History is not over yet, and the central bank has become the “man of last resort”-“lender of last resort” and “dealer of last resort”. The central bank’s “big contract” behavior has made its balance sheet hard to drop. Relative to the scale of GDP, the Fed’s total assets have reached a historical high (35%) since its establishment, far exceeding the peak of 22.7% during World War II. With the return of inflation, the possibility of the economy slipping into stagflation has increased. This is the worst quadrant of the Merrill Lynch clock and a blind spot for monetary policy. The main aspect of the current contradiction is no longer stagnation, but inflation. Higher-than-expected inflation in prices may bring unexpected shrinkage of monetary policy.
In the minutes of the April meeting on interest rates, the Fed first mentioned “scaling asset purchases” (taper), which aroused the market’s concern about when the Fed will withdraw from unconventional policies. With the restart of reverse repurchase tools (O/N RRP), the most lenient period has passed. The choice of the exit method and timing of unconventional monetary policy depends not only on the operation of the macro economy, but also on the combination of different policy tools, especially fiscal policy. If the fiscal policy remains loose or increases, the pace of monetary policy withdrawal can be accelerated. In the current macro-quadrant-the output gap and unemployment gap are negative, structural unemployment still exists, inflationary pressures are significant, fiscal policy remains active, and easy monetary policy to withdraw in a timely manner is appropriate.
The three rounds of quantitative easing after the 2008 financial crisis and the 2017-2019 scale reduction have provided a frame of reference for thinking about the withdrawal of this round of easing policies. Looking back at a longer history may be more enlightening. The first thing to ask is, which stage in history are we more like?
The historical coordinates of the U.S. economy
If you use one word to summarize the characteristics of the global macroeconomic operation since 2008, it should be: secular stagnation. It was Lawrence Summers, a famous economist who brought it back to the public eye. The story has to start with the “Great Depression” of 1929-1933.
In early 1933, Roosevelt came to power and the US economy began a long process of recovery. From 1933 to 1936, the US economy rebounded strongly. Fearing that excess reserves would intensify inflation, from July 1936 to July 1937, the Federal Reserve raised the statutory reserve ratio three times in a row, doubling the reserve requirement ratio for fixed deposits and demand deposits, resulting in the U.S. economy in 1937-1938. Falling into recession-real GDP growth in 1938 was -3.3%, which was 16 percentage points lower than in 1936.
In this context, Alvin Hansen (AH Hansen) reiterated the “long-term stagnation” (first proposed in 1934) in his 1938 American Economic Association (AEA) speech, which sparked widespread discussion among scholars, and from the end of World War II to the early 1950s Reach the peak. Hansen believes that the structural reasons for the long-term economic stagnation include: the economy has matured and the production possibility boundary is no longer expanded; the population growth rate has declined; the stagnant technological progress and the shortage of capital-intensive innovation have led to insufficient investment demand to absorb savings. . Lawrence Klein (1947) first linked “long-term stagnation” with the negative natural interest rate in Vickersell’s meaning: once the natural interest rate becomes negative, subject to the restriction of zero interest rate going offline, investment demand will face The problem of long-term insufficiency, monetary policy is also difficult to achieve. Beginning in the early 1950s, a new round of technological revolution led the global economy into the post-war “golden age”, and the problem of “long-term stagnation” also disappeared. The number of academic publications focusing on this problem continued to decline until 2012.
On November 8, 2013, at the IMF meeting to commemorate Stanley Fisher (Stanley Fisher), Summers revisited the “long-term stagnation.” In response to the phenomenon that the super-loose monetary policy since 2008 has failed to boost the US economy, Summers believes that the natural interest rate may have become negative, and investment demand is insufficient to absorb savings at any interest rate level greater than zero. The New York Fed’s calculations also show that after the 2008 financial crisis, the natural interest rate in the United States fell off a cliff, and continued to stay at a low level after 2013, the lowest value since the 1960s. The impact of the new crown epidemic in 2020 has caused it to continue to fall below zero. Then, any interest rate level greater than or equal to zero will have a tightening effect. With the gradual withdrawal of the temporary relief policy during the epidemic, can the US economy be able to repair the output gap internally?
The first “long-term stagnation” in American history
If the current United States is still in the recovery cycle after the 2008 financial crisis, and the new crown epidemic is just another negative impact in the process, then the post-crisis era story cannot provide the answer to “what is the way out for long-term stagnation”, but ” The story after the Great Depression may be instructive.
Figure 1: The size of the Fed’s balance sheet (1914 to present)
Data source: Center for Financial Stability (CFS), Federal Reserve, Hopkins University, Wind, Orient Securities Wealth Research Center
Zero interest rates are a basic feature of “long-term stagnation”. Except after 2008, the “Great Depression” is another period in the history of the United States where a combination of “low long-term interest rates + zero short-term interest rates” appeared (Figures 1, 2). Comparing these two periods, we will find that the interest rate of the US money market, the Fed’s monetary policy operation and the expansion of the balance sheet, and the behavior of financial institutions such as banks all show similar characteristics.
Until the early 1930s, the Fed was still trapped in the gap between the gold standard and the principle of real bills, and it still used the discount rate and borrowing reserve mechanism to regulate money market liquidity. During the “Great Depression”, the financing needs of the real economy sector were extremely low, and commercial banks were also hoarding reserves. In September 1932, the three-month Treasury bill interest rate hit the zero lower limit for the first time, and thereafter it has maintained a low-level and volatile pattern. Although the discount rate has fallen to a low level, it is still higher than the short-term interest rate of the money market. Therefore, the monetary policy is tight, which can be manifested in the contraction of money supply and commercial bank credit.
The Banking Act of 1932 gave the Federal Reserve the power to use government bonds as a guarantee and issue Federal Reserve Notes—this is today called QE. From 1932 to the outbreak of World War II, the Fed was very cautious in buying national debt on the open market until the outbreak of World War II.
In December 1941, Japan raided Pearl Harbor and the United States declared war on Japan. Under the influence of the expansion of the fiscal deficit and inflation expectations, the price of U.S. Treasury bonds fell in response. The Federal Reserve responded positively and strengthened its cooperation with the Ministry of Finance to jointly formulate a long-term plan to maintain the order of the Treasury bond market. In the spring of 1942, the Ministry of Finance and the Federal Reserve reached a compromise plan to control the term structure of Treasury bond interest rates: the 3-month Treasury bill interest rate was fixed at 0.375%; the 1-year short-term Treasury bond interest rate range was 0.875%-0.9%; the 7-9-year medium-term interest rate The upper limit is 2%, and the upper limit of the interest rate of long-term government bonds of 10 years and above is 2.5%. Judging from the history of interest rates, this level of interest rates is relatively low for the wartime economy. To maintain low interest rates, debt monetization is the most direct result.
When the term structure of the national debt interest rate is fixed to an upward sloping state, the optimal investment strategy (one) is to buy long-term national debt, hold it for a period of time and then sell it (riding the yield curve). Therefore, investors have dumped Treasury bills in exchange for medium and long-term government bonds. Therefore, until the end of World War II, the Fed did not need to purchase long-term Treasury bonds to control long-term interest rates below 2.5%. On the contrary, in order to maintain short-term interest rates, the Fed must buy short-term Treasury bonds.
From March 1942 to February 1946, the balance of Treasury bonds held by the Federal Reserve increased by US$20.7 billion, accounting for 53% of total assets and 11.5% of total Treasury bonds in circulation, but the number of long-term Treasury bonds it held was only 10 Billion U.S. dollars, a net decrease of 600 million U.S. dollars. On the contrary, holdings of treasury bills increased from zero before the war to 13 billion U.S. dollars. From the perspective of the maturity structure of the stock bonds, the three-month treasury bills held by the Fed accounted for 76% of the total issuance, short-term treasury bonds with maturities of three months to one year accounted for 20%, and medium-term treasury bonds and long-term treasury bonds accounted for only 7% and 0.8%. At the end of World War II, the Fed’s balance sheet reached a record high, accounting for 22.7% of GDP. Historical experience tells the Fed that “release water” will definitely cause inflation. Therefore, how to withdraw from the “unconventional” debt management policy during the war is a top priority.
In February 1946, it is said that because of the anger and complaints of housewives who could not find burgers on the shelves, President Truman gradually relaxed price controls. Inflation began to climb in the second quarter and reached a height of 20% in March 1947. In August 1947, in order to curb inflation expectations and adjust the divergence between the actual yields of Treasury bonds of different maturities, the Federal Reserve and the Ministry of Finance reached a new agreement, agreeing to increase the interest rate on Treasury bills from 0.375% to 0.875%. After more than a year, the Fed has been fighting for higher short-term interest rates, but the upper limit of long-term interest rates has been maintained until 1951. This is the first time in the history of the Fed that it has conducted a “distortion operation.”
With the increase in short-term interest rates, the term spread narrowed. The market expects that long-term interest rates will also rise, and long-term government bonds with a 2.5% interest rate are no longer attractive. At the end of 1947, investors began to sell long-term government bonds and buy short-term government bonds. Long-term interest rates are approaching the 2.5% ceiling, and the Fed has to passively purchase long-term Treasury bonds. By the end of 1948, the Fed’s long-term treasury bonds had increased to 11 billion U.S. dollars, accounting for nearly 50% of the total treasury bonds held. During most of the period, long-term and short-term government bonds showed a trend of ebb and flow. It was not until March 1948 that most of the funds for purchasing long-term bonds were obtained by expanding the balance sheet. In February, June, and September, the Federal Reserve raised the statutory reserve ratio three times in a row, with a cumulative increase of 6 percentage points. This stabilized the price of long-term Treasury bonds and partially hedged the impact of purchasing Treasury bonds on excess reserves. Starting in the fourth quarter of 1948, the economy weakened, long-term bond interest rates began to decline, and the Fed’s bond purchase pressure declined.
Figure 2: U.S. natural interest rates and economic growth trends continue to decline
Data source: New York Fed, Orient Securities Wealth Research Center
The war on the Korean Peninsula interrupted the Fed’s gradual withdrawal from the wartime interest rate policy. In June 1950, the FOMC voted to raise the one-year interest rate, but the Treasury Department refused, and the Federal Reserve at that time had to implement it. With the strengthening of inflation expectations, the Federal Reserve and the Treasury Department reached an agreement on March 3, 1951, that the Federal Reserve no longer undertakes the task of maintaining the upper limit of interest rates on long-term Treasury bonds. On the second day, Chairman McCabe and Secretary of the Treasury Department Snyder issued a joint statement: The Treasury Department and the Federal Reserve have reached a consensus and believe that debt management policies and financial policies should be further improved so that the government can successfully allocate funds, and Achieve minimum debt monetization. The interest rate on long-term Treasury bonds immediately broke through 2.5%. Throughout the second half of the 20th century, the yield on long-term U.S. bonds never returned to the level of 2.5%.
Throughout the 1950s, the Fed’s total assets and the scale of its treasury bonds did not grow. The ratio of total assets to GDP continued to decline. In 1961, it fell to less than 10%, which was 13% lower than the previous high. By the 1980s It is further reduced to a low of 5%, which is a perfect scale reduction. Although the credit is mainly in the denominator-economic growth that can be driven by technological innovation, the “independence” of the Federal Reserve after the 1951 “Agreement” cannot be underestimated.
The “Independence” of the Federal Reserve and Martin’s Reflection
When the Federal Reserve was formally established in November 1914, its total assets were only 250 million U.S. dollars, accounting for 0.66% of GNP. Among them, gold reserves were 200 million U.S. dollars, accounting for 84% of total assets. It can be seen that the Fed’s ability to regulate the economy was very limited in the early days of its establishment. From a political standpoint, it often took orders from the President and was regarded as a vassal of the Treasury Department. It did not have much autonomy. One of the main tasks was to smooth the liquidity of gold flows. Conditional interference. During the Great Depression and World War II, the Federal Reserve’s conditions for issuing Federal Reserve Notes were relaxed and its power was strengthened, but it was still subject to the Treasury Department. After the 1951 “Agreement”, the Fed achieved true independence. Therefore, some people think that the date of signing the agreement is called the “Independence Day” of the Fed, and others believe that it is the “magna carta” of modern American monetary and debt management policies. However, this did not happen overnight. The “Agreement” in 1951 opened a new chapter in history, and the development of events stemmed from reflections on history.
The wartime debt management policy was not without benefits. It provides successful experience in open market operations and yield curve management. The Fed began to think about the importance of national debt in monetary policy and the Fed’s role in the national debt market: When the discount rate and the “borrowed reserve mechanism” fail, the Fed How to provide liquidity to the market? In order to better manage the crisis, what other basic institutional work needs to be done? In response to these problems, the Federal Reserve has carried out systematic research, laying the foundation for the modern central banking system. Focusing on the relationship between debt management and monetary policy, the scope of open market operations, and qualified dealer programs, the “special committee” led by Fed Chairman Martin and New York Fed Chairman Allan Sproul conducted separate studies. .
In dealing with the relationship with the Treasury Department, the Federal Reserve Bank of New York suggests deepening the integration of debt management and monetary policy. “The Treasury Department cannot only focus on debt management, and the Fed cannot only focus on credit policy. The two need to strengthen cooperation on the basis of equal status, and it is impossible to solve the problem by subordinating one institution to another.” For open market operations, New York The Fed believes: “Effective credit policies may require open market operations in the long-term and short-term government securities markets in order to affect the attractiveness of government securities relative to private debt instruments. In this case, maintaining the supply of long-term tradable government bonds is necessary for credit Policy is very important.”
The Special Committee put forward different views and agreed that: “The FOMC should keep its intervention in the market at an absolute minimum level to comply with its credit policy… Since the FOMC is always ready to intervene, the normal order of the market will inevitably be weakened. In any market, the development of specialized institutions and systems aims to protect the market with spontaneous strength and flexibility, and to make it broad and deep. This idea is often suppressed by the official’motherhood’, and private market institutions are particularly vulnerable to randomness. The emergence of interference from official actions. According to market standards, official actions always seem to be erratic, causing individuals or individuals to be unable to reasonably assess and anticipate the risks of such behavior in advance when predicting market prospects.”
Unlike the Federal Reserve Bank of New York, the FOMC believes that the inflexibility of the government securities market and the lack of depth and breadth are not because the Federal Reserve has too little involvement, but too much. Since then, protecting market freedom has become the new code of conduct. Of course, the FOMC also emphasized that the Fed will still intervene if necessary to maintain a well-ordered market. The Special Committee made two recommendations on restricting the Federal Reserve’s intervention in the government securities market.
First, under normal circumstances, open market operations are limited to short-term government bonds. The committee believes that when the FOMC intervenes to implement monetary policy, if it only buys or sells very short-term government securities, it will minimize market interference. The only exception is that when the government securities market becomes disordered, it intervenes in the long-term and long-term Treasury bond market, and is limited to correcting the disorder in the market, rather than maintaining the order of the market. The Commission’s definition of “disorder” is: selling so quickly and so dangerously that it prevents short covering and new orders from investors who usually seek to profit from weak market purchases. In short, it was the “fire sale” behavior when the market was facing liquidity shocks. The Fed needed to act decisively and act as the “fire-fighting captain”, that is, the “dealer of last resort.”
Second, abandoning the policy of assisting in the issuance of treasury bonds has formed a later open market operation style that prefers treasury bonds. The Special Committee believes that support for financing by the Ministry of Finance represents the tendency of the FOMC to over-intervene. The Special Committee recommends that during the issuance of national debt, not to purchase: any upcoming national debt, any newly issued national debt, and any outstanding bonds with a maturity equivalent to the maturity of the bonds for sale. At the same time, it also advocates that the Fed should be prepared to inject reserves through the purchase of short-term Treasury bonds to support troubled issuance.
As Martin is the chairman of the Federal Reserve and the chairman of the FOMC, the opinions of the special committee have the upper hand. Martin and Sproul finally reached a consensus, and both agreed that under the conditions at the time, it was beneficial to limit open market operations to short-term government bonds, and it should be adjusted dynamically in the future based on monetary policy objectives. The core tenet of the new paradigm of monetary policy is to minimize intervention in the market and minimize intervention in government financing under market conditions. Until 2008, short-term Treasury bonds were the mainstay of the Fed’s open market operations. Since then, the market has entered a state of “disorder”, and the Fed has also adopted the “exception” clause, but the hypothetical “exception” situation has become a routine operation.
The history since 2008 has moved from “Martin time” to “Sproul time”. If inflation expectations rise further, the Fed may return to “Martin time” again.
Learning from history: How does the Fed shrink its balance sheet beautifully?
The key to the implementation of the yield curve control policy before and after World War II is that the coordination of different quantitative monetary policy tools separates price increases and inflation expectations. The latter is essential for stabilizing long-end interest rates. At that time, the quantity theory of money could still effectively explain inflation (expected) fluctuations. The Fed also increased the statutory reserve ratio when purchasing treasury bonds. The former increases the base currency and the latter reduces the currency multiplier. Therefore, the growth rate of M1 and M2 is significantly lower than that of the base currency. For stabilizing long-term interest rates, stabilizing inflation expectations is more effective and more sustainable than buying long-term government bonds directly. Therefore, throughout World War II, the Fed’s retention rate of long-term Treasury bonds with maturities of more than 10 years was below 3%, and it was less than 1% in 1944-1947. After 1947, the form changed. With the relaxation of price control, inflation volatility has intensified, and the Fed has to intervene.
The key variable to break the original equilibrium is inflation expectations. Once inflation expectations are formed, the long-term interest rate ceiling will be under pressure. The paradox is that only by easing interest rate restrictions can inflation expectations be curbed, but there is always one party who needs to bear the losses caused by the upward interest rate, but this time it is the turn of the Ministry of Finance. Through the debt swap program, the Ministry of Finance has frozen the liquidity of the long-term government bond market at a higher cost and stabilized the bond market order. Creditors either reduced the duration or received a higher risk premium. The Fed finally won the power to make monetary policy independently. This can be regarded as a win-win situation. Only when inflation expectations remain low can debt management and yield curve control policies be sustainable. It is worth emphasizing that at this stage, even if monetary policy is subordinate to debt management, even if the Fed is attached to the Treasury Department and the White House, it has also raised the reserve ratio to suppress market inflation expectations. Looking back at the present, one cannot help but ask: Is Modern Monetary Theory (MMT) a historical retrogression, or is it advancing with the times?
The persistence of inflation is an important constraint on the behavior of the Federal Reserve. For more than 30 years, globalization based on the US dollar credit standard is the background for understanding the inflation rate. The globalization of intra-industry trade in intermediate goods, the decline in the price of capital factors, the increase in labor supply, and the changes in monetary policy rules are all important reasons that explain the global de-inflation and the flattening of the Phillips curve. However, the three major changes after the 2008 financial crisis-globalization, demographics, monetary policy framework, and political-ideological left turn, laid the groundwork for the rise in US inflation in the medium and long term.
In the first quarter of 2021, the year-on-year GDP growth rate of the United States returned to positive for the first time, and the GDP gap continued to converge. However, employment problems still exist, especially for the low-income group of employees who still have a gap of nearly 30% compared to before the epidemic. Inflation is a looming gray rhino, full of uncertainty. In April, overall inflation reached 4.2%, and core inflation hit 3%. Although there are reasons for the base period, an inflation rate greater than 2% in the medium and long term has become a consensus expectation. If exogenous shocks are superimposed, inflation will rise. In this way, credit contraction is a necessary option, the cost of the US government’s issuance of treasury bonds will also increase, and US fiscal sustainability will no longer be an indisputable issue.
If the Fed wants to shrink its balance sheet beautifully, it first needs to be independent from the debt management policy that supports the price of Treasury bonds; secondly, it needs to think from the perspective of the counterparty of the Fed—the dealer, because medium and long-term Treasury bonds and MBS are Fed assets. Therefore, the question that needs to be asked is: Under what circumstances are the medium and long-term Treasury bonds and MBS attractive to traders to facilitate the Fed’s “shipping”? From the historical experience during World War II, a steep and relatively stable term structure of interest rates may help. Third, maintaining a relatively proactive fiscal policy in a sustainable manner requires expanding the tax base and filling tax loopholes while increasing expenditures, leveraging private sector investment and consumer demand, and alleviating poverty in the course of economic growth. Rich differentiation. This is the Biden administration’s “both…and…and…”. Biden is reformulating a progressive plan to lead the United States back to the “Roosevelt era.”
In the final analysis, whether the Fed can shrink its balance sheet beautifully again depends on whether the US economy has endogenous growth momentum. From a historical perspective, the reason why the U.S. economy was able to break free from the “Great Depression” and the Fed’s ability to shrink its balance sheet beautifully? With high-density R&D investment, the federal government plays an extremely important role in basic R&D investment and promoting military-civilian integration.
The relative size of the Fed’s balance sheet shrinks, and there is only one way: the expansion of the balance sheet is slower than the economic growth, the larger the gap, the faster the process of shrinking the balance sheet, and the rest are details. Of course, the numerator and the denominator are not separated. Generally speaking, only when the contraction of the numerator is endogenous-as a result of the expansion of the denominator, the Fed can shrink its balance sheet beautifully.