During normal times central banks typically vary the price of money to achieve their monetary stability objectives. The most common instruments of choice are interest rates and exchange rates.
Setting interest rates
In countries where the exchange rate is free to find its own market level, the relevant price of money is the interest rate. However, the financial system comprises many different interest rates that are often determined by commercial decisions not by the central bank. So, for the sake of credibility, central banks need to choose a price, an interest rate, that they can actually control.
In the Fed’s case the target interest rate of choice is the federal funds rate – an overnight borrowing rate agreed by an exclusive club of key market players. Since the fed funds market is populated by only authorised entities, the borrowing that takes place can be unsecured, without the need for collateral. Moreover, since what is being borrowed and lent are reserves (US$ deposits at the Fed) the Fed itself can effectively steer the rate into whatever target range it chooses.
The Fed’s control principally stems from its monopoly control over the supply of reserves which it can squeeze and expand through open market operations (purchases and sales of securities by the New York Fed, usually via repo, in exchange for central bank deposits). In normal times, reserves are relatively scarce so fine-tuning the fed funds rate is relatively straightforward. However, although the GFC happened many years ago, its legacy lives on. In particular it changed the fed funds market in significant respects.
First, the fed funds market has shrunk markedly since the GFC – a mirror image of the huge rise in reserves. Around a decade ago the volume of reserves borrowed was over $250bn. However, borrowing collapsed by the end of the 2008 falling below $60bn by end 2015. Borrowing is currently in a $80bn-$100bn range. This contraction reflects the huge amount of excess reserves that were built up after three huge rounds of QE – reducing the need for most eligible entities (the notable exception being foreign banks) to borrow.
Second, the existence of such large reserves combined with an institutional wrinkle, has required new central bank tools to control the key fed funds rate. The wrinkle in question is that the Federal Home Loan Banks (FHLBs) are allowed to participate in the fed funds market but are not eligible to receive interest on excess reserves. Not only does this mean that FHLBs are, by far, the main supplier of fed funds but also has contributed to the spectacle of the effective fed funds rate falling below the so-called “floor” interest rate – the interest rate on excess reserves (IOER).
As well as exploring the mechanics of interest rate setting another key objective of this Session 12 segment is to reinforce understanding of balance sheet truths about commercial bank reserves. In particular, you will be able to avoid common pitfalls and illusions, such as,
- “large reserves prove that banks are hoarding liquidity rather than supporting lending”
- “negative interest rates boost credit supply”
- “reserves are deposits not lent out to households and non-bank companies”
Setting exchange rates
So far we have focussed on the interest rate price of money. But central banks can also try to manipulate exchange rates. What they cannot do – unless, unusually, they can limit cross-border capital flows – is to juggle both at the same time. The reason is the famous impossible trinity.
If you want to moderate a strong exchange rate, maybe because it’s killing your export industry, then you will probably need to cut interest rates. But cutting interest rates could add to inflation problems – making exports more expensive for global customers. Getting a dream combination of interest and exchange rates is not easily achievable. Unless your economy is in a perfect sweet spot you either tweak interest rates and let the currency take the strain (a floating exchange rate regime) or you choreograph the exchange rate and let interest rates find their own level (a managed exchange rate regime).
Managing the currency does not necessarily mean that it is fixed for all time or that, like Ecuador and some others, you do not even have a domestic currency. Indeed, there is nothing that stops a country flip-flopping between interest rate management and exchange rate management (China and Switzerland often do this). The point about the impossible trinity is that you cannot do both simultaneously.
Why would some countries choose to fix their exchange rates rather than interest rates? Usually this because of an understandable fear of floating. Leaving currencies to their own devices – especially in a world of hot, fickle capital flows – can be especially damaging for countries that are both highly dependent on trade and whose credibility (their
criminal risk record) is in question (that is, the bulk of emerging and developing countries). Floating can get economies into big trouble.
We already know that, at a domestic level, the financial system is prone to amplify trends. In other words finance is procyclical – a small boom quickly morphs into a large boom and vice versa. At the global level, the same overshooting problem clearly exists. When in fashion, emerging markets attract huge waves of global capital, pushing up their exchange rates and setting the seeds of an export-led recession and reckless borrowing in (temporarily depreciating) US dollars. When the narrative turns sour, foreign capital exits as quickly as it arrived. The domestic currency buckles, US$-denominated debt breaks companies and the banks. It does not look pretty.
But the undoubted dangers of floating does not mean that fixing your exchange rate is an easy choice, Far from it. Fixing the exchange rate is a huge commitment that, if broken, can unleash severe and lasting damage on an economy. Some countries can survive failures in fixed exchange rate regimes (UK’s White Wednesday, for example). But, even in Britain’s case, the ERM car crash did huge damage to the government’s reputation. More generally, failing to stick with a fixed currency regime can be much more devastating – leading to substantial, prolonged losses of output and jobs. In extreme cases, such as the 2001 collapse of Argentina’s peg versus the US$, it can lead to street riots and undignified political exits.
The bottom line is that pegging your currency does not guarantee stability. The peg will be of a nominal exchange rate, not the real exchange rate – and it is the latter, of course, that really matters for your country’s competitiveness. Changing the peg will undermine confidence and leave permanent scars on credibility – economic and political. Mistakes can be costly and long-lived. Successful currency pegs typically only occur if sacrifices are willing to be made in terms of deep-rooted, probably painful, social and economic reforms. But if countries have the appetite for such reforms then why be fazed by the rugged landscape of floating?
Are there lesson here for Europe’s EMU? It is hard to argue that the region is an optimum currency area. The ragbag of countries that currently make up the Eurozone contains very different structural characteristics that cannot be readily straitjacketed by single currency rules. Some have likened EMU to the gold standard, drawing unnerving parallels with the path to the inter-war chaos of the 1930s. Maybe that is a bit too pessimistic; we shall see.
14 Nov 2018