Manmohan Singh is a senior economist at the IMF. The views below are his own, rather than that of the IMF or its executive board.
Two recent Federal Reserve papers have argued that the balance sheet run-off (or shrinking in the size of its asset holdings) is equivalent to tightening.
A Federal Reserve Board of Governors paper by Edmund Crawley et al says $2.5tn of Fed balance sheet unwind would approximately equate to a 0.50 percentage point of tightening, or 20 basis points per trillion dollars. Meanwhile, Stefania D’Amico and Tim Seida of the Chicago Fed analyse 10 year US Treasury bonds data to reach an estimate of 25 bps per trillion dollars.
Remember that under the previous timetable, a $1tn unwind would take around two years. From this September, the faster pace of unwind ($95bn a month of US Treasuries and mortgage-backed securities), will take about a year.
Similar research has been done by IMF (published in CATO journal) in which we show that a $1tn change in pledged collateral can move short‐term rates by as much as 20 basis points. Intuitively, bonds with long tenors can be sliced/diced for very short term in repo/sec lending/prime brokerage/derivative markets. And intuitively, more UST (or similar good collateral like MBS or German Bunds) in the market domain means more collateral availability, and better market functioning (ie, “reverse” monetary policy transmission improves).
In other words, if you factor in collateral reuse, effective supply from collateral going to market is more than the nominal amount that the Fed unwinds. Thus, the trillion dollar unwind applied in the two Fed papers means more than $1tn (ie, 20-25 bps tightening per $1-2tn of unwind, assuming duration of collateral released allows that is around 2 at present, as explained by my previous post on collateral velocity). Such equivalence to interest rate tightening is marginal at best, especially if unwinding a trillion takes a very long time (1-2 years plus).
The intuition can be seen from the lens of moneyness. Many textbooks still use the conventional IS-LM model to describe the relationship between interest rates and economic output. Here, the IS curve represents investment and savings. The LM curve represents liquidity demand and money supply. The point where they intersect represents the equilibrium in output and money markets.
We were taught (illustratively) that via IS/LM curves, LM shifts are parallel:
But LM can pivot, since the role of collateral in money markets is often overlooked in macroeconomics:
Technical explainer: the LM curve is typically derived from the equation M=f(Y, r), where money demand is a function of output (Y) and benchmark interest rates (r). The latter is assumed to be sufficient to determine the entire yield curve, inclusive of all money market rates and risk premia. However, the role of pledged collateral markets (C) in the transmission of monetary policy is ignored. C is also a f(r) and a metric for moneyness.
In the “old” framework, an inward shift in the IS curve due to a contraction in the economy can be neutralized shifting the LM curve out and lowering rates (even to negative levels), so they intersect at the same level of output as before. This IS-LM framework suggests that, via QE, the LM curve shifts right (money is pumped into the economy) but ignores the good collateral (and moneyness) that was taken out of the economy via QE.
In the “new” IS-LM model, changes in monetary policy may not always result in a parallel shift in the LM curve; here, the LM curve may pivot and intersect the IS curve at different points, depending on the slope. Some research suggests that QE may increase output initially but may have a decreasing effect as QE increases in scale. The new IS-LM model supports these findings. The red dots illustrate the change in output relative to the slope of the new LM curve after netting the “moneyness” that is taken out as collateral is silo-ed by central banks. Illustratively, too much QE may result in output that is below the initial starting point before the crisis. Similarly, too little QT does not bring us back to the starting point.
As policymakers chart a course through balance sheet policies, they should recognize the trade-off between the moneyness lost (or gained) by purchasing (or unwinding) collateral during QE (or QT). Cross-border portfolio shifts (eg, US Treasuries) can diminish or even reverse the impact of ever-larger QE interventions on asset prices, as described in a paper by John Geanakoplos and Haobin Wang. Similarly, marginal QT will do little towards the “T”. The ‘new’ LM curve factors in the role of collateral in money markets and adds a new wrinkle to the monetary policy framework.