Looking for an exit

In addition to testifying before Congress, Federal Reserve Chair Ben Bernanke today tried to explain the Fed’s plans and options directly to the public through an op-ed in the Wall Street Journal. Here I provide some background on what Bernanke’s talking about in terms of an “exit strategy” for the Fed, and offer some thoughts on his remarks.

The basic power of the Fed derives from its ability to create money, which it can use to buy assets or extend loans. We can summarize the Fed’s actions in terms of either the asset side of its balance sheet (the assets and loans it holds), or the liabilities side (the money or other obligations it has created). Let’s start with the asset side. Up until January of 2008, by far the most important assets held by the Fed were short-term Treasury bills. As last year wore on, the Fed significantly expanded its loans in the form of currency swaps with foreign central banks, direct lending to U.S. banks through term auction credit, and the Commercial Paper Lending Facility. Altogether such measures more than doubled the various asset holdings of the Fed by the end of the year, despite the fact that the Fed sold off 40% of its original T-bills.



Figure 1. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to July 15, 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.
fed_asset_07_21.gif



In 2009, the Fed has been winding down some of these programs, with significant declines in swaps, CPLF, and TAC, replaced by big increases in items such as mortgage-backed securities and agency debt. The changes over the last few months should not by any stretch be described as a return to “plain vanilla” central banking. The risk on MBS and agencies is greater than that for T-bills, and the asset level today remains 130% above its value at the start of 2007.

Where did the Fed obtain the funds with which it acquired all these new assets? To say that it did so by “printing money” would be inaccurate. The Fed doesn’t lend a half trillion in term auction credit by handing out big bundles of green paper with Ben Franklin’s picture on them. Instead, it creates an entry in an account that the recipient bank has with the Fed known as the bank’s Federal Reserve deposits. The bank could, if it wanted, use those credits to ask the Fed for those Ben Franklin souvenirs. Instead the bank presumably used the new deposits to pay for some obligations or make some loans, either of which it would instruct the Fed to implement by transferring those reserves to some other bank. That bank in turn could use the reserves to ask for C-notes, or pass them on to somebody else through its own loans or any other expenditures.

And the buck stops– where? In normal times, the process of banks putting any excess reserves to use would continue until there’s enough expansion of banking and economic activity that ultimate recipients did want to turn those reserves into green currency. And once that happens, it would not be a misleading summary of the bottom line to say that the Fed eventually paid for its original asset purchase by “printing money”.

But in the fall of 2008, the Fed did not want that to happen. It wanted to extend a trillion in new loans, but it did not want to see currency held by the public go up by a trillion dollars, out of fear the latter would be very inflationary. The Fed’s thinking was that we didn’t need a traditional inflationary expansion of credit, but instead needed to allocate credit to particular functions without having conventional measures of the money supply swell.

The graph below describes how the Fed did that, looking now at the liabilities side of the Fed’s balance sheet. The height of Figure 2 at any date is identical, by definition, to the height of Figure 1, but whereas Figure 1 was looking at what the Fed did with its funds, Figure 2 summarizes how the Fed obtained those funds. In other words, Figure 2 looks at where the reserve deposits the Fed created ended up, and explains why the dramatic actions of Figure 1 haven’t yet shown up as currency held by the public.



Figure 2. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to July 15, 2009. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.
fed_liab_07_21.gif



One big factor has been the accounts that the U.S. Treasury holds with the Fed. Essentially, the Fed asked the Treasury to borrow some money through public auctions, which it did. Banks paid for these new T-bills by instructing the Fed to transfer to the Treasury the Federal Reserve deposits that they’d received from the Fed as a result of the programs in Figure 1. The Treasury then just left the funds sitting there in its accounts with the Fed. In effect, the Fed obtained the funds for some of its actions on the asset side not by “printing money” but instead by having the Treasury borrow funds on its behalf on the liabilities side.

However, an even bigger volume of the deposits that the Fed created are still just sitting on the banks’ books. The way the fed funds market functioned in 2007, that would never have happened. Why close your bank’s books for the day with funds just sitting there in an account with the Fed, earning no interest, when you could loan them out overnight instead? A big bank would never do such a thing in 2007. But they’re happy to do so in 2009, in part because the overnight lending opportunities are not particularly attractive at the moment, and in part because the Fed now pays interest on those reserves. From the bank’s point of view, funds left on deposit with the Fed at the end of the day aren’t idle at all, under the new system adopted in the fall of 2008.

One of the points that Bernanke makes in his op-ed is that the Fed could continue to use this device, if need be, to prevent essentially any volume of its asset side activity from showing up as an increase in currency held by the public, simply by raising the interest rate the Fed offers to pay on reserves to whatever level is necessary to persuade banks to continue to hold these funds idle overnight. In effect, the Fed is through this device borrowing directly from the public to fund its asset-side activities rather than by “printing money”.

Should that allay any inflationary concerns people may have about the doubling in the size of the Fed’s balance sheet? In a narrow mechanical sense, perhaps. It is true that the new assets have not yet shown up as an increase in the money supply, and it is true that the Fed has the power to prevent them from doing so in the future. But my concerns about inflation are not that the Fed would lose the ability to target a particular level for the money supply, and certainly are not concerns about the next six months, where I still see deflation as a bigger worry than inflation. Instead, my concern is that the current fiscal trajectory is fundamentally inconsistent with the Federal Reserve choosing to keep inflation under control. Both devices, ballooning of the Treasury’s account with the Fed and enabling the Fed in effect to borrow directly on its own, are indeed as much fiscal measures as they are monetary. But to someone worried about the increasing co-mingling of monetary and fiscal policy, that blurring of the lines is not a reassuring development.

My specific worry is that we will eventually face a crisis of confidence in the Treasury and the dollar itself. It is true, as Bernanke suggests, that raising the interest rate paid on reserves in such a setting would be a policy tool that could be used in response. But it would be an unattractive measure to the point of perhaps being impossible to use in practice, for the same reason other countries have dreaded raising interest rates in the face of collapsing real economic activity and a flight from their currency.

I fear that the United States government is mistakenly assuming that it can borrow essentially unlimited sums without undermining confidence in the dollar itself. The real question of a successful exit strategy, in my opinion, is how do we extricate ourselves from the joint fiscal commitments currently assumed by the Treasury, the Fed, the FDIC, the Medicare and Social Security trust funds, and various and sundry implicit and explicit federal guarantees?

The answer, in my opinion, is not to be found in the Treasury doing even more borrowing on behalf of the Fed or the Fed doing even more borrowing on behalf of itself.

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51 thoughts on “Looking for an exit

  1. David Pearson

    Bravo, Professor. You have correctly labeled what the exit plan will involve, and that is a political decision. The mechanics, which Ben Bernanke keeps pointing to, are largely irrelevant. The question is, would he exit while unemployment is still high? And what would be the impact on Treasury yields if the Treasury has to compete with the Fed for private savings?
    The real question is why the Fed refuses to discuss this in public. One argument is that they are in the business of managing expectations, and that business necessitates being disingenuous if it serves the greater good.
    However, there is a cost. The lack of transparency, the opacity in intentions, the reluctance to be open about the real costs — these are all things that, like sand in bearings, erode the functioning of our democracy. Pointing this out, in the past, has been the province of wild-eyed conspiracy theorists. Has the message now gone mainstream?

  2. Ivan Hall

    As omniscient as Bernanke may be, the whole thing appears to simply be a shell game. The banks look better on paper, and earn interest on imaginary money.
    A better analysis for our troubles, also appears in the 7/21 WSJ edition, on page C1. The article by Ellen Schultz.
    In this case we’re talking about real money and real people.

  3. baychev

    why so much writing when all this could be summarised as follows:
    all the fed did was to swap dud assets with marginal haircuts for treasuries and other direct loans. the idea was to create the mirage that the participant banks have money good asset side on the balance sheet.
    once those loans expire, the banks will be naked again. if they are rolled perpetually, the impact could be either inflationary or deflationary.
    inflationary scenario: the collateral depreciates and the fed simply extends the swaps/loans for an indefinite period, and that money goes into the real economy.
    deflationary scenario: the fed has no desire to increase the money stock and pressures banks to repay the loans and cancels the swaps and the banks are again left with their dud assets and no ability to extend credit before further recapitalization.
    for now the fed is sitting on its hands and hoping those assets are really worth something close to par.

  4. Sergei

    If US private sector savings continue to rise, the US current account deficit could turn into a surplus, in which case the US treasury would not need to rely on foreigners to fund its fiscal deficits. US consumers and private entities can fund the governments deficits directly. In that scenario, would there be a crisis of confidence on the dollar? After all, Japan’s public sector has run huge deficits and accumulated mountains of debt, but there doesn’t seem to be any crisis on confidence on the yen…

  5. Z

    Why does the process have to be reversed? Could the Fed not simply raise the reserve requirement and effectively ‘wipe out’ the excess reserve liability, since these reserves would not be in excess anymore? Granted, this will mean that a larger share of banks’ assets will be tied up with the Fed – but that could be interpreted by the general public as a requisite for a well-capitalised financial system.

  6. Ned

    First, thank you for such a clear (and clear-headed) presentation.
    It seems to me that implicit here are enormous off-the-books _fiscal_ subsidies to a small number of favored institutions, as well as a shift of huge amounts of risk effectively to taxpayers. This is in addition to all of the market distortions created by the various and sundry Fed programs. If nothing else, these inflict collateral damage and delay and reduce the quality of any incipient recovery.
    You mention the risk of loss of confidence in the dollar as a result of the massive borrowing. An additional magnification of risk involves MBS and other supposedly AAA securities on the Fed’s books in massive amounts starting to more visibly show losses (it’s amazing how little reporting there is on recent GSE losses.)
    I see no signs that either the Fed or Treasury are trying to get ahead of the problem. On the contrary, by allowing the Street to siphon off most of the temporary (and possibly illusory) profits, they demonstrate the same attitude that led to the crisis in the first place, which may very well exacerbate a vicious cycle.
    Our financial system is built on confidence. The more that confidence turns out to have been misplaced, the greater the disastrous effects. Yet, most of the relatively few who understand what’s going on, not to mention the public at large, seem content to wring their hands and hope for the best.
    No wonder we have such a mess on our hands!

  7. Fishsticks

    Thank you for providing a clear and comprehensible discussion of the Fed and it’s balance sheet.
    Fishsticks

  8. PJ

    In my opinion, you are underestimating the lack of confidence by the public. The public don´t believe in rosy economic prospects and save the money. These savers put the money in the banking system and banks use that money to buy treasuries. They only delay future inflation.
    But it will come the day that these savers will turn that money in to real goods and services. When? When the economic picture show rosy expectations or… The public truly believes that prices are jumping and will jump much more in the future.
    So I believe that dollar got fall anyway. Not only by the fiscal federal deficit but because the savers could start spending, widening the trade deficit and rise inflation expectations. The dollar can´t sustain unless inflation expectations are low. But one day savers will start spending and the FED isn´t available to rise rates because politically is suicidary.
    So the real problem is the combination of fiscal deficits, trade deficits and the insustainable demand of the american economy by insolvent and debted consumers. This combination is fatal for the dollar, im my opinion, and the FED can’t do nothing to avoid that. The FED can avoid the crash but can´t avoid the loosing power of the dollar. The FED can slowly the depression in the american economy but can´t stop that ugly momentum. The FED can slowly the velocity of economic fall but can´t avoid that fall.
    So unless the war come to public concern, the dollar shall fall because the cure for that fatal combination is rising discount rates and stops any possible economic recuperation.
    The really winner will be €uro because ins the only international currency with one really independent central bank. And the €uro is the currency who is similar to the currency desired by China and his allys.

  9. JKH

    In normal times, the process of banks putting any excess reserves to use would continue until there’s enough expansion of banking and economic activity that ultimate recipients did want to turn those reserves into green currency.
    Not entirely. Excess reserves get converted into a combination of required reserves and currency. The former corresponds to a higher magnitude expansion of bank deposits. That along with currency increases non-bank money assets in proportion to the desired deposit/currency mix.
    That deposit/currency mix is now about 10:1. The effective reserve ratio isnt much more than 1 per cent for all checkable and time deposits. On that basis, banking system deposits would have to increase about 9 times (roughly $ 70 trillion) in order to absorb all of these reserves. This is an outlandishly absurd scenario, of course, pointing to the unique funding role of the current excess reserve position.
    It is true that the new assets have not yet shown up as an increase in the money supply
    Not entirely. There is a money supply increase of the first order as a banking system liability corresponding to the excess reserve asset. This increase is embedded other things equal in whatever money supply stats have been reported in total. The Fed can only attempt to reign in higher order or multiplier increases by paying interest on reserves.

  10. OregonGuy

    Perhaps the Fed would be more transparent if its scope of action was limited to price level management and lender of last resort operations. Given the Fed’s current role of managing equity and real estate prices, GDP growth, employment, inflation, and foreign exchange a high degree of opacity seems inevitable.
    Being at the helm of the Fed bestows the power to influence the economy of the Western world. The temptation to pull the levers must prove irresistible.
    God help us if an egomaniac like Larry Summers takes Bernancke’s place.

  11. JKH

    Wrong math above.
    Banking system deposits would have to double, roughly, (about $ 8 trillion) to create enough demand for currency, based on existing ratios.

  12. Steve Kopits

    Excellent. Feel free to write more on this.
    Also, might you consider a post on the prospects of the recovery? Feldstein, Summers and Yellin has all made sorts of vague and ominous comments about the recovery, but I have not run across anything particularly specific from them, and it would be nice to have an analysis along the lines of your post on the effects of inventory rebuilding.

  13. ahk

    Thank you for clarifying some of Fed’s mysterious behaviors.
    However, I don’t understand the purpose of all these manipulations. Is the ultimate goal to stimulate the economic activity by encouraging lending? Then why pay for toxic assets to banks only to induce them to hold the credit/money at the Treasury rather than to lend it to consumers and businesses?
    I don’t get it. Could someone explain this to me? Thank you.

  14. MikeR

    JDH,
    Looking back at your posts over the past year on the topic of the Fed Balance sheet, you have done a great job explaining what is going on. Very educational.
    Off topic, you have also posted on the Conference Board’s leading economic index, which at 100.9 is up from 98 over the past few months, but still down from its highs of over 104. In a future post, can you explain the implication for quarterly GDP of a LEI that is up over the quarter but down over the year? Will GDP be up?

  15. Stefan

    The Fed can screw around all it wants. Eventually we are going to have to improve our balance of payments. This can only be done by being a more productive people. If not, the dollar is shot.

  16. Ivars

    I agree with Wesbury: Increase rates now, V shaped recovery has actually begun in July, so by October things must be back to pre-Lehman levels.I also agree with his reasoning about information driven panic and pessimism. But then, I am an optimist as well…
    I do not know if increasing rates now is the same as exit strategy, but to reduce inflation bubble, sure. We are in transient processes here, inside, very difficult to filter oscillations out.

  17. Tom Hickey

    This crisis arguably began as an incipient dollar crisis with the Fed under Alan Greenspan artificially manipulating banking finance in order to influence the economy. Since that time events have been consistently unfolding to produce the ultimate result, undermining of confidence in the dollar. This is another proof that market forces are always right and command-based economics always fails in the end.
    This is not an argument for laissez-faire, however, which ends in monopolies. The world economy is now pretty solidly based on market socialism, which leaves private enterprise free in discretionary fields and regulates public utilities for the common good.
    However, regulation and oversight aimed at protecting the common good is different from manipulation that favors one segment over another. The Fed is run by the financial sector for chiefly for the financial sector.
    The result that is unfolding is disastrous for the common good in that it will debase the currency if carried to its conclusion. And yes, banking and finance (money and credit) are public utilities that are rightly handled based on fiduciary standards that protect all. Economic “liberalism” in these fields enriches the top echelon at the expense of the common good by capturing wealth created through production without adding productive value. Time for Congress to get a gripe and rein in the predators before the dollar takes a big hit while the US sinks in compounded debt.

  18. Spry

    Nice post professor.
    I know there are no simple answers here. But would you like to see the Fed cut back on expansionary monetary policy sooner than Bernanke seems to be implying? Should the Fed control inflation not by paying higher and higher interest on reserves but by cutting back on spending (lending and purchases of long-term securities)? This obviously risks prolonging the recession but is it worth it considering the dire long-term consequences to fed independence and fiscal imbalance.

  19. Nemo

    When the Fed pays interest on reserves, where does that money come from?
    Is the idea to reign in inflation by creating more money?

  20. John Lee Hooker

    Congratulations James, your summary is well written. Cheers, one free beer for you.
    “I fear that the United States government is mistakenly assuming that it can borrow essentially unlimited sums without undermining confidence in the dollar itself.” These are my worries, too.

  21. Andy Harless

    JDH:
    “…certainly are not concerns about the next six months, where I still see deflation as a bigger worry than inflation…”
    But why only the next six months? Even if we get a rapid recovery, which is unlikely, it will take (based on historical experience) more than 4 years for the unemployment rate to get back down to even a conservative recent estimate of the NAIRU. That’s 4 years (or more likely 5 or 6, or even a decade if we get a second dip or the recovery is very slow) of deflationary pressure in the labor market. Recent experience suggests that recoveries can indeed be disiflationary, and in this case, potentially deflationary.
    Granted, this pressure could be offset by the effect of a dollar crisis, but under those circumstances, it’s not clear to me that a dollar crisis is a bad thing (provided that the Fed doesn’t overreact in trying to support the dollar with higher interest rates). We need an adjustment in the current account, and a weak currency is the way to achieve it. Unless US workers somehow start to insist on being paid in euros, the inflationary impact would be temporary, as the effect of a one-time drop in the dollar gradually fades out and the deflationary pressure from the labor market continues.
    But even that I have trouble imagining. Unless the other major-currency countries first go into an inflationary boom, a full-blown dollar crisis will be a disaster for their economies. They will have every reason to support the dollar by cutting rates or, if necessary, by buying dollars.

  22. anon

    “When the Fed pays interest on reserves, where does that money come from?”
    From interest on assets that would otherwise go to treasury. That’s self evident.

  23. jg

    Glad to read that you are concerned about the monetary and fiscal path that we are on, Professor.
    But, I was disappointed to see that you were a signatory to the ‘Let the Fed alone, do not subject them to an audit’ letter.
    As you have laid out very well in many pieces before, the U.S. taxpayer will get hit — e.g., via reduced interest income receipts from Fed to Treasury — for missteps by the Fed. The Fed has indeed taken on dodgy assets, as seen by the recent hits to its Maiden Lane investments.
    We need to see the full, unvarnished truth — what the potential hits to the Fed balance sheet are — because, as I understand it, the U.S. taxpayer is on the line for any capital losses incurred by the Fed, not just reduced interest income.

  24. Darel

    “I fear that the United States government is mistakenly assuming that it can borrow essentially unlimited sums without undermining confidence in the dollar itself.”

    Question: Does the US have China by the b*lls, or not? If so — the implication being that China MUST continue to loan the US “unlimited sums” regardless of its complaints regarding US monetary policy — then Bernanke/Geithner/Summers are not making any mistakes at all. Now whether this is a foolish strategy or not is an honest and desirable question. That is not the same as asking whether this pathway is sustainable, which indeed it may be.

  25. J.Goodwin

    What rate is the fed paying on overnight deposits? Logically that rate has to be bounded by the 28-day treasury bill since it would be less expensive to finance the asset side of the balance sheet by borrowing from the treasury if the rate paid rose above that (most recent 28 day auction investment rate was 0.152% (zero percent plus a bit)

  26. don

    “Instead, my concern is that the current fiscal trajectory is fundamentally inconsistent with the Federal Reserve choosing to keep inflation under control. Both devices, ballooning of the Treasury’s account with the Fed and enabling the Fed in effect to borrow directly on its own, are indeed as much fiscal measures as they are monetary. But to someone worried about the increasing co-mingling of monetary and fiscal policy, that blurring of the lines is not a reassuring development.”
    “I fear that the United States government is mistakenly assuming that it can borrow essentially unlimited sums without undermining confidence in the dollar itself. The real question of a successful exit strategy, in my opinion, is how do we extricate ourselves from the joint fiscal commitments currently assumed by the Treasury, the Fed, the FDIC, the Medicare and Social Security trust funds, and various and sundry implicit and explicit federal guarantees?”
    I share these sentiments, and exactly as you have presented them. The decline in the dollar will play a role.
    Sergei – Japan’s debt is internal, whereas much of ours is external. And even with the recent growth of savings, we are still borrowing 3% of GDP from abroad, which I believe is unsustainable.

  27. fwm

    The co-mingling of monetary and fiscal policy is just one example of a pattern of cooperation and policy agreement/acquiescence between the Fed and the Administration of the day. Do we really have two independent voices? I can’t remember the last time there was major policy disagreement, on such far-ranging topics as talking down the dollar, and privatizing social security. If the “independent” Fed is given the job of overseeing systematic risk in the financial system, perhaps it would be more efficient to assign that task directly to the White-house.If it walks like a duck, talks like a duck,then it probably is a duck.

  28. RebelEconomist

    “Up until January of 2008, by far the most important assets held by the Fed were short-term Treasury bills”
    Wrong (terminologically, if not factually)! About two thirds of the Fed’s treasuries in Jan 2008 were notes and bonds. As I have been pointing out in many forums for a long time, the Fed’s choice of monetary assets contributed to the conundrum (of low long term rates) before the bust in exactly the same way that present asset purchases are now supposed to hold, say, mortgage rates down – except that the Fed formerly dismissed the influence of their choice whereas they now make a virtue of it. This should not be forgotten when the causes of the financial crisis are assessed.

  29. Lord

    You may be underestimating the difficulty investors would have replacing the dollar. Sure they could buy euros, gold, or commodities, driving up their prices on which they would face losses if they ever sold. Flows have diminished and domestic savings taken their place. More domestic spending would mean less need for government borrowing. The dollar remains overvalued so its diminishment is welcome.

  30. ECONOMISTA NON GRATA

    Sergei:
    “….but there doesn’t seem to be any crisis on confidence on the yen…”
    That’s because there is a dollar…..
    Econolicious

  31. Hapless Consumer

    Citizens did not send a check to the Fed, loaning them money. That is, nothing was removed from circulation to buy the bonds with. The Fed electronically printed money, and gave to home buyers and public agencies for immediate spending. The reserves are a mirage. A bribe to the banking system to get them to go along with this high risk scheme (knowing they could lose their monopoly on electronically printing money). Consumers are losing purchasing power per hour worked under this system. Fixed income retirees are losing period.
    Let CPI prices fall already so non leveraged consumers can buy more per hour worked, and retirees can finally gain something from productivity increases. Why should the central bank confiscate all of the productivity increase for redistribution to deadbeat borrowers (in the form of lower interest rates)?

  32. crljones

    Well J. Goodwin, once the dollar is worth half what it is now vs the Euro & Yen they can lend America half the same US$ amount and it will only cost them 1.5% of GDP – so that will be what will solve that problem of sustainability! Of course oil prices will be back at $140 so Texas (and AK?)will have to fund the bigger California deficit (on account of how much energy the consume) but that will just ensure the Republicans get back in all the faster. cheers!

  33. Ivars

    irst official confirmation of V-shaped recovery ( though in East Asia, but that is where it begins). If true, it will be reflected also in U.S. stocks already in autumn of 2009 (rally has started already) although the true recovery in the U.S.A and Europe may come only in 2010.
    Quote:”East Asias rebound from the global economic crisis may be V-shaped and central bankers must retain expansionary monetary policies even as risks to the recovery dissipate, the Asian Development Bank said.
    The economies including China, South Korea and Indonesia will probably grow faster than the 3 percent estimated in March, before accelerating to 6 percent in 2010, the Manila-based institution said in a report today, leaving its March forecasts unchanged. The estimates dont include Japan, South Asia and Central Asian nations. ”
    However, why bankers should retain expansionary ( inflationary ) monetary policies? I guess this is said just to manage expectations so that people do not get scared, and in reality interest rates will go up and central bank money supply dry out sharply, rather fast. Probably also in Autumn 2009.

  34. KnotRP

    A cheaper dollar does not help retire dollar debt.
    It has to result in a wage spiral, which is on my list
    of Things That Cannot Happen This Decade.
    Sometimes, enough stupid moves simply leads to check mate. The political can has finally been kicked into a well.

  35. DickF

    Professor,
    You are doing the best analysis of the FED balance sheet of anyone I have seen.
    Thank you!

  36. DickF

    Professor,
    I was looking at this again over lunch and a question came to my mind. It appears that Treasury was actually selling t-bills to banks so that they would borrow more than they could with only collateralized loans. Also it allowed the banks to earn a higher interest rate on the t-bills.
    That being the case do you know how much of the t-bill issue Goldman Sachs bought? I believe that Goldman changed itself into a “bank” and that made it elegible for interest payments on reserves, but they also received TARP money and then Treasury held its t-bills auction. How much did Goldman buy? If I am reading this right Goldman could buy billions of t-bills with TARP money that paid a relatively high interest rate. I might be able to find this but I wanted to throw it out there for others to consider.
    It appears that the FED paying .25% was not enough to generate the borrowing the FED wanted from the banks so the use of t-bills allowed them to pay a higher interest rate without any of the money actually slipping into the economy. It appears that the only purpose of the FED increase in money creation was to “stimulate” the banks not the economy and even the TARP money probably slipped into this bank interest scheme.
    What is your take on this?

  37. Fullcarry

    “The way the fed funds market functioned in 2007, that would never have happened. Why close your bank’s books for the day with funds just sitting there in an account with the Fed, earning no interest, when you could loan them out overnight instead?”
    There was no excess reserves in 2007. Banks had to compete by paying the funds rate to acquire those reserves.
    Currently banks cannot extinguish aggregate excess reserves in any material way. They can only shuffle it amongst themselves. Only the FED can have a significant impact on the amount of excess reserves through changes in its balance sheet.

  38. Mike Laird

    JDH, that’s an excellent analysis and very clear writing. Thanks. You should be on the Fed’s Board. Maybe you could get them to focus again on monetary management, and stop their wandering off to be a handmaiden to bank acquisitions and bankruptcies, their pursuit of super-fiduciary regulatory powers, and their desire to dabble in fiscal affairs.

    But thanks for all you do.

  39. Tom

    Thanks for trying to shed light on a very important and little-understood topic. The situation is especially opaque since the Fed is resisting Freedom of Information Act requests. But I’m afraid your explanation is misleading.
    Money newly created by the Fed can enter and is entering the economy without being converted into paper currency. Such money can also enter the economy as electronic money in accounts held by private banks: as M1, M2 or less liquid forms of money. Compared to last year, a much greater portion of newly created money is entering the economy this year, as the Fed is using more newly created money to purchase assets (Treasuries, agency debt, and mortgage-backed securities), and less to make short-term loans (private banks are much freer to utilize money received by selling assets than money received as credit by pledging assets). Also, the Treasury stopped its supplementary borrowing program that funded part of the Fed asset expansion last year.
    Newly created money has been entering the economy even as the Fed has been decreasing its assets this year. For example, money that was created last year and lent out as Term Auction Credit, which was likely largely sitting idle making balance sheets look better, could be entirely extinguished as those credits are recouped, but instead some of it is being used to purchase assets, and thus only recently entering the economy.
    Moreover, even newly created money that sits idle as reserves at the Fed can impact liquidity by giving private banks less reason to hoard as cash other, previously existing money.
    However, since this is all occurring in a context of a credit contraction, in which more credit is being recouped than is being lent, M1 and M2 growth have been fairly moderate.
    None of this changes the fact that when money is created, all other money from the same issuer is devalued. Money creation is not magic. But this devaluation does not have to take the form of immediate consumer price inflation. If the money temporarily sits idle, it is only a latent effect, which might never be realized if the money is extinguished before it is utilized. If it enters the economy, it can counter consumer price deflation, or counter asset price deflation (eg the recent bottoming of home prices), or counter wage deflation (and exacerbate unemployment), or create asset price inflation (eg the recent stock rally).
    Money creation doesnt only affect price levels, it also changes the relative wealth of groups and individuals. Newly created money enriches especially its recipients, and next recipients from those recipients, and so on, at the expense of those who fall late in or outside that chain. Recent money creation has been used to recapitalize the financial sector, support lending to the housing sector and support the federal stimulus, so the recipient chain is very complex. But there are some clear winners (investment banks, AIG, home owners, investors in stocks) and clear overall losers (any American who doesnt own a home or stocks).
    Bernanke is thinking wishfully when he says that inflation can be simply controlled by increasing the rate of interest paid on reserves. It is true that paying interest on reserves gives the Fed a new, more direct and heavy-handed mechanism to reduce liquidity. But for that reason it is a very difficult mechanism to employ: political and market resistance will be powerful. I expect that as a rule the Feds interest-rate moves will be in reaction to, and not pre-emptions of, consumer price inflation.

  40. NotAnEconomist

    “However, an even bigger volume of the deposits that the Fed created are still just sitting on the banks’ books.”
    What else can they do but sit at the Fed (short of banks keeping them as vault cash, or the public withdrawing them as currency)? As fullcarry said, banks can’t get rid of excess reserves in the aggregate.
    “One of the points that Bernanke makes in his op-ed is that the Fed could continue to use this device, if need be, to prevent essentially any volume of its asset side activity from showing up as an increase in currency held by the public, simply by raising the interest rate the Fed offers to pay on reserves to whatever level is necessary to persuade banks to continue to hold these funds idle overnight.”
    Again, what else can banks do but leave these funds idle overnight? They can lend them to other banks, but this does nothing to increase currency held by the public, and, in the aggregate, the reserves remain on deposit with the Fed. Payment of interest on reserves may make banks less likely to create new bank deposits (to the extent that it reduces the opportunity cost of not lending), or more likely to do so(via the recapitalisation effect), and it may set a floor for the Fed funds rate, but I don’t see how it is anything other than a very blunt instrument in influencing the amount of currency held by the public.

  41. Tom

    “What else can they do but sit at the Fed (short of banks keeping them as vault cash, or the public withdrawing them as currency)?”
    The bank that is holding the reserves can do anything it wants with the money, within the constraints imposed by its regulators. Possibilities include purchasing assets, lending to individuals or companies, or lending to other banks (which can likewise do whatever it wants with the money, within the constraints imposed by its regulators). The more the money is utilized, the larger the portion of it that will be converted into paper currency. But that portion is not very important. The much more important factor is the money multiplier effect, which occurs when a bank lends money that is then deposited in a bank and lent out again and then deposited again …
    Money stock figures such as M1 and M2 that include money existing in electronic form in bank accounts are the important gauges of liquidity. Only a small portion of money is in the form of currency at any one time.
    Where JDH is right is in pointing out that the Fed is not actually “printing money”, it is creating money electronically. But from there he wanders off into a misleading discussion about when and whether this newly created money is turned into circulating paper currency, which is simply unimportant. There is no reason to get hung up on whether or when newly created money gets turned into paper currency. Money gets converted from electronic to paper and back again all the time, so what? The only reason anyone talks about “printing money” is ancient habit: that’s how money was created in a bygone age. The relevant issue is, how much money is the Fed creating and what portion of it is entering the economy?
    We don’t have that information. We can get a rough idea of how much money the Fed is creating, by looking at the Fed’s weekly reports (We would need the Fed’s complete transaction history to get accurate numbers). But there is nothing in those reports that tells us how much of the newly created money is entering the economy. You will not find this in the weekly reported total amount of money that private banks are holding in reserve accounts at the Fed. This is merely an accounting of the portion of private banks’ cash hoards that are held at reserve accounts at the Fed (where they are immune to the money multiplier effect, as opposed to the portion of private banks’ cash hoards that are held on deposit at private banks).
    And don’t get the idea from the apparent stability of the weekly reserves count that it is a mostly stable, idle cash hoard; there is a constant circulation of money between different banks’ accounts at the Fed, and a constant circulation into and out of all of the reserve accounts as all of the private banks frequently add to or withdraw from their own reserve accounts.
    So, all we know for certain is that M1 and M2 growth have accelerated since September, and this is happening despite a collapse in credit, which extinguishes M1 and M2 money as the money multiplier effect reverses. That means some of the newly created money is entering the economy.

  42. JDH

    Tom: (1) Money is an asset, not a flow. It is measured at a particular point in time, and if you define the asset you have in mind, there’s nothing mysterious about measuring its magnitude. We have reasonably accurate measures of the values of a number of key assets as of bank closure on Wednesdays. (2) Currency held by the public accounts for more than half of M1. (3) The relevance of currency held by the public is its role in asset market equilibrium. Reserve deposits are neither created nor destroyed by anything banks do, other than converting deposits to currency. Interbank transactions will continue until demand for reserve deposits equals supply of reserve deposits. In the absence of artificially propping up demand for reserve deposits, that equilibrium would involve a lot of stimulus given the current size of reserve deposits.

  43. NotAnEconomist

    When Bernanke says things like “But as the economy recovers, banks should find more opportunities to lend out their reserves”, it just grates with me. Banks don’t actually lend out their reserves (to the public) – I suppose what he refers to is the possible conversion of excess reserves to requires reserves by bank balance sheet expansion. But bank lending isn’t reserve-constrained, it is capital-constrained, and the presence of large quantities of reserves sitting at the Fed (where else would they sit, once created?) is not, of itself, indicative of an unwillingness of banks to lend, and isn’t required in order to stimulate bank lending. It just reflects net reserve creation actions of the Fed & Treasury.

  44. Tom

    Thanks James.
    I stand corrected on (2). But in my defense, this is a highly unusual feature of the US, resulting from the use of retail sweep accounts, which (somewhat artificially) lowers reported M1, and from foreign use of US currency. In most developed economies currency is less than 10% of M1.
    On (1), the total net money creation or extinction over the course of a week is not the same as the total money creation and total money extinction over the course of a week.
    On (3), you are correct that “Reserve deposits are neither created nor destroyed by anything banks do, other than converting deposits to currency” – the only way that reserve deposits as a whole can be drawn down is for them to be converted into currency. But the fungibility of money renders that limitation almost irrelevant. An individual bank that wants to draw down its reserve account is not obliged to take delivery of a truck of cash. Say it wants to buy stocks. It buys them, and the reserves get re-assigned to the banks of the stocks’ previous owners. Money is moving between banks’ reserve accounts like that all the time. Money held in reserve accounts can be used for whatever purpose its owner wishes, most of which don’t require conversion into currency, and some of which (lending) result in money multiplication and thus expansion of M1 and/or M2 (and/or of broader money). The reserves only get converted to currency to the extent that there is growing demand for currency on the market.
    Once the Fed started paying interest on reserves, the relationship between Fed money creation and the volume of currency in circulation changed dramatically. If you really beleive that the growth of currency in circulation is a good gauge of the extent of liquidity being added to the economy by the Fed, you are very far wrong.

  45. JDH

    Tom: If what I had meant to say was “the growth of currency in circulation is a good gauge of the extent of liquidity being added to the economy,” then what I would have said would have been, “the growth of currency in circulation is a good gauge of the extent of liquidity being added to the economy”.

    What I do believe is “the relevance of currency held by the public is its role in asset market equilibrium” and “interbank transactions will continue until demand for reserve deposits equals supply of reserve deposits”. I would encourage you to try to understand those statements before you appoint yourself the arbiter of where I am right and wrong.

    And, by the way, I agree completely that “once the Fed started paying interest on reserves, the relationship between Fed money creation and the volume of currency in circulation changed dramatically.” That, indeed is the essential point I was making.

  46. Tom

    Thanks, James.
    I don’t mean to be pointlessly argumentative. I understood what you wrote about demand/supply for reserve deposits and currency’s role. I was trying to paraphrase your thesis from your main article, where you wrote that “In normal times, the process of banks putting any excess reserves to use would continue until there’s enough expansion of banking and economic activity that ultimate recipients did want to turn those reserves into green currency … [but] the Fed could continue to use this [new] device [of paying sufficient interest on reserves] … to prevent essentially any volume of its asset side activity from showing up as an increase in currency held by the public … Should that allay any inflationary concerns people may have … In a narrow mechanical sense, perhaps. It is true that the new assets have not yet shown up as an increase in the money supply.”
    My understanding of your position was that, as long as newly created money doesn’t show up as increased currency in circulation, it isn’t adding to the liquidity in the economy and won’t cause inflation. If that’s not what you meant, please explain.
    And my retort is, the newly created money *has* shown up as an increase in money supply. Firstly, it has increased M0, and namely its excess reserves component, which I contend is just as liquid as other forms of money. This increase does not appear in M1 or M2, because excess reserves are not counted in M1 or M2 (which until recently didn’t matter, since excess reserves were insignificantly small). Secondly, it has led to an increase in the rate of growth of currency in circulation. Thirdly, it has led to an increase in the rates of growth of M1 and M2, despite the recessionary credit contraction.
    As for the reserves/currency relationship, there is a big difference between the old regime (no interest on reserves) and new regime (interest is paid on reserves). In the old regime, the creation of central bank money meant the appearance of excess reserves, which in turn led to a chain of transactions through which those excess reserves were converted into an equal amount of currency plus a much larger amount of commercial bank money. In that way the Fed got a lot of monetary stimulus out of ever newly created central bank money dollar. In the new regime, the creation of central bank money only adds to an already large volume of excess reserves and does not necessarily set off any such chain of transactions, as there is not necessarily (and certainly not now) much incentive to reduce excess reserves. However, the excess reserves can be utilized in ways that lead to the creation of commercial bank money without increasing the total volume of circulating currency, so the monetary stimulus received per dollar of central bank money created is still more than 1:1.
    Getting back to a point I made earlier, I suggest you follow the very rapid recent growth of “non-borrowed reserves”. Whereas last year most of the excess reserves were owed back to the Fed in the short term, now most of them are unencumbered cash.
    All in all, a very large monetary stimulus is underway. But since it is going mainly to Wall Street, while Main Street is still a scene of cost-cutting, layoffs, curtailed credit and excess capacity, there isn’t much upward pressure on CPI. Without the new liquidity we would have seen somewhat more consumer price deflation and significantly more asset price deflation.
    By the way, congrats on the citation of this article in Wolfgang Munchau’s column in the FT.

  47. JDH

    Tom: My position is not that “as long as newly created money doesn’t show up as increased currency in circulation, it isn’t adding to the liquidity in the economy and won’t cause inflation”. My position is that “the relevance of currency held by the public is its role in asset market equilibrium” and “interbank transactions will continue until demand for reserve deposits equals supply of reserve deposits”.

  48. Jeremy

    What can I say. Thank you both so much for your blog. Thank you to all the wise people posting on these forums. I may not ever fully grasp the sheer magnitude of the Fed and Treasury liabilities however I can confidently say that the ECONOBROWSER blog is best described as a tremendous ASSET!
    Thx

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