Wednesday, August 26, 2015

What Will a Fed Tightening Look Like?

The Federal Reserve has created quite a situation for itself with the three bouts of Quantitative Easing (the QE's). They appear to be considering raising the fed funds rate at the September meeting, but the rout of stock markets worldwide has many now arguing that the action should be postponed, on the assumption that an apparent tightening of policy would only make things worse.

Ironically, even those who've long been calling for a return to "normal" short rates are now becoming a bit reluctant to see it happen, for fear that both the economy and markets are on the verge of going south and that their longstanding advice will get the blame if the market declines continue.

How Would the Fed Tighten?

This isn't a question with a simple answer. It used to be, but no longer. In the "old days" prior to implementation of the QE's all the Fed would do is intervene directly in the fed funds market by selling some of its securities to the banking system. It would do so when funds were trading at, say, 3%, thereby signaling that 3% (or something higher) was the new floor to the fed funds rate. The funds market would adjust to that signal immediately and begin to trade in a higher range. Should it drop to 3% again, the Fed would simply sell more securities.

However, this only worked because banks needed to hold a specific level of bank reserves to meet their reserve requirements and because there were never more than a few hundred million dollars worth of excess reserves in the system. Thus, by draining only that few hundred million, the Fed could ensure that funds traders would be scrambling to meet their reserve obligations by the end of the reserve week, bidding up the fed funds rate in the bargain.

Now, however, with $2.5 trillion of excess reserves in the system, the Fed can't raise the fed funds rate with a simple draining operation as they used to be able to do. Say they try to signal a move to a 0.5% funds rate by selling a billion dollars worth of their portfolio thereby draining a billion dollars from the banking system. Would it matter? Not at all. The banks would still be sitting on almost $2.5 trillion in excess reserves, on which the Fed currently pays them interest at a .25% rate. If the Fed tries to get fed funds to trade at 1/2% the banks will hit any bid over 1/4% because that would be a better rate than what they're currently earning on their excess reserves at the Fed. With $2.5 trillion available for hitting the bid, the banks will win that battle and funds will not trade above 0.25%.

So, What's the Answer?

Clearly, the Fed has to somehow neutralize the $2.5 trillion in excess reserves if they're to effect a tightening in the form of raising the fed funds rate. They have two obvious ways to do this. The Fed can either sell enough securities to directly drain the entire amount, or they can offer to pay the banks a higher interest rate on their excess reserve position. Since selling $2.5 trillion worth of long maturity debt into what would surely be a deteriorating market would be highly impractical, over the short term at least, it's obvious that the Fed will instead raise the rate they pay on reserves, probably to the upper end of the new target range, since it will become a ceiling for the funds rate, as outlined above.

Thus, rather than the market being clued to an eventual tightening by a Fed open market operation, as in the not-all-that-distant past, instead the Fed will just announce that it's raising the interest rate it's paying on reserves. That will be the tightening. It will be a simple announcement, rather than an open market operation.

Some Implications of Raising the Interest Rate Paid on Reserves

Those of you who've read the earlier posts here will be aware that I think that paying interest on reserves, and particularly on excess reserves, was a huge mistake. That said, such interest is now being paid and that has several implications.

First, as described above, a tightening will now very likely take the form of an announcement that the Fed is raising the interest paid on reserves. Now, the vast majority of the public, and this includes a reasonably large majority of investors I suspect, will have no idea what that announcement means. It could actually be phrased in such a way as to sound quite innocuous, as in, "The Fed is announcing that the rate it will pay on reserves held by the banking system will be increased to 1/2 percent as of today." Accompany that with some gibberish about maintaining the health of the banking system and an added note that it's leaving the discount rate unchanged, and many investors might not even realize it's a tightening until it's explained to them later. Meanwhile, the fed funds rate might even continue to trade well under 0.5% for a bit, further confusing the matter.

Second, if you've read the post preceding this one covering the massive increase in demand deposits in the banking system, you might realize by now that the only reason for the increased level is the existence of the ZIRP (Zero Interest Rate Policy). If ZIRP disappears, then so does the rationale for the massive increase in demand deposits. That means that as the Fed gradually raises short term interest rates the level of demand deposits in the banking system will plummet.

Finally, and again drawing on the previous post, whereas I believe the dramatic falloff in the growth of demand deposits in the banking system since February of this year could well indicate that the economy is either already in, or is soon entering, a recession, the plummeting demand deposit balances that will occur when the Fed raises rates will not carry the same meaning. Instead, it will simply mean that the level of demand deposits will be returning to what it would have been had ZIRP not made people indifferent between short-term savings account and checking accounts. That is, once they can earn interest on their savings accounts again, they will begin again to minimize their demand balances.

But, because the Fed most likely doesn't agree with the analysis here, there's a significant danger that it will misinterpret a sharp drop in the level of demand deposits and somehow seek to counteract it. I doubt they'll be able to stop demand deposits from falling, but should they manage to find a way they could indeed open the doors to a significant rise in the inflation rate.


Thus, if a tightening is to occur, it's likely to take the form of an announcement that the Fed will be paying a modestly higher rate on bank reserve positions. That rate is currently 1/4%. From all indications, it will probably be raised to 0.5% if the Fed goes through with a tightening.

They will also probably begin to intervene in the fed funds market entering sooner to do reverse repurchase agreements with quasi-bank entities at a somewhat higher rate. Currently those funds trade between zero and 0.25%. This is a fairly technical issue, but it could confuse people because fed funds will often trade well below 0.5% at times. It involves the repurchase facility the Fed recently established to do business with entities that don't have direct access to the banking system's fed funds market.

One final note, from the perspective of a proponent of the strong form of monetary policy: This wouldn't really constitute a tightening at all. It would just be the beginning of a restoration of normalcy to the banking system, a restoration that will be necessary if the Fed is to ever again be able to utilize its normal operating tools, that is, those used for decades prior to the implementation of the QE's.

By the way, that meager 1/4 percent increase in the rate the Fed would be paying on reserves will cost them over $6 billion in additional interest payments per year, a tidy sum that might explain why all of this has taken so long to materialize (as suggested in The Fed's Massive Conflict of Interest.)

Monday, August 24, 2015

Is the U.S. Economy in Recession?

In this post I'd like to briefly discuss what the Fed's ZIRP (Zero Interest Rate Policy) has done to corrupt the money numbers and then explain why, in spite of the difficulty of analyzing corrupted numbers, the United States is probably already in a recession, one that started in the 2nd quarter of this year and continues today.

Explaining the Excessive Growth in Currency in Circulation

Anyone who has read the Strong Form of Monetary Policy that I've described in earlier posts might be wondering why currency growth has not reflected the inflation rate recently. Currency growth the past five years has been on the order of 8% per year whereas per the government inflation has been running at less than 2%.

Because a lot of U.S. currency goes overseas, especially in times of international turmoil, some of the excess growth could be explained in that manner. However, ZIRP is also likely to be partly the cause, although not to the extent that it has influenced growth in demand deposits (as will be explained next). When there is no effective cost to carrying cash, people are likely to be indifferent as to the whether to carry an excess of it, for they're not earning anything on the alternatives to cash, including their NOW accounts. Businesses, in particular, would be less sensitive to having well-stocked cash registers.

Yet, most people won't arbitrarily decide to carry wads of cash around just because it's costless, for the simple reason that they might lose it, or have it stolen. That, of course, includes businesses. Then, of course, there's yet another explanation: Perhaps the government inflation numbers are understated, as some fairly reputable sources do, in fact, claim, and that inflation is really running 4 to 5% instead?

Explaining the Excessive Growth in Demand Deposits

This one is far easier. Shorter term savings accounts are earning so little in interest that people are very likely to carry far larger balances in checking accounts today without worrying about the opportunity cost. When $10,000 is likely to earn less than a dollar in a money market fund over a year, why bother? The result has been that demand deposit growth averaged around over 21% per year over the five years ending in February 2015 versus NOW account growth over that time of less than 6%.

When there's no opportunity cost (in the form of lost interest) to holding cash or demand deposits, people, and businesses, simply hold more cash.

Why No One Pays Attention to the Money Numbers Anymore

The favored number of the ancient monetarists (way back in 1979) was M1, which consisted then primarily of currency in circulation plus demand deposits. Five years ago, in February of 2010, M1 was $1,715 billion. This year's February number was $2,995 billion, up at an annual rate of 11.8% over the five years. Monetarists of the past would be expecting a massive inflation rate to have resulted by now.

Very few monetarists at the time focused just on the demand deposit component, but it has gone in the same five years from $458 billion to $1,277 billion, for a 21.6% annualized rate of increase. Note that it has also become a far larger component of M1 in the doing. Under the strong form of monetary policy that I espouse, inflation would be raging by now if that sort of increase had occurred with interest rates not so close to zero percent.

Obviously, then, the money numbers have contained nothing but misleading information since ZIRP became the order of the day. And, in truth, they've contained little information since 1980 when NOW accounts were introduced, as explained in earlier posts.

Finally, Why Might the U.S. Already be in Recession?

While the above discussion explains why neither M1 nor its demand deposit component should contain much guidance for future inflation, that doesn't mean that demand deposits aren't useful for determining whether or not a recession is looming.

Here are the interesting numbers: $1217, $1202, $1204, $1193, $1206. Those are the demand deposit totals, in billions, for February, March, April, May, and June of this year. And the first four weeks of July only averaged $1217 as well, before a huge burst in the last four days of July that brought the total for July to $1,227 billion. Note the virtually zero growth from February to late July following a five year run of growth in excess of 20%.

As explained in earlier posts, while I no longer believe the Fed is capable, under its current operation procedures, of causing such a contraction in the growth rate of demand deposits, that doesn't mean that the contraction itself has no forecasting power.

Indeed, it seems highly unlikely that the virtual cessation in the steady 20%+ growth of demand deposits over the five years since February of 2010 means nothing at all. To the contrary, one needs to ask if the almost five month period of virtually zero growth in demand deposits is a reflection of something, perhaps an economic contraction that has been underway for several months now?

Under the old monetary regime of the 1960's and 70's, such a cessation of demand deposit growth was usually a precursor of an impending recession, particularly if it persisted for six months or so. Back then, however, the Federal Reserve was usually the direct cause of the slowing growth of demand deposits, something that's unlikely today.

Conclusion: Be Careful of the Second Quarter GDP Revisions

On July 30th the government announced that GDP grew at a 2.3% annualized rate, or about 0.6% for the quarter alone. In three days, on August 27th, the first revision will be announced. Don't be surprised if it's a downward revision, perhaps not to negative territory, but downward. By the second or third revision, it could well be a negative number. And, whether or not the 2nd Quarter number is revised downward, the 3rd Quarter GDP number could very well come in at an outright negative number if the sharp falloff of demand deposit growth holds meaning.

So far, the only suggestive evidence of weakness, besides a long topping formation in the stock market that began, perhaps not coincidentally(?), in late February, is a small drop in the last Leading Indicator number and relatively weak retail sales figures for the past few months. If we are in a recession, the news generally lags the event itself and upcoming announcements will confirm it.

Note, by the way, that the Federal Reserve had precious little to do with initiating any recession that might result, and that it also will have precious little to do with ending it, having boxed itself in from a policy perspective as explained in a recent post.

Thursday, August 20, 2015

Has the Federal Reserve Made Itself Irrelevant?

The previous Monetary Policy posts explained why the Fed has essentially lost control of the money supply. By "lost control," I don't mean that it's out of control to the upside, but that the Fed simply doesn't control the level of the money supply any longer due to the operational changes they've made since the 2008 financial panic.

How Does the Fed Control Money? Their Answer

The Fed has always operated as though they controlled the money supply and ultimately the price level, i.e., the rate of inflation, by manipulating short term interest rates. If the short term rate was too low, people borrowed more, the economy grew faster, and the money supply and possibly the inflation rate would increase in response. To slow the process, the Fed would raise rates.

Today, under their own view of how monetary policy operates, clearly the Fed has to a considerable extent lost its power to influence economic growth. The short-term rate is essentially zero and has been for years now, but the economy continues along a slow growth path with low inflation. And even to achieve that, the Fed had to augment its normal operating procedures with the QE's.

As some are now beginning wonder, what would the Fed do if the economy slowed today?  With short rates nearly zero, driving them a bit lower is unlikely to change anything. More Quantitative Easing, perhaps? Negative interest rates for savers? Or just admit that the current operating procedures don't work because, clearly, they don't.

How Does the Fed Control Money? The OnTrack Economics Answer

The previous posts on monetary policy described a "strong form" of monetary policy by which the Fed has direct control over the level of the money supply. Following an injection of excess reserves, money grows. Then the economy responds and eventually the price level (inflation) responds. Similarly, withdrawing reserves shrinks money, causes the economy to contract, and puts downward pressure on the inflation rate. This is a model that can be shown to have worked in the past. Furthermore, it's the most obvious operating procedure to deploy in a system of fractional reserves, but one the Fed has apparently never consciously adopted.

Unfortunately, because the Fed chose to implement the QE strategy, it now finds itself in a position where it will be extremely costly (to the Fed itself and, by extension, to the taxpayers) to adopt the approach indicated by the strong form of monetary policy. An earlier post explains how the Fed is now exposed to losses of both portfolio value and annual income on the order of hundreds of billions of dollars should it attempt to return to a time when the level of excess reserves in the banking system averaged just a few hundred million dollars, as would be required to implement the strong form.

The Obvious Conclusion: The Fed Is Now Irrelevant to its Purpose

Sure, the Fed can still cause all sorts of economic mischief. It can leave rates low, penalizing savers, pumping asset markets, and protecting the most massive positive carry trade of all time (on its own books), or it can seek to drive them into negative territory by issuing regulations that deter large banks from taking on additional deposits. Alternatively, it can start raising rates, but to what purpose? The increases it suggests it will take are extremely modest and will have little effect on either the economy or the inflation rate, so why bother, except perhaps to reduce political pressure from savers incensed by ridiculously low interest rates?

Meanwhile, as a testament to the Fed's current irrelevance, the money supply, the economy, and prices, will fluctuate unimpeded by anything the Fed does. The $2.5 trillion of excess reserves in the banking system assures that. If the economy starts to heat up, the reserves are there to permit a rapid expansion of the money supply, an expansion that the Fed will be unable to halt without neutralizing the entire balance of excess reserves. Until those reserves are somehow neutralized the money supply can grow unimpeded, without any sort of a governor to keep it in check. That doesn't mean it will, but it can, and it might.

And if the economy starts to once again contract, they're out of ammunition. The banking system could contract and nothing is in place to halt the contraction because the Fed has rendered the level of excess reserves irrelevant. Ironically, in doing so, the Fed unwittingly made itself irrelevant as well, as we are now seeing.

Perhaps it's finally time to bring this grand, failed, financial experiment to an end and rewrite the Fed's mandate?

Monday, August 17, 2015

Positive-Carry Trades Often End Badly

A positive carry trade in the bond market is relatively easy to understand. Usually longer maturities yield more than shorter maturities, and weaker credits yield more than stronger ones. Buying a long bond and financing it by borrowing in the short term market thus yields a positive earnings spread each day the trade is on the books. Any decline in the price of the long bond must, of course, be deducted from that positive spread to evaluate the profitability of the carry trade.

How Carry Trades Start, and Tend to Build

When the Fed is perceived to be in an easing stance bond traders tend to start carrying more long bond inventory, financing that inventory in the overnight repo market. Both sides of the trade stand to make money, with the financing cost dropping the longer the Fed eases, and with the price of the long bond generally rising over time in response to the easing.

As profitability in the original trade grows, more risk tends to be taken. That is, the carry trade position tends to increase in magnitude. More bonds are bought, at successively higher prices, the price continues to rise, financing costs continue to fall, etc.

How Carry Trades Tend to End

As with any successful investment (to that point), the first entrants tend to do the best, often because they are just better at assessing trends and risks, but sometimes because they just got lucky. In time, the success of the carry trade draws more and more participants, the result being that the bond market gets overloaded with traders all on the same side of a trade, long bonds being financed short.

The ending is often brutal, with an unexpected Fed tightening or, more likely, an unexpected Fed announcement of an impending policy reversal, causing a fall in bond prices. Those last into the trade, already underwater immediately due to the drop in the asset they hold and faced with an impending increase in financing costs to boot, begin to exit the trade. Others try to follow and some even try to set short positions.

The net result is that those who entered the trade late suffer losses that can be significant, but those who entered early end up quite satisfied with the net result. Carry trades are very popular because, all things equal, they make income with each passing day. Plus, markets, particularly short term markets, tend to trend due to the influence of Fed policy (which always trends.)

The Federal Reserve's Perfect Carry Trade, Established by Law

Until recently the fed enjoyed the perfect carry trade, an unending guaranteed profit established by law.

Every dollar bill and piece of change held by individuals, businesses, and foreigners was first issued by the Fed to a bank in the banking system in exchange for an equal amount of that bank's reserves held at the Fed. That is, the banks traded bank reserve balances for actual currency. Since currency in the vault counts toward meeting reserve requirements, the bank was unaffected.

Not so with the Fed, however. The Fed issues a nearly costless piece of paper to the bank, a piece of paper that represents a liability to the Fed (which is why they all say Federal Reserve Note on them). Offsetting that liability is an asset portfolio that typically was composed of short term maturities like U.S. T-Bills. Similarly, in the past the reserves that banks were required to hold at the Fed were costless, in that until recently the Fed paid no interest on those reserves.

Thus, virtually all of the Fed's liabilities were costless and all of their assets earned the short-term rate available at the time. The perfect carry trade, always profitable, persisting forever, and even growing steadily as the economy and associated money supply expanded over time.

The carry trade was exactly the reason that the Federal Reserve, even after paying all of its operating costs, could remit a significant profit to the U.S. Treasury (and thereby to the taxpayers) each year. One is even tempted to wonder whether the excessive money growth that has been a constant feature of monetary policy ever since the Fed's inception might be due to the carry trade doing better the more the money supply grew.

The Largest, Highest-Risk, Carry Trade of All Time

Over the past several years the Fed has:

1. Decided to pay interest on reserves, thereby exposing the financing side of its carry trade to a new financing risk.

2. Decided to shift its portfolio massively to the long end, thereby exposing said portfolio to the risk of future market fluctuations in bond prices.

3. Decided to increase its portfolio to around $4.5 trillion from a bit under $1 trillion a few years ago.

In other words, should interest rates now rise the Fed will see it's financing costs rise, its portfolio likely fall in value, perhaps significantly, and will be subject to losing on both ends of a $4.5 trillion portfolio.


When a federal agency under the direct control of Congress takes it upon itself to turn a sure annual gain for the taxpayer into a highly risky gamble for said taxpayer without first taking it to Congress for discussion and approval, but just goes ahead and does it on its own, it's time for Congress to intervene. Here are three suggested questions at any future hearing:

1. How much price risk does the Fed portfolio have under various assumptions of rising rates?

2. How much of an income hit will the Fed take under various assumptions of rising rates?

3. Do these risks in any way compromise the Fed's decision-making process, especially when considering whether to raise the short term rate of interest?

Now, admittedly, the Fed has earned a lot of money over the past several years while carrying this trade and that should be taken into account. However, they've also completely overwhelmed the Treasury's decision to extend the maturity of the debt at historically low interest rates, a fact that will be made clear should interest rates ever rise to the point that the Fed runs at an annual deficit and has to go to Congress for its funding, rather than remitting funds annually as it has typically done.

For some concept of the likely outcome in a rising rate environment see the post that started this recent series of posts here at OnTrack Economics: The Fed's Massive Conflict of Interest.

Tuesday, August 11, 2015

Monetary Policy: Part 6 - Getting from Here to There

In 1980 establishing monetary policy based on the strong form of monetary theory described in the previous posts would have been a relatively trivial matter, both operationally and politically. In fact, without the advent of NOW accounts in late 1980 that might have actually happened. I was at the Tennessee Consolidated Retirement System until mid-1979 and from my position as Bond Portfolio Manager I had excellent access to the writings and thinking of most of the prominent Wall Street economists at that time.

One of them, H. Erich Heineman of Morgan Stanley in particular, had started to home in on the concept of Effective Reserves by the time I left Tennessee. Had NOW accounts not been authorized, I suspect that he, or one of his fellow economists, would have discerned the relationship I described in previous posts. I know he suspected it, but the advent of NOW accounts destroyed the operating environment in which the strong form of monetary theory operates.

A Brief Summary of the Desired End Point

1. Demand accounts need to be the only accounts for settling day-to-day transactions and must not bear interest. That ensures their minimization by users.

2. Savings accounts must carry at least a modest interest rate of 2% or so. That ensures that they will be preferred over leaving unused funds in checking accounts. The Fed can easily manage fed funds so that short rates stay above a 2% floor. (Note: While this point will be controversial, the Fed managed to put the fed funds rate exactly where they wanted it year after year for over four decades.)

3. Bank reserves must not bear interest. That ensures their minimization by the banking system.

4. The Fed should then adopt the strong form of monetary theory and begin to supply a consistent level of total reserves to the banking system, letting interest rates go where they will, even on fed funds.

5. Congress should restrict the Fed's mandate to one, and only one, purpose, that being to maintain a steady price level, neither deflationary nor inflationary. They should have no mandate for seeking to manage economic growth whatsoever.

So, How to Get from Here to There?

The toughest part will be forcing the Fed to take either a tremendous loss on their current portfolio of long maturity debt or to pay what will likely be on the order of $100 billion a year to banks out of their operating earnings. This will be necessary because for the strong form of monetary theory to be implemented around $2.5 trillion of Excess Reserves currently in the system have to somehow be either removed or neutralized.

Removing them permanently will require the Fed to sell well over $2.5 trillion of their long maturities. Why "well over"? Because as soon as the market realizes that's the way it's going to go, the long end of the market will take a huge beating and the Fed will be selling its portfolio at a significant loss, on the order of hundreds of billions of dollars as explained in an earlier post.

Neutralizing that amount of excess reserves without liquidating the Fed's portfolio will require the Fed to pay the banks to sit on the excess reserves rather than circulating them, for if the fed funds interest rate rises above the 1/4% they're now being paid, they will circulate them. This might partly explain the Fed's relatively recent interest in a long-term repurchase agreement facility, incidentally. If they did a one-year reverse repo with the banking system today at, say, 2%, they'd lock in their cost of neutralizing them at only $50 billion for the year. Of course, they'd have to take a similar action a year later at the rate prevalent at the time, whether that be 2% or 6%.

This is all doable, by the way, although the likelihood of the current Fed doing it would be about zero even if they suddenly bought into the strong form of monetary theory. It's just too big a hit, regardless what direction they go, so they'll either muddle along for another decade or so or be forced to take action by a change in the laws under which they operate.

Question: What About Seasonal Needs for the Money Supply?

The Fed has always operated on the assumption that the economy needs an increase in the money supply around the holiday season and has obliged by providing the reserves needed to support that increase. But what if they didn't?

Two things would happen. First, interest rates on short term funds would rise around the holidays, both on short-term savings balances and particularly on fed funds, for there would indeed be pressure to round up demand balances to pay for the increased economic activity. However, the second thing that would happen is that savers would come to expect higher interest rates during the holidays and would concentrate the lending of their money on those periods. Thus, higher rates would make more funds available. The effect on demand balances is simply that they would circulate more rapidly during holidays, rather than increasing as they traditionally did.

This takes some thinking through to understand how it will work out. For example, what if too many people tried to convert savings accounts to demand accounts? The fixed level of reserves supplied by the Fed wouldn't support the increase so, again,  what would happen? Everyone's reserve requirement would go up, but the reserves wouldn't be provided, so the fed funds rate would increase, perhaps by several percent. But that would also cause interest rates on short-term savings deposits to rise, thereby pulling money back into savings from demand accounts.

Perhaps a case could be made for giving the Fed some seasonal flexibility, but it would be interesting to first see what would happen if they didn't have it. For as the QE's have shown, if you give a bureaucracy some flexibility, they will use it to the utmost.

A Note to Congress: Is This Really What You Authorized?

A decent case could be made that the Fed of the middle decades of the 20th Century already had too much power to influence events. They really could, if they wanted, implement policy in a way that would influence elections. Maybe they even did that once or twice. Who knows?

But the Fed of the past decade has taken actions never, ever, anticipated in the law authorizing its existence. The entire purpose of the three QE's, for example, was to directly influence rates at the long end of the debt markets. In doing so their actions also had a direct bearing on stock prices, commercial real estate prices, art prices, home prices, etc., all while driving savings rates to nearly zero for every retiree in the country who had been relying upon a CD portfolio for income. Did Congress ever intend to delegate such power? Ever?

Not only that, but during this time of exceptionally low interest rates, the U.S. Treasury has made a concerted effort to extend the maturity of the U.S. public debt. That action has been entirely contravened by the Fed as it purchased those same maturities and placed them back in government hands, i.e., their own portfolio. Thus all of the Treasury's efforts have been in vain and the taxpayers will foot the bill should rates eventually rise, for it is the taxpayers that will be on the hook for the eventual losses the Fed is forced to take to restore some measure of normalcy to monetary policy.

Conclusion to Monetary Policy, Parts 1 - 6

The original purpose of OnTrack Economics was to set forth The Strong Form of Monetary Theory where people might eventually find it. If you've examined earlier posts, prior to this latest burst, you'll probably have come across my earlier 2001 paper, A Monograph on Monetary Policy, explaining the theory, and much of the content of these recent posts, all in one place. What the paper didn't anticipate, however, is the off-the-rails policies pursued by the Fed for the past several years. These recent posts explain the policy again, but also address the issue of how to restore the original Fed operating environment for without that step, the strong form can't be implemented.

Also, if you do read the paper, written in 2001, note that at the end it described Japan's deflationary dilemma at the time, prescribes a way out, but also warns that following in their footsteps by allowing rates to fall to near zero could lead to a similar decade of performance here in this country. For those not fortunate enough to see their asset portfolios increase, the last decade feels very much like that as they continue to endure falling real incomes year after year.

We can do better.

A Closing Note: I suspect that this will be the end of this burst of posts unless someone takes note of the material here and wants to explore it in more detail. Should that happen, I'd be more than willing to flesh out the ideas put forth here, as well as attempt to counter the inevitable objections.

Monday, August 10, 2015

Monetary Policy: Part 5 - The Perfect Monetary Policy

The previous post describes an alternative theory of money growth. I prefer to call it The Strong Form of Money Growth, contrasting it to the Fed's long-term adherence to what is clearly A Weak Form of Money Growth.

The Strong Form Versus the Weak Form

As already described in previous posts, the Fed has always operated as though money growth is a result of demand rather than supply. That is, they first adjust interest rates in the hope that a rate increase or decrease will cause the desired change in economic activity, after which the demand for money will adjust accordingly. Then, as money demand adjusts, hopefully in their preferred direction at the time, the Fed supplies the new amount demanded. This is a weak form of money growth because it requires such a significant lag time for the level of money supplied to adjust.

In the strong form described in the previous post, the money supply adjusts almost immediately in response to the infusion of a larger-than-needed supply of excess reserves. Markets, other interest rates, and the economy then adjust accordingly. Thus, in the strong form, the Fed has absolute control over the supply (not demand, but supply) of money in the economy.

One might ask why the money supply always tended to grow then, and rarely dropped, even in recessionary periods, during the 60's and 70's. This was probably due to the Fed treating daily reserve provision as a routine process, one in which they wanted to ensure that the reserves to cover the banking system's daily needs were almost always present. Then, when they did make a mistake, it tended to be because they added a modest amount of reserves that weren't needed at the time, then locked in the resultant increase in the money supply by following their normal routine of supplying the needed reserves. They were operating assuming the weak form of money growth, so any growth was viewed as a reaction to rates rather than to the reserves supplied earlier.

Monetary Policy Implications of the Strong Form Theory

If the strong form of monetary theory is correct, then the Fed has absolute control over the amount of money circulating in the economy at any given time. Suppose this to be the case. Several issues immediately arise

First, if it's conceded that inflation is caused by increasing the money supply beyond what is needed, then the primary goal should be to stabilize the money supply. Under the strong form, this is trivial, and could indeed be done by one person at the Fed with access to good data and a computer program. Just assign that person the task of keeping the seasonally adjusted level of total reserves in the system constant.

Second, it immediately becomes obvious under the strong form that the Fed is capable of causing recessions any time they desire. This assigns the Fed Chairman and Board so much power that their mandate should be changed so that the direction of economic activity is of no concern of theirs. That is, maintain stable money and let the real world work out why economic activity is going up or down. For if the strong form is reality, it's quite clear the the Fed would be capable of deciding presidential elections simply by ensuring that the current administration goes into the election either burdened with an ongoing recession or being carried along on a monetary boost. Recessions, in particular, often decide presidential elections. In fact, it's quite likely that the Fed has, in the past, decided a few without intending it.

Third, again assuming the strong form is correct, adjustments could, and should, be made to the rules under which the banking system operates so that the Fed isn't frustrated in its effort to maintain a stable money supply (and price level.)

Adjustments Suggested if the Strong Form is to be Implemented

Demand deposits should no longer earn interest. Why? Because that ensures that people will minimize them in their personal and business accounts. It's the minimization that makes the strong form work. Without it, the Fed won't know if funds in the system are being held for transactions (demand balances) or instead constitute savings balances, and it's demand balances that generate inflation in the strong form, not savings.

To ensure minimization of demand accounts, the interest rate on savings should be a rational positive number, not zero or near-zero as is the case today. At an effective rate of zero on short-term savings balances people just let the funds sit in their checking accounts earning no interest, as is the case today. This can easily be accomplished under the strong form. Just have the Fed intervene in the funds market whenever rates fall below, say, 2%. Market participants would soon learn that 2% is the least they should expect to earn on savings balances.

To clearly differentiate demand balances from savings balances, not only should demand balances earn no interest, but they should be the only accounts available for same-day, and probably even next-day transactions. In other words, all debit cards would be issued only on zero-interest demand accounts, and would not be tied to savings accounts. Similarly, a delay of one or even two days would be required to replenish a checking account from savings.

In addition to demand balances not earning interest, neither should the total reserve balances held at the Fed earn interest. This is essential if fed funds traders are to seek to minimize their excess reserves each week. Paying them to hold them would obviously frustrate that process, a fact in evidence today with over $2.5 trillion of excess reserves sitting on the sidelines earning interest from the Fed.

The Zero Boundary Issue

The zero boundary issue, or problem as it is seen by the Fed today, is the thinking that the economy can be so stagnant that interest rates fall to zero, and that once there the Fed loses the ability to cut interest rates further in an effort to stimulate the economy. Implicit in this theory is that money reacts to the economy, of course, and with a lag at that. But the zero boundary issue is really a non-issue under the strong form, particularly if the Fed operates it as described above. The money supply can always be maintained at the desired (stable) level under the strong form. Just set total reserves accordingly.

Then combine a Fed rule that limits it to managing a stable money supply with the operating procedure to maintain the fed funds rate above 2%, and the zero boundary issue disappears. It's still possible that a recession caused by external factors could drop long rates below 2%, but then people would just decide whether to move money shorter or not. They would always be able to earn savings account interest at some part of the yield curve.

Note that nothing is said about the Fed managing the fed funds rate in the strong form argument (with the exception of keeping it above 2%, that is.) The Fed would maintain a stable total reserve balance and short term rates would go where the economy drove them on a day to day basis. This would include the rate on fed funds which would fluctuate on its own unimpeded by the threat of Fed intervention. That is, the Fed should just supply or drain reserves as needed without regard to the fed funds rate at the time. In fact, they should probably intervene at exactly the same time each day, so it would be clear that the interest rate at the time was completely irrelevant.

Getting There from Here

The next post will address the issues the Fed would face in implementing the suggestions presented here. Unfortunately, even if all agreed to do so, the Fed actions of the past six years have placed some significant roadblocks in the way of getting there. The roadblocks aren't impassable although they could be extremely expensive to negotiate.

For some additional insight as to the expense involved, refer to an earlier post: The Fed's Massive Conflict of Interest.

Interestingly, the politics of the matter seem to be lining up in such a way that it might actually be possible to realign Fed policy in the manner described here. Of course, that would mean that first people would have to decide that the strong form of monetary policy is an accurate depiction of reality. That will obviously be the real, and possibly insurmountable, problem.

Continue to Monetary Policy: Part 6 - Getting from Here to There

Friday, August 7, 2015

Monetary Policy: Part 4 - Solving the Mystery of Money Growth

As monetary policy became the focus of many in the bond markets in the 1970's more and more attention was directed to the weekly release of the M1 Money Supply each Thursday after the markets closed. (M1 consisted then of currency and demand deposits.) An unexpectedly large increase, on the order of a few billion dollars, often tanked the bond market, whereas an unexpected drop of a billion or so would generate a rally. Not everyone became a monetarist, but most market participants paid attention to the money numbers at the time.

The Fed's Operating Procedure Then and Now

When the money supply rose above a band the Fed considered prudent, it would tighten policy eventually. The way it did this was to intervene in the fed funds market, draining funds unexpectedly. That action would convince fed funds dealers that they needed to conduct their transactions at a new, somewhat higher, interest rate level. They would soon learn, from further Fed interventions, whether that new level was a quarter, a half, or a full percent, higher than the previous level.

The Fed was operating under the theory described in a previous post, i.e., that raising short rates would cause all rates to increase, thereby eventually slowing the economy and, along with that slowing, the demand for money would also slow. As also described in that post, this was a long and uncertain process resulting in many pauses along the way and usually culminating in an overshoot as the Fed found itself tightening during what would eventually be determined to be the start of a recession.

Today, the Fed still operates under the same theory but finds itself in a bind because zero percent on fed funds doesn't seem to be low enough to generate the economic recovery they anticipated. Thus, we got QE1 through QE3 and the Fed attempted, successfully, to lower the interest rate on longer maturities by taking direct action.

The Fed Funds Market Operating Procedures

Following my realization that Effective Reserves was a better indicator of the Fed's actual policy than was the M1 money supply, I started paying closer attention to other weekly monetary events. One of these was the behavior of the fed funds rate on Wednesdays. Each week, every bank in the system had to settle its books with the Fed at the end of trading on Wednesday. That is, their final average reserve balance for the period was calculated at close of business Wednesday. That was matched against their required balance as determined by their deposits for the previous week, ending Wednesday. That is, required reserves lagged deposits by one week.

There was one additional feature in the system. If a bank was either long or short on its required reserve balance on one Wednesday, it could carry forward the balance against the next week's requirement. So, for example, if it was short $5 million at the end of week one, it could make up the shortfall by ensuring that it held an extra $5 million at the end of week two.

That particular feature meant that when there was a surplus of fed funds in the market for whatever reason, the fed funds rate would come under some downward pressure on Wednesday afternoon, but not undue pressure. After all, any extra balance could be applied against next week's reserve requirement, so why sell funds cheaply? However, if that surplus remained in the market at the end of week number two, the banks as a system simply didn't need them, so they sold them at any price because they couldn't carry their excess forward for another week.

The result was that a surplus of excess reserves in the banking system would drive the fed funds rate to exceptionally low levels on the second week, sometimes as low as 1 or 2 percent even when rates were far higher during the remainder of the week.

Another Personal Discovery: The Real Source of Money Growth

On Thursday afternoon, the Fed would announce last week's M1 number and the current week's excess reserve figure. I soon noticed that the excess was usually abnormally high, on the order of $400 to $600 million, during week's when the fed funds rate plunged on Wednesday afternoon. And because the process really began a week earlier, it was also unusually high the preceding week.

Over a period of a few months I began to notice a pattern to the occasional unexpected money bursts that would occur. When two consecutive weeks of a high excess reserve position occurred, then the M1 number released a week later would show a significant increase. Also, quite often, the excess reserve position would again be unusually high and would have been presaged by another weak fed funds market the day earlier, on Wednesday.

So, I started to wonder. Is the money supply somehow responding almost immediately to the extra reserves in the banking system? Eventually, I decided that was the case. Somehow, the system was circulating the excess in a way to generate a rapid increase in demand deposits. And since during those consecutive weeks when the banking system as a whole was in an excess reserve position, every funds desk manager was desperately trying to get the reserve position back down, it seemed a reasonable conclusion that somehow those rapidly circulating reserves found their way into customer demand balances, perhaps via overnight loans too cheap to pass up. Regardless, that was the pattern.

Some Evidence That Was Indeed What Was Happening

I wish I had it at hand. I had it and later discarded it, so I'll describe it instead. There was one particular year, either 1977 or 1978, I believe, during which over 100% of the M1 money growth that year could be accounted for by adding up the increases in M1 that were announced during the specific periods I described above. That is, there was a three week period of high excess reserves in the system accompanied by an immediate burst in M1. As I recall there were five, perhaps six, such periods in the entire year. More than 100% of the year's growth in M1 were associated with those periods. The rest of the year, consisting of about 2/3 of the weeks in the year, M1 actually fell.

If someone chooses to investigate the above claim, all that need be done is go back to the weekly reports of excess reserves and M1 issued at that time. Why at that time? Because seasonal adjustments smooth out historical data. You'll need to look at the original data. The most likely year was 1978.

A New Theory: The Hot Potato Theory of Money Growth

Eventually I concluded that excess reserved do indeed feed rapidly into demand deposits. I believe this happens because the managers on the funds desks are selling reserves with such abandon on the relevant weeks that the money simply gets lost in the system. Not really, of course, but loans get made, particularly overnight and very short term loans, and those loans get deposited in another bank, whose funds desk manager then discovers them, sells the resultant excess to another bank, another loan is made, and the process continues until the end of trading is called. When the accounting is made, someone ended up with the hot potato.

Mistakes Then Followed Mistakes

Interestingly, the Fed's ongoing use of a different theory of money growth, i.e., that interest rates affect the economy which only later affects money growth, kept them from correcting the erroneous infusion of excess reserves. After a money burst, the Fed would recalculate everyone's new required reserve balances and would then supply those reserves accordingly, instead of acting as would be indicated here, and simply take them back out again. Had they done so, the process likely would have reversed itself, with loans being taken off the books just as fast as they went on in the excess weeks, and M1 would have dropped to its previous lower level.

Instead, by supplying the newly-required, higher, level of reserves, the Fed effectively locked in its earlier mistake and the burst in M1 became permanent.

The next post will summarize the implications for Fed policy had this all been realized back in 1980. Unfortunately, subsequent events overran these discoveries, rendering them all but irrelevant today.

Continue to Monetary Policy: Part 5 - The Perfect Monetary Policy

Thursday, August 6, 2015

Monetary Policy: Part 3 - The Stable Decades (cont.)

The Federal Reserve spent the four decades after WWII targeting the level of interest rates, and in particular the overnight fed funds rate, with what could only be considered disastrous results. The 50's were marred by recession after recession, four in all. The 60's saw modest inflation result in government-imposed price controls followed by a resurgent inflation when they were dropped later. And the 70's saw a serious recession followed by the infamous "stagflation" when a stagnant economy was paired with near-double-digit inflation and long-term treasury rates bordering on 10%. The early 80's saw nearly 20% short rates, 14% long rates, and another serious double-dip recession. This track record hardly qualifies as a success for the Federal Reserve in that era.

But Stability Reigned in the Operating Rules

Yet, that was the time frame during which the Fed's operating rules remained relatively stable. It was also, not coincidentally, a time when a growing number of both monetarists and investors became interested in monetarism as a theory that explained what was happening to both prices and economic activity.

This was a time when so little changed in the system's banking rules that patterns began to appear, patterns from which deductions could be made and conclusions drawn. In fact, by 1980 a few prominent economists were beginning to home in on what was really going on with monetary policy. Then the introduction of NOW accounts blew it all out of the water.

Lessons to be Learned from the Stable Decades

At this point I'm switching to first person for a bit because this is a personal story of discovery. By 1975, as bond portfolio manager at the Tennessee Consolidated Retirement System in Nashville TN, I had become seriously interested in monetary theory. At that time the Fed of St. Louis branch of the Federal Reserve was the keeper of the Monetary Base, a measure of bank reserves, currency in circulation, and an adjustment factor that they calculated to account for the occasional (then quite minimal) changes in reserve requirements from time to time. They put the Monetary Base forward as a leading indicator of both money growth and the economy, a concept that I found interesting and useful.

Then, sometime in early 1976 I had a Eureka moment. Inflation by then had accelerated significantly and people were finding that cash didn't go as far as it used to go. Or, more accurately, the cash in one's wallet didn't last as long as it needed to before the next regular infusion. It suddenly dawned on me that the currency we all carry, or did then before debit cards at least, was an exceptionally stable amount and was increased only reluctantly, and in response to inflation that had already occurred. That was the insight, the Eureka! For at that time currency in circulation was a large component of the Monetary Base, but the Monetary Base was considered a leading indicator of money growth, economic growth, and inflation. But, clearly, people were reacting to inflation by increasing the money in their wallets, not the reverse. Virtually no one rationalized that inflation would be high over the next year so they'd better prepare for it by starting to carry more cash.

Assuming you buy that rationale, which I obviously did, the first question that arises is: "What is a lagging indicator of inflation (cash in your wallet) doing in a leading indictor of inflation (the monetary base)?" The obvious answer, to me at least, was that it doesn't belong there at all. So I took it out.

That left a much smaller number that consisted only of Total Reserves plus the Fed of St. Louis's adjustment factor, a number that I began to refer to as Effective Reserves. And that was a far more interesting number.

The Role of Effective Reserves and the Economy

In a future series of posts I might reanalyze the data from 1946 to 1980. I did it years ago and later discarded the original data. Today, that data is not readily available due to the many seasonal adjustments that have been applied over the succeeding years. I've looked at the current data and some of what I'll now describe can still be discerned, but it's not as convincing as the originally-reported data. I'll leave it at that.

What I found was that whereas the twists and turns in the M1 Money Supply (which was followed closely by most monetarists at that time) would indeed presage both economic turns and inflation, it was far less sensitive than Effective Reserves.

In fact, almost without fail for over 35 years any economic slowdown was presaged by a plateauing and sometimes a downturn of Effective Reserves that began almost exactly six months earlier. And if Effective Reserves turned back upward at some point (as it inevitably did) the economy would begin to recover almost exactly six months thereafter. There was a point in the late 1970's where you could count on a surprising drop in retail sales, for example, just by noting that it had been nearly six months since Effective Reserves topped out.

Effective Reserves and Inflation

What I found with inflation was equally interesting, and informative. If Effective Reserves and the GNP Deflator (its name at the time) were each indexed to 100 in the late 1940's the Deflator then tracked Effective Reserves with a lag for the next 40 years, with one notable exception. That was during the price control era of the early 1970's. President Nixon implemented price controls when inflation was running what later turned out to be a relatively modest 4% or so (as I recall) and inflation naturally slowed, or at least prices stopped rising.

However, Effective Reserves did not stop their steady rise and so the spread between the Effective Reserves line and the GNP Deflator line began to widen, with Effective Reserves outpacing the Deflator. This marked an incipient inflation, as it turned out. When price controls were eventually removed inflation picked up, eventually rising faster than the Effective Reserves line, for it had some "catching up" to do. Thus, ironically, the Carter inflation of the late 70's could actually have been a hangover effect from the Nixon price control era. In the end, the lines converged once again.

Volcker than took over the Fed and tightened viciously, driving interest rates on fed funds to nearly 20% because that was the theory the Fed operated under. Rates had to go up to get inflation under control.

But inflation was already under control according to the Effective Reserves measure. It had already plateaued and the Deflator had nearly caught up to it. According to the Effective Reserves measure, inflation was conquered and the economy was in trouble. The aftermath consisted of a serious double-dip recession and the commencement of a sustained drop in the inflation rate for almost 20 years resulting in the Fed of the early 2000's having to worry about possible deflation.

Question: Why Would Effective Reserves Track with the Deflator in a Growing Economy?

That is, why wouldn't a growing economy require a larger money supply to keep prices stable instead of falling. This question nagged me a lot during the 70's and early 80's and the best I could come up with, since the two measures tracked so reliably, is that the banking system has a productivity factor just like any other industry.

So, if economic growth required, say, 3% more money each year just to hold prices stable, and the banking industry got, say, 3% more efficient at pushing people's money around from place to place, perhaps it would even out. That's obviously speculation on my part, but it seems reasonable, especially since we had 40 years of relatively stable banking rules so any adaptations would be gradual, rather than sudden reactions to changing rules.


The evidence indicated to me that turns in Effective Reserves presaged both economic turns and changes in the rate of inflation. So if the Fed wants to keep inflation under control while not causing undue declines and accelerations in economic conditions, they should have simply targeted Effective Reserves rather than the fed funds rate.

By targeting, I mean that they should have sought to keep them stable, not rising or falling, either of which tends to influence economic growth. Instead, let the economy react to real factors, rather than fed-induced ones, and worry mainly about keeping inflation in check.

In the next post I'll describe what I learned about money growth in response to Fed actions, and how it is that I believe that maintaining a stable money supply was a trivial matter under the operating rules of the stable decades, although that was rarely achieved due to the theory the Fed was operating under at that time.

Continue to Monetary Policy: Part 4 - Solving the Mystery of Money Growth

Wednesday, August 5, 2015

Monetary Policy: Part 2 - The Stable Decades

This next few posts discuss the operation of monetary policy from WWII through to 1980 when NOW accounts were suddenly introduced. These were the stable decades in terms of the operating environment, although they were anything but stable in terms of the results. The instability of results had nothing to do with the operating system, but everything to do with the operators, for the operators simply didn't understand how the system actually functioned.

The Perceived Role of Interest Rates

For most of the Fed's existence up through 1980 the economic theory relied upon, and espoused, by the Federal Reserve held that the level of interest rates govern economic activity. This remains true to the present day, by the way.

Thus, if the economy was slowing, the Fed would cut interest rates, while if it was growing too fast and inflation was beginning to surge, it would raise interest rates. Actually it would cut or raise the interest rate, that rate being the rate of interest paid on federal funds in the interbank market. The theory essentially states that rising rates will slow economic activity whereas falling rates will encourage economic activity. Of course, this is true as the activity in the housing market often demonstrates. But it's the wrong theory upon which to base the operation of monetary policy. It's a reactionary policy, and therefore too slow, leading inevitably to large swings in economic activity and inflation.

The Essential Role of Interest Rates

There is only one interest rate that really matters to monetary policy, and that rate is zero percent, for that is the one and only rate that should be allowed on all transaction balances, or what we know as demand deposits, or checking accounts. It's also the rate paid on cash, incidentally. No one earns interest on the cash in their pockets, nor should they be permitted to earn interest on balances in their banks that they intend to be used for immediate purchases.

Why is this important? Why is paying interest on checking a terrible idea? Because it renders the operating mechanism of a fractional reserve system useless. And how does it do that? It makes holders of checking account balances indifferent to how much they hold in checking and how much they hold in savings.

When interest was only paid on savings deposits, people rationally minimized their checking account balances, even when interest on savings was relatively low. Some interest is better than no interest, after all. Similarly, they minimized the cash in their pockets. Importantly, this remained true regardless of the level of interest rates on savings. Again, some interest is better than none and a lot of interest is even better yet, but checking accounts and cash were always minimized by their holders. And as long as they were minimized at the outset, the level of interest rates on savings and other alternatives mattered little to monetary policy. The key to an operational fractional reserve system is the minimization of cash and demand balances by their holders.

Where the Fed Erred in the Stable Decades

Because both cash and checking balances earned no interest, the fractional reserve system in place since the Fed's founding could operate as planned. The problem is that the Fed didn't operate it as planned. Instead, because they followed the economic theory that put the cart of interest rates ahead of the monetary horse, and decided to manage interest rates instead of required reserves. But doing so was painfully slow-acting and often just plain wrong. Time after time, the Fed could be shown to have been tightening (raising rates) well after the economy had already gone into recession.

It generally takes four to six months before a recession is even suspected, much less acknowledged. Acknowledgement might take several quarters. Similarly, the Fed can be shown many times in the past to have been easing well after the economy had already been heating back up. The operating policy using interest rates as a lever of policy suffered from too much lag time to be truly effective. In fact, because of that lag time the Fed really never knew if it had tightened enough but would worry that it had and pause in the effort. This often prolonged the entire process until the Fed finally got ahead of things (or so they thought) and the economy would finally slow (with the Fed still in tightening mode several months after.)

What those operating the Fed at the time failed to realize is that they possessed all they needed within the reserve requirement mechanism itself. Interest rates needed no consideration whatsoever, other than the need to keep short term rates somewhat positive at a minimum, a trivial exercise given their control over the fed funds market.

The next post or two will seek to explain how monetary policy actually operated in the stable decades. Without the Fed's knowledge, it was exceptionally effective at producing the results obtained during that time. That the results were less than optimal is no fault of the operating system, for it performed exactly as programmed by the operators at the time.

Continue to Monetary Policy: Part 3 - The Stable Decades (cont.)

Tuesday, August 4, 2015

Monetary Policy Theory: Part 1 - Fractional Reserves

The next few posts will describe the operation of monetary policy prior to late 1980 when NOW accounts were first widely authorized. NOW accounts enabled banks to begin paying interest on demand deposits, that is, on what were essentially just checking accounts. Prior to the authorization of NOW accounts, checking accounts could not draw interest. NOW accounts were a concession to the rapid growth in money market accounts during the high-interest era of the late 1970's.

How a Fractional Reserve System Works

Under a system of fractional reserves each bank is required to hold a certain percentage of its deposit base in the form of reserves at the Federal Reserve System. For example, if the only form of deposits were checking accounts (demand deposits) and the reserve requirement was 10%, then a bank with demand deposits of $1 million would have to deposit $100,000 at the Fed in a "Required Reserve" balance.

Now assume that only demand deposits are permitted and that the reserve requirement is 10%. If total demand deposits in the system are $10 billion, then the required reserves at the Fed would have to be $1 billion. But the Fed can change the level of reserves in the system at will. All it has to do to add, say, $10 million in reserves, is purchase that dollar amount of securities from the banking system. The bank sends in the securities to the Fed and receives a $10 million increase in its reserve balance at the Fed in return. Because those reserves are not currently needed to be held against deposits they are considered "excess reserves."

And, since the bank doesn't need that additional $10 million as required reserves, it lends out the money either to a customer or by lending it in the fed funds market. As the money circulates from bank to bank, and from customer to customer, and as the economy grows, eventually the total demand deposits in the banking system will rise by $100 million and the $10 million in excess reserves would be converted to required reserves. Thus, by adding reserves to the banking system, the Fed will have allowed the overall banking system (and perhaps the economy) to grow. This is known as a Fed easing.

Effecting a Tightening

To reverse the process, perhaps to cool off an overheating economy or to suppress a rising inflation rate, the Fed withdraws required reserves from the banking system. It does this by selling securities from its portfolio to a bank in the system. Say the Fed wants to reverse the above action. It then sells $10 million of it securities to a bank in the system. The bank takes in the securities and to pay for them has its balance of required reserves at the Fed reduced by $10 million.

Now the banking system has a deficit of required reserves. If the Fed refuses to accommodate that deficit, interest rates will tend to rise and banks will make less loans because they are scrambling for reserves. Ultimately, the deposits in the banking system will diminish to the point where the lower level of reserves is sufficient to meet the reserve requirement.

In theory, this is how a fractional reserve system is supposed to work. That is, to keep the money supply, and consequently the price level of goods and services, stable, the Fed simply provides a constant level of reserves.


The first complication is that all deposits aren't demand deposits. In fact, savings deposits used to be commonly called time deposits to distinguish them from demand deposits. Each holder of a savings account received clear notification when opening an account that the money couldn't necessarily be withdrawn on less than a few day's notice. Demand deposits, in contrast, could be withdrawn (demanded) immediately.

Because time deposits were judged to be a more stable component of the deposit base of any bank, the Fed set a lower reserve requirement on them. In our present example, let's say that's only 2%. When interest rates were low as was the case for most of the Fed's existence up until the late 1970's, savings balances did remain quite stable, growing along with the economy and not reacting to the level of interest rates.

Once interest rates started rising significantly in the 1970's people started looking for ways to maximize the income on their checking balances. Mutual funds began offering Money Market Funds to people in response. In the beginning, they only permitted the withdrawal of relatively large sums at one time, say $500 or $1,000, so that people wouldn't use them in place of their traditional checking accounts.

However, in time the banks managed to convince the regulators to let them compete with money market funds. That led to the introduction of NOW accounts which were essentially interest-bearing checking accounts with some modest restrictions. Once they came onto the scene most people converted their checking accounts to NOW accounts and many blended both their checking and savings accounts into one NOW account instead.

The Problem Posed by Differing Reserve Requirements

Because NOW accounts were really a blend of demand deposits and savings (time) deposits, they more or less destroyed the fractional reserve system in place until that time because of the differing reserve requirements on demand deposits and savings deposits. Suddenly savings deposits weren't stable anymore. Instead they were mixed in with interest-bearing checking accounts. Furthermore, as will be discussed later in more detail, checking accounts (demand deposits) were no longer minimized by their holders since they now earned interest. That, as will be covered in the next post, had major negative implications for monetary policy as it had been conducted up to that time.

The next post will discuss the period between WWII and the introduction of NOW accounts and will describe how the Fed once had a monetary tool that worked exceptionally well, but let it slip out of their grasp with the introduction of NOW accounts because they never actually understood how it worked. In fact, if they had understood, NOW accounts would never have been authorized and money market funds would have had their usage in daily transactions restricted.

Continue to Monetary Policy: Part 2 - The Stable Decades

Monday, August 3, 2015

The Fed's Massive Conflict of Interest

What explains the Federal Reserve's reluctance to raise rates today? The conventional wisdom is that the economy remains soft and inflation hasn't yet shown signs of increasing. While both of these points are to an extent true, the soft economy could well be at least partly due to the serious hit that retirees have taken to their portfolio of fixed income investments, including the near-zero income they've earned on their typical Certificate of Deposit portfolios for the past six years.

Meanwhile, the current administration continues to pile regulation upon regulation to hamstring healthy industries while doing little to encourage economic activity otherwise.

As for inflation, it clearly hasn't spiraled out of control as feared by many monetarists, including myself, although I will argue in a future post that the Fed has relinquished its control over the price level by implementing its recent policies of paying interest on reserves, driving the fed funds rate to near zero, and expanding excess reserves into the trillions (from a few hundred million dollars previously, skipping right past the billions.)

The Conflict the Fed Now Faces: Huge Losses When Rates Go Up

First, let me say that I'm not going to do the sort of research that needs to be done to accurately quantify my claims here. No one is taking this issue seriously yet, so that level of examination of the problem is not yet needed. Others will do it should this conflict finally be taken seriously.

It's sufficient to say that the Fed's current portfolio of long-maturity debt instruments will take a significant hit if they ever return short rates to a reasonable level of, say, 5%. On a long treasury, the hit could be on the order of 25% to 35% of the Fed's original purchase price. And if inflation were to head toward 5% the resulting 8% or so rate on long treasuries could drive the loss to well over 50% of their purchase price.

If we assume the Fed's portfolio has $3 trillion of long securities subject to just a 25% loss in value from their purchase price, the loss would be $750 billion. Now, the Fed has been making money for the past several years by means of a massive carried interest trade since they've effectively financed their long portfolio with funds bearing almost a zero cost, i.e., the fed funds rate. Again, assuming a $3 trillion portfolio yielding, say, 3%, would mean that they've been clearing almost $100 billion per year on their position.

Incidentally, one argument that could be made for the Fed's reluctance to raise rates the past few years it that they want to bank that $100 billion per year for as long as possible so that they have a defense against the criticisms they will receive  over their inevitable losses when they someday are forced to raise rates.

Interest on Reserves Will Aggravate the Losses

The conflict deepens when the relatively new policy of paying interest on reserves is considered. There are only two obvious ways to neutralize the impact of over $2.5 trillion in excess reserve in the banking system. The Fed can either drain them or pay banks to continue to hold them.

Obviously, if they attempt to drain the reserves, they will have to commence selling their massive long portfolio. Such an action would further drive down prices of the securities they still hold, deepening the losses described above.

More likely, however, the Fed will decide to continue paying banks to hold their excess reserves. Currently banks receive a nominal rate, 0.25% (1/4 of one percent) to hold the over $2.5 trillion in excess reserves. That still amounts to a cost to the Fed of over $6 billion a year, however. But if the Fed were to raise rates by 1%, to 1.25%, each increase of said 1% will cost the Fed $25 billion in fees they would have to pay the banks to continue holding their excess reserve balance. Otherwise, they would simply sell them in the fed funds market.

Of course, banks attempting to liquidate $2.5 trillion in reserves they don't need would drive the fed fund rate back to zero again. Therefore, the Fed absolutely must either drain those reserves or pay the banks a high enough rate to continue to hold them. Thus, a 5% funds rate would imply that the Fed must assume a $125 billion annual operating expense if they are to neutralize the current excess reserve balance.

Conceivably, the Fed could do a massive reverse repurchase operation wherein they would lock in a longer-term rate for a time, alleviating the initial impact on their income statement. That is, they might convince the banking system to hold, via a, say, one-year repurchase agreement priced at 1%, the Fed's security portfolio, thereby draining the excess position for a year at a cost of only $25 billion. However, if rates at the end of that year were, say, 5%, the cost of a repeat operation would put the cost up to the $125 billion level for the following year.


The Federal Reserve has created a situation, via the various QE's, that now saddles it with a massive conflict of interest should they need to raise rates. That conflict is comprised of two parts, both parts amounting to hundreds of billions of dollars each in conceivable costs to the Fed.

It would not be at all hard to conceive of a situation in which the Fed's long portfolio is $500 billion underwater all while they are paying the banking system over $100 billion per year to neutralize the excess reserve position they generated when purchasing that long portfolio. One would think that prospect has received some internal consideration when the discussion of raising the fed funds rate comes up.

What is surprising is the lack of any such consideration in the financial markets and the political world. This is especially ironic since it has been the U.S. Treasury's intent to lengthen the maturity of the public debt at this time of exceptionally low interest rates, and yet the Fed has effectively reversed that decision by implementing its massive QE's.

Sadly, the policy hasn't even worked out as intended, enriching bond investors, stock investors, art investors, and real estate investors, but doing little to get the economy and the job markets growing again. And yet it continues. Perhaps the above-described conflicts have more than a little to do with that?