The Fed’s discount rate hike

The Federal Reserve Board announced on Thursday that it is raising the interest rate at which banks borrow from the Fed’s discount window to 0.75%, a 25-basis-point increase, and intends to return discount lending primarily to the traditional overnight loans.
“The rate hike cycle begins,” declared 24/7 Wall St, and
Business Week reported:

Treasuries fell, pushing yields to the highest levels in at least five weeks, amid concern the Federal Reserve’s increase in the discount rate signaled policy makers are moving closer to lifting benchmark borrowing costs.

But I don’t believe that’s what the discount rate hike means at all.

The Fed sometimes has used discount rate changes as a signal of its intentions for interest rates more broadly. But the Fed press release accompanying the move stated flatly that’s not the case this time:

The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy….

The same message was emphatically repeated in statements by Fed Governor Elizabeth Duke and Federal Reserve Bank of New York President William Dudley. Maybe you have a theory that the way the Fed communicates that it intends to raise rates is by denying that it intends to raise rates. If so, I can’t help you.

The Fed described its true intentions in the minutes of the Jan 26-27 FOMC meeting:

Staff briefed the Committee on current usage of the discount window and other liquidity facilities and suggested additional steps policymakers could take to normalize the Federal Reserve’s liquidity provision. These steps included continuing to scale back amounts offered through the Term Auction Facility (TAF); returning to the pre-crisis standard of one-day maturity for primary credit loans to all but the smallest depository institutions; and increasing, initially to 50 basis points from 25 basis points, the spread between the primary credit rate and the upper end of the Committee’s target range for the federal funds rate…

All of which the Fed has now implemented. The FOMC minutes also indicated that the purpose of a discount rate hike would be

discouraging depository institutions from relying on the discount window as a routine source of funds when other funding is generally available…. Participants generally agreed that such steps to return the Federal Reserve’s liquidity provision to a normal footing would be technical adjustments to reflect the notable diminution of the market strains that had made the creation of new liquidity facilities and expansion of existing facilities necessary and emphasized that such steps would not indicate a change in the Committee’s assessment of the appropriate stance of monetary policy or the proper time to begin moving to a less accommodative policy stance.

The Fed does not want to be lending to financial institutions on a permanent basis, and for this reason has been winding down the TAF and other lending facilities.



Subset of Federal Reserve assets, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to February 10, 2010. Wednesday values, from Federal Reserve H41 release.
swaps: central bank liquidity swaps;
MMIFL: net portfolio holdings of LLCs funded through
the Money Market Investor Funding Facility;
CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility;
TALF: loans extended through Term Asset-Backed Securities Loan Facility plus net portfolio holdings of TALF LLC;
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;
fed_asset_facil_feb_10.gif



The Fed clearly sees winding down the level of discount window lending as part of the same process. Raising the discount rate and returning to one-day loans are the ways it intends to finish doing that.

Discount window lending by the Federal Reserve (sum of primary credit, secondary credit, and seasonal credit), in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to February 10, 2010. Wednesday values, from Federal Reserve H41 release.
fed_discount_feb_10.gif



As I noted last week, despite phasing out various facilities, the Fed intends to allow its massive MBS holdings– an alternative form of long-term lending by the Fed– to decline only gradually. Choosing to sell off some of these would be an important signal that the Fed’s assessment of the economy and near-term plans have changed.

Raising the discount rate would not.

Mortgage-backed securities held outright by the Federal Reserve, seasonally unadjusted, from Jan 1, 2007 to February 10, 2010. Wednesday values, from Federal Reserve H41 release.
fed_mbs_feb_10.gif



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33 thoughts on “The Fed’s discount rate hike

  1. Spry

    Good point Professor.
    The reaction of the media and to a certain extent treasuries is surprising. It’s like they just reacted after reading the headline without analyzing the details.
    Or maybe the market thinks that the fed will start tightening without much warning, so their statement about not tightening right now does not mean much.

  2. Rajesh

    The Fed does not need to sell its MBS holdings to reduce its balance sheet. It can simply refrain from reinvesting the principle (from refinancing, defaults and amortization) it receives every month from the securities. This will slowly (and silently) reduce its balance sheet.
    In addition, reverse repurchase agreements and the new Term Deposit Facility can help slow the excess reserves from being deployed all at once.
    But first, it must normalize it’s lending operations, complete its MBS purchases and conduct the last TAF auction with spooking the markets.
    I wish them luck.

  3. flow5

    Primary & Secondary credit on the FED’s balance sheet had fallen to only $15,163b as of Feb. 17, 2010 (so the FED hiked this rate 2 days later)
    Furthermore 5 facilities that had a reserve impact have expired: PDCF, AMLF-ABCP-MMFLF, MMIFF & SFP. 3 of these are tied to the primary credit rate (or the Discount Rate that was raised on 2/19/2010, & with maturities shortened).
    The CPFF, TSLF, TOP, (ABS TALF on March 31), & (TAF on March 8), funding & lending facilities have expired or will shortly expire.
    The Federal Reserves large scale asset purchases of $300 billion of Treasury securities, and purchases of $1.25 trillion of agency MBS and of $175 billion of agency debt securities will expire by MARCH 31 2010.
    It appears to me that the FED is following a systematic, staggered, logical, & predictable approach to unwinding the liquidity funding facilities associated with former exigent market circumstances.
    But now we have a problem. The stimulus is virtually gone. Economic lags are set to end just a little later (after the 1st quarter). Thus, if this weakness isn’t offset, we are set up for an economic double dip.

  4. Cedric Regula

    Ditto.
    The Fed also said they think financial conditions have improved ($140B in banking bonuses as evidence, I would think) so they always have tried to encourage interbank lending to smooth out liquidity among banks directly rather than servicing everyone at the discount window.
    When they start the rest of it… reverse repos, term deposits, and paying interest on reserves is still hard to guess. For us and them, I’ll bet.
    Krugman thinks we are turning into Japan because we got a low print on the CPI (and PCE) ex food and energy, of course. The culprit there would be falling imputed rents and cheap Chinese stuff(dumping?). I’m not convinced that turns us into Japan however.

  5. ReformerRay

    I all this purchase of Mortgage Backed Secuities a good thing? Would the country not be better off quicker if the Fed no longer tries to prop up the housing market?
    Japan tried to avoid recognizing bad bank debts for more than a decade. The U.S. seems determined to not recognize the extent to which housing is more expensive than the public is willing or able to support.
    Sure, letting the market in housing go will produce an over-reaction. But the over-reaction will lay the foundation for growth. What we are doing now is just waiting for more trouble.

  6. MF

    Rajesh:
    When you say “the new Term Deposit Facility can help slow the excess reserves from being deployed all at once”, I don’t get it -and I have seen this time of statement several times in mainstream media and Professor Hamilton has made similar statement in the past.
    I think this type of statement reflects a lack of understanding of how monetary operations work. When the Treasury/Fed decided they will not issue or sell treasury bills to cover MBS purchase, and rather, simply pay interest on reserves at the Fed, this meant automatically that excess reserves would increase at the Fed. This high level of excess reserves say nothing about banks lending activity, economic activity and the prospect for future inflation.
    This is very well explained in a NY FED paper
    http://www.newyorkfed.org/research/staff_reports/sr380.pdf
    “First, the Federal Reserves new liquidity facilities have created, as a byproduct, a large quantity of reserves and these reserves can only be held by banks. Second, while the lending decisions and other activities of banks may result in small changes in the level of required reserves, the vast majority of the newly-created reserves will end up being held as excess reserves almost no matter what banks do. The central message of the article is that the data in Figure 1 only reflect the size of the Federal Reserves policy initiatives; they say almost nothing about the effects these initiatives have had on bank lending or on the level of economic activity.”

  7. Brian

    Yes, but you don’t address WHY the Fed raised the discount rate on a Thursday after the market closed; this was a dangerous move in that it could’ve triggered a market panic. The Fed at least should’ve done it on a Friday afternoon when many traders clear their positions or people just aren’t paying attention. This of course had the Fed out hopping around Friday calming the markets saying that liquidity will not be pulled and consumer rates will remain as are (Fed funds rate).

    Yes the Fed wants to discourage banks from borrowing through the discount window, but to do what?

    Well, let’s say I’m a too-big-to-fail financial institution. I go to the discount window and borrow dollars. Then I take those dollars to my fellow European too-big-to-fail financial institution and invest those dollars in Euros, and then turn around and buy high yielding sovereign debt (like Greece, Spain, and so forth). The spread on this trade has a potential for massive profits.Unfortunately, the media continues to demonstrate its poor reading skill in announcing that a Greek bailout is coming when the EU press statement said no such thing; however, one may inevitably come. So, yes, the above strategy is risky, but what do I care: I’m too-big-to-fail: and so is my European counterpart. And if it fails, I can still pay back the Fed because the rate to borrow was virtually zero, or I simply don’t pay it back. Also, by too-big-to-fails leveraging on sovereign debt it begins to put more pressure on political powers to bailout the said country, thus paying me, the too-big-to-fail financial institution; and in the meantime I make a huge profit and thus pay myself a huge bonus at the end of the year.

    This is what the Fed wants to prevent, as well as trying to turn those investments back into the US, primarily back into US Treasuries, and when the cost to borrow goes up, I might be forced into safer, albeit lower spreads.

    This is also why the Fed might have felt that it could not wait for a “safer” time to raise the discount window.

    I also find it interesting that the CPI percentages didn’t add up properly, at least under the “housing” category, and this mathematical “error” made it look like inflation was under control. We’ll see if the BLS corrects this “mistake”, or fix the calculating bug in their excel program; it does make one wonder if the numbers were quickly changed, maybe too quickly, that is, someone forgot to make sure the numbers add up properly.

    And the Commitment of Traders Report from the CFCT shows a huge short position on the S & P, maybe someone knows something, or that someone is about to lose quite a bit of money. If the Fed pulls the liquidity form the stock market it sure would make that 401k Treasury annuity plan look more appealing to the public.

    So, is it tightening, normalizing, or simply gambling?

    Sincerely,

    Your Humble and Friendly Neighborhood Speculator

  8. Cedric Regula

    MF,
    I thought I understood it well enough, until I read the Fed paper statement you posted.
    I think it works like this.
    1) “Required reserves” are a rule imposed on the fractional banking system. The amount to be held by banks as a liquidity buffer is something like 8% of zero term savings and checking demand deposits. Surprisingly, bank CDs are exempted, because they are considered term deposits.
    2) The amount greater than that is called “excess reserves”, and is voluntarily held by the banks. They can change their mind about what they do with those funds at any time, and it would take a serious departure from Websters if it meant anything else.
    3) Everyone agrees that the Fed “created” money (Fed speak for printing money, electronically, of course, due to high cost of paper and associated environmental impact for such a large quantity) so that the Fed could purchase long term paper assets. (MBS, Treasuries and whatever else is stashed away in Maiden Lane, etc…) and pay for them with the created money. This money became designated as “excess reserves” if the banks chose to leave it under custody of the Fed.
    Not too surprising we may not understand the concept, when the Fed makes statements like this in the paper you paper you posted…
    “they say almost nothing about the effects these initiatives have had on bank lending or on the level of economic activity”
    It would be more correct if they re-phrased it this way and said…
    “Fed initiatives have had no effect on bank lending or on the level of economic activity, other than propping up asset values like stocks, bonds and commodities. Excess reserves represent the fraction of Fed initiatives that were used for no purpose at all.”
    Then we would understand.

  9. Bruce Krasting

    You are expecting the MBS portfolio of the Fed to decline gradually. How gradually?
    The prepay speeds are close to 20%. This would imply a reduction of $200b in the next 12 months.
    As this happens there will be plenty of pressure for spreads to widen on MBS. Bye Bye RE market if we get to 6% on new mortgage credit. We should get to that level by August……

  10. Rob

    Many thanks Prof, I’ve almost given up on main stream media…
    Just reread your post from last week (and comments). So as long as the payments to the Fed from their MBS exceed their payments on excess reserves there is no increase in the monetary base and no resulting inflation?
    And since the Fed knows exactly what receits will be (explicilty backed by Govt, i.e., us), it knows exactly where it can jack up the discount rate to an appropriate level and still be non-inflationary? (ht C. Regula Feb 14 comments)
    $1.1T in excess reserves earning 0.75% (annually) works out to be ~$8.25B in interest payments to the banks. If those govt backed MBS are indeed paying more, is it just accounting/reserve requirements that prevent the banks from making the obvious decision to buy them back from the Fed?
    Also, coulnd’t the Fed use its additional authority to mandate a higher reserve requirement from banks to preclude excess reserves from spilling out? (And not have to pay $ on these reserve requirements)?

  11. MF

    Cedric Regula,
    Paying interest on excess reserves is a PERFECT SUBSTITUTE to issuing/selling treasury bills.
    Why would excess reserves have any more effect on asset prices than emitting treasury bills?? There is no difference between parking your reserves at the Fed at 0.25% (or whatever the rate is) and buying short term treasury bills with a yield of 0.25%.
    The Fed actions was designed to exchange illiquid assets (MBS) for liquidity (basically cash in the form of excess reserves). If Treasury would have decided to issue treasury bills to cover MBS purchase by the Fed, then this action would have de facto amounted to an asset swap between something illiquid (MBS) and something so liquid that it could be considered cash-like (short term treasury bills). There is no difference whatsoever between the two approaches in term of impact on asset prices.

  12. T-Dub

    Bruce:
    The missing part of your comment is that the prepay speed is not constant and is largely driven by refinancing and move-up buyers. There aren’t too many move-up buyers in this market and there are not many people are suddenly coming into huge sums of cash to pay down their principal. If we get to 6% mortgage rates then prepay speeds will drop off a cliff. With rates at historic lows, I don’t see that there will be much (if any) refi activity over the next decade. But, to your point, if we see mortgage rates rise significantly, the RE market will get hammered.

  13. Cedric Regula

    MF,
    I’ll add one more paragraph to my modified Fed statement.
    First Paragraph
    “Fed initiatives have had no effect on bank lending or on the level of economic activity, other than propping up asset values like stocks, bonds and commodities. Excess reserves represent the fraction of Fed initiatives that were used for no purpose at all.”
    Second Paragraph
    “Fed initiatives did prop up demand(prices) for MBS, Treasuries, and whatever got stuffed away in Maiden Lane, since the Fed was the buyer with newly created money, altho it is unknown what the price is in the Maiden Lane case because these securities are still believed to be toxic and unmarketable. Banks have not engaged in much lending with the created money injected into the banking system (the banks either sold the assets to the Fed, or the money the Fed spent gets deposited in banks), but banks have used some of the liquidity to purchase Treasury bonds, stock and commodities. The unused portion resides at the Fed in the form of excess reserves. However, this has allowed banks to pay huge bonuses in 2009, but bank trading desks are now looking for retail investors, mutual funds and pension funds to fill the role of bagholder for these overpriced assets.”

  14. Tom

    I generally agree. It is nonetheless a small signal that the Fed is moving towards tightening, but nothing like previous discount rate hikes. Still the big question is: what if anything does the Fed plan to do to keep rates so low after the end of MBS purchases?

  15. MF

    Cedric Regula:
    Liquidity (or call it cash or money)in the form of excess reserves does not disappear from the economy because a given Bank decided to buy stocks or commodities. For the banking system as a whole, whatever individual banks do with excess reserves, approx the same amount will end up as excess reserves at the end of the day (although the owners of these reserves could change, the overall amount will stay approximately the same).
    Think about it this way: if a Bank A who is happy holders of these excess reserves decides “to put them to use” by buying stocks or commodities, the guy that sell these stocks or commodities will receive the cash and he will deposit it at his bank (called it Bank B). At the end of the day Bank B will park this cash at the Fed in the form of excess reserves to at least earn some form of return on it. So the overall amount of excess reserves did not change, but the owner of these excess reserves is now Bank B.
    Liquidity (call it cash or money) does not disappear from the economy, it will always end up in a bank account somewhere unless people/businesses start to massively stack it under their mattress.
    Whether a Bank owns excess reserves or treasury bills is absolutely immaterial in its decision to grant loans or invest in stocks/commodities.

  16. Anonymous

    MF wrote: Liquidity (call it cash or money) does not disappear from the economy, it will always end up in a bank account somewhere unless people/businesses start to massively stack it under their mattress.
    Those excess reserves will dissapear as the Prof noted, when the MBS are prepaid, or mature. The Fed get’s the principal back, and assuming they bought at par (or a discount), they can extinguish those excess reserves. Just an accounting identity. What isn’t retired is what they have paid as interest on those loans, if I understand what is going on, which I might not

  17. Anonymous

    $1.1T in excess reserves x 0.0075 ~= $8.25B/year (using an annual rate). Which is ~1%/year increase in the precrisis Fed’s BS

  18. JDH

    MF: You are correct that actions by any individual bank do not affect the aggregate quantity of reserve deposits. You are wrong to infer from this that the supply of reserve deposits is irrelevant.

    Equilibrium requires the supply to equal demand for reserve deposits. In general this equality is assured by adjustment of yields, prices, and other asset volumes. It is true that at the moment, supply equals demand for reserve deposits at a very low interest rate and at a huge volume of reserves. It is false that those would remain the characterization of equilibrium as the economic recovery builds strength.

    You are correct that reserve deposits at the moment are a very similar asset as T-bills, and that the government creates both asset classes. You are wrong to infer from this that the quantity of either asset that the government creates is irrelevant.

    Equilibrium requires the supply to equal the demand for T-bills. It is true that at the moment, supply equals demand for T-bills at a very low interest rate and at a huge level of government borrowing. It is false that this will remain the case regardless of investors’ perceptions of other investment opportunities and the future fiscal soundness of the U.S. expenditures and receipts.

  19. Cedric Regula

    MF,
    JDH already gave his explanation, which I wholly agree with, but I’ll flesh it out a bit more with a different slant.
    I guess I should back off of my terminology about whether excess reserves are used or unused, and try it from a transactions standpoint. But hey, the Fed never releases first drafts either, so why should I.
    The volume of reserves does not change, unless the Fed does something to make it change. They call it “shrinking or expanding the balance sheet”.
    These excess reserves can be used to facilitate transactions. As you say they get transferred from one bank account to another, but that was because either a loan was made, or an asset was purchased. Not doing anything is an option, which is why I fell into my unfortunate use of the word “unused”.
    The banks are making choices between lending money, buying Treasuries, or corporate bonds, or stocks or commodities.
    I happen to know that bank analysts who have studied industry income statements the past couple quarters state that the bulk of bank operating profits came from their trading desk activities, not lending activities.
    So this is why I make the point that banks are choosing their most profitable activity, trading, over lending and Fed policy has misfired in my opinion and fueled something that was never considered traditional banking, or stimulative of the real economy. Other than make commodity prices go up, of course.
    Volker thinks this is a problem too.

  20. MF

    JDH,
    Respectfully, for both of your points, you repeat a typical error from economists which is to think that short term Government bond yields (or interest rate on excess reserves) is decided through the “free market” and that investors perceptions plays a role in this. The Fed DICTATE the rate paid on excess reserves and DICTATE what the short term yields on U.S. government bonds will look like. Period. Have you ever seen 1 month or 3 month treasury bills significantly departing from the Fed fund rate? This is not a free market in any way. The FED stands ready to inject/withdraw liquidity (ie. adjust qty) to make sure that the target rate it has set is achieved.
    So when you say that:”It is false that this will remain the case regardless of investors’ perceptions of other investment opportunities and the future fiscal soundness of the U.S. expenditures and receipts.”. This is wrong. Again, short term yields (whether for bonds or excess reserves) are NOT decided by the free market interaction in any way. How else would you explain current yields on 3-months T-Bills world wide? Japan has the highest debt-to-GDP ratio in the world and is able to borrow for three months currently at 0.13%, while Australia with one of the lowest debt-to-GDP ratio in the world is currently borrowing for 3 months at 3.74%! U.S. 3 months is at 0.10%. UK three months is at 0.47%. Canada three months is at 0.17%. Does anyone really believe that these rates reflect investors perception? The fact that Australia is so much higher is strictly explained by the fact that their target rate is currently at 3.75%.
    In conclusion, you don’t have to take take my words for any of this stuff. Read the following November 2009 paper from the Bank for International Settlements (http://www.bis.org/publ/work292.pdf):
    “In fact, the level of reserves hardly figures in banks lending decisions. The amount of credit outstanding is determined by banks willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.The aggregate availability of bank reserves does not constrain the expansion directly. The reason is simple: as explained in Section I, under scheme 1 by far the most common in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system. From this perspective, a reserve requirement, depending on its remuneration, affects the cost of intermediation and that of loans, but does not constrain credit expansion quantitatively.The main exogenous constraint on the expansion of credit is minimum capital requirements.By the same token, under scheme 2, an expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. Given the very high substitutability between bank reserves and other government assets held for liquidity purposes, the impact can be marginal at best. This is true in both normal and also in stress conditions. Importantly, excess reserves do not represent idle resources nor should they be viewed as somehow undesired by banks (again, recall that our notion of excess refers to holdings above minimum requirements). When the opportunity cost of excess reserves is zero, either because they are remunerated at the policy rate or the latter reaches the zero lower bound, they simply represent a form of liquid asset for banks. ”

  21. MF

    Anonymous:
    You are right, I should have specified that Excess Reserves will go down as MBS are repaid (Assets and Liabilities on the FED Balance sheet will go down when this happens)

  22. GYSC

    Don’t worry pal the easy money will keep flowing even though it is making no real difference in anyone on the streets life, but please do continue with the textbook baloney that thinks soem rate on borrowing makes any difference at all when you have no job. Classic.
    Try this thought:
    “Lets face it: J6P has seen no benefit to the FED’s actions since this all started in 2007. For the most part they have gotten screwed as they have watched the yields on their CD’s drop to 0%. Perhaps some that have money can now borrow at lower rates but who wants to borrow when you don’t have a job?”
    Have a model for that reality yet??

  23. JDH

    MF: I did not use the term “free market”. I did speak of supply and demand.

    In your opinion, do the current holders of T-bills want to own them, or not want to own them? Do they want to hold more than they are holding right now? If so, what force prevents them from placing an order to buy? Do they want to hold less than they are holding right now? If so, what force prevents them from placing an order to sell? Do they not care? If not, why not? Do the yields available on alternative investments matter for their decision, or do they not matter?

    My answer to the above questions is that the current configuration of yields is such that supply equals demand. Current holders of T-bills do not want to hold more than they currently hold, nor less than they currently hold, because if they did so desire, they would buy or sell. The result of such buying or selling would be to change the configuration of yields until demand does equal supply.

    And this condition of supply equals demand holds at the moment for a very low T-bill yield because alternative investments are regarded as unattractively risky. But it has not always been so, nor will it always remain so.

  24. Michael Krause

    When the Fed is done buying next month, I imagine the prepay rate will fall substantially as refi activity disappears. 20% sounds impossible in such a situation. Lets say the average 30 yr mortgage is 3 years in. That means an annual principal paydown rate of 1.7%. Even if the average mortgage on the Fed’s books is 10 years in, the annual paydown rate is 2.3%. Add a little more for normal prepay, and I’d imagine anything more than 4% prepay + principal reduction in the absence of refi activity [which will soon disappear] is unlikely. That’s $50B/yr max of Fed automatic balance sheet reduction. The game changes when rates fall or hover and modulate, but that’s not likely the game going forward.
    If anything, we’ve learned that going forward the size of the balance sheet is of little consequence if IOR/Fed Funds (interest on reserves) rates are set high enough to bring down loan volumes. Thanks for that link MF again.

  25. ppcm

    There are three markets the physical market were real Tbonds are exchanged for money at a price set through various tortuous shadow banking practicices.
    The primary market where the hoarding (see banks balance sheets) of TBonds is taking place, the IRS (interest rates swaps) as illustrated (not recorded,not traceable as a whole in Europe) by the OOCC reports,the contract default swaps (CDS) where there is no reports,no regulation,where banks and financial corporations are betting against or for, their countries of domicile.As an aside one may wonder, how banks could lend to each other, when unable to assess the real VAR on their own contingent liabilities.
    Liquidity in one these markets will trigger the fate of the underlying assets,where constraints are loosely set under Basle not complied with under banks supervision bodies.
    Should one be willing to probe test the potential of the lethal shadow banking, please see:
    Subprime derivatives, 4 banks ended up to be the full market when the primary function that is the mortgage financing was already in troubles since long. Few participants were surprised to see a 24 std deviation downfall.
    The secondary effects, that is when liquidity is drying in one of the trading floor, banks will close their contribution as liquidity providers to secondary issues like municipalities FRN, corporates FRN (at the great satisfaction of the issuers whom can see the prospect of buying their debts on the cheap and meanwhile record capital gain profits on their own liabilities).
    See Greece and others shadow liabilities window dressing.
    See all litigations from China to Italy,municipalities on interest swaps.
    Agree the law of supply and demand is prevailing but contrary to the Chinese adage” if the meal is good do not ask the cook how he made it”, it is time to look at how meals are cooked, they have been proved toxic.
    I would add this financial disaster, is already three years old and no progresses are recorded as to cure its predicaments.

  26. MF

    JDH:
    You can call it supply and demand interaction instead of free market, but the fact remains… short term yields are NOT determined by investors perceptions or by whether investors are in a mood to hold T-Bills or not. The yields available on alternative instrument does not matter.
    When a government creates a deficit or do an asset swap through its Central Bank (eg. exchanging liquidity for MBS), by definition, it injects liquidity (call it cash or money) in the economy. This liquidity does not disappear from the private economy, and at the end of each day will end up buying the T-Bills issue (at approx. the target rate) OR end up being being parked at the FED as excess reserve at the target rate (remember my earlier example with Bank A and Bank B). This liquidity has NO other place to go (unless you assume people prefer to stack it under their mattress at 0% yield instead of getting a 0.25% yield).
    Lets assume for the sake of it that when the FED bought MBS,it did not pay interest on excess reserves, and that the Government did not cover these purchases with T-Bills issue. The injection of liquidity in the economy from MBS purchase would create an imbalance in the interbank market that would tend to drive the rate to zero. Of course, in such situation, the FED would not standstill since it wants the FED fund rate at approx 0.25%. So the FED would intervene through open market operations by selling T-Bills to withdraw the surplus liquidity and make sure the target rate is achieved. The FED can not do this on a massive scale, because it would eventually run out of T-Bills to sell. So for massive liquidity injection (eg. MBS purchase) either the Treasury issues T-Bills or the FED pay interest on excess reserves to maintain the FED fund rate at the targeted level.
    In conclusion, a country with its own floating currency decides on its short term borrowing cost through its Central Bank NO MATTER WHAT THE SUPPLY AND DEMAND INTERACTION IS. This precisely explains the problems of Greece, Ireland Portugal and Spain right now. They have no control over their short term borrowing cost (if you have more faith in the EURO than in Greek bonds… it might make sense to stack EUROS under your mattress at 0% instead of buying a Greek bond at 5% that will default in 6 months!). Don’t listen to analysts that would have us believe that the UK will go the way of Greece or Ireland… the UK was smart enough to keep its own floating currency. Although its deficit as a share of GDP is comparable to Greece, and its debt level is skyrocketing, the UK Government is still borrowing for 3 months at 0.47%!!! (remember that a sovereign Government could always resort to issuing short term bonds, particularly in times of crisis)

  27. Cedric Regula

    MF,
    You’re describing what central banks think their job is, so I don’t see any big revelation.
    They call QE “unconventional policy”, which is CB speak for acknowledging they are being heavy handed with their fiat currency powers, but believe the situation warrants it.
    One minor point, Tbills have quite often traded below .25% the past two years, even with the Fed paying interest on reserves. It even went negative a couple times.
    It all more or less works when the public has reasonable faith in the currency and government credit. In the case of the PIGS, we are seeing credit risk become an issue. That’s when people don’t show up for the auction when governments need to roll over the debt. Here it would make sense for people to put Euros in their mattress, but in the case of other failing countries like Argentina, etc…, you get capital flight out of the country.
    I’m more worried about what ppcm alludes too. In addition to CBs doing somewhat transparent monkeying with market interest rates, we have developed a huge private banking sector derivatives market (unregulated) basically insuring against defaults and interest rate moves. That sounds like AIG on steroids to me, and Warren Buffet calls it financial WMD.

  28. ppcm

    The monetary,fiscal, bifurcations in the land of Epiminide are a reflection of the cultural wealth , where the Cretese paradox is now universally treasured beyond the borders of the Lethe.
    Do not worry Greece today is not the cause celebre of V Hugo,Pushkin or Byron, Sheyley. The malfunctioning of the financial institutions, demonstrating daily their inability to assess their risks be they domestic or international should be for sure a subject of more weighed interest .

  29. spencer

    I give this a very different reading than you:
    The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy….
    I read it to say that this specific action will have little impact rather than a message that it is not the start of something.
    I read it as very much a shot across the bow.
    The Fed has been warning of a change in policy this year, and this action is just a message to everyone that has not so far taken the warnings seriously to take them seriously.

  30. JBH

    Flow5: A double-dip will not happen because there is a VERY large inventory correction still to come (few professionals understand this except for Goldman, Royal Bank of Scotland, and a few others), lasting on a tapering off basis through 2011. Ordinary nominal dollar inventory-to-sales ratios are not telling the correct story and are not generally reliable for forecasting purposes. You must look at the LEVEL of real inventories in the NIPA accounts in conjunction with the inventory investment component of GDP and work through the logic of the current situation. The outsized and projected-to-continue contribution to GDP growth from the ordinarily tiny inventory investment component will be further augmented by pent-up demand for consumer durables and business equipment and software spending, also of huge and longer-lasting-than-usual proportions due to the historic length and depth of this recession. This recovery is different in more ways than just the deleveraging phenomenon and the capital constrained banking system.

    Tom: Yes the discount rate hike is a sign that the Fed is moving toward tightening.

    Spencer: Yes, about this being a shot across the bow. There have been 4 or 5 such shots since the January FOMC statement was released in which Kansas City Fed president Hoenig dissented. Various Fed presidents have suddenly started speaking up about exiting MBS sooner rather than later.

    More generally, regarding the notion of a fed funds rate hike, early-stage inflation is already brewing. The core goods PPI is up at a 56% rate over the past 3 months (not seasonally adjusted). That is not a typo. The core intermediate goods rate is up at a rate of 5%. Most importantly it is now above the core finished goods rate, which will now start rising from its current 2% 3-month annualized rate. Like the relationship between the marginal and average cost curves, intermediate goods inflation always drags the finished goods rate with it. “Always” is not a typo. Admittedly, there is a long lag between the finished goods PPI its pass-through to the CPI. But odd things are happening this recovery. A gigantic whipsaw is taking place as pricing power collapsed in the financial panic of late-2008 early-2009, and now businesses are making up for that plunge in prices with a vengeance. This is neither cost-push nor demand-pull, but rather a different breed you might call rebound inflation. Import prices ex petroleum are whipsawing back now too, and import price inflation has turned positive with a vengeance. Nearly the only thing that has kept the core CPI down is the sum of owners’ equivalent rent and ordinary rent. Ordinary rents — surprise of surprises — turned up in the latest report, an early sign that OER will soon turn too (or at least stop falling). There are many other overlapping signs that early stage inflation is coming back. Given the Fed’s notable preoccupation with keeping inflationary expectations anchored, and with its hugely bloated balance sheet needing to be unwound, the Fed has to be worried. This larger casting of the net regarding inventories and early-stage inflation informs and gives more weight to the notion that the discount rate hike is indeed a shot across the bow that monetary tightening a la a hike in the funds rate may well come quicker than you think.

  31. kharris

    Um, anybody else notice that the Fed is getting ready to drain $195 bln in liquidity over the next 2 months? After being forced to inject that amount in helping Treasury to avoid the debt ceiling. SFP is back, even though the facilities it was created to fund are going out of business. Timing of the announcement allows Bernanke to address the increase in the SFP at tomorrow’s testimony.

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