Fed Watch Thread

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....Let me explain why our enlarged balance sheet does not compromise our ability to tighten monetary policy. Although our enlarged balance sheet has led to a sharp rise in excess reserves in the banking system, this has the potential to spur inflation only if banks lend out these reserves in a manner that generates a rapid expansion of credit and an associated sharp rise in economic activity. The ability of the Federal Reserve to pay interest on excess reserves (IOER) provides a means to prevent such excessive credit growth.

Because the Federal Reserve is the safest of counterparties, the IOER rate is effectively the risk-free rate. By raising that rate, the Federal Reserve can raise the cost of credit more generally. That is because banks will not lend at rates below the IOER rate when they can instead hold their excess reserves on deposit with the Fed and earn that risk-free rate. In this way, the Federal Reserve can drive up the rate at which banks are willing to lend to more risky borrowers, restraining the demand for credit and preventing credit from growing sufficiently rapidly to fuel an inflationary spiral.

For this dynamic to work correctly, the Federal Reserve needs to set an IOER rate consistent with the amount of required reserves, money supply and credit outstanding needed to achieve its dual mandate of full employment and price stability. If the demand for credit were to exceed what was appropriate, the Federal Reserve would raise the IOER rate—pushing up the federal funds rate and other short term rates—to tighten broader financial conditions and reduce demand.2

If the demand for credit were insufficient to push the economy to full employment, then the Federal Reserve would reduce the IOER rate—pushing down the fed funds rate and other short term rates—to ease financial conditions and support demand, recognizing that the IOER rate cannot fall below zero. While the mechanism is different, the basic approach is very similar to the way the Federal Reserve has behaved historically.

Although our ability to pay interest on excess reserves is sufficient to retain control of monetary policy, it is not bad policy to have both a “belt and suspenders” in place. As a result, we have developed means of draining reserves to provide reassurance that we will not—under any circumstance—lose control of monetary policy. These include reverse repo transactions with dealers and other counterparties, auctions of term deposits for banks, or securities sales from the Fed's portfolio.

A related concern is whether the Federal Reserve will be able to act sufficiently fast once it determines that it is time to raise the IOER. This concern reflects the view that the excess reserves sitting on banks' balance sheets are essentially “dry tinder” that could quickly fuel excessive credit creation and put the Fed behind the curve in tightening monetary policy.

In terms of imagery, this concern seems compelling—the banks sitting on piles of money that could be used to extend credit on a moment's notice. However, this reasoning ignores a very important point. Banks have always had the ability to expand credit whenever they like. They didn't need a pile of “dry tinder” in the form of excess reserves to do so.

That is because the Federal Reserve's standard operating procedure for several decades has been a commitment to supply sufficient reserves to keep the fed funds rate at its target. If banks wanted to expand credit that would drive up the demand for reserves, the Fed would automatically meet that demand by supplying additional reserves as needed to maintain the fed funds rate at its target rate. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves on their own balance sheets or can source whatever reserves they need from the fed funds market at the fed funds rate.3

So we have the means to tighten monetary policy when the time comes, but do we have the will? I think there should be no doubt about this. It is well understood among all the members of the FOMC that allowing inflation to gain a foothold is a losing game with large costs and few, if any, benefits.

In this regard, some have argued that Fed officials might be reluctant to raise short-term rates because such increases would squeeze the net interest margin on the Fed's System Open Market Account (SOMA) portfolio. Although it is true that a rise in short-term interest rates would reduce the Fed's net income from the extraordinary high levels seen in 2009 and 2010,4 this will not play a significant role in the Fed's monetary policy deliberations.

Fed policy is driven by the objectives set out in the dual mandate, and the net income earned by the Fed is the consequence of the policy choices that advance those objectives. The Federal Reserve's net income statement does not drive or constrain our policy actions. In short, we act as a central bank, not an investment manager.

It is also worth pointing out in passing that a failure to raise short-term interest rates at the appropriate moment based on our dual mandate objectives would also be a losing strategy with respect to net income. Inflation would climb, bond yields would rise and the Fed would ultimately be forced to raise short-term rates more aggressively, or to sell more assets at lower prices to regain control of inflation. This would almost certainly result in larger reductions in net income than a timelier exit from the current stance of monetary policy.

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I.e., the FED "pegs" interest rates. The FED's monetary transmission mechanism is the now via IORs (remuneration rate on excess reserves).

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oo

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It is said that hedge fund assets (and leverage!) have returned to pre-crisis levels. Surely, global sovereign wealth funds have grown only more gigantic. And it is worth noting that China's "reserve assets" have jumped 46% in only two years to an incredible $2.847 trillion. The world is awash in liquidity/"purchasing power" like never before. This is all worth keeping in mind as we contemplate the likelihood of ongoing unrest in the Middle East and potential supply and price shocks. The Goldman Sachs Commodities Index ended last Friday at the highest level since August 2008.

www.atimes.com/atimes/Global_Economy/MC01Dj02.html

Doug Noland

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In the long run, the law of one price will prevail; the US dollar cannot become so cheap relative to other currencies that a multimillion dollar home in Malibu only costs the equivalent of six month’s wages in Switzerland… or that a new Corvette equals the price of an electric bicycle in Singapore.

www.sovereignman.com/expat/the-market-is-telling-us-that-the-dollar-is-finished/

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What are they teaching in Money & Banking? This will be who your competing against in the markets:

Review Questions for Exam 2, Econ 4560Spring 2010 1.

Central Bank Balance Sheet sa. Before 2007, what was the single most important asset held by the Fed? The singlelargest liability?---

Federal Reserve notes have been the largest liability onthe Federal Reserve's balance sheet.

What are the single most important asset and liability in 2009?

Whats happened to theFeds holdings of US Treasury securities? Why? --

The size of the Federal Reserve's asset portfolio did not increase immediately because it simultaneously reduced itsholdings of Treasury securities following the financial meltdown. Mortgage Backed Securites would be the Federal Reserves largest asset while deposits are its largest liability.

b. Write out the equations we derived for the monetary base (MB) and nonborrowedreserves (NBR).MB = Securities (minus reverse repos) + Loans + CPFF+ MMIFF + LLCs + Swaps +Gold Certificates & SDRs + Float + Other Assets + Treasury Currency O.S. - Treasury Deposits (Genɡl + Supplemental) - Foreign & Other Deposits - Other Liab - Capital Account. NBR = Securities (minus reverse repos) + CPFF+ MMIFF + LLCs + Swaps + Gold Certificates & SDRs + Float + Other Assets + Treasury Currency O.S. - Treasury Deposits (Genɡl + Supplemental) - Foreign & Other Deposits - Other Liab - Capital Account ɢ Currency Held by the Public

1. Suppose float falls by $100m, central bank swaps rise by $300m, and currency heldby the public risesby $50m. What happens to NBR and MB?---NBR and MB will rise

2. Suppose that Treasury Deposits at the Fed rise by $400m, loans through the TermAuction Credit Facility rise by $200m, and the Fed¢Òs holdings of Mortgage BackedSecurities rises by $500m. What happens to NBR and MB?---Both will increase.

c. Using T-accounts indicate the effects of the following events on reserves and themonetary base.---

1. The central bank engages in a $20m open market sale to non-bank governmentsecurity dealers.

2. The Fed makes a $100m loan to banks via the Term Auction Credit Facility.

3. The Fed makes a $200m loan via Primary Dealer Credit Facility.

4. The Treasury sells $5m of its gold to the public and then retires an equivalent amountof its gold certificates previously issued to the Federal Reserve.

5. Suppose the federal government wants to spend $50m more than its tax revenues.a. However, rather than sell bonds to the public, suppose it sells $50m in new bondsdirectly to the Federal Reserve. (This is prohibited by law in the U.S., but suppose it wasn¢Òt). Using T-accounts show what happens to the Treasury and Fed¢Òs balance sheets when bonds are sold directly to the Fed by the Treasury.

Then show what happens when the Treasury spends the funds from the sale of securities. Use t-accounts for the Treasury, Fed, and Private Banks.

Indicate what happens to reserves and the monetary base at each stage of this process.

b. Now, suppose that instead of selling $50m in new securities that the federalgovernment raises taxes by $50m and that the public pays the higher taxes by writing checks on checkable deposit accounts at private banks.

Trace through the effects of this using t-accounts.

Indicate what happens to reserves and the monetary base at each stage of this process.

a. What is traded in the federal funds market? What are the two methods of buying & selling in this market?---

The central bank goes to the open market to buy a financial asset such as government bonds, foreign currency or gold. To pay for this, bank reserves in the form of new base money (for example newly printed cash) is transferred to the sellers bank, and the sellers account is credited. Thusly, the total amount of base money in the economy has increased.

Conversely, if the central bank sells these assetsin the open market, the amount of base money that the buyer's bank holds decreases, effectively destroying base money.

b. Illustrate the determination of the equilibrium federal funds rate using demand andsupply curves.

1. What are the sources of demand in this market?

What is the explanation of the slopeof the demand curve?

Does it matter if the Fed pays interest on reserves or not?

What makes this curve shift over time?

2. Explain the slope of the supply curve in this market and explain what causes thiscurve to shift.

3. Explain why, under the current discount rate procedures, the discount rate sets theupper bound onthe value the actual fed funds rate can take.

4. The Fed has followed other central banks such as the European Central Bank andestablished a©ødeposit facility¢¥ where that pays banks interest on their reserves held at the Fed.Suppose the Fed setthe rate paid on reserves deposited in the reserve facility below the target fed funds rate.

Explain therole of the deposit facilities interest rate in limiting downward fluctuations in the actualfed funds rate.

c. The Fed tries to keep the actual funds rate at the target level, but if we compare theactual funds ratewith the target level, the actual rate may be slightly above or below the target level from one day toanother. Illustrate and explain why this happens.

3. Define what is meant by the term structure of interest rates and briefly distinguish between the expectations hypothesis and the term (liquidity) premium theory of the term structure.

4. Suppose the fed funds rate is 2.5%. Suppose financial market participants expect the fed funds rate to remain at this level for 3 months and then rise to 3.0% for the next 9 months.

Suppose the Fed meets today and immediately raises the fed funds rate to 3%. After this action, financial market participants expect the fed funds rate to remain at this level for a year.

How does the Fed¢Òs actiontoday affect the3-month, 6-month, and 1-year T bill rates?

5. After studying the term (liquidity) premium of the term structure and how the Fed has adjusted thefed funds rate in the past, we argued that a change in the fed funds rate target by the Fed would affect short-term interest rates (1-year or shorter) most strongly, medium-term rates (up to 5 years) next interms of magnitude of effect and long-term rates least in terms of magnitude of effect.

6. Are the results in the Kuttner article we discussed consistent with this? Explain briefly.

7. In a few sentences explain the economic logic of why the long-run AS curve is vertical in a diagram with inflation on the vertical axis and output on the horizontal. (Note: simply saying that an increase inɡ has no effect on Y in the long-run is not an explanation but is merely a verbal description of a vertical

8 Briefly explain why the short-run AS curve is positively sloped. (Again, simply sayingthat an increasein É¡ leads to an increase in Y is not an explanation.) What causes the curve to shift?

9. What are the four components of aggregate demand? What are the major determinants of each type of spending? What is the long-run equilibrium real interest rate? What are its determinants?

10. In discussing dynamic aggregate demand, we used the Taylor Rule as a descriptionof how a centralbank sets its target for the interest rate.a.

What does the Taylor Rule tell us are the most important determinants of the targetreal interestb.

Discuss briefly how a change in each of these determinants affects the target realinterest rate. For example, one determinant of the target real interest rate is the relation between the actual inflation
rate and the target inflation rate. If the actual inflation rate rises above the target rate, we said thecentral bank would raise its target real interest rate in order to reduce spending and push the actual inflation rate back to target.

Provide a similar explanation for the other determinants of the target real

11. Explain the reason our dynamic aggregate demand curve is negatively sloped in a diagram with inflation on the vertical axis and output on the horizontal. How can the central bank affect the slope of the dynamic aggregate demand curve? Explain how the slope is affected.

12. What would cause the dynamic aggregate demand curve to shift? Illustrate.

13. Suppose the economy of the Isle of Lucy is in long-run equilibrium.

a. Illustrate this in the É¡ , Y diagram.

b. Suppose the central bank of the Isle of Lucy decides the inflation rate is too high andconsequently reduces its target inflation rate. Using our model, illustrate and explain the short-run and long-run effects on Y and É¡ of a reduction in the target inflation rate.

c. What happens to the real interest rate in the short-run and long-run? What happens tothe nominal interest rate in the short-run and long-run?

14. Suppose we are initially in long-run equilibrium, but the government is running a budget deficit. Suppose the government decides to reduce this deficit by cutting government purchases of goods, other

a. What happens to the long-run equilibrium real interest rate? Explain briefly.

b. Illustrate the short-run and long-run effects of the cut in government purchases on É¡and Y. Explain

15. Assume the central bank can forecast accurately and that it knows the magnitude and timing of the effects of its actions on dynamic aggregate demand. What would the central bank want to do to its target real interest rate if it forecast the following events?

Consider each event separately. Hint:determine what each of the events would do to either dynamic aggregate demand or aggregate supply and then figure out what the central bank would want to do to keep output and inflationas close to

a. The emergence of business pessimism about future sales, other things equal.

b. Stock prices rise substantially, other things equal.

c. Suppose that because of population growth the natural level of output is expected toincrease, other

16. In just a sentence or two, explain why it is easier for central banks to deal with shifts in dynamicaggregate demand than with shifts in aggregate supply.

17. Suppose you are an economic advisor to the government of the Isle of Lucy, which isin the process of forming a central bank. Suppose the President of the country, R. Ricardo, tells you the government has established two primary goals for the conduct of monetary policy by the centralbank©÷one goal is price stability (operationally defined as a low target rate of inflation) and the other is high levels of output (operationally defined as output equal to the natural level).

Mr. Ricardo further explains that heisn¢Òt sure which goal should be the primary goal, but he would like to choose the weights so that fluctuations in both output and inflation are at low levels. He asks you how to choose the weights to achieve this. What would you tell him to do? Why?

18. What does a central bank need to know and be able to do in order to offset shocks toaggregate demand? In your discussion define lags and indicate the implications for monetary policy.

19. Based on the Walsh article, we briefly discussed uncertainty and monetary policy. What types of uncertainty did we mention? What does the certainty equivalence principle suggest policymakers should do? What does Brainard suggest ©øconservative¢¥ policy makers should do?

20. We distinguished between asset price channels and credit channels in the monetary transmission mechanism. List the asset price channels and describe what is at work in each channel.

21. Discuss how contractionary monetary policy affects aggregate demand through thebank lendingchannel. Discuss how contractionary monetary policy affects aggregate demand through the balance

22. List the various channels through which monetary policy might affect consumption.Do the same for

23. Why might we expect the effects of monetary policy to differ in different regions of the country?

24. Are the effects of monetary policy in the US the same in all regions of the country?Explain briefly

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William H. Gross |

March 2011 Two-Bits, Four-Bits, Six-Bits, a Dollar•A successful handoff from public to private credit creation has yet to be accomplished, and it is that handoff that ultimately will determine the outlook for real growth and stability.
•Because quantitative easing has affected all risk spreads, the withdrawal of nearly $1.5 trillion in annualized check writing may have dramatic consequences.
•Who will buy Treasuries when the Fed doesn’t? The question really is at what yield, and what are the price repercussions if the adjustments are significant.

...Speaking of investment tips, no clue or outright signal could have been any clearer than the one given in December 2008, labeled “Quantitative Easing.” While the term was new, the intent was obvious: (1) pump public money into the financial system to replace private credit that was being destroyed in the process of deleveraging; (2) lower interest rates on intermediate and long-term mortgages/Treasury bonds and in the process flush money into risk assets – most visibly the stock market; and (3) forecast publically then hope that higher stock prices would lead to a wealth effect, and in turn generate new private sector lending, job creation and a virtuous circle of economic expansion that would heal the near-fatal wounds of Lehman and its aftermath. If that was the game plan, then so far, so good, I’d say. Interest rates are artificially low, stocks have nearly doubled since QE I’s first announcement in December of 2008, and the U.S. economy will likely expand by 4% this year, although a $1.5 trillion budget deficit must share QE’s Oscar for most stimulative government policy of 2009/2010.

Many critics, though, including yours truly, would wonder whether Quantitative Easing policies actually heal, as opposed to cover up, symptoms of an unhealthy economy. They might at the same time ask simplistically whether it is possible to cure a debt crisis with more debt. As I have discussed in numerous Investment Outlooks, the odds of an ultimate QE success seem critically dependent on several criteria: (1) initial sovereign debt levels that are relatively low. Reinhart and Rogoff in their book “This Time Is Different” have suggested an 80–90% of GDP limit to sovereign debt levels before they become counterproductive; (2) the ability of a country to print globally acceptable scrip – especially enhanced if that nation has the reserve currency status now ascribed to the U.S.; and (3) the willingness of creditors to believe in future real growth as a rebalancing solution to current excessive deficits and debt levels.

Most observers would agree with us at PIMCO that QE I and II programs were initiated and employed under the favorable conditions of (1) and (2). The third criterion (3), however, is more problematic. A successful handoff from public to private credit creation has yet to be accomplished, and it is that handoff that ultimately will determine the outlook for real growth and the potential reversal in our astronomical deficits and escalating debt levels. If on June 30, 2011 (the assumed termination date of QE II), the private sector cannot stand on its own two legs – issuing debt at low yields and narrow credit spreads, creating the jobs necessary to reduce unemployment and instilling global confidence in the sanctity and stability of the U.S. dollar – then the QEs will have been a colossal flop. If so, there will be no 15%+ tip for the American economy and its citizen waiters. An inflation-adjusted “negative buck” might be more likely.

Washington, Main Street – and importantly from an investment perspective – Wall Street await the outcome. Because QE has affected not only interest rates but stock prices and all risk spreads, the withdrawal of nearly $1.5 trillion in annualized check writing may have dramatic consequences in the reverse direction. To visualize the gaping hole that the Fed’s void might have, PIMCO has produced a set of three pie charts that attempt to point out (1) who owns what percentage of the existing stock of Treasuries, (2) who has been buying the annual supply (which closely parallels the Federal deficit) and (3) who might step up to the plate if and when the Fed and its QE bat are retired. The sequential charts 1, 2 and 3 are illuminating, but not necessarily comforting.

www.pimco.com/Pages/Two-Bits-Four-Bits-Six-Bits-a-Dollar.aspx

What an unbiased observer must admit is that most of the publically issued $9 trillion of Treasury notes and bonds are now in the hands of foreign sovereigns and the Fed (60%) while private market investors such as bond funds, insurance companies and banks are in the (40%) minority. More striking, however, is the evidence in Chart 2 which points out that nearly 70% of the annualized issuance since the beginning of QE II has been purchased by the Fed, with the balance absorbed by those old standbys – the Chinese, Japanese and other reserve surplus sovereigns. Basically, the recent game plan is as simple as the Ohio State Buckeyes’ “three yards and a cloud of dust” in the 1960s. When applied to the Treasury market it translates to this: The Treasury issues bonds and the Fed buys them. What could be simpler, and who’s to worry? This Sammy Scheme as I’ve described it in recent Outlooks is as foolproof as Ponzi and Madoff until… until… well, until it isn’t. Because like at the end of a typical chain letter, the legitimate corollary question is – Who will buy Treasuries when the Fed doesn’t?

I don’t know. Reserve surplus sovereigns are likely good for their standard $500 billion annually but the banks are now making loans instead of buying Treasuries, and bond funds are not receiving generous inflows like they were as late as November of 2010. Who’s left? Well, let me not go too far. Temporary voids in demand are not exactly a buyers’ strike. Someone will buy them, and we at PIMCO may even be among them. The question really is at what yield and what are the price repercussions if the adjustments are significant. Fed Vice Chairman Janet Yellen in a speech just last week confirmed the theoretical rationale that Treasury yields are directly linked to the outstanding quantity of longer-term assets in the hands of the public. If that quantity is suddenly increased in one year as the charts imply, what are the yield consequences? What I would point out is that Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%. This conclusion can be validated with numerous examples: (1) 10-year Treasury yields, while volatile, typically mimic nominal GDP growth and by that standard are 150 basis points too low, (2) real 5-year Treasury interest rates over a century’s time have averaged 1½% and now rest at a negative 0.15%! (3) Fed funds policy rates for the past 40 years have averaged 75 basis points less than nominal GDP and now rest at 475 basis points under that historical waterline.

As a counter, one would argue (and I would partially agree) that the U.S. and indeed developed global economies must keep yields artificially low for some time if post Lehman healing is to take place. But that of course is the point. By eliminating QE II, the Fed would be ripping a Band-Aid off a partially healed scab. Ouch! 25 basis point policy rates for an “extended period of time” may not be enough to entice arbitrage Treasury buyers, nor bond fund asset allocators to reenter a Treasury market at today’s artificially low yields. Yields may have to go higher, maybe even much higher to attract buying interest.

Investors should view June 30th, 2011 not as political historians view November 11th, 1918 (Armistice Day – a day of reconciliation and healing) but more like June 6th, 1944 (D-Day – a day fraught with hope for victory, but fueled with immediate uncertainty and fear as to what would happen in the short term). Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets. 15% gratuities may lie ahead, but more than likely there is a negative two-bit or even eight-bit tip lying on the investment table. Like I did 45 years ago, PIMCO’s not sticking around to see the waitress’s reaction.

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Nominal gDp may exceed 5% in the 1st & 2nd qtrs.

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In economics, crowding out is any reduction in private consumption or investment that occurs because of an increase in government spending. If the increase in government spending is not accompanied by a tax increase, government borrowing to finance the increased government spending would increase interest rates, leading to a reduction in private investment. --Wikipedia

The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market. The intersection of the IS and LM curves is the "General Equilibrium" where there is simultaneous equilibrium in both markets.[1] IS/LM stands for Investment Saving / Liquidity preference Money supply. -- Wikipedia

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The entire 2011 fiscal budget deficit could be monetized (without inflationary consequences), by (1) either raising reserve ratios, or (2) raising the remuneration rate on excess reserves.

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May 3rd is a safe entry point to sell T-Bond futures.

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Shifts of aggregate demand

The following exogenous events would shift the aggregate demand curve to the right. As a result, the price level would go up. In addition if the time frame of analysis is the short run, so the aggregate supply curve is upward sloping rather than vertical, real output would go up; but in the long run with aggregate supply vertical at full employment, real output would remain unchanged.

Aggregate demand shifts emanating from the IS curve:

An exogenous increase in consumer spending
An exogenous increase in investment spending on physical capital
An exogenous increase in intended inventory investment
An exogenous increase in government spending on goods and services
An exogenous increase in transfer payments from the government to the people
An exogenous decrease in taxes levied
An exogenous increase in purchases of the country's exports by people in other countries
An exogenous decrease in imports from other countries
Aggregate demand shifts emanating from the LM curve:

An exogenous increase in the nominal money supply
An exogenous decrease in the demand for money (in liquidity preference)



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Shifts of aggregate supply

The following exogenous events would shift the short-run aggregate supply curve to the right. As a result, the price level would drop and real GDP would increase.


An exogenous decrease in the wage rate
An increase in the physical capital stock
Technological progress — improvements in our knowledge of how to transform capital and labor into output
The following events would shift the long-run aggregate supply curve to the right:

An increase in population
An increase in the physical capital stock
Technological progress

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Beggar thy neighbour, or beggar-my-neighbour, is an expression in economics describing policy that seeks benefits for one country at the expense of others. Such policies attempt to remedy the economic problems in one country by means which tend to worsen the problems of other countries

The term was originally devised to characterize policies of trying to cure domestic depression and unemployment by shifting effective demand away from imports onto domestically produced goods, either through tariffs and quotas on imports, or by competitive devaluation. The policy can be associated with mercantilism and the resultant barriers to pan-national single markets.

"beggar thy neighbour" policies were widely adopted by major economies during the Great depression of the 1930s.

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Monetary Policy at the Zero Bound
Daniel L. Thornton, Vice President and Economic Adviser

The Federal Open Market Committee (FOMC) has been implementing monetary policy by setting a target for the federal funds rate since about 1990. Implementing monetary policy by setting a target for the funds rate enabled policymakers and monetary policy analysts to characterize changes in the stance of monetary policy by simply observing whether the target was increased or decreased. However, with the federal funds rate target currently between zero and 25 basis points, the FOMC can no longer ease policy by reducing the target rate given the zero lower bound on nominal interest rates.1

Instead, the Federal Reserve has attempted to ease policy by engaging in quantitative easing (QE): the large-scale purchase of government and other securities with the primary intent of reducing longer-term interest rates. Given the difficulty of characterizing monetary policy using QE, it is natural to want to equate a given quantity of assets purchased with a given reduction in the federal funds rate target in an environment when the FOMC could reduce the target.

Indeed, in a Congressional hearing on February 9, 2011, Representative Tim Huelskamp questioned how the Fed ¡°picked $600 billion¡± when the FOMC decided on a second round of QE (called QE2) at its November 2010 meeting. Fed Chairman Ben Bernanke responded, ¡°We asked the hypothetical question, if we could lower the federal funds rate, how far¡ªhow much would we lower it?¡± He noted that ¡°a powerful monetary policy action in normal times would be about a 75 basis point cut in the federal funds rate. We estimate that the impact on the whole structure of interest rates from $600 billion is roughly equivalent to a 75 basis point cut.¡±2

This synopsis focuses on an important reason to be skeptical of such equivalency estimates. Chung et al.¡¯s article is used to illustrate how analysts estimate the funds rate target change equivalency of a given QE action. Chung et al. estimate that the FOMC¡¯s 2009 QE actions resulted in about a 50-basis-point reduction in the 10-year Treasury yield, which they then estimate is equivalent to about a 200-basis-point cut in the federal funds rate.3 The latter estimate, which is similar to Chairman Bernanke¡¯s, is based on a regression of quarterly changes in the 10-year Treasury yield on quarterly changes in the funds rate over the 1987-2007 period. They note that their estimate of the coefficient on the funds rate of ¡°about 0.25¡± implies ¡°that a 100 basis point reduction in short-term rates is typically associated with a 25 basis point decline in long-term yields¡± and concluded that the ¡°50 basis point drop in bond yields through conventional means rather than asset purchases should ordinarily require something like a 200 basis point cut in the federal funds rate¡±4 (emphasis added).

However, these authors and others have failed to notice that the relationship between changes in 10-year Treasury yields and changes in the funds rate (on which their estimate rests) changed dramatically beginning in the late 1980s and essentially vanished by the mid-1990s. Consequently, the average relationship between changes in the 10-year Treasury yield and changes in the funds rate over the 1987-2007 sample period is not indicative of the relationship between changes in the funds rate and changes in the 10-year Treasury yield that existed for more than a decade prior to the financial crisis.

The table illustrates the marked change in the relationship. The table reports the estimates of the intercept on slope coefficients and corresponding significance levels (p-values), along with estimates of ¨CR2 and the standard error, from a simple regression of the change in the 10- year Treasury yield on the change in the funds rate using quarterly averages of daily figures over three sample periods: 1987:Q1¨C2007:Q4, 1995:Q1¨C2007:Q4, and 2000:Q1¨C 2007:Q4. The estimates over the full sample period confirm the conclusion by Chung et al. that a 200-basis-point reduction in the federal funds rate target would correspond to about a 50-basis-point reduction in long-term yields. The estimate of the slope coefficient over the 1995:Q1¨C2007:Q4 and 2000:Q1¨C2007:Q4 periods is about a third of that over the entire sample. Moreover, the estimates are insignificantly different from zero, and the estimate of ¨CR2, which was only about 10 percent over the entire sample period, declines to zero over the latter sample periods.

Hence, there has been no statistically significant relationship between quarterly changes in the funds rate and quarterly changes in the 10- year Treasury yield since the mid-1990s.5 This suggests that, at best, it is misleading to use estimates of the relationship between these rates obtained with data before the mid- 1990s to equate a given level of asset purchases by the Fed with a specific change in the FOMC¡¯s funds rate target. Such estimates are not valid for translating QE actions into funds rate target changes. Consequently, they provide no guidance for the appropriate amount of QE actions the FOMC should undertake. ¡ö

1 To better understand the zero lower bound, see Daniel L. Thornton. ¡°Nominal
Interest Rates: Less Than Zero?¡± Federal Reserve Bank of St. Louis, Monetary
Trends, January 1999;
research.stlouisfed.org/publications/mt/19990101/cover.pdf.
2 See Dow Jones. ¡°Rep. Paul D. Ryan Holds a Hearing on the U.S. Economic
Outlook.¡± House Committee on the Budget, p. 38; findarticles.com/p/
news-articles/political-transcript-wire/mi_8167/is_20110209/rep-paul-ryanholds-
hearing/ai_n56848469/pg_28/?tag=content;col1.
3 Chung, Hess; Laforte, Jean-Philippe; Reifschneider, David and Williams, John C.
¡°Have We Underestimated the Likelihood and Severity of Zero Lower Bound
Events?¡± Working Paper No. 2011-01, Federal Reserve Bank of San Francisco,
January 2011, p. 24;
www.frbsf.org/publications/economics/papers/2011/wp11-01bk.pdf.
4 From Chung et al., p. 28. See footnote 3.
5 For the results using monthly average data, see Daniel L. Thornton. ¡°The
Unusual Behavior of the Federal Funds Rate and Treasury Yields: A Conundrum
or an Instance of Goodhart¡¯s Law?¡± Working Paper No. 2007-039D, Federal
Reserve Bank of St. Louis, September 2007, revised August 2010;
research.stlouisfed.org/wp/2007/2007-039.pdf.
Economic SYNOPSES Federal Reserve Bank of St. Louis 2
research.stlouisfed.org
Posted on February 25, 2011

=====================================

What he is trying to say is that Keynes's liquidity preference curve is a false doctrine & that the money supply can never be managed by any attempt to control the cost of credit.

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JOHN MASON Federal Reserve QE2 Watch: Part 4.0

The Federal Reserve continues to pump funds into the banking system. Reserve balances at Federal Reserve banks reached $1.3 trillion on March 2, 2011. This is up from $1.1 trillion on
February 2 and up from $1.0 trillion on December 29, 2010.

These balances serve as a relatively good proxy for the excess reserves in the banking system which averaged $1.2 trillion over the two-week period ending February 23, 2011.

As we have reported before, there are two drivers of this increase in bank reserves. The first, connected with the Fed’s program of quantitative easy, is the acquisition of United State Treasury securities.

Over the past four weeks the Federal Reserve has added almost $100 billion to its portfolio of Treasury securities. Only about $18 billion of these purchases were offset by maturing Federal Agency issues and mortgage-backed securities.

Since the end of last year, the Fed has added $220 billion to its Treasury security portfolio. In this case the Fed was replacing a $48 billion decline in the other securities that were maturing.

And, in the past 13-week period, Almost $320 billion were added to the Treasury portfolio, replacing about $80 billion in maturing Agency issues and mortgage-backed securities.

The second driver has been the action surrounding Treasury deposits with Federal Reserve banks. Since these deposits are a liability of the Fed, a reduction in these deposits increases reserves in the banking system. There are two important accounts here, the Treasury’s General Account and the Treasury’s Supplementary Financing Account.

The Supplementary Financing Account has been used for monetary purposes and in the current case, the Treasury has reduced the funds in this account by $100 billion. All of this reduction came in February.

The Treasury’s General Account is used in conjunction with Treasury Tax and Loan accounts at commercial banks and is the account that the Treasury writes checks on. Generally tax monies are collected in the Tax and Loan accounts and then are drawn into the Federal Reserve account as the Treasury wants to write checks. When the Treasury writes a check, it is deposited in commercial banks, so that bank reserves increase.

Over the past four weeks, the Treasury’s General Account has dropped by almost $70 billion. Thus, between this account and the Treasury’s Supplementary Financing Account the Fed has injected almost $170 billion reserves into the banking system in February.

I need to call attention to the fact that funds moving into and out of the General Account can vary substantially. For example, since the end of the year (which includes the February change) this account has only fallen by $39 billion. Over the last 13-week period, the account has actually increased by $4 billion. Tax collections build up toward the end of the year and then are spent during the first quarter of the year preparing for another buildup around April 15, tax collection time.

The bottom line, the Federal Reserve is seeing that plenty of reserves are being put into the banking system. But, the commercial banks seem to be holding onto the reserves rather than lending them out.

Still, the growth rates of both measures of the money stock seem to be accelerating. The year-over-year growth rate of the M1 measure of the money stock was growing by about 5.5% in the third quarter of 2010. The growth rate increased to 7.7% in the fourth quarter and is growing at a 10.2% rate in January 2011.

The M2 measure of the money stock has also accelerated, going from a year-over-year rate of increase of 2.5% in the third quarter to 3.3% in the fourth quarter to 4.3% in January.

On the surface these increases in money stock look encouraging in terms of possible future economic growth. However, we are still seeing the same behavior of individuals and businesses in the most recent period that we have observed over the past two years.

The growth rates of both measures of the money stock still seem to be coming from people that are getting out of short term “investment” vehicles and are placing these funds in demand deposits or other transaction accounts, or in currency.

The first piece of evidence of this relates to the reserves in the banking system. The total reserves in the banking system have remained roughly constant over the past year. Yet, the required reserves of the banking system have increased by 10% year-over-year. This situation could only happen if demand deposit-type of accounts, which require more reserves behind them, were increasing relative to time and savings accounts, which have smaller reserve requirements.

Looking at the individual account items we see that demand deposits at commercial banks rose at a 20% year-over-year rate of growth in January. The non-M1 part of the M2 measure of the money stock rose by only an anemic 3% rate. Thus, the substantial shift in funds from time and savings accounts to transaction accounts continues. There is no indication of a speeding up of money stock growth connected with the reserves that the Fed is injecting into the banking system.

An even more dramatic shift can be seen if we include institutional money funds in the equation and look at what has happened in the banking system over the past nine weeks. The non-M1 portion of M2 increased by $22 billion over this time period. However, funds kept in institutional money funds declined by roughly $40 billion. This means that accounts that Milton Freidman would have labeled “a temporary abode of purchasing power” actually declined by $18 billion since the start of the year.

Demand deposits and other checkable deposits rose by about $21 billion. One could note that currency in the hands of the public also rose by $16 billion.

The public continues to move money from relatively liquid short-term savings vehicles to assets that can be spent by check or cash. This is not the kind of behavior one gets in an economy that is confident and expanding. This behavior can roughly be called “defensive”.

So, another month has gone by. The Fed is aggressively executing its program of quantitative easing. Yet, it still seems to be “pushing on a string.” Why is it I retain the feeling that the Federal Reserve’s effort is just spaghetti tossing, seeing what might stick to the wall?

The longer this policy continues, the less confidence people seem to have in both Ben Bernanke and the Federal Reserve. I shutter to think what Bernanke and the Fed will do to us when the banking system actually does start lending again.

Note that some members of the Fed’s Open Market Committee are suggesting that QE2 end abruptly at the end of June when the current program is slated to expire. (See "Policy Makers Signal Abrupt End to Bond Purchases in June": www.bloomberg.com/news/2011-03-04/fed-policy-makers-signal-abrupt-end-to-bond-purchases-in-june.html.)

Does everyone in the Fed seem “tone deaf” to you? They just seem to act on pre-conceived ideas and have no sense or feel of the banking system and financial markets. Another confidence raiser.

===================

No, deposit shifts from savings/investment (interest-bearing) to transactions based (non-interest-bearing) accounts represent an overall increase in the transactions velocity, or turnover, of the money stock (not a DEFENSIVE move, but rather an OFFENSIVE one). (i.e., just the opposite of the rate-of-change in Friedman's income velocity on the FRED's database),

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Velocity of Federal Reserve deposits --- JAMES HAMILTON

www.econbrowser.com/archives/2011/03/velocity_of_fed.html

I've been emphasizing that the U.S. Federal Reserve has not been printing money in the conventional sense of creating new dollar bills that have ended up in anybody's wallets. Instead, the Fed has been creating new reserves by crediting the accounts that banks maintain with the Fed. Today I'd like to offer some further observations on how those reserve balances mattered for the economy historically, how they matter in the current setting, and how they may matter in the future.

Currency in circulation (blue) and reserve balances with Federal Reserve Banks (maroon), in billions of dollars

When the Fed makes a purchase of, for example, U.S. Treasury bonds, it does so by simply crediting an account that the selling institution maintains with the Fed, creating new funds out of thin air.

The selling bank surrendered T-bonds which the Fed now owns, and has command of new reserve deposits, with which it can do anything it likes. For example, the bank could use the funds to buy some other asset, by instructing the Fed to transfer its balance to those of the bank from which it wants to buy the asset.

Alternatively, the bank could use the reserve deposits to make a loan, pay another bank for funds owed, withdraw them by asking for cash from the Fed, or simply hold on to the reserve deposits.

Reserve deposits are an asset like any other, and if a bank makes a conscious decision to hold on to them, it is because it regards this asset as at least as attractive as any alternative use it might make of the funds. Equilibrium requires that the supply created by the Fed equals the quantity banks desire to hold.

Before 2008, the primary demand for reserves came from the fact that the Fed required banks to hold certain levels of reserves. The banking system as a whole held a little more than required, because many individual banks wanted to avoid penalties or extra costs that might result if some last-minute withdrawals caused the bank to lose its reserves at a late hour in the day when it would be hard for the bank to borrow funds to replace them.

The fed funds rate, which is the interest rate banks charge each other for an overnight loan of reserves, was very sensitive to the level of excess reserves in the system, and gave the Fed a credible tool for maintaining a desired target for the fed funds rate by adding small amounts of reserves with T-bill purchases, or removing small amounts with T-bill sales.

To understand how that equilibrium worked, consider an individual bank that initially had what it thought was the right level of reserves for its own needs. Suppose a customer of the bank unexpectedly deposits a check drawn on another bank, which that bank honors by instructing the Fed to send its reserves over to the receiving bank. The receiving bank now has a much larger reserve balance than it needed. It would therefore try to find some other use of the funds, for example, by buying an asset or lending the funds to another bank, rather than leave them idle at the end of the day.

The sending bank would likewise find itself short, and likely either sell some assets or borrow reserves on the fed funds market, perhaps ultimately borrowing the reserves back from the receiving bank. The result was that reserve balances were passed back and forth between banks many times each day, with each receiving bank almost always finding something better to do with the funds than just hang on to them overnight.

One can get a sense of the scope of this by looking at the volume of transactions on Fedwire, the system a bank uses when it wants to instruct the Fed to debit its account with the Fed and credit the account of the bank to which it wants to make a payment. For example, on an average day in 2006:Q1, about $2.2 trillion in reserve deposits were sent between banks over Fedwire, despite the fact that reserve balances only averaged $13 billion each day. In other words, each dollar of reserve deposits was trading hands something like 2,200/13 = 170 times each day before finally ending up being held by somebody when the books were closed for the day. The graph below plots this concept of "velocity of reserve deposits" for the last two decades.

Ratio of (1) average daily value of transactions on Fedwire (from Federal Reserve Board) to (2) average daily value of reserve balances with Federal Reserve Banks (from Federal Reserve Bank of St. Louis), 1992:Q1 to 2010:Q3.

One can also see from the figure how radically differently the system is functioning today. In 2010:Q3, about $2.4 trillion was transferred each day on Fedwire. Compared to over a trillion dollars in reserves outstanding, that implies a velocity of 2.3. In the current setting, a given dollar of reserves is transferred about twice from one bank to another, and then as likely as not just sits there for the rest of the day.

A key reason that the system functions so differently today is that banks really don't see much better use for the funds than just holding on to them as reserves. A bank gets paid 0.25% annual interest for maintaining the reserve balances with the Fed, which is actually substantially better than you'd get from buying a 1-month T-bill. Many banks are still afraid to make any but the very safest of loans. In such a setting, the Fed could create all the reserves it wants, and it's not clear that much if anything has to change as a result.

However, the situation is not going to stay like this forever. When banks do start to see something better to do with their funds, one could imagine the situation changing pretty quickly. The Fed's plan when that starts to happen is to remove some of those reserves by selling off some its assets, and preserve the incentive for holding reserves by raising the interest rate paid on them.

But a recent note by economists Huberto Ennis and Alexander Wolman of the Federal Reserve Bank of Richmond observes that negotiating the details of that transition could prove tricky in practice. Put a trillion dollars in reserves together with a velocity in the tens or hundreds, and pretty soon you're talking about real money.

================

The payments system (FED-WIRE), does use live data, but the "demand for reserves" is a contrived (regulatory), function & not fundamentally related to economic activity.

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What About All Those Bank Reserves
Sunday ~ March 6th, 2011 in Economics | Tags: Bank Reserves, Fed, interest on reserves, Jim Hamilton, Money | by Karl Smith

Jim Hamilton has another nice piece on Federal Reserve deposits. I have a couple of quibbles but mostly they are a matter of perspective. Hamilton says

I’ve been emphasizing that the U.S. Federal Reserve has not been printing money in the conventional sense of creating new dollar bills that have ended up in anybody’s wallets. Instead, the Fed has been creating new reserves by crediting the accounts that banks maintain with the Fed

This is probably a workable framework for people who think of printing money and inflation as being synonymous. Though its not how I think about it. I think of issuing reserves as printing money.

Both reserves and cash are what we think of as “high powered money.” (NO, cash has no expansion coefficient). High powered money is the ultimate base for all the assets that we use for buying stuff, such as our checking accounts. The more high powered money out there the more checking accounts there can be.

Issuing a new checking account is how a bank makes a loan and this increase in lending increases demand in the economy. So, printing more reserves would tend to increase demand. That was pretty much how things worked up until the Fed started paying interest on excess reserves.

Once a bank issues a new checking account the law says that you have to dedicate some of your reserves to backing that account. These reserves are required reserves. Required reserves do not get interest payments from the Fed. (NO, excess & required reserves are remunerated at the same .25%).

Thus when a bank decides to make a loan it has to switch some of its interest paying excess reserves over to non-interest paying required reserves. The fact that they loose the interest payment is what discourages them from doing this.

My overarching point is that there will be some people who suspect that Hamilton is shifting definitions to hide the Fed “true printing of money.” Yet, even if you think of issuing reserves as printing money – which is the frame that I use – Hamilton’ logic still follows through. It follows because the interest on reserves policy breaks the traditional link between printing reserves and increasing demand in the economy.

Hamilton goes on

Many banks are still afraid to make any but the very safest of loans. In such a setting, the Fed could create all the reserves it wants, and it’s not clear that much if anything has to change as a result.

However, the situation is not going to stay like this forever. When banks do start to see something better to do with their funds, one could imagine the situation changing pretty quickly. The Fed’s plan when that starts to happen is to remove some of those reserves by selling off some its assets, and preserve the incentive for holding reserves by raising the interest rate paid on them.

So this is correct but one could easily confuse very wonky concerns with a breakdown in monetary policy.

So before all of this interest on reserves business the Fed managed the money supply by targeting the Fed Funds market. That is, the Fed kept the price at which banks loaned reserves constant.

Now suppose I am the manager at BigTime Bank. I decide for whatever reason that I want to make trillions of dollars in loans. To do this I need to acquire more reserves. I go into the Fed Funds market and start borrowing these reserves from other banks. This will tend to drive up the interest rate on reserves, which is the Fed Funds rate.

However, the Fed is targeting the Fed Funds rate. This means that in response to my action the Fed will increase the supply of reserves in order to push the interest rate right back down. The result is that the Fed automatically accommodated my desire to make a bunch of loans by increasing the supply of reserves.

So what stops me as the manager of BigTime Bank from flooding the market with new loans and driving up demand? What stops me is that I have to pay interest on all of these reserves. (NO, banks are reserve constrained & not all deposits are reservable). If the interest I am getting on loans is not competitive with the interest I have to pay to borrow all of these reserves then its not worth it for me to do this.

So, the ultimate control on how willing BigTime Bank is to make loans, is the Fed Funds rate. That’s why changes in the Fed Funds rate were historically a big deal.

Now, lets think about the current world. Here what is stopping BigTime Bank from making a bunch of loans? Its that by making a bunch of loans BigTime Bank has to move some of its reserves from excess to required and thereby lose the interest payment the Fed is offering on excess reserves (NO, they receive the same payment rate from the FED).

From the BigTime Bank’s point of view this is the same cost. Issue more loans and either pay out more money from borrowing in the Fed Funds market or loose out on interest on reserves. In both cases it’s the interest rate that is holding the BigTime Bank back.

If the Fed wants to cool down the economy then, what it does under the current policy is to raise the interest rate on reserves. That will function just like raising the Fed Funds rate on the old policy.

So in terms of core monetary policy there is no real difference between regimes. There are a wonky concerns about making sure that the entire system functions without a hiccup since it hasn’t been done this way before.

There are also concerns about managing the Feds balance sheet. The Fed expanded the amount of excess reserves that banks had and then paid interest on those reserves. However, that wasn’t just a give away from the Fed to banks. In exchange the banks had to give the Fed some of their interest bearing assets including lots of Mortgage Backed Securities in the beginning and Treasury Bonds now.

The Mortgage Backed Securities and Treasury Bonds are both paying higher interest rates than the Fed is currently paying on reserves. So in terms of immediate cash flow the Fed is making more money now. However, Mortgage Backed Securities and Treasury Bonds are also “riskier” than reserves. They are risky because they pay a fixed interest rate, while the interest on reserves will theoretically fluctuate with the economy.

If economic growth picks up the Fed will be forced to raise the interest it pays on reserves. This is just like it would have to raise the Fed Funds rate in an overheating economy.

If the economy is growing fast enough then interest on reserves will have to be raised to a higher rate than the interest the Fed receives on Mortgage Backed Securities and Treasury Bonds. This would result in losses for the Fed. Its not exactly clear what “losses for the Fed” will mean, but for the sake of calm markets its best if we just don’t go there.

This means that the Fed will want to get out of the business of holding all of these securities at some point and its not clear how or when that might happen.

====================

by commentor JHOOPER: "New loans also need to incur ALLL provision which hurts a bank's capital position. Not to mention a loan is a 100% risk weighted asset whereas reserves and government securities are 0% to 20%"

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Also in the 4th qtr of 2010 (according to St. Louis's FRED database), your Vi (income velocity is falling), when Vt (transactions velocity), i.e., money that is actually exchanging hands is actually rising.

One explanation lies with the asset liquidation, debt reduction, & deleveraging that was taking place:

WASHINGTON, Jan. 22 (seekingalpha.com/symbo...) -- "The U.S. Federal Reserve said U.S. consumers have begun DIPPING INTO THEIR SAVINGS and investment accounts for the FIRST TIME in nearly 60 years.

In the two years ending in September 2010, U.S. consumers have WITHDRAWN $311 billion from savings and investments, representing a NET DRAW from their disposable income of about 1.4 percent for the first net retreat in 57 years, The Wall Street Journal reported Saturday.

For the previous 57 years, on average consumers' financial assets GREW by 12 percent of their disposable income per year.

The SPENDING helps the economy, but a DRAW DOWN IN SAVINGS could haunt consumers if they are hit with hard times in the future, the Journal said."

========================

Additional evidence lies in deposit classification shifts:

Deposit shifts from savings/investment (interest-bearing) accounts, to transactions based (non-interest-bearing) accounts represent an overall increase in the transactions velocity, or turnover, of the money stock.

The transactions velocity of money turns over 69 times faster than income velocity (1996 base year). And the transactions velocity of demand deposits turns over 15 times faster than the transactions velocity of ATS & NOW accounts (& 56 times faster than MMDA accounts).

Even if you use income velocity, a shift from M2 income velocity @ 1.7 times/qtr, to M1 velocity @ 8.2 times/qtr, represents a 5 fold increase in how fast the money (which was being liquidated & shifted), was eventually being spent in the 4th qtr of 2010. I.e., aggregate monetary purchasing power (money X's velocity) was was being driven by an increasing number of transactions (increasing number of bank debits).

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www.themoneyillusion.com/?p=9191&cpage=1#comment-61616
Scott Sumner's Blog
Models and Markets
Bruce Bartlett sent me a new paper by Peter Ireland.

This paper uses a New Keynesian model with banks and deposits, calibrated to match the US economy, to study the macroeconomic effects of policies that pay interest on reserves. While their effects on output and inflation are small, these policies require important adjustments in the way that the monetary authority manages the supply of reserves, as liquidity effects vanish and households’ portfolio shifts increase banks’ demand for reserves when short-term interest rates rise. Money and monetary policy remain linked in the long run, however, since policy actions that change the price level must change the supply of reserves proportionately.

I found the long run neutrality of monetary policy to be quite interesting, as I’d assumed that relationship broke down with interest on reserves. The fact that IOR has little effect on inflation and growth is also interesting, but I would caution that this sort of finding needs to be interpreted with caution.

In December 2007 the Fed was trying to decide between cutting rates by 1/4 and 1/2 point. They actually cut them by 1/4 point, and the Dow promptly fell by 300 points. Because fed funds futures showed a 58% chance of a 1/4 point cut and a 42% chance of a 1/2 point cut, we can infer that the Dow would have risen about 400 points with a 1/2 point cut. (One of the few things even anti-EMH types accept is that the expected return on the Dow over any 2 hour period is roughly zero.)

Are there any models that predict that a 1/4 swing in the fed funds target would mean 700 points on the Dow? I doubt it, because most models look at these things rather mechanically. But in the real world the effect of a change in almost any monetary policy variable (fed funds rate, the base, IOR, M2, etc) depends almost entirely on how the change impacts the expected future path of policy.

I agree with Peter Ireland that a decision to pay IOR will have very little macroeconomic impact, ceteris paribus. On the other hand, ceteris is rarely paribus. It’s possible that an IOR decision might lead to changes in the expected path of monetary policy. For instance, it might lead to fears that future QE would be less effective, as banks would have an incentive to hoard any extra cash. Or markets might have already been expecting QE (to provide liquidity during a banking crisis) and the additional step of IOR might lead them to think the QE will not immediately drive short term rates to zero.

Since the impact of a policy depends on its impact on the expected future path of policy, it is almost impossible to model these effects. They are highly contingent on the economic situation in which they occur. For instance, the December 2007 quarter point cut would normally have had little market impact, but coming on the edge of the Great Recession, its impact was greatly magnified. It made investors far more pessimistic about future Fed policy (correctly pessimistic, I might add.)

Does this mean there is no hope of ever being able to estimate the impact of policy decisions? Far from it. Louis Woodhill looked at the only three IOR decisions in the Fed’s 98 year history. In each case stocks fell very sharply around the time of the decision:

At the time of the Fed’s IOR announcement, the S&P 500 was down by a total of 12.18% from its pre-Lehman close, 15 trading days earlier. However, the day that the Fed announced IOR, the S&P 500 fell by 3.85%, and it was down by a total of 17.22% three days later.

On October 22, 2008, the Fed announced that it would increase the interest rate that it paid on reserves. The S&P 500 fell by 6.10% that day, and it was down by a total of 11.11% three days later. On November 5, 2008, the Fed announced another increase in the IOR interest rate. The S&P 500 fell by 5.27% that day, and it was down by a total of 8.60% three days later.

To play it safe it’s probably better to go with the single day returns, as the EMH suggests the effect on asset prices should be immediate. On the other hand, the concept of IOR was fairly unfamiliar to Wall Street, so arguably there might have been some delay as the program was discussed and explained. But even using the more conservative one day window, what are the odds of three drops like that occurring on the only three days in history when the IOR was raised? I’d guess no more than 1 in 10,000. Economists get published with results no more unlikely than 1 in 20, and yet I am so skeptical of statistical significance that even 1 in 10,000 seems merely suggestive to me. I think IOR might have had a significant contractionary impact, but I am not certain.

Whenever the model says one thing and the markets say another, I always go with the markets. The markets seemed to think the IOR program was a big mistake, and the QE2 program was an important step in the right direction. That’s all we know right now, and probably all we’ll ever know.

PS. After the third and final increase in IOR, the S&P500 actually fell 10% in just two days. Thus the market declined over 38% in 10 trading days–October 6, 7, 8, 9, October 22, 23, 24, 27, and November 5, 6. Think about what it means for US equities to lose 38% of their total value in 10 trading days. Coincidence? Maybe, but a pretty unlikely one. Using 2 day windows the total drop was about 24%. Even the three single day drops add up to more than a 15% decline.

And then there is Sweden, with its negative IOR and record RGDP growth. Hmmm . . .

Memo to Bernanke: Cut the IOR to 0.15%. It will give banks a bit less incentive to just sit on all the QE you’re sending their way. But it will still be high enough to prevent the MMMFs from going belly up. And you guys at the BOG can do it on your own–no pesky regional bank presidents to deal with. Even Ron Paul will approve—less subsidy to fat cat bankers. Git er done.

===========================

fmwww.bc.edu/EC-P/WP772.pdf
The Macroeconomic Effects of Interest on Reserves

Comparing IORs to economic activity is as meaningful as Hamilton’s comparison of FED-WIRE transfers to IORs.

However, IORs are not only contractionary (absorb commercial bank deposits -just like reserve requirements & reserve ratios), they also induce dis-intermediation (an outflow of loan-funds from the non-banks, just like raising & eliminating REG Q ceilings). This assumes no offsetting action by the monetary authorities.

Because IORs increase the cost of loan-funds (esp. mortgage rates), & the capitalization rates on company earnings, they thus cannot but have an overall deleterious effect upon the economy. But considering our budetary morass (& IORs potential to absorb Treasurys - to avoid crowding out), they are probably a necessary evil.

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Arlington, Va.) -- If oil prices continue to climb, it could force the Federal Reserve to make a new round of asset purchases, according to Atlanta Fed President Dennis Lockhart.

Appearing at the National Association of Business Economics in Arlington, Va., Lockhart said that while he doesn't think additional purchases are currently warranted, more stimulus could be needed if oil prices continue to climb.

0Email Print "If [the rising price of oil] plays through to the broad economy in a way that portends a recession, I would take a position we would respond with more accommodation," Lockhart said at the conference.

Though he doesn't think current oil prices around $106 a barrel are a problem, he said the evidence is clear that oil spikes can bring about a recession.

"I think at the $120 range ... it's a manageable level," he said. "Around $150 it becomes a much more serious concern."

=================

What would be the best response? Pump oil from the strategic oil reserves seems a better option.

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"Consumer credit outstanding in December rose $6.1 billion showing, for the first time in the recovery, gains for both revolving and non-revolving credit. Revolving credit, up $2.3 billion, rose for the first time in 27 months. Non-revolving credit, reflecting strength in vehicle sales, extended its run of strength with a gain of $3.8 billion. Looking ahead to January’s number, there may be some modest help from motor vehicle sales which edged up 0.6 percent for the month but the amount boosting consumer credit will depend in part on the share split of sales to consumers and to businesses

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Donald Kohn “I know of no model that shows a transmission from bank reserves to inflation”

DEAD WRONG. I discovered the model in JULY 1979. It still works as magnificently today as it did then. Long-term (CORE), inflation bottomed in JAN (as previously predicted in JUNE 2010 – when I first looked at it).

[vl]

"I think at the $120 range ... it's a manageable level," he said. "Around $150 it becomes a much more serious concern."

Read more: notmsnmoney.proboards.com/index.cgi?board=moneytalk&action=display&thread=273&page=13#ixzz1FxCYUSw5

Fifty Cents wreaks pretty decent havoc on the average American's budget. Workers only averaged a percent raise outside Wall Street. Based on current trending, $120/bbl would be exceeding $5/gallon at the pump. That puts a LOT of bicycles on the blacktop that impede logistics. No more hot dogs for the Nathan's kiosks. What does a Starbuck's do without coffee deliveries?
These guys live in white rooms without windows, not Reality.

Your whole thread chronicles the End of white collar fiat superiority.

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2010 jan …… 0.13 …… 0.538
….. feb …… 0.056 …… 0.507
….. mar …… 0.072 …… 0.558
….. apr …… 0.056 …… 0.552
….. may …… 0.067 …… 0.477
….. jun …… 0.038 …… 0.474
….. jul …… 0.078 …… 0.499
….. aug …… 0.031 …… 0.49
….. sep …… 0.045 …… 0.542
….. oct …… -0.01 …… 0.386
….. nov …… 0.041 …… 0.321
….. dec …… 0.099 …… 0.32
2011 jan …… 0.089 …… 0.155
….. feb …… 0.091 …… 0.233
….. mar …… 0.131 …… 0.322
….. apr …… 0.1 …… 0.232
….. may …… 0.111 …… 0.204


First column is the proxy for real-output. Second column is the proxy for inflation indices. Inflation (core) obviously bottomed in JAN.

Real-output is rocketing upward in the 1st & 2nd qtrs.

I think the FED is too easy at this point (but may be offsetting the climb in petroleum products).

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Commercial bank credit peaked @ $9,557.8T on 10/22/2008. As of 2/23/2011 it stands @ $9,121.6T. Bank credit proxy is the best available, & most current figure, approximating commercial bank credit (i.e., member bank loans & investments).

Because every time a CB makes loans to or buys securities from the non-bank public it creates new money, initially demand deposits, the volume of CB deposit liabilities closely match total system wide assets.

From Sept 66 to Dec 69 bank credit proxy was included in the FOMC's directive (a target).

Because bank credit hasn't grown, we can assume that liabilities haven't grown?

Without number crunching, here is an old analysis of the debits & credits:
========================
Professional economists have no excuse for misinterpreting the savings investment process. They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking system, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy.

The expansion of bank credit and new money-TRs (transaction deposits) by the CBs can be demonstrated by examining the differences in the consolidated condition statements for the banks and the monetary system at two points in time.

Increases in CB loans and investments/earning assets/bank credit, are approximately the same as increases in TRs & time deposits/savings deposits (TDs)/bank liabilities/bank credit proxy (excluding IBDDs).

That the net absolute increase in these two figures is so nearly identical is no happenstance, for TRs largely come into being through the credit creating process, and TDs owe their origin almost exclusively to TRs - either directly through transfer from TRs or indirectly via the currency route.

There are many factors, which can, and do, alter the volume of bank deposits, including: (1) changes in currency held by the non-bank public, (2) in bank capital accounts, (3) in reverse repurchase agreements, (4) in the volume of Treasury currency issued and outstanding, and (5) in Reserve Bank credit. Although these principle items are largest in aggregate, they nevertheless have been peripheral in altering the aggregate total of bank deposits.

For the Monetary System:

Thus the vast expansion of deposits occurred despite:
(1) an increase in the non-bank public’s holdings of currency $801.2b
(2) an increase in other liabilities & bank capital $39b
(3) an increase in matched-sale purchase agreements $32.2b
(4) an increase in required-clearing balances $6.7b
(5) the diminution of our monetary gold & silver stocks; etc.(-)$6.6
(6) an increase in the Treasury’s general fund account $4.9b

Factors offset by:
(1) the expansion of Reserve Bank credit $847.5b
(2) the issuance of Treasury currency; $35.9b

These “outside” factors made a negligible contribution in bank deposit growth the last 67 years of $4.4b (deposits declined by $877.4b and were offset by the expansion of $883.4b).

For the incredulous reader I make this assignment: Please explain how the volume of TRs and TDs could grow since 1939 from $48 billion, to $ 8,490 (NSA) billion, even while the banks were paying out to the non-bank public a net amount of (-)$801.2 billion (NSA) in currency.

Federal Reserve Bank credit since 1939 (2.6b), has expanded by billion 847.5 (NSA), (-$801.2 of which was required to offset the currency drain from the commercial banks. The difference in the above figures outlined above was sufficient to supply the member banks with $46b of legal reserves.

And it is on the basis of these legal reserves that the banking system has been able to expand its outstanding credit (loans and investments) by over (+) $8,462 trillion (SA) since 1939. (40.7)

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I.e., total deposit liabilities should not have changed much because bank credit didn't change much. So the inference should be that the growth in M1 is related not to bank lending & investing, but to depositor shifts in deposit classifications. And aggregate monetary purchasing power was upheld due to an increase in the transactions velocity of money (i.e., despite no money stock growth).

But when these shifting balances stop or reverse, bank credit must begin to expand again, or aggregate monetary purchasing power will fall (bringing gDp down with it).

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Are Bank Reserves and Bank Lending Connected?
Silvio Contessi, Economist

Depository financial institutions (DFIs)¡ªcommercial banks, savings banks, saving and loan institutions, and credit unions¡ªin the United States are required to hold a certain amount of their assets in the form of vault cash or deposits with Federal Reserve Banks. For most DFIs, their vault cash (including cash in automated teller machines), held to service customers¡¯ day-to- day business needs, meets or exceeds the required reserves. Larger banks typically satisfy their requirement with deposits at the Federal Reserve Banks, in addition to their vault cash.

In ¡°normal¡± times for monetary policy, a DFI¡¯s lending is constrained by its need to satisfy reserve requirements because each dollar loaned tends to reduce its deposits at the Fed by a dollar. Unless the bank can attract additional deposits, this depletion of its Fed deposits limits its lending. ¡°Excess reserves¡± typically are defined as the amount of deposits held at Reserve Banks above and beyond the amount necessary to satisfy the statutory reserve requirements.1

Since the summer of 2008 the financial climate for DFIs has been anything but ¡°normal.¡± During this period, the level of deposits held by DFIs at Reserve Banks increased roughly by a factor of 50¡ªfrom $20.4 billion at the end of August 2008 to more than $1 trillion at the end of December 2010. This expansion, in the aggregate, is entirely due to a single factor beyond the control of the DFIs, either individually or in the aggregate¡ª the aggressive expansion of the Fed¡¯s balance sheet.

The Fed¡¯s balance sheet expansion has had two goals: reducing interest rates on longer-term assets and increasing bank lending. The former has been explored in issues of Monetary Trends.2 Here, I explore the latter goal, focusing on the large degree of heterogeneity among banks in reserves accumulation. The distribution is of interest because smaller banks tend to lend to small businesses, while larger banks tend to lend to larger firms.

During 2009-10, larger firms experienced receptive bond and capital markets¡ª CFO magazine recently characterized large-firm debt and equity finance as ¡°dirt cheap.¡±3 Smaller firms, however, still cite tighter bank lending terms as constraints to increased borrowing. For simplicity, I focus on the ratio of banks¡¯ excess reserves to required reserves. Unfortunately, the required and excess reserves for individual banks are not published by bank regulators. As a substitute, for each quarter between 2008:Q3 and 2010:Q2, I use publicly available bank-level data to compute measures of required and excess reserves using rules as similar as feasible to the ones used by the Federal Reserve.4

Over the 2008:Q3¨C 2010:Q2 period, the distribution of the excess to- required reserves ratio has become more dispersed (less peaked and with a fatter tail), indicating that more banks have accumulated larger amounts of excess reserves. Figure 1 shows the 100 largest banks. Figure 2 shows all other banks. Large increases in excess reserves have prompted some analysts to argue that depository institutions are ¡°hoarding cash,¡± thereby impeding the growth of lending and slowing the recovery from the 2007-09 recession.

Analysis of the cross-sectional data suggests that some banks may be maintaining such large reserve positions as a precautionary hedge in an uncertain environment. Many banks, especially smaller ones, likely recall the autumn of 2008 when repurchase agreement (repo) markets closed and, absent Federal Reserve actions, liquidity was unavailable at any price. As long as the strength of the recovery remains uncertain, there are few other investment opportunities, after adjusting for risk and taxes, with anticipated returns greater than the near-zero interest (currently 0.25 percent) the Federal Reserve pays on deposits. ¡ö

1 See Board of Governors of the Federal Reserve System. ¡°Reserve Requirements.¡±
October 26, 2010; www.federalreserve.gov/monetarypolicy/reservereq.htm.
2 See Anderson, Richard G. ¡°Is More QE in Sight?¡± Federal Reserve Bank of
St. Louis Monetary Trends, November 2010;
research.stlouisfed.org/publications/mt/20101101/cover.pdf.
3 Ryan, Vincent. ¡°Multiple Choice.¡± CFO, December 1, 2010;
www.cfo.com/article.cfm/14540065.
4 For an analysis of more accurate measures, see Anderson, Richard G. and
Rasche, Robert R. ¡°Retail Sweep Programs and Bank Reserves, 1994-1999.¡±
Federal Reserve Bank of St. Louis Review, January/February 2001, 83(1), pp. 51-72;
research.stlouisfed.org/publications/review/01/0101ra.

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Memo to Bernanke: Cut the IOR to 0.15%. It will give banks a bit less incentive to just sit on all the QE you’re sending their way. But it will still be high enough to prevent the MMMFs from going belly up. And you guys at the BOG can do it on your own–no pesky regional bank presidents to deal with. Even Ron Paul will approve—less subsidy to fat cat bankers. Git er done. --SCOTT SUMNER

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I hear a loud sucking sound.

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Actually, focusing on CB bank credit is misleading. The MSBs, CUs, & S&Ls became money creating depository financial institutions (DFIs) after they were given the legal authority by the DIDMCA in 1980. You would have to add (?) some of their loans & investments to CB bank credit to put the number into proper perspective.

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FED-WIRE transactions down, Contractual Clearing Balances are at their lowest levels in 2 years. Are IORs to blame?