- Thu
- Oct 3, 2013
- Updated: 7:16pm
Does Beijing truly understand the Fed's QE plan?
The exercise of flooding the market with money that people in hard times don't want to borrow may result in quantitative hardening
China has called for greater consultation on the US Federal Reserve's plans to taper quantitative easing to avoid unnecessary risks to the global economy and disruption to currency markets.
SCMP, August 28
I wouldn't ordinarily bother with this sort of talk out of Beijing except that it is an echo of what is now being said by Christine Lagarde, a French labour lawyer who seriously undermined her country's fiscal position as finance minister.
This resounding achievement made her the obvious choice for managing director of the International Monetary Fund. Christine Lagarde loves to talk big at big talk shops but if she advises anything, be wise and place your bets the other way.
The first chart sets out the real economic risk here. It shows you that before 2008 the reserves maintained by US deposit-taking institutions were closely in line with the generally low levels required.
Then, in September 2008, the actual reserves suddenly shot up, to more than US$2 trillion now, even though the required reserve level remained modest. This represents what is called "quantitative easing", a programme of massive bond purchases by the Federal Reserve.
The reasoning had it that the US economy was in a spot of trouble and flooding the market with money through bond purchases would keep interest rates low and liquidity ample, thus allowing the economy to recover quickly.
Unfortunately, it contravenes a rule of the universe more basic than the Ten Commandments of Moses or the Four Laws of Thermodynamics - thou canst not push against a rope.
If people don't want to borrow money, then they simply won't, and in hard times people don't want to borrow money. What they want is time to pay off debt and get their personal or corporate balance sheets back in shape. Until that is done, they don't borrow.
And that is how things have turned out in the US. All that money is just sloshing around the financial system. As evidence, I present the second chart. The velocity of the money supply (GDP divided by M1) has come down sharply since 2008. If quantitative easing had actually kick-started the US economy, as it was expected to do, this ratio would have gone up, not down.
And now here is the danger. At some point the US economy will indeed revive, people will start making use of all that money in the financial system and then the Fed will have to sponge it up with a programme of quantitative hardening.
It is not doing so yet. It just says it may "taper" quantitative easing. But it may have to do a good deal more than this if it is to avoid robbing the savings of an entire nation through a blow-out of inflation.
That's the risk in good times of printing money heavily in bad times and it's a good question whether the Fed has the courage or the political support to raise interest rates sufficiently for the purpose when that time comes.
I wonder if they really understand in Beijing what is at stake here. I'm sure Christine Lagarde does not.
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20Comments
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5:31pm
If you want to control debt, control the money supply and raise interest rates, but then governments around the world would not be able to service their sovereign debts and the whole system starts to crack. What we are in now is a revolving door where nobody can get off.
1:29pm
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(1) Treasury issues securities to supplement tax income to meet public finance needs
(2) Fed “prints” money to buy T securities
(3) banks buy T securities to meet regulated reserve and to park surplus “money”
(3) Fed reserves are banks’ deposits of required reserves and excess reserves
(4) Fed paid no interest on reserves; Treasury pays interests on securities
(5) Feb began (2008?) to pay interest (~0.25%pa) on reserves (>$1.5T 2012)
equal-to-equal, how do – (in your words)
“banks decide whether to keep their money in (short-term) treasury paper, or to sell that paper to the Fed and keep the money in their reserve account there”?
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It depends on rate differentials
Remember OT of SEP 2011?
Even with hindsight, experts can’t agree on its policy effectiveness.
But market realities then were clear that ST T securities were acutely in short supply
Corporate treasurers rushed about looking ways to improve return on “surplus” funds
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Fed reserve is not exactly a closed system
qe and recession will expand reserves volumn
and accentuate interest rates effects thru which it interacts with the market
TH is right
it’s catastrophic
especially as Fed seems desensitized to unemployment
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When David Stockman was budget director
a U Chicago professor argued in every issue of Newsweek
that the US could / should simply write off all debts from its books
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224 words
8:35am
The Fed began paying interest on reserves to facilitate QE. QE is injection of large quantities of (newly printed) money into the market. This is done by buying up government bonds. Paying interests on overnight reserves gives banks increases the incentive for banks to sell government bonds to the Fed. Indeed, the rate differential there (between overnight reserves and government securities) is key.
Fed reserves are a closed system. That is not to say they are fixed. Indeed, they can expand or contract, but only if the Fed allows them too. Again: this is the monetary base you are talking about. The Fed controls the monetary base. No other party can unilaterally alter its aggregate size. Banks do not lend out Fed reserves. Bank lend against their Fed reserves. There is no reason why increased credit creation would lead to a decrease in Fed reserves unless the Fed wants it too.
pslhk, I am sorry but don't think I can explain it any more clearly than I already have. I can only suggest you pick up an economics textbook like 'Modern Principles of Economics' by Cowen & Tabarrok, or read up on the subject elsewhere. I believe I already pointed you in the direction of this post here, which is fairly eloquent on the subject:
****ftalphaville.ft.com/2012/07/03/1067591/the-base-money-confusion/
10:14pm
It has been decades since I last bought any textbook
In any case I checked Amazon and your suggestion is USD191.98
Every summer vacation I spend time loitering in U libraries / bookstores
and return with boxes of books
As textbooks prices goes thru stratosphere
I finally fully agree with J Rogers:
Bright young people who know what they want to do don’t need u education
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This weekend’s FT reviews T Harford’s Undercover Economist Strikes Back
For only £20, the review says it can take readers to “the intermediate level”
Good refresher perhaps for some graduate courses I took decades ago
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The reviewer, a professor, also notes:
macroecon is navel gazing art that ignores intellectual progress in other fields,
and tries to discuss financial crisis assuming nonexistence of banks
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The professor reviewer may be right
Why we each with our own micro preferences
should be so focused on banks and reserves?
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It’s time for a power nap
Have a good Sunday
8:51am
now I've some understanding about how you understand feb operation
I should revisit your good work soonest after taking care of other matters
On return, one of the point I may wish to discuss (if your patience lasts) is:
"if a bank wants to add USD 100m to its Fed reserve account"
We seem to have an agreement on what your deem important
"the rate differential between t bills and reserve deposits"
Again, your care to discuss is very much appreciated
6:41am
for jve to finish the performance of aug 29
copy of my comment
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jve’s enthusiasm about “reserves” is more infective than effective
in the discussion about a prognosis or pro forma obituary of qe
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[The analyses of JvdK and] TH [are] clear and consistent about qe’s effects
in the market on interest rate, fundflow, and prices
[Their] focus isn’t on reserves which have,
as [they] merely noted en passant,
(swollen / intensified / inflected?)
due to the market’s lack of appetite
for investment / consumption
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jve hasn’t explained why he is so overwhelmed by reserves
on which his tangled comments are either hackneyed or nebulous
Let’s see if jve may help us breathe easier and answer three questions:
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(1) “they (Fed?) may … buy more money than they sell” (jve 8:14 on JvdK)
How exactly do they do it / why are there willing sellers of “money” to the Fed?
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(2) What is the average / nominal / indicative spread between
what banks receive for reserves deposited in the Fed and
what they pay to attract the funds (for) deposit with the Fed?
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(3) Answers to the above should help jve explain
the meaning / relevance / validity
of his belief “The reserves are a closed system”
in the discussion about qe’s effects on the market
8:32am
Yet, let me try to answer your questions insofar I understand them.
(1) The Fed conducts 'open market' operations. It is the prevailing method by which it executes its monetary policies. Simply said (although it really is quite a bit more complicated), this means they buy and sell bonds from market participants: the primary brokers, i.e. the major banks. The Fed pays for these bonds with money, which gets credited to these banks' reserve accounts with the Fed. This 'money' basically comes out of nowhere. Voila the fabled money printing. Hence, from the Fed's perspective: they buy and sell money, and get paid for it in T-notes, T-bills and T-bonds. It is by controlling the aggregate of money bought and money sold that the Fed manages the supply of money: that is both the size of the monetary base, an the cost of money (since of course the price of money, ie the interest rate, is always a function of supply relative to demand).
(2) Banks don't attract deposits from customers and then put them on deposit with the Fed. A bank can't just go to the Fed and say 'Hey, I got USD 100m in customer deposits here, please take it and put it on my reserve account. Cheerios.'
8:33am
So if a bank wants to add USD 100m to its Fed reserve account, it has to bring the Fed USD 100m worth of T-bills/T-notes. In other words: it first has to use its new capital (the depositor money in question) to make a loan to the government. That is a very important point: it must first buy the T-somethings from a third party (could be the government even). That third party receives USD 100m in return. Money stays in the system (in fact, it will probably multiply because of factional reserve banking and the money multiplier, but that is a different story). It does NOT just go straight into the reserve accounts with the Fed and sits there.
Hence, the question is not what the rate differential is between customer deposits (this, after all is set by the bank - they can set it to anything they like to attract deposits), and Fed reserve deposits. The key question here is what the rate differential is between short-maturity government paper, and the Fed reserve deposits.
This is the differential that makes banks decide whether to keep their money in (short-term) treasury paper, or to sell that paper to the Fed and keep the money in their reserve account there
8:35am
And no, it isn't about money sitting idly at the Fed. That money in the reserves account is all newly minted. Created out of thin air to pay for all those government bonds the banks have been carrying to the Fed as fast as they can. But remember: the banks don't create those bonds out of thin air. They buy from other parties for real money. This is how the Fed pumps money into the system, and how it increases liquidity in the system. For every dollar that sits in those overnight reserve accounts, somebody somewhere has switched out of a longer maturity government debt instrument and received money in return. Money they will -hopefully- invest, spend or lend out for more productive purposes.
8:37am
So to sum it up again, he large reserve accounts we currently are observing are:
i. The only possible result of QE. Again: there is nowhere else the money can go. A bank can't take money out of its Fed account. It can only decrease the balance by buying back treasury paper from the Fed. It is then effectively making a loan to the government.
ii. A feature, not a bug. The Fed has purposely tried to keep liquidity high. Its aim is to crowd out the treasury market and thus force the bank's capital structure to be as liquid as possible. This is with various goals: reducing the incentive to save for the private sector, increasing the incentive to spend/invest for the private sector, ensuring credit creation is as cheap as it can get, and so on.
iii. Not necessarily an indication of (lack of) lending activity, as discussed in my comments below.
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