Monetary non-transmission

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Since the Treasury-Reserve Accord of March 1951, it has been within the power of the Manager of the Open Market Account at the Federal Reserve Bank of New York to control the total volume of Reserve Bank credit, the total volume of member bank legal reserves, & the total volume of commercial bank credit.

Essentially monetarism entails the fulfillment of the following conditions:

(1) The monetary authorities use two tools to control the money supply -- legal reserves and reserve ratios. If these tools are to be effective, all legal reserves of all money creating insitutions have to be in a form which the monetary authorities can quickly ascertain and absolutely control. The only type of bank asset that fulfulls this requirement is interbank demand deposits in the District Reserve banks owned by the member banks (like the ECB). Similarly, the monetary authorities have to have complete discreation over changes in reserve ratios. This is essential since under fractional reserve banking (the essence of commercial banking) these ratios determine the minimum volume of legal reserves a bank must hold against a specific volume and type of deposit liablity.

(2) the two basic monetary aggregates of concern to the monetary authorities, in addition to the volume of legal reserves in the system, are the means-of-payment money supply and the volume of commercial bank credit. Money supply figures should include the U.S. Treasury's balances in the commercial and the Reserve banks, as well as currency held by the non-bank public and transaction deposits (excluding interbank demand deposits) in the commerical banks.

The volume of bank credit is a necessary component of the monetary control apparatus, since any expansion of commercial bank credit involving loans to, or purchases of securities from the non-bank public results initially in a concomitant expansion of the money supply. In the control of these aggregates, the monetary authorities are completely dependent on their power to control the volume of bank credit. They have no power over the volume of the Treasury's General Fund Account or the currency holdings of the public.

(3) In regulating the money supply, the monetary authorities using monetarist guidelines will be cognizant of the volume and rate-of-change of money flows, i.e., the volume of money times its (transactions) rate-of-turnover (MVt). It should be quite obvious that the extent of money's impact on prices and the economy is measured by money flows, not the stock of money. If the transactions velocity of money were a constant, it would not matter...

(4) and above all else recognize that even a temporary pegging of a series of federal funds rates (policy rate) over time, forces the Fed to abdicate its power to regulate properly the money supply.

I.e, there is only one interest rate that the Fed can directly control; the discount rate charged to bank borrowers. The effect of Fed operations on all other interest rates is indirect, and varies widely over time, and in magnitude.

In other words, the FRB-NY (the Central Reserve bank since the 12 District Reserve bank's operations were consolidated in 1933), could control the volume and rate of money creation via its open market operations (OMOs) - given the proviso that adequate market breadth & depth exists for the targeted collateral.

These transactions were conducted between the FRB-NY's "trading desk" & its primary security dealer counterparties (which are all member commercial banks), either by buying securities in the secondary money market thereby expanding its balance sheet (& thus creating new excess reserves at the disposal of the CBs, i.e., additional legal lending capacity), & or by selling assets from its SOMA portfolio, thereby contracting its balance sheet, etc.

But with the introduction of the payment of interest on excess reserve balances in Oct 2008, this "Open Market Power" has been completely emasculated. Now the remuneration rate is used to sterilize the "trading desk's" open market operations of the buying type (i.e., sterilize the expansion of reserve bank credit on its blown-out balance sheet).

There was a time (before 1942 and before the federal debt became a controlling economic factor), that demand deposits fluctuated up and down with the business cycle, Commercial banks were commercial banks and when business demand for loans increased, so did demand deposits, & vice versa.

But today the Keynesian training of the Fed's senior economic (technical) staff resolutely advises that interest is the price of money (exclusively CB lending/investing), & not the price of loan-funds, or CB + NB lending/investing (a doctrine that confuses money with liquid assets). This was the argument for turning 38,000 financial intermediaries into 38,000 commercial banks via the DIDMCA of March 31st 1980.

This monetary transmission mechanism presumes that a "liquidity preference curve" exists which represents the supply of money. In this system interest is the cost which must be paid if lenders are to forego the advantages of liquidity. All of this has little or nothing to do with the real world, a world where interest is paid on checking accounts (e.g., deregulation of Reg Q ceilings).

The FOMC therefore surmises that the money stock can be controlled through the manipulation of a series of interest rate pegs at the front-end segment on the yield curve. Thus the FOMC seeks to establish & re-establish a specific interest rate corridor where: (1) the general collateralized repo rate equals the "floor" (the one day cost of carry on agencies), & (2) the remuneration rate or policy rate (is the rate paid to the banks on their excess & required reserve balances not to lend), & (3) the discount rate or "ceiling" (the penalty rate at which Walter Bagehot & Paul Volcker would surreptitiously lend unlimited amounts of credit).

As financial innovations began to flourish in the early 60's, the CBs began to buy their liquidity (as opposed to following the old fashioned practice of storing their liquidity), this Keynesian misconception (demand for money), re-emerged when William McChesney Martin, Jr. changed the operating criteria at the "trading desk" from using a “net free” or “net borrowed” reserve position approach (the Continental Illinois bank bailout provides a spectacular example of this practice), to using the Federal Funds "Bracket Racket" c. 1965.

By using the wrong criteria (interest rates, rather than member bank legal reserves) in formulating & executing monetary policy (i.e., by changing the monetary transmission mechanism), the Fed became an engine of inflation. The demarcation was clear cut: as the money supply (which had grown at less than 2 percent in the decade ending in 1964), accelerated to a grow at a rate in excess of 6.5 percent in the subsequent decade, etc.

It is an incontrovertible fact. The money stock can never be managed by any attempt to control the cost of credit. That's what the Treasury-Reserve Accord of March 1951 was all about. The effect of tying open market policy to a fed funds bracket was to supply additional (& excessive) legal reserves to the commercial banking system when loan demand increased.

Since the member banks maintained no excess reserves of significance, the banks had to acquire additional reserves to support the expansion of deposits, resulting from their loan expansion. If they used the Fed Funds bracket (which was typical), the rate was bid up & the Fed responded by putting though buy orders, reserves were increased, & soon a multiple volume of money was created on the basis of any given increase in legal reserves.

I.e., a rise in the target FFR to the top of the bracket triggered open market purchases: a fall to the lower end of the bracket, selling oeprations. Open market operations of the buying type added legal reserves to the commercial banking system; selling operations reduced reserves.
This combined with the rapidly increasing transaction velocity of demand deposits resulted in a further upward pressure on prices. This is the process by which the Fed financed the rampant real-estate speculation that characterized the 70's

I.e.,Keynes's liquidity preference curve is a false doctrine. Interest, as our common sense tells us, is the price of obtaining loan-funds, & not the price of money. The price of money is represented by the reciprocal of the various price indices. If the price of goods and services rises, the "price" of money falls. Interest rates, in any given market, at any given time, are the result of the interactions of all the forces operating through the supply of, and the demand for, loan funds (not the supply of and demand for money).

Loan funds, of course, are in the form of money, but there the similarity ends. Loan funds at any given time are only a fraction of the money supply -- that small part of the money supply which has been saved, and is offered in the loan credit markets.

To the Keynesians, high interest rates are evidence of "tight money", low rates of "easy money", and, a proper rate of growth of the money supply is obtainable by manipulating the policy rate. Consequently, to bring interest rates down the money supply should be expanded and vice versa" [sic].

It is true that an expansion of both Reserve Bank credit, & or commercial bank credit, either siphons demand off the money market, or produces a concomitant increase in the volume of new money (loan-funds), and that the initial effect is to depress interest rates, other things being equal. If, however, the increase in the volume of money flows exceeds the changes in the volume of goods and services offered in the markets, prices will rise. And if the price increases are broadly based and chronic, we have inflation

A tight money policy is when the Fed restricts the expansion of member bank legal reserves sufficently to restrain the increase of money flows (MVt) at a rate no more than 2% or 3% in excess of the rate-of-change in real gDp. While recognition of these time lags is important, it is even more significant to know that the same policy actions by the Fed can produce diametrically opposite effects in the long run as compared to the short run.

(1) A spectacular example of these mechanics occurred when Paul Volcker was Chairman:

(a) when Volcker drained legal reserves between 1/23/80 & 6/18/80, from $46,250b to $43,143b (instantly lowering both short & long-term rates - T-bills fell from 16.00% on 3/25/1980 to 6.18% on 6/13/1980), &

(b) then as Volcker reversing policy - dramatically injecting reserves between 6/18/80 & 1/21/81, from $43,143b to $48,815b (instantly raising both short & long-term rates - T-bills peaked at 17.01% by 5/13/1981).

This ill conceived transition came full circle in the early 1990's. In Dec 1990 the non-transaction reserve requirements were reduced from 3% to zero: releasing $13.2b in legal reserve balances. In April 1992, the Fed lowered its reserve ratios from 12% to 10% on transaction based deposits: reducing reserve requirements by $8.9b (or in total it reduced legal reserve requirements by 1/3).

Subsequently, legal (fractional) reserves ceased to be binding: because increasing levels of vault cash (larger ATM networks), retail deposit sweep programs, the pyramidying of correspondent's pass thru accounts, fewer applicable deposit classifications, & lower reserve ratios, combined to remove most reserve, & reserve ratio, restrictions. Thus the stage was set for the Great-Recession of 2008-2012.

I.e., Lawrence K. Roos, past President, FRB-STL & part-time member of the FOMC (the Fed's policy making arm) was cited in the WSJ's "Notable and Quotable" colmun, April 10, 1986, as follows:

"...I do not believe that the control of money growth ever became the primary priority of the Fed. I think tha there was always and still is a preoccupation with stabilization of interest rates". I.e., monetarism has never been tried.

But the only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves.

Take one last example:
 
Greenspan raised the target FFR 17 successive times from June 30, 2004 until June 29, 2006), but every single rate increase was “behind the inflationary curve”, i.e., the roc in the proxy for inflation always remained expansionary. In other words, Greenspan NEVER tightened monetary policy.

Then as the economy (& housing), started collapsing, Bankrupt you Bernanke lowered the target FFR 7 consecutive times (from 9/18/07 until 4/30/08), but every policy rate change was behind the inflationary curve (i.e., the proxy for inflation, or roc's in MVt, continued to be contractionary)

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"when the Fed last officially changed reserve requirements, in 1992, it was attempting to ease the credit crunch of that time and improve the profitability of depository institutions without expanding the money supply or lowering interest rates"

I.e., the Fed opted not to use its "Open Market Power" during an identical period where interest rates were trapped in zero bound territory (ZIRP). Instead, the Fed abdicated both its employment & inflation mandates to appease the commercial bankers (i.e., the CBs excess reserve balances already averaged below subpar maintenance levels).