Thursday, August 12, 2010

"We don't know what we are doing"--the Fed

The Federal Reserve has two basic problems right now. First, those running the Fed don’t know what they are doing. Second, they are doing a terrible job explaining this to the world.

Never have I seen such confusion in such an important institution. Never have I seen such inadequate leadership.

We have experienced the end of the Fed’s exit strategy, the effort undertaken by the Fed to reduce the size of the Fed’s balance sheet. The exit strategy was designed to reduce the massive amounts of reserves pumped into the financial system by the Fed so that a period of hyper-inflation would not result. That exit strategy saw the Fed’s balance sheet grow by $331 billion over the twelve-month period the “exit” strategy was in place. Excess reserves held by the banking system rose by 38% during the same time period.

One can only imagine what the end to the "exit strategy” will mean for bank reserves.

So, the Fed is now not going to let its balance sheet decline. As securities mature it will replace those securities with newly purchased securities. Impact is “net zero” on the balance sheet. If the economic recovery does not pick up steam or if it stalls or even declines, the Fed will purchase even more securities resulting in a further increase in bank reserves.

The reason for this change in focus? Well, the Fed has observed that the economy is moving more slowly than previously thought.

This is the Fed and the Fed leadership that continued to fight inflation as the housing market tanked and financial institutions balanced on the edge of collapse. The Fed seems to have totally missed the August 2007 meltdown of hedge funds failing to act until September 2008. Then, in the fall of 2008, Bernanke panicked and we got the infamous TARP legislation and an inconsistent mish-mash of bailouts that “saved the financial system.” (

The Fed continues to frame its statements in terms of the weakness of the economy. However, in the statement released after the last meeting of the Open Market Committee the Fed admits that “Bank lending has continued to contract.”

This is all the attention the Fed gives to the banking system; the industry which the Fed supposedly knows intimately? And, this banking system has over $1.0 in excess reserves and is not lending? This banking system that has 775 banks on the FDIC’s list of problem banks? This banking system that Elizabeth Warren claims has 3,000 banks facing severe solvency problems? This banking system that has one out of every 2 banks in it in trouble?

The statements of the Fed just don’t coincide with what people and the financial markets see out in the real world.

There seems to be a significant disconnect between what is going on in the Federal Reserve and what is going on in the world. Damn those econometric models!!!

We got where we are because the Fed didn’t understand what was happening and then threw everything it could against the wall to see what would stick. I fear that we are experiencing déjà vu all over again!


Flow5 said...

(1)The BOG's remuneration rate @ .25% on excess reserves (interbank demand deposits - IBDDs), held at the District Reserve Banks, owned by the member banks, now exceeds the Daily Treasury Yield Curve (from 6 months), to now all the way out to 1 full year.

In effect, the FED has tightened monetary policy as IORs (interest on reserves), are the functional equivalent of required reserves.

I.e., an increase in the volume of outstanding un-used IBDDs (other things being equal), acts just like an increase in the volume of required reserves would; both types of reserve balances decrease the legal lending capacity of the member commercial banks (by siphoning the funds out of the commercial banking system).

Note: the Board of Governors of the Federal Reserve System (BOG) defines legal reserve requirements as: "the amount of funds that a depository institution must hold in reserve against specified deposit liabilities". Bank reserves are held as vault cash & as District Reserve Bank deposits.

I.e., the FED has doubled the maturity distribution (based on Treasury securities), now covered under the level of the remuneration rate (in just the last couple of months).
By increasing the variety, and thus the volume, of competitive instruments and yields (vis a' vis IORs), the FED makes it less and less likely that the member banks will want to make new loans or purchase new investments (i.e., it is less and less likely that the money supply will grow).

Note: every time a commercial bank makes a loan to, or buys securities from, the non-bank public, it initially creates an equal volume of new money.
This senario is contractionary.

It belies a downward contraction, and a cumulative and reinforcing, deflationary spiral, i.e., credit destruction. It belies a full scale induced depression.

Flow5 said...

(2) Consumer credit (revolving & non-revolving) has teadily declined from Dec. 2008 ($2,594,109T) to Jun. 2010 ($2,400,973T), or by ($193,131b), at the same time currency and demand deposits have steadily grown.

So how does the volume of consumer credit decrease, while the M1 money stock increases? (every time a commercial bank makes a loan to, or buys securities from, the non-bank public, it creates initially, an equal volume of new money). Part of the answer must be dis-savings.

Flow5 said...

(3) Another overlooked deflationary development is that: when the dis-savers tap into their accumulated savings, and in the process, shift their prior balances, from interest-bearing deposits, into transaction deposits, the FED automatically applies a higher level of required reserves to these residual liabilities.

Given $10,000 of beginning (total), deposits (including all savings), and the transfer of $500 dollars into, at once, reservable liabilities (from prior savings accounts), the FED has unwittingly tightened credit conditions.

There are still $10,000 of total system deposists, however, now an additional $500 has been lumped with whatever transaction deposits there were in the beginning (before tapping into their savings), but then the member banks now must hold aside new idel required reserves deposits.

And the money supply is likely further reduced as a result (if this contraction is not offset with added Federal Reserve Bank Credit). See H.4.1 Factors Affecting Reserve Balances

Flow5 said...

(4) Duiring Dec 1990, the reserve ratio for non-transaction (non-personal and time and savings deposits), was reduced from 3 percent to 0 percent. The reserve ratio on net euro-currency liabilities was also eliminated (reduced from 3 percent to 0 percent).

Then, in April 1992, the reserve ratio on transaction accounts was reduced from 12 percent to 10 percent.

These legal reserve requirements were reduced or eliminated because "LENDERS HAD ADOPTED A MORE CAUTIOUS APPROACH TO EXTENDING CREDIT". This caution was exerting a restraining effect on the cost and availability of credit. To some types of borrowers. By reducing depository funding costs and thus providing borrowers with easier access to capital markets, the cuts in reserve requirements were designed to put the banks in a better position to extend credit.

In particular the cut to the requirement on non-personal time deposits was aimed directly at spurring bank lending because these accounts are often used as a marginal funding source. Of course it was recognized that some, but not all, of the benefits stemming from reserve requirement cuts would likely be passed, over time, to borrowers and lenders.

Flow5 said...


Under Public Law 109-351-OCT. 13, 2006

On October 1, 2011 the Financial Services Regulatory Relief Act of 2006

(under the "increased flexibility for the Federal Reserve Board to Establish Reserve Requirements) states in Section 19(b)(2)(A) of the Federal Reserve Act (12 U.S.C) 461(b)(2)(A) is amended:

(2) in clause (ii), by striking "and not less than 8 per centum," AND INSERTING "(and which may be ZERO)".

The FED has been trying to eliminate this tax [sic] for the last 31 years. But on the basis of any given increase in excess reserves (when reserves were binding), the member banks created a multiple volume of new money and credit and in the process acquired a multiple expansion of new bank earning assets (what a racket).

Flow5 said...

(6) Consumers have been tapping their savings (now their largely tapped out). In the process, bank customers have been shifting their balances from interest bearing savings accounts into primarily -demand deposits. This represents, for the most part, a one-time transaction, from non-m1, into m1 deposit classifications.

The Great Recession’s dis-savings is analogous to the "time bomb" that took place in the 1st qtr of 1981 (with the widespread introduction of ATS, NOW, & MMMF accounts which produced 19.2% increase in gNp in the 1st qtr). It is a velocity relationship.

After people have initially dipped into their accumulated savings, and after a time lag, the effect of this liquidation and their spending behavior, eventually has to die out.

Because of the magnitude of the previous dis-savings (and nothing to replace it), and for this reason standing alone, we can expect another downswing.

I.e., this "dis-savings" proportionately, is akin to monster QE stimulus - that is now expiring. That is from a monetarist point of view, aggregate monetary demand is completely collapsing

Anonymous said...