March 06, 2011
Velocity of Federal Reserve deposits
I've been emphasizing that the U.S. Federal Reserve has not been printing money in the conventional sense of creating new dollar bills that have ended up in anybody's wallets. Instead, the Fed has been creating new reserves by crediting the accounts that banks maintain with the Fed. Today I'd like to offer some further observations on how those reserve balances mattered for the economy historically, how they matter in the current setting, and how they may matter in the future.
When the Fed makes a purchase of, for example, U.S. Treasury bonds, it does so by simply crediting an account that the selling institution maintains with the Fed, creating new funds out of thin air. The selling bank surrendered T-bonds which the Fed now owns, and has command of new reserve deposits, with which it can do anything it likes. For example, the bank could use the funds to buy some other asset, by instructing the Fed to transfer its balance to those of the bank from which it wants to buy the asset. Alternatively, the bank could use the reserve deposits to make a loan, pay another bank for funds owed, withdraw them by asking for cash from the Fed, or simply hold on to the reserve deposits. Reserve deposits are an asset like any other, and if a bank makes a conscious decision to hold on to them, it is because it regards this asset as at least as attractive as any alternative use it might make of the funds. Equilibrium requires that the supply created by the Fed equals the quantity banks desire to hold.
Before 2008, the primary demand for reserves came from the fact that the Fed required banks to hold certain levels of reserves. The banking system as a whole held a little more than required, because many individual banks wanted to avoid penalties or extra costs that might result if some last-minute withdrawals caused the bank to lose its reserves at a late hour in the day when it would be hard for the bank to borrow funds to replace them. The fed funds rate, which is the interest rate banks charge each other for an overnight loan of reserves, was very sensitive to the level of excess reserves in the system, and gave the Fed a credible tool for maintaining a desired target for the fed funds rate by adding small amounts of reserves with T-bill purchases, or removing small amounts with T-bill sales.
To understand how that equilibrium worked, consider an individual bank that initially had what it thought was the right level of reserves for its own needs. Suppose a customer of the bank unexpectedly deposits a check drawn on another bank, which that bank honors by instructing the Fed to send its reserves over to the receiving bank. The receiving bank now has a much larger reserve balance than it needed. It would therefore try to find some other use of the funds, for example, by buying an asset or lending the funds to another bank, rather than leave them idle at the end of the day. The sending bank would likewise find itself short, and likely either sell some assets or borrow reserves on the fed funds market, perhaps ultimately borrowing the reserves back from the receiving bank. The result was that reserve balances were passed back and forth between banks many times each day, with each receiving bank almost always finding something better to do with the funds than just hang on to them overnight.
One can get a sense of the scope of this by looking at the volume of transactions on Fedwire, the system a bank uses when it wants to instruct the Fed to debit its account with the Fed and credit the account of the bank to which it wants to make a payment. For example, on an average day in 2006:Q1, about $2.2 trillion in reserve deposits were sent between banks over Fedwire, despite the fact that reserve balances only averaged $13 billion each day. In other words, each dollar of reserve deposits was trading hands something like 2,200/13 = 170 times each day before finally ending up being held by somebody when the books were closed for the day. The graph below plots this concept of "velocity of reserve deposits" for the last two decades.
One can also see from the figure how radically differently the system is functioning today. In 2010:Q3, about $2.4 trillion was transferred each day on Fedwire. Compared to over a trillion dollars in reserves outstanding, that implies a velocity of 2.3. In the current setting, a given dollar of reserves is transferred about twice from one bank to another, and then as likely as not just sits there for the rest of the day.
A key reason that the system functions so differently today is that banks really don't see much better use for the funds than just holding on to them as reserves. A bank gets paid 0.25% annual interest for maintaining the reserve balances with the Fed, which is actually substantially better than you'd get from buying a 1-month T-bill. Many banks are still afraid to make any but the very safest of loans. In such a setting, the Fed could create all the reserves it wants, and it's not clear that much if anything has to change as a result.
However, the situation is not going to stay like this forever. When banks do start to see something better to do with their funds, one could imagine the situation changing pretty quickly. The Fed's plan when that starts to happen is to remove some of those reserves by selling off some its assets, and preserve the incentive for holding reserves by raising the interest rate paid on them.
But a recent note by economists Huberto Ennis and Alexander Wolman of the Federal Reserve Bank of Richmond observes that negotiating the details of that transition could prove tricky in practice. Put a trillion dollars in reserves together with a velocity in the tens or hundreds, and pretty soon you're talking about real money.
Posted by James Hamilton at March 6, 2011 07:04 AMdigg this | reddit
Thanks Professor for that explanation.
One question. You say: "The selling bank surrendered T-bonds which the Fed now owns, and has command of new reserve deposits, with which it can do anything it likes. For example, the bank could use the funds to buy some other asset, by instructing the Fed to transfer its balance to those of the bank from which it wants to buy the asset. Alternatively, the bank could use the reserve deposits to make a loan, pay another bank for funds owed, withdraw them by asking for cash from the Fed, or simply hold on to the reserve deposits."
So, in theory, the banks could have used the reserves they got in QE1 ($1.7 trillion) to purchase UST's which they traded back to the Fed in QE2---creating a circular trade?
Is this just conspiracy theory or could this have really happened?
Posted by: Raskolnikov at March 6, 2011 08:25 AM
And what happens if the Fed wants to sell assets but can only sell at a loss?
Rates are higher and prices lower now than when the Fed bought much of what it's holding. So if it tried to sell, it would be selling at a loss... even more so to the degree that Fed selling further depresses prices. The Fed is the biggest Treasury holder in the world, after all.
So what happens if they sell at a loss? Is the amount of the loss just left permanently in the economy as a gift to the banks?
Posted by: W.C. Varones at March 6, 2011 08:30 AM
Raskonikov: Note that no wealth is created by this transaction-- assets of like value are simply swapped. If banks buy T-bonds for $1 T and sell them to the Fed for $1 T, at the end banks are in exactly the same position as they were at the start.
The reserves created in QE2 were used to purchase T-bonds; at the end of which the private sector will have $600 B less in T-bonds than they would have in the absence of the program, the Fed will have $600 B more in T-bonds than they would have in the absence of the program, and banks will have $600 B more in reserves than they would have in the absence of the program.
Posted by: JDH at March 6, 2011 08:32 AM
Sounds like you have been reading Hussman.
Posted by: mc at March 6, 2011 08:46 AM
"creating new funds out of thin air"
I wish people wouldn't say things like that. Every time the Fed buys a $100 bond, the Fed's assets rise by $100 as its liabilities rise by $100. It therefore has enough assets that it could buy back all the money it has issued, whether that money was in the form of paper or bookkeeping entries.
The "money out of thin air" idea makes the Fed sound like a counterfeiter. But the Fed puts its name on its dollars, holds assets against those dollars, and stands ready to use those assets to buy back the dollars it has issued.
Posted by: Mike Sproul at March 6, 2011 09:09 AM
Thank you for the explanation, Professor.
You say that "No wealth is created by this transaction-- assets of like value are simply swapped."
Yes, but doesn't the Fed need to purchase the Treasuries to keep rates within the desired range....
While, at the same time, QE1 has moved the toxic assets from bank balance sheets onto the Fed's balance sheet. I expect that the banks feel that is a pretty good deal.
And, now, QE2 is having a positive effect of equities, although I am unsure how the transmission takes place. There seems to be a lot of disagreement and confusion on this point.
Posted by: Raskolnikov at March 6, 2011 09:15 AM
Then what was the point of the exercise? Why give the banks reserves if they are not using them? Just to puff up the reserves so that the banks can pretend to have enough? Just to suppress interest rates by buying up bonds? The Fed created the QE program, it said, because it couldn't lower short-term rates below zero. But just having reserves pile up in reserve accounts would seem to be ineffective as a stimulus.
Posted by: Moopheus at March 6, 2011 09:48 AM
Dr. Hamilton: Very good post, thank you! I have a question however... If the Federal Reserve would do nothing but raise the reserve requirement (right now-for example) so that the ratio of excess reserves to total reserves fell to pre-crisis levels, would that not also raise velocity to similar levels-despite interest (@0.5%) being paid on reserves? What dynamics would we expect to see in that situation?
Posted by: Doc at the Radar Station at March 6, 2011 10:46 AM
If you drill into the cpi, you see that things you buy on a daily basis like food and fuel are going up. Housing, which you buy two or three times in a life time, is holding the average down. So we have inflation where it hurts us and deflation where it doesn't help us.
I think Bernanke is just whistling as he passes the grave yard, and he hopes he can get out of Dodge before a Black Swan shows up and causes the whole house of cards to explode, to mangle some metaphors.
Posted by: Walter Sobchak at March 6, 2011 11:13 AM
"When banks do start to see something better to do with their funds, one could imagine the situation changing pretty quickly..."
And this is where you lost me. Any individual bank can do something else with their funds, but in aggregate they only have two choices: hold excess reserves or hold physical cash.
"Put a trillion dollars in reserves together with a velocity in the tens or hundreds, and pretty soon you're talking about real money."
The volume of transfers has been quite stable, between $2T and $3T/day for the past several years, with a long-term growth trend. There's no reason to expect it to suddenly jump 10- or 100-fold. The "velocity" is purely a derived variable; it will go back up when reserves decline, not before.
Posted by: lilnev at March 6, 2011 11:24 AM
W.C. Varones: If the Fed made such a big capital loss that it could not reduce reserves to its desired level using asset sales, the alternative would be to ask the Treasury to pile up some of the reserves in its account, as it did with the Treasury Supplemental Financing Account, in which the Treasury sells T-bills and just parks the funds in its account with the Fed, in effect draining reserves away from private banks.
Note that at the moment the Fed is in fact making a huge profit rather than a loss, which it turns over to the Treasury and which contributed $9 billion to the Treasury's receipts in the month of January alone (see Table 4 of the Monthly Treasury Statement). Some argue it would be a good idea for the Fed to be turning less of these receipts back to the Treasury at the moment in order to build up working capital against the contingency of future losses.
mc: Hadn't read the Hussman piece; any similarities are due to the fact that I'm saying things that are true.
Mike Sproul: Good point.
Raskolnikov at March 6, 2011 09:15 AM: Traditionally yes, the Fed buys or sells securities to keep the fed funds rate at its target. But at the moment, the fed funds rate is stuck at zero regardless of what the Fed does.
It simply is not correct that the Fed is currently holding large amounts of "toxic assets". It has small holdings of junk related to Bear Stearns and AIG, but the vast majority of its holdings are Treasury securities and agency mortgage-backed securities for which the Treasury is already on the line to make good no matter who holds them.
Doc at the Radar Station: I have reported here the velocity on total reserve deposits, not just excess reserves. The denominator does not change when you raise the reserve requirements. That is, however, another possible tool for raising the demand for reserves.
Posted by: JDH at March 6, 2011 11:25 AM
lilnev: The aggregate condition is exactly what I am referring to when I say "Equilibrium requires that the supply created by the Fed equals the quantity banks desire to hold." The way to understand how that equilibrium works is to consider the decisions made by an individual bank. Even though some bank somewhere must hold the reserves, an individual bank need not. The individual bank decisions represent the demand for reserves, the Fed's open market operations determine the supply of reserves, and equilibrium requires supply to equal demand.
Posted by: JDH at March 6, 2011 11:32 AM
My concern is that whether an individual bank is holding treasuries or cash the 'reserve' amounts are the same. Thus once created, there they sit. And that's the reserve number when the banks finds opportunities to leverage those reserves for lending to the private economy.
The only certain mechanism that would 'freeze' volatility, once unleashed on larger than normal reserves, is interest rates. That's what Volcker did and that produced a very nasty recession.
Spectacular for bond buyers, however, as interest on even short term CDs went over 10%.
Posted by: beezer at March 6, 2011 11:52 AM
Thanks, James, that was a really interesting explanation.
Posted by: Andy at March 6, 2011 12:14 PM
Doc at the Radar Station:
Note that $2 trillion + is still sent over Fedwire each day. This is because the banks who NEED reserves each day still need them. Raising the reserve requirement will increase the cost of funding for these banks. The higher level of excess reserves is because there is a different group of banks with excess assets. Traditionally, Fed deposits have been a poor place to park excess assets as reserves paid nothing and t-bills paid interest. We are seeing more excess reserves simply because reserves now pay interest, and at a higher level that t-bills.
Posted by: Paul at March 6, 2011 12:16 PM
In the abscence of the Fed [or some other central bank] buying the $600 billion of Tres. debt, $600 billion of real savings would have been consumed to fund the US gov't.
Is there no cost associated with fooling the market into thinking that there exists more savings than in fact exists?
Posted by: Bryce at March 6, 2011 12:20 PM
Does anyone produce/maintain the second chart on a daily/wekly basis using up-to-date data?
I would love to have access to such updates every morning of every trading day!!!!!
Posted by: esb at March 6, 2011 12:43 PM
'Put a trillion dollars in reserves together with a velocity in the tens or hundreds, and pretty soon you're talking about real money."
The question, it seems to me, is how fast this change might come.
"Some argue it would be a good idea for the Fed to be turning less of these receipts back to the Treasury at the moment in order to build up working capital against the contingency of future losses."
But aren't these "Fed profits" in the main the proper income of taxapyers? (the fiction that the Fed makes the money is just a construct to give them independence in that they don't need an appropriation from Congress.
And if the Fed does make substantial losses, aren't they, in effect, practicing unauthorized fiscal policy? (I believe you made this point before. If so, I would certainly agree. In fact, in my view the fiction of the Fed's profit measure may allow them to hide inappropriate losses - they would just turn over less than the appropriate amount, based on what rightfully belongs to taxpayers, to Treasury.)
Is it likely that the Fed would ever make a net loss, and could this threaten their independence?
Posted by: don at March 6, 2011 01:07 PM
Bryce, your problem is not getting what it really going on. How many times does it need to be said, hood wink, slight of hand.
The FED hasn't bought jack of US treasuries. Literally. What they "bought" is irrevelant inside the overall US debt network. It is all about confidence hence liquidity for capital transfusions. The FED is trying to do alot by not doing that much at all. What they have done may make you believe they are doing alot, but what they can do is far more "intrusive" when times get more desperate and QE no longer works to provide confidence and liquidity.
Little surprise the economy has accelerated since QE II during the "eye" of the financial hurricane. Matter of fact, since they waited to November when they should have done it earlier, has all types of political conspiracy written all over it.
Posted by: The Rage at March 6, 2011 01:42 PM
Does it matter? It will anyway end up with stiock market going down in H2 2011, and the USA in second recession in Q1 2012:
Does it matter what the FED does in the meantime? The problem is, what to do and by whom ( not the current parties of power) when recession hits again, with minus 2-4% and, as it seems, will last at least 1,5-2 years.
Some longer term and more human behavior related thinking is required than economic numbers of yesterday.
Posted by: Ivars at March 6, 2011 01:43 PM
Dr. Hamilton, would you mind extending the first graph back to 1996?
Posted by: aaron at March 6, 2011 02:27 PM
Bryce Is there no cost associated with fooling the market into thinking that there exists more savings than in fact exists?
What are you talking about? Are you trying to argue that the economy would be better off with higher interest rates? Sorry, just not understanding your point.
The Wicksellian interest rate that would clear the market at full employment is in negative territory, but the nominal rate cannot go below zero. As I recall, Goldman-Sachs had it at around negative 8% at the nadir of the recession. The reason the Wicksellian clearing interest rate is negative is that there's too much global savings, not too little as you seem to believe.
Posted by: 2slugbaits at March 6, 2011 02:35 PM
Good until the last part. Bank lending was never reserve constrained to begin with. The Fed sets and interest rate target, and drains or supplies reserves necessary to accommodate the price (interest rate). Therefore the old tools to raise interest rates remain, and have been enhanced so excess reserves won't lead to a zero fed funds rate. Bank lending is capital constrained however.
As Dr. L. Randal Wray points out in his paper Understanding Policy in a Floating Rate Regime-
"..demand for reserves is highly inelastic, and because the private sector cannot easily increase the supply (by attracting deposits of cash), the overnight interest rate would be highly unstable without central bank accommodation. Hence, relative stability of overnight rates requires “horizontal” accommodation by the central bank. In practice, empirical evidence of relatively stable overnight interest rates over even very short periods of time supports the belief that the central bank is accommodating horizontally."
@W.C. Varones"And what happens if the Fed wants to sell assets but can only sell at a loss?"
Then it is a fiscal operation where the financial assets of some in the non-government sector rise as a result. For more on this see What if the government just prints money. by Dr. Scott Fullwiler
Posted by: Tschäff at March 6, 2011 04:54 PM
The payment's system (FED-WIRE), does use live data, but the "demand for reserves" is a contrived (regulatory), function & not fundamentally related to economic activity.
Posted by: flow5 at March 6, 2011 05:04 PM
At the risk of sounding like a broken record... banks always invest or make loans on the basis of risk-return tradeoff -subject to capital requirements. Level of reserves has no role in this.
I feel that the entire premise of your post is that Banks could do things with reserves that they could not do with T-Bills or bonds, this is entirely false. Reserves are accounts at the Fed, T-Bills and bonds are accounts at the Treasury (you want to open an account at the Treasury, you go ahead: http://www.treasurydirect.gov/). Canada has basically the same kind of system as the U.S. WITH zero reserves in aggregate (so Banks only have accounts at the Treasury if you will through their holdings of Government bonds); does banks in Canada complain about the fact that trading in the interbank market is difficult or impossible? Of course not. You do not need reserves to trade in the interbank market, to make loans, to invest or whatever.
Bssed on the above, your graph is unfortunately meaningless. In a no reserves system like Canada, the denominator would be zero and your graph would be infinite. Would you conclude that the "velocity of reserves deposit" is infinite in Canada? I hope not. In the case of the U.S., the denominator has been raised by the Fed during the crisis, so no wonder why there is an abrupt collapse. The Fed may just as well decide tomorrow to start selling its treasuries holdings and bring excess reserves toward zero, the line of your graph would then be skyrocketing (so Banks' reserves accounts would decrease, and their Treasury accounts would increase). Would this lead you to conclude anything on the level of activity in the interbank market or on the "velocity of reserves deposit"? I hope not.
Finally, if reserves requirements are eliminated (as it was discussed last year) and the Fed start targeting an end-of-day aggregated level of reserves of close to zero (as is the case in Canada), would you forecast that this move would have a major impact on interbank actvity or lending? Again, I hope not.
Posted by: Qc at March 6, 2011 06:27 PM
How do you know there is too much savings when so much of what is borrowed has not been saved but created out of thin air?
Posted by: Bryce at March 6, 2011 08:00 PM
"banks will have $600 B more in reserves than they would have in the absence of the program."
Shouldn't they have already bought nearly $300 billion worth of bonds in QE2 thus far? According to your chart, bank reserves have not risen nearly so much as the reported rate of their purchases would imply. Reserves plus currency haven't, either. So the "money" would seem to be going elsewhere, no?
Posted by: Shan at March 7, 2011 03:29 AM
Hmmm, well, the chart apparently isn't quite up-to-date enough to show the latest increase in reserve balances, up $200 billion in the past four weeks. In other recent months, if I'm reading this data correctly, the effect on reserves of QE2 purchases was substantially offset either by other asset sales or by increases in US Treasury account balances. So I guess the big expansion really just started this past month.
Posted by: Shan at March 7, 2011 05:13 AM
Doc at the Radar Station,
If you want to see the results of the FED raising the interest rates when reserves are in excess look at 1937. Raising the reserves will just put more pressure on banks to increase reserves.
Excellent history. Thanks for the post.
One of the primary reasons that banks are not lending is the deleveraging that has come from the economic contraction. Just consider real estate as one example.
Real estate was leveraged to insane levels during the early 2000s. A combination of destructive fiscal policy coming from congress to push home ownership caused prices to shoot through the roof. Owners very quickly pulled the equity out of their real estate. Remember all the talk about homes becoming ATMs?
Today many real estate owners are underwater. They are either holding on by their finger tips or dealing with foreclosure. Government programs are still propping up owners so there just are not qualified borrowers.
Additionally banks got burned when the bottom fell out of the market so they are being very cautious about extending themselves.
Professor, this comment In such a setting, the Fed could create all the reserves it wants, and it's not clear that much if anything has to change as a result may be the most important in your whole post. It is a serious indictment of Paul Krugman and his minions and exposes the total futility of their recommendations. Krugman would overwhelm the reserves with money creation causing the money creation to explode into price increases, chronic inflation. I do not call Krugman America's Rudolph Havenstein for nothing.
Posted by: Ricardo at March 7, 2011 05:54 AM
Just wanted to say I have learnt a lot from reading your blog for around two years and fired my earlier post about the Hussman article
more as a hat tip to him and to point out that just last week he was all over this particular topic. He has been very eloquent on a lot of issues surrounding the financial crisis and certainly on the nature of QE2.
Posted by: MC at March 7, 2011 06:07 AM
How does the FED unwind this position without causing a spike in rates on treasuries, mortgages, corporate bonds, etc? I assume the FED will begin selling treasuries after the FED is sure that a recovery is sustainable. At that point, market rates for borrowed funds are already rising, then the FED adds fuel to the fire. Paying higher rates to banks on excess reserves will also drive baseline rates up.
Speculators will smell this coming a mile away so rates will begin to increase long before the FED moves.
Again, how does the FED reduce excess reserves without creating a rate spike? Anyone?
Posted by: tj at March 7, 2011 06:27 AM
Oil futures seem to be about to move into backwardation and the change has been pretty sharp. I've been looking at historical precedent and 2007 is the obvious parallel.
In December 2007, you posted on the subject:
I found this report that includes a historical graph of the level of contango/backwardation in the oil futures market:
Using this measure (near month less 11 months out) I think the last month would look very similar to the middle of 2007, from -7 or 8 to -1 or 2.
I guess the chief market effect is that there is no chance making money buying spot and selling futures because difference in price is already well below storage costs ($.75/month, I think.)
Do you think this is worth paying attention to?
Posted by: Bob_in_MA at March 7, 2011 06:46 AM
To add, I think a level of disconnection in the public mind is based on the observation that banks aren't lending much and a constructed chain of cause that goes back to the Fed. I mean, of course, the various, often incoherent arguments about "crowding out" but specifically much less the actual technical "crowding out" but an inchoate notion that something must be happening.
You hit that right on the head when you note banks aren't willing to lend. They have lots of money. They aren't willing to lend.
If the point I'm making sounds off, consider that people like John Taylor have advanced a version of this, that money is sitting on the sidelines because of inchoate worry about future tax increases. Having actually been in business, I know that's nonsense: if your business has sufficient demand now, there is money available to borrow at very low rates and that makes investment now much more attractive, particularly given the weakness of competition. Problem is, as you note, demand is off so credit is off so banks aren't lending.
Posted by: jonathan at March 7, 2011 08:42 AM
Do have have any comment on the following quotes?
Don Kohn (Former FRB Vice Chair):”I know of no model that shows a transmission from bank reserves to inflation”.
Vitor Constancio (ECB Vice President): “The level of bank reserves hardly figures in banks lending decisions; the supply of credit outstanding is determined by banks’ perceptions of risk/reward trade-offs and demand for credit”.
Posted by: markg at March 7, 2011 09:24 AM
"The Fed's plan when that starts to happen is to remove some of those reserves by selling off some its assets, and preserve the incentive for holding reserves by raising the interest rate paid on them."
So you're telling us that anyone who really wants to teach Macro correctly (as opposed to currently) will now have to note that the break-even r for business is going to perpetually be higher than the breakeven r for financial institutions?
Good thing economists know there is no need to produce value to make money. (That will become class 2, I assume.)
Posted by: Ken Houghton at March 7, 2011 11:15 AM
Jim in this week's Economist.
Posted by: Steven Kopits at March 7, 2011 12:27 PM
"Don Kohn (Former FRB Vice Chair):”I know of no model that shows a transmission from bank reserves to inflation”."
Kohn is ignorant & arrogant (& I can name a few others at the FED who fit that bill).
The model exists & still works. I discovered it in JULY 1979.
Posted by: Anonymous at March 7, 2011 01:32 PM
Ricardo It is a serious indictment of Paul Krugman and his minions and exposes the total futility of their recommendations. Krugman would overwhelm the reserves with money creation causing the money creation to explode into price increases, chronic inflation. I do not call Krugman America's Rudolph Havenstein for nothing.
Honestly, sometimes I have no idea where you get this stuff. If you want to disagree with Krugman, then fine; but please bother to at least get his argument straight. Krugman does not favor massive money creation; in fact, he's been pretty skeptical as to the limits of any kind of monetary policy tools, which is why he's been arguing for fiscal policy. There may well be some economists arguing for "overwhelming the reserves with money creation," but Krugman isn't one of them. I suspect that you are a bit confused about Krugman's actual arguments concerning Japan in the 1990s and you are carrying this confusion forward to the current situation.
Posted by: 2slugbaits at March 7, 2011 01:51 PM
Don Kohn (Former FRB Vice Chair):”I know of no model that shows a transmission from bank reserves to inflation”.
THEN WHAT IS THIS?
2010 jan …… 0.13 …… 0.538
….. feb …… 0.056 …… 0.507
….. mar …… 0.072 …… 0.558
….. apr …… 0.056 …… 0.552
….. may …… 0.067 …… 0.477
….. jun …… 0.038 …… 0.474
….. jul …… 0.078 …… 0.499
….. aug …… 0.031 …… 0.49
….. sep …… 0.045 …… 0.542
….. oct …… -0.01 …… 0.386
….. nov …… 0.041 …… 0.321
….. dec …… 0.099 …… 0.32
2011 jan …… 0.089 …… 0.155
….. feb …… 0.091 …… 0.233
….. mar …… 0.131 …… 0.322
….. apr …… 0.1 …… 0.232
….. may …… 0.111 …… 0.204
First column is the proxy for real-output. Second column is the proxy for inflation indices. Inflation (core) obviously bottomed in JAN.
Real-output is rocketing upward in the 1st & 2nd qtrs.
I think the FED is too easy at this point (maybe its accommodating petroleum price shocks).
Posted by: Anonymous at March 7, 2011 02:34 PM
Excess Reserves ... true, current money printing is not going into the real economy via traditional lending mechanisms and their leverage effects ... but are you not missing how FED money printing is going into the financial economy(and thus trickling into the real economy), via the repo market? Do excess reserves and velocity of money even matter, if everything "repo-able" is being repo-ed at the Fed for this newly printed cash, leveraged at 100x (there is no reg capital requirement for banks on Fed repo), and used to finance and buy derivatives, commodities, and equities, treasuries, etc. ... Lastly, Prof, wasnt such a policy tried in the late 60s, otherwise known as Operation Twist (to twist the long end of the yield curve), and was it not a total failure, ultimately defeated by Volcker himself 10years later?
Posted by: ASG in NYC at March 7, 2011 08:16 PM
"THEN WHAT IS THIS?"
what's the transmission mechanism?
Posted by: studentee at March 7, 2011 10:32 PM
banks have no greater operational ability to buy equity assets after qe2 than they had before
Posted by: studentee at March 7, 2011 10:38 PM
"Many banks are still afraid to make any but the very safest of loans. In such a setting, the Fed could create all the reserves it wants, and it's not clear that much if anything has to change as a result."
banks do not lend reserves. it is the price set on reserves that matters for determining lending desires, not the quantity in the system. empirically, the price set on excess reserves has almost no affect on any indirect lending actions taken by banks
Posted by: studentee at March 7, 2011 10:41 PM
Banks have no choice but hold these excess reserves - if they buy another asset that just transfers the 'cash' to a different insitution who now ends up long reserves.
But I would suspect:
1-There is a level of reserves beyond which injecting more generates no benefits (ie. the marginal impact falls to zero for a given size of economy / banking system regardless of the condition of the banking system)
2-If the Fed ever sell the QE securities (okay this may never happen) then if there is a net loss generated in doing so, this will be equivalent to a permanent injection of reserves into the banking system (reserves injected = total price paid for treasuries whereas that which will be drained will be the proceeds generated net of interest payments and these could be two very different figures - especially if one reasonably assumes UST sales will occur in a falling market/ at lower prices than which they purchased them). If the loss is large enough such that the Fed does not have enough non-QE assets to offset / sell to drain these reserves, then I suppose reserve obligations have to rise?
Posted by: C Jones at March 8, 2011 04:19 AM
2Slugbaits, You/Krugman rely on bad memories. Let me give you three quotes. Granted Krugman has been on both sides of the issue. That way he can claim to not have said what he actually said. Pay close attention to what I highlighted in bold print below, a quote not even a year old.
Note: For Krugman, American's Havenstein, this is not new rhetoric. He has been promoting this same economic poison of monetary expansion for decades.
12/1999 On Japan
"Now in standard macroeconomics it is possible to compensate for downward price inflexibility by increasing the money supply instead: the economy doesn’t have enough M/P, so if P won’t go down just raise M instead. In the liquidity-trap case illustrated by our little model, however, raising current M is ineffective, essentially because it’s a different ratio - Pe/P, where Pe is the expected future price level - that is out of line. But all is not lost for monetary policy. A credible commitment to expand not only the current but also future money supplies, which therefore raises expected future prices - or, equivalently, a credible commitment to future inflation - will still succeed in raising the equilibrium current price level and hence current output."
8/8/2001 promoting a weak dollar and housing stimulation.
"Housing, long-term rates haven’t fallen enough to produce a boom there. The trade balance is going to get worst before it gets better because the dollar is still very strong. It’s not a happy picture.”
"The actual lessons of 2009-2010, then, are that scare stories about stimulus are wrong, and that stimulus works when it is applied. But it wasn't applied on a sufficient scale. And we need another round.
I know that getting that round is unlikely: Republicans and conservative Democrats won't stand for it. And if, as expected, the G.O.P. wins big in November, this will be widely regarded as a vindication of the anti-stimulus position. Mr. Obama, we'll be told, moved too far to the left, and his Keynesian economic doctrine was proved wrong.
But politics determines who has the power, not who has the truth. The economic theory behind the Obama stimulus has passed the test of recent events with flying colors; unfortunately, Mr. Obama, for whatever reason -- yes, I’m aware that there were political constraints -- initially offered a plan that was much too cautious given the scale of the economy's problems.
So, as I said, here's hoping that Mr. Obama goes big next week. If he does, he'll have the facts on his side."
Posted by: Ricardo at March 8, 2011 05:12 AM
Jim, we've been over this many times. I'm glad you're explicitly acknowledging that excess reserves are in fact liquid money.
But the relationship between Fedwire transaction volumes and excess reserve levels is very different from what you describe. Banks use Fedwire as a clearinghouse for all kinds of transactions in the economy. For example company A's payment to company B is likely to be settled through a Fedwire payment from company A's bank's Fed account to company B's bank's Fed account.
So, what you're really showing is evidence that the increased level of excess reserves has not led to any visible increase in the volume of transactions in the economy. In fact, the volume of Fedwire transactions has declined, by about 20% since the start of the crisis. Fedwire is by far not all transactions, but it is a large sample. So why the reduction in Fedwire transactions, despite the increase in money supply, however you measure it?
I suppose the holding of excess reserves by most banks reduces their need to borrow on the federal funds market, and consolidation of the banking sector has increased the portion of transactions that are settled internally by banks that hold the accounts for both parties in the transaction.
As for why banks haven't lent more to the economy, resulting in more expansion of broad money and more conversion of reserves into currency, here it's true that the 0.25% interest paid on reserves is the clincher. But the reserves being created by the Fed are not all being retained as excess reserves - currency is up 7% in the past 12 months, with similar increases in broad money and a burst of M1 growth at the end of 2010.
With increased excess reserves, what you're really looking at is decreased leverage among the banks. The Fed is encouraging this decreased leverage by paying 0.25% interest on reserves, which are basically the denominator in the leverage ratio. That decreased leverage has counteracted the increased base money supply, reducing its impact on broad money supply.
But it's important to understand that there is not a like-for-like competition between excess reserves and Treasuries. A bank can deploy $1 of excess reserves to ultimately buy several dollars of Treasuries through leverage. This doesn't happen overnight, it happens through a chain of transactions. So there's a delay between the Fed's creation of reserves and the conversion of excess reserves into currency, broad money and required reserves. During the period last year when the Fed wasn't creating more reserves - February to November - the conversion of reserves into currency et al proceeded, and at no slow pace.
Posted by: Tom at March 8, 2011 07:01 AM
"agency mortgage-backed securities for which the Treasury is already on the line to make good no matter who holds them."
And that is suppose to make me feel good, that its ok that bad agency loans are on the Feds balance sheet instead of the Treasuries, even though its basically the same thing but with a lot less transparency at the Fed.
Posted by: dave at March 8, 2011 08:28 AM
ASG in NYC
"Lastly, Prof, wasnt such a policy tried in the late 60s, otherwise known as Operation Twist (to twist the long end of the yield curve), and was it not a total failure"
There were other mitigating factors. The fact is the CBs pay for what they already own. Money flowing "to" the non-banks actually never leaves the CB system as anybody who has applied double-entry bookkeeping on a national scale should know. The correct interpretation comes from 1966.
FED-WIRE transactions have declined but that is related to other factors. What has driven the economy has been the increase in the transactions VELOCITY of money.
Posted by: flow5 at March 8, 2011 10:14 AM
Ricardo You never disappoint. True to form you have confirmed what I suspected in my earlier post...namely, you have completely bungled and misinterpreted Krugman's argument regarding Japan. His argument was that Japan's central bank needed to credibly promote the expectation of higher inflation. Emphasis on two key words: "credible" and "expectations." His argument is that because no one believes Bernanke and the Fed will actually allow inflation to run away that monetary policy by itself will not work. In other words, Bernanke cannot credibly promise inflation. It's the Fed's sterling credibility that is preventing it from ramping up expectations of high inflation. And also note that he talks about "expectations" rather than actual inflation. In his math it's not inflation that breaks the back of the Japanese liquidity trap; it's the expectation of inflation.
Krugman does argue for more stimulus, but not monetary stimulus...although he is not against QE2. He simply doesn't think it has the firepower to do the job. The 9/2/2010 quote you cited was an argument for fiscal stimulus, not monetary expansion.
Sorry, but you are completely confused about his arguments, which probably explains why you think he is been on both sides of things.
Posted by: 2slugbaits at March 8, 2011 01:51 PM
Man do you know how Krugman thinks. It is as if you two were in the same body. :-)
My only response is that if what you say is true then Krugman/Havenstein is a terrible writer because I simply quoted his words without comment. If his word do not speak for themselves then something is wrong with his words.
And I have to say that it made me laugh when I read, Emphasis on two key words: "credible" and "expectations." His argument is that because no one believes Bernanke and the Fed will actually allow inflation to run away that monetary policy by itself will not work. In other words, Bernanke cannot credibly promise inflation.... And also note that he talks about "expectations" rather than actual inflation. In his math it's not inflation that breaks the back of the Japanese liquidity trap; it's the expectation of inflation.
So Krugman is just playing a little game with us. He is fooling us just to make us expect inflation. His words are really not "credible" but we should still have the "expectations" that they are "credible." So, Krugman is not recommending real inflation. Gosh, that would be awful. But then making people think he means inflation when he really doesn't, now that's the ticket. How incedible. :-)
That is funnier than Abbott and Costello.
Posted by: Ricardo at March 8, 2011 02:20 PM
You neglected to answer my question:
"How do you know there is too much savings when so much of what is borrowed has not been saved but created out of thin air?"
Your statement that there is too much savings is interesting juxtaposed to the fact that the US as a nation is, after allowing for depreciation & govt borrowing, DISSAVING!
Posted by: Bryce at March 8, 2011 06:06 PM
I took disposable income (DI) from BEA table 2.6 and expentitures I classify as non-discretionary expenses (NDE)from table 2.4.5U. It shows that around 2004, NDE exceeded half of DI. It declines some in the 2008 crash, but it is on the rise again and already about at pre-crash levels.
It'd probably good to see this against easing and also with saving. Savings is easy for me to add, but the M1 data is too much for me to handle.
Posted by: aaron at March 9, 2011 06:43 AM
At the worst of the recession the Fed believed interest rates needed to be at negative 5% in order to clear given that demand for investment was less than what people wanted to save. In other words, I=S only at negative 5%. Goldman-Sachs estimated the clearing rate at negative 8%. Both the Fed and Goldman-Sachs numbers were derived from slightly different versions of the Taylor rule.
If you want a more visual representation of the problem, then let me suggest a few graphs from Brad Setser at the time. Setser looked at the Fed's Flow of Funds data. Private sector demand collapsed from roughly 15% of GDP to negative 1%. Meanwhile developing countries, China and Germany were running massive account surpluses. So huge capital inflows (or to use Bernanke's phrase, "global savings glut") and a huge collapse in private sector demand. That doesn't give you I=S. Given global income levels people wanted to save more than was demanded. Since interest rates could not fall below zero the only way to equilibrate investment demand with people's desired saving (partly to repair balance sheets) was for income (i.e., GDP) to fall.
You may have to adjust your browser to see the right part of the charts.
Posted by: 2slugbaits at March 9, 2011 01:53 PM
Are banks indifferent as to whether they hold an asset i.e. a Treasury note, or an equal excess reserve at the Fed? If not why not?
Posted by: Hugh D'Andrade at March 9, 2011 02:34 PM
Ricardo Krugman was talking about Japan in the 90s. If you had bothered to actually read the math in his paper you might have noticed that his point was that merely increasing the amount of monetary base would not generate inflation in Japan because they were in a liquidity trap. That's what a liquidity trap means. In the context of the old IS-LM workhorse it meant the LM curve was flat. Krugman simply used the intuition found in the IS-LM framework and updated it to include an Euler constraint for intertemporal consistency, although I believe he still retained the two asset (bonds/money) world. Anyway, I've heard enough from you to conclude that quoting isn't the same as understanding.
Posted by: 2slugbaits at March 9, 2011 02:54 PM
"However, the situation is not going to stay like this forever."
As long as the Fed keeps paying interest on reserves (as it has since 2008), there is no reason for the situation to change.
Again: reserves do not enable lending, and reducing reserves will not prevent banks from lending.
Poster Qc has it exactly right.
Posted by: Max at March 9, 2011 04:26 PM
I appreciate your response. 2 quibbles:
1) You are presenting a snapshot of a collapse. I believe that prices express the truth & shouldn't papered over but headed.
2) ~half of the "global savings glut" was unsterilized money creation by the Asian & Petro-state CBs: not my idea of savings.
Should I conclude that you approve of our current dissaving--consumption of our seed corn--in the US?
Posted by: Bryce at March 9, 2011 07:10 PM
Re the question "So what happens if (the FED) sell at a loss? Is the amount of the loss just left permanently in the economy as a gift to the banks?
the answer is that the loss is transferred to the Treasury as an offset to the earnings that the FED sends to the FED.
Check out the Fed's 4.1 for Jan. 6, 2011, wherein the FED adjusted its power of offset. I believe the FED always had this power, but offsetting a loss on an asset sale was done annually. IF the FED was going to initiate sales of losing assets on a serious basis, this annual adjustment would not do. If sizable losses occurred and went down to the bottom of the FED's balance sheet, the FED would be hard pressed to say 'yes, our equity may be close (or below) zero, but don't worry, we'll adjust it at the end of the year.'
The new policy allows daily offsets against earnings due to the Treasury.
As Prof. Hamilton points out, the transfer of earnings to the Treasury have been very hefty, as one would expect from the increasing amounts of interest generating Treasury paper on the balance sheet. Thus, the new policy could allow very hefty losses on asset sales to be masked by effectively charging them to the Treasury.
Bottom line - when the FED buys assets on which it might suffer a loss, the Treasury bears the risk.
Posted by: davepowers at March 10, 2011 12:04 PM
re Shan's "well, the chart apparently isn't quite up-to-date enough to show the latest increase in reserve balances, up $200 billion in the past four weeks. In other recent months, if I'm reading this data correctly, the effect on reserves of QE2 purchases was substantially offset either by other asset sales or by increases in US Treasury account balances. So I guess the big expansion really just started this past month."
The existence of the Supplemental Financing program is what provides the FED with an alternative to adding to Bank reserves. Under SFP, the Treasury sells paper raising cash, which it loans to the FED for Fed usage.
A chart of the SFP shows that the FED alternates between using it and reserve crediting. In the initial stages of QE, the Fed borrowed around $550 bn from the Treasury. Then this was wound down, first to $200 bn debt, then to a mere $5 bn. During this time, bank reserves skyrocketed and provided the wherewithal for QE and paying back the Treasury SFP.
In 2010, the FED shifted to SFP mode, ramping up the borrowing to $200 bn. That was the source of QE during 2010. That's why bank reserves didn't escalate during 2010.
In 2011, the FED has shifted back to 'typing' bank reserves. During a three week period in Feb. 2011, bank reserves went up over $200bn, as the FED paid back appox. $75 in the SFP loan, bought approx. $75 in QE/Treasury purchases and another appox. $75 bn in covering Treasury checks for govt. operations.
I wish someone would address the relative impacts of the two alternatives. My amateur guess is that SFP funding has less of an impact, primarily from the Treasury selling short term paper vs. FED buying intermediate term paper. With reserve 'typing', esp. at the scale now being used, I suspect that the impact is much more significant, esp. if the so called reserves provide fuel for stock and commodity speculation.
Posted by: davepowers at March 10, 2011 12:18 PM
I continue to wonder whether the bank reserves at the FED truly 'just sit there.'
Would the masterminds at the banks really allow $1.3 trillion (and growing) reserves to just sit there, when they could utilize complex financial operations to have their cake (interest earning reserves at the FED) and eat it too (utilizing same reserves to finance investment speculation)? And aren't they really clever enough to find a way to do just that?
All it would really take is to apply a securities lending program to the bank reserves, probably via the overnite fed funds lending/borrowing mechanism.
When, for example, a state investment pool (one that takes tax collections from state, local govt, and school districts and invests them in a money market like fund) engages in securities lending, they 'lend' assets from the fund, but are able to keep the assets on their financial statements, AND collect interest on such fixed income investments AND collect a small lagniappe or fee for loaning out the asset. They, so they think, have their cake and eat it too.
Securities lending as described allows all sorts of further investing by the banks and hedge funds involved on the other side of the programs, including shorting operation and stock and commodity speculation.
Why couldn't (and wouldn't) the same investment whizzes apply a similar approach to the supposedly sterile bank reserves?
Posted by: davepowers at March 10, 2011 12:30 PM
Thanks for posting the reference to FEDWIRE.
FEDWIRE is described as allowing reserve transfers as follows: "The Federal Reserve Banks provide the Fedwire Funds Service, a real-time gross settlement system that enables participants to initiate funds transfer that are immediate, final, and irrevocable once processed."
However, the Fed Funds market allows lending and borrowing of reserves, usually due to be resolved overnite (although they can be rolled over or otherwise structured to effectively serve as longer term lending/borrowing).
The FEDWIRE description as allowing final and irrevocable transfers sounds as though it is a different system that Fed Funds which are not irrevocable, but mere loans.
So does FEDWIRE truly capture all the movements and usages of the 'just sitting there' bank reserves?
Posted by: davepowers at March 10, 2011 12:53 PM
davepowers at March 10, 2011 12:53 PM: Fed funds loans are a private contract between banks whereas Fedwire carries a specific instruction from the bank to the Fed. A typical fed funds loan would be associated with two separate Fedwire transactions, a first one on the day of the loan in which the lending bank instructs the Fed to debit its balance and credit the balance of the borrowing bank, and a second one on the day the loan is repaid in which the borrowing bank instructs the Fed to debit its balance and credit the balance of the lending bank.
Posted by: JDH at March 10, 2011 12:58 PM
got it, thanks for that clarification.
Can these sort of transactions be utililized by a bank or bank client (say hedge fund) to support stock/commodity investments. I've seen bank description of the fed funds market as allowing such activity. Combining these loans with repo agreements and other more complex financial arrangements might be included in these sort of activities.
If so, then the growing level of reserves could provide fuel for investment speculation and resulting price inflation.
Your comment notes that there were $2.2 trillion in daily FEDWIRE transactions in 2006 vs. $2.4 trillion more recently. While this activity requires much larger levels of reserves to maintain, this is still a lot of daily transaction. The portion of the $2.4 trillion need not support or relate to all the normal economic operations that we had back in 2006 (which included a highly developed mortgage market).
So long as the daily $2.4 trillion somehow funnels into the more narrow arena of stock and commodity speculation, that might be enough to fuel price inflation in those areas.
Posted by: davepowers at March 10, 2011 01:10 PM
re ASG " but are you not missing how FED money printing is going into the financial economy(and thus trickling into the real economy), via the repo market? Do excess reserves and velocity of money even matter, if everything "repo-able" is being repo-ed at the Fed for this newly printed cash, leveraged at 100x (there is no reg capital requirement for banks on Fed repo), and used to finance and buy derivatives, commodities, and equities, treasuries, etc."
Support for what ASG suggests is found in the fact that banks are allowed to combine Fed Funds lending/borrowing with repo agreements and securities lending in their financial reporting. This makes it less easy to differentiate how much the fed funds market transactions impact financial statements and suggest some kind of link between the three - fed funds, securities lending and repo'ing are joined at the hip for reporting purposes.
For example, the liability side of the Bank of America balance sheet at the end of Spt. 2010 showed $296 bn 'fed funds purchased and securities loaned or sold under agreements to repurchase.' The asset side showed $271 bn for the combined fed funds, securities lending and repo'ing deals.
These are big numbers. Something is going on re: the supposedly just sitting there reserves.
Posted by: Anonymous at March 10, 2011 02:42 PM
Bryce I believe that prices express the truth & shouldn't papered over but headed.
Nominal prices cannot be less than zero even when they should be. That's the problem.
Should I conclude that you approve of our current dissaving--consumption of our seed corn--in the US?
Where are you getting this dissaving nonsense? The central problem is that there is more global savings than there is demand for that savings. The way the economy equilibrates savings and investment with a zero interest rate is to contract income. Were it not for the government soaking up some of that excess saving the recession would be even worse. Did you see Setser's chart of the Flow of Funds data? Private sector demand for investment plunged.
Posted by: 2slugbaits at March 10, 2011 04:27 PM
Slugs are used in a famous method of fishing.
Posted by: aaron at March 10, 2011 05:25 PM
Based on the just issued Fed balance sheet for week of March 10, bank reserves have increased a cool $300 bn in just five weeks. From $1.08 trillion to $1.38.
This covered the lion share of three 'expenditures,' namely $125 bn in paying off the Fed's debt to the Treasury under SFP, appox. $105 bn in QE 2 purchases and $100bn in covering Treasury checks for govt. operations.
Posted by: davepowers at March 10, 2011 05:31 PM
It makes no substantive difference whether the banks holds reserves or treasury securities, it only changes the duration of the assets held. It swaps a longer duration treasury note for a shorter duration federal reserve note, which operationally is like moving money from the banks savings account at the Fed to their checking account at the Fed. No wealth created.
Second, banks do not "lend reserves" in the modern system. They are never reserve constrained, only capital constrained. If banks want to lend, they can -- they do not need "more reserves." The concept of reserves in excess of the reserve requirement is an accounting artificact of a prior era. Loans (based on the banks capital position and demand for loans)create deposits.
Thus, the only thing QE2 can possibly accomplish is to promote a behavioral speculation in risky assets, which is not a recipe for economic growth. The creation of credit through the bank channel is only accomplished through the normal process of borrowing and lending. And this process is not hindered or helped by QE2, or lack thereof.
These are simply long-duration open market operations, but are destined to fail to produce the desired effect because the concept must be based on price rather than quantity. In Fed Funds, the FOMC stands ready to purchase an infinite number of securities to set the rate they want. Under QE2, they only promise to purchase a set quantity. Thus, they have told us they have no control over long rates, which are still market determined.
Posted by: Chad Starliper at March 22, 2011 08:50 AM
RE Chad Second, banks do not "lend reserves" in the modern system. They are never reserve constrained, only capital constrained. If banks want to lend, they can -- they do not need "more reserves." The concept of reserves in excess of the reserve requirement is an accounting artificact of a prior era. Loans (based on the banks capital position and demand for loans)create deposits.
I'd agree if we're talking about routine bank lending for consumer/business lending. However, 'lending' and 'borrowing' of bank reserves at the FED most definitely occurs - it's called Fed Funds market. In 'normal' times it was used to cover reserve shortfalls at banks w same. In these unnormal times, I suggest Fed Funds borrowing is married to securitieslending/repo agreement transactions to provide fuel for hedge fund/bank associate stock and commodity speculation.
Posted by: davepowers at April 1, 2011 11:22 AM
The latest (3-31) Fed balance sheet is out.
Asset side grew by $21 bn due to QE purchases of treasury paper, net of MBS rollover.
Plus Fed had to pay off final installment of the SFP loan from the Treasury ($20 bn) and cover $12 bn in Treasury check for govt. operations.
Net - Fed had to come up with $52 bn for this. They accomplished this by typing up $47 bn in new bank reserves, with balance of cash raised by the recent reverse repo agreements ($4.4 bn) and printing currency (little over $1 bn).
Claims have been made that the reverse repo agreements drain liquidity from the banks, who exchange cash for temporary holding of financial paper (MBS, Treasury) previously on the FED's balance sheet. But the added typed reserves offset any such 'drainage' by a factor of 10-1, so there was not much drainage going on, even if one assumes the reverse repo deals accomplish that purpose.
Posted by: davepowers at April 1, 2011 11:26 AM