NY Fed’s Dudley tees off on reserve-driven inflation view

Posted on July 30, 2009 @ 10:00 am (Thursday) by WARREN MOSLER

Dudley almost has it.

NY Fed’s Dudley tees off on reserve-driven inflation view

As Dudley notes, the fears of higher inflation expressed in that survey are likely being influenced by the Fedâ€™s balance sheet expansion, which has of necessity increased excess reserves.

The argument that large amounts of excess reserves will fuel credit expansion and eventually inflation goes back to Karl Brunnerâ€™s formulation of the money multiplier hypothesis. According to this schema, holding excess reserves â€“ which historically earned zero interest â€“ would entail lost returns relative to holding earning assets. To avoid this cost, banks would seek to lend out excess reserves, thereby increasing credit, economic activity, and price pressures. As Dudley notes, this logic breaks down when reserves become earning assets, as they have since last fall when the Fed began paying interest on reserves.

He is wrong on that part. It does not matter if they are earning assets or not. In no case does reserve availability have anything to do with lending. It is about price, not quantity.

This counter-argument doesnâ€™t excuse the Fed from responsibility for controlling inflation. The Fed still needs to set interest on excess reserves (IOER) rate consistent with a cost of capital that will promote price stability and sustainable growth. As Dudley points out, the IOER rate is effectively the same as the funds rate.

Just my theory, but seems to me they have this part backwards. The way I read it, it is lower interest rates that promote price stability.

In addition to the foregoing argument, Dudley also makes a novel and clever point

Hardly!!!

about the argument that excess reserves on bank balance sheets are â€˜dry tinder:â€™ â€œBased on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They donâ€™t need a pile of â€˜dry tinderâ€™ in the form of excess reserves to do so. That is because the Federal Reserves has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not.â€

Got that part right, except the Fed has no choice but to allow that to happen.

While the meat of Dudleyâ€™s talk centered on conceptual issues regarding bank reserves, he also made some remarks on the economy and policy. On the economy, Dudley sees recovery driven by three forces â€“ fiscal stimulus, an inventory swing, and a rebound in housing and auto sales â€“ but remaining subdued by historical standards for four reasons â€“ a waning of support to personal incomes, ongoing adjustment to lower household wealth, weak structures investment, and a response to monetary policy easing that should be more constrained than in the past. Because the recovery is expected to be subdued, Dudley remarked that concern about when the Fed exits its very accommodative policy stance is â€œvery premature.â€

Here he still implies there are grounds for concern when in fact it is a non event.

Just as Dudley gave little indication that policy would be tightened anytime soon, he also reinforced the perception that an expansion of asset purchases is highly unlikely. He did so by noting that there are three costs to purchasing assets: a misperception of the intent of asset purchases that could increase inflation expectations,

He is still in the inflation expectations camp.

a reduction in bank leverage ratios from higher reserve balances which could slow credit growth,

Yes, as I have previously stated, quantitative easing is best understood as a bank tax.
Glad to see that aspect here.

and added interest rate risk on the Fed balance sheet.

Like I said above, he’s almost got it.

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Latest from Pimco

Posted on July 21, 2009 @ 2:44 pm (Tuesday) by WARREN MOSLER

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What If?

By Paul McCulley, Managing Director, PIMCO

The whole world, it seems, is wrapped around the axle about exit strategies from putatively unsustainable policies: (1) the Fed’s bloated balance sheet, with some $800 billion of excess reserves sloshing ’round the banking system, in the context of an effective zero Fed funds rate; and (2) the Treasury’s huge budget deficit, unprecedented in peace time and set to stay huge, implying a Treasury debt/GDP ratio approaching 100% within a decade’s time.

For some, usually with Monetarist roots, this combination of policies is a classic brew for a major bout of inflation (eventually, it is always stressed). For others, usually with Austrian tendencies, this policy brew is a deflationary force, as it will provoke foreign investors to flee both the dollar and Treasuries, driving up real interest rates, pole axing any revival in risk asset prices, themselves backed by the fruits of bubble-driven mal-investment. And, I’m quite sure, there are some with a foot in both camps.

So it’s not easy to actually define conventional, or consensus, wisdom. In fact, many of my Keynesian brethren seem to be struggling with what to do, arguing against any further near-term fiscal stimulus, or at least unless enacted simultaneously with long-term fiscal restraint. Indeed, I recently publicly uttered something along these lines, though I hedged myself by saying long-term fiscal responsibility rather than restraint (responsibility is in the eye of the beholder, while restraint is more categorical).

In any event, there does not seem to be any serious consensus as to how the policy mix should be adjusted, if at all, despite clear and present evidence of massive unemployment and underemployment, which is putting downward pressure on nominal personal income (the product of fewer jobs, fewer hours and decelerating wages, almost to the zero line).

And rapidly declining interest income as savings rates ‘reset’ to 0, and borrowing rates stay high, with the spread going to lenders with near 0 propensities to consume.

And government net interest payments are flat to down as well even with higher deficits.

This is not the stuff of a self-sustaining revival in aggregate demand. Thus, my tentative conclusion is that maybe the consensus professional economist view is that America should simply accept that it’s going to have its version of Japan’s lost decade, the Calvinist aftermath of the preceding sin of booming growth on the back of ever-increasing leverage and mal-investment.
But if that sobering view is indeed the new consensus, shame on my profession! There is another way. And, irony of ironies, it is not a new way, but rather an old way, one defined by no less than Paul Krugman in 1998 and Ben Bernanke in 2003, when lecturing Japan about what to do. I have enormous respect for the intellectual horsepower of both men, and what they preached back then deserves a re-preaching, even if I’m the humble preacher that must take the pulpit.

Krugman in May 1998
In a delightfully wonkish paper,1 using the enormous horsepower of the IS-LM (investment savings-liquidity preference money supply equilibrium) framework,

Unfortunately that’s a fixed fx/gold standard model with no application to non convertible floating fx currency.

he made a powerful case for what Japan should do to bootstrap itself out of the deflationary swamp. I’ll spare you the wonkish part and cut to his commonsensical conclusion.

In the midst of deflation in the context of a liquidity trap, with the central bank’s policy rate pinned at zero, it is not enough for the central bank to print money,

Right, that’s just an exchange of financial assets, and with lending not reserve constrained has no effect on lending and/or the real economy.

accommodating massive fiscal policy stimulus, he argued. Not that this is not a necessary policy action. It is. But it is not sufficient, Krugman pounded the table, because if the public believes that the central bank will, in the future, un-print the money – in today’s jargon, implement an exit strategy from money printing – then the printed money will simply be hoarded, rather than spent, because deflationary expectations will remain entrenched.

‘Unprinting money’ is simply the CB selling securities which again is an exchange of financial assets and has no effect on lending or the real economy, apart from the resulting interest rates which the CB controls via price in any case.

To get the public to spend the money, Krugman argued, the central bank should make clear that the printed money will remain printed, shifting deflationary expectations to inflationary expectations. In his famous conclusion, actually advice to the Bank of Japan, Krugman declared (his italics, not mine):

“The way to make monetary policy effective is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.”

This confirms a lack of understanding of monetary operations. The ‘printing/unprinting of money’ is simply a financial asset exchange that does not add net financial assets to the non govt sectors, and has no influence on lending.

In a follow-up (similarly wonkish) paper2 in 1999, Professor Krugman refined his argument, stressing that the core of his thesis could be implemented through a credible inflation target that was appreciably higher than the prevailing negative inflation rate in Japan. Thus, he was not so much arguing that the Bank of Japan should act irresponsibly, but rather act irresponsibly relative to orthodox, conventional thinking, which itself was irresponsible, in that it emphasized the need for an eventual exit strategy from liquidity trap-motivated money printing.

He is also ‘trapped’ in ‘inflation expectations theory’ that is also the result of not understanding monetary operations, or that taxation is a ‘coercive’ measure that removes the ‘neutrality of money’ from the model.

To get out of the trap, he emphasized, the central bank needed to radically change expectations to the notion that there was no exit strategy, at least until inflation was appreciably higher – not just inflation expectations, but inflation itself. Only then would the commitment to higher inflation be credible, with the central bank not just talking the reflationary talk, but walking the reflationary walk, turning deflationary swamp water into reflationary wine.

As an interesting aside, a little over a year ago the media reported that consumers had pulled back their spending due to inflation and elevated inflation expectations. Not supposed to happen the way expectations theory says they will accelerate purchases. But that’s another story and moot in any case.

Naturally, the Bank of Japan didn’t listen to Krugman at the time; orthodoxy is as orthodoxy does. In March 2001, however, the Bank of Japan did serve up a small beer from the Krugman still, adopting Quantitative Easing (QE), re-enforcing its zero interest rate policy (ZIRP) with an explicit target for massive creation of excess reserves, committing to retaining that policy until the year-over-year core CPI moved above zero on a “stable” basis. A very small beer indeed.

No beer, in fact, as above, as would have been Krugman’s plan, as above.

But to its credit, the Bank of Japan tiptoed the reflationary walk, sticking with QE for five years, exiting in March 2006, after the year-over-year core CPI had turned positive in November 2005. A small beer is better than no beer.

It turned positive after they finally let the deficit get to 8% and not try to cut it with a consumption tax. Also, higher energy and food prices bled through to core through the cost channels some.

Bernanke in May 2003
Professor Bernanke became Fed Governor Bernanke the prior year, making his most famous speech in November 2002, “Making Sure ‘It’ Doesn’t Happen Here,”3 detailing the Fed’s anti-deflationary toolbox. That’s the speech that the markets are using as a roadmap for Chairman Bernanke’s present anti-deflation policy path (it’s actually been quite a good roadmap!). But a speech in May 2003, “Some Thoughts on Monetary Policy in Japan,”4 is equally important, I think, because it provides a roadmap for what the Fed might do if present anti-deflation policies prove to be inadequate to the task.

The speech is not quite as wonkish as Krugman’s May 1998 missive, but is still robustly analytical. Perhaps that’s why my profession and the media do not give it the attention it deserves. But Mr. Bernanke’s speech does have strong Occam’s Razor conclusions, and they are eerily the same as Krugman’s, perhaps even stronger.

No, Mr. Bernanke did not advocate to the Bank of Japan that it credibly commit to acting irresponsibly, Krugman’s clever turn of phrase. In fact, as noted above, Krugman didn’t really, either; he simply wanted the Bank of Japan to act responsibly, which would be deemed irresponsible in the context of orthodox thinking. Both men know how to think outside the proverbial box!

The real problem is their tools don’t do anything in theory or, as repeatedly demonstrated, in practice. It’s not their fault. They don’t have any other tools.

At the time, Mr. Bernanke was a table-thumping advocate for the Fed to adopt an explicit inflation target. But in Japan, he upped that analytical ante by advocating that the Bank of Japan adopt a price level target, not an inflation target.
And there is a huge difference. An inflation target “forgives” past deflation (or below inflation target) sins. In contrast, a price level target does not forgive those sins, but rather demands that the central bank atone for them by explicitly pursuing sufficient inflation to restore the price level to a plateau that would have been achieved if those sins had not been committed. More specifically, he advocated that the Bank of Japan should (his italics, not mine):

“… announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred. (I choose 1 percent to allow for the measurement bias issue noted above, and because a slightly positive average rate of inflation reduces the risk of future episodes of sustained deflation.) Note that the proposed price-level target is a moving target, equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and rising 1 percent per year thereafter. Because deflation implies falling prices while the target price-level rises, the failure to end deflation in a given year has the effect of increasing what I have called the price-level gap. The price-level gap is the difference between the actual price level and the price level that would have obtained if deflation had been avoided and the price stability objective achieved in the first place.

A successful effort to eliminate the price-level gap would proceed, roughly, in two stages. During the first stage, the inflation rate would exceed the long-term desired inflation rate, as the price-level gap was eliminated and the effects of previous deflation undone. Call this the reflationary phase of policy. Second, once the price-level target was reached, or nearly so, the objective for policy would become a conventional inflation target or a price-level target that increases over time at the average desired rate of inflation.”

This is very powerful stuff!

Yes, if there were any tools in the Fed’s tool box that were applicable.
There only tool is setting the term structure of rates, and even then they struggle to figure out how to accomplish that simple task due to their lack of understanding of monetary operations and reserve accounting.

And the problem is, as above, with current institutional arrangements rate cuts have taken income from savers and given it to lenders which has resulted in a net drop in aggregate demand rather than an increase.

Mr. Bernanke knew he was breaking some new ground, at least from the mouth of a sitting policymaker. In actuality, he was drawing on some powerful academic work of Eggertsson and Woodford,5 which laid out the case that a price level target would likely have a more powerful effect on inflation expectations than simply an inflation target above the prevailing level of inflation (or in Japan’s case, deflation). How so? A price level target pegged at the starting point of a period of deflation – or below target inflation – implies that the central bank is explicitly committed to reflation, meaning that in the short-to-intermediate term, the central bank will explicitly aim for an inflation rate that is higher than its long-term “desired” rate.

Unfortunately the fed has no tools that have a transmission mechanism that can make any of that happen.

Mr. Bernanke recognized that such a policy could unmoor long-term inflation expectations, creating a deleterious rise in long-term interest rates.

Yes, the belief in inflations expectations theory leads to those conclusions.
Unfortunately that theory holds no water. It fails to recognize taxation is coercive (as above) which obviates inflation expectations theory as the cause of the price level.

But in his view, this was a risk worth taking, in part because he felt that a central banker with strong communications skills could draw a distinction between (1) a one-time reflation to correct a deflated price level back up to a level that would have been achieved in the absence of deflationary sins and (2) the central bank’s long-term inflation objective. But he acknowledged it would be tricky.

But his case didn’t rest simply on skilled central bank communications. While he felt that generating a positive shock to short-to-intermediate inflation expectations would have the effect of reducing real interest rates (remember, the real rate is the nominal rate minus inflation expectations), he did not think that effect was assured and even if it was, he did not believe it would be sufficient to stimulate private sector aggregate demand robust enough to reduce Japan’s output gap.

Rate cuts did not add to aggregate demand in Japan any more than they have here. They had the same institutional issue- the non government sectors are net savers and rate cuts reduce net interest income.

Bernanke recognized this effect which he called the fiscal channel in his 2004 paper.

Thus, he advocated explicit cooperation between the fiscal authority and the monetary authority, with the latter subordinating itself to the former. And you thought Krugman was radical!

While the passage on this topic6 in Bernanke’s speech is a bit long, it is so powerful that I think it deserves a full hearing. Here it is:

“My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt – so that the tax cut is in effect financed by money creation.

Why would it matter if the BOJ bought the JGB’s or not? Again, all that does is deprive the non government sectors of interest income.

Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.

That ‘money stock’ is also irrelevant. Reserves are functionally nothing more than one day JGB’s.

Under this plan, the BOJ’s balance sheet is protected by the bond conversion program,7 and the government’s concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector.

Both those concerns are moot if one understands reserve accounting and monetary operations.

Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but – because the BOJ purchased government debt in the amount of the tax cut – no current or future debt service burden has been created to imply increased future taxes.

Yes.

As taxes function only to reduce aggregate demand and not to ‘fund expenditures’ (with a non convertible currency and floating fx)

Taxes can be reduced to whatever point is necessary to get demand up to desired levels.

Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices.

The tax cut alone does that. The ‘monetary’ proposal does nothing apart from being part of the process to set interest rates.

The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about ‘broken’ channels of monetary transmission. This approach also responds to the reservation of BOJ officials that the Bank “lacks the tools” to reach a price-level or inflation target.

The BOJ did lack the tools. It’s all about fiscal policy.

Isn’t it irresponsible to recommend a tax cut, given the poor state of Japanese public finances?

‘Poor state’ is not applicable to a government with non convertible currency/floating fx. Payment is by crediting member bank accounts at its own central bank. Taxing debits said accounts. The government doesn’t ‘have’ or ‘not have’ ‘money’ at any time. All it does is run its own spread sheet.

To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ’s purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan’s fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.

Debt to GDP is different only because bank reserves aren’t counted as ‘debt’ while JGB’s are even though they are functionally identical apart from maturity.

Nor does debt to GDP matter in any case.

Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example.

As above, these could be done without the BOJ with identical effect.

The BOJ’s purchases would mitigate the effect of the new spending on the burden of debt and future interest payments perceived by households, which should reduce the offset from decreased consumption.

Why is that a concern? Higher propensities for households to save means taxes can be even lower. What’s wrong with an economy with a high savings propensity and lower taxes to sustain demand?

More generally, by replacing interest-bearing debt with money, BOJ purchases of government debt lower current deficits and interest burdens and thus the public’s expectations of future tax obligations.

These ‘interest burdens’ are payments from the government to the non government sectors. With a permanent 0 rate policy there doesn’t have to be any at all. It’s a political choice.

Of course, one can never get something for nothing; from a public finance perspective, increased monetization of government debt simply amounts to replacing other forms of taxes with an inflation tax.

Not if the starting point is an output gap. The output gap is a result of fiscal drag resulting from taxes being too high relative to savings desires. Cutting taxes removes that fiscal drag and allows the economy to return to full employment which is where it would be without that fiscal drag.

More people working and producing output is not getting something for nothing. Only when at full employment can you get ‘no more’ from fiscal adjustments (ex productivity gains).

But, in the context of deflation-ridden Japan, generating a little bit of positive inflation (and the associated increase in nominal spending) would help achieve the goals of promoting economic recovery and putting idle resources back to work,

Yes, the tax cut alone was all that was and still is in order.

which in turn would boost tax revenue and improve the government’s fiscal position.”

And that adds fiscal drag which eventually brings the economy down again.

The idea is to sustain taxes at full employment levels, and not at some revenue target.

Powerful, powerful stuff!

Yes

And Now to the USA at Present
The United States is not presently suffering deflation in goods and services prices, although the core CPI has dipped slightly below the Fed’s putative 2% “target.” So the extreme measures that Krugman and Bernanke advocated for Japan do not translate fully to the United States. But they do translate a lot more than the consensus is even willing to discuss in politically correct circles.

America is in a liquidity trap, driven by private sector deleveraging borne of asset price deflation, meaning that private sector demand for credit is axiomatically flat to negative, despite a Fed funds rate pinned against zero. The only source of credit demand growth in the United States is the Treasury itself.

More simply, the US is suffering from a severe lack of aggregate demand that’s ruining millions of lives.

And until the deleveraging process runs its course, consensus agrees that there is nothing wrong with such bloated Treasury demand for credit: In a recessionary foxhole, Keynesian religion dominates all other economic religions.

So why not an immediate, full, payroll tax holiday and an immediate $500 per capita distribution to the states (per capita is the key to making it ‘fair’ to all)

The payroll tax holiday simply stops taking 20 billion a week from the wages and salaries of people working for a living which is also ‘fair’ and not ‘rewarding bad behavior’ and regressive enough for the democratic majority to be categorically against.

But not all believers are equally devout, as noted at the outset, with many against any further ramping up of Keynesian stimulus, at least without a contemporaneous move to ensure long-term fiscal responsibility, so as to prevent a deleterious increase in long-term Treasury interest rates.

Again, understanding monetary operations and reserve accounting would put those fears to rest.

Best!

Warren

So what should Washington do, if and when – and I stress “if and when”; I’m not making a forecast here! – private sector aggregate (nominal) demand growth looks like it’s going to languish in Japan style for the indefinite future? The answer: Take one cup of Krugman’s advice for Japan and two cups of Bernanke’s advice for Japan – responsibly act irresponsibly relative to orthodoxy.

Yes, as Bernanke intoned, there are no free lunches. But no lunch doesn’t work for me. Or the American people. While it is true, as Keynes intoned, that we are all dead in the long run, I see no reason to die young from orthodoxy-imposed anorexia.

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India Should Rely on Lower Rates to Stimulate Growth, OECD Says

Posted on June 24, 2009 @ 8:11 am (Wednesday) by WARREN MOSLER

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India Should Rely on Lower Rates to Stimulate Growth, OECD Says

by Kartik Goyal

June 24 (Bloomberg) — India should cut interest rates
rather than boost government spending if further measures are
needed to stimulate growth, the Organization for Economic
Cooperation and Development said.

They need to read Bernanke’s 2004 paper which makes it clear lower interest rates are contractionary via the fiscal channel and need to be matched by fiscal expansion to overcome that effect.

Additionally, in today’s environment, lower rates hurt savers a lot more than the help borrowers. Rates for savers have fallen a lot more than rates for borrowers due to risk perceptions and implied capital costs as net interest margins for lenders have increased to over 4%. This also means reduced aggregate demand and begs additional fiscal measures to sustain GDP.

So while I strongly favor lower rates, I also recognize that one of the benefits of lower rates is that they allow reduced taxes or increased public expenditure to sustain output and employment at desired levels.

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Continuing Claims->UE Rate->FF Rate

Posted on June 19, 2009 @ 11:46 am (Friday) by WARREN MOSLER

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Karim writes:

The chart attached shows the last 3 cycles in continuing claims, the unemployment rate and the FF rate.

Continuing claims is a coincident to leading indicator of the unemployment rate. Its interesting that in the last two cycles, continuing claims made what appears to be a double top before the unemployment rate peaked. In those cycles, the lag between the peak in the unemployment rate and the first Fed rate hike was 12mths (June 2003-June 2004) and 19mths (July 1992-Feb 2004).

While this cycle is notably different than the others in many respects (size and speed of economic deterioration as well as policy response), look for the Fed to make some reference (implicit or explicit) to the unemployment rate coming down in a sustainable fashion before tightening policy. Based on history, even if this month was the peak in the unemployment rate, the first hike seems unlikely until mid-2010. Based on likely further deterioration in the ue rate, first hike unlikely before 2011.

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Nonsense from Wells Fargo

Posted on June 11, 2009 @ 12:47 pm (Thursday) by WARREN MOSLER

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Please send this on to Eugenio Aleman at Wells Fargo

Thinking The Unthinkable: The Treasury Black Swan, And The LIBOR-UST Inversion

Posted by Tyler Durden

>   The below piece is a good analysis of a hypothetical Treasury/Dollar black swan
>   event, courtesy of Eugenio Aleman from, surprisngly, Wells Fargo. Eugenio does
>   the classic Taleb thought experiment: what happens if the unthinkable become
>    not just thinkable, but reality. Agree or disagree, now that we have gotten to
>   a point where 6 sigma events are a daily ocurrence, it might be prudent to
>   consider all the alternatives.

In previous reports, I have touched upon the concerns I have regarding the overstretching of the federal government as well as of monetary policy while the Federal Reserve tries to maintain its independence and its ability, or willingness, to dry the U.S. economy of the current excess liquidity.

Excess reserves are functionally one day Treasury securities.
It’s a non issue.

Furthermore, we heard this week the Fed Chairmanâ€™s congressional testimony on the perils of excessive fiscal deficits and the effects these deficits are having on interest rates at a time when the Federal Reserve is intervening in the economy to try to keep interest rates low.

His thinking is still on the gold standard in too many ways.

Now, what I call â€œthinking the unthinkableâ€ is what if, because of all these issues, individuals across the world start dumping U.S. dollar notes, i.e., U.S. dollar bills?

The dollar would go down for a while.
Prices of imports would go up.
Exports would go up for a while

All assuming the other nations would let their currencies appreciate and let their exporters lose their hard won US market shares, which is certainly possible, though far from a sure thing.

Why? Because one of the advantages the U.S. Federal Reserve has over almost all of the rest of the worldâ€™s central banks is that there seems to be an almost infinite demand for U.S. dollars in the world, which has made the Federal Reserveâ€™s job a lot easier than that of other central banks, even those from developed countries.

In what way? They set rates, that’s all. It’s no harder or easier for the Fed than any other central bank.

if there is a massive run against the U.S. dollar across the world then the Federal Reserve will have to sell U.S. Treasuries to exchange for those U.S. dollars being returned to the country, which means that the U.S. Federal debt and interest payments on that debt will increase further.

Not true. First, they have a zero rate policy anyway so they can just sit as excess reserves should anyone deposit them in a bank account, and earn 0. Or they can hold the cash and earn 0.

This means that we will go from paying nothing on our â€œcurrencyâ€ loans to having to pay interest on those U.S. Treasuries that will be used to sterilize the massive influx of U.S. dollar bills into the U.S. economy, putting further pressure on interest rates.

No treasuries have to sold to sterilize anything.
A little knowledge about monetary operations would go a long way towards not letting this nonsense be published in respectable forums.

If we add the nervousness from Chinese officials regarding U.S. debt issues, then we understand the reason why we had Treasury secretary Timothy Geithner in China last week â€œcalmingâ€ Chinese officials concerned with the massive U.S. fiscal deficits. I remember similar trips from the Bush administrationâ€™s Treasury officials pleading with Chinese officials for them to continue to buy GSEs (Freddie Mac and Freddie Mae) paper just before the financial markets imploded.

Yes, they have it wrong, and it’s making the administration negotiate from a perceived position of weakness while the Chinese and others take us for fools.

But the situation today is even more delicate because of the impressive amounts of U.S. Treasuries s we will have to issue during the next several years in order to pay for all the programs we have put together to minimize the fallout from this crisis.

Issuing Treasuries does not pay for anything. Spending pays for things, and spending is not operationally constrained by revenues.

The Treasuries issued support interest rates. They don’t ‘provide’ funds.

Furthermore, if China and other countries do not keep buying U.S. Treasuries, then interest rates are going to skyrocket.

There’s some hard scientific analysis. They go to the next highest bidder. The funds to pay for the securities come from government spending/Fed lending, so by definition the funds are always there and the term structure of rates is a matter of indifference levels predicated on future fed rate decisions.

This is one of the reasons why Bernanke was so adamant against fiscal deficits in his latest congressional appearance.

And because on a gold standard deficits can be deadly and cause default. He’s still largely in that paradigm that’s long gone.

Of course, the U.S. government knows that the Chinese are in a very difficult position: if they donâ€™t buy U.S. Treasuries, then the Chinese currency is going to appreciate against the U.S. dollar and thus Chinese exports to the U.S., and consequently, Chinese economic growth will falter.

Yes, as I indicated above.

The U.S. and China are like Siamese twins joined at the chest and sharing one heart. This is something that will probably keep Chinese demand for Treasuries elevated during the next several years. However, this is not a guarantee, especially if the Chinese recovery is temporary and they have to keep on spending resources on more fiscal stimulus rather than on buying U.S. Treasuries.

Again, this shows no understanding of monetary operations and reserve accounting. The last two are not operationally or logically connected.

Thus, my perspective for the U.S. dollar is not very good. And now comes the caveat. Having said this, what is the next best thing? Hugo Chavezâ€™s Venezuelan peso? Putinâ€™s Russian rubble? The Iranian rial? The Chinese renminbi? Kirchnerâ€™s Argentine peso? Lula da Silvaâ€™s Brazilian real? That is, the U.S. dollar is still second to none!

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Trichet Sees Automatic Exit From ECB’s Non-Standard Measures

Posted on June 5, 2009 @ 8:22 am (Friday) by WARREN MOSLER

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The ECB remains way ahead of the fed regarding monetary operations.
It has been setting rates and letting quantity adjust and now addresses
unfounded concerns of ‘exit strategies’ head on.

(I take issue only to the extent of the potential inflationary implications and influence on growth and employment of interest rate policy in general, but that’s another story.)

The covered bond purchase could have utilized a rate target rather than a quantity target but their policy might not be to target a specific rate.

Also note they accept collateral down to a bbb rating from their member banks, which is includes bank paper and is functionally very close to unsecured lending- a policy that i have been suggesting would have served the fed well from the beginning of the crisis.

Trichet Sees Automatic Exit From ECBâ€™s Non-Standard Measures

June 5 (Bloomberg) — European Central Bank President Jean- Claude Trichet said banks will seek less credit from the ECB when the economy improves, automatically reducing the amount of money in the system and ensuring a non-inflationary recovery.

By concentrating its non-standard policy measures on the supply of unlimited liquidity to banks, the ECB has ensured it has â€œan in-built exit strategy,â€ Trichet said in a speech in Warsaw today. â€œThat is, when tensions in financial markets ease, banks will automatically seek less credit from the ECB.

This will be a decisive element in ensuring a non-inflationary recovery.â€

The Frankfurt-based ECB, which has cut its benchmark interest rate to a record low of 1 percent, has said it will loan banks as much money as they need for up to 12 months and pledged to buy 60 billion euros ($85 billion) of covered bonds in an effort to revive lending. The ECB yesterday lowered its economic forecasts for this year and next. It now expects the economy of the 16 nations using the euro to shrink by about 4.6 percent this year before returning to positive quarterly growth rates by mid-2010.

â€œOnce the macroeconomic environment improves, the Governing Council will ensure that the measures taken can be quickly unwound and the liquidity provided absorbed,â€ Trichet said. â€œHence, any threat to price stability over the medium and longer term will be effectively countered in a timely fashion.â€

Merkelâ€™s Warning

German Chancellor Angela Merkel on June 2 scolded the Federal Reserve and Bank of England for pumping too much money into their economies and said that by deciding to buy covered bonds, the ECB had â€œbowed somewhat to international pressure.â€

She urged a return to a â€œpolicy of reason.â€

Trichet said the ECBâ€™s â€œbold yet solidly-anchored responseâ€ to the worst economic crisis since World War II is â€œencouraging.â€ While long-term inflation expectations remain anchored around the ECBâ€™s 2 percent limit, â€œour measures show some signs of revival in the functioning of money markets in Europe,â€ he said.

Trichet added that the crisis has not altered the ECBâ€™s primary objective of maintaining price stability. â€œThis objective will always provide the context and limits within which our course of action is framed and enacted.â€

Trichet Says ECB Will Buy Covered Bonds Next Month

by Neil Unmack

June 4 (Bloomberg) — The European Central Bank will start buying 60 billion euros ($85 billion) of three- to 10-year covered bonds from July, President Jean-Claude Trichet said.

The central bank will buy bonds rated at least BBB- in the primary and secondary markets until June 2010, but doesnâ€™t plan to purchase other assets, the ECB said after policy makers held interest rates at a record-low 1 percent. The ECB said on May 7 it will buy covered bonds in a bid to revive the market, which lenders use to finance mortgages and public-sector loans.

Covered bond issuance increased after the ECB announced the purchase program last month, with banks selling 26.8 billion euros of the debt, according to data compiled by Bloomberg. The $2.8 trillion market had been roiled by the credit crisis, and sales had halved to 48.6 billion euros by May 7, compared with 99.4 billion euros in the same period a year earlier.

â€œItâ€™s supportive for the primary and secondary covered bond market,â€ said Leef Dierks, a credit analyst at Barclays Capital in Frankfurt. â€œWe expect the issuance window to remain open, and believe that the positive momentum in the secondary market will continue.â€

To be included in the ECBâ€™s purchase plan, covered bonds â€œmust be eligible for use as collateral in the euro systemâ€™s credit operations,â€ Trichet said. The bonds must â€œhave as a rule a volume of about 500 million euros or more and in any case not lower than 100 million euros,â€ he said.

Bond Eligibility

Bonds bought by the central bank must comply with the so- called UCITS directive, a European regulatory framework for mutual funds, or have â€œsimilar safeguards,â€ Trichet said, without being more specific.

â€œThey want to get the most bang for their euro, and that means helping the bonds that will have the widest investor support in the market,â€ said Ted Lord, head of covered bonds at Barclays.

The ECB said it will buy bonds through â€œdirect purchasesâ€ rather than following the Bank of Englandâ€™s example of using auctions.

â€œWe would like more clarity on how these direct purchases will work,â€ said Heiko Langer, a covered bond analyst at BNP Paribas SA in London. â€œWill we know how much they have bought, what they have bought, and at what price?â€

Regarding the euro regionâ€™s economy, Trichet said confidence may improve more quickly than has been forecast.

â€œRisks to the economic outlook are balanced,â€ he said. â€œOn the positive sideâ€ there are â€œstronger-than-anticipated effects from stimulus measures underway and other policy measures taken. Annual inflation rates are projected to decline further and become negative over the coming months.â€

Covered bonds are backed by real-estate or public-sector debt and tend to have a higher rating than straight corporate bonds because theyâ€™re also supported by a borrowerâ€™s pledge to pay.

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Claims/ECB/BOC

Posted on June 4, 2009 @ 12:12 pm (Thursday) by WARREN MOSLER

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Initial claims down 4k to 621k

Continuing claims down 15k, first drop in 2009

Some possibility of Memorial Day week distorting data

Both measures consistent with ongoing job losses and rising unemployment rate, but a slower pace than in recent months

Have no bearing on tomorrowâ€™s numbers as data came after survey week for NFP.

Interesting focus on FX from both ECB and BOC this morning:

From BOC:

–In recent weeks, financial conditions and commodity prices have improved significantly, and consumer and business confidence

have recovered modestly. If the unprecedentedly rapid rise in the Canadian dollar (which reflects a combination of higher

commodity prices and generalized weakness in the U.S. currency) proves persistent, it could fully offset these positive factors.

–Key is term ‘unprecedented’ and that rise in C$ is not fully explained by the rise in commodity prices.

From ECB:

–ECB staff updated its forecasts for growth and inflation. Main change was in 2009 growth forecast:

Now -4.1% to -5.1% from estimates of -2.2% to -3.2% in March

Trichet stated: â€œits very important u.s. repeats strong dollar policyâ€.

The Euro is not trading far from levels that Trichet described as â€˜brutalâ€™ in the past.

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Dallas Fed interview

Posted on May 25, 2009 @ 9:17 pm (Monday) by WARREN MOSLER

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Don’t Monetize the Debt

by Mary Anastasia O’Grady

May 23 (WSJ) — From his perch high atop the palatial Dallas Federal Reserve Bank, overlooking what he calls “the most modern, efficient city in America,” Richard Fisher says he is always on the lookout for rising prices. But that’s not what’s worrying the bank’s president right now.

His bigger concern these days would seem to be what he calls “the perception of risk” that has been created by the Fed’s purchases of Treasury bonds, mortgage-backed securities and Fannie Mae paper.

Mr. Fisher acknowledges that events in the financial markets last year required some unusual Fed action in the commercial lending market. But he says the longer-term debt, particularly the Treasurys, is making investors nervous. The looming challenge, he says, is to reassure markets that the Fed is not going to be “the handmaiden” to fiscal profligacy. “I think the trick here is to assist the functioning of the private markets without signaling in any way, shape or form that the Federal Reserve will be party to monetizing fiscal largess, deficits or the stimulus program.”

If he actually understood it I would expect him to say the concept is inapplicable with a non convertible currency and floating exchange rate regime.

Richard Fisher.

The very fact that a Fed regional bank president has to raise this issue is not very comforting. It conjures up images of Argentina. And as Mr. Fisher explains, he’s not the only one worrying about it. He has just returned from a trip to China, where “senior officials of the Chinese government grill[ed] me about whether or not we are going to monetize the actions of our legislature.” He adds, “I must have been asked about that a hundred times in China.”

Without knowing the right answer which is that lending is in no case reserve constrianed.
Causation runs from loans to deposits and reserves, and not from reserves to loans.

A native of Los Angeles who grew up in Mexico, Mr. Fisher was educated at Harvard, Oxford and Stanford.

Must have skipped the classes in reserve accounting.

He spent his earliest days in government at Jimmy Carter’s Treasury. He says that taught him a life-long lesson about inflation. It was “inflation that destroyed that presidency,” he says. He adds that he learned a lot from then Fed Chairman Paul Volcker, who had to “break [inflation’s] back.”

Deregulating natural gas in 1978 is what broke the back of inflation as utilities switched from crude to natural gas and even cuts of 15 million barrels per day by OPEC were not enough to keep control of prices.

Mr. Fisher has led the Dallas Fed since 2005 and has developed a reputation as the Federal Open Market Committee’s (FOMC) lead inflation worrywart. In September he told a New York audience that “rates held too low, for too long during the previous Fed regime were an accomplice to [the] reckless behavior” that brought about the economic troubles we are now living through. He also warned that the Treasury’s $700 billion plan to buy toxic assets from financial institutions would be “one more straw on the back of the frightfully encumbered camel that is the federal government ledger.”

In a speech at the Kennedy School of Government in February, he wrung his hands about “the very deep hole [our political leaders] have dug in incurring unfunded liabilities of retirement and health-care obligations” that “we at the Dallas Fed believe total over $99 trillion.”

Hopefully he is worried about possible inflation and not solvency.

In March, he is believed to have vociferously objected in closed-door FOMC meetings to the proposal to buy U.S. Treasury bonds. So with long-term Treasury yields moving up sharply despite Fed intentions to bring down mortgage rates, I’ve flown to Dallas to see what he’s thinking now.

Hopefully he is concerned with the purchases possibly lowering interest rates too much for his liking and not about the size of the fed’s balance sheet.

Regarding what caused the credit bubble, he repeats his assertion about the Fed’s role: “It is human instinct when rates are low and the yield curve is flat to reach for greater risk and enhanced yield and returns.” (Later, he adds that this is not to cast aspersions on former Fed Chairman Alan Greenspan and reminds me that these decisions are made by the FOMC.)

“The second thing is that the regulators didn’t do their job, including the Federal Reserve.” To this he adds what he calls unusual circumstances, including “the fruits and tailwinds of globalization, billions of people added to the labor supply, new factories and productivity coming from places it had never come from before.” And finally, he says, there was the ‘mathematization’ of risk.” Institutions were “building risk models” and relying heavily on “quant jocks” when “in the end there can be no substitute for good judgment.”

Never does mention the role of fiscal policy. Like the massive 2003 retro tax cuts and spending increases that drove the next few years, including housing. Helped of course by the lender fraud.

What about another group of alleged culprits: the government-anointed rating agencies? Mr. Fisher doesn’t mince words. “I served on corporate boards. The way rating agencies worked is that they were paid by the people they rated. I saw that from the inside.” He says he also saw this “inherent conflict of interest” as a fund manager. “I never paid attention to the rating agencies. If you relied on them you got . . . you know,” he says, sparing me the gory details. “You did your own analysis. What is clear is that rating agencies always change something after it is obvious to everyone else. That’s why we never relied on them.” That’s a bit disconcerting since the Fed still uses these same agencies in managing its own portfolio.

Agreed. Can’t have it both ways. And now they are threatening to downgrade the US government as well

I wonder whether the same bubble-producing Fed errors aren’t being repeated now as Washington scrambles to avoid a sustained economic downturn.

He surprises me by siding with the deflation hawks. “I don’t think that’s the risk right now.” Why? One factor influencing his view is the Dallas Fed’s “trim mean calculation,” which looks at price changes of more than 180 items and excludes the extremes. Dallas researchers have found that “the price increases are less and less. Ex-energy, ex-food, ex-tobacco you’ve got some mild deflation here and no inflation in the [broader] headline index.”

Mr. Fisher says he also has a group of about 50 CEOs around the U.S. and the world that he calls on, all off the record, before almost every FOMC meeting. “I don’t impart any information, I just listen carefully to what they are seeing through their own eyes. And that gives me a sense of what’s happening on the ground, you might say on Main Street as opposed to Wall Street.”

It’s good to know that a guy so obsessed with price stability doesn’t see inflation on the horizon. But inflation and bubble trouble almost always get going before they are recognized. Moreover, the Fed has to pay attention to the 1978 Full Employment and Balanced Growth Act — a.k.a. Humphrey-Hawkins — and employment is a lagging indicator of economic activity. This could create a Fed bias in favor of inflating. So I push him again.

“I want to make sure that your readers understand that I don’t know a single person on the FOMC who is rooting for inflation or who is tolerant of inflation.” The committee knows very well, he assures me, that “you cannot have sustainable employment growth without price stability. And by price stability I mean that we cannot tolerate deflation or the ravages of inflation.”

Mr. Fisher defends the Fed’s actions that were designed to “stabilize the financial system as it literally fell apart and prevent the economy from imploding.” Yet he admits that there is unfinished work. Policy makers have to be “always mindful that whatever you put in, you are going to have to take out at some point. And also be mindful that there are these perceptions [about the possibility of monetizing the debt], which is why I have been sensitive about the issue of purchasing Treasurys.”

Yes, seems the Fed is worried about perceptions they know not to be true, but struggles to come with a way to communicate the operational realities.

He returns to events on his recent trip to Asia, which besides China included stops in Japan, Hong Kong, Singapore and Korea. “I wasn’t asked once about mortgage-backed securities. But I was asked at every single meeting about our purchase of Treasurys. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States. That seems to be the issue people are most worried about.”

As I listen I am reminded that it’s not just the Asians who have expressed concern. In his Kennedy School speech, Mr. Fisher himself fretted about the U.S. fiscal picture. He acknowledges that he has raised the issue “ad nauseam” and doesn’t apologize. “Throughout history,” he says, “what the political class has done is they have turned to the central bank to print their way out of an unfunded liability. We can’t let that happen. That’s when you open the floodgates. So I hope and I pray that our political leaders will just have to take this bull by the horns at some point. You can’t run away from it.”

Does not sound like he understands, operationally, what that is currently all about, but instead still uses gold standard rhetoric.

Voices like Mr. Fisher’s can be a problem for the politicians, which may be why recently there have been rumblings in Washington about revoking the automatic FOMC membership that comes with being a regional bank president. Does Mr. Fisher have any thoughts about that?

This is nothing new, he points out, briefly reviewing the history of the political struggle over monetary policy in the U.S. “The reason why the banks were put in the mix by [President Woodrow] Wilson in 1913, the reason it was structured the way it was structured, was so that you could offset the political power of Washington and the money center in New York with the regional banks. They represented Main Street.

Yes, there is a power struggle going on in the Fed

“Now we have this great populist fervor and the banks are arguing for Main Street, largely. I have heard these arguments before and studied the history. I am not losing a lot of sleep over it,” he says with a defiant Texas twang that I had not previously detected. “I don’t think that it’d be the best signal to send to the market right now that you want to totally politicize the process.”

Speaking of which, Texas bankers don’t have much good to say about the Troubled Asset Relief Program (TARP), according to Mr. Fisher. “Its been complicated by the politics because you have a special investigator, special prosecutor, and all I can tell you is that in my district here most of the people who wanted in on the TARP no longer want in on the TARP.”

At heart, Mr. Fisher says he is an advocate for letting markets clear on their own. “You know that I am a big believer in Schumpeter’s creative destruction,” he says referring to the term coined by the late Austrian economist. “The destructive part is always painful, politically messy, it hurts like hell but you hopefully will allow the adjustments to be made so that the creative part can take place.” Texas went through that process in the 1980s, he says, and came back stronger.

This is doubtless why, with Washington taking on a larger role in the American economy every day, the worries linger. On the wall behind his desk is a 1907 gouache painting by Antonio De Simone of the American steam sailing vessel Varuna plowing through stormy seas. Just like most everything else on the walls, bookshelves and table tops around his office — and even the dollar-sign cuff links he wears to work — it represents something.

He says that he has had this painting behind his desk for the past 30 years as a reminder of the importance of purpose and duty in rough seas. “The ship,” he explains, “has to maintain its integrity.” What is more, “no mathematical model can steer you through the kind of seas in that picture there. In the end someone has the wheel.” He adds: “On monetary policy it’s the Federal Reserve.”

Ms. O’Grady writes the Journal’s Americas column.

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FRB press release–reg D and remuneration

Posted on May 21, 2009 @ 8:46 am (Thursday) by WARREN MOSLER

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This will allow them to raise rates simply by paying interest on reserves and not require them to first ‘unwind’ their portfolio as was the case in Japan.

Press Release

May 20 — The Federal Reserve Board on Wednesday announced the approval of final amendments to Regulation D (Reserve Requirements of Depository Institutions) to liberalize the types of transfers consumers can make from savings deposits and to make it easier for community banks that use correspondent banks to receive interest on excess balances held at Federal Reserve Banks.

The amendments would also ensure that correspondents that are not eligible to receive interest on their own balances at Reserve Banks pass back to their respondents any interest earned on required reserve balances held on behalf of those respondents. The Board is also making other clarifying changes to Regulation D and Regulation I (Issue and Cancellation of Federal Reserve Bank Capital Stock).

The Board has revised Regulation D’s restrictions on the types and number of transfers and withdrawals that may be made from savings deposits. The final amendments increase from three to six the permissible monthly number of transfers or withdrawals from savings deposits by check, debit card, or similar order payable to third parties. Technological advancements have eliminated any rational basis for the distinction between transfers by these means and other types of pre-authorized or automatic transfers subject to the six-per-month limitation.

The Board also approved final amendments to Regulation D to authorize the establishment of excess balance accounts at Federal Reserve Banks. Excess balance accounts are limited-purpose accounts for maintaining excess balances of one or more institutions that are eligible to earn interest on their Federal Reserve balances. Each participant in an excess balance account will designate an institution to act as agent (which may be the participantâ€™s current pass-through correspondent) for purposes of managing the account. The Board is authorizing excess balance accounts to alleviate pressures on correspondent-respondent business relationships in the current unusual financial market environment, which has led some respondents to prefer holding their excess balances in an account at the Federal Reserve, rather than selling them through a correspondent in the federal funds market. A correspondent could hold its respondentsâ€™ excess balances in its own account at the Federal Reserve Bank; however, doing so may adversely affect the correspondentâ€™s regulatory leverage ratio. As market conditions evolve, the Board will evaluate the continuing need for excess balance accounts.

In October 2008, the Board adopted an interim final rule amending Regulation D that directed Federal Reserve Banks to pay interest on balances held by eligible institutions in accounts at Reserve Banks. The final rule revises those provisions as they apply to balances of respondents maintained by “ineligible” pass-through correspondents–that is, entities such as nondepository institutions that serve as correspondents but are not eligible to receive interest on the balances they maintain on their own behalf at the Federal Reserve. Specifically, the final rule provides that only required reserve balances maintained in an ineligible correspondent’s account on behalf of its respondents will receive interest. Ineligible correspondents will be required to pass back that interest to their respondents. Both required reserve and excess balances in the account of an eligible pass-through correspondent will continue to receive interest and those correspondents are permitted, but not required, to pass back that interest to their respondents.

The final amendments to Regulations D and I will become effective 30 days after publication in the Federal Register. Excess balance accounts will be available for the reserve maintenance period beginning July 2, 2009.

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