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  • Dec 28, 2014
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Jake's View
PUBLISHED : Thursday, 29 August, 2013, 12:00am
UPDATED : Thursday, 29 August, 2013, 3:56am

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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What I found crazy about this QE is the fact that it claims it will help people to consume more and relaunch the economy.
Actually it just serves the purpose of banks and the market.
Being listed just keep you in a crazy and unstoppable loop. If you don't move you'll die. Hence the QE allows them to keep moving when there are in trouble ie. 2008-9.
Just think it as the movie Speed as we are the passengers, complete victims and have nothing related to the crazy guy who puts the bomb. The only difference is that we don't have a Keanu Reaves and that the speed just keep on increasing.
Lastly then, the velocity of money. Ha ha ha. It is very funny. Apart from the fact that we are well past the era in which V was considered a meaningful measure (the economy has moved on, thank you), Mr van der Kamp shows M1 velocity. This EXcludes the bank reserves he is talking about.

M1 is only coins, bank notes and their near-equivalent like current accounts and short term deposits. It is a very narrow measure.

So it is the wrong measure. But it gets worse, Mr van der Kamp is once again misleading readers by his now infamous selective data practices. Rarely do we see a supposedly 'straight-up' columnist display such rampant intellectual dishonesty.

Have a look at the full graph:

Notice how Mr van der Kamp willfully left out the whole part of it that shows that M1 velocity (a very narrow, and pretty much irrelevant measure, but anyway) is basically at the same level it was for all of the 80s and most of the 90s? How it is really the late 90s and the early 2000s that are the off-the-trend period?

And insofar velocity is relevant, economist ever since the 1980s (thank you Milton), have preferred to look at MZM Velocity. MZM is money with zero maturity, a much wider definition than M1. Beyond MZM, we are really talking about credit instruments.

See for yourself how well MZM V fits Mr van der Kamp's narrative:

Oh right. It doesn't.
(>>> continued)

And also no, if the Fed deems that credit creation is going too fast (inflation etc), it doesn't necessarily have to 'sponge up' the excess reserves. The Fed controls the cost of credit (or attempts to) through its benchmark interest rates: the cost of money. In turn, it executes the price setting of money by open market operations. This has always been the case, long before QE.

If the Fed begins to raise interest rates, it will, as always, use its open-market operations to execute that policy. As part of this, they may deem it necessary to (in aggregate) buy more money than they sell. That would be Quantitative Tightening. Or it may not do so, in practice it has hardly ever been necessary for the Fed to be aggressive in its open market operations, as the market knows very well it is pointless to fight the central bank on the cost of money.

Then, as for the point that QE hasn't been good for the rest of the world, and any future Fed policy might not be good either. Firstly, so what? It is not the Fed's mandate to set monetary conditions for the rest of the world. Secondly, what's new?
Sigh. Mr van der Kamp clearly doesn't understand how monetary policy actually works in a fractional reserve system.

Credit creation in a fractional reserve system is in practice sheer infinite, regardless of the size of the monetary base and regardless of the reserve requirements. Reserve requirement in economies with open capital accounts (note how this is different in China) are a liquidity control measure, not a credit control measure. I stress: the reserve requirements referenced here have nothing to do with a bank's capital structure, and hence nothing to do with its ability or willingness to lend.

Any bank can create 'money' in a fractional reserve system. They can freely create loans insofar their capital structure allows it, and that is, in practice, very, very far (see: pre-2007).

The reserves however (required and excess) are (the lion's share of) simply the monetary base. It is fixed. It cannot be altered except if the Fed allows it to. All monetary base money has to be in an account held with the Fed. It doesn't matter by which bank, it is a zero-sum game.

When banks would start lending more, you will not see any move in these reserves. At best, you might notice a slight move from excess to required reserves, but even that is up for debate given the details on how 'required' reserves are calculated.

(>>> continues)
You really have trouble writing coherently, and there is not much point in trying to have a discussion with someone who writes in loose fragments, without respecting the basic structural requirements for a body of text to qualify as argumentative (or even just explanatory) prose.

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.'
Interesting idea
Try it on the banker who holds >60% of your debt papers
and propose reversed rights and obligations for creditor and debtor
debtor must ensure creditor can honor payment at maturity
creditor should ensure debtor’s depreciation of debt value
A better solution of US debt problem than inflation
The only way a bank can increase/decrease the balance of its account with the Fed is by engaging in transactions with the Fed. And that solely means: the buying/selling of government bonds (see above).

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
jve, has done a good job of analyzing your 'presented' methods of gauging the likely impact of a possible QE plan. I know it goes against the grain for you, but I do notice an absence of qualifiers - I think, possibly, might - in your writing. This was one of the first things I was taught in economics/fiscal policy - we are dealing largely with theories. Perhaps instead of putting yourself up and Beijing and Lagarde down you could save some words/column space and actually publish the full graphs, as jve suggests, and allow readers to make educated guesses about what will happen.
It's a very simple, age old piece of common sense, if you print money faster than the growth of production, prices go up. It's called inflation.
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.
Let’s see if 200 words suffice
(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”?
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
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
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
224 words




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