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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


Jake van der Kamp is a native of the Netherlands, a Canadian citizen, and a longtime Hong Kong resident. He started as a South China Morning Post business reporter in 1978, soon made a career change to investment analyst and returned to the newspaper in 1998 as a financial columnist.

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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The first (3) is false. That answers the question that follows, which is based on that false assumption.

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:
Thanks again jve
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
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
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
The professor reviewer may be right
Why we each with our own micro preferences
should be so focused on banks and reserves?
It’s time for a power nap
Have a good Sunday
jve, thank you for your kind patience
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
Please let’s take a step back and sideway (to TH), staying on qe
for jve to finish the performance of aug 29
copy of my comment
jve’s enthusiasm about “reserves” is more infective than effective
in the discussion about a prognosis or pro forma obituary of qe
[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
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:
(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?
(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?
(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
You are (hopefully) beginning to see how QE works. There is some debate about this, but the consensus remains that the Fed HAS TO offer a higher reserve account interest than the yield on short-term gov paper. If not, it will have trouble executing its QE objectives. Bank's would not come running with their government bonds to the Fed anymore, if they could get a higher yield on those than they get on reserves. This would complicate matters for the Fed's open market operations. As I said, there is debate about this and how these problems might be overcome and imposing a lower (or even negative) reserve deposit rate might be able to drive the treasury market into negative yield territory too, but it remains a largely academic discussion with little practical purpose at this point.

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.
3) There is no question in 3, but let me assert again: the Federal Reserve System, as in: the reserves private banks hold at the Fed, is (are) a closed system. Banks can not unilaterally decide to change the balances. They can only alter their balances by transacting with the Fed. It takes two to tango, and with unlimited firepower, its sheer size and its far-reaching powers over the treasury markets, it is clearly the Fed who leads the dance there. Transactions between banks may alter their individual reserve accounts (once all is done and settled), but do not alter the aggregate balance of the Federal Reserve System.

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.
With due respect, jve
I don’t think your reference to FRS
and JvdK use of M1 for illustration are determinant
in the right or wrong of this category of arguments
Reserves are not simply an aggregate system
Where it sits it incurs a cost and
that’s partly why recycling dollars
isn’t just a moral obligation of the banking system
Velocity matters not simply to balance the equation
This isn’t pure maths and there are competing formulae
What matters is the more than subtle social consequences
entailed in the dynamics inherent in varying the factors
The Fed began paying interest on excess reserves in 2008 which is the main reason why reserves start taking off around that time. Prior to 2008 banks would make every effort to lend out excess reserves.
This article could have been published nearly verbatim in 2009. When are the inflationary Chicken Littles going to admit they are wrong and shut up?
The need is to decide which is the least devil
After many years of recession
that has taken care of the unemployment issue,
now concealed, structural and accepted
it's no longer a principal Fed concern
With no industrial locomotive in the offing
qe serves mainly welfare functions
and polarizes wealth distribution
As the age of petro-dollar ends
FOOD may be the dollar's new pedestal




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