Last year, TCH published a research note and Banking Perspectives article that demonstrated how tighter liquidity regulations contribute to a lower equilibrium real federal funds rate (AKA r*) and why that should be a concern. In sum, and as explained more fully below, tighter liquidity regulations lead investors to accept lower yields on liquid assets, including federal funds loans, because those assets have a higher “convenience yield” or “money premium,” lowering r*. A lower r* reduces the effectiveness of monetary policy and increased the likelihood of the Fed ending up at the zero lower bound again. As a result, the consequence for r* could be a material cost to be taken into account when calibrating liquidity regulations (or adopting new regulations as currently proposed by the Fed and other banking agencies).
Although our work presented evidence that r* is low and the convenience yield is high, we did not estimate the extent to which r* was being held down by the convenience yield as opposed to other causes, including the most commonly cited cause: the slowdown in productivity growth. However, estimates by several New York Fed economists that are discussed in a recent series of blog posts as well as in a Brookings paper, indicate that an increase in the convenience yield is currently the primary reason why r* is currently low.
What is r*?
The Fed conducts monetary policy primarily by taking actions that change the overnight real federal funds rate, an interest rates banks charge each other on unsecured loans. The “real” federal funds rate is the nominal rate minus expected inflation. Higher real interest rates slow economic activity and reduce inflation, and lower real rates boost economic activity and increase inflation. The equilibrium real federal funds rate is the rate above which monetary policy is contractionary and below which it is stimulative. A variety of estimates currently put r* at around 1 percent, down from a historical average of about 2 percent.
Why is a low r* a bad thing?
When r* is low, the Fed has to target a lower federal funds rate to achieve the same amount of stimulus as when r* is high. If r* is 1 percent and expected inflation is 2 percent (the Fed’s target for inflation), then the nominal federal funds rate will normally be about 3 percent. If the Fed needs to provide more stimulus than can be achieved by cutting interest rates 3 percentage points, the Fed will again hit the zero lower bound. If that happens, the Fed will turn to forward guidance (promising to keep rates low in the future) and asset purchases, which are less effective monetary policy tools.
How do liquidity regulations lower r*?
Liquidity regulations require banks to maintain a more liquid balance sheet. For example, the liquidity coverage ratio (LCR) requires banks to hold “high-quality liquid assets” (HQLA) in an amount equal to the bank’s projected 30-day net cash outflow (cash out minus cash in) under severe stress. A bank can satisfy its LCR by holding Treasury securities, which boosts HQLA, or equivalently by lending overnight federal funds, which boosts cash inflows. The yield on either asset in equilibrium (along with other forms of HQLA or very short term lending) will be lower because the asset provides the additional benefit of making the bank more liquid.
How large is the effect of liquidity regulations on r*
As shown in the exhibit (taken from the New York Fed blog posts, using their estimates derived from a model of the economy) r* is currently about 75 basis points below its long-run normal level. Furthermore, about two-thirds of that decline owes to a higher convenience yield (the orange shaded region). No doubt much of the rise in the convenience yield reflects the greater value placed on liquidity in the aftermath of the financial crisis, but it is noteworthy that at least half the decline occurred after the LCR was announced by the Basel Committee in December 2010, well after the crisis. Moreover, the convenience yield remains elevated even as the impact of lower productivity (the blue shaded region) has ebbed.
What then shall we do?
Liquidity regulations have both costs and benefits. By helping maintain counterparty confidence, they can reduce the likelihood that short-term investors in banks, including other banks, will pull back in a liquidity squeeze and that there will be a corresponding fire sale of assets to meet outflows. By ensuring that banks can meet outflows for 30 days, they buy time for the central bank to carefully determine if lender-of-last-resort support is safe and appropriate. But they also increase the cost of lending because banks have to hold a substantial quantity of low-yielding HQLA along with their loan portfolio, or fund that portfolio exclusively with expensive term funding and equity. Those increased costs translate into a lower supply of credit and a lower level of GDP.
It now seems that a further cost needs to be added to the cost-benefit analysis with respect to liquidity regulation. In particular, when doing that analysis, the Fed should take the extraordinarily high cost of a low r* into account. For example, those costs could lead to the conclusion that a new liquidity regulation the Fed has proposed, the Net Stable Funding Ratio, should not be adopted. That conclusion seems especially likely given that the regulation already failed a cost benefit test that the Fed endorsed.
Moreover, the benefit from making liquid assets held by banks usable to meet liquidity shortfalls is even higher when factoring in the potential corresponding increase in r*. For example, as we recently argued, the Fed could count required reserves – the percentage of customer deposits that banks must in turn deposit at the Fed – as HQLA. The Fed would be able to do so if it changed the regulation governing required reserves to stipulate that banks can use them to help meet customer outflows in a stress event. Relatedly, the Fed could take steps to ensure that banks are willing and able to use their HQLA when there is a stress event, reducing demand by banks for HQLA over and above their LCR requirements. Lastly, and in the longer term, as described in a TCH working paper, the Fed could consider recognizing the liquidity value of collateral pledged to the discount window when evaluating each banks’ LCR. Such recognition can be accomplished in compliance with the LCR by allowing banks to borrow against the collateral but hold the proceeds of the loans at the Fed until needed. Such an arrangement would also have the advantage of charging banks for the implicit liquidity support they currently receive for free.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.
