The Fed’s new balance sheet

My previous post reviewed the profound changes in the balance sheet of the U.S. Federal Reserve over the last 18 months. Here I comment on some of the concerns that the new Fed balance sheet raises for the conduct of monetary policy.

I would suggest first that the new Fed balance sheet represents a fundamental transformation of the role of the central bank. The whole idea behind open market operations is to make the process of creating new money completely separate from the decision of who receives any fiscal transfers. In a traditional open market operation, the Fed buys or sells an existing Treasury obligation for the same price anyone else would pay for the security. As a result, the operation itself does not involve any net transfer of wealth between the Fed and the private sector. The philosophy is that the Fed should base its decisions on economy-wide conditions, and leave it entirely up to the market or fiscal authorities to determine where those funds get allocated.

Assets of the Federal Reserve, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release.
Agency: federal agency debt securities held outright;
swaps: central bank liquidity swaps;
Maiden 1: net portfolio holdings of Maiden Lane LLC;
MMIFL: net portfolio holdings of LLCs funded through
the Money Market Investor Funding Facility;
MBS: mortgage-backed securities held outright;
CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility;
TALF: loans extended through Term Asset-Backed Securities Loan Facility;
AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III;
ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility;
PDCF: loans extended to primary dealer and other broker-dealer credit;
discount: sum of primary credit, secondary credit, and seasonal credit;
TAC: term auction credit;
RP: repurchase agreements;
misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding;
other FR: Other Federal Reserve assets;
treasuries: U.S. Treasury securities held outright.

The philosophy behind the pullulating new Fed facilities is precisely the opposite of that traditional concept. The whole purpose of these facilities is to redirect capital to specific perceived priorities. I am uncomfortable on a general level with the suggestion that unelected Fed officials are better able to make such decisions than private investors who put their own capital where they think it will earn the highest reward. Apart from that general unease, I have a particular concern about the motivation for the Term Asset-Backed Securities Loan Facility, whose goal is to generate up to $1 trillion of lending for businesses and households by catalyzing a revival of loan securitization. I grant that securitization was an enormously successful device for funneling vast sums into sundry loans. For example, securitization successfully turned 80% of quite shaky subprime loans into Aaa-rated assets. To put that in perspective, only five U.S. companies currently have the ability to issue Aaa-rated debt. So yes, a device that transformed weak loans into Aaa-rated debt was marvelously successful at attracting capital from all over the world into U.S. private lending.

Ratio of total mortgage debt (from Table L.2 of Flow of Funds Accounts) to nominal GDP (from BEA Table 1.1.5).

But the whole premise behind those Aaa ratings– that securitization could isolate a “safe” component of a pool of fundamentally risky loans– was deeply flawed. It is impossible to diversify away aggregate or systemic risk. All that the device did was to mislead investors into thinking they were protected from those nondiversifiable risks and push those risks onto the taxpayers and the Fed. Before we decide that securitization is the road out of our present difficulties, I would like a detailed and convincing explanation of why the past mistakes are not going to be repeated again.

A second concern I have with the new Fed balance sheet is that it has seriously compromised the independence of the central bank. To my knowledge, every hyperinflation in history has had two key ingredients: (1) budget deficits that could not be resolved politically, and (2) a central bank that assumed the obligations that the fiscal authority could not.

In the U.S. today, there is little question in my mind that repaying the projected deficits with tax increases or spending cuts will be extremely difficult politically. Each additional trillion dollars would roughly require doubling the personal income tax rate on all Americans for one year, something I cannot see the political process delivering. There is enormous pressure in the current situation to defer solutions and look for temporary fixes with off-balance-sheet measures. The reason that the Fed is sought as a partner for the Treasury in all these new actions is because the Fed is perceived to have deeper pockets than the Treasury. This is not a situation that a self-respecting central bank should let itself get into.

My third concern is that the new Fed balance sheet has handicapped the Fed’s ability to fulfill its primary mission, which I see as promoting a stable and predictable low rate of inflation. Which of the Fed’s new assets would it sell off when it needs to absorb back in the huge volume of reserves it has recently created? The Fed’s hoped-for scenario is that the reserves won’t need to be called back in until the situation has stabilized and the facilities are no longer needed. But I am concerned instead about the possibility of a dramatic shift in the perceptions of foreign lenders, in which case inflationary pressures could emerge in a situation that is far more chaotic than the one we currently face.

I recommend instead that the Fed should be buying Treasury Inflation-Protected Securities in the current situation. Tim Iacono says that’s like the Mafia buying “protection” from itself. But my point is that TIPS represent an asset that would gain in value at a time the Fed needs to sell them, meaning that the logistical ability of the Fed to drain reserves quickly in such circumstances is without question.

What we need in the current situation is a central bank that is a bulwark of stability. A profound lack of confidence in the U.S. government itself would make our current problems look like a walk in the park. If the Fed had the means and the credibility to deliver a stable and low inflation rate, I believe that would go a long way to solving our current problems.

But it’s not clear the Fed has either the means or the credibility.

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44 thoughts on “The Fed’s new balance sheet

  1. Peter

    I think that concerns about future garden-variety inflation are justified but it is simply incorrect that present actions of the Fed presage future hyperinflation. In fact, has there ever been a case of hyperinflation while the Fed central bank has stopped increasing the monetary base? I think not, but please correct me if I am wrong.
    It seems to me that concerns about how quickly or effectively the fed will be able to drain liquidity are simply overdone.

  2. Michael Krause

    Agreed with Peter. This seems to me when banks start moving those new reserves (and all of the other injections of money start moving), we will move to a new (higher) price level. If the Fed is unable to avoid that price move (which I think is likely, considering so many of these new assets they’ve acquired are relatively illiquid), I think the Fed will only be able to get (relative) control by projecting to the market that *going forward* it will target slow inflation growth (1-3%), saying it will retard money supply growth to a slower rate than the one time move we just saw.
    Hyperinflation is an unjustified fear, but I see no reason why we won’t experience 100% inflation over a period of 3-4 years, then a leveling off will occur. Hyperinflation is about the rate of money printing, not so much the amount of money out there.
    In the meanwhile (for long term positioning), enjoy the low prices while you can and buy tangible assets to protect your wealth.

  3. JDH

    Peter and Michael: I raise the issue of hyperinflation not in reference to the current status of the Fed balance sheet, but instead in reference to the current status of explicit and implicit Treasury debt combined with the erosion of central bank independence.

  4. Nemo

    What about the explicit Constitutional mandate giving Congress alone the authority to confiscate and spend the people’s wealth? Can Congress really delegate that authority to a quasi-private institution? (And have they?)

  5. pireader

    Professor Hamilton —
    Your unattractive scenario runs together two separate issues.
    First, can the Fed absorb back the reserves that it’s recently created? Yes, if we assume cooperation by the Treasury. If the Fed could not sell off the dubious assets now on its books, then the Treasury can issue T-notes to soak up the liquidity instead. Same result.
    Second, can a foreign government (e.g., China) dump its holdings of US Treasuries? Yes, and presumably the Fed would “print money” to buy them back (keeping down interest rates). So what’s that government’s next move?
    It can hold the dollars, having exchanged interesting-bearing obligations for non-interest-bearing. Not likely.
    It can spend those dollars in the US, which would solve our recession problem very nicely.
    Or it can convert the dollars to its home currency (renminbi or whatever). That drives down the dollar’s exchange rate, triggering a US export boom, again helping with our recession–and drives up their currency’s value, cratering their exports. Which seems unlikely, since they originally bought those Treasuries to hold down the value of their currency, precisely in order to foster exports.
    Do any of these alternatives seem likely to you?

  6. piqued

    Dr. Hamilton,
    If I could vote on it, you’d be up for that prize in honor of the dude who invented dynamite. Which is how I will describe these essays to my friends. Simply the greatest, most cogent, and erudite essays that I have read on this topic.
    Thank you.

  7. Michael Krause

    Prof Hamilton: What do you think of the status of the BOJ balance sheet and their dependency on exports to finance their savings rates (which help set govt debt service costs to be low)? If we (the US dollar and treasury/agency debt load) are a TNT time bomb waiting to explode, then by the same logic isn’t the Japanese Yen up for a major impending nuclear devaluation?

  8. Michael Krause

    Prof Hamilton: Another question: Your suggestion that the Fed buys TIPS to protect its balance sheet is an interesting one, but isn’t this ultimately a deceptive accounting trick? The Fed + Treasury balance sheet comes out the same TIPs or standard treasuries issued.
    If treasury issues TIPS, lets say $100 worth, isn’t treasury making a bet (one they are entitled to make, since between them and the Fed, they control policy to set price level) that CPI goes nowhere? If price level is double at the end of the ten year period, the treasury needs to return $200 in principal. The treasury has assumed a $100 loss. The Fed’s gain is the treasury’s loss, which in turn is a wash. Let’s say the Fed sells the security before maturity. If the treasury is marking to market its TIPS exposure, isn’t it taking a loss in the intermediate term equal to the Fed’s gain?
    This is versus alternative where the treasury sells standard treasuries, pockets the $100, and the Fed needs to sell before maturity at $80 (adverse interest rate move). The treasury has an unrealized gain of $20 (since they sold a security to the market for $100 that they can now buy back at $80). The Fed has a loss of $20. Since the Fed’s profits get distributed to treasury in the end, its all the same in the TIPS or not.

  9. Martin

    Why does it seem almost everyone assumes an inflationary environment in which the economy recovers to full employment and is again humming along. I know other countries have numerous examples of inflation and hyper-inflation with a stagnant or declining economy (we have the 70s, there is Weimar, Latin America in the 80s, Zimbabwe as the worst example). I would love to read a cogent article on where inflation would manifest itself.
    It seems to me that with global wage arbitrage keeping worker wages from growing very fast that any inflation is likely to leave out American workers unlike in the 70s when there were strong unions who could negotiate to push wages up. So, in light of this statement, through what mechanism could inflation occur? If wages aren’t inflating what is left? Credit expansion? How would that occur given the level of debt we currently have in the private sector?
    If wages can’t inflate and private sector credit can’t inflate, then how is any inflation not going to lower standard of living? It seems to me that the only expansion that can occur is exactly what we are seeing, using the government and Fed balance sheets. Where is the end game on that expansion though? As the article says, perhaps the shift would come from a large change in perception from foreign lenders. I think this is the crux of where we are headed, but who knows when that would occur…there are still strong arguments for the Asian exporting countries to devalue their currencies and that Europe will be in worse shape than we are keeping the euro from appreciating. Until those other powers break from dollar hegemony, I don’t see where inflation really takes hold in the US.

  10. G Commenter

    I agree with the posters saying that this doesn’t presage hyperinflation. Admittedly, in times like these, I may be careless for dismissing the possibility of extreme scenarios, but it would take a LOT more than just a doubling in the monetary base to pave the road for true hyperinflation. On the fiscal side, the government doesn’t benefit nearly as much from *ANY* amount of inflation as they used to. The portion of outlays that’s indexed to inflation (primarily social security) is much larger now than it was during the 70s uptick in inflation. Moreover the government’s heavy stake in the mortgage market, via the GSEs and bailout efforts, seems to incentivize them to keep nominal interest rates low for quite a long time. I wish I could also say inflation-indexed government bonds played a major role in these incentives, but they’re too small a chunk of the market. Perhaps most importantly, as James alludes, the IRS can raise money much more easily than in any of the countries that have experienced hyperinflation. Hyperinflation is sort of a desperation tactic used by governments that aren’t capable of raising funds in less harmful ways.

    In short, a whole lot else would have to change very drastically in order for hyperinflation to become at all likely. I suspect the fed’s recent policy changes would seem insignificant in comparison to the sheer magnitude of the other changes that would have to take place to put us on that path. I also suspect we’ll never find out since it won’t happen.

    I agree with Michael who says we might experience high inflation over a few years. That would be extremely unfortunate, and IMO avoidable, but at least it seems possible from here. And the Fed’s recent activity DOES contribute significantly to the likelihood of this scenario.

  11. DickF

    Fantastic post! I can’t shout it any louder.
    If you take the truth in your post and connect it to Geithner’s lastest request from congress to give him undefined total power to nationalize any business in the United States and even reaching outside under many circumstances and you have a total transformation of the US into a Fasicist state almost exactly like that of Mussolini’s Italy before he was forced to join with Hitler.
    We must never forget that Mussolini was first a socialist. His Fascism grew from his attempt to make socialism politically acceptable to a conservative government.
    Geithner has promised to make the trains run on time if only we will give him dicatatorial power and the Bernanke FED will supply the financing.
    I am amused as I think of those who accused Bush of being a Fascist yet they have no idea what a Fascist really is. You want Fascism? You got Fascism!

  12. Rajesh

    The biggest factor in the closing of the current U.S. budget deficit would be the resumption of growth. Much of the growth of the deficit this year is the fall off of tax revenue. Bill Clinton would never have posted a surplus if not for the revenue on dot-com capital gains. Obviously, investor are reducing tax revenue due to capital losses last year. But assuming the stock market does not go down forever, the losses will eventually become gains again.
    Which is not to say that spending cuts and tax increases may not be needed, but the size of such measures looks a lot larger now than what will eventually be needed. I also do not think it wise economically for the Federal government to run a surplus.

  13. JimP

    The Fed should STOP paying interest on reserves. What we are going through is a direct result of this policy – of their deliberate refusal to reflate. They did this in 1936 and are doing it again. It is an utter and gross failure – as it was with Andrew Mellon. What we are going through is not due to some big market or debt failure. It is due to the direct refusal of the Fed to expand the currency base sufficiently – a direct desire on their part to have deflation. As this blog post makes completely clear.
    By the Taylor rule interest rates are now 6 full percent too high – and what is the Fed doing about this? Nothing whatever. It is a gross failure.
    The deflationists are running the show. We are our own Andrew Mellon now – and it is totally insane.
    For a contrary point of view – see here:
    or here:
    Inflationary expectations are now entirely unanchored. People are hording, in their houses, both gold and currency – because they have no clue if this will have an inflationary or deflationary outcome.
    It is the direct responsibility of the Fed to anchor these expectations – as Bernanke knows full well.
    He should do so – by announcing two policy changes:
    1. To STOP paying interest on excess reserves and rather start CHARGING interest on them. Drive the cash out of the banks.People will spend it. Prices will rise. Employment will return.
    2. Announce a PRICE LEVEL target. Not an inflation rate target – but a price level target – as Greg Mankiw described on his blog. In x years from now prices in the US will be y% higher than they are now. A moderate but firm commitment to inflation. This will alter inflationary expectations – anchor them in a positive direction – and people will respond by spending – which is just what we need.
    Drop this sterilized screwing around in particular credit markets. Drop all those programs – leave those particular credit spread levels up to the markets. And buy the long bond, or currencies, or foreign bonds, or equities, by the trillions. This whole nightmare would fade away as a bad dream.
    Though I don’t actually think they would have to buy anything. I think the announcements alone would do the trick just fine. Especially if Obama would act like Roosevelt did. When Roosevelt came in the economy and the banks were both in much worse shape than they are now. Roosevelt announced a surprise inflation – as a direct policy – a goal – by changing the dollar price of gold. In the first two months of his administration the economy took off like a rocket – because people came to expect inflation rather that deflation. Obama plus Bernanke could do exactly that again.
    Why in the heck don’t they? I wish I knew. They are choosing not to – because they believe the deflationist twaddle – that this is a big big system wide world wide problem that can only be fixed by years and years of pain and suffering – because somehow we deserve it. To hear that view, just read Alan Abelson in Barron’s. He cackles this, with pleasure and joy, over and over and over. It is utter trash.

  14. Eckland

    It is good to see a serious economist (like James) actually commenting on the serious problems developing with the US fiscal authorities and central bank. Most commentators are still pretending that the USA is special and the problems that have happened in emerging markets can’t happen here. The USA (and UK) have very serious fiscal problems and have compromised the independence of their central banks. They could end up like Argentina or they could not but an understanding of the seriousness of the problems involved is key to getting out of this without a disaster.

  15. Kieth

    Why do people assume that Chinese holders of US treasuries will be content to redeem these instruments for cash? Chinese and other bond holders can convert those treasury bills to ownership of US factories, farmland and, yes, golf courses. Just printing the money does is not going to solve anything. The Chinese may well be more prudent and successful at this than the Japanese were and are.
    It is not a good trade.

  16. Chris

    One thing I heard on Bloomberg Economy recently but haven’t seen commented on here is the existing authority that the Fed has to issue bonds. The discussion I heard indicated that this could be used to quickly unwind the expansion of the Fed’s balance sheet thereby extinguishing any inflationary pressure without the need of selling newly acquired private sector (perhaps heavily discounted) bonds.

  17. JDH

    Michael Krause: If the TIPS are, as currently, held by the public, the unified balance sheet of the Treasury/Fed has a capital loss when inflation goes up. If instead they are purchased by the Fed, the unified balance sheet does not have a loss.

    But my main point concerned not capital gains or losses but instead the logistics of having assets that could be sold in a hurry and with a net stabilizing effect if inflation expectations suddenly spiked.

  18. Felipe

    What is quantitative easing?
    Quantitative easing merely involves the central bank buying bonds (or other bank assets) in exchange for deposits made by the central bank in the commercial banking system – that is, crediting their reserve accounts. The aim is to create excess reserves which will then be loaned to chase a positive rate of return. So the central bank exchanges non- or low interest-bearing assets (which we might simply think of as reserve balances in the commercial banks) for higher yielding and longer term assets (securities).
    So quantitative easing is really just an accounting adjustment in the various accounts to reflect the asset exchange. The commercial banks get a new deposit (central bank funds) and they reduce their holdings of the asset they sell.
    Proponents of quantitative easing claim it adds liquidity to a system where lending by commercial banks is seemingly frozen because of a lack of reserves in the banking system overall. It is commonly claimed that it involves “printing money” to ease a “cash-starved” system. That is an unfortunate and misleading representation.
    Invoking the ‘evil-sounding’ printing money terminology to describe this practice is thus very misleading – and probably deliberately so. All transactions between the Government sector (Treasury and Central Bank) and the non-government sector involve the creation and destruction of net financial assets denominated in the currency of issue. Typically, when the Government buys something from the Non-government sector they just credit a bank account somewhere – that is, numbers denoting the size of the transaction appear electronically in the banking system.
    Does quantitative easing work? The mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment.
    It is based on the erroneous belief that the banks need reserves before they can lend and that quantititative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.
    But this is a completely incorrect depiction of how banks operate. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).
    The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.
    The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.
    Check also Bill Mitchell’s blog

  19. Michael Krause

    JDH: Got it, but isn’t the suggestion to do TIPS versus regular treasuries coming from an angle of preventing capital losses on the Fed balance sheet?

  20. stunney

    The Treasury can buy the Fed’s new and unusual assets by issuing new bonds to the Fed. That keeps those assets from causing losses upon sale to the private sector being realized in the government’s combined accounting, and also provides the Fed with a new stock of higher quality assets which it can use to drain reserves from the banking system to combat excessive inflationary pressures.
    Any realized losses on the low-quality assets should be covered by increasing taxes on the plutocracy. The truth after all is that their bloated incomes are really a tax on the rest of us. So raising taxes on them is really like a tax refund for the ordinary taxpayer.

  21. anon

    Very nicely written and substantially correct.
    Can you extend to describe how the current excess reserve position is being interpreted/ misinterpreted?

  22. John Lee

    Gentlemen, I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves . . . I intend to rout you out, and by the Eternal God I will rout you out! Andrew Jackson
    Smart man this Andrew Jackson, does anybody know this man ?

  23. tom m

    RE: The whole purpose of these facilities is to redirect capital to specific perceived priorities. I am uncomfortable on a general level with the suggestion that unelected Fed officials are better able to make such decisions than private investors who put their own capital where they think it will earn the highest reward.
    Would you feel more comfortable if the Fed were democratized? For example, by demoting the unelected district presidents from the FOMC, and making monetary policy democratically accountable to the congress? (Something like this has been proposed by Dean Baker and others, I believe.)

  24. jg

    Excellent post, Professor.
    Maybe you can be the brains behind us rabble (I had to look up ‘pullulating’).

  25. Echo

    Creating money, de facto transferring ownership to member banks (putting it on deposit at the Fed in their names), is not exactly neutral with respect to motivation. I notice that the Fed never puts newly created money on deposit in ordinary consumers’ names, so they can earn interest on it or withdraw it. The current system transfers purchasing power away from consumers, and into financial system leverage. It is a form of forced savings, where consumers never get paid back for the loan. Regulatory capture by lobbies has converted the money creation system into monetization of financial sector leveraged profits.

  26. Turbo

    One of the core problems with the US economy at the moment is that the debt to gdp ratio, at over 3:1, is too high. A 35% inflation over say two years brings that to a more managable 2:1. If you assume most fixed incomes adjust with cola, then the primary losers in this scenario would be net savers (typically the wealthy). Given the populist political climate, rapid expansion of the Fed’s balance sheet and apparant loss of independence, I don’t think it’s too far fetched to worry about a significant reflation event – whether the Fed can control this process and maintain any credibility whatsoever is the wildcard. FDR did it by confiscating private holdings of gold in 1933. Different monetary system, same result? High, accelerating inflation would also have a serious political backlash, so there’s strong incentive not to let the process spiral into hyperinflation. JDH is correct to worry that the conditions for hyperinflation are being put in place though.

  27. acerimusdux

    I’m glad to see this post, after responding to the last, as it at least addresses some of my concerns.
    “In a traditional open market operation, the Fed buys or sells an existing Treasury obligation for the same price anyone else would pay for the security. As a result, the operation itself does not involve any net transfer of wealth between the Fed and the private sector.”
    Exactly. What is missing though, is that the power to issue currency is so extraordinary that this is an essential check on this power. Overriding this, in theory, essentially allows the bankers themselves, who control the Fed, to authorize net transfers of taxpayer wealth to themselves.
    “I am uncomfortable on a general level with the suggestion that unelected Fed officials are better able to make such decisions than private investors who put their own capital where they think it will earn the highest reward.”
    Yes, but do you really trust elected officials to make such decisions more wisely? What is really at issue here ought to be accountability and the potential for systemic corruption. What we are talking about allocating here are taxpayer funds (as ultimately the Fed would not be allowed to fail either). So what we are talking about is the Fed overstepping it’s bounds and intruding into fiscal policy. It may be that elected officials will also allocate this capital poorly, but they are at least accountable at the ballot box for any such failures.
    It appears that this has been authorized by congress, and so is not technically illegal, but it is grossly irresponsible for congress to have abdicated this authority and allowed such a conflict of interest to occur.
    The truth is we still have a congress full of ninnies who are all to happy to abdicate any responsibility or authority so long as this enables this them to point the finger of blame elsewhere when things finally go wrong. I fear a repeat of the Gulf War, where no one will admit to voting for this, and we will hear assorted excuses from congressmembers about how it isn’t their fault, and how they were lied to and made to fear some imminent catastrophy had they voted otherwise.

  28. don

    Yes. Exactly the sentiment I have tried to express on several occasions on these boards.
    The only qualifier I have is that, at least for the near future, I think foreign lenders are overwilling to supply loans to the U.S. China is asking for a global currency, IMHO, not because it has lost faith in the dollar, but because it wants an outlet to maintain its export-led growth. With waning net U.S. loan demand, this would require intermediation of dollar-denominated loans to the rest of the world (a hard thing to get done right now), or substantial further depreciation of the yuan, which China rightly perceives would may pose political problems.

  29. Silas Barta

    I grant that securitization was an enormously successful device for funneling vast sums into sundry loans. For example, securitization successfully turned 80% of quite shaky subprime loans into Aaa-rated assets. To put that in perspective, only five U.S. companies currently have the ability to issue Aaa-rated debt. So yes, a device that transformed weak loans into Aaa-rated debt was marvelously successful at attracting capital from all over the world into U.S. private lending.
    Why do people keep repeating this myth? There’s nothing inherently wrong with turning subprime mortgages into AAA bonds. For example, if I loan out $1 billion in mortgages to deadbeats, and I sell a bond that entitles the bearer to the first $1 recovered or paid back, one month from now, what rating does that bond deserve? AAA, of course. Because it’s extremely unlikely that one will be unable to recover even $1 from that pool.
    What was wrong with the recent wave of securitization was *not* the issue of “turning junk loads into AAA bonds”, but rather, the overly aggressive assumptions about the fraction of the loans that is “extremely likely” to be recovered. To list the errors:
    -They applied the model to loans made with stricter standards than in the historical data.
    -They applied the model to loans with smaller down payments than in the historical data.
    -They were predicated on real estate prices going to unrealistic multiples of local incomes.
    -They included no margin of safety.
    Had they done the above, they might have been able to sell just 5% as AAA.
    Prof. Hamilton, you correctly note the problematic 80% recovery rate assumption, but you still carry on as if it’s an integral part of the fabric of reality that junk loans cannot feed into AAA bonds, which is just not true.

  30. sjp

    Silas, I don’t see how JDH said what you claim he said. He merely pointed out that securitization allowed more capital to fund mortgages that previously received much less funding. Moreover, making sure we remember how many agents (before securitization) could put out AAA rated debt makes the point that such debt is hard to come by. It certainly seems as though Wall Street’s methods for creating AAA debt held some flaws, as you note — I think that is the extent of JDH’s point.

  31. Felipe

    According to Mosler,
    There are excess reserves because the Fed has decided to not do what it used to do, sell or “reverse out” its securities to offset operating factors that caused reserves to increase.
    These operating factors include Fed purchases of securities.
    The reason the Fed would “drain” excess reserves was to keep the interest rate at its target rate.
    By paying interest on reserves it can accomplish that without selling its securities.
    Reserves are functionally one day securities, as all treasury securities are nothing more than deposits at the Fed anyway.
    And previous concerns about the Fed running out of securities were also addressed by being able to pay interest on reserves.
    The idea that banks hold reserves (for any reason) “instead” of lending is nonsensical.
    All that paying interest on reserves does regarding lending behavior is increase the rates banks might charge for loans.
    As always regarding the Fed, it’s about price, not quantity.
    With a 0% interest rate policy interest on reserves discussions are moot anyway.
    Available at

  32. SMG

    Does the Feds holding long-term treasury securities help to cover some of the credit risk the Fed is taking on?
    Suppose the Fed decides to hold $300 billion worth of long-term securities and that the average interest payment is 2 percent. This would be $6 billion less in interest payments (on an annual basis) that the Treasury pays out because the Fed returns interest income on government securities to the Treasury (at least to a first approximation).
    Given these assumptions, it seems the Fed could afford to loose up to $6 billion from its other endeavors without taxpayers being on the hook. Is this correct?

  33. Get Rid of the Fed

    “My third concern is that the new Fed balance sheet has handicapped the Fed’s ability to fulfill its primary mission, which I see as promoting a stable and predictable low rate of inflation.”

    I believe that the fed’s “missions” are supposed to be full employment [does not say at what wage level or real earnings level], low inflation [as in price inflation], and moderate interest rates. In my opinion, the fed goes about this with an “unstated mission”. That would be to produce more and more debt on the lower and middle class and maximize the chances of the debt being repaid to the spoiled and the rich. Hopefully, this debt will also jack up asset prices for the spoiled and the rich too.

  34. Get Rid of the Fed

    “If the Fed had the means and the credibility to deliver a stable and low inflation rate, I believe that would go a long way to solving our current problems.”

    If the fed believes that the best way to produce price inflation is with more and more debt on the lower and middle class and the lower and middle class have too much debt, what happens?

  35. Ken Kesler

    After viewing your graph, it becomes even clearer that they do not have a clue as to what they are doing.
    I am appalled that not one voice was heard that asked “Wait a minute. What would happen if we do nothing?”

  36. Hitchhiker

    Great post Professor. What is with all these folks like Prof Thompson from UCLA and many posters here that want the primary mission of the Fed to be full employment? Are we overcome with monetarists? Do they honestly believe the Fed can exercise absolute control over economic expansion or contraction with monetary policy and damn the consequences?
    You are a sane voice in the wilderness. It really is quite amazing to read people like Prof Thompson contort and twist facts in an attempt to rationalize what is obviously a pre-conceived agenda.
    “Once science has to serve, not truth, but the interests of a class, a community, or a state, the sole task of argument and discussion is to vindicate and to spread still further the beliefs by which the whole life of the community is directed. As the Nazi minister of justice has explained, the question which every new scientific theory must ask itself is: “Do I serve National Socialism for the greatest benefit of all?””
    F.A. Hayek

  37. Jim Kahn

    I may be confused here, but the “capital gain” on the TIPS is not real, it’s just inflation compensation. The TIPS securities maintain their real value while nominal bonds get killed. So if the Fed were to, say, exchange nominal bonds for TIPS, wouldn’t that be a signal to the markets that inflation is coming? The Fed would be unloading assets that are going to get killed by inflation in exchange for assets that will be protected.

    Regarding interest on reserves, in recent posts you’ve suggested that the rate is the same as the Fed Funds target, but I don’t think that’s the case. According to the New York Fed website, “The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points.” Obviously that’s not an issue now, given the zero lower bound, but when they began the policy that discount would have been in place.

  38. JDH

    Jim Kahn: It was the subsequent revisions to that policy that concerned me. See the current policy: “Under the new formulas, the rate on required reserve balances will be set equal to the average target federal funds rate over the reserve maintenance period. The rate on excess balances will be set equal to the lowest FOMC target rate in effect during the reserve maintenance period. These changes will become effective for the maintenance periods beginning Thursday, November 6.” In other words, under standard conditions the target rate equals the interest rate paid on reserves. This is what I find problematic.

  39. Yu'er

    Another superb post from JDH.
    I still don’t understand why JDH thinks paying interest on excess reserve is a problem. Granted, the revision is insane: they wanted the approval from Congress saying it would be a useful tool in managing fed funds rate as the rate on reserve will serve as a floor. Then seeing the effective rate fell under the floor for just a month they simply destroy the tool. So we are back to the square 1. But this is unlikely the reason banks are not lending.
    Copying myself: could it be that the reason banks continue to lend less is there are fewer credit-worthy borrowers around? Investment grade corporate have no problem getting funding: first quarter issuance of non-financial company bonds was more than triple that of the same peiord last year. The average yields was only 6.9, not too bad compared with 6.2 average for the 10-year period through July 2007. Yes, the spreads are much wider, as they should be — why should a sensible lender allow the same price distortion in private loans as these created in treasuries by the Fed?

  40. Yu'er

    I suspect the federal reserve is in the game of managing expectations. They are probably happy to hear all this talk about the risk of higher inflation. In fact, this may be the true motive behind their recent QE — that’s how one is supposed to push down the real rate when the nominal rate is zero. The fact that they include TIPS in their purchasing of treasuries is consistent with this hypothesis. The problem, of course, is that expectations are extremely difficult to manage. “Beware of what one wishes for” is what comes to my mind.
    I share JDH’s view that the federal reserve should not in the business of directing credit. I think the Benanke Fed shows a shocking deficiency of humility about its ability, the 2003 episode of promising extremely low rate “for a considerable period” included. That said, one possible reason that Fed has taken on so much recently might simply due to the manpower shortage in the department of Treasury. Apperantly, the Treasury secretary has none of the usual deputies under him right now. And none is arriving soon. And whoever thinking about volunterring needs to be prepared for an additional full blown tax audit, because they want EVERY expense and charity receipts for the past 5 years as part of the 6-8 weeks FBI background check on every position that needs Senate confirmation. Oh, by the way, Senate still has 1000+ confirmations to go through in the pipeline when they are not too occupied with that populist rage to work. Really boosts one’s confidence in our government in this time of crisis, no?

  41. MDueker

    JDH notes that the central bank has transformed itself to help replace the shrunken shadow banking system, which has withered in the face of systemic risks. He then asks,

    “Before we decide that securitization is the road out of our present difficulties, I would like a detailed and convincing explanation of why the past mistakes are not going to be repeated again.”

    One way to view the situation is that the Fed is encouraging GSE-based securitization, where the underwriting standards were fundamentally sound, notwithstanding some subprime stuff the GSEs bought. Thus, the Fed’s participation might aid not only in the reconstitution of securization but in restoring sound underwriting standards as well.

    One of the ironies of the MBS crisis is that right-leaning politicians criticized the GSEs for their market share, so the GSEs retrenched after 2004 or so to placate them—and lending standards went out the window. Regulation would have been required for the GSE underwriting standards to be followed to a sufficient degree by the private-label securitizers. The fact that the GSEs also bought some subprime MBS to placate liberal politicians meant that the GSEs collapsed with the subprime market.

    The restoration of GSE lending standards across the marketplace should prevent a recurrence of systemic risk coming from mortgage securitization.

    The Fed’s role in providing some demand side for what remains of the shadow banking system will prove to be temporary. Extraordinary circumstances do call for extraordinary, but temporary, measures.

    The concern about the Fed’s balance-sheet expansion is that for every dollar of reserves entering the system now, perhaps less than a dollar will be taken out later if the Fed has to sell GSE bonds or other assets at a price below par. It is possible then, that an upcreep in inflation expectations could be a self-fulfilling prophecy under the current arrangement. Technically, however, a capital loss on the Fed’s balance sheet represents a one-time monetary injection and not ongoing money growth.

  42. Shawkat Hammoudeh

    Yes, the US economy is moving away from the Greet recession to a Great Reflation. Yes, we are having a Great Reflation because we have been moving up from the brink of a great deflation. It is obvious the Great Recession and the Great Revelation are concomitantly taking place and have currently intertwined. Some people have jumped to conclude that the Great Reflation portends to high inflation coming soon. I do not see strong signs that foretell inflation is coming soon. There are my reasons: (1) There is high excess capacity in many industries and capital spending is low; (2) There is high unemployment in the labor market; (3) The foreclosures are increasingly making it to the market and there are no signs that indicate that real state spending will increase significantly; and (4) The consumers (70% of the economy) are de-leveraging and increasing their savings (now 8% of disposable income). Moreover, inflation expectations that are calculated based on the 10-Treasury indexed notes is about 1.78% which is below the Feds target of 2%. Furthermore, the Fed is aware of the increase in the monetary base and has enough tools to siphon off Banks excess reserves to prevent them from turning into money which usually leads to high inflations

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