Category Archives: CBs

Chinese economist sounds off on US monetary policy

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Right, this is the nonsense that’s been moving the speculators and portfolio managers, but not the underlying fundamentals.

If an asset inflation does materialize it will be for an entirely different reason.

>   
>   (email exchange)
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>   On Wed, Dec 9, 2009 at 2:03 PM, wrote:
>   

Yesterday, U.S. Fed Chief Ben Bernanke declared the U.S. economy is facing “formidable headwinds” and effectively vowed to continue printing paper dollars like there’s no tomorrow.

The reaction from China came quickly, as Andy Xie, recently named by BusinessWeek as one of China’s most influential economists, pulled no punches.

Xie accused the Fed chief of “poisoning” the U.S. economy by keeping interest rates near zero and creating a tidal wave of newly printed paper dollars. He warned that the next global crisis will be driven by asset inflation.


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Greek Facts

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Greece is small, 2.7% of Eurozone GDP and roughly 3.9% of
Eurozone public debt.

* Greece is not an economic basket case. GDP is declining by 1.1%
in 2009, much less than the 4.0% fall in the Eurozone as a whole (EU
Commission estimates).

* Having had less of a recession, Greece will likely lag in the
recovery. For 2010, the EU Commission projects a 0.3% fall in GDP for
Greece and 0.7% growth for the Eurozone. We are much more optimistic
for the Eurozone (2.2% growth in 2010) and Greece (1%).


* Greece has a huge current account deficit. But the shortfall has
already declined from a peak of 15.2% of GDP in the year to 3Q 2008 to
11.9% in the year to 3Q 2009. It looks set to fall much further.


* One third of Greek export revenues come from transport services,
including shipping. Transport has been hit hard by the post-Lehman
collapse in global trade. The recovery in global trade should benefit
the external position of Greece and its corporate tax revenues.


* Greece does not have an unusually severe banking problem. Many
Greek banks have a solid domestic deposit base. Greek banks have
already scaled back their use of ECB liquidity from 7% of the total in
June to 5% in September. Our banking analysts foresee no major
problems for the Greek banks to unwind ECB liquidity further Greek
Banks, 26 November 2009

It is not about the specific banks. It is about the risk of a ‘run’ on the banks, a liquidity crisis, triggered by a fear that the govt. deposit insurance is not credible. See more below.

* Greece has a serious fiscal problem. The EU expects a fiscal
deficit of 12.7% for 2009, roughly in line with Ireland and the UK.

The critical distinctions is the UK obligations are at the ‘federal’ level, where Greece and the other ‘national govts’ in the Eurozone are more like a US state.

The EU projects that Greece will have the highest debt-to-GDP ratio of
all EU members in 2011 at 135.4%.

Far higher than California, for example, which was well under 25% of its GDP.

* The rise in the debt-to-GDP ratio for Greece from 2007 to 2011
will be 39.8ppts. This is bad. But it is below the projected increases
for the UK (44 points) and Ireland (71.1 points), roughly in line with
Spain (37.9) and not much worse than the US (35.7 points according to
IMF estimates).


* As we are more optimistic on growth, we believe that the rise in
the debt ratio will be smaller in Greece and in most other countries
than the EU projects.

None of the EU national govts could survive a liquidity crisis without the ECB itself.

* Greece has a new socialist government facing an immediate
crisis. That might even make the fiscal adjustment less difficult. The
government can blame the pain on its predecessor. It may face less
opposition from trade unions than a conservative government would. Of
course, the new government will have to make the promised adjustment
in its budget soon (vote due on 23 December). More may have to follow
in early 2010.


* Greece is not primarily an issue for the ECB. Central banks are
the lenders of last resort to banks, not to governments. Greece has a
fiscal problem, not primarily a banking problem.

True, but the point is deposit insurance, and not liquidity for the banks.
A run on the banks due to fear of credible deposit insurance would mean the ECB would have to fund the entire bank system which would mean extending ‘allowable collateral’ to any and all bank assets including the copy machines and the carpets, as well as any intangibles on the books.

In the highly unlikely case that worst came to worst, that is if the Greek
government could no longer fund itself on the capital market, the
decision what assistance the EU or the Eurogroup would offer to Greece
under which conditions would be up to finance ministers and heads of
governments, not to central bankers. It would be a political issue.

Yes, and how long would it take to make that decision?
If it is longer than a day or so, the govt would be shut down and the banks would have no source of deposit insurance.

* Greece is a member of the inner family of Europe, the Eurozone.
In the market turmoil in February and March, top European officials
(Eurogroup head Juncker, EU Commissioner Almunia and even some finance
ministers such as the German one) stated that a Euro member in trouble
would get an help if need be, in exchange for fiscal conditions.

All unspecified, and widely suspected to be empty rhetoric.

These statements have not been retracted. Of course, the Euro partners of
Greece may not be eager to repeat such statements just yet. They may
not yet want to take the pressure off the Greek government to make
fiscal adjustments.

Nor do they want to write the check and introduce moral hazard.

* Many Eurozone governments face fiscal challenges. Many finance
ministers of the more peripheral members would probably want to avoid
the rise in their own financing costs that would come if a
restructuring of Greek public debt were to blow out spreads across
Europe much further. The German government would be very unlikely to
veto conditional assistance, in our view. In the highly unlikely case
that assistance may be needed, such theoretical help could take the
form of an EU guarantee for newly issued Greek public debt in exchange
for some IMF-style fiscal conditions.

Yes, very possible. But, again, how long would it take to reach that decision if a liquidity crisis did happen?

I am not saying any of this is going to happen.
I am saying the systemic risk is inherent in the institutional structure of the Eurozone.


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bernanke

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Karim writes:

DOVISH-Focus largely on headwinds to growth; token paragraph (new) on the dollar; repeats the ‘2Es’ (exceptionally low for an extended period)

Excerpts

* Today, financial conditions are considerably better than they were then, but significant economic challenges remain. The flow of credit remains constrained, economic activity weak, and unemployment much too high. Future setbacks are possible.

* My own view is that the recent pickup reflects more than purely temporary factors and that continued growth next year is likely. However, some important headwinds–in particular, constrained bank lending and a weak job market–likely will prevent the expansion from being as robust as we would hope.

* access to credit remains strained for borrowers who are particularly dependent on banks, such as households and small businesses.. the fraction of small businesses reporting difficulty in obtaining credit is near a record high, and many of these businesses expect credit conditions to tighten further.

* With the job market so weak, businesses have been able to find or retain all the workers they need with minimal wage increases, or even with wage cuts. Indeed, standard measures of wages show significant slowing in wage gains over the past year. Together with the reduction in hours worked, slower wage growth has led to stagnation in labor income. Weak income growth, should it persist, will restrain household spending. The best thing we can say about the labor market right now is that it may be getting worse more slowly… a number of factors suggest that employment gains may be modest during the early stages of the expansion.

* I expect moderate economic growth to continue next year. Final demand shows signs of strengthening, supported by the broad improvement in financial conditions. Additionally, the beneficial influence of the inventory cycle on production should continue for somewhat longer. Housing faces important problems, including continuing high foreclosure rates, but residential investment should become a small positive for growth next year rather than a significant drag, as has been the case for the past several years. Prospects for nonresidential construction are poor, however, given weak fundamentals and tight financing conditions.

* The foreign exchange value of the dollar has moved over a wide range during the past year or so. When financial stresses were most pronounced, a flight to the deepest and most liquid capital markets resulted in a marked increase in the dollar. More recently, as financial market functioning has improved and global economic activity has stabilized, these safe haven flows have abated, and the dollar has accordingly retraced its gains. The Federal Reserve will continue to monitor these developments closely. We are attentive to the implications of changes in the value of the dollar and will continue to formulate policy to guard against risks to our dual mandate to foster both maximum employment and price stability. Our commitment to our dual objectives, together with the underlying strengths of the U.S. economy, will help ensure that the dollar is strong and a source of global financial stability.

* The Federal Open Market Committee continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.


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foreign dollar buying

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The possibility of announcing an exit from Afghanistan with the funds saved to pay down the deficit would be extremely popular short term and contribute to lower GDP and higher levels of unemployment over the medium term.

Those shorting dollars are selling them to foreign central banks who want their currencies weaker vs the dollar. This means it is unlikely they ever sell their dollars.

Float to lower crude prices and modestly declining us gasoline consumption would threaten the viability of the dollar shorts.

Much of this has been a reaction to the fed building its portfolio, which many presume to be an inflationary act of ‘printing money’ which it is, in fact, not.


Dollar Overwhelms Central Banks From Brazil to Korea

By Oliver Biggadike and Matthew Brown

Nov. 12 (Bloomberg) — Brazil, South Korea and Russia are losing the battle among developing nations to reduce gains in their currencies and keep exports competitive as the demand for their financial assets, driven by the slumping dollar, is proving more than central banks can handle.

South Korea Deputy Finance Minister Shin Je Yoon said yesterday the country will leave the level of its currency to market forces after adding about $63 billion to its foreign exchange reserves this year to slow the appreciation of the won. Chile Finance Minister Andres Velasco said the same day that lawmakers approved an increase in local debt sales to finance spending, a move that will allow the government to keep more of its dollar-based savings overseas and slow the peso’s rally.

Governments are amassing record foreign-exchange reserves as they direct central banks to buy dollars in an attempt to stem the greenback’s slide and keep their currencies from appreciating too fast and making their exports too expensive. Half of the 10-best performers in the currency market this year came from developing markets, gaining at least 14 percent on average, according to data compiled by Bloomberg.

“It looked for a while like the Bank of Korea was trying to defend 1,200, but it looks like they’ve given up and are just trying to slow the advance,” said Collin Crownover, head of currency management in London at State Street Global Advisors, which has $1.7 trillion under management.

The won, after falling 44 percent against the dollar in March 2009 from its 10-year high of 899.69 to the dollar in October 2007, is now headed for its biggest annual rally since a 15 percent gain in 2004. It traded today at 1,160.32, up 8.6 percent since the end of December.

‘Suffered Tremendously’

Brazil’s real is up 1.6 percent this month, even after imposing a tax in October on foreign stock and bond investments and increasing foreign reserves by $9.5 billion in October in an effort to curb the currency’s appreciation. The real has risen 33 percent this year.

“We have to be careful that our exchange rate doesn’t appreciate too much as to deindustrialize the country,” Marcos Verissimo, chief of staff at Brazil’s state development bank known as BNDES, said yesterday at a conference in Sao Paulo. “The capital goods industry has suffered tremendously.”

Russia’s Bank Rossii increased its foreign reserves by 15 percent since March 13 as it sold rubles in an attempt to cap the currency’s gain. Even so, the surge in commodities prices this year means Russia’s steps to fight a stronger ruble may “not be productive,” the International Monetary Fund said yesterday. Energy, including oil and natural gas, accounted for 69.5 percent of exports to countries outside the former Soviet Union and the Baltic states in the first nine months, according the Federal Customs Service.


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Faber on Gold

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He may be right, but for the wrong reason.
Central Banks buying securities and growing their portfolios of financial assets, aka ‘quantitative easing, has nothing to do with inflation or aggregate demand.

However, direct Central Bank purchase of gold do amount to what I call ‘off balance sheet deficit spending’ which does support the price of whatever they buy and can go on indefinitely as a function of political will:

Gold Price Won’t Drop Below $1,000 an Ounce Again, Faber Says

By Zijing Wu

Nov. 11 (Bloomberg) — Gold won’t fall below $1,000 an ounce again after rising 27 percent this year to a record as central banks print money to help fund budget deficits, said Marc Faber, publisher of the Gloom, Boom & Doom report.

The precious metal rose to all-time highs in New York and London today as the dollar weakened. The Dollar Index, a gauge of value against six other currencies, has declined 7.9 percent this year and today fell to a 15-month low. News last week of bullion purchases by the Indian and Sri Lankan governments raised speculation that other countries would follow suit.

“We will not see less than the $1,000 level again,” Faber said at a conference today in London. “Central banks are all the same. They are printers. Gold is maybe cheaper today than in 2001, given the interest rates. You have to own physical gold.”

China will keep buying resources including gold, he said.

“Its demand for commodities will go up and up and up,” he added. “Emerging economies will grow at the fastest pace.”

In contrast, Western countries will be lucky to avoid economic contraction, while the Federal Reserve will maintain interest rates near zero percent, he said.


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China hopes U.S. keeps deficit to appropriate size

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Translation:  China threatens to liquidate it’s dollars to keep the dollar weak so China can peg to it and increase global exports??? 

China hopes U.S. keeps deficit to appropriate size

(Reuters) – China hopes that the United States will keep its deficit to an appropriate size to ensure basic stability in the U.S. dollar exchange rate, Chinese Premier Wen Jiabao said on Sunday.

“We have seen some signs of recovery in the U.S. economy … I hope that as the largest economy in the world and an issuing country of a major reserve currency, the United States will effectively discharge its responsibilities,” Wen told a news conference in Egypt.

“Most importantly, we hope the United States will keep an appropriate size to its deficit so that there will be basic stability in the exchange rate, and that is conducive to stability and the recovery of the global economy,” he added.

The premier had expressed concern in March that massive U.S. deficit spending and near-zero interest rates would erode the value of China’s huge U.S. bond holdings.

China is the biggest holder of U.S. government debt and has invested an estimated 70 percent of its more than $2 trillion stockpile of foreign exchange reserves, the world’s largest, in dollar assets.

“I follow very closely Chinese holdings of U.S. assets because that constitutes a very important part of our national wealth. Our consistent principle when it comes to foreign exchange reserves is to ensure the safety, liquidity and good value of the reserves,” Wen said.


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Short-Rate Thoughts: DEFLATION – Radical Thesis Turnaround

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Well stated!

*Not house view.

Since March I have been arguing that the world was a better place than people thought. I am now shifting my core view, which still might take several months to develop in the marketplace.

Skipping to the Conclusions

1. Deflation will be the surprise theme of 2010, when Congress will go into a pre-election deadlock; elections have only underscored this is the public direction

2. Excess Reserves will neither generate new lending nor generate inflation; actually, the quantity of reserves (M0) basically has no real economic effect

3. ZIRP and QE actually CONTRIBUTE to the deflation mostly by depriving the spending public of much-needed coupon income

4. When Federal Tax Rates increase in 2011 this problem will become even more severe

5. The overall level of public indebtedness (vs GDP) will not put upward pressure on yields in this backdrop and there will be a reckoning in the high-rates/deficit hawk community

6. Strong possibility that QE will actually be upsized next year rather than ended when the Fed observes these effects (and this might actually make things WORSE)

The Explanation (a Journey)

It seemed fairly intuitive and obvious for thousands of years that the Earth was at rest and the Sun moving around it. Likewise, it has seemed that the Fed controls the money supply, balances the economy by setting interest rates and fixing reserves which power bank lending, that more Fed money means less buying power per dollar (inflation), that the federal government needs to borrow this same money from The People in order to be able to spend, and that it needs to grow its way out of its debt burden or risks fiscal insolvency. I have, in just a fortnight, been COMPLETELY disabused of all these well-entrenched notions. Starting from the beginning, here is how I now think it works:

1. The first dollar is created when Treasury gives it to someone in exchange for something ammo, a bridge, labor. It is a coupon. In exchange for your bridge, here is something you or anyone you trade it with can give me back to cover your taxes. In the mean time, it goes from person A to person B, gets deposited in a bank, which then deposits it at the Fed, which then records the whole thing in a giant spreadsheet. Liability: One overnight reserve/demand deposit/tax coupon. Asset: IOU from Treasury general account. Tax day comes, Person A pulls his deposit, cashes in the coupon, the Treasury scraps it, and POOF, everything is back to even.

2. For various reasons (either a gold-standard relic or a conscious power restraint, depending who you ask), we make the Treasury cover its shortfall at the Fed and SWAP one type of tax-coupon (a deposit or reserve) for another by selling a Treasury note. Either the Fed (in the absence of enough reserves well get to this) or a Bank (to earn risk-free interest) or Person A (who sets a price for his need to save) is forced out his demand deposit dollar and into a treasury note at the auction clearing price. What about the fact that treasuries aren’t fungible like currency? On an overnight basis, that doesn’t really constrain anyones behavior. A reserve or a deposit means you get your money back the next day. Same thing with a treasury. Functionally its cash and wont influence your decision to buy a car. Likewise for the bank. In the overnight duration example, it does NOT affect their term lending decisions if they have more reserves and few overnight bills, or more bills and fewer reserves. Its even possible to imagine a world (W. J.Bryans dream) where the Fed, with its scorekeeping spreadsheet, combines the line-items we call treasuries and reserves.

3. Total public sector dissavings is equal to private sector savings (plus overseas holdings) as a matter of accounting identity. This really means that the only money available to buy treasuries came from government itself (here I am being a bit loose combining Tres+Fed), from its own tax coupons. If there arent enough ready coupons at settlement time for those Treasuries, the Fed MUST supply them by doing a repo (trading deposits/coupons for a treasury by purchasing one themselves at least temporarily). They dont really have a choice in the matter, however, because if the reserves in the banking system didnt cover it, overnight rates would go to the moon. So in setting interest rates they MUST do a recording on their spreadsheet and the Fedwire and shift around some reserve-coupons (usable as cash) for treasury-coupons (usable for savings but functionally identical).

4. Thus monetizing the deficit is actually just the Feds daily recordkeeping combined with its interest rate targetting, just keeping the score in balance. However, duration is real, as only overnight bills are usable as currency, and because people (and pensions!) need savings, they need to be able to pay taxes or trade tax-coupons for goods when they retire, and so there is a price for long-term money known as interest rates. The Fed CAN affect this by settings rates and by shifting between overnight reserves, longer-term treasuries, and cash in circulation. When the Fed does a term repo or a coupon sale, they shift around the banking and private sectors duration, trading overnight coupons for longer-term ones as needed to keep the balance in order.

5. But all this activity doesnt influence the real economy or even the amount of money out there. The amount of money out there dictates the recordkeeping that the Fed must do.

6. This is where QE comes in to play. In QE, aside from its usual recordkeeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it needed to do all along. Again, they force people out of treasuries and into cash and reserves.

7. The private sector is net saving, by definition. It has saved everything the Treasury ever spent, in cash and in treasuries and in deposits. In fact, Treasuries outstanding plus cash in circulation plus reserves are just the tangible record of the cumulative deficit spending, also by IDENTITY.

8. So when QE is going on, there is some combination of savers getting fewer coupons which constrains their aggregate demand just like a lower social security check would, and banks being forced out of duration instruments and into cash reserves. I do not think this makes them lend more their lending decision was not a function of their cashflow but rather a function of their capital and the opportunities out there (even when you judge a banks asset/equity capital ratio, there is no duration in accounting, so a reserve asset and a treasury asset both cost the same). If they had the capital and the opportunities, they would keep lending and force the Fed to give them the cash (via coupon passes and repos, which we then wouldnt call QE but rather preventing overnight rates from going to infinity). As far as I can tell, excess reserves is a meaningless operational overhang that has no impact on the economy or prices. The Fed is actually powering rates (cost of money) not supply (amount of money) which is coming from everyone else in the economy (Tres spending and private loan demand).

9. Ill grant there is a psychological component to inflation phenomenon, as well as a preponderance of ignorance about what reserves are, and that might result in some type of inflationary event in another universe, but not in the one we are in where interest rates are low and taxes are going up and the demand for savings is therefore rising rather than falling.

10. One can now retell history through this better lens. Big surpluses in 97-01, then a big tax cut in 03. Big surpluses in 27-30, then a huge deficit in 40-41. Was an aging Japanese public shocked into its savings rate or is that savings just the record of the recessionary deficit spending that came after 97? It will be interesting to watch what happens there as the demographic story forces households to live moreso off JGB income will this force the BOJ to push rates higher or will they never get it and force the deflation deeper?

11. There are, as always mitigating factors. Unlike in the Japan example, a huge chunk of US fixed income is held abroad, so lower rates are depriving less exported coupon income which is actually a benefit. There is of course some benefit from lower private sector borrowing rates as well MEW, lower startup costs for new capital investment, etc. Also, even if one denies that higher debt/gdp ratios are what weakened it (rather than Chinas decisions again something unavailable to Japan), the dollar IS weaker now which is inflationary. But this is all more than offset, I think, by ppls expectation that higher taxes are coming, and thats hugely deflationary and curbs aggregate demand via multiple channels.

12. Additionally, there seems to be a finite amount of political capital that can be spent via the deficit, and that amount seems to be rapidly running out. See https://portal.gs.com/gs/portal/home/fdh/?st=1&d=8055164. The period of deficit stimulus is mostly behind us. Instead, people are depending upon ZIRP and the Fed to stimulate the economy, and in fact there is marginal, and possible negative, stimulation coming from that channel. The Fed is taking away the social security checks knowns as coupon interest.

13. Finally, there is a huge caveat that I cant get around, which is whether we are measuring inflation correctly. It happens that I don’t think we are strange effects like declining inventory will provide upward pressure and lagged-accounting for rents providing downward pressure in the CPI. This is an unfortunate, untradeable fact about the universe that I think will be offset by other indicators (Core PCE) sending a better signal. But this is part of the reason this whole story will take time to develop in the marketplace. As a massive importer of goods and exporter of debts we are not quite Japan, but the path of misunderstanding is remarkably similar.

* Credit due Warren Mosler and moslereconomics.com for guiding my logic.

J. J. Lando


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GOLD: Making new highs

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If gold is a bubble it certainly hasn’t broken yet.

And if central banks decide to buy it in size they are capable of running it up until they decide to stop.
It’s what I’d call off balance sheet deficit spending. When a CB buys gold functionally it’s govt spending without taxing, adds to demand, etc. just as if the tsy had bought the gold with deficit spending, but it’s not accounted for as part of the deficit.

So we go out and spend enormous effort and energy to build the heavy equipment and related hardware to dig vast holes in the ground we call gold mines, bring up immense quantities of ore to get tiny quantities of gold out of it and by labor and energy intensive refining to make it into gold bars, which we then spend more time and energy to transport to each CB’s hole in the ground also constructed with large quantities of real resources, and spend more time and materials guarding our gold in our hole in the ground against someone going to the the trouble to take our gold out of our hole in the ground and put it in their hole in the ground. (Steve Cianciola, circa 1970)

Printing new highs in Gold this morning in London (1093.10 the high paid so far) 1 month atms up another +1.5pts (after being up 3.5pts yesterday: 17 –>20.5) as we continue to see a lot of interest and short dated upsides from a variety of accounts/investors over the past 24hrs. I have attached GSJBWere note below with their thoughts on IMF gold sales to India which they published overnight – it’s a quick read and just reiterates what we have been saying on the desk that this has been most certainly a key development for the gold market on its own; also worth noting that GSJBWere raised 12-month trading range in Gold to $950 – $1200/oz.


GSJBWere Commodities: Gold Sector: Indian Rope Trick
Commodities | Australia

• The International Monetary Fund (IMF) has completed a sale of 200 tonnes of gold to India, for a consideration of US$6.7 billion.


• The quantity is a little under 50% of the total of 403.3 tonnes of gold to be sold by the IMF, approved for sale as recently as September this year. It also constitutes half of the annual sales capacity agreed by the current Central Bank Gold Agreement.


• The gold price rallied to a fresh record high above US$1,085/oz shortly after the news was released.


• The fact that such a large sale was executed off-market and without any negative impact on the gold price will greatly reduce concerns about the overhang of the remaining 203 tonnes of approved sales quota.


• Furthermore, we find it hard to imagine that India will be the only country looking at gold as an opportunity to diversify its reserves away from the US dollar.


• We therefore view this development as very positive for the gold price outlook, and we have raised our 12-month trading range to US$950 – $1,200/oz (formerly $925 to $1,100/oz).


• We have also raised the base price for our gold price assumptions to $1,000/oz (formerly $950/oz), given that the average price in October exceeded our expectations at $1,043/oz. The changes to our annual average gold price assumptions and earnings estimates are tabulated below.


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Goldman- Excess Reserves Irrelevant and the FED does not need to execute Reverse Repos with Non-Primary Dealers

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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 contained”. 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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Conservatives Say Low Rates Are U.K.’s Best Route Out of Slump

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Earlier this year I thought the UK was on track with their understanding of their monetary system.

Recent headlines don’t look so promising:

Conservatives Say Low Rates Are U.K.’s Best Route Out of Slump

By Robert Hutton and Jennifer Joan Lee

Oct. 28 (Bloomberg) — Philip Hammond, a lawmaker who speaks on Treasury policy for the Conservatives, said the opposition party wants the Bank of England to keep interest rates low and will cut the deficit to allow this to happen.

“It is essential that in the recovery we are able to continue to keep monetary policy relatively loose,” Hammond said in an interview at Bloomberg’s office in London. “We will only be able to do that if we have got the deficit under control.”

The focus on monetary policy contrasts with Prime Minister Gordon Brown’s argument that maintaining government spending is the best bring Britain out of the worst recession since World War II.

With an election due within seven months, the question of how and when to cut spending is at the heart of the debate between the ruling Labour Party and the opposition. Brown argues that maintaining spending and cutting taxes are the best ways to return to growth. The Conservatives say those steps risk lifting inflation and interest rates, choking off recovery.

“What has got Britain through the recession so far has been the activist monetary policy at the Bank of England, keeping interest rates low, supporting the economy through quantitative easing,” Hammond said. “We will only be able to do that if we have sent a clear signal to the markets that we intend to execute a plan to get the deficit under control. We need to make a start in 2010.”

‘Active Monetary Policy’

Conservative leader David Cameron yesterday said he was “a great believer in an active monetary policy,” a step away from previous comments that the bank’s quantitative easing program would have to end soon.

Cameron told journalists that a speech he’d made at the start of the month had been misunderstood. “The point I was making was about how easy or difficult to fund our debt, because the market for gilts hasn’t really been tested yet, because of QE,” he said. He repeated his point that the intervention will have to end some time. “You can’t go on indefinitely.”

Policy makers at the central bank will decide next week whether to extend their asset purchase program, which is pumping

175 bln pounds ($286 bln) in newly created money into the economy.

The program has increased demand for U.K. government bonds, known as gilts, as the Treasury sells a record 220 bln pounds of debt this year.

The Conservatives have repeatedly warned this year that Brown’s spending plans are putting the U.K.’s AAA debt rating at risk. Hammond’s boss, George Osborne, told an audience of financiers on Monday that it was only the likelihood of a Conservative victory at the next election that was keeping Britain’s debt costs down. Conservatives have led Labour in polls for two years.


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