I've had a few exchanges recently on the question of what
gives the central bank the ability to set interest rates, including on Nick
Rowe's most recent post.
The discussion prompted me to read Woodford's paper Monetary Policy in the Information Economy in which he discusses various possible
implications of improvements in the efficiency of the use of monetary
base. The paper includes an excellent
analysis of the operation of a corridor system and the role of rates and quantities in such a system.
Woodford also considers how the central bank might set rates
in a world where its liabilities had no useful function beyond any interest
rate paid on them. Normally, central bank
liabilities have other uses. Currency
has a convenience value; reserves are used in clearing. Woodford wants us to think about what might
happen if currency became obsolete and where clearing had became so efficient
that reserves were no longer needed (assuming also that there are no mandatory reserve
requirements).
He explains how this might work through an arrangement whereby
there is a small aggregate positive balance held by commercial banks with the central
bank. The central bank would decide what
rate to pay on this balance and Woodford shows how this would then force all
commercial banks to base their rates around this benchmark. The balances that commercial banks hold
with the central bank in this system are functioning just like any other interbank
balance. They have no longer have any special
role in clearing.
Woodford says[1]:
"Why should the
central bank play any special role in determining which of these outcomes should
actually occur, if it does not possess any monopoly power as the unique
supplier of some crucial service? The answer is that the
unit of account in a purely fiat system is defined in terms of the liabilities
of the central bank."
I don't actually like the idea that the dollar
is defined by central bank liabilities.
We can certainly make various observations about the relationship
between liabilities of the central bank and those of commercial entities,
including about the legal and commercial obligations over the rate at which
liabilities get exchanged. But there
isn't anything beyond that. There isn't
anything additional to those relationships that constitutes defining the dollar
(and I'm not sure those relationships themselves actually constitute defining
the dollar), so I don't really like the introduction of this concept.
That said, Woodford goes on to specify one of the most
important of such relationships. This is
(from above) that "[a] financial contract that
promises to deliver a certain number of U.S. dollars at a specified future date
is promising payment in terms of Federal Reserve notes or clearing balances at
the Fed...". The important points
here are that, if another party (bank or non-bank) holds a balance at Bank A, a) it can require Bank A to deliver obligations of the Fed as settlement; and b)
it is entitled to receive such obligations at par (dollar for dollar).
It is worth noting that as
a commercial matter, banks also undertake to settle by delivery of claims on
other banks. If I have money with Bank A, I can ask Bank A to pay into may account at Bank B. This is economically equivalent to Bank A depositing money with Bank B and then transferring title to that deposit to me. However, once Bank A has committed to delivering Fed obligations at par, it is no more onerous to also undertake to similarly deliver claims on other banks.
In order for the central
bank to be able to set rates, is it sufficient that other banks commit to an either-way
exchange of central bank liabilities for their own liabilities? In fact, whilst this is critical, slightly
more is needed.
To see this we need to
understand what the equivalent provision would mean if applied to the central
bank. Let's imagine that everything is
in equilibrium with interest rates at 5% and the central bank then decides to lower
its deposit rate to 4%. At this point,
anyone (bank or non-bank) holding deposits with the central bank would (if they could)
require the central bank to settle that deposit by delivery of a claim on
another bank (paying 5%). In Woodford's
scenario, this would rapidly lead to all of the outstanding central bank
liabilities being extinguished, whereupon the rate on them would be
meaningless.
It is therefore critical
that the central bank does not undertake to redeem its deposit liabilities by
delivering claims on other banks. If a
commercial bank wishes to reduce its balance with central bank, it must
do so by lending the excess out. This is
what forces the rates of all the other banks into line.
The fact that the central bank will not redeem its deposit
liabilities in this way, when the commercial banks must do so is what Nick Rowe
calls "asymmetric redeemability".
In one form or another, it is essential to a central bank's ability to
set interest rates. Normally, we do not
notice it, because things like currency are by their very nature irredeemable
and so it seems odd to even frame the question that way.
In Woodford's hypothetical scenario, where balances with the central
bank are otherwise no different from all other interbank balances, it's easier
to see.
[1] It
was this section, quoted by PeterN in a comment on Nick Rowe's post, that
prompted me to read this paper.
