The Center of the Universe

The Fed Plan to Revive High-Powered Money

Don’t only drop the interest rate paid on banks’ excess reserves, charge them.

That would be a tax that reduces aggregate demand

By Alan S. Blinder

December 10 (WSJ) — Unless you are part of the tiny portion of humanity that dotes on every utterance of the Federal Open Market Committee, you probably missed an important statement regarding the arcane world of “excess reserves” buried deep in the minutes of its Oct. 29-30 policy meeting. It reads: “[M]ost participants thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage.”

They don’t realize paying interest on Fed liabilities is a subsidy to the economy any more than Professor Blinder does.

As perhaps the longest-running promoter of reducing the interest paid on excess reserves, even turning the rate negative, I can assure you that those buried words were momentous. The Fed is famously given to understatement. So when it says that “most” members of its policy committee think a change “could be worth considering,” that’s almost like saying they love the idea. That’s news because they haven’t loved it before.

So what exactly are excess reserves, and why should you care? Like most central banks, the Fed requires banks to hold reservesmainly deposits in their “checking accounts” at the Fedagainst transactions deposits. Any reserves held over and above these requirements are called excess reserves.

Not long agosay, until Lehman Brothers failed in September 2008banks held virtually no excess reserves because idle cash earned them nothing.

No, because Fed policy was to keep banks net borrowed, and then implement its policy rate via the Fed’s interest rate charges for the subsequent ‘reserve adds’ which were functionally loans from the Fed.

But today they hold a whopping $2.5 trillion in excess reserves, on which the Fed pays them an interest rate of 25 basis pointsfor an annual total of about $6.25 billion. That 25 basis points, what the Fed calls the IOER (interest on excess reserves), is the issue.

Yes, thereby supporting their policy rate decision, which happens to be a ‘range’ a bit above 0, which also happens to be a display of the Fed’s failure to understand monetary operations.

Unlike the Fed’s main policy tool, the federal-funds rate, the IOER is not market-determined. It’s completely controlled by the Fed. So instead of paying banks to hold all those excess reserves, it could charge banks a small fee, i.e., a negative interest rate, for the privilege.

At this point, you’re probably thinking: “Wait. If the Fed charged banks rather than paid them, wouldn’t bankers shun excess reserves?” Yes, and that’s precisely the point. Excess reserves sitting idle in banks’ accounts at the Fed do nothing to boost the economy. We want banks to use the money.

Reserves are assets. They can’t be ‘used’ to boost the economy. Banks can sell their reserves to other banks, but in any case the total persists as Fed liabilities. Nothing the banks can do will change that.

If the Fed turned the IOER negative, banks would hold fewer excess reserves, maybe a lot fewer. They’d find other uses for the money. One such use would be buying short-term securities. Another would probably be lending more, which is what we want.

When banks buy securities or lend, their reserve account is debited and the bank of the seller of the securities or of the borrower gets its reserve account credited. That is, the assets called reserves are merely shifted from one bank to another, with the quantity of reserves held by the banking system remaining unchanged.

A second reason for cutting the IOER answers some of the criticisms the Fed has taken for its asset-buying programs called quantitative-easing: Doing so would stimulate the economy without increasing the size of the Fed’s balance sheet. In fact, the Fed could probably shrink its balance sheet.

Why would charging banks a fee stimulate the economy?

And further note that, before the current budget agreement, these ‘fees’ were called taxes, and for a good reason! ;)

To understand why, think back to the good old days, when excess reserves were zero. When the Fed injected reserves into the banking system, banks would use those funds to increase lending, thereby creating multiple expansions of the money supply and credit. Bank reserves were called “high-powered money” because each new dollar of reserves led to several additional dollars of money and credit.

I’ll give Professor Blinder the benefit of the doubt and assume the ‘good old days’ were the days of the gold standard, a fixed fx regime, where banking was continuously reserve constrained, interest rates were market determined, and bank lending was thereby constrained by the necessity to keep ‘real dollars’ on hand to meet depositors potential demands for withdrawals.

With today’s floating fx policy none of this is applicable.

The financial crisis short-circuited this process. As greed gave way to fear, bankers decided to store trillions of dollars safely at the Fed rather than lend them out. High-powered money became powerless money.

Here it seems he conflates the issue of liquidity and interbank lending with the issue of lending to the real economy, along with more inapplicable gold standard analysis.

Banking is always a case of loans creating deposits. And with today’s institutional structure, when deposits carry reserve requirements, in the first instance those requirements are functionally overdrafts in that bank’s reserve account at the Fed. And an overdraft is a loan, and booked as a loan from the Fed on statement day if it persists. So in fact loans create both deposits and any required reserves at the instant the loan is funded.

So rather than ‘high powered money’ as is the case with a gold standard, reserves today are best thought of as residual.

The Fed compounded the problem in October 2008 by starting to pay interest on reserves. And these days, the 25-basis-point IOER looks pretty good compared with most short-term money rates.

As it always is due to ‘market forces’. The entire term structure of rates continuously adjusts to the Fed’s policy rate which generally imposed by targeting the Fed funds rate.

If banks were charged rather than paid 25 basis points, they would find holding excess reserves a lot less attractive. As some of this excess central-bank money became “high-powered” again, the Fed would want less of it. So its balance sheet could shrink.

I don’t follow this part at all. Banks always find holding reserves ‘unattractive’ as the Fed funds rate is likewise their marginal cost of funds. So reserves are, in general, never a profitable investment, and banks are always looking for investments that yield more, on a risk adjusted basis, than their cost of funds.

What are the arguments against turning the IOER negative? Over the years, Fed officials have made three, none of them cogent.

One is that cutting the IOER would have only modest stimulative effects. Well, probably. But are there more powerful tools sitting around unused? Besides, there is at least a chance that we’d get more new lending than the Fed thinks.

There’s a much larger chance that this new tax, though modest, will nonetheless reduce aggregate demand. With the economy a large net saver, and the govt a large net payer of interest, in general higher rates increase income and lower rates decrease income.

Second, there is a limit to how far negative the IOER can go. After all, banks can earn zero by keeping paper money in their vaults. So if the Fed charged a very high fee for holding excess reserves, bankers might find it worthwhile to pay the costs of bigger vaults and more security guards in order to keep huge stockpiles of cash. Sure. But a mere 25 basis point fee is not enough incentive for them to do so.

If it was realized negative rates are a tax, the argument would never get this far.

Third, a negative IOER could drive short-term interest rates even closer to zero, as banks moved balances from their reserve accounts into money market instruments. And that, we are told, would wreak havoc in the money markets. Really? Perhaps that was a legitimate concern three years ago, but we have now lived with money-market rates hugging zero for years, and capitalism has survived.

And if we eliminated the FDIC deposit insurance cap there would be no need for money market funds in the first place.

Besides, the Fed paid no interest on reserves for the first 94 years of its existence, the European Central Bank has been paying its banks nothing since July 2012, and the Danes have been charging a fee since then. In no case did anything terrible happen.

Instead the banking system was kept net short reserves, and the Fed- the monopoly supplier of net reserves- used the rate charged to cover that ‘overdraft’ to set its policy rate.

That said, suppose the policy failed. Suppose the Fed cut the IOER from 25 basis points to minus 25 basis points, and banks didn’t react at all; they just held on to all their excess reserves. In that unlikely event, cutting the IOER would neither provide stimulus nor enable the Fed to shrink its balance sheet. However, the Fed would start collecting about $6.25 billion per year in fees from banks instead of paying them $6.25 billion in interesta swing of roughly $12.5 billion in the taxpayers’ favor. Some downside.

Like any other tax…

Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is the author of “After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead” (Penguin, 2013).

The automatic fiscal stabilizers are far too aggressive as they do their thing to abort this recovery.

>   
>   (email exchange)
>   
>   Nice data on shrinking deficit due to private sector growth and not “cuts” in governments
>   spending.
>   

Smallest budget deficit in 5 years is great news

Lots of talk on how the expiring unemployment benefits will alter January jobs numbers.

Size of labor force?
Participation rate?
Will they suddenly accept low paying service sector jobs?
Go on disability?
Etc. etc.

In theory total jobs should be about the same, as this type of thing for all practical purposes doesn’t cause anyone to increase head count. It can, however, put downward pressure on labor should these people ‘substitute’ for whoever would have been hired otherwise, but a lower rate of pay.

Time will tell. But in any case, it’s a cut in govt spending that thereby gradually results in fewer jobs than otherwise:

Extended Unemployment Aid Likely to End (WSJ) A financial lifeline for people who have exhausted their state unemployment benefits is on the verge of coming to an end, after Republicans and Democrats clashed in budget talks over how to cover the cost of extending emergency benefits that have aided workers since the financial crisis. The program, which provides aid for the long-term unemployed, was left out of a budget deal announced by Republican and Democratic negotiators Tuesday night. Democrats and the White House sought an extension of the plan, but the $25 billion cost have reduced the chance it will be continued. Top Democrats in both the House and Senate acknowledged the benefits would expire at the end of the year. The White House estimates that 1.3 million people will lose emergency federal jobless assistance on Dec. 28, with another 1.9 million people losing the aid in the first half of 2014.

Looks like the general drift to lower growth rates may still be in progress.

Headline retail sales year-over-year with 3 mo moving average:

Longer term chart:

And auto sales chart shows how they sagged during the October govt. shutdown with lost sales subsequently recovered, but on balance relatively flat for 2013:

Lots of noise in claims data this time of year, but, again, claims are about separations, not new hires, though correlation has been pretty good:

Of course all they have to do is pay interest on all reserve balances…

Fed Moves Toward New Tool for Setting Rates (WSJ) An experimental bond-trading program being run at the Federal Reserve Bank of New York could fundamentally change the way the central bank sets interest rates. Fed officials see the program as a potentially critical tool when they want to raise short-term rates in the future to fend off broader threats to the economy. Launched this year, it is still in a testing stage and isn’t expected to be fully implemented for years. The Fed would use the facility to raise short-term interest rates by borrowing in the future against its large and growing securities portfolio. When it does want to raise rates, it will use securities it accumulated through its bond-buying stimulus programs as collateral for loans from money-market mutual funds, banks, securities dealers, government-sponsored enterprises and others. The rates it sets on these loans, in theory, could become a new benchmark for global credit markets.

Budget Deficit in U.S. Narrows as Job Gains Bolster Revenue

By Kasia Klimasinska

December 11 (Bloomberg) — The budget deficit in the U.S. last month narrowed more than economists forecast as rising employment and a rallying stock market boosted revenue to a November record.

Spending exceeded revenue by $135.2 billion, compared with $172.1 billion in November 2012, the Treasury Department said today in Washington. The median estimate in a Bloomberg survey of 17 economists was for a $140 billion gap. Receipts rose 12.8 percent to the highest ever for the month, while spending fell 4.8 percent.

Declining unemployment has helped reduce the countrys deficit as a share of gross domestic product by more than half in the past four years to $680.3 billion in fiscal year ended Sept. 30 from a record $1.42 trillion in 2009. The Congressional Budget Office has projected the shortfall will shrink further this year and next as stronger economic growth lifts individual and corporate taxes.

Weve seen spending come down and tax receipts outperforming, based off of a little bit better economic growth, said Michael Brown, an economist at Wells Fargo Securities LLC in Charlotte, North Carolina. As long as we maintain a pace of job growth that is consistent with what weve seen over the last couple of months, that trend of increase in revenue should continue.

>   
>   Here’s Bob Toll on the TOL conference call yesterday. Given its
>   market niche, I would expect TOL to be the strongest of the
>   homebuilders—and note that 20% of sales were all cash. (I don’t
>   know how that compares with historical experience, but it seems
>   high.) This was from the prepared remarks, fyi.
>   

Since August 1, 2013, the beginning of our fourth quarter, through this past weekend, which is halfway through our first quarter, our business has been basically flat compared to the same period of time one year ago. During that 19-week timeframe last year, two weeks were highly unusual. Hurricane Sandy hit on Thursday, October 25, 2012, and wiped out sales in about half our markets that weekend. The contracts which would have been signed that last weekend of October 2012 were pushed into the first week of November 2012. Because November is a new fiscal quarter for us, our reported results and comparisons to last year are affected. Excluding this first week of November 2012, our last five weeks of business have been flat to one year ago.

And as mentioned, the full 19-week period since August 1 has also been flat. We believe this leveling of demand will prove temporary based on still significant pent-up demand, the gradual strengthening of the economy and the improving prospects of our affluent customers.

Highlights
A big jump in rates held back mortgage applications in the December 6 week which, after very steep declines in the prior week, inched only 1.0 percent higher for purchase applications and 2.0 percent higher for refinance applications. Down 10 percent year-on-year, the purchase index remains especially depressed in a what is a negative indication for underlying home sales. The average rate for 30-year mortgages with conforming loans ($417,500 or less) jumped a steep 10 basis points in the week to 4.61 percent.

Classic from 1999-

Congrats on the budget surplus on the left, and warning that savings is too low on the right!

WSJ July 1999

Pension contributions function as taxes:

Increased pension contributions

On Monday, a senior Senate Democratic aide said that workers would not have to increase their own contributions toward their pensions as much as previously thought.

The Congressional Budget Office had previously estimated that if each employee contributed an additional 1.2 percent of their salaries to get the same retirement annuities, it would save the government $19 billion over 10 years.

Says its backed by taxes and men with guns…
;)

PAUL KRUGMAN: Bitcoin’s Value Is Driven By The Fact That It Sounds Impressive

As previously discussed, this happens with every down cycle, and is disproven every time demand picks up.

Meanwhile, real wages continue to under perform and remain disgraceful

This new Fed paper says that everyone who left the labor force since early 2012 is not coming back. In other words, the labor market is tighter than the Fed thinks and the NAIRU is higher which is why wages are rising, see also chart below:

Excerpts:
“The decline in the participation rate since the first quarter of 2012 is entirely accounted for by … retirement.”

“…a plausible conjecture is that the 2008 financial crisis and associated losses of wealth might have had the effect of delaying their retirement age, while the subsequent recovery of financial wealth has allowed more of them to retire in the last few years.”


Fed: “On the Causes of Declines in the Labor Force Participation Rate”


In the attached GEP from earlier this year we also found that most of the decline in the participation rate is driven by longer-term, structural factors, such as demographics.

Happy to discuss, let us know.

Full size image

A bit more austerity on the way, seems:

Bundle of Tax Breaks Again Set to Lapse

(WSJ) Congress appears almost certain to allow a batch of temporary tax breaks to lapse at the end of 2013. The breaks range from broad provisions such as research credits for businesses and a sales-tax deduction for individuals, to narrower ones such as a credit for buying electric motorcycles. The number of temporary tax breaks has snowballed from a handful in the 1980s to more than 50 now, and some lawmakers are beginning to think the package might have become excessive. While extending them for a year or two at a time has helped mask their price tag, the Congressional Budget Office said that if the existing temporary breaks were extended over the next decade, they would cost the U.S. government almost $1 trillion. To keep the package intact, lawmakers rely on a tactic known as logrolling, supporting each other’s priorities in order to preserve their own breaks.

Pretty much all forecasters expect improvement in 2014 largely from what they call a reduction in fiscal drag. Their logic goes something like this (with the actual numbers varying a bit with different analysts):

Without the deficit reduction in 2013 that subtracted 2% from growth, growth would have been 4%. Therefore, when the fiscal drag ends, growth will return to the underlying 4% pace.

I’m suggest their logic is faulty.

The difference is that of ‘adding less’ vs ‘subtracting’

It’s not like the private sector alone was expanding at a 4% clip, and then govt came along and took away 2%.

It’s that by my count the private sector was growing at -2%, and govt was going to add 6% to that for 2013, but proactively reduced its support to only 4% in 2013 by cutting spending and raising taxes, resulting in 2% GDP growth rather than 4%. And for 2014 that ‘lost support’ will not be added back.

Expanding:

Assume, for example, GDP started 2013 at 100, and was forecast to go to 104 as stated above. Assuming nominal growth about 1.5% over real growth, let me push that up to 105.5.

That assumption included, say, federal deficit spending of 6% of GDP (starting at maybe a 7% rate and ending at maybe a 5% rate).

That is govt was forecast to make a net positive 6% contribution to spending by spending that much more than its income, aka ‘credit expansion’. Or, said another way, the total government spending contribution was over 20% of GDP, with all but 6% of that ‘offset’ by taxation that reduced incomes elsewhere.

Also note that the economy is currently ‘demand constrained’ as there is an output gap. In other words GDP could be higher, as a matter of accounting, simply by, for example,
govt hiring more people who are currently not working for pay, via the govt spending that much more than its income (adding to the deficit). Or GDP could be lower simply by govt cutting back, which is what actually happened, as recognized by the analysts.

That is, net govt spending was proactively reduced by about 2% due to tax increases and sequesters.

And federal deficit spending averaged perhaps 4% of GDP rather than 6% of GDP, thereby reducing said GDP..

That is, government contributed that much less to GDP. And that lost contribution will not be restored, as, if anything, there will be further deficit reduction forthcoming from Congress in 2014.

So my point is the 4% forecast for 2013 was not that much private sector growth that was then reduced by the deficit reduction measures. Instead, the growth forecast included the federal deficit contributing 6% to GDP, which was subsequently reduced by Congress to only 4%.

In fact, without the remaining 4% contribution of that net federal spending, nominal GDP might have been -.5% and real -2%.

And 2014 is starting out with federal deficit spending forecast to add only about $600 billion, which is less than 4% of GDP.

So to recap, the original forecast for 4% growth included the full 6% contribution from govt. And when that contribution was proactively reduced to 4%, growth forecasts were correctly cut to 2%.

And my point is that the assumed ‘underlying growth rate’ of 4% in fact presumed the then 6% contribution from govt which was subsequently reduced, thereby lowering ‘the underlying growth rate’ for 2013 to 2%.

It’s not that the private sector was responsible for 4% growth and that the govt took away 2% of that with the tax increases and sequesters.

In fact, it was more that the private sector was -2% on its own due to ‘demand leakages’/unspent incomes/savings desires including non residents) and govt support that was to boost that to +4% was cut back, resulting in a 2% rate of GDP growth for 2013.

I am not saying that GDP growth can’t pick up in 2014.

I am saying that the logic behind the widespread forecasts for a pick up in growth is universally faulty.

And that if growth does pick up it will be from an increase in non govt ‘spending more than incomes’, aka an increase non govt credit expansion.

While this is certainly possible, traditionally it comes from housing, which currently isn’t generating any credit expansion, and cars which are no longer generating meaningful increases.

Worse, in prior cycles we got the private sector credit expansion need to support relatively low output gaps only from expansion we never would have let happen if we had been aware of the consequences. These included the Bush sub prime expansion, the Clinton .com/y2k credit expansion, the Reagan S and L credit expansion, and the earlier Wriston emerging markets credit expansion. And I don’t see anything like that happening currently.

And so without the prerequisite acceleration of non govt credit expansion, the maths tell me 2014 GDP growth will remain at best at approximately the 2% level of 2013. And, with so little support from federal deficit spending, I see serious downside risks should private sector credit expansion falter for any reason.

And note too that the continuation of 2% GDP growth closes the output gap only by reducing estimates of potential output, primarily by assuming the drop in the participation rate is structural.

And even the modest employment gains we’ve seen are at risk. The growth rate of employment has been almost identical to the underlying rate of real growth, which improbably implies no productivity growth. So if there is any positive underlying productivity growth, and real growth remains the same, employment growth will decline accordingly.

Lastly, the ‘automatic fiscal stabilizers’ are continuously at work. So when private sector credit expansion does contribute to growth, the govt ‘automatically’ cuts back its support via reduced transfer payments and increased tax receipts, thereby tempering the positive effect of the private credit expansion, and making it that much more difficult for the growth to continue.

This means that even the current 2% growth rate will at some point get ground down by our current institutional structure. With growing risks that this could be very much sooner rather than later.

If the price of natural gas happens to go back towards $10, the US’s ‘energy advantage’ pretty much goes away. And it’s becoming increasingly legal to export it to hurry that day…

So let’s hope for the best!

And that much closer to the end of this cycle, absent a big fat credit bubble

CBO: Federal Deficit declined Sharply in October and November compared to last year

Personal consumption expenditures: New autos

Consumer Credit

Employment continues to grow at the pace we’ve seen for the last couple of years at a pace that’s perhaps a bit ahead of population growth (chart).

The question is whether this is sufficient for the Fed to taper, which I’d say is anyone’s guess right now.

The FOMC clearly doesn’t like QE, but at the same time seems to me they will shy away from doing anything that might cause further increases in mortgage rates?

And for those who believe QE ‘works’ to sustain growth (or, as some believe, bring it back from the future), they have to be very concerned that with all the QE they’ve done this is all we have to show for it, wondering how bad it would have been without the QE, or what might happen if they back off.

October personal Income also was released at 8:30am and was weaker than expected, with the govt. shutdown likely a factor, so, as it’s been for a while, it’s a matter of waiting for cleaner data.

Inflation indicators continued weak as well, further complicating the tapering debate:

Personal Income and Outlays:

Highlights:
Overall consumer spending picked up a bit as expected at the beginning of the fourth quarter but not by much, to plus 0.3 percent in October vs plus 0.2 percent in September. Strength was in durable goods reflecting strong auto sales. Smaller gains were posted for nondurable goods and services.

The income side of the report is especially soft, at minus 0.1 percent following two very strong months at plus 0.5 percent. The decline is the first since January and may be related to the impact of the government shutdown on private wages. Wages & salaries are especially soft, up only 0.1 percent following gains of 0.4 and 0.6 percent in the two prior months.

Inflation readings are very soft with the price index unchanged and the core index up only 0.1 percent. The year-on-year rate for the price index is only plus 0.7 percent with the core year-on-year rate at plus 1.1 percent, both declining in the month and both well below the Fed’s goal of 2 percent.

PCE Deflator Graph
Personal Income Y/Y Graph