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
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
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
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