Federal Reserve reverse repurchases

Here I offer some thoughts on Bloomberg’s account that the Fed has made inquiries with its dealers about the feasibility of a significant increase in the Fed’s reverse repo operations.

First, a little background. The traditional tool of monetary policy is an open market purchase, in which the Fed purchased U.S. Treasury securities that had previously been held by someone in the private sector. The Fed would pay for those securities by crediting deposits in an account that the selling bank had with the Federal Reserve. These reserve deposits of banks represent claims that the bank could use, if it wished, to withdraw green currency from the Federal Reserve. The volume of reserve deposits historically was extremely important in determining the interest rate at which banks would lend the deposits to one another overnight. The traditional understanding of monetary policy was that the Fed would use open market purchases to achieve its desired objectives for the overnight interest rate and the money supply.

If the Fed wished to implement a purely temporary increase in the volume of reserve deposits, historically the tool of choice was a repurchase agreement, in which the Fed would buy a particular security with a promise to return it at a specified future date. The purchase was again implemented by creation of reserve deposits, and when the security was returned, those deposits came back into the Fed.

The Fed began to see a new potential use for these repos after the initial banking difficulties in August 2007. Although repos were traditionally used as a device for temporarily injecting reserves, their structure amounts to a collateralized loan from the Fed to the counterparty. The Fed’s objective subsequent to August 2007 was to increase the volume of its lending and support the market for certain securities that it could accept as collateral for repos. Thus the Fed utilized an expansion of repurchase agreements as one of the initial tools for responding to the crisis, simply rolling them over to create a de facto expanded lending facility.

The graph below tracks the various assets held by the Federal Reserve since the beginning of 2007. The height of the graph represents the total asset holdings at the end of each week, with the colors indicating the contribution of each category. Repos are represented by the turquoise band. This traditionally had been small and highly variable, but grew significantly in the early phases of the financial crisis. Later the Fed came to use direct loans through its Term Auction Facility in preference to repos. Since January, the Fed has been directly buying up mortgage backed securities and agency debt in the way it used to purchase Treasury securities.



Figure 1. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to September 23, 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_sep_09.gif



A separate question is what happens to all the reserve deposits created through this process. The Fed has never wanted to see the huge volume of reserves it created end up as currency held by the public, for fear this would be inflationary. It has relied on several devices to keep that from happening. One was use of the Treasury’s account with the Fed, another traditional feature of Fed operations that ballooned as it became adapted to new purposes. The Fed asked the Treasury to borrow funds that it simply left in deposit in its account with the Fed. These idle reserves held by the Treasury absorbed some of the vast increase in new reserves created by the Fed.

A more important tool was that the Fed started paying interest on reserves in October 2008, and by November had increased that rate to the target fed funds rate itself. This created a very strong incentive for banks to simply hold reserves idle at the end of each day rather than lend them out on the overnight fed funds market. In effect, by paying interest on reserves, the Fed is borrowing directly from banks and using the proceeds for the various asset expansions detailed above.

The graph below shows the Fed’s liabilities at the end of each week. The height of the graph is, by definition, exactly equal to the height of the previous graph at every date. The first graph tracks what assets the Fed acquired with its operations, while the second graph shows where the funds it created ended up. The surge in the Treasury account (in yellow) and excess reserves of member banks (green) explain why the huge expansion in the Fed’s balance sheet has not translated so far into a massive increase in the quantity of currency held by the public (blue).



Figure 2. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to September 23, 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_sep_09.gif



The question under discussion at the moment is the extent to which the Fed could continue to rely on these two devices– Treasury borrowing on its behalf and banks’ willingness to simply hold the ballooning reserves– to contain the monetary consequences of its expansion. The traditional political gamesmanship over the debt ceiling could well induce the Treasury to want to discontinue its facilitation of the expansion of the Fed’s balance sheet, in which case the Fed must either reduce some of its lending or count on banks to hold even more excess reserves. Some in the Fed are assuming that they could always ensure the latter outcome, if needed, by raising the interest rate the Fed pays on reserves. But clearly the Fed has no desire at the moment to raise interest rates, so it’s difficult for me to imagine them taking that step any time soon.

Where else could the Fed get the funds? Fed Chairman Ben Bernanke described his contingency thinking last July:

the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Just as the Fed converted the use of repos, which had historically been used on a small scale to temporarily add reserves, into a much larger operation with which it could lend broadly on a long-term basis, it is now contemplating using the reverse repo, which had historically been used on a small scale to temporarily drain reserves, into a much larger operation with which it could borrow broadly on a long-term basis. Thus we saw the following report from Bloomberg last week:

The Federal Reserve has started talks with bond dealers about withdrawing the unprecedented amount of cash injected into the financial system the last two years, according to people with knowledge of the discussions.

Central bank officials are discussing plans to use so-called reverse repurchase agreements to drain some of the $1 trillion they pumped into the economy, said the people, who declined to be identified because the talks are private. That’s where the Fed sells securities to its 18 primary dealers for a specific period, temporarily decreasing the amount of money available in the banking system.

There’s no sense that policy makers intend to withdraw funds anytime soon, said the people. The central bank’s challenge is to decrease the cash without stunting the economy’s recovery and before it sparks inflation. Fed Chairman Ben S. Bernanke said in a July Wall Street Journal opinion article that reverse repos are one tool to accomplish that goal without raising interest rates.

“One thing the Fed has to figure out is if they can launch pilot programs without spooking the market and creating the perception that they are about to tighten,” said Louis Crandall, chief economist at Wrightson ICAP LLC, a Jersey City, New Jersey-based research firm that specializes in government finance. “They are discussing things like accounting issues, and updating the governing documents to the volume of reverse repos the dealer community could absorb.”

Is this a feasible interim plan for handling the liability side without increasing either the money supply or interest rates? In a mechanical sense I believe the answer is yes. But the nature of inflationary pressures that we should be watching at the moment would arise from a depreciation of the dollar relative to other currencies and increase in the dollar price of internationally traded commodities. A modest move toward a weaker dollar and slightly higher inflation would be welcome. But the concern in my mind is whether a flight from the dollar could become more precipitous and destabilizing. It may not be the most likely scenario, but it is one for which I hope there has been some contingency planning.

And if the Treasury and the Fed think they could prevent that simply by borrowing even more without raising interest rates, they are mistaken.

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38 thoughts on “Federal Reserve reverse repurchases

  1. Rob

    I am slightly confused about this: Did the Fed buy the assets from the banks which are now showing up on the banks’ accounts as reserves? Did they buy at face value or did they apply a haircut? If so, would it have been more worthwhile for the Fed to have engaged if a repo of those assets with the banks, i.e. the Fed gave them the cash for the assets but with the right to put them back to the banks. In other words, those reserves would be automatically self-liquidating?
    Or is it now the case that regardless of what the Fed now does, there is a permanently higher balance sheet at the Fed?

  2. JDH

    Rob: Let me start with your second question. If the Fed were to roll over less of its term auction credit or sell some of its mortgage-backed securities, its balance sheet would contract. Its intention is eventually to do just that. But it is worried that the financial system remains very fragile, which is why it is looking at interim steps like the reverse repos.

    On your first question, for the TAC, it is the value of the loan (what the bank has promised to pay), not the collateral, that is counted as the Fed’s asset. For the MBS, I believe they are carried as whatever the Fed paid for them.

  3. Cook

    So the Fed has swapped liquid reserve deposits to banks in exchange for illiquid MBS and other risky assets. But now that credit markets have stabilized they are worried that the banks will use those reserves to buy even more risky assets so the banks can make even bigger profits. Too bad, the only reason credit markets have stabilized is that everyone believes that if the banks get into more trouble, the Fed will take even more bad assets off their hands and trade them for even more liquid reserves.

  4. Rajesh

    The Fed could raise the interest rate it pays on excess reserves above the target rate for Fed Funds. In theory, the Fed Funds rate should never fall below the interest rate the Fed pays on excess reserves but in practice we see the effective Fed Fund rate below the target Fed Funds rate. Excess reserves don’t generally contribute to bank capital which is the primary restraint on lending currently; however, interest on excess reserves does contribute to bank earnings (because it is not matched by an increase on the liability side.)
    Another policy the Fed should consider is raising the discount rate, currently only 25 basis points above the Fed Funds versus 100 basis points before the crisis. This would discourage banks from borrowing in the discount window and seeking funds either in the TAF auctions or in the Fed Funds market itself. It would also signal that the Federal Reserve is willing to re-impose market discipline on weak banks.

  5. Doctor Who

    I think Ben Bernanke clarified in his WSJ article and later in the Monetary Policy Report that the use of reverse repos is mostly a technical matter.
    In principle the Fed now controls the fed funds rate by setting interest rate on deposits and discount rate. But since not all financial instutions reiceive interest on reserves, the deposit rate may not always work exactly as intended, so the Fed may use other tools as well.
    So all this does not really have much to do with either monetary aggregates or interest rates.

  6. Bob_in_MA

    Professor Hamilton: “A modest move toward a weaker dollar and slightly higher inflation would be welcome.”
    I know this is a side issue to your primary point, but if the weaker dollar brought higher prices for imported commodities, so headline CPI rose, but the current underutilization kept any rise in wages well below that, wouldn’t it be a bad thing? This is where I think the people advocating for modest inflation have it wrong. What we would most likely end up with is $3+/gal gasoline, essentially a tax increase for 95% of consumers. And Treasury yields would rise, even if there weren’t a dollar crisis. The wish is that we will have “good” inflation (primarily wage inflation) that outweighs bad inflation. But isn’t the opposite just as likely, if not more so?
    I think aiming for any sort of appreciable inflation is a nonstarter and Bernanke sees it that way too. There must be some fear of a dollar crisis. It had to have effected Geithner’s thinking when he was laughed at in Beijing at the mention of our strong dollar policy.
    I’m wondering if the administration might tell Congress to cool it with things like the idiotic home buyer tax credit. A veto of that would be both good policy and a demonstration of fiscal restraint. Well, a little fiscal restraint.

  7. Max

    Thanks for explaining the basics in this great post, James. Many blog posts on this subject assume greater background knowledge on the part of the reader, and consequently lose me. I learned a lot from this article.

  8. DickF

    Professor,
    Thank you again for continuing to watch this situation. I agree with your conclusions though I am in fact frightened that the FED has too many balls in the air and Bernanke, the master juggler, will see them all fall down in a big mess just as soon as he makes one misstep. The potential for disaster is huge while the reality of success just seems to continue to slip away. He is making a very risky bet with our money and our lives.

  9. andi

    does market care in the long term where the toxic waste is stashed way..be it the balance sheet of FED or various banks. Obviously, till the toxic assets are whittled down to their actual worth, the game is not over. What would have taken 1-2 yrs will now take decades. Pain will less acute but will linger for long time.

  10. RebelEconomist

    I find the Fed’s terminology confusing. From their point of view, the operation that they are considering is “repo”, not “reverse repo”. This confusion is evident in Bernake’s description of the REVERSE repo operation as involving “the sale by the Fed of securities from its portfolio with an agreement to buy the securities back”. It is a trivial point, but I think that it is symptomatic of the Fed’s in-bred attitude towards their market operations where I think that features such as coupon passes and disregard for foreign exchange reserves contributed to the present crisis.
    One potential problem that I can see with this method of withdrawing reserves is that the primary dealers will presumably have to, in turn, borrow from the market, in which case even if the primary dealers pass on the treasuries that the Fed lends to them, because the market will demand better collateralisation from the primary dealers than they can demand of the Fed, the primary dealers may have insufficient collateral to participate.
    Also, If I may, I have a couple of specific questions for you, JDH:
    (1) where you get the two graphs from – do you keep the data and plot them yourself, or copy the graphs from elsewhere?
    (2) Do you know whether the QE programmes (eg $1.25 MBS) are specified in market value or nominal terms?
    Thanks.

  11. JDH

    RebelEconomist: I create the graphs myself from the raw H41 data, consolidated as described in the notes.

    I believe the MBS are carried at acquisition cost.

  12. David Pearson

    Rebel,
    There was some talk that the Fed would reverse-repo with money market funds to avoid impacting primary dealer profits — er, I mean, liquidity.
    In the bigger picture, the reverse repo talk is but a symptom of the Fed’s lack of clarity in communicating policy. So they are supposed to buy an additional $500-odd billion in MBS/Agencies, but at the same time reverse-repo $185b? Why not just buy $185b less MBS? The impact on the monetary base would be the same. This signals that the primary object of policy is mortgage spreads. Of course, we knew that, but the Fed has never come out and told us. Why not? Ostensibly, its because this admission would take Fed policy dangerously close to fiscal policy (targeting specific sectors of the economy). The Fed doesn’t want to be seen usurping the role of Congress, even though the $185b reverse repo talk proves that it is. But wait, there’s a price to be paid: Congress is not that stupid. They see the Fed taking on a fiscal role, and they want to re-take some degree of control over their traditional “power of the purse”. Hence the drive in Congress to audit the Fed.
    We will be absorbing the costs of “asymmetrical” Fed policy for years to come. One of those costs will be less Fed independence. Too bad Bernanke will never accept the blame for that.

  13. venky

    Prof.,
    The really interesting thing here is everyone’s uncertainty about money flow into the economy from the reserves. Could you use this setting to tell us what theoretical models of money use in the economy would predict? You have left us hanging by only telling us that everyone from the Fed to the financial sector to the production sector are warily watching each other.

  14. Cedric Regula

    Playing the Devil’s Advocate, I’d have to echo Dave Pearson and say “what’s the point?”. JDH went into some nuances of monetary machinations I wasn’t aware of, like the Fed having the Treasury sell bonds and deposit the cash at the Fed, to soak up liquidity (I didn’t know they were trying to do that, I thought all along they were trying to stimulate the economy. And the terrible problem we had is the zero limit on interest rates. But what do I know).
    But then they dropped a $1.8 trillion QE bomb, which included buying $300B from the treasury. Here the reason was to manipulate the long end of the treasury curve and MBS spreads. Oh yes, I did hear Ben use the word “crowding” once as another reason.
    So now they are worried about all that money out there, but they can’t sell MBS, treasuries and whatever else right back into the market because yields would go up, again weaken bank balance sheets thru market to market rules, and stifle any recovery in housing and the economy. Of course if they wait we still get the same problem eventually and if the economy does recover and we see some inflation again, whether this comes from dollar weakness, commodity inflation, import inflation or domestic reasons, then MBS and treasuries on the Fed and bank balance sheets drop in price. Deja vue, except bigger now.
    So now they are worried about how to withdraw liquidity, without making interest rates go up. I guess that’s where this would be all headed. Maybe Marx has some ideas?
    One thing that I remember from my econ 101 book is the Fed could raise reserve requirements and make the excess money stay put. Is there some reason they don’t ever consider that one? The only thing I can think of wrong with it is weak banks could have a problem complying.
    But I can see the worries about trying to pull a trillion in liquidity thru the primary dealers back into the Fed by using reverse repos.
    And if these reverse repos are long term in nature(I would think they would need to match the maturities of the QE stuff), then aren’t these kind of like “central bank bonds” or sterilization bonds?
    Come to think of it, I thought the Fed already used up its old stock supply of t-bills that it usually would use to trade for cash with its dealers when doing repos. But the Fed did buy all those QE treasuries. Would they use those????
    I’m afraid I’m getting terribly confused again. If anyone knows how to straighten out this rambling, have at at it.

  15. Cedric Regula

    venky.
    Here’s an expalnation from by Van Hoisington and Dr. Lacy Hunt. It’s the first time I’ve seen velocity and the money multiplier combined together in a discussion. Makes you understand the concept of high power money better.
    But they explain why inflation is not the concern yet.
    However, I think doing QE was a big mistake and they have complicated things greatly by doing it, and the bang for the buck doesn’t seem to be there.
    ======================================
    THE COMPLEX MONETARY CHAIN
    The link between Fed actions and the economy is far more indirect and complex than the simple conclusion that Federal asset growth equals inflation. The price level and, in fact, real GDP are determined by the intersection of the aggregate demand (AD) and aggregate supply (AS) curves. Or, in economic parlance, for an increase in the Fed’s balance sheet to boost the price level, the following conditions must be met:
    The money multiplier must be flat or rising;
    The velocity of money must be flat or rising; and
    The AS or supply curve must be upward sloping.
    The economy and price changes are moving downward because none of these conditions are currently being met; nor, in our judgment, are they likely to be met in the foreseeable future.
    Aggregate demand (AD) is planned expenditures for GDP. As defined by the equation of exchange, GDP equals M2 multiplied by the velocity of money (V). M2 equals the monetary base (MB) multiplied by the money multiplier (m). Professors Brunner and Meltzer proved that m is determined by the currency, time, and Treasury deposit ratios, as well as the excess reserve ratio. The money multiplier moves inversely with the currency, Treasury deposit ratios, and excess reserve ratios and positively with the time deposit ratio. For example, if those ratios rise on balance, then m will decline. By algebraic substitution AD(GDP) = MB*V*m. In our present case, the massive increase in the Fed’s balance sheet has created a sharp surge in excess reserves, and thus m has fallen.
    Obviously the preceding paragraph is as clear as mud. It is included to provide mathematical proof of the complex connection between monetary actions and real world results. The practical and straightforward fact is that GDP has declined in the face of a surge in M2 growth. The labor market equivalent of GDP (aggregate hours worked) has declined at a record rate over the last 18 months, the entire span of the recession (Chart 2). That is, the monetary surge was totally offset by other factors; thus, the recession deepened and inflation was nonexistent.
    The conventional wisdom is that the massive increase in excess reserves might eventually be used to make loans and reverse the economic contraction now underway, or that the velocity of money might increase. First, there is a very good explanation for the surge in excess reserves. The Fed now pays interest on its deposits, so banks have been incentivized to shift transaction deposits from riskier alternatives to the safety and liquidity offered by the Fed. Historically transaction deposits at the banks have fluctuated around 3% to 7% of a bank’s balance sheet. In the second quarter, excess reserves averaged $800 billion which is 4.4% of the $18 trillion of bank debt (including off balance sheet). If this is the amount needed for transaction purposes, then this “high powered” money is not available for making loans and investments.
    Second, velocity (V), or the turnover of money in the economy, is far more likely to fall than to rise. This is because V tends to fall when financial innovation reverses downward. As this process continues excess leverage will eventually diminish and together they will lead V lower. This process has already begun in the household sector.
    In addition, the Fed needs an upward sloping supply curve to get the economic ball rolling. Today we estimate that the AS curve is flat. The reason it is in this perfectly elastic shape, rather than upward sloping, is that we have substantial excess labor and other productive resources. For example, in June the work week was at a record low while the U6 unemployment rate was at an all time high of 16.5%. No wonder wages are deflating. Further, industry capacity utilization was at a four decade low at 68.3%, while manufacturing capacity was at a six decade low for the longer running series at 65.0%. Indeed, when excess resources are extreme, the AS curve is likely to be not only horizontal, but shifting outward, meaning that prices will be lower at any level of aggregate demand or GDP. Thus, even if Fed actions could shift the aggregate demand curve outward, which it cannot do under present circumstances, inflation would still be a long way down the road. Thus, theory and current evidence clearly point to deflation as the overwhelming economic risk.

  16. RebelEconomist

    JDH,
    Thanks – your graphs are particularly useful. You said in your first comment above that the MBS are carried at cost, which is why I asked about how QE is specified. As I am sure you know, cost and nominal value can differ considerably, so the base money impact of the QE programme can differ (and perhaps even be deliberately adjusted as it progresses), depending on how the programme is specified, so it would be useful to know. I would expect, for example, that the debt ceiling is specified in nominal terms.

  17. Charles R. Williams

    The Fed has many tools at its disposal to control the money supply. The risk is that the markets will misunderstand what they are doing. Take the explosion in the monetary base. Since the Fed started paying interest on excess reserves, the monetary base has ceased to have any economic significance. As the author points out, the Fed is short federal funds and long on commercial paper, mortgage backed securities and long-term treasury debt. This is a massive repeat of Operation Twist designed to keep mortgage rates low to prop up the housing market and to ensure that markets exist for certain kinds of debt given the collapse of the shadow banking system.
    Our main interest in the techniques the Fed chooses to use is whether it disguises what they are up to and whether it confuses financial markets.
    The rate the Fed pays on excess reserves is now the true federal funds rate. When demand for credit expands the Fed will either accommodate it by holding that rate constant or choke it off by raising the rate. This will be a difficult call but nothing the Fed has done by paying interest on excess reserves makes it any more difficult to implement.

  18. Bill

    Question ?
    If Fed borrows from money markets using MBS ( I fear it will be exclusively )as collateral, and the MBS are proved worthless or nearly so , would not this cause a considerable mark below par $1 . And wouldn’t the masses ( you and I ) lose our arses being in a MM ? Could this happen ? or Why won’t it happen

  19. AWH

    JH
    a good article, generally thorough, but not answering why? as Rob and Bill are asking.
    “worried that the financial system remains very fragile..”
    is not a satisfactory answer. the more likely answer is they bailed out the banks through buying this stuff at overvalued prices. Prices it will never ever sell for again. And it does not have to be worthless to be a huge eventual loss problem for the Fed. If it is only worth 80 – 90% of the secret price they bought it for, it will down the road cost the taxpayers hundreds of billions. So kick that can way down the road by reverse repoing it for years…

  20. Fullcarry

    “This created a very strong incentive for banks to simply hold reserves idle at the end of each day rather than lend them out on the overnight fed funds market.”
    This is slightly misleading. The net effect of the FED paying interest on reserves is to put a floor under where the fed fund market would trade. Excess reserves do get lent out all day long in the money markets by banks, but because the banking system can’t in aggregate reduce excess reserves, all overnight rates will get pinned to the interest the FED pays.

  21. AWH

    The Fed could of course, ask each bank to buy back the crud at the same (amortized) and accrued interest book value the Fed bought it for. in effect treat all this stuff as an ex post repo?
    I will bet heavily they will not. the reason they wont, and the reason they wont sell even a tiny bit back is that it would reveal the emperor’s sartorial situation, as i noted earlier.

  22. ppcm

    Professor Hamilton
    Thanks for your very clear and concise explanations on Fed repos with the banking industry,may I attempt to stretch their effects :
    A bond purchase by the Fed from the Banks is balance sheet beneficial when it comes to, not only liquidity but prudential ratios as it decreases their balances sheet assets and free up more capital and reserves required under Bale.
    When in reverse, liquidity is retreived and banks balance sheets are swolen it becomes Prudential ratios negative. As you mentioned these bilateral transactions are kept neutral to the public.
    Now I have more questions than answers
    Those bilateral Fed /Banks operations on AAA sovereigh bonds are requiring liquidities from banks and may as well impact their liquidity ratios (stocks,bonds markets assets prices are not neutral in the liquidity ratios, Banks real profits are not neutral in the liquidity ratios)
    As the for the central banks how will they deal with further debts?
    (IMF)
    Rebalancing public and private spending
    The fiscal response to the crisis was to increase government spending, lower taxes, and accept much larger fiscal deficits. Given the collapse of private demand, and the inability to reduce interest rates below zero, governments clearly chose the right response. But large deficits lead to rapid increases in debt, and, because debt levels were already high in many countries, such increases cannot go on for long. As large deficits continue debt sustainability comes increasingly into question. And with this comes the risk of higher long-term interest rates, both because of anticipated crowding out of private borrowers by government borrowers and because of a higher risk of default.
    How much longer can the fiscal stimulus continue? On its own, in most advanced countries, probably not very long. The average ratio of debt to gross domestic product (GDP) for the G-20 advanced economies was high before the crisis, and is forecast to exceed 100 percent in the next few years. (The situation is substantially different in a number of emerging market countries, where debt was much lower to start, and where there is more room for deficit spending.)
    As for the public it has kept its liquidity savings on very short term and not helping the banks liquidity ratios.
    http://www.ecb.int/pub/pdf/mobu/mb200909en.pdf
    What are the implications?

  23. jg

    “…But the concern in my mind is whether a flight from the dollar could become more precipitous and destabilizing…”
    Yes, it will, and it will begin in earnest as early as November, Professor (purportedly, the Chinese have given Treasury/Fed through end of October to present plausible plans to stop the devaluation of the dollar and, hence, Chinese reserve assets).
    Lovely memo from Arthur Burns (scroll down two screens or so) on capping the price of gold and working with fellow central bankers on such:
    http://www.zerohedge.com/article/smoking-gun-fed-controlling-gold
    Folks, get some gold and silver to protect yourselves from the criminal enterprise known as The Federal Reserve.

  24. KnotRP

    So Bankers sold assets at non-market valuations to the Fed in exchange for cash, which became bank reserves….and now the Banks are going to use those same reserves to buy the Fed’s assets (really, the assets the Banks sold to the Fed above market price), but with a promise that the Fed will buy them back at an increased price on a future date. This isn’t far from the communist joke that “they pretend to pay us, and we pretend to work”. If the goal is to crash the purchasing power of the dollar, I would bet it will work.
    Looks like some parachutes are actually knapsacks.

  25. MPO

    “purportedly, the Chinese have given Treasury/Fed through end of October to present plausible plans to stop the devaluation of the dollar and, hence, Chinese reserve assets”
    Or they’ll do what, exactly?
    Snapshotting this one for a revisit in about six weeks.

  26. Alan

    This is a highly illuminating article. At the risk of sounding like an amateur in the world of finance and banking (I am), let me pose a fundamental question. Milton Friedman’s lesson regarding the Great Depression (Monetary History of the US) appeared to be that the Federal Reserve should do all it can to keep the money supply level or slightly rising during a recession/depression. The destruction of the money supply by the Fed from about 1930 play a large role in deepening and prolonging the depression. OK, so Bernanke would have learned that lesson.
    However, what is the money supply? Bernanke almost doubles the money supply (if I read your graph correctly) overnight and then uses various tools to ensure that none of this is ever available for the recovery. Meanwhile stats on M1 sand M2 show little relative change over this period. My index of M2 grew from 1.08 in August 2008 to 1.18 in June 2009 (See: Fed Reserve Stat Release, 6Aug09: http://www.federalreserve.gov/releases/H6/Current/.) How does this comport with Friedman’s injunction? Are the positions of gamblers at the roulette table in Las Vegas a part of the money supply? And do we cover their loses for fear of its impact on casino employment?
    If this is not a part of the money supply, then what macroeconomic theory are we operating on here?

  27. Maximum Liberty

    Bill asks:
    “If Fed borrows from money markets using MBS (I fear it will be exclusively) as collateral, and the MBS are proved worthless or nearly so, would not this cause a considerable mark below par $1?”
    Bill is correct. Sometimes the Fed talks about this publicly. Watch for articles in which Big Ben Bernanke talks about “capital losses” on his balance sheet. Every dollar of capital losses is a dollar of base money injected into the economy that, in the long run, he can’t pull back out of the economy except to the extent that (a) the Fed makes a profit* or (b) the federal taxpayer gives the Fed a bail-out. If he can’t pull that dollar back out, it eventually causes inflation. The timing depends on a huge number of variables. And (I think) he could keep putting off the day of reckoning, though there is an implicit cost to doing so. For example, he could raise reserve ratios or raise the interest he pays banks so that they keep the new base money in reserve. But the reserve requirement is essentially a forced loan that damages the banks that have to make it. And paying interest on reserved increases those reserves. So, it is a two-edged sword at best.
    Max
    * Yes, sometimes the Fed makes a profit. If interests rates fall dramatically (gee, when did that happen?), the current value of a financial instrument with distant future payments goes up as the discount rate goes down. But this is just a paper profit unless the Fed is willing to liquidate those financial instruments. Since low interest rates usually mean we are in a recession, and selling financial instruments usually raises interest rates, and the Fed doesn’t usually raise rates in a recession, it seems unlikely that they would lock in the profit. But, as we come out of the recession, the Fed will presumably sell some long-dated assets and lock in some profits. They can use that to offset capital losses. One problem with this is that their huge stock of treasuries were (until recently) short-dated and their new stock of MBS are long-dated. Since I agree with David Pearson that a lot of their monetary policy is oriented toward the housing market, I don’t see them selling MBS’s as quickly as they might have sold long treasury bonds. And that means less scope for profits with which to offset capital losses on those same MBS’s.

  28. RebelEconomist

    anon at September 28, 2009 08:43 PM,
    Yes, the Fed designates a temporary OMO according to the counterparty’s perspective…..which is the opposite of how they designate a permanent OMO (eg today’s operation is described as a “coupon purchase”)!
    By the way, if you are close to the Fed, perhaps you can answer my question to JDH about whether the QE programmes are specified in nominal or market value terms.

  29. AWH

    rebel
    everything i said above would be completely wrong if the purchases were done and booked at market value. As the acquisition prices were secret we dont know. Bernanke said there were haircuts. its reasonably clear to me and inferred by all their later actions including the reverse repo planning that these were a small fraction of haircut down to reasonable or market values.
    I would go further. I say they intend to promote the fiction, at least for now, that this asset backed can be held to maturity and valued at book. you will note that, at least for now, the market isnt “buying” that. Literally. Nothing sells at current pricing that is not guaranteed.

  30. flow5

    How will the FED be able to “exit” in the face of our Insurmontable Federal Budget Deficit???
    I believe that the most important paper written in the last few years is “Paying Interest on Reserves, It’s More Important Than You Think”. It’s by Scott Fullwiler.
    Excerpt:
    “To summarize, consideration of interest payment on reserve balances demonstrates that bond sales are offsetting, interest-rate maintenance perations, not financing operations. With IBRBs eventually the entire national debt could be held exclusively as reserve balances. As Abba Lerner (1943) envisioned, Treasury bond sales would occur simply because the private sector desired Treasuries for use as collateral or as risk-free, fixed-rate investments. With NIBRBs all reserve balances except those necessary to settle payments are drained via security sales by either
    the Fed or the Treasury. Reserve requirements necessitate that some additional reserve balances
    be left in circulation. Thus, when a deficit is incurred, the quantity of bonds sold depends upon
    the method of interest-rate maintenance. As the impacts upon the net financial assets of the
    private sector from replacing credited NIBRBs with an interest bearing bond or simply crediting
    IBRBs at the outset are identical, it is arbitrary to refer to the former as financing and to the latter as monetization. While government spending might be limited as a result of self-imposed legislation or lack of public support, the federal government is not inancially constrained even where the Treasury issues bonds”
    This is the future. There is no “exit”.

  31. Anonymous

    Cedric Regula: “The link between Fed actions and the economy is far more INDIRECT and COMPLEX than the simple conclusion that Federal asset growth equals inflation”
    Aggregate demand = our means-of-payment money times it’s rate of turnover
    M2 is a spurious number. it does not represent just “money” per se. “money” is the measure of liquidity
    the “monetary base” is not a base for the expansion of money & credit. 47 percent of the base is currency held by the non-bank public. currency has no expansion coefficient.
    the lag for nominal gdp is variable
    the lags for real-growth & inflation are always the same
    income “velocity” is a contrived figure; only the transactions velocity of money is valid
    this is all straightforward and easy. there is no ambiguity whatsoever. IT HAS ALWASY WORKED

  32. Philip Wan

    James is correct. The Fed has taken over US asset price inflated value risks from the private sector and quarantined them (for how long?)by buying MBS. They have also absorbed excess liquidity (and keep currency volume consistent) by increasing reserves via paying small interest thus arresting consumer price inflation (demand-pulled). But devaluation of USD which is a function of interest rate and global confidence (faith?)in US would see cost-pushed inflation being imported. C-P inflation can be slowed by the collective will of the American people to reduce their consumption and start exporting (one hopes the world wants to buy). But to do that effectively US has to use its own raw materials and keep labour cost low. It is a new game and a new mind set. There is no other alternative for past SINs, when you are sick only bitter medicine and time can cure. Now Tsy secretary has previously urged other countries to participate in sale of US Tsy bonds but I remember a Chinese sage said wisely that “he who borrows will sorrow”.

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