Raising rates is a stimulus

There are two broad categories of monetary policy instrument: 1) measures which are aimed at influencing market interest rates, and 2) transfers from the central bank to the private sector.

‘Conventional’ monetary policy, which alters the rate at which banks can borrow reserves and therefore determines money market rates, is the main example of type (1) policies. Forward guidance is also an example. These are policies which aim to change the price of credit and the discount rate for assets throughout the economy. The transmission mechanism is the price of money.

‘Unconventional’ policies involve a transfer from the central bank to the private sector. QE, tiered reserves, TFS, TLTROs etc., are all examples of this. Some of these are contingent transfers.

To make clear why QE is a transfer consider the following: the central bank buys assets under its QE programme 10% above their current market price and then sells them back to the market at the market price a day later. That is a transfer of 10% to the private sector.

Ironically, most CBs have made money from QE programmes (although the ECB and the BoE – on its post-Brexit purchases – are likely to lose money). But this is an accident. QE is a contingent transfer to the private sector. Central banks expect to lose money from QE. Think of it like this: if QE works, bond prices should fall relative to the price at which the CB bought them. Why? Because if it works, growth, inflation and real interest rates will be higher than pre-QE. Mervyn King was (almost) clear in this point.

Of course, this transfer is contingent. If the market is wrong about long term interest rates at the point of QE occurring, and subsequently believes them to be much lower, the transfer is negative, and CBs make unexpected profits. This is what happened to the Fed.

Tiered reserves are very clearly a transfer from the CB to banks. A point Miles Kimball, Martin Sandbu and Simon Wren-Lewis have also made.

The use of the IOR to manage market interest rates is interesting, because it is both conventional and unconventional. The Fed is now raising the IOR in an attempt to target money market rates. As evidenced by the recent share price performance of US money center banks, raising the IOR is also a transfer to banks holding reserves (a transfer in return for no additional risk).

If you think that marginal changes in the Fed funds rates, in the region of 50 to 150 basis points, are trivial in the context of cyclically varying risk premia and exogenous sectoral effects throughout the economy, the most significant effect of current Fed policy is a transfer payment to holders of bank equity.

About The Author

Eric Lonergan is a macro fund manager, economist, and writer. His most recent book is Money (2nd ed) published by Routledge. He is also a supporter of Big Issue Invest (BII), the investment arm of The Big Issue, and is one of the initial limited partners in BII’s Social Enterprise Investment Fund LP. In a personal capacity, he makes direct investments in social enterprises. He also supports and advises The Empathy Museum.

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