gonegolfin
Member
My latest missive ...
--
Many financial analysts and financial media have misinterpreted or misunderstood Fed policies and programs during this financial crisis. The principal mistake made has centered around the claim that the Fed has been "printing money" and expanding the money supply to combat the asset deflation we have been experiencing. In other words, unmitigated inflationary monetary policy. The Fed has only recently engaged in the "printing of money" (creating reserves which increases the monetary base) and only has indirect control over the money supply. I want to use this missive to provide an overview of what has happened since the crisis formally erupted in the eyes of the financial media as well as explain my opinion of Fed goals with respect to their operations.
I want to come right out and say that I (and others - see below article) think the principal goal of the Fed is to save the banking system and nurse it back to its former health, but attempt to do so in a non-inflationary manner. Now how can they do this? Or more accurately, how do they think this can be accomplished? ... because I think that they will ultimately fail miserably. Preserving the banking system and all of the benefits it confers to the banking establishment is of primary importance. But the Fed continues to have a significant problem in that the banks continue to be saddled with ill-performing assets on their balance sheets, with other ill-performing assets already being held by the Fed in return for cash or securities lent by the Fed to the banks. Thus, for a period of time beginning late last year and continuing to the present, the Fed engaged in programs that essentially transferred credit risk from the banks to the Fed itself. It did this by establishing various loan programs, such as the Term Auction Facility (TAF) and the TSLF (Term Securities Lending Facility). But the alphabet soup of liquidity programs did not stop there. The lineup expanded dramatically in 2008 and will continue to expand in 2009.
The Fed began its measures late last year and early this year by lending either cash or treasury securities in exchange for ill-performing bank owned assets (such as GSE agency debt and GSE agency mortgage-backed securities). Now, Fed purchases of these ill-performing assets results in an increase in bank reserves (purchases made with newly created money, not treasury securities as in the TSLF), which increases the monetary base (not the money supply). Remember that the monetary base consists of currency in circulation (M0) plus bank reserves (reserve balances plus bank vault cash). The M1 money supply does not include bank reserves. When the Fed purchases securities in the open market, it credits the Federal Reserve reserve account of the selling institution for the amount of the sale (if it is a permanent open market operation) or loan (if it is a temporary open market operation or part of a specialized Fed lending program). This is what is referred to as "creating" or "printing" money. However, the money supply remains unchanged (assuming the securities were assets of the banking system and not being sold on behalf of investors/customers). An increase in the money supply occurs if/when the bank(s) lends off of this newly increased reserve base or chooses to invest these reserves in securities (such as the purchase of treasuries).
But with all of this Fed lending, why were bank reserves mostly not increasing until September of this year? Because the Fed was sterilizing these injections by selling treasuries from its portfolio into the open market. These Fed asset sales drain reserves from the banking system. So, the net effect was that the Fed was mostly swapping good debt (treasuries) for questionable debt (various securities held by the banks that were not receiving bids in the free market) ... with the amount of unsterilized injections exactly enough to result in the federal funds rate trade where it was trading (it was falling as some amount of reserves entered the system). This means that our currency has been increasingly backed (during this time period to the present) by securities of lesser quality on the asset side of the Fed balance sheet (see balance sheet components below). The Fed portfolio of treasuries has sunk from about $780 billion in treasuries to less than $300 billion at present (See Footnote 1 below). But dumping the principal and most stable Fed asset (besides the small amount of Gold stock) was not the cure. The problem was/is much bigger than a few hundred billion dollars of treasuries could solve.
This is when the Fed began to expand its balance sheet (this past September). It did this principally in two ways. First, it temporarily sterilized some of its liquidity operations (such as increased TAF lending) via participation with the Treasury in the Treasury Supplemental Financing Program (TSFP). Here, the Treasury auctioned approximately $559 billion and deposited the proceeds with the Fed in a special Treasury account named the "US Treasury, supplemental financing account". This account is represented on the liability side of the Fed balance sheet along with bank reserve deposits. These auctions drained reserves from the banking system as Treasury securities were being sold (taking in cash) and because the Treasury is not a depository institution (Treasury deposits with the Fed are not bank reserves). Of course, at the same time the Fed was also creating new reserves in the banking system, which outpaced the TSFP drain of reserves. This is the second way in which the Fed expanded its balance sheet (additional unsterilized asset purchases through its lending programs). Thus, the Treasury supplemental financing account at the Fed was increasing along with bank reserves. The TSFP allowed the Fed more flexibility in managing monetary policy and specifically more control over reserve levels (which could lead to inflation of the money supply) while continuing to aid the banks without dumping treasuries from its own portfolio. TSFP balances are now declining as the issued treasuries are maturing (resulting in rising bank reserves), which should increase demand for upcoming Treasury auctions as this money comes free. For those that are interested, you can see a summary of the Fed's latest balance sheet here ... FRB: H.4.1 Release--Factors Affecting Reserve Balances--December 11, 2008.
But the Fed soon had another tool at its disposal, which allowed the Fed to sunset the TSFP. The Fed was granted the authority to pay interest on both required reserves (which helps recapitalize the banks) and excess reserves held at the Fed. Hence, all of the excess reserves created by the Fed that resulted in an explosion of the monetary base over the last three months has been encouraged to stay on deposit with the Fed by Fed interest payments on these excess reserves. The result has been flat to tepid growth in the M1 money supply. Hence, the creation of all of these reserves has yet to lead to the substantial increases in the money supply that folks are expecting. However, the asset side of the Fed balance sheet is becoming less and less stable. That is certainly not good for the currency.
All of this is a lead-in to an excellent article written by Michael Rozeff entitled "Federal Reserve bond Sales?". It was a refreshing read as Mr. Rozeff truly understands the mechanics and plumbing of Fed operations. He discusses a supposed proposal by the Fed that has worked its way into the media that involves the sale of Federal Reserve interest bearing debt. In other words, Federal Reserve bonds. The Fed issues debt today, but it is non-interest bearing debt. That is, the Federal Reserve Notes you hold in your wallet or purse. But these proposed Fed bonds would be interest paying debt obligations that would certainly compete with Treasury securities. Who would buy these bonds? I agree with Mr. Rozeff in that only troubled banks (banks receiving help from the Fed) would purchase these securities. I also think it would also require some level of coercion. Such as ... you either buy these Fed bonds or we will not roll over your TAF loans.
So, obviously, this would be another tool that the Fed could use to drain reserves (debit reserve accounts) from the banking system (legal issues aside) ... reserves that were created by continued purchases of questionable assets from the banks in return for cash (credited to reserve accounts). Thus, an attempt to control the size of bank reserves and keep inflation (expansion of the money supply) in check while moving questionable assets from the banks to the Fed. As Mr. Rozeff explains, there is the potential for a continued cycle of Fed asset purchases (injecting bank reserves) followed by the issuance of Fed bonds (draining reserves). The issuance of Fed bonds would essentially be the refinancing of the liability side of the Fed balance sheet. That is, refinancing recently created bank reserves into Fed bonds. This would allow the Fed to continue expanding the size of its balance sheet in a non-inflationary manner, while resuscitating the banks. Of course, this comes at a severe cost and is why I think it will ultimately fail. The Fed cannot continue to diminish the quality of the asset side of its balance sheet as this is what backs the outstanding currency in the system, the bank reserves, and ultimately the money supply. It is a dangerous game the Fed is playing. And we have a front row seat.
The following is a very "dumbed down" version of the Fed balance sheet, but is still quite useful in understanding what I have presented as well as the content in Mr. Rozeff's article.
Principle Components of the Federal Reserve Balance Sheet
Assets
* Treasuries
* Repurchase Agreements (temporary loans for collateral used to help manage the Fed funds target)
* Loans
o Term Auction Facility (TAF)
o Term Securities Lending Facility (TSLF)
o Commercial Paper Funding Facility (CPFF)
o Discount Window (Primary Credit)
o Other Loans (such as AIG loans, Primary Dealer Credit Facility, Maiden Lane LLCs)
* Currency Swaps (with foreign central banks)
* Gold stock
* Misc and other Fed assets
Liabilities
* Currency in Circulation (Federal Reserve Notes)
* Bank Reserves on deposit with the Fed
* Reverse Repurchase Agreements
* Federal Reserve deposits, other than reserve balances (TSFP, General Treasury account)
* Other Misc.
"Federal Reserve Bond Sales?" by Michael Rozeff
Federal Reserve Bond Sales? by Michael S. Rozeff
Footnote 1: The Fed actually reports approximately $476 billion of treasuries on the asset side of its balance sheet. However, the TSLF loans (lending of treasury securities in return for acceptable collateral) are represented as off-balance sheet items. Accounting for the outstanding TSLF balance leaves the Fed with less than $300 billion in treasuries.
Brian
--
Many financial analysts and financial media have misinterpreted or misunderstood Fed policies and programs during this financial crisis. The principal mistake made has centered around the claim that the Fed has been "printing money" and expanding the money supply to combat the asset deflation we have been experiencing. In other words, unmitigated inflationary monetary policy. The Fed has only recently engaged in the "printing of money" (creating reserves which increases the monetary base) and only has indirect control over the money supply. I want to use this missive to provide an overview of what has happened since the crisis formally erupted in the eyes of the financial media as well as explain my opinion of Fed goals with respect to their operations.
I want to come right out and say that I (and others - see below article) think the principal goal of the Fed is to save the banking system and nurse it back to its former health, but attempt to do so in a non-inflationary manner. Now how can they do this? Or more accurately, how do they think this can be accomplished? ... because I think that they will ultimately fail miserably. Preserving the banking system and all of the benefits it confers to the banking establishment is of primary importance. But the Fed continues to have a significant problem in that the banks continue to be saddled with ill-performing assets on their balance sheets, with other ill-performing assets already being held by the Fed in return for cash or securities lent by the Fed to the banks. Thus, for a period of time beginning late last year and continuing to the present, the Fed engaged in programs that essentially transferred credit risk from the banks to the Fed itself. It did this by establishing various loan programs, such as the Term Auction Facility (TAF) and the TSLF (Term Securities Lending Facility). But the alphabet soup of liquidity programs did not stop there. The lineup expanded dramatically in 2008 and will continue to expand in 2009.
The Fed began its measures late last year and early this year by lending either cash or treasury securities in exchange for ill-performing bank owned assets (such as GSE agency debt and GSE agency mortgage-backed securities). Now, Fed purchases of these ill-performing assets results in an increase in bank reserves (purchases made with newly created money, not treasury securities as in the TSLF), which increases the monetary base (not the money supply). Remember that the monetary base consists of currency in circulation (M0) plus bank reserves (reserve balances plus bank vault cash). The M1 money supply does not include bank reserves. When the Fed purchases securities in the open market, it credits the Federal Reserve reserve account of the selling institution for the amount of the sale (if it is a permanent open market operation) or loan (if it is a temporary open market operation or part of a specialized Fed lending program). This is what is referred to as "creating" or "printing" money. However, the money supply remains unchanged (assuming the securities were assets of the banking system and not being sold on behalf of investors/customers). An increase in the money supply occurs if/when the bank(s) lends off of this newly increased reserve base or chooses to invest these reserves in securities (such as the purchase of treasuries).
But with all of this Fed lending, why were bank reserves mostly not increasing until September of this year? Because the Fed was sterilizing these injections by selling treasuries from its portfolio into the open market. These Fed asset sales drain reserves from the banking system. So, the net effect was that the Fed was mostly swapping good debt (treasuries) for questionable debt (various securities held by the banks that were not receiving bids in the free market) ... with the amount of unsterilized injections exactly enough to result in the federal funds rate trade where it was trading (it was falling as some amount of reserves entered the system). This means that our currency has been increasingly backed (during this time period to the present) by securities of lesser quality on the asset side of the Fed balance sheet (see balance sheet components below). The Fed portfolio of treasuries has sunk from about $780 billion in treasuries to less than $300 billion at present (See Footnote 1 below). But dumping the principal and most stable Fed asset (besides the small amount of Gold stock) was not the cure. The problem was/is much bigger than a few hundred billion dollars of treasuries could solve.
This is when the Fed began to expand its balance sheet (this past September). It did this principally in two ways. First, it temporarily sterilized some of its liquidity operations (such as increased TAF lending) via participation with the Treasury in the Treasury Supplemental Financing Program (TSFP). Here, the Treasury auctioned approximately $559 billion and deposited the proceeds with the Fed in a special Treasury account named the "US Treasury, supplemental financing account". This account is represented on the liability side of the Fed balance sheet along with bank reserve deposits. These auctions drained reserves from the banking system as Treasury securities were being sold (taking in cash) and because the Treasury is not a depository institution (Treasury deposits with the Fed are not bank reserves). Of course, at the same time the Fed was also creating new reserves in the banking system, which outpaced the TSFP drain of reserves. This is the second way in which the Fed expanded its balance sheet (additional unsterilized asset purchases through its lending programs). Thus, the Treasury supplemental financing account at the Fed was increasing along with bank reserves. The TSFP allowed the Fed more flexibility in managing monetary policy and specifically more control over reserve levels (which could lead to inflation of the money supply) while continuing to aid the banks without dumping treasuries from its own portfolio. TSFP balances are now declining as the issued treasuries are maturing (resulting in rising bank reserves), which should increase demand for upcoming Treasury auctions as this money comes free. For those that are interested, you can see a summary of the Fed's latest balance sheet here ... FRB: H.4.1 Release--Factors Affecting Reserve Balances--December 11, 2008.
But the Fed soon had another tool at its disposal, which allowed the Fed to sunset the TSFP. The Fed was granted the authority to pay interest on both required reserves (which helps recapitalize the banks) and excess reserves held at the Fed. Hence, all of the excess reserves created by the Fed that resulted in an explosion of the monetary base over the last three months has been encouraged to stay on deposit with the Fed by Fed interest payments on these excess reserves. The result has been flat to tepid growth in the M1 money supply. Hence, the creation of all of these reserves has yet to lead to the substantial increases in the money supply that folks are expecting. However, the asset side of the Fed balance sheet is becoming less and less stable. That is certainly not good for the currency.
All of this is a lead-in to an excellent article written by Michael Rozeff entitled "Federal Reserve bond Sales?". It was a refreshing read as Mr. Rozeff truly understands the mechanics and plumbing of Fed operations. He discusses a supposed proposal by the Fed that has worked its way into the media that involves the sale of Federal Reserve interest bearing debt. In other words, Federal Reserve bonds. The Fed issues debt today, but it is non-interest bearing debt. That is, the Federal Reserve Notes you hold in your wallet or purse. But these proposed Fed bonds would be interest paying debt obligations that would certainly compete with Treasury securities. Who would buy these bonds? I agree with Mr. Rozeff in that only troubled banks (banks receiving help from the Fed) would purchase these securities. I also think it would also require some level of coercion. Such as ... you either buy these Fed bonds or we will not roll over your TAF loans.
So, obviously, this would be another tool that the Fed could use to drain reserves (debit reserve accounts) from the banking system (legal issues aside) ... reserves that were created by continued purchases of questionable assets from the banks in return for cash (credited to reserve accounts). Thus, an attempt to control the size of bank reserves and keep inflation (expansion of the money supply) in check while moving questionable assets from the banks to the Fed. As Mr. Rozeff explains, there is the potential for a continued cycle of Fed asset purchases (injecting bank reserves) followed by the issuance of Fed bonds (draining reserves). The issuance of Fed bonds would essentially be the refinancing of the liability side of the Fed balance sheet. That is, refinancing recently created bank reserves into Fed bonds. This would allow the Fed to continue expanding the size of its balance sheet in a non-inflationary manner, while resuscitating the banks. Of course, this comes at a severe cost and is why I think it will ultimately fail. The Fed cannot continue to diminish the quality of the asset side of its balance sheet as this is what backs the outstanding currency in the system, the bank reserves, and ultimately the money supply. It is a dangerous game the Fed is playing. And we have a front row seat.
The following is a very "dumbed down" version of the Fed balance sheet, but is still quite useful in understanding what I have presented as well as the content in Mr. Rozeff's article.
Principle Components of the Federal Reserve Balance Sheet
Assets
* Treasuries
* Repurchase Agreements (temporary loans for collateral used to help manage the Fed funds target)
* Loans
o Term Auction Facility (TAF)
o Term Securities Lending Facility (TSLF)
o Commercial Paper Funding Facility (CPFF)
o Discount Window (Primary Credit)
o Other Loans (such as AIG loans, Primary Dealer Credit Facility, Maiden Lane LLCs)
* Currency Swaps (with foreign central banks)
* Gold stock
* Misc and other Fed assets
Liabilities
* Currency in Circulation (Federal Reserve Notes)
* Bank Reserves on deposit with the Fed
* Reverse Repurchase Agreements
* Federal Reserve deposits, other than reserve balances (TSFP, General Treasury account)
* Other Misc.
"Federal Reserve Bond Sales?" by Michael Rozeff
Federal Reserve Bond Sales? by Michael S. Rozeff
Footnote 1: The Fed actually reports approximately $476 billion of treasuries on the asset side of its balance sheet. However, the TSLF loans (lending of treasury securities in return for acceptable collateral) are represented as off-balance sheet items. Accounting for the outstanding TSLF balance leaves the Fed with less than $300 billion in treasuries.
Brian
