There's a problem with the transmission....

In my last post, I pointed out that QE does not work when the transmission mechanism for monetary policy is impaired because of a damaged and risk-averse financial sector. This caused some confusion among those who think that throwing money at banks automatically makes them lend, so I attempted to explain it on twitter. Predictably, I ended up in an extended discussion first with David Beckworth and then with Andrew Lilico, in the course of which it became clear - to me, at any rate - that not only does QE fail when damaged banks aren't lending normally, but it actually impairs the transmission mechanism itself. This might explain why QE seems to become less effective the more of it you do. It's like hard water. It gradually clogs up its own pipes. 

To explain this, let me first go through the money creation process in our fiat money system and the ways in which QE influences that process.

The monetary base, M0, is created by the central bank. It consists of notes & coins, and bank reserves - the money that banks use to settle payments. M0 makes up maybe 10-15% of the total money in circulation. The rest - "broad money" - is created in the course of lending both by banks and by non-banks that do bank-like things. It should be remembered that non-banks are the customers of banks: cash held by non-banks always finds its way into banks. 

Bank reserves never leave the banking system. They are not "lent out", as is often claimed. When a bank lends, it creates a deposit "from nothing", which is placed in the customer's demand deposit account. When that loan is drawn down, the bank must obtain reserves to settle that payment - but the payment simply goes to another bank (or even the same one), either directly through an interbank settlement process, or indirectly via cash withdrawal and subsequent deposit. The total amount of reserves in the system DOES NOT CHANGE as a consequence of bank lending. Only the central bank can change the total amount of reserves in the system. This is usually done by means of "open market operations" - buying and selling securities in return for cash. 

Because banks create deposits from nothing when they lend, the availability of reserves at the time of loan creation is not a constraint on lending. When the financial system is functioning normally, banks borrow reserves from each other to settle payment requests, and if there is a shortage of reserves in the system the central bank will create more: alternatively if there are more reserves in the system than are needed to settle payments, the central bank would normally drain them by selling securities back into the market. Some central banks impose a "reserve requirement" of, say, 10% of eligible deposits: this is a liquidity buffer to ensure that banks can meet most payment requests without having to borrow from each other or from the central bank. If there is a positive reserve requirement, it is the central bank's responsibility to ensure that there are sufficient reserves in the system to enable all banks to meet the reserve requirement.

It should be apparent from this that the monetary base RESPONDS TO lending demand. It does not drive it. This is borne out by evidence that if anything, M0 creation lags broad money creation

That's the basic mechanics of the system. However, it is not quite that simple. Monetary policy may influence lending demand by means of reserve adjustments. If the central bank decides to reduce the total amount of reserves in the system, scarcity of reserves pushes up the interest rate at which banks will lend to each other: conversely, increasing the amount of reserves pushes down the lending rate. The increased cost of reserves is supposed to act as a brake on lending. Unfortunately, when banks are chasing market share instead of margin - as they were in the early to mid-2000s - increasing the cost of reserves is not a particularly effective brake on lending unless the increase is very large. Increasing market share can compensate for loss of margin to quite an extent (this is why low-margin retail lending is only really viable as a high-volume business). And in the end, no central bank is going to allow payments to fail because of scarcity of reserves. Indeed in Europe, reserve creation by the Eurosystem to facilitate payments is automated. 

QE can be regarded to an extent as large-scale open market operations. The central bank buys securities in return for newly-created cash. If the securities are bought directly from banks, then the banks simply replace riskier and less liquid assets with cash. If the securities are bought from institutional investors or individuals, the cash still ends up in banks in the form of deposits. Either way, though, the total amount of reserves in the system increases.   

The UK, US and Japan have all done extensive QE, and as a consequence the banking system is now awash with US dollar, sterling and yen reserves far in excess of the amount needed to settle payments. Increasing the amount of reserves in the system was supposed to encourage banks to lend. But the financial sector is badly damaged in all three countries: bank balance sheets are full of non-performing loans that tie up capital and are not easy to unwind. Additionally, there is regulatory pressure on banks to reduce their risks and shrink their balance sheets. Shrinking a bank balance sheet means selling or unwinding unwanted loan portfolios. If a lot of banks are doing this all at once, the effect must be a reduction in overall lending volume. Remember I said that money is created when banks lend? When loans are paid off - or written off - money is destroyed. So general deleveraging in the banking sector, as we have been seeing for the last five years in the US and UK and for the last fifteen years in Japan, means that broad money supply is likely to be stagnant or actually falling. Now, it may be that QE encourages some banks to maintain higher levels of lending than they would otherwise have done, because in theory it reduces their funding costs (though that may not actually be true in practice, as I shall discuss shortly). We simply don't know. But what is clear is that the size of the monetary base has nothing whatsoever to do with broad money supply. When banks are deleveraging, broad money may still fall even when the monetary base is increasing.

To be fair, the Bank of England and the Fed both noted that damaged banks were not likely to increase lending and QE should achieve its effects mainly in other ways. But what they both missed was the damaging effects of QE on the flow of money through the financial system and the consequences for monetary policy transmission.

QE increases the amount of reserves in the system and reduces the amount of other forms of safe security, particularly various forms of government debt. Since the financial crisis, borrowing and lending between banks and non-banks has become more-or-less completely collateralised, with the debt of highly-rated sovereigns being the preferred choice of collateral. There is also a scarcity of collateral due to collapse of US MBS issuance, increasing shortages of high-quality sovereign debt due to sovereign downgrades, and regulatory changes encouraging buildup of safe asset reserves and hoarding of collateral. One of QE's effects is to reduce even further availability of safe collateral and therefore increase its price. THIS IS DELIBERATE. The stated intention of QE is to depress government bond yields to make them less attractive to investors and therefore nudge those investors towards riskier assets. Unfortunately this also increases the cost of the collateral needed by banks and non-banks to obtain funding, including from central banks. It could be argued that whatever encouragement increased reserves give to banks to lend is offset by the increasing cost and scarcity of the collateral needed to obtain the funds to settle lending. It's a wash.

Which brings me to the problems with monetary policy. The first thing to note is that as the increased availability of funds is balanced by increased cost and scarcity of collateral needed to obtain funds, QE makes no difference to liquidity in the financial system. This point has been brilliantly (and repeatedly) made by Peter Stella and the IMF's Manmohan Singh, but it seems no-one is listening. The extra reserves provided by QE are in no sense expansionary. If anything, QE is contractionary, because it reduces the velocity of money in the financial system. When collateral is scarce, funding flows are impeded. There may be more actual funds available, but if they aren't moving, they aren't any use. 

The second point concerns the means by which central banks influence the behaviour of banks. Because the fundamental driver of lending is the risk versus return profile for both lenders and borrowers, lending is intrinsically cyclical. Central banks attempt to dampen the cyclicality of lending by means of macroprudential regulation and monetary policy. Of these, the second is arguably more important: macroprudential regulation historically has had limited success. But large-scale QE fundamentally changes the way monetary policy is transmitted. When the system is awash with excess reserves, central banks cannot use reserve scarcity to drive up the cost of funding. The "funds" rate (Fed Funds in the US, "bank" rate in the UK) becomes useless as a policy measure. When reserves are excessive, therefore, policy must be transmitted via the deposit rate. 

Most central banks pay interest on excess reserves placed with them by banks: normally that rate is some distance below the interbank lending rate, to encourage banks to lend excess reserves to each other instead of parking them at the central bank. But as funding rates crash to zero, the deposit rate suddenly becomes far more important. Positive interest on excess reserves is currently used by both the US and the UK to prevent repo rates turning negative and prop up the short end of the Treasury yield curve. But this means that parking funds at the central bank becomes an increasingly attractive proposition for damaged banks that don't want to lend. To "nudge" banks towards productive lending, policy makers are now thinking about cutting central bank deposit rates to zero or even below. The consequences of negative rates are not fully understood, but even the brief look that I had a while ago suggested that they might not be quite what policy makers anticipate. And the problem with relying on deposit rates as the primary means of monetary policy transmission is that they are not underpinned by coherent macroeconomic modelling and their effects are not well understood. Some might argue that this is true of funds rates too, but it's far worse with deposit rates because they have never been used in this way before. Policymakers are making it up as they go along. And the economics profession is not exactly helping. The extent of disagreement among economists about how monetary policy works under these exceptional circumstances is eye-watering. It is telling that many of the most useful contributions to the debate about how best to conduct monetary policy at present have come from the financial blogosphere, not from the economics profession.

In short, monetary policy transmission is weirdly distorted by the effects of excess reserves and it has become extremely difficult for central banks to influence bank behaviour. Because monetary policy is hampered and there is reluctance to use fiscal policy as a complementary toolset, some politicians have been looking to macroprudential regulation to nudge banks towards more productive lending. This is madness. It is not the job of prudential regulators to repair damaged economies by, for example, watering down bank capital requirements intended to reduce the likelihood of catastrophic bank failures. I would rather see acceptance that, as Pozsar and McCulley (among others) have suggested, when interest rates are very low and monetary policy transmission is impeded there is a need for complementary fiscal policies.

There is much that I haven't covered in this post, and even what I have described here is controversial because it rests on an unconventional view of how the monetary system works (although perhaps not that unconventional now, since it is consistent with recent papers by both the Fed and BIS). You may disagree with much of what I have written, and I welcome constructive comments. A huge topic that I have not yet discussed is the whole question of expectations management, not only in relation to QE and its effects but in the transmission of monetary policy. I shall return to this in another post. In the meantime, Woodford is well worth reading on this matter. 


Related links:

Inflation, deflation and QE - Coppola Comment
Does the Federal Reserve fully control the money supply? - John Aziz (The Week) (with very cool charts!)

The whole question of collateral shortage, monetary policy transmission and (potentially) negative rates has been extensively covered in the financial blogosphere. Here are some of the best posts.

   When safe assets return - FT Alphaville 
   The decline of safe assets - FT Alphaville
   Pledged collateral in an IS/LM framework (part 1) - Manmohan Singh at FT Alphaville
   Pledged collateral in an IS/LM framework (part 2) - Manmohan Singh at FT Alphaville
   A confederacy of dorks - Interfluidity  
   (and all the links in this post, plus Interfluidity's previous posts on the "floor" system. A fascinating and important debate)
   The roving cavaliers of credit - Steve Keen
   When governments become banks - Coppola Comment
   The strange world of negative interest rates - Coppola Comment
   Central bank reserve creation in the era of negative money multipliers - Stella & Singh (Vox)

The recommendation of this post, as others I have written, is for fiscal & monetary coordination as suggested in this paper:

Helicopter money - Pozsar & McCulley

Implicit in this post is the idea (as spelled out in the Vox link above) that the traditional "money multiplier" does not exist. This was recently confirmed in these papers from the Fed and BIS:

Money, reserves and the transmission of monetary policy - Federal Reserve
The bank lending channel revisited - Disyatat, BIS

This paper from the Hungarian Central Bank documents the lack of connection between size of central bank balance sheet (i.e. reserve expansion) and broad money growth:

The effect of the monetary base on money supply - Andras Komaromi, MNB

For a good description of how endogenous money creation works in a fiat money system, read Cullen Roche's paper:

Understanding the modern monetary system - Roche

This paper has a US focus and it is likely that things work slightly differently in other countries: for example, the European banking model relies much less on disintermediated "shadow" banking. Perhaps we need more papers describing how money creation works in the UK, Europe and Japan. 

On expectations, a subject that I haven't addressed at all yet but discussed extensively with David Beckworth - here's Woodford's paper on the importance of forward guidance:

Methods of policy accomodation at the interest-rate lower bound - Woodford


   
   











Comments

  1. I think the worst thing about QE till now is that it created an illusion in the minds of policy makers that something will happen whereas it hasn't really done anything for economic growth.

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  2. I agree that David Beckworth is clueless on this issue. He seems to be so keen to get his NGDP idea to work that he cannot bear contemplating the possibility that one element that underpins it (monetary policy or more specifically QE) might be defective.

    I pointed out to him some time ago that if QE doesn't work, that does not really destroy his NGDP idea, because the latter idea can work via fiscal policy. But doesn't seem to get that fiscal policy point.

    ReplyDelete
    Replies
    1. Hi Ralph,

      I've had conversations with him where he seemed to think NGDP can/could work via fiscal policy. Perhaps these were after you interacted with him.

      Delete
  3. You've captured very well the ill effects of QE now. The fiscal side has its ills too. So is the best method Keynesian which relies on fiscal policy while holding monetary policy prudent, Monetarism which relies on monetary policy while maintaining conservative fiscal policies or do we go with Austrianism where the market is allowed to find its harmony (note: not equilibrium)?

    ReplyDelete
    Replies
    1. Keynesian. But we have to be very careful. Debt levels are high. We should be looking for forms of fiscal stimulus that have high multipliers - such as infrastructure spending - or that can be done on a balanced-budget basis. In my view we should also be looking for tax cuts targeted at those with the highest marginal propensity to consume, and perhaps a limited debt jubilee. But it certainly can't be a spending free-for-all, and we should not forget that in the medium term we also need structural reforms.

      Delete
    2. In the past, the world has solved these problems many times through war. It's a bit unsettling.

      Also, we are running into the dilemma where nominal growth requires ever-expanding private/public debt, but real assets capable of backing debt are becoming less valuable to the world.

      Delete
  4. I have been developing a new model based on changes in labor share. The model is still in the early early stages, but it is showing that low labor share is affecting monetary policy. Labor share used to be stable, and has now dropped to a new "equilibrium". The conclusion is that the economy itself has shifted to a new equilibrium dynamic of liquidity closer to what ones sees in Latin American countries.
    I can only offer these raw insights as possible seeds for new insights into the problems of monetary policy.

    Here are 3 links about the model...
    http://effectivedemand.typepad.com/ed/2013/05/monetary-policy-of-effective-demand-the-basics.html
    http://effectivedemand.typepad.com/ed/2013/05/universal-model-for-monetary-policy.html
    http://effectivedemand.typepad.com/ed/2013/05/the-autopsy-of-the-fed-funds-rate.html

    ReplyDelete
  5. Ms Coppola

    You are businesswoman. You teach singing.

    Let's illustrate. All numbers are for illustration purpose as I have no clue about the prices of singing lessons.

    - Your sell price is $100/hr of teaching singing.
    - Since I don't know your costs, but let's assume for illustration purpose that ..abruptly....the government charges for electricity during singing lessons about 10 times more than normal price.
    - Hence Profit = Sell price - Costs.

    If Sell Price = or < Cost, then you wouldn't be teaching.

    Assuming that electricity would increase up to $80/hour from a normal of $8/hr then you'd pass on that cost to your students, hence new Sell Price would be $180/hr for a singing lesson.

    Out of 20 students, only 2 could afford this new price due to const increase, hence you would be obligated to fire the person who cleans up the piano and violinist whom you hire.

    My point is:
    There are 4 items for analysis:
    - Inflation of costs
    - Deflation of costs
    - Inflation of end product
    - Deflation of end product

    For any business:
    Profit = Sell price - costs.
    If profit is zero or negative, nothing will be produced and you would not be teaching.

    The formula above is what matters.

    Question:
    How does QE affect:

    - All 4 items above
    - Profit
    - Existence of productive businesses

    ReplyDelete
    Replies
    1. QE makes no direct difference to any of those items. As I explained in this and my previous post, QE increases the value of financial assets and increases the amount of bank reserves. Both financial assets and bank reserves are STOCKS, whereas your example is entirely FLOWS. In this post I noted that the velocity of money is also slowed because of collateral shortages: this clearly is a flow effect, which if anything is contractionary so would exert downwards pressure on prices.

      The question, therefore, is to what extent QE influences the price of input costs such as electricity, and the incomes of my customers. Of the two I can tell you now the second is far more important, since the service I sell relies on discretionary spending, which is always the first item to be cut (before long-term savings, debt service and essential purchases) when people's incomes are under pressure. QE fails to offset the effects of fiscal tightening on people's incomes, but because the Chancellor mistakenly believes that it does offset fiscal tightening, it may be that the fiscal consolidation is harsher than it would be without QE. Therefore it is possible that QE directly affects the ability of my customers to afford my lessons even without the absurd price rises you hypothesise. Beyond that, in the absence of counterfactuals it is impossible to tell to what extent the pressure on my customers' real incomes and the affordability of my lessons has anything to do with QE. It is not always possible to build up macroeconomic effects (in this case downwards pressure on prices due to QE-induced slowed velocity coupled with lack of bank lending) from microfoundations (in this case the specific cost base and customer profile of my particular business). And it would be extremely dangerous to generalise macroeconomic effects from one particular example.

      You give no reason for the ridiculous price rise in electricity, so I assume it is not due to QE. QE does nothing whatsoever to shield businesses from the effect of government-imposed price rises and/or increases in indirect taxes.

      I've answered your questions as best I can but I really don't see what relevance your example has to the subject of this post, to be honest.

      Delete
    2. I appreciate it you took the time to reply at length.
      I need to read the reply few times.

      Delete
    3. Ma'am
      I read the reply 3 times.

      - Yes, I assumed electricity was up due to QE
      - Yes, I am taking micro economic examples as generalization.
      - Yes, based on my work experience and other's work experiences, I see QE affecting cost inflation with little or no margin to pass on that cost onto the final consumers.

      Again, I appreciate it very much you took the time at 1.36 in the morning to reply at length.
      Thx a lot. You fully answered my questions, as usual.

      Again

      Delete
    4. Why do you assume that the sole cause of energy price rises is QE?

      Delete
    5. I am not assuming, I simply see it in my industry.

      I could not explain it how until Kaminska's 'artificial shortage' posts.

      Commodities are in artificial shortage due to excessively excessive excess of reserves.

      Since money by default looks for a collateral, a lot of it has gone for financing deals on commodities thus starving the economy of energy and commodities.

      Delete
    6. Sadly not supported by evidence. Oil & commodity prices are currently falling despite massive QE by both Japan and US.

      Delete
    7. Oil + Commodity prices are 3 - 5 times as high as in 2003, 10 yrs ago.

      Y/Y measurement makes no sense to me since super inflation of oil and commodities has ...plateaued due to ..unaffordability of end consumers.

      When I started to work in this industry, business was great. As soon as commodity prices jumped high, it got extremely competitive.
      It's extremely tough to finalize a sale. We're doing ok, but it's quite tough.

      I do both, design and sale. I have to design and sell the project. I speak with hundreds of people on the phone all over North America.

      Delete
    8. You cannot blame 10 years of inflation in oil and commodity prices on QE, which did not start until 2009 anywhere except Japan. And you are ignoring all the other causes of high oil and commodity prices. Geopolitics, for starters. The secular decline of the US dollar over that time - these things are priced in dollars, remember - and that is not necessarily to do with QE, either (it is much more likely to be due to low policy rates). And the fact that these are among the most rigged markets in the world.

      There are no counterfactuals. You simply do not know what long-term impact, if any, QE has had on world commodity prices. None of us do. It is far too simplistic to home in on a single cause for price changes.

      Delete
    9. QEs started right after the dot.com crash.
      The stock market recovered miraculously.

      I'll give you 100% crude oil price increase due to Geopolitical problems as it happened in the past, but not 500%.
      That's why I say $40-50/barrel crude oil is normal which is 100-150% higher than the traditional $15-20/barrel.

      In principle, central banks' job is QE.
      What we know as QE is the ..Large Scale Asset Purchase.

      During WW1 and WW2 the Gov ordered the Fed to do QE, as it is doing now. White House ordering the Fed to do QE.
      http://www.foxbusiness.com/markets/2010/11/09/fed-breaking-law/

      Delete
    10. Ektrit Kris Manushi2 June 2013 at 20:19

      I am not trying to convince you or change your mind.
      I am giving you my perspective.

      Delete
    11. Ektrit Kris Manushi2 June 2013 at 20:31

      I think my analysis is correct based on countless hours of reading and personal experience.

      Am I sure? Almost, but not yet fully.
      Can I prove anything I say? Not yet.

      It's a process. Everything is a process and we adjust as we go.

      Delete
    12. No, Kris. QE was not done by any central bank except the Bank of Japan in the early 2000s.

      QE was actually done by the Fed in the 1930s at the height of the Depression, not by central banks during the war years.

      I think you are confusing QE with monetizing debt and printing money to fund spending. They are not the same thing.

      Delete
    13. Ektrit Kris Manushi2 June 2013 at 21:20

      Well, ok.
      Let's at least agree that Haydn's The Creation I'm listening to right now is absolutely fantastic

      Delete
  6. Frances

    Excellent posting!

    I agree with you utterly. The size of monetary base has nothing to do with a broad money supply.

    But I was a little confused because of the expression of “cash” in: “QE can be regarded to an extent as large-scale open market operations. The central bank buys securities in return for newly-created cash”.

    Actually it is not cash, but electronic entry.

    If the Fed buys securities, it pays for those securities by crediting the bank accounts of the people who sold them to the Fed. Those accounts are reserves that the banks hold with the Fed. The Fed pays the securities by increasing the amount of reserves that banks hold in their accounts at the Fed. The amount of currency in circulation is not affected by these activities. A large quantity of these reserves is electronic entries at the Fed. They are not cash. They are not in circulation. Therefore they are part of the monetary base. But they are not part of any broad measure of the money supply. Thus the Fed is not printing money in order to pay the securities it acquires as Bernanke explains in his new book “The Federal Reserve and The Financial Crisis”.

    I think it’s just a rhetorical trifle from me.

    Best.

    ReplyDelete
    Replies
    1. Yes, good point. I was a trifle loose with words there. The increase in reserves arising from QE has nothing to do with cash in circulation. Thanks for pointing this out.

      Delete
  7. My take on what is going on now is that, for whatever reason (I have some ideas, but that isn't the main point here), the world has become a riskier place. People asking for loans were overconfident and assuming they would be able to pay, when they weren't. That's why so much debt has had to be written off, and there is still a lot of toxic debt around. I have no reason to believe that this problem has disappeared. The world is still riskier than most people reckon.

    If this is the real issue, then it looks like there really isn't anything that central banks can do to fix things (correct me if I'm wrong). In fact, trying to encourage lending when in fact loans are more likely to default than ever could make things worse. Everybody seems to assume that a return to normal rates of growth is possible in some way. What if that is exactly the problem? What if it isn't realistically possible to return to what used to be normal rates of growth?

    ReplyDelete
  8. "Only the central bank can change the total amount of reserves in the system".

    When the Treasury spends this increases the amount of reserves in the banking system.

    ReplyDelete
    Replies
    1. No it doesn't. Treasury spending makes no difference to the amount of reserves unless it is directly funded by central bank money creation. No Western government finances itself in this way at the moment. Reserve expansion from Treasury spending is 100% offset with funding by taxation or debt, both of which reduce the level of reserves. It's a wash.

      Delete
    2. "Flows of funds between the TGA and private depository institutions were important prior to the crisis because the TGA is maintained on the books of the Federal Reserve; increases in TGA balances stemming from Treasury net receipts drained reserves from the banking system and, in the absence of offsetting actions, put upward pressure on the federal funds rate. Conversely, decreases in TGA balances resulting from Treasury net expenditures added reserves to the banking system and, absent offsetting actions, put downward pressure on the funds rate".

      (FRBNY: Current Issues in Economics and Finance 2012)

      www.newyorkfed.org/research/current_issues/ci18-3.pdf

      "The Treasury's receipts and expenditures affect not only the balance the Treasury holds at the Federal Reserve, they also affect the balances in the accounts that depository institutions maintain at the Reserve Banks. When the Treasury makes a payment from its general account, funds flow from that account into the account of a depository institution either for that institution or for one of the institution's customers. As a result, all else equal, a decline in the balances held in the Treasury's general account results in an increase in the deposits of depository institutions. Conversely, funds that flow into the Treasury's account drain balances from the deposits of depository institutions".

      http://www.federalreserve.gov/monetarypolicy/bst_frliabilities.htm

      Delete
    3. Exactly as I described. Spending (flows of funds OUT OF Treasury account) increases reserves, taxation and debt issuance (flows of funds INTO Treasury account) both reduce them. Therefore as government's inflows from taxation and debt issuance balance its outflows over an accounting period, there is no net change in reserves.

      My version was shorter, that's all.

      Delete
    4. the point is a government deficit normally results in excess reserves within the banking system, which have to be drained through 'offsetting actions' if the Fed targets a particular positive funds rate, and doesn't pay interest on reserves at that target rate:

      "Treasury net expenditures added reserves to the banking system and, absent offsetting actions, put downward pressure on the funds rate""

      http://www.newyorkfed.org/research/current_issues/ci18-3.pdf

      These 'offsetting actions' to drain excess reserves include open market operations by the Fed, bond sales by the Treasury, and (prior to 2008) Treasury calls on TT&L accounts.

      "If, in the pre-crisis regime, the Treasury had deposited all of its receipts in the TGA as soon as they came in, and if it had held the funds in the TGA until they were disbursed, the supply of reserves available to the banking system—and hence the overnight federal funds rate—would have exhibited undesirable volatility. To dampen the volatility, the Fed would have had to conduct frequent and large-scale open market operations, draining reserves when TGA balances were declining and adding reserves when TGA balances were rising".

      http://www.newyorkfed.org/research/current_issues/ci18-3.pdf

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    5. James,

      All the Fed is doing is smoothing out reserve volatility arising from timing differences between Treasury funding and spending.

      When the Treasury funds ahead of spending, and deposits the difference in the TGA, reserves are drained. When the Treasury spends, reserves are increased. The two are balanced within an accounting period but don't necessarily happen at the same time. Therefore if the Fed took no action, reserve levels would vary with the TGA balance. The Fed does open market operations to balance the reserve changes arising from TGA movements, so that reserves are not subject to sudden swings due to Treasury debt issuance or spending. That does not mean that the Treasury running a deficit results in excess reserves overall. It does not, unless the deficit is financed directly by money creation. The net effect on reserves of debt-financed Treasury spending is zero.

      Delete
    6. Frances,

      say that pre-QE the government was running a balanced budget. As usual there would be no excess reserves in the banking system, and the Treasury would have its usual $5 billion balance in the TGA.

      If the government then went $1 billion into deficit, for example, the TGA balance would go down by $1 billion and the banks would end up with $1 billion in excess reserves. This would put downward pressure on the funds rate. To stop the rate from falling either the Fed or the Treasury would then have to sell bonds, draining the excess reserves.

      -------------

      Alternatively, the Treasury could plan to deficit spend $1 billion, and choose to sell bonds in advance. This would drain reserves, putting upward pressure on the funds rate. To stop the rate from rising the Fed would buy bonds, adding reserves to offset the effect of the Treasury's drain.

      Then, when the Treasury deficit spent $1 billion, the banks would end up with $1 billion in excess reserves, putting downward pressure on the funds rate. Again, either the Fed or the Treasury would then have to sell bonds to drain the excess reserves, to stop the funds rate from falling.

      Delete
    7. James, you are still conflating deficit spending with bond issuance. The two have equal and opposite effects on reserve balances. I explained the mechanism here: http://coppolacomment.blogspot.co.uk/2013/01/central-banks-safe-assets-and-that.html

      Debt-funded deficit spending is reserve neutral. The spending increases reserves, and the debt issuance drains them by an equal amount.

      Therefore the Treasury deficit spending does NOT mean the Fed has to sell bonds. The Treasury issuing sufficient debt to cover the deficit is enough in itself to neutralize the effect on reserves.

      Delete
    8. "James, you are still conflating deficit spending with bond issuance".

      No I'm not.

      "Therefore the Treasury deficit spending does NOT mean the Fed has to sell bonds"

      Yes it does, if treasury deficit spending results in excess reserves and the Fed targets a particular positive funds rate.

      "The Treasury issuing sufficient debt to cover the deficit is enough in itself to neutralize the effect on reserves".

      No it's not, see my examples above.

      Delete
    9. 1) Yes you are conflating them

      2) No it doesn't, if the Treasury is covering the deficit spending with its own debt issuance

      3) Yes it is. Your examples showed that Treasury-issued debt DID neutralize reserve effects. The differences were timing differences.

      Delete
    10. "Your examples showed that Treasury-issued debt DID neutralize reserve effects. The differences were timing differences"

      let's start with the simplest example.

      1. Treasury sells bonds.

      Payment for the bonds drains reserves from the banking system, putting upward pressure on the funds rate.

      As such, the Fed adds reserves to the banking system by buying bonds from banks or primary dealers, so as to maintain the funds rate at its target level.

      2. The Treasury now has an increased deposit in its account at the Fed. Banks have no excess reserves. The funds rate is at the Fed's target level.

      3. Treasury spends. This adds excess reserves to the banking system, putting downward pressure on the funds rate.

      As such, the Fed sells bonds to banks or primary dealers, draining the excess reserves so as to maintain the funds rate at its target level.

      Delete
    11. OMG....

      This is a wash. Reserve movements are neutral across the entire transaction. The differences are TIMING differences. It's the equivalent of running a daylight overdraft at the Bank of England funded with interest-free repo - which banks do all the time.

      I rest my case.

      Delete
    12. If the Fed doesn't sell bonds after step 3 to drain the excess reserves added by the deficit spending, the fed funds rate falls.

      So this statement is incorrect:

      "Therefore the Treasury deficit spending does NOT mean the Fed has to sell bonds".

      Here's a different example, following on from the one above:

      1. The Treasury is currently running a deficit. It raises taxes to balance the budget. Taxes drain reserves from the banking system, putting upward pressure on the funds rate. So the Fed buys bonds, adding reserves to maintain the funds rate.

      2. The Treasury now has an increased deposit in its account. Banks have no excess reserves, etc.

      3. Treasury deficit spends. This adds excess reserves to the banking system.

      Delete
  9. in a world of increasing operational scarcity, the competition engendered leads to the current situation where the winners consolidate and protect their winnings and the rest, the losers are left to go more and more in the direction of slavery and death. this comment relates also to earlier posts...consolidation in a time of increasing scarcity and survival...

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  10. Three economic factors causing the problems are
    1) The EMs - BRICS etc, producing vast quantities of quality consumer goods using low labor costs and efficient production methods. Developed nations cannot compete in the manufactured finished goods market and try to make up in luxury goods (Bentley, RR, iPhone etc). But they do not make good the losses - nowhere near. Huge loss of incomes, unemployment, low manufacturing outputs.

    2) Digital tech shrinks money supply does not increase it (usually) - newspaper and mags selling less, WH Smith in trouble, Pearson in trouble etc - you name it. A digital advance reduces costs but also assets. - automatic supermarket teller machines etc. Digital tech reduces the workforce and there is not a competitive edge because everyone can make the same advances - result asset reduction for same output. A large printing paper machine is an asset written off by a cheap computer system. Tech produces shrinkage of money supply and employment.

    3) NPLs - bad debts shrinking money supply is deflationary. Impaired loans - we all know the story here. Again a lot of money getting written off - deflationary.

    People will not take out loans unless they see a profit over time from such an action.

    As soon as profits become tangible (e.g. from a housing bubble or manufacturing possibilities) then those reserves will certainly be used to take out loans in a big way. But if there is no profit because of 1) 2) and 3) they will just stay as reserves - its no brainer.

    Ran out of time to complete this (sorry..) :(




    ReplyDelete
  11. Got plenty of knowledge regarding transmission shop from reading the post shared above. The company is trying their best to becoming expert in the art of providing such kind of transmission services in those customers who are needy for it. Now a days, several firms are establishing who can provide the same quality comfort to us.

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