Rethinking the value of collateral for money markets

Manmohan Singh is a senior economist at the IMF. The views below are his own, rather than those of the IMF or its executive board.

Two recent Federal Reserve papers have argued that balance sheet liquidation (or shrinking the size of its asset holdings) equates to tightening.

A Document of the Board of Governors of the Federal Reserve by Edmund Crawley et al says $2.5 trillion in unwinding of the Fed’s balance sheet would roughly equate to a tightening of 0.50 percentage points, or 20 basis points per trillion dollars. Meanwhile, Stefania D’Amico and Tim Seida of the Chicago Fed analyze 10-year U.S. Treasuries data to reach an estimate of 25 basis points per trillion.

Keep in mind that under the previous schedule, a $1 billion settlement would take about two years. From this September, the faster pace of unwinding ($95 billion per month of US Treasuries and mortgage-backed securities) will take about a year.

Similar research has been done by the IMF (published in the journal CATO) in which we show that a $1,000,000,000 change in pledged collateral can cause short-term rates to vary by up to 20 basis points. Intuitively, long-dated bonds can be sliced/very short-dated in the repo/dry lending/prime brokerage/derivative markets. And intuitively, more USTs (or similar good collateral like MBS or German Bunds) in the market realm means more collateral available and better functioning of the market (i.e. the “reverse” transmission of monetary policy improves).

In other words, if you factor in the reuse of collateral, the effective supply of collateral going to the market is greater than the nominal amount the Fed is unwinding. Thus, the trillion-dollar unwind applied in the two Fed documents means more than $1 billion (i.e. a tightening of 20 to 25 basis points for every 1 to 2 billion settlement dollars, assuming the term of collateral released is around 2 at the moment, as explained by my previous post on collateral velocity). Such an equivalence with a tightening of interest rates is marginal at best, especially if the unwinding of a trillion takes a very long time (1 to 2 years and more).

Intuition can be viewed from the perspective of money. Many textbooks still use the conventional method Model IS-LM describe the relationship between interest rates and economic output. Here, the IS curve represents investment and saving. The LM curve represents the demand for liquidity and the money supply. The point where they intersect represents the equilibrium of production and money markets.

We were taught (as an indication) that via the IS/LM curves, the LM offsets are parallel:

But LM can pivot, since the role of collateral in money markets is often overlooked in macroeconomics:

Technical explanation: The LM curve is usually derived from the equation M=f(Y, r), where the demand for money is a function of output (Y) and benchmark interest rates (r). The latter is assumed to be sufficient to determine the entire yield curve, including all money market rates and risk premia. However, the role of collateral markets (C) in the transmission of monetary policy is ignored. C is also f(r) and a metric for monetary value.

In the “old” framework, an inward shift of the IS curve due to a contraction in the economy can be neutralized by shifting the LM curve outward and lowering rates (even to negative levels) , so that they intersect at the same production level as before . This IS-LM framework suggests that via QE the LM curve shifts to the right (money is injected into the economy) but ignores the good collateral (and monetary value) that has been taken out of the economy through EQ.

In the “new” IS-LM model, changes in monetary policy do not always result in a parallel shift in the LM curve; here, the LM curve can pivot and intersect the IS curve at different points, depending on the slope. Some research suggests that EQ may increase production initially, but may have a diminishing effect as EQ scales up. The new IS-LM model corroborates these results. The red dots illustrate the evolution of output in relation to the slope of the new LM curve after netting the “monetary” which is withdrawn when guarantees are ring-fenced by central banks. As an illustration, too much QE can lead to lower production than the initial pre-crisis starting point. 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 monetary value lost (or gained) by buying (or unwinding) collateral during QE (or QT). Cross-border portfolio shifts (e.g., US Treasuries) can lessen or even reverse the impact of ever-increasing QE interventions on asset prices, as described in an article by John Geanakoplos and Haobin Wang. Likewise, marginal QT will do little towards the “T”. The “new” LM curve takes into account the role of collateral in money markets and adds a new dimension to the monetary policy framework.