Floors and ceilings

No, this isn't a post about derivatives. It's about the relationship between reserves and safe assets. I think it is  time I brought the two together and created a unified explanation of the behaviour of safe assets in the presence of excess reserves which earn a positive rate of interest. 

The "interest on excess reserves" (IOER) debate and the safe assets issue are two sides of the same coin. On one side we have the central bank and the system of regulated banks: on the other side we have non-banks and the Treasury. Together, all of these make up the financial system.  

This is how I see it working at present.

The central bank creates excess reserves through buying assets held by the private sector (QE), mostly (but not exclusively) consisting of various forms of government debt. The central bank pays interest on those excess reserves, thus creating an interest-bearing safe asset for banks (but not non-banks).

Banks won't lend when the Fed Funds rate is below the IOER rate, obviously, because they can earn more by depositing funds with the central bank. The Fed Funds rate therefore rises - which is the reason for paying interest on excess reserves, as Scott Fullwiler explains. But it can't break the IOER rate. It remains stuck between the IOER rate and the zero lower bound: 

(larger version here)

In the US, this means a "corridor" of 0 to 0.25%, with the zero lower bound as the floor and the IOER rate as the ceiling. Thus the debate on the US's supposed "floor" system entirely missed the point. What the US actually has is a corridor system with rate inversion. 

Rate inversion has some distinctly weird effects. When the Fed Funds rate is significantly below the IOER rate, banks that are short of reserves will bid it up to eliminate the difference with IOER. The two should be the same. But that ignores the effect of commercial transactions. In reality, the Fed Funds rate is usually slightly below the IOER rate, because banks can earn a few risk-free pennies by borrowing from money market funds at a rate somewhere below the IOER rate and depositing those funds at the central bank at the IOER rate. That's exactly what the European banks were doing until the ECB put a stop to it by cutting its deposit rate (IOER) to zero. This round-tripping enables banks to make some return while doing absolutely zero lending. Nice for damaged and risk-averse banks, not so good for the circulation of money in the economy.

Positive IOER also props up the short end of of the Treasury yield curve, because T-bills are a risk-free substitute for reserves. The round-trip I described above depends on banks buying T-bills to use as collateral for money market borrowing. But they won't do that if the yield is at or above the IOER rate. So T-bill yields are forced into the same narrow corridor as the Fed Funds rate, and in fact usually sit slightly below it. Here's the 3-month T-bill, for example:

(larger version here)

So short-term risk-free rates and the Fed Funds rate end up being forced into the same narrow corridor between the IOER rate and the zero lower bound. The result is gridlock. Funds do not flow freely through the financial system, but are diverted into commercial banks who sit on them: banks will lend, but only against very good collateral - which is scarce for a number of reasons including QE. The result is that non-banks experience a shortage of liquidity, while commercial banks earn money from NOT lending. And no-one except commercial banks can make money unless they take more risk, which they don't want to do (and are under regulatory pressure not to do).  

That's where we are now, I think. Now to add the Treasury side of the conundrum.

The shortage of safe assets has led to calls for government to issue more short-term debt to improve liquidity conditions in the shadow banking system. Now, suppose that the Treasury did auction additional short-term debt instruments to provide more safe assets primarily for non-banks. Settlement of that securities sale would drain central bank reserves by an (almost) equal amount, because the vast majority of payments are made via commercial banks. This reserve drain would be unsterilised, because the money would be transferred to the Treasury's deposit account at the central bank, which is not included in the monetary base. Therefore the effect of the Treasury creating safe assets for non-banks would be to reduce the amount of safe assets (reserves) created by the central bank for banks. The total amount of safe assets in the system would remain the same, but their nature would change. 

We are already used to thinking of QE as replacing debt with money. Treasury debt issuance does the opposite, i.e. it replaces money with debt. Or alternatively, we can think of QE as moving safe (non-cash) assets from non-banks to banks, and Treasury debt issuance as moving them back again. 

It is not sensible to ignore non-banks in the conduct of monetary policy, especially in a financial system as disintermediated as that in the US. Both money and government debt are needed by the financial system: the balance between the two is currently distorted and this is having untoward effects, especially on the shadow banking system whose lifeblood is the collateral that is becoming scarce. A large part of the problem is the assumption that money is solely the responsibility of the central bank, and debt is about government financing. As I've said before, for a sovereign currency-issuing government neither of these is true.  Monetary and fiscal policy are both ways of managing money: they affect the economy in different ways because of the different institutions through which they work. And short-term government debt and currency are both "money" as far as financial markets are concerned.

The central bank is the lender of last resort - or perhaps more accurately, as Perry Mehrling suggests, the DEALER of last resort - for banks. And because non-banks don't have central bank support but can use government debt as a risk-free asset, effectively the Treasury is the lender or dealer of last resort for non-banks. Banks and non-banks together make up the financial system. Therefore we can regard fiscal policy as monetary policy applied to non-banks, and monetary policy as fiscal policy applied to banks. Interest rates are monetary taxes: taxes are fiscal interest rates. They do the same job on opposite sides of the bank/non-bank divide, i.e. controlling the total amount of "money" (in its broadest sense) in circulation. And there is of course a considerable overlap, since in reality the divide between banks and non-banks is entirely artificial: interest rate policy affects non-banks and taxation affects banks. Central banks and governments therefore are partners in the management of the financial system as a whole. 

Monetary policy - in the sense of the economic policy operated by central banks - is indeed usually dominant in practice, because the central bank is the currency issuer and because nearly all non-banks conduct their business through banks (the only ones that don't are either very small or criminal). So interest rate policy, by affecting banks' costs, affects the cost of monetary transactions for non-banks. But fiscal policy is in its own way equally powerful: in fact it could be argued that one of the reasons for insisting on central banks' independence and the dominance of monetary policy is that fiscal policy is so powerful it can be dangerous if poorly designed and managed. Monetary policy also generally works faster than fiscal policy - as Mark Carney put it, it is more "nimble". But I think there are occasions when fiscal policy is not only faster but more effective than monetary policy because it can be better targeted. The use of fiscal tools to achieve monetary policy ends is a much neglected area. I shall return to this in a subsequent post. 

Since the 1980s there has been a somewhat antagonistic stance between government and central bank. As one economist puts it, "central banks and governments are constantly sparring in a policy chess game": inflation targeting by central banks effectively dampens any attempt by the fiscal authorities to either loosen or tighten policy, and there is a presupposition that politicians can't be trusted to manage economic policy. This in my view is outdated, if indeed it was ever true. After all, a central bank is only as independent as politicians allow it to be.

Our present arrangements - monetary dominance, under-use of fiscal tools, fiscal and monetary policy cancelling each other out - cause the needs of non-banks to be neglected and encourage preferential treatment of banks. It is essential that monetary policy encompasses the whole financial system, not half of it. Whether we like it or not, things that are not banks but do bank-like things are here to stay: they have existed in various forms for hundreds of years, and although the current direction of regulation appears hostile to some of them, they perform useful functions. It's worth remembering that non-banks are not just hedge funds and SPVs - they include, among other things, insurance companies, wealth funds and thrifts (building societies). The role of the Treasury in supporting non-banks should be recognised, and fiscal tools should become an essential part of monetary policy. Therefore the antagonistic stance of central banks and governments that arose from the fiscal and monetary mismanagement of the 1970s must end. Cooperation, not competition, should be the order of the day. 


  1. I find your points about MMFs strange. Banks in aggregate do not borrow money from MMFs. MMFs, like everybody else in this world, keep their accounts in banks. Banks in aggregate simply exploit their access to something that non-banks do not have access to. It is not only about MMFs, it existed long before QE and it is access to interbank market. In exactly the same sense banks sell short-term deposits to corporates. So there is no difference between MMFs and corporates which all do basic cash management which is one of the most basic corporate services of banking.

    Moreover, MMFs and corporate deposits are just about the liability side of the banking system. It has nothing to do with assets and lending.

    Additionally, blaming banks for "suffering" from competition and therefore making just a couples of bps, instead of the full spread, is a strange approach :) It is very good and healthy that they make just a couple of points. We, retails, too often do not get any of this.

    There is additional point that excess reserves are generally vertical money while MMFs etc are horizontal money. Yes, the borders are blurred but we need to keep it in mind whenever we bring Treasury in.

    1. You aren't correct that MMFs "keep their money in banks". They don't - they repo it out against collateral, because that is safer for them. Remember that they have very large cash balances that far exceed bank deposit insurance limits. For them, therefore, exchanging cash for T-bills provides them with the deposit insurance that they can't get from bank accounts. The money they repo out would of course go THROUGH banks for settlement, but that's not the same as saying that MMFs "keep funds in banks". However, what is happening is that banks are borrowing the money from them in exchange for T-Bills then depositing that money at the central bank for a few basis points spread.

      Government debt can also be regarded as a form of "vertical money", or "outside money". That's how markets regard it. T-bills and reserves are substitutes.

    2. I said they keep their *accounts* in banks. Banks technically do not borrow whatever whoever has in those accounts. However competition pushes rates on accounts of big guys like MMFs very close to interbank rates because big guys can easily move money around as they please.

      "banks are borrowing the money from them in exchange for T-Bills then depositing that money at the central bank for a few basis points spread"

      Do MMFs have accounts at the central bank? I never cared about this detail.

    3. I was talking about money, not bank accounts. You are conflating the two, but they are not the same. The point is that MMFs hold large amounts of "money" in the form of T-bills and other short-dated safe securities, not bank accounts.

      MMFs are not banks, so would not have central bank accounts. Transaction settlement has to be intermediated through a bank, as I said.

    4. Ok, lets be very precise and split "money" into deposits and reserves. Since we seem to agree that MMFs generally cannot have accounts at the central bank:
      1. Banks cannot borrow reserves from MMFs since the latter do not have accounts with the central bank and therefore cannot lend reserves.
      2. MMFs have bank deposits which is just one asset type.
      3. Competition pushes rates on MMFs deposits close to interbank rates. Whether it happes via repo or direct deposits is beside the point.
      4. MMFs can also do repo with their own banks, buy their own bank bonds or buy any bonds from the clients of the same bank. Such transactions do not lead to any external settlement but are still perfectly correct and happen all the time all over the place.

    5. You're not getting it.

      1) I did not say banks borrowed reserves from MMFs.

      2) MMFs do large amounts of cash lending in the form of repo. Settlement of these transactions is of course intermediated through banks. But the counterparties include investment banks doing repo as part of their trading activity.

      3) The repo rate will indeed be close to interbank rates - which are in the 0-0.25% corridor. Deposit accounts are of course a substitute, for smaller amounts, so I would expect those rates to be in the same corridor too. I did say that ALL risk-free rates were in that corridor. That would include repo and deposit rates.

      4) MMFs are only doing what they have always done, and they are not the focus of this post. It is the behaviour of BANKS that is different. In a risk-averse environment, positive IOER acting as a rate ceiling effectively means they are paid not to lend.

      The European banks' round-tripping with euro MMF funds is graphically described in this post by Sober Look:


      The lifting of the FDIC limit after the financial crisis enabled MMFs and others to find safety for large deposits in banks rather than bills, but the limit has now been reimposed, so they would now be moving funds back into paper.

    6. Looks like we are talking past each other. If you want to bring MMFs into the picture in order for banks to deposit funds and earn IOR they have to borrow reserves from MMFs which they obviously cannot do. So banks earn IOR in full amount regardless of MMFs and MMFs earn close to running interbank rate regardless of excess reserves. The two processes are independent.

      But ignoring all this MMFs story, banks earn their full IOR regardless of their lending or not lending activities which makes your "paid not to lend" look very strange. Lending or not lending does not change neither the volume of reserves nor the interest rate paid on them, nor the total income of banks from this asset position. I am not even bringing up the topic of loans creating deposits.

    7. Well, yes you are right that in aggregate banks will earn the same IOER regardless of their borrowing from MMFs or any other source other than the central bank, and regardless of lending. The existence of positive interest on excess reserves means that banks can make a small return without lending anything to anyone. That's the point I was making, really.

      However, we have to be careful about fallacy of composition here. Banks in aggregate earn the same IOER regardless of their borrowing and lending, but individual banks do not. Banks will compete for deposits in order to gain a larger share of the available pool of reserves. The deposit insurance limit stops them gaining large wholesale deposits by means of deposit accounts, but they can get them through repo transactions.

      I've obviously muddied the waters a bit by talking about the MMF round trip. I only included that because it is a (partial) explanation for the Fed Funds rate being lower than the IOER when they should really be the same. There may be other explanations.

  2. Brilliant post, just a small technicality: is it not 100% rather than merely a "vast majority" of bond sales that are paid for via commercial banks? I can't imagine anyone is actually going to the Treasury building with bags of pound coins (or notes) to buy gilts.

    1. No, it isn't quite 100%. There are a small number of individuals who pay the Treasury directly by cheque, and those payments go straight into the Treasury's account at the central bank without being intermediated through a commercial bank.

    2. If I make you a cheque for £12, you send it to your bank. Your bank looks at it, notes down what is written on it, and then sends it back to my bank. At the end of the day my bank will instruct the BoE to debit their account at the BoE of £12 and credit the account at the BoE of your bank of the same amount.

      So for gilt sales, the cheque will cause the BoE account of the buyer's bank to be debited by that amount which is in turn credited to the Treasury's account at the BoE. Monetary base shrinks by the exact same amount as if they paid electronically. A cheque is really just a slow way to do an electronic transfer.

      So I think we're still at 100% unless George Osborne is buying gilts with the office's chequebook.

  3. MMMFs are the CB's customers. No asset has the “monetary store of purchasing power” quality unless there can be a net conversion of that asset into money. It must be possible to effect this conversion without necessitating that any present money holder reduce/liquidate his holdings (e.g., MMMFs don’t meet this criterion when their (N.A.V.) breaks a $1) & they do not have FDIC insurance coverage.

    With rehypothecation, collateral can be pledged (used) & re-pledged (reused). Fractional reserve banking (the creation of new money & credit) is a function of the velocity of the banking system's deposits (not their volume) within a common depository. Likewise, shadow banks can create a multiple volume of credit based on the velocity of collateral.

    I.e., deposit taking (legal tender) & fungible collateral (lawful money) are somewhat equivocal as they approximate a medium of exchange, a unit of account, & a standard of value, (though not a store of value).

    In the Federal Reserve sysetem, CB deposit expansion is dependent upon a “money multiplier” (now over 100x required reserves/the base). Likewise, collateral expansion is delimited by its “churn” factor. So collateral expansion (shadow banking) is more circumscribed. The expansion coefficient of the Shadow Banking system depends upon the liquidity or convertibility of acceptable collateral (safe assets).

    Zerohedge recommends:

    (1) “The (sizable) Role of Rehypothecation in the Shadow Banking System” by Manmohan Singh and James Aitken

    (2) “Haircuts” by Gary Gorton and Andrew Metrick

  4. CBs (from the standpoint of the system) pay for what they already own. Reserves are not a tax. On the basis of these newly acquired reserves, the CBs create a multiple volume of credit & money. And, through this money, they acquire a concomitant volume of additional earnings assets. The tax was the elimination of Reg Q ceilings.

    CBs are credit creators. The non-banks (NBs) are credit transmitters. The CBs compete with the NBs for their share of the loan-pie, but not for their funding. Lending by the CBs is dependent upon monetary policy, not the savings practices of the public.

    The CBs can force a contraction in the size of the NBs & create liquidity problems in the process, by outbidding the NBs for the public’s savings.

    This process is called “disintermediation” (an economist’s word for going broke). The reverse of this operation cannot exist. Transferring saved deposits through the NBs cannot reduce the size of the CB system. Deposits are simply transferred from the saver to the NB to the borrower, etc.

    The IOeR policy induces dis-intermediation within the NBs (where the size of the NBs shrink, but the size of the CB system remains the same).

    The NBs were the most important lending sector in the U.S. economy - or pre-Great Recession, 82% of the lending market (Z.1 release, sectors, e.g., MMMFs, GSEs, etc.).

    Every effort should encourage the flow of savings thru the NBs (the customers of the CBs). I.e., the Fed should get the CBs out of the savings business (making the CBs more profitable). The IOeR policy does the opposite. It stops & reverses the flow of savings into real-investment.

    1. I utterly disagree that banks don't need commercial deposits. Loans create deposits, yes, but deposits fund loans. And loan deposits exist to be SPENT, not held. At the individual bank level, the creation of a loan is followed by its withdrawal, leaving a funding gap. Across the banking system AS A WHOLE the movement of loan deposits is a wash, of course, but that is not true at the individual bank level: individual banks must obtain funds to cover the funding gap left by any sort of deposit withdrawal including loan deposits. Without deposits placed with banks for savings purposes, bank funding is far more unstable because it forces them to become dependent on external sources of funding, principally the interbank market, and on bond issuance, which takes time. Excessive reliance on interbank funding was a major cause of the bank failures in 2007-8 both in the US and the UK.

      I recommend you read this excellent description of how modern banking works from JKH at Monetary Realism:


    2. "I utterly disagree that banks don't need commercial deposits"

      The concept is abstract to be sure, nevertheless easy to prove. The fact is commercial bank deposits can never leave the system in the first place. And money (savings) flowing through the non-banks never leaves the system either (as anyone who has applied double-entry bookkeeping on a national scale should know), & why should the CBs pay for something they already own?

      The source of all savings/time deposits to the CB system is other transaction deposits, directly or indirectly (& only temporarily), via the currency route, or thru the CBs undivided profits accounts.

      "forces them to become dependent on external sources of funding"

      Its no theory. And that's not what was projected to happen, nor what happened during the credit crisis of 1966 in the U.S. In 1961 money center NYC banks began issuing large denomination negotiable CD’s. Its use enabled these large banks to draw funds out of banks all over the country & indeed the world. By late 1965 market interest rates had risen to levels that no longer made 4 ½ per cent CD’s attractive. Consequently as they matured they could not be replaced, the issuing banks had large outflows of funds & faced a liquidity crisis.

      The effect of the 5 ½ per cent ceiling was to dry up the non-banks, especially the savings & loan associations, which paralized the housing industry.

      The solution was to reverse the flow of funds (divert savings from being impounded within the CBs), to encourage their flow through the NBs. Reg Q ceilings were twice lowered for the CBs thus forcing savings to flow through the S&Ls, & MSBs (preferential ceilings were first unnecessarily imposed for the NBs during the crisis).

      Increasing the volume of savings being transferred through the NBs increased the number of mortgages these institutions made, but did not impact the composition of loans & investments the CBs were making. I.e., disintermediation can only occur within the NBs, but not the CBs.

      True, Bank of America may end up losing deposits to JP Morgan Chase (& they may have to sell some of their liquid earning assets in the process), but these are simply replaced by the other bank.

      Same applies to the contractionary IOeR policy.

    3. You are confusing the individual with the aggregate - which is the fallacy of composition that I mentioned before. As I explained in my earlier comment, across the banking system as a whole the movement of funds is a wash. But to individual banks, funding is a real issue. I have done loan and funding accounting for banks, and various forms of ALM reporting. Believe me, funding is a BIG issue for banks, and a prudent bank will not want to be dependent on wholesale or interbank funding, particularly for longer-term forms of lending. The larger the structural mismatch between the asset & liability maturity profiles, the greater the risk of liquidity problems. Time deposits are safer forms of funding than demand deposits, because they can't suddenly be withdrawn.

      I'm well aware of the problems that the regulation Q limits caused for non-banks. But removing retail deposits from banks is not a good idea. It forces them to seek funding from the wholesale markets - which as I said in my previous comment, is more unstable. Or it forces them to issue negotiable instruments to obtain funding - like your CDs. Loan accounting by itself DOES NOT enable individual banks to fund themselves. That is a complete fallacy. Nor is it true that because reserves never leave the banking system, therefore banks don't need deposits. They do.

      The difference between banks and non-banks is nothing to do with the accounting for loans and everything to do with their sources of funding. A bank can tap the wholesale and interbank markets for funding, and as a last resort the central bank. Thrifts (building societies, in the UK) may not be able to use the wholesale markets, certainly can't use the interbank markets (although they can obtain funding from commercial banks) and can't access central bank funding. That's why disintermediation is a problem for them. But they are far from being the only non-banks, and in fact most non-banks use the wholesale markets for funding.

      JKH's article is the best description I have ever seen of how bank lending and funding works. I really suggest you read it.

    4. "confusing the individual with the aggregate"

      Nope. EVERYONE else is confused. I have a perfect raw IQ score. Just think how smart the guy who formulated it is.

      1966 is the paradigm. You are not familiar with it.

    5. Consider that I "cracked the code" in July 1979. Monetary lags are not long & variable. Lags have been mathematical constants for the last 100 years.

    6. Read JKH's article. He lacks an adequate knowledge of money & central banking.

    7. "provide the required reserve levels as a matter of automatic operational response – after the loan and deposit expansion that generates the requirement has occurred"

      Policy only accommodates lending (c. 1965). That's when the operations at the FRBNY's "trading desk" began to be dictated by the federal funds "bracket racket" (using interest rates as the monetary transmission mechanism). Prior to that William McChesney Martin, Jr. used free reserves (for 13 years), as a guide to monetary operations. Prior to that the FED pegged governments, etc.

    8. Legal (fractional) reserves ceased to be binding c. 1995: because increasing levels of vault cash/larger ATM networks (in 1959 liquidity reserves began to count), retail deposit sweep programs (beginning 1994), fewer applicable deposit classifications (including the "low-reserve tranche" & "exemption amounts") & lower reserve ratios (since 1980), & reserve simplification procedures have combined to remove reserve, & reserve ratio, restrictions.

    9. JKH has learned his catechisms. You should try mine:

      The first column is the roc in the proxy for real-output (exactly 10 months for the last 100 years). So stocks are still a buy.

      The second column is the roc in the proxy for inflation (exactly 24 months for the last 100 years). So gold is a sell.

      The surrogate for MVt is required reserves on the BOG's H.3 release, ignore all seasonally mal-adjusted figures. This concept represents a trillion dollars of proprietary "intellectual property".

      The roc in the proxy for inflation peaks this month.

      2012-09 ,,,,,,, 0.033 ,,,,,,, 0.158
      2012-10 ,,,,,,, 0.018 ,,,,,,, 0.150
      2012-11 ,,,,,,, 0.025 ,,,,,,, 0.138
      2012-12 ,,,,,,, 0.038 ,,,,,,, 0.125
      2013-01 ,,,,,,, 0.043 ,,,,,,, 0.148
      2013-02 ,,,,,,, 0.043 ,,,,,,, 0.155 spike
      2013-03 ,,,,,,, 0.053 ,,,,,,, 0.138
      2013-04 ,,,,,,, 0.043 ,,,,,,, 0.133
      2013-05 ,,,,,,, 0.033 ,,,,,,, 0.135
      2013-06 ,,,,,,, 0.025 ,,,,,,, 0.128
      2013-07 ,,,,,,, 0.025 ,,,,,,, 0.108
      2013-08 ,,,,,,, 0.018 ,,,,,,, 0.070

      The roc in the proxy for real-output is still climbing. Stocks should resume their upward path after the seasonal pressure ends in the next 2 weeks.

      See how the effective FFR has been ticking up? (.13%->.15%)

      This indicates there is some pressure in the interbank market for additional required reserve balances. You wouldn't think that would be a problem with so many excess reserves in the system. Obviously not so when the Fed drains (mops up) reserves after the holidays.


      " * Indicates the last day of a maintenance period"

      02/20* 0.15 0.04 5/16 0.04 0.00 - 0.25

      02/19 0.15 0.05 5/16 0.04 0.00 - 0.25

      02/18 Holiday - No data.

      02/15 0.16 0.05 5/16 0.04 0.00 - 0.25

      02/14 0.14 0.05 5/16 0.04 0.00 - 0.25

      02/13 0.14 0.05 5/16 0.04 0.00 - 0.25

      02/12 0.13 0.05 5/16 0.04 0.00 - 0.25

      02/11 0.14 0.09 5/16 0.04 0.00 - 0.25

      02/08 0.14 0.05 5/16 0.04 0.00 - 0.25

      02/07 0.13 0.10 5/16 0.04 0.00 - 0.25

    10. See: "Primary Dealer Cash Shortage?" by ZeroHedge

      "Bankrupt you Bernanke" is incompetent. And everyone's got the wrong idea.

      Seasonal adjustments have their roots in the fallacious "real bills" doctrine:

      "In the original federal reserve act of 1913 "It was anticipated that credit extended by the Federal Reserve Banks to commercial banks would rise & fall with seasonal & longer term variations in business activity"

      And: "From the beginning, the Federal Reserve was reasonably successful in accommodating the seasonal swings in the demand for currency—in the terminology of the act, providing for “an elastic currency”."

      The FOMC is tasked to provide yearly seasonal adjustments as business activity waxes (the FRBNY's "trading desk" injects reserves) & wanes (mops them up). And the problem is the FOMC doesn't recognize that the theory & mechanics are the same for seasonal mal-adjustments & the "real Bills" arguments.

      The Fed screwed up during the holidays. They always do. This year is worse than others. This delays any concerted effort to manage "expectations". When will the Fed be "back-on-track"? - probably, once again, thru sheer luck (or when both inflation & the economy simply "stall-out").

      Monetary policy objectives should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real-gDp. Contrary to economic theory, & Nobel laureate, Dr. Milton Friedman, monetary lags are not “long & variable”. The lags for monetary flows (MVt), i.e. the proxies for (1) real-growth, & for (2) inflation indices (for the last 100 years), have been mathematical constants.

      However, the FED's target (interest rates), is INDIRECT, varies WIDELY OVER TIME, & in MAGNITUDE. What the net expansion of money will be, as a consequence of a given injection of additional reserves, nobody knows until long after the fact (& since Oct 2008, the Fed's new IOeR policy has emasculated this "open market power"). The consequence is a delayed, remote, & approximate control over the lending & money-creating capacity of the banking system.

      The money supply (& commercial bank credit), can never be managed by any attempt to control the cost of credit (i.e., thru pegging the interest rate on governments; or thru "floors", "ceilings", "corridors", "brackets", etc). In other words, Keynes’s liquidity preference curve is a false doctrine.

      Irving Fisher's "equation of exchange" is a truism: roc's in MVt = roc's in n-gDp. Roc's in bank debits (our means of payment money times its rate of turnover-MVt) can serve as a proxy for all transactions (aggregate monetary purchasing power). I.e., without the IOeR policy, member bank legal reserves should grow at no greater rate than would allow rate of increase in monetary flows to equal the rate of increase in real output.

      There is evidence to prove that [roc] in nominal-gDp can serve as a proxy figure for [roc] in all transactions (the R2 was always > .95 up until the Fed discontinued the G.6 debit & deposit turnover release in 1996). Rates-of-change in real-gDp have to be used as a policy standard. This needs no disclaimer. This is, & always has been, the "Holy Grail".

    11. That's just a lot of MMT propaganda. You buy into that tripe? It would be better to be confused at a higher level.

    12. I'm not going to discuss this any more. This discourse is wrong in so many ways I don't know where to start. I think you are seeing so many trees you've forgotten you're in a wood.

      You've quoted ZeroHedge as a source several times, and you've trashed an article by someone who has extensive knowledge of banking and finance. ZeroHedge is hardly a reliable source of information. What is your reason for relying on it? And what is your own background and experience?

    13. Your MMT comment arrived after my last one. Let me explain my position.

      I do not "buy into" MMT "propaganda". My thinking is my own and is based upon both training and extensive experience of banking and finance.

      MMT's description of how the financial system works in a fiat money system is correct. I don't subscribe to their political agenda. But they present a considered heterodox economic argument that deserves much more respect than you give it by describing it as "tripe".

    14. "provide the required reserve levels as a matter of automatic operational response"

      JKH is a dumbshit. Where was the automatic accommodation in Feb 2007 when the Fed drained reserves by 7b & stocks fell 3.3%. You nor him don't know enough about M&B to blog.

    15. "And what is your own background and experience?"

      I'm the world's best Treasury Futures bond trader. So I don't listen to crap.

    16. One of your comments went into my spam folder for some reason. I have reinstated it.

      The effective Fed Funds rate won't break 0.25%, as I explained in the post. There may be some pressure for reserves but it really isn't significant at those rates.

      JKH is not talking about monetary "accommodation" or "tightening" or "draining reserves". Those are macroeconomic tools. He is, like me, talking about the central bank's responsibility to ensure 1) that the banking system as a whole has sufficient reserves to enable all payments to be settled 2) that individual banks are provided with reserves if necessary to meet requirements (or where there is no reserve requirement, as in Canada, to ensure that the bank can meet its settlement obligations). This is all to do with flows of funds, not macroeconomics. The central bank does drain excess reserves when tightening monetary policy, and that action may be inappropriate: I think many people would agree that the Fed's decision to tighten monetary policy in 2007 was very wrong. But that has nothing to do with the provision of reserves to meet settlement requirements.

      I would correct JKH on one thing, though. The only central bank that provides reserves automatically is the ECB (or more correctly the Eurosystem) through the Target2 system. Other central banks will lend to banks against collateral to meet reserve shortfalls: for example the UK uses intraday repo at zero interest. It's not exactly automatic, but no central bank would ever refuse to provide liquidity for payments settlement. They may sterilise that through open market operations or interest rate rises, though.

      I'm sure you're a great trader, but you don't know much about banking.

      I do not tolerate rudeness on my blog. If you can't be polite to me and others, please don't comment.

    17. Hamilton's about microeconomics? I don't have a sense of etiqutte concerning these issues & there is a reason. I understand the extent of U.S. policy maker's errors. Hamilton doesn't have a clue.

      Economists are mental midgets. Usain Bolt's fast not only because he works out, but because of his genetics. Genius isn't 99% sweat without the innate ability to think.

      I critique our policy makers the same way I unabashedly do athletes. Needless to say I frequently get censored or banned.

      I got kicked out of grade school just prior to the first escalation of the Viet Nam in 1965 for dying my hair green (my German principal told me to cut it when my hair wasn't even over my eyebrows or my ears).

    18. JKH: "deposits fund loans"

      Deposits don't fund loans. Clearing balances fund loans. From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, & probably its costless legal reserves & thereby it’s lending capacity. But all such inflows involve a (1) decrease in the lending capacity of other commercial banks (outflow of cash & due from bank items) or (2) is a consequence of an expansion of Reserve Bank credit. Hence, all CB liabilities are derivative.

      Commercial bank credit creation is a "system" process. No bank, or minority group of banks (from an asset standpoint), can expand credit (& the money stock), significantly faster than the majority group are expanding. E.g., if the money center commercial banks hold 80 percent of total bank assets, an expansion of credit by the country banks, & no expansion by large NYC banks, will result, on the average, of a loss in clearing balances equal to, 80 percent of the amount being checked out of the country banks. & the FED, through controlling the reserves of the NYC banks, can control the expansion of total bank credit (money center, & country banks)

    19. AND:

      "central bank's responsibility to ensure 1) that the banking system as a whole has sufficient reserves to enable all payments to be settled"

      The Fed's payment & settlement responsibility/functions, nor the money stock, can never be managed by any attempt to control the cost of credit. Keyenes's liquidity preference curve is a false doctrine. The Fed's transmission mechanism has been, & will continue to be - unworkable.

      Bernanke has crashed the markets multiple times: on Feb 27, 2007:

      Not “seasonally mal-adjusted” required reserves:

      1/17/2007 ,,,,,,, 38275
      1/31/2007 ,,,,,,, 47566
      2/14/2007 ,,,,,,, 39070
      2/28/2007 ,,,,,,, 43272
      3/14/2007 ,,,,,,, 38149

      These are of course the “true ups”. But if you look at the original figures you will find that Bernanke drained $7b of reserves in one reserve maintenace period. That’s fundamental.

      Some people think Feb 27, 2007 started across the ocean. “On Feb. 28, Bernanke told the House Budget Committee he could see no single factor that caused the market’s pullback a day earlier”. In fact, it was home grown.
      Again on May 6th (the flash crash):

      Written on Mar 30 11:31 am prior to the MAY 6th FLASH CRASH:

      "Contrary to economic theory, & Nobel laureate Dr. Milton Friedman, monetary lags are not "long & variable". The lags for monetary flows (MVt), i.e., the proxies for (1) real-growth, and for (2) inflation indices, are historically, always, fixed in length. Assuming no quick countervailing stimulus:

      jan..... 0.54.... 0.25 top
      feb..... 0.50.... 0.10
      mar.... 0.54.... 0.08
      apr..... 0.46.... 0.09 top
      may.... 0.41.... 0.01 stocks fall

      Been saying this for the last 6 months. Should see shortly. Stock market makes a double top in Jan & Apr. Then the real-output of final goods & services falls/inverts from (9) to (1) from Apr to May.

      Recent history indicates that this will be a marked, short, one month drop, in rate-of-change for real-output (-8)

      flow5 Message #10 - 05/03/10 07:30 PM
      The markets usually turn (pivot) on May 5th (+ or - 1 day).

    20. JKH doesn't know what he's talking about:

      Black Monday Oct 19 1987.

      On Sept. 4 the Fed raised (1) the discount rate 1/2 percent to 6, & (2) the federal funds rate 1/2 percent to 7.25 (up from 5.875 percent in Jan). On Sept. 30 fed funds spiked at 8.38; fell to 7.30 by Oct. 7; then rose to a peak of 7.61 Oct 19 (Black Monday).

      At the same time, (Sept. & Oct 87), the decline in the proxy for real-gdp (its rate of change) plummeted (the sharpest decline in the statistical release). Then the quantity of legal reserves bottomed in the bi-weekly period ending 10/21/87. This was the trigger.

      At the time, the 30 year conventional mortgage yielded 11.26 percent, up from 8.49 percent in Jan. 87, & moody's 30 year AAA corporate bonds yielded 11.06 percent on 10/19/87, up from 9.37 in Jan. 87.

      The preceding tight monetary policy & the sharp reduction in legal reserves, had forced all interest rates up in the short run (when inflation & real-gdp were subsiding).

      And the banks scrambled for reserves at the end of their maintenance period (& bank squaring day), to support their loans-deposits (contemporaneous reserve requirements were in effect exacerbating the shortfall & response time). Apparently a significant number of banks, or large banks with large reserve deficiencies, tried to settle their obligations at the last moment. And the NY “trading desk” failed to accommodate the liquidity needs in the money market.

      Black Monday's trigger was obscured because the decline in monetary flows (MVt) which overlapped Qtr3’s & Qtr4’s GDP (quarterly reports are used by the Bureau of Economic Analysis to measure gross domestic product – not monthly).

      The Fed quickly reversed their policy when the markets panicked, i.e., they brought the volume legal reserves back into alignment.

      The United States has the largest national economy in the world, with a GDP for 2006 of 13.21 trillion dollars. Fed 27, 2007 didn't start in China, it started here. That's why the Shanghai market dropped 6.5% May 30 2007 without affecting other world markets.

    21. Contrary to JKH, the Fed doesn't know how to manage a clearing & payment system:

      At the height of the Doc.com stock market bubble, Greenspan initiated a "tight" monetary policy (for 31 out of 34 months). A “tight” money policy is defined as one where the rate-of-change in monetary flows (our means-of-payment money times its transactions rate of turnover) is no greater than 2-3% above the rate-of-change in the real output of goods & services. Note roc's in legal reserves are used as a proxy figure for roc's in MVt.

      Greenspan then wildly reversed his “tight” money policy (at that point Greenspan was well behind the employment curve), & reverted to a very "easy" monetary policy -- for 41 consecutive months (i.e., despite 17 raises in the FFR, -every single rate increase was “behind the inflationary curve”). I.e., roc's in required reserves (MVt) were never corrected.

      I.e., Greenspan NEVER tightened monetary policy.
      Then, as soon as Bernanke was appointed to the Chairman of the Federal Reserve, he initiated a "tight" money policy (ending the housing bubble in Feb 2006), for 29 consecutive months, or at first, sufficient to wring inflation out of the economy, but persisting until the economy plunged into a depression). I.e., the roc in the proxy for inflation (using required reserves as a proxy) was a negative figure for 29 consecutive months.

      The FOMC continued to drain liquidity despite its 7 reductions in the FFR (which began on 9/18/07). I.e., despite Bear Sterns two hedge funds that collapsed on July 16, 2007, & immediately thereafter filed for bankruptcy protection on July 31, 2007 -- as they had lost nearly all of their value), the FED maintained its “tight” money policy (i.e., credit easing, not quantitative easing).

      I.e., Bernanke didn’t initiate an “easy” money policy until Lehman Brothers later filed for bankruptcy protection (& it was one the Federal Reserve Bank of New York’s primary dealers in the Treasury Market), on September 15, 2008.
      And Greenspan didn't start "easing" on January 3, 2000, when the FFR was first lowered by 1/2, to 6%. Greenspan didn't change from a "tight" monetary policy, to an "easier" monetary policy, until after 11 reductions in the FFR, ending just before the reduction on November 6, 2002 @ 1 & 1/4% (approximately coinciding with the bottom in equity prices).

      I.e., Greenspan was responsible for both high employment (June 2003, @ 6.3%), & high inflation (rampant real-estate speculation, followed by widespread commodity speculation).
      Bernanke then relentlessly drove the economy into the ground, creating a protracted un-employment, & under-employment rate, nightmare.

    22. POSTED: Dec 13 2007 06:55 PM |
      10/1/2007,,,,,,,-0.47,,,,,,, -0.22 * temp bottom
      11/1/2007,,,,,,, 0.14,,,,,,, -0.18
      12/1/2007,,,,,,, 0.44,,,,,,,-0.23
      1/1/2008,,,,,,, 0.59,,,,,,, 0.06
      2/1/2008,,,,,,, 0.45,,,,,,, 0.10
      3/1/2008,,,,,,, 0.06,,,,,,, 0.04
      4/1/2008,,,,,,, 0.04,,,,,,, 0.02
      5/1/2008,,,,,,, 0.09,,,,,,, 0.04
      6/1/2008,,,,,,, 0.20,,,,,,, 0.05
      7/1/2008,,,,,,, 0.32,,,,,,, 0.10
      8/1/2008,,,,,,, 0.15,,,,,,, 0.05
      9/1/2008,,,,,,, 0.00,,,,,,, 0.13
      10/1/2008,,,,,,, -0.20,,,,,,, 0.10 * possible recession
      11/1/2008,,,,,,, -0.10,,,,,,, 0.00 * possible recession
      12/1/2008,,,,,,, 0.10,,,,,,, -0.06 * possible recession

      Trajectory as predicted:

      The Commerce Department said retail sales in Oct 2007 increased by 1.2% over Oct 2006, & up a huge 6.3% from Nov 2006.


      In Dec 2007 we irrevocably knew that liquidity had to be injected into the commercial banking system before the fall of 2008. It was obvious: unless money flows expanded at least at the rate goods & services were offered, output couldn't be sold & hence the work force will be cut back.

    23. Welcome to the comedy club. With a little study you can bust a gut.

    24. You are still talking about monetary policy, not about the workings of banks. I don't really need the history lesson - I saw the crash coming LONG before 2007.

      This conversation is now at an end.

    25. It ended in 1963:

      “Profit or Loss from Time Deposit Banking” -- Banking & Monetary Studies, Comptroller of the Currency, United States Treasury Department, Irwin, 1963, pp. 369-386.

  5. Re Carney’s claim that monetary policy is more nimble than fiscal, I have doubts. Anyone know of any decent research into this?

    Re the lack of any quick response to interest rate changes, see:


    Re the relatively quick response to fiscal changes (and by “quick” I mean a significant effect well within a year) see:

    1. http://www.nber.org/digest/mar09/w14753.html

    2. http://www.kellogg.northwestern.edu/faculty/parker/htm/research/johnsonparkersouleles2005.pdf


    1. Truth by repeated assertion I reckon Ralph.

      There's nothing quicker at responding than the automatic fiscal stabilisers.

    2. Good point about automatic fiscal stabilisers. I bet they work even quicker than the six to nine month time lag that features in the studies I referred to above.

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  7. Frances,

    You say, “…especially on the shadow banking system whose lifeblood is the collateral that is becoming scarce.” Why exactly do banks (shadow or otherwise) need “the collateral” (which I assume is synonymous with “safe assets”)?

    I.e. if a firm wants to borrow £X for a project, and it cannot persuade a bank to lend it funds for the project, then the loan shouldn’t be made. Of course if the firm has some safe assets, then it can use those assets as collateral. But that does not prove that making the loan will bring benefits.

    Put another way, I see no problem in a hypothetical economy where there is no government debt or any similar form of safe asset. I.e. I see no problem in an economy where the only collateral offered is the actual project or asset to be created with the borrowed funds (e.g. borrowing to build a house, or in the case of a firm, borrowing to fund the purchase of a machine).


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