Goldman- Excess Reserves Irrelevant and the FED does not need to execute Reverse Repos with Non-Primary Dealers
Posted by WARREN MOSLER on November 2nd, 2009
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Hopefully, when Goldman talks, people listen:
Clarification from author Franesco Cafagna: Views expressed in this piece are his own and are not necessarily reflect the view of Goldman Sachs
1. Do excess reserves really matter and does the FED really need to drain them?
The short answer is: I don’t think so. The total amount of reserves currently in the banking system is the sum of all Required Reserves (including a certain amount that banks hold for precautionary reasons) and Excess Reserves. The FED HAS to provide the banking system with the amount of Required Reserves it needs otherwise rates spike higher (potentially to infinity if the discount window or other forms of “marginal lending facilities†did not exist): the amount required is the result of banks’ individual credit decisions (how many loans they make) and the FED’s job is to estimate that amount and provide it to the system. But the FED does not control this number. When it comes to Excess Reserves, lots of people worry about the potential long-term inflationary impact they may have. The truth is that they don’t matter because they bear no weight in banks’ credit decisions (how many new loans they make). They simply appear on banks’ balance sheets as an Asset that gets “invested†every night in the form of a deposit that they leave at the FED and on which they currently get a 25bps remuneration. If the FED decided to drain excess reserves via Reverse Repo the impact on the system as a whole would be zero because the system as a whole is “self containedâ€. To understand this let’s think of the most extreme case: the FED drains all excess reserves via one giant Overnight Reverse Repo executed with all the
banks in the banking system. At a macro level all that’s happened is that each bank has changed its Excess Reserve asset (which is effectively an O/N asset) into and O/N Reverse Repo and the two are virtually identical. Another way to think of this is that Excess Reserves are ALREADY being drained every night because banks leave them on their account at the FED every night. The only thing that will change is the liquidity profile of banks IF the FED decided to execute Reverse Repos longer than 1 day: in that case a 1-day assets (excess reserve) would be transformed into a longer asset (Reverse Repo longer than 1 day). Whilst this may affect individual institutions, the system as a whole is unaffected because this amount “extra cash†in the system (excess reserves) is NOT being used for anything. It just sits at the FED every night. So effectively it’s being “drained†already every night. So all this talk about excess reserves and their potential inflationary impact seems misplaced: they are just irrelevant and the FED simply does not need to drain them because they are “self-drained†every night anyway.
2. Does the FED really need to execute Reverse Repos with Non-Primary dealers?
This item has gained press coverage following the Fed’s release of the last Fomc minutes in which it was clear that it debated the possibility of executing large scale reverse repo operations with non-primary dealers: the motivation behind this discussion is the perceived balance-sheet capacity constraint that the 16 Primary dealers might face (a Reverse Repo increases the assets of the broker-dealer entity facing the Fed). This statement by the Fed has created all kind of debate across the street with various dealers coming up with all kinds of estimates of the overall size that the Primary dealers can handle (with some estimates being as low as 100-150bn out of a total of over 800bn that the Fed might want to execute). Leaving aside the actual need to execute Reverse Repo in the first place (point 1 above) and assuming that the Fed will, in fact, choose to execute these operations because it has stated that they are part of the exit strategy policy, I think the alleged Primary Dealers’ balance sheet capacity constraint has been VASTLY exaggerated. It’s true that a Reverse Repo increases the assets of a broker-dealer entity, but this is an issue only for stand-alone broker-dealers (Jeffreys and alike). For Primary Dealers with big commercial banks operations (JPM, Citi, BOA) I don’t believe that this is an issue at all: since they are already sitting on big amounts of Excess Reserves and because 23A (which regulates the activity between a bank entity and its affiliates) does not impose any restriction on the amount of UST, Agencies and Agencies MBS repos that a bank can execute with an affiliate broker-dealer entity, this means that the JPMs of the world could potentially execute reverse repo operations with the Fed up to the amount of excess reserves they are already sitting on without increasing their balance sheet by 1 single cent: it would simply be a transformation of an asset (excess reserves of the bank entity) into another (reverse repo of the broker-dealer entity). So, in my view, the conclusion has to be that the Primary Dealers can in fact absorb a much bigger amount of Reverse Repo than originally thought even by the Fed itself and that realistically the only other counterparties that the Fed might engage directly for these kind of operations are the GSEs: but in this case the reason would not be balance sheet driven but would be driven by the distortion that the GSEs’ participation in the fed funds mkt creates (call me if you would like to discuss this further).
By Franesco Cafagna
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November 3rd, 2009 at 11:14 am
Francesco is spot-on. I sent him a congratulatory email. Now maybe he’ll turn his attention to the deficit terrorists!
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November 3rd, 2009 at 12:23 pm
On capacity constraints, the analysis seems to overlook the fact that excess reserves currently are distributed beyond banks that own or are (e.g. Goldman, Morgan) dealers. So there’s the question of what share of total system reverses will be absorbed by bank/dealer balance sheets that currently hold in aggregate only a subset of system excess reserves. I.e. they can absorb their current share without affecting their own balance sheet size, but what is that in total compared to $ 800 billion?
Doing reverses with the GSE’s would correct the lower bound problem for fed funds, although there must be other ways they can tackle that.
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warren mosler Reply:
November 3rd, 2009 at 2:32 pm
rev rp’s are functionally equiv to paying interest on reserves.
both are interest bearing accounts at the fed.
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JKH Reply:
November 3rd, 2009 at 2:54 pm
Right.
But GSE’s don’t currently earn interest on their Fed balances. That’s why the lower bound failed before the target rate/range reached the current level. In fact, technically, its still failing at 25 basis points, because the GSE’s aren’t earning 25 basis points. So they’re lending below that.
Unless they’ve changed the interest rule for GSE’s recently, but I don’t think so. They certainly hadn’t when funds were in the 2 to 1 per cent range.
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Scott Fullwiler Reply:
November 3rd, 2009 at 3:02 pm
They did change it to allow balances held in correspondent banks to earn interest back in May. That was the main issue I encountered regarding difficulties keeping the target at the rate paid on rbs in the fall of 2008. I haven’t seen anything indicating GSEs have ever received interest on their rbs.
Scott Fullwiler Reply:
November 3rd, 2009 at 3:07 pm
Fed could set a target rate for its rev rps with GSEs equal to the rate paid on rbs, of course. Lacker suggested essentially this for all financial institutions holding rbs in his rb-sweeps account speech back in 2006, noting it would be operationally equivalent to paying interest on rbs (which the Fed wasn’t allowed to do at the time).
JKH Reply:
November 3rd, 2009 at 3:19 pm
I didn’t see your post, Scott. But agree that reverse RPs with GSEs would get around the lower bound problem if they still don’t earn interest on reserves, which I think is the case.
Matt Franko Reply:
November 5th, 2009 at 10:28 pm
JKH, (Hope you see this)
#1 Your missive above is the best run thru of the past year Fed actions I have ever come across on the internet. Be sure to save that it looks like you put a lot of time and thought into it and you may be able to use it again I’m sure. It reads as better minutes of the Fed meetings than the supposed “minutes” that the Fed itself puts out!
2. FYI I checked Yahoo! Finance and they have mrq total cash at Fannie of $136B and Total cash at Fredie of $305B. FWIW. $441B thats perhaps a lot to be working against the Fed.
3. HELP! Since loans create deposits, if a bank grants a new loan to a customer for $1M, and deposits the customers loan proceeds into a in house account ($1M new deposit); I assume (I may be wrong) that banks required reserves will increase by about $100k (10% of $1M new deposit), but will the other $900k of the loan proceeds (and now also a deposit) then constitute “excess” reserves? Am I looking at that right? Resp,
JKH Reply:
November 5th, 2009 at 11:41 pm
Thanks, Matt.
Increase in required reserves depends on the type of deposit account.
E.g. demand deposit will be 10 per cent requirement.
Time deposits 0 per cent (I think).
If you look at the entire US banking system, the actual weighted average reserve requirement on deposits in aggregate is less than 1 per cent due to time deposit dominance and things called sweep accounts (I think) that minimize end of day demand balances.
Anyway, use 10 per cent for your example; i.e. 100K.
The Fed will calculate the reserve requirement after it gets the info that the deposit has been created; i.e., with a lag.
Once the both the Fed and the bank acknowledge the reserve requirement is in force, the Fed will inject that amount of reserves into the system. E.g. the Fed does 100K in repo agreements with dealers – i.e. dealer sells securities to the Fed with a repurchase agreement. The Fed keeps rolling over that portfolio to maintain reserves. It has other asset initiatives as well it can use to manage its balance sheet in such a way as to maintain required reserve levels.
Anyway, the 100K is an expansion of reserves for the system.
The bank with the 1M deposit then has to compete for an additional 100K in deposits in order to top up its reserve account.
(Attracting 100K in new deposits from other banks clears that amount of new reserves into its account at the Fed.)
The end result is 1M loan; 100K reserves; 1.1M deposits.
The reserve requirement calculation process then repeats for the 100K in additional deposits.
Sounds like the textbook multiplier in reverse. But it doesn’t spin out of control, because required reserves for the system as a whole end up being relatively miniscule; less than 1 per cent in total as noted above.
Ball park talking upwards of $ 10 trillion in total bank deposits (mostly time deposits) and less than $ 100 billion in required reserves, probably closer to $ 50 billion (I haven’t looked lately; too lazy to do it right now.)
BTW, the people who worry about $ 1 trillion in excess reserves being “used” by banks to lend are not only ignorant of MMT; they haven’t come close to working out the math on a scenario basis. E.g. weighted average reserve ratio of 1 per cent as noted above would mean deposit expansion of $ 100 trillion in order to “use up” current excess reserves. That’s an expansion of the US banking system by 1000 per cent in balance sheet size. You’d think that the people who are wailing over the “threat” posed by excess reserves might do a little investigation of the absurdity of the arithmetic their argument implies.
JKH Reply:
November 3rd, 2009 at 3:15 pm
My point is clearer in the case of the 2 to 1 per cent range as an example.
Things are fuzzy currently because interest on reserves of 25 basis points should be acting as a lower bound on funds, but its not. Yet I think they’ve stipulated the target as a range of 0 to 25. Somewhat inconsistent with interest on reserves as a lower bound, but consistent with the fact that the lower bound is failing.
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Scott Fullwiler Reply:
November 3rd, 2009 at 3:41 pm
Yes, agree.
I think there’s a second issue that would require a bit of investigation, perhaps, but that is . . . how relevant is the posted daily effective fed funds rate anyway when there are about $800b in ER? At some point, under current operating procs, the qty of ER become so large and widely distributed that the fed funds rate would be trivial, but I don’t know if we’re there.
A related point is that it does appear that the correspondent banks not receiving interest on rbs was at least somewhat economically significant in terms of the fed funds market and effective rate “mattering.” I don’t know how significant it is that the GSEs don’t receive interest, though, given that correspondent banks do now.
JKH Reply:
November 3rd, 2009 at 3:48 pm
I don’t know the answer to your second point. The GSE’s collectively are huge so I would have thought their balances would be material relative to potential rate distortions.
I don’t understand your first point. Not sure how you mean “funds rate would be trivial” relative to distribution of ER balances. Unless you’re suggesting fed funds trade velocity would decline because of stagnant surpluses. Interesting point if so, but I suspect there’s still a high velocity of trade with daily volumes far exceeding outstanding balances of $ 800 billion (my guess).
JKH Reply:
November 3rd, 2009 at 4:04 pm
On second thought, $ 800 billion in daily funds trade sounds like a lot. I really don’t know how the daily volume stacks up against the reserves outstanding. Interesting.
Matt Franko Reply:
November 3rd, 2009 at 5:16 pm
JKH, If a bank could get FFR on excess from the Fed, why would a bank with excess loan FF to a bank that was reserve deficient when you could just get it risk free from the Fed?
JKH Reply:
November 3rd, 2009 at 5:44 pm
Matt,
In a normal positive rate environment, the Fed would set the reserve interest rate as the lower bound of a managed fed funds trading range. E.g. fed funds target 3 per cent; interest on reserves 2.75 per cent. Keep in mind that in a normal positive rate environment, excess reserves wouldn’t be bloated up the way they are today. The excess would be much more marginal, so the bids for fed funds would tend to be closer to the target level than would be the case today with $ 800 billion in excess.
(It’s fair to remind that one of Warren M.’s proposals is to design a system in which interest rates are normally zero, but that’s not the system we have today.)
Matt Franko Reply:
November 3rd, 2009 at 11:47 pm
JKH,
Thanks again for your analysis here! (and your insightful tie-in to Warrens ZIRP proposal which IMO may be required if excess reserves stay at super-elevated levels)
The Fed’s current approach of setting FFR/paying interest on reserve balances seems to me to be a “figure it out as we go” approach. The way you and Scott F. spit-balled it above, I’m not sure if the Fed is setting the policy rate via FOMC fiat and then pay or charge that rate on or for reserves to enforce it, or if they are still using open market operations, or a hybrid of both. A year ago when they started paying, on excess they were paying FFR-75bp, then somewhere it went to FFR-35bp, then it went to FFR-0bp where we are now. Are these procedures written down anywhere you know of? If not I say they are sort of “winging it”. I havent found anything on the Fed’s site other than press releases.
Why dont they just decide the rate at the FOMC, then simply pay that rate exactly for required and excess reserves and let deficient banks just borrow directly from the Fed (as Warren proposes) at the same rate? Just shut down the inter-bank FF market. With this approach, there would be no “range”, upper bound, lower bound, etc..there would just be “the rate”. Simple. Fed would create/use new reserve balances to pay the (hopefully low) interest on reserves. Thanks again JKH.
JKH Reply:
November 4th, 2009 at 9:09 am
Matt,
My interpretation of how the existing system has worked is as follows:
The historic level of excess reserves was around $ 10 billion – tiny by comparison to today’s level of $ 1 trillion or thereabouts. By definition, $ 10 billion used to be the level that didn’t require any payment of interest on excess reserves. That’s because it was the amount of excess reserves that resulted on average in the effective (actual) fed funds rate moving around within a trading range that was acceptable to the Fed, relative to its target rate. That might have included upper and lower “bounds†within 1/8 or 1/4 per cent (for example) of the target rate, where the “bound†is measured in some statistical sense of infrequency. The lower bound was not “set†as a contractual interest rate in that case; it was simply a statistical description of where funds might trade infrequently on occasions when there were system reserve dislocations that caused trading to move in that direction. Such a level was the statistical or implicit result of setting the quantity of excess reserves at around $ 10 billion on average. And a similar interpretation would apply on the upside, where an “upper bound†represented a statistically low probability for the funds trading level in that direction. Whatever the actual range was (I don’t have statistics in front of me), by definition it was acceptable to the Fed, or they would have changed the average excess reserve level to get the average result they were comfortable with over time.
The Fed started to put more than $ 10 billion excess into the system during the crisis. At first, there was an actual demand for a higher level of excess reserves because of banks’ reluctance to lend to each other, and resulting dislocations in reserve distribution (i.e. hoarding), and associated spikes in the fed funds rate. That meant the kind of statistical behaviour noted above was no longer reliable. Highly excessive hoarding with only $ 10 billion available to hoard would have caused the funds rate to spike above what otherwise might have been expected.
So with the crisis, the Fed was initially forced to put in a far higher level of excess reserves in an attempt to maintain an orderly trading range for effective fed funds trading levels relative to target, while satisfying an increased demand for excess reserves. The problem they then faced is that putting in more and more excess reserves is like playing with dynamite in terms of fed funds rate volatility on the downside. (The excess reserve expansion started well before the funds target hit the zero bound.) The more they put in to stop rate spikes on the upside due to hoarding demand, the greater the risk for volatile dislocations on the downside, depending on the distribution of excess reserves throughout the system on any given day.
That’s the reason that they began to pay interest on reserves – it was an attempt to create a more formal lower bound for the effective fed funds rate, given the increasing amount of excess reserves being supplied to the system. That way, they could attempt to control upside volatility through supply, while controlling downside volatility through a “stop†boundary, whereby banks with undesired excess positions would not be motivated to lend below that rate.
A second factor is that the Fed started to create ever more excess reserves as a result of its special lending programs. You can argue that the purpose of these programs was not to create excess reserves so much as to provide credit where it was needed, given the reluctance of the commercial banks to take on certain kinds of credit risk. That’s why Bernanke referred to this set of programs as “credit easing†rather than “quantitative easingâ€. Credit was the primary objective. The associated excess reserve creation was the balance sheet liability consequence of the Fed’s credit actions, rather than the primary objective in itself. It’s hard to say when the Fed reached that point, but it was somewhere between $ 10 billion and today’s excess reserve position, which is roughly $ 1 trillion. So the excess reserve position, which started out as the Fed’s direct response to the crisis, ended up as a combination of that initial motive plus something that was a consequence of its credit strategy.
The third factor is that while the Fed was increasing excess reserves, it was also gradually bringing the target funds rate down to where it is now, which is essentially the zero bound. At the zero bound, the ideas of target, lower bound, and upper bound get very confused because everything is so compressed. The Fed decided to pay interest of 25 basis points on reserves at this level.
It’s not clear how fed funds would trade if the excess reserve position were at $ 1 trillion, but with a target rate of, say, 2 or 3 per cent. Similarly the trading pattern would be different with a lower level of excess reserves at the same target rate. Whatever the combination of excess reserves and target rate, the Fed would be faced with the choice of where to put in a lower bound (reserve interest) in order to balance downside and upside volatility at a reasonable level.
Setting the interest rate level on reserves requires some experimentation because the trading range for funds depends on the mix of pure excess reserve demand (depending on credit risk as perceived by the commercial banks) versus any additional excess reserve supply that has been created by Fed credit programs (depending on general credit conditions as perceived by the Fed). The greater the supply of excess reserves simply due to Fed credit creation, as opposed to true commercial bank demand, the more downward pressure there will be on the fed funds rate. That argues for setting the lower bound interest rate somewhat tighter to the target level. The greater the supply of excess reserves due to actual commercial bank hoarding demand, the greater will be the demand for reserves in the fed funds market. That argues for setting a lower bound interest rate further away from the target level, in order to discourage such hoarding relative to the interest rate incentive.
As noted, the zero bound is a special case. I don’t know why the Fed chose a reserve interest rate of 25 basis points when the indicated “target range†for funds (the target is usually a single rate in positive rate environments) is 0 to 25 basis points. In other words, they’ve set reserve interest at the upper bound of an announced “target rangeâ€. (Note that “target range†used in this sense is different than an effective trading range as I’ve used the term above.) However, setting the reserve interest rate at a relatively elevated level would be consistent with my argument above that a higher rate would be consistent with excess reserves being Fed supply driven more than commercial bank demand driven. And that’s my belief, in a relative sense. As the Fed’s balance sheet has expanded, for a variety of reasons, commercial bank interbank lending conditions have improved somewhat. So the expanding excess reserve position is more the consequence of other Fed initiated balance sheet strategies than a response to commercial bank hoarding demand.
So, because of dynamically evolving conditions, the Fed had to experiment as to where to set the lower bound through payment of interest on reserves, particularly as the target rate was being reduced in stages down toward the zero bound. I don’t have a link, but I’m certain the Fed actually announced that such a process of experimentation and “groping†was going to be necessary in the early days of paying interest on reserves, due to the unusual configuration of cross currents that would affect the trading level for funds. And the issue may well emerge for the Fed again, if there is still a material level of “excessively excess†reserves (as opposed to $ 10 billion) on its balance sheet at such point in the future when it begins to increase the fed funds target rate above the zero bound.
(Again, one of Warren M.’s proposals is zero interest as a structural feature, which would avoid all of this tinkering. I believe his proposal also streamlines the borrowing architecture along the lines you’ve suggested, for both zero and positive rate environments.)
JKH Reply:
November 4th, 2009 at 9:27 am
P.S. as already noted in the reverse repo discussion, the current reserve interest rate of 25 basis points is failing somewhat as a lower bound on the effective funds rate. This is due to a specific technical glitch in that the GSEs keep balances at the Fed but don’t earn interest on them. Therefore they are willing to lend at rates lower than the reserve interest rate. This glitch could be repaired directly by the Fed paying the GSEs interest on balances, or indirectly by the Fed doing reverse repos with the GSEs to absorb their excess balances. The Fed may also have had this existing glitch in back of mind in setting the reserve interest rate where it did, since the effect currently means some marginal unwanted downward pressure on the funds rate.
November 3rd, 2009 at 1:01 pm
“a deposit that they leave at the FED and on which they currently get a 25bps remuneration”
At 0.25% on $800B that’s about $2B (annual) renumeration to the banks current, if FFR ever goes up again to say 5%, current policy would result in $40B to the banks. This seems like it would be a lot of renumeration to the banking industry for just holding excess reserves.
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JKH Reply:
November 3rd, 2009 at 1:20 pm
Matt,
The system as a whole is forced to hold them according to how the Fed chooses to create them.
If FFR goes up and the reserves are still there, the Fed will be earning (FFR +) on the risk assets it holds on the other side of the balance sheet. It then essentially passes on the risk free component of what it is earning to the banks. It net earns the risk premium less actual credit losses.
Also, the Fed will need to pay close to target FFR on reserves to put a lower bound on effective FFR. It would lose control of interest rate policy if it didn’t pay on balances it has forced into the system.
The Banks are essentially earning the risk free rate on aggregate balances over which they have no choice but to hold in aggregate. Also, they may have to pay interest on offsetting balances on the liability side of their balance sheets.
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November 5th, 2009 at 11:17 am
I don’t know Warren, when I read anything to do with Goldman Sachs I think of this stuff, and it sort of discredits anything coming out of their mouth (even if it’s factually correct!)
http://www.democracynow.org/2009/11/4/sachs
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JKH Reply:
November 5th, 2009 at 11:55 am
Much of the piece’s criticism blames Goldman for selling AAA securities that turned out bad. Not really Goldman’s job to rate the rating. Did Goldman put out published reports recommending these securities while they were shorting them? Did they have a conflict that resembled a published stock recommendation while shorting the stock? How much of their position was hedged versus outright, and with what timing? It’s supposedly a big boy market on the wholesale side. Maybe they’re guilty, but the analysis of these issues by those making the charges often exhibits uncertain foundations. Perhaps some generic similarity here to the bogus criticism on the AIG bailout payment to Goldman – a risk against which Goldman was already hedged – the bailout payment just meant it didn’t have to collect on its hedge, not that would have gone down without it. The net effect made no difference to Goldman, although it cost the taxpayer. Not surprising with their risk management they would already have been hedged. I don’t mind invoking possibly innocent until proven guilty when the analysis is weak. I would echo Warren M’s comment on the other thread – i.e. Goldman is a response to the institutional structure in place. Their job is not to be choir boys. But they’re pretty smart, including one very bright bond trader.
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Mike S Reply:
November 6th, 2009 at 1:17 pm
The problem that in this particular case, we can be relatively sure that top management knew that this was happening, and blessed a trade that was probably illegal.
Not only that, with the AIG situation, they were in possession of material non-public information on the state of the market. CDO’s are securities, last I checked. You cannot make trades based on material non-public information.
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DCC Reply:
November 9th, 2009 at 8:45 pm
“…the bogus criticism on the AIG bailout payment to Goldman – a risk against which Goldman was already hedged – the bailout payment just meant it didn’t have to collect on its hedge, not that would have gone down without it.” JKH Nov 5, 2009
What was Goldman’s hedge and who was the counterparty to Glodman’s hedge. Thanks.
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JKH Reply:
November 9th, 2009 at 9:59 pm
http://www.businessinsider.com/how-did-goldman-hedge-its-exposure-to-aig-2009-3
http://zerohedge.blogspot.com/2009/06/filings-disclose-goldman-sachs-aig.html
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November 9th, 2009 at 9:00 am
Looking forward to seeing how the courts decide on all this.
A single legal decision can bring down any firm.
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November 9th, 2009 at 8:41 pm
Regarding JKH’s Nov. 5, 2009 post “…the bogus criticism on the AIG bailout payment to Goldman – a risk against which Goldman was already hedged – the bailout payment just meant it didn’t have to collect on its hedge, not that would have gone down without it.”
What was Goldman’s hedge and who was the counterparty to Glodman’s hedge. Thanks.
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November 9th, 2009 at 8:43 pm
Regarding JKH’s Nov. 5, 2009 post “…the bogus criticism on the AIG bailout payment to Goldman – a risk against which Goldman was already hedged – the bailout payment just meant it didn’t have to collect on its hedge, not that would have gone down without it.”
What was Goldman’s hedge and who was the counterparty to Goldman’s hedge. Thanks.
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November 19th, 2009 at 11:51 am
The FED’s policy tool, interest on reserves (IOR’s), the FOMC’s interest rebate on member bank reserve balances (which Congress made the taxpayers responsible for), has induced widespread dis-intermediation among the non-banks (the most important economic sector in this recession/depression — or 82% of the lending market, Z.1 release, sectors, e.g., MMMFs, GSEs, overnight repos, etc.).
I.e., the intermediaries have shrunk in size & the size of the member banks has remained essentially the same. The non-banks are financial intermediaries – intermediaries between saver & borrower. The member banks are new money and credit creators (they always create new money in the lending process, member banks do not loan out existing deposits).
A trillion dollars + in monetary savings (if you count just the verifiable portion in excess reserves), was siphoned out (via redemptions, etc.), of the non-banks (e.g., hedge funds, investment banks, finance companies, insurance companies, mortgage companies, pension funds, etc.).
The financial press has attributed this to deleveraging. However, the member banks (18% of the lending market, Z.1 release), has suffered no dis-intermediation (just portfolio readjustments).
Monetary savings (savings held beyond the income period), are impounded within the banking system. They are lost to investment, consumption, or to any type of payment (if held in this form). I.e., savings held within the monetary system have a transactions velocity of zero, and are a leakage in the Keynesian national income concept of savings.
Such a “cessation of circuit income” has adverse effects on production and employment, and requires large dosages of money to counter-act.
Thus under one view, the quantitative easing performed by the FED (an increase in legal reserves), has been substantially erased. But we are not done. If the FOMC raised the average reserve ratios on member bank deposits, the volume of required reserves would increase (which if large enough, could induce bank credit contraction), ceteris paribus.
This process is the same as if the FOMC raised the remuneration rate on excess & required reserves, vis a’ vis other competitive instruments and yields. It would also increase the volume of legal reserves, ceteris paribus (which also acts to reduce the monetary system’s lending capacity).
Quantitative easing was tried, but there were opposing forces that rendered it immeasurable.
The solution is to redirect savings to the non-banks, and velocity (consumption & investment), will rebound, without unnecessarily forcing prices (stagflation), higher. This re-routing was successful in the housing crisis of 1966 (such targeted redirection is used in a command economy). In 66, both the member bank’s and non-bank’s profits were revived, and the housing market (and the economy along side it), recovered thereafter, etc., etc.
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November 19th, 2009 at 12:04 pm
I.e., it is undisputed that the bankers “compete”, to pay for what they already own. The source of all time/savings deposits within the commercial banking system, are demand/transaction deposits -directly or indirectly through currency, or the member bank’s undivided profits accounts.
Money flowing “to” these intermediaries (non-banks) actually never leaves the commercial banking system, as anybody who has applied double-entry bookkeeping on a national scale should know. The growth of these intermediaries/non-banks, cannot be at the expense of the member banks. And why should the commercial banks pay for something they already have? I.e., interest on time deposits.
Savings impounded within the commercial banking system are lost to investment, indeed to any type of expenditure (i.e., both consumption & investment has a velocity of zero). If monetary savings are not invested, then prices, production, employment, & incomes will contract (along with the production of goods & services).
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February 10th, 2010 at 3:34 pm
Can anyone answer this question for me? If QE is $1.725 trillion and excess reserves are $1 trillion, where are the other $725 billion?
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JKH Reply:
February 10th, 2010 at 7:03 pm
QE is $ 1 trillion – same as excess reserves.
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February 10th, 2010 at 10:28 pm
I was thinking that Fed buys $300bn tsya, $175bn Agency debt and $1.25 trillion MBS = $1.725 trillion. If excess reserevs = $1 trillion I figured the other $725bn probably went into treasuries.
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JKH Reply:
February 10th, 2010 at 10:47 pm
That’s about right for treasuries, although treasuries are on the other side of the balance sheet from excess reserves. The approximate numbers now are:
Assets
Treasuries 800
Other 1500
Total 2300
Liabilities
Currency 900
Excess R. 1100
Other 300
Total 2300
See:
http://www.federalreserve.gov/releases/h41/Current/
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Ramanan Reply:
February 11th, 2010 at 6:49 am
JKH: I think Ed’s question was that the Fed announced a QE of around $1.7T and it doesn’t seem to be mirrored $-for-$ by an increase of reserves from the pre-crisis levels.
This page gives the total assets purchased by the Fed
http://www.clevelandfed.org/research/data/credit_easing/index.cfm
Ed:
The Treasuries purchases was worth around $300B and Agency Debt and MBSs purchases till date is around $1.13T. However, the Fed just let the old Treasuries it held mature – as you can see from the graph. If you want to consider the difference between now and mid-crisis levels, you should remember that total lending to the markets came down rapidly. Another factor is that currency in circulation increased by $200-$300B I imagine depending on which periods you compare. (because of bank runs ?)
There are two more factors – the Treasury’s account has increased a lot in the last few years. I think fluctuated from $5B to around $100B. The other think is what JKH reminded us recently – the Supplementary financing account – Z.1 has a different number than H.4.1 (??)
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JKH Reply:
February 11th, 2010 at 7:32 am
Ramanan,
Can you point me to where the Fed “announced a QE of $ 1.7 trillion”?
For starters, they don’t use the term QE. They use credit easing, which has to do with asset composition, not liability composition. QE when used refers to the size of the net reserve objective of an easing program, and the easing program is typically done by purchasing government bonds exclusively.
That’s my understanding. I’ll buy you tickets to the next MMT movie if I’m wrong.
February 11th, 2010 at 8:01 am
JKH,
http://www.federalreserve.gov/newsevents/press/monetary/20090318a.htm has some numbers. I think the markets started thinking that they are doing “QE” on this day (March 2009) – they used the phrase QE, though the Fed had already started purchasing agency debt and agency MBSs before that date.
Yes I had actually asked/mentioned to Bill on his blog that Bernanke uses the phrase credit easing instead of quantitative easing.
http://bilbo.economicoutlook.net/blog/?p=661&cpage=1#comment-516
I disagree with some parts of my own comment there now … but somehow I have been thinking that they were “forced” to do credit easing for some time now …
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JKH Reply:
February 11th, 2010 at 8:46 am
Ramanan,
What the markets “started thinking” is irrelevant to the fact of what actually happened. The markets “think” there’s a deposit multiplier as well.
The Fed doesn’t use the term QE because that’s not what it’s been doing. That’s crystal clear from Bernanke’s speeches, where he’s emphasized many times asset initiatives as the strategy, and reserve effects only as a necessary by product. He actually does know what he’s doing in some respects.
The distinction is important because it’s the erroneous QE interpretation that is consistent with the error made by “the market” in interpreting the reserve effect as an end in itself – as in the multiplier. That’s not what the Fed’s been doing.
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Ramanan Reply:
February 11th, 2010 at 9:26 am
JKH:
Yes agree. I just meant to say that the Fed had started purchasing securities before March 2009 (in addition to acting as the LOLR) but only in March 2009 did the markets realize that they are purchasing. I mean a big part of the market.
Yeah, I think he knows that there is no multiplier but still appears confused on many things. He did he say what he said yesterday – http://federalreserve.gov/newsevents/testimony/bernanke20100210a.htm Why the reverse repos ?
This http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm says
However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base.
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JKH Reply:
February 11th, 2010 at 9:55 am
Agreed. I said he knows what he’s doing in SOME respects. I refuse to throw him under the bus entirely. But his communication on the “role” of excess reserves once they’ve been created, or the “threat” they pose unless they’re withdrawn, has been suboptimal, to be sure, if not downright wrong.
Matt Franko Reply:
February 11th, 2010 at 10:00 am
JKH,
I’ve been hoping that Bernanke is starting to “get it”.
This is from Bernanke’s Testimony he submitted yesterday:
“Most importantly, in October 2008 the Congress gave the Federal Reserve statutory authority to pay interest on banks’ holdings of reserve balances. By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.8
The Federal Reserve has also been developing a number of additional tools it will be able to use to reduce the large quantity of reserves held by the banking system. Reducing the quantity of reserves will lower the net supply of funds to the money markets, which will improve the Federal Reserve’s control of financial conditions by leading to a tighter relationship between the interest rate on reserves and other short-term interest rates.”
So in para 1 above he looks like he “gets it”, even perhaps to the point that longer term rates are just the market anticipating what they at the Fed will do (vice “inflation expectations”). But can you conjecture what he is talking about in the second para with his “tighter relationship”…could you forsee some operational aspect(even slight) that would result in them losing some degree of control of short term rates via paying int on reserves alone? Or he could just be just givng “lip service” to those who fear the level of reserves?
Resp,
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February 11th, 2010 at 10:32 am
Matt,
Great questions in several areas.
On the “tighter relationship” – there have definitely been problems in achieving a perfectly “efficient market” arbitrage relationship between Fed funds and the rate on reserves. One aspect is that the GSEs keep balances at the Fed on which they earn no interest by statute, so they’re willing to lend below the reserve interest rate. Another aspect is that arbitrage requires nominal balance sheet usage by banks that proactively borrow fed funds to leave surpluses at the Fed. That balance sheet usage is not an issue in terms of risk adjusted capital, but it is an issue in term of nominal leverage ratios. Given the instability that generated this mess, banks are reluctant to put pedal to the metal in terms of aggressively arbitraging the rate discrepancy out of the system. So those are two operational aspects where there is some uncertainty about ideal functioning of the funds market, simply based on the discipline of reserve interest, without reserve contraction. Nevertheless, I think it’s a safe bet and I think the Fed thinks it’s a safe bet that the interest rate discrepancy would be minor relative to a campaign of increasing the fed funds target over time. Notwithstanding that, the Fed would be sensitive to the public perception that “they don’t have control over the funds rate” in that sort of environment, however exaggerated, theatrical and political such claims would be.
I think your “lip service” question is really interesting and important as to why they’re saying what they’re saying. I’m one that believes that Bernanke has been learning on the job. I don’t throw him under the bus because he didn’t predict the GFC, and I give him credit for his operational response to the crisis. In particular, I suspect he has thought through the issue of reserves more clearly than what his speeches imply. It’s worthwhile noting that the MMT understanding of reserves is consistent with the way in which real world banking decisions are made, only to degree that bank CEOs properly understand the same thing. I think this is in large part the case. I think banks are quite well disciplined by capital allocation. (The fact that risk was mis-measured or that capital requirements were too thin is really a separate issue from that of capital discipline as a process per se.) The only way that excess reserves can become a “threat” in an economic recovery is if bank CEOs start approving of risk taking as a substitute for holding risk free reserves, and if they do that in a way that contravenes their capital discipline. But so long as they are bound by their capital discipline, any effect on excess reserves is purely coincidental to what matters. In terms of “lip service”, I think it’s quite possible that he is viewing the entire reserve withdrawal issue as a prudent hedge against that sort of “CEO risk”. Put another way, if it turned out that Bernanke actually understood MMT (because we don’t KNOW FOR SURE that he doesn’t), his words would be explainable not only in sense of such a hedge, but that the current environment may not be the best tipping point politically to explain to the rest of the world (including most of the economics profession), that they don’t know what they’re talking about.
I’m not throwing him under the bus.
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