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.

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,

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.

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.

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 …

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.

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 (??)

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/