Russian Sanctions: Questions and Answers

This post is authored jointly with our friend and colleague, Professor Richard Berner, Co-Director of the NYU Stern Volatility and Risk Institute.

Russia’s invasion of Ukraine is altering global security and economic relationships. In this post, we focus on the financial and trade sanctions imposed on Russia. These sanctions are the most powerful and costly punishments imposed on a major economy at least since the Cold War. Their speed, breadth and coordinated global support appear unprecedented.

Not surprisingly, the impact is immediately visible. The damage to the Russian economy and financial system includes, but is not limited to, a plunge of the ruble (by about 40 percent versus the dollar over the past month amid heightened volatility); runs on domestic banks; a sharp hike in the central bank’s policy rate; imposition of capital controls; shutdown of the Russian stock market; collapse in the value of Russian companies traded on foreign stock exchanges; removal of Russian equities from global indexes; and the collapse of Russia’s sovereign credit rating to junk status.

The purpose of this post is to pose and provisionally answer a series of questions raised by this new sanctions regime.…

Monetary Policy Operations Redux

On September 17, the overnight Treasury repurchase agreement (repo) rate spiked to 6%—up from just 2.2% a week earlier and the highest level in more than 15 years (see DTCC GCF repo index). Oddly, this turmoil occurred at a time when the Fed had begun lowering its policy rate for the first time in more than a decade and market participants anticipated further policy easing ahead.

What led to this sudden disruption in short-term funding markets that been relatively calm in recent years? Had the Fed lost control? In our view, the explanation for the sudden rise in overnight interest rates is straightforward: the shrinkage of the Federal Reserve’s balance sheet that began in October 2017 reduced the aggregate supply of reserves gradually to where banks’ demand for reserves was insensitive to interest rates. Consequently, large temporary fluctuations in the supply of reserves that would have had virtually no impact even a few months ago, triggered sizable upward interest rate fluctuations.

Consistent with this view, the Federal Reserve recently took action to prevent a recurrence of the September disorder. At an unscheduled video conference meeting on October 11, the FOMC agreed to additional regular purchases of Treasury bills at least into the second quarter of 2020. The goal of this balance sheet expansion is to maintain reserve balances at least as high as their level in early-September before the turmoil began.

In the remainder of this post, we discuss the evolution of the supply and demand for reserves in recent years. We argue that, because no one—including the Fed—knew the precise level of reserves at which the demand curve would become inelastic, an episode like the one on September 17 was virtually inescapable as reserve supply declined. If our diagnosis of the cause is correct, then recent actions should help put the issue to rest. Yet, given the inevitability of the event―that the day would come when shrinking reserve supply hit the inelastic part of the reserve demand curve―the Fed could (and should) have been prepared. If so, it could have avoided even a temporary dent in its well-deserved reputation for operational prowess….

Cash is king, but $100 bills are for crooks

People have been saying for years that cash will disappear. So far, they have been spectacularly wrong. Over the past decade, the face value of U.S. dollar paper currency in public hands has doubled. Today, there is nearly $1.6 trillion in banknotes outstanding, more than 80 percent of which is in $100 bills (see chart)! In fact, there are thirty-nine $100 bills in circulation for each of the 326 million residents of the United States.

Why is 90 percent of the U.S. increase in circulation accounted for by $100 bills? One possible explanation is that, with nominal interest rates near zero, the opportunity cost of holding cash has dwindled, reducing the incentive to deposit rising inventories of cash in a bank. The second, and more compelling, reason for the big increase in large-denomination notes is more troubling: it facilitates illicit activity. Money laundering, tax evasion, drug dealing, human trafficking, and a whole host of other criminal activities run on cash. Big banknotes are a convenient way to transfer funds anonymously with finality. A $100 bill weighs less than a gram, so $1,000,000 weighs roughly 10kg and is small enough to fit in a medium-size briefcase.

To put it simply, most of the U.S. currency in circulation is almost surely being used by criminals....

Yogi Berra and the Dollar

Some forecasters are confidently predicting a large further rise in the U.S. dollar against key currencies like the euro and the yen. And a few ominously warn of impending currency wars where central banks outside the United States will manipulate their currencies to gain a global trade advantage.

Not so fast. First, currency forecasting is a hazardous business. And second, even if (as widely projected) the dollar were to rise substantially, its appreciation would seem consistent with relative growth prospects, not currency management by policymakers.

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Money, Banking, and Financial Markets