I’ve written before about Iranian monetary sanctions. We can disagree on motives and targets, but monetary sanctions are undeniably a very powerful instrument. They work because in severing Iran from the global payments network, the sanctions degrade the liquidity of Iranian wealth. I’m going to borrow this idea and see if I can apply it to central bank monetary policy. Can a central bank like the Federal Reserve conduct monetary policy by manipulating the *expected liquidity* of the liabilities it issues? Can the Fed hit its inflation targets by sanctioning its own deposits or, put differently, by freezing and/or unfreezing them?
Let’s say that the expected return from holding a Federal Reserve liability can be decomposed into 1. capital appreciation/depreciation (ie. inflation); 2. interest (either interest on reserves [“IOR”] or the federal funds rate), and 3.”liquidity services”.
Traditionally, an inflation-targeting central bank manipulates the interest rate portion of a dollar’s return up or down in order to make inflation, the dollar’s expected capital appreciation, rise or fall to its target. Here’s what I’m curious about. What happens if the Federal Reserve holds the interest rate fixed but manipulates the “liquidity services” of Fed liabilities? Will this be sufficient to make inflation rise or fall to target?
All assets provide varying degrees of liquidity services, but the liquidity (or “moneyness“) of central bank liabilities are supreme. In the US, deposits held at at the Fed can be used to make Fedwire payments. Fedwire is an interbank clearing and payment system hosted on the books of the Federal Reserve. Banks make payments in order to settle cheques, buy and sell securities, and make other large time-sensitive payments on behalf of clients. The average value per transfer over Fedwire is about $5 million. In 2011, $663 trillion in transactions were conducted via Fedwire. That’s a lot of liquidity.
Let’s say the Fed announces that going forward some not insignificant percentage of all deposits held at the Fed will be frozen for a period of time, say a month. While frozen, deposits will still earn IOR, but banks won’t be able to sell them on Fedwire. The distribution of frozen deposits will be random. No bank knows if they will be afflicted or not. When, after a month, a deposit is unfrozen, some other random deposit in the system is frozen.
Just like monetary sanctions, the freezing of Fed deposits will have the effect of degrading their anticipated liquidity services. Banks who had previously been sure of the superior saleability of Fed deposits now face the possibility that they won’t be able to utilize them should some unanticipated need arise. In response, banks will simultaneously try to rebalance their portfolio towards other liquid assets by selling some of the Fed deposits they hold. But the stock of outstanding Fed deposits is fixed. The only way for the system to equilibrate is for the price of all other assets to rise, or, put differently, for inflation to increase.
In this scenario, the Fed loosens policy (creates inflation) by either increasing the margin of deposits that are frozen or by lengthening the period for which they will be frozen. It tightens by unfreezing and shortening. Playing around with its liquidity-services tools allows the Fed to hit its inflation target.
Conversely, the Treasury tightens Iranian monetary policy by freezing Iranian deposits in the international payments system and loosens by increasing the ability of Iranian’s to participate in the system. The Treasury’s target is unrealistic—Iran must stop developing the bomb. A more realistic target would be Iranian NGDP.
Apart from serving as a mental exercise, using liquidity tools in monetary policy might be useful at the zero-lower bound. We know that the Fed can’t set a negative interest rate at the ZLB because everyone will quickly convert Fed deposits into Fed cash in order to escape the penalty. The Fed therefore loses its ability to drive up inflation.* Miles Kimball‘s vision of a conversion penalty on cash withdrawals is one way to limit the dash for cash, thereby allowing central banks to set negative rates. A more extreme fix is to simply ban cash.
Because cash is a day-to-day feature of regular people’s lives (well, criminals too), implementing cash penalties or bans might be a bit awkward. If instead we try to escape the ZLB by reducing the liquidity of Fed deposits and creating a bit of inflation, this shifts the burden of coping from the public to banks. Won’t banks simply evade the sanctions by converting deposits into Federal Reserve cash? Unlikely, since they’d be forfeiting IOR and have to pay storage and transportation costs on cash.
*Market monetarists don’t believe this and think large scale purchases can do the trick. I don’t disagree.