot go insolvent in the same way a private company can (although politically, the optics would be bad). In any case, the proper way to view the issue is from the perspective of a consolidated Fed/Treasury balance sheet. The issue concerns optimal maturity structure and the impact on the government's consolidated balance sheet as market interest rates change.

It is also Larry's view that the Fed has been carrying "significant" default risk through its holdings of mortgage-backed securities. While I think there are good reasons to let the MBS portion of the Fed's balance sheet run off, I think Larry is once again overstating concerns (even if I grant his point about potential market distortions). The MBS purchased by the Fed are not legacy assets--they constitute senior tranches of securities issued well after the real estate market bottomed out. In short, they're about as safe as securities backed by private assets get. That's not to say that the Fed should be holding such assets. My own view is that the Treasury should have issued bonds against such securities. Doing so would have gone some way to alleviating the worldwide shortage of safe assets.

Larry concludes with a plea for "normalization." Let's go back to a world where bank reserves are scarce. But why? In what world does it make sense to render liquidity scarce? Milton Friedman argued that optimal debt policy entails eliminating all liquidity premia. Almost every economic model I am aware of supports this notion. An appeal to follow historical norms is not an economic argument.
Let me sum up. I think there are two types of arguments one can bring to bear on the question of central bank balance sheet policy as a fiscal debt-management device. The first is economic and the second is political.

The political argument is based on the idea that an independent and accountable central bank is a good idea. To protect central bank independence, it would be unwise for a central bank to operate with the expressed purpose of managing the debt--a realm guarded jealously by the fiscal authority. I think this is a good and practical argument against becoming too enthused with large central bank balance sheets. But this is not the argument that Larry is making.

Larry's argument is an economic one. An economic argument against the Fed helping to manage the debt, suggested to me by my colleague Steve Williamson, is that the Fed does not really have the tools to do the job properly. In particular, the Fed cannot issue debt that can circulate widely. The only liability it can issue--reserves--is clearly inferior to short-term treasury debt. In particular, reserves can only be used by banks with reserve accounts, while treasuries can circulate outside the banking system. This is a good point. It basically says "since the Treasury can do the job better in principle, better the Fed not do it at all." But this not the argument Larry is making either.

Larry's argument implicitly assumes (possibly correctly) that the Treasury has structured its debt optimally. If it has, then there is no "free lunch" for the Fed. If this is the case, then I would have to agree. (And it's heartwarming to see Larry thinking so highly of a government agency's ability to run its operations!)

As I reflect back on the original argument I put forth, I think I would now put it in the following way. First, I would not advocate that the Fed explicitly pursue balance sheet policy as a way to help government financing. As I made clear in my original post, the recommendations I was making were predicated on the assumption of the Fed achieving its dual mandate. If in the course of achieving the dual mandate the Fed is saving the Treasury billions of dollars, then what's the rush to reverse operations? The fear of exposing the taxpayer to duration risk may be a reason--if you feel the Treasury already has its debt structured optimally. But the fact of consistently positive and sometimes very large remittances from Fed to Treasury for years (and even decades) might lead one to question that assumption.


  1. Some might have very good intuition for the concepts and language Larry uses ("duration risk") but I like to start with the question of who has a comparative advantage in bearing the risk of productivity shocks. This is basically the question that Robert Shiller engaged in his advocacy of NGDP-linked sovereign debt, suggesting that countries should shift this risk to the rest of the world.

    The US doesn't issue such debt, but it does participate in a risk-management regime, involving banks and others that hold bonds. When necessary, the Fed lowers rates, and this recapitalizes banks and provides capital appreciation to other users of such bonds. Markus Brunnermeier is especially well-known for discussion of this redistributive type of monetary policy. One may ask if it's time to move to a cleaner risk-management implementation that optimizes for multiple objectives, including the liquidity satiation advocated by Milton Friedman (which you mention in your post). For example, if the US issues all debt in perpetual form, with GDP deflator as the accounting unit, then this is money and it also stabilizes the US budget in a way that allows for tax smoothing.

    But that would be a big change in the system, perhaps too radical for US officials to contemplate seriously.

  2. The interesting question concerns how Treasury does in fact manage the maturity structure of its debt. I’ve not seen much written on this (although I haven’t looked very hard).

    For one thing, given that fiscal management and planning would rationally consider a forecast for Fed profit remittances, which in turn must consider Fed balance sheet structure, it should be the case that Treasury does in some way manage the consolidated maturity structure – in the sense that it should be responding in real time (at least fiscal year time) to the expected marginal risk/return effect of QE type interest rate transformations undertaken by the central bank, along with everything else it needs to consider. So the “already optimal” point is a bit tricky I think.

    The question concerns risk management. Commercial banks got slammed by interest rate risk in the 1980’s. One obviously has to consider the difference when comparing that with the general interest rate environment today, as well as the difference between government financial risk management and private sector financial risk management (e.g. the usual solvency economics comparison issue, the fact that the central bank doesn't need to take unrealized marked to market losses on Treasuries into a recognized capital position, etc. etc.) So there are important mitigating factors from that starting point.

    But risk is risk. And in both cases one needs to consider the difference between economic present value risk and interest margin risk. Notwithstanding the very good bet that “short funding” interest rate risk generally works well through the long run (as indicated by your graph - with the 1980’s being the most concerning in that regard), the potential for stomach churning interest rate resets in a rising rate environment still needs to be considered – for example, in the extreme case where the entire consolidated federal debt is short funded. This isn’t just political. It’s a matter of recognizing risk and how it could affect the budget in an unexpected way, notwithstanding the reasonable bet that this can easily be absorbed over the long run. And if it’s imprudent to fund the entire federal debt on that basis because of that, then limits need to be determined.

  3. Dr. A, you might enjoy the Brookings panel in which Larry Summers points out that the Treasury lengthening term and the Fed shortening term have been at cross purposes. Summers et al argue that we might take out the middle man, Fed in this case, and just issue all debt as bills. That really got the Treasury official on the panel squirming. Sort of the anti-Cochrane. JC likes a big Fed balance sheet for banking system soundness reasons but wants the debt in perpetuals, I think.

    I notice your argument has little to do with "stimulus" or with trying to manipulate the term structure. As I read you, the Fed -- acting for Treasury -- might just respond to the term structure that exists. It is quite different from the standard argument for QE. I do not mean that as criticism. Just joining the conversation. Thanks. (I will come back with the link.)


    That's the link to the debt management panel at Brookings.

  5. I think this is an example of differences in language and intuitions. A macro theorist might talk about productivity shocks and their effects on financial market equilibrium. But as a market practitioner, JKH will talk about the tools now in use to manage such risk, which are bonds and interest rate derivatives.

    The reaction to Robert Shiller included people asking if his innovations are really needed, and what would actually change in the market. I think it would clean up and simplify the macroeconomic risk management system, while also making it more effective, and consuming fewer human resources. We also need to relax important constraints like the ZLB that are connected with the interest-rate management methodology.

  6. I'll add two points to White's arguments.

    Until 2007 Fed remittances came almost entirely from seigniorage, which is a free lunch. Post 2007, Fed remittances resulted from normal risk-taking. The two are different not in degree, but in kind.

    Second, the Fed has serious flaws when it comes to government liability management. First, it does not concern itself with the budget. If the Fed bets wrong and short rates spike, the deficit will widen from CBO baseline. There are people at Treasury and at the Treasury Borrowing Advisory Committee (TBAC) that are to manage this type of rate risk. Are you aware of anyone at the Fed that has this specific role, and how many people they manage? The topic seems to be absent from the staff presentation in the FOMC minutes. I would check the org chart! :)

    1. Diego, on your second point, I find it rather wak. The Treasury has to manage duration risk of its own debt, I'm not sure why they cannot do the same with Fed liabilities. And how about not counting on high levels of Fed revenue to begin with? Then the Treasury can only be pleasantly surprised. On average, as the data plainly shows, the Treasury receives revenue from the Fed. Why are you so keen for the Treasury to give that up?

  7. David,

    ..."I'm not sure why they cannot do the same with Fed liabilities."

    Here's a reason:
    Imagine the Fed sent Treasury an memo: "ICYMI, we've just transformed $3tr of your term debt into T-bill equivalents." For Treasury to offset the duration impact of this, they would have to short $3tr nominal of bond futures. The alternative, exchanging term debt for IOR-paying reserves, is not possible. If they shorted the futures, the Fed could simply send Treasury a second email: "ICYMI, to maintain the desired effect of QE, we went into the bond futures market and took the other side of your recent trade; therefore, your consolidated duration risk remains the same".

    Any attempt by Treasury to manage the term structure of consolidated (i.e. including Fed balance sheet) liabilities would require the Fed's cooperation; that in turn requires the Fed give up independently conducting QE.

    1. Let's go back to what appears to be your main concern:

      "If the Fed bets wrong and short rates spike, the deficit will widen from CBO baseline."

      So, your solution for this "problem" is for the Fed to immediately remove its capacity to remit close to $100B/year to the Treasury--an act that would have an immediate and long lasting impact on the deficit. But this would be OK because now the Treasury doesn't have to worry about Fed remittances moving unexpectedly up and down? I'm afraid I just don't follow this line of reasoning.

  8. David,

    "remove its capacity to remit close to $100B..."

    I think I hear a post hoc fallacy. Observed positive returns are not evidence of the absence of risk (so it says on every mutual fund advertisement). The Fed has no special "capacity" to remit revenues by taking duration risk as Treasury's fiduciary.

    In any case, why not do a post on a "behind the curve" scenario for the Fed? It raises rates, but inflation rises by more (as you argue, the Fed's models are not predictive...). The Fed is reluctant to catch up as it mistakenly sees inflation as "transient". What would happen to deficit projections as rates and inflation rose together? How would this feed back into inflation expectations? Let's say the Fed caught up, and sparked a downturn. To fight it, it does another $3tr in QE. What would happen to the deficit and inflation in the next cycle with $6tr in T-bill equivalents facing rate rises? I've never heard a Fed speaker or related economist, or a Treasury official, explore the risk of this scenario. It would be refreshing to see it rigorously explored and even dismissed. Since you've stepped into the public finance sphere, you're the logical person to take that on :).

  9. "The Fed has no special "capacity" to remit revenues by taking duration risk as Treasury's fiduciary."

    As I said in my post, years and years (decades even) of elevated remittances, one fluke after another. No amount of evidence will convince you of my "post hoc fallacy."

    As for the scenario you'd like me to write about, I don't have the time to do it right now. But I have written about balance sheet risk in the past:

  10. In agreement with your risk piece. Why the Fed is (seemingly) unconcerned with the scenarios you present remains, however, a mystery.

  11. I want to question the basic premise, restated in your response to Larry White:

    “The gist of my story went something like this. Suppose that the Fed makes a one-time purchase of a 10-year treasury bond yielding a risk-free 2.5% annual nominal coupon. Suppose that the purchase is financed by "printing" reserves. (Note, this asset purchase and method of finance describes the basic nature of QE). Suppose further that the interest paid on reserves remains below 2.5% for the duration of the bond. Then the Fed makes a profit off the rate of return differential in each of the 10 years it holds the bond on its books. If I understand my critics correctly, none would dispute the financial benefit associated with this Fed intervention as far as the public purse is concerned; at least, as long as it is somehow known ex ante that the short rate will remain below the long rate in the manner assumed.”

    First, let the interest rate on reserves be zero. If the Fed bought a T-bill from a bank for $100 that paid 6 basis points, the average on 4-week T-bills from fall 2008 through the end of 2015, or if it bought a $100 10-year Treasury yielding 2.5 percent, the Federal debt outside the Fed would fall by $100 and the monetary base would rise by $100. The Fed would have higher earnings by the amount of the interest, higher in the case of the higher yielding security, but in either case the additional profit would equal the interest paid by the Fed and equal the higher payment from the Fed to the Treasury. A differential effect due to the duration premium would have no effect on the Treasury debt reduction, or on the initial or subsequent changes in the sum of Fed and bank credit, or on money.
    This is “pre-2008 monetary economics.”

    Now suppose the Fed pays an interest rate on reserves, say 25 basis points, that exceeds the market rate on comparable term T-bills, 6 basis points. This additional action means that when the Fed conducts open market operations buying T-bills or longer-term Treasury securities that have a comparable risk-adjusted yield, the depository institution will profit by selling the Treasury security and holding excess reserves. No increase in the effective monetary base, currency or required reserves, takes place. The Fed expands its credit without affecting monetary aggregates. In effect the Fed can bail out banks, extending its credit to banks by acquiring questionable assets or more risky assets, without affecting money. Now the money supply does not expand, nor does total credit (Fed plus bank credit). Banks swap credit for excess reserves and the Fed has the T-bills as part of Reserve Bank Credit. Federal debt outside banks still goes down by 100, but the Fed excess reserve offsets this. The Fed owes more annual interest than the Treasury owed on the T-bills. The true fiscal position (on a consolidated Treasury plus Fed basis) worsens rather than improving as in the Open Market Operation described above, and by the extent that the interest rate on reserves exceeds the interest rate on T-bills.

    This is a bad deal for the taxpayer. The taxpayer now pays 25 basis points for the $100 of excess reserves banks hold instead of the 6 basis points Treasury was paying banks, or its risk adjusted equivalent for a 10-year security. Of course there is no new effective monetary base and no new money or total credit in this case. Fed credit goes up, but bank credit declines by an equal amount. This is called financial repression, which is known to reduce private risk-taking and economic growth. The extra cost to the Fed for excessive interest will soon reach about $20 billion per year when the interest rate on reserves is put up to one percent.

    Eliminating interest on excess reserves would solve the balance sheet size problem with little adverse effect so long as Fed assets are liquidated at the same pace.

  12. I omitted my summary in the note above. My principal point is that interest on reserves policy has shifted the Fed’s focus of monetary policy to credit policy, and the effect of expanding the Fed’s credit has been to repress the banking sector and cause taxpayer losses. Your focus on Fed shift to acquiring risky long-term assets and thereby boosting its revenue is not a meaningful issue. The higher Fed revenue just offsets the higher interest payments with a higher duration premium on longer-term debt. The same is true for MBS that carry a default premium, but the analysis is more complicated to the extent that the issuers are or are not part of the Federal Government. The rise in revenue, like the rise in assets, has been at the expense of the banking system and the efficiency of our financial system.

    When the Fed conducts monetary policy, the constraint on the size of the Fed’s balance sheet is its inflation objective. The constraint on its balance sheet with QE credit policies is how much financial repression it wants to cause, or the limits on the ability to suck all the risky assets out of depository institutions and on to the Fed's balance sheet.