The Actual “Ammunition” Issue

Pundits often make the mistake of assuming that expansionary monetary policy somehow uses up “ammunition” by reducing interest rates, which gives central banks less room to cut rates in a future recession. Actually, the reverse is true. Expansionary monetary policy boosts the equilibrium (or natural) nominal interest rate, and hence gives central banks more “ammunition” in the conventional sense of the term. This is precisely why some economists advocate a higher trend rate of inflation—to give the Fed more ammunition.

There is another sense in which conserving ammunition does make sense. For any given size of the Fed’s balance sheet, monetary policy is more expansionary when bank reserve demand is lower. Unfortunately, since 2008, the Fed has made a number of changes that boost reserve demand and hence reduce “ammunition”. (I use scare quotes because in a technical sense central banks have near infinite ammunition; the problems are legal and psychological.)

One recent change is obvious; the payment of IOR has increased demand for bank reserves. Some would argue that this isn’t really a problem, as the rate of interest paid on reserves can be reduced to zero in a crisis. Maybe, but it wasn’t reduced to zero during the worst banking crisis of the past 80 years.

A bigger problem is changes in regulation that artificially boost the demand for bank reserves, discussed in an excellent post by Greg Baer and Bill Nelson:

In September 2019, the repo market broke down because banks and broker-dealers did not step in to equilibrate a supply-demand imbalance caused by corporate tax payments and Treasury securities settlement. Banks were unwilling to use their reserve balances to lend into the repo market, in part because of a supervisor preference that banks hold reserves rather than Treasuries.  Banks also were unwilling to raise funds to lend into the repo market for two reasons: leverage requirements and GSIB surcharges generally made the resulting balance sheet expansion too expensive, and banks were reluctant to upend their capital and liquidity allocations to respond to a temporary event.

The Fed responded to the breakdown by further expanding its balance sheet and actively considering creating a standing repo facility that would mirror its standing reverse repo facility.Reportedly, the standing facility might not just lend funds to commercial banks (which already borrow through the discount window) and primary dealers (which already participate in Fed open market operations) but also hedge funds and other participants in the FICC sponsored repo program.  In short, the Fed stepped in to solve a problem caused by its increased role in financial markets by further expanding its role in those markets and by planning to increase its role in them still further.

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