could you comment on Gramm & Savings contention in the 8/2 WSJ that the Fed’s reverse-repos shrink the money supply? It has gotten serious pushback in the letters section of today’s WSJ. But if true, it would seem to explain a lot.
I don’t know. Isn’t that sad? I have a Ph.D in economics, and I spent 6 years working at the Fed, and I don’t really understand the intricacies of how it operates these days.
Back in the 1980s, when I read Marcia Stigum’s Money Market, I thought I understood repos and reverse repos. If the Fed is doing a repo, it is buying a security from a dealer that it will sell back to the dealer on a specified date, perhaps in a day, perhaps in a week. In effect, the Fed is lending to the dealer, using the security as collateral. Repo lending is expansionary. When the Fed wants to tweak short-term interest rates down, it does more repo.
Reverse repos have the Fed playing the role of borrower and the Wall Street firm playing the role of lender. As the name suggests, it is a repo in reverse. That would suggest that, all else equal, the Fed doing reverse repos is contractionary.
But nowadays a lot of “monetary policy” comes in the form of regulation, including capital requirements. I gather that regulatory issues may have driven the increase in reverse repos. So I cannot say for sure that the reverse repos are contractionary, because it could depend on how they interact with capital requirements and other regulations.
In general, I regard the Fed as affecting the allocation of capital rather than overall macroeconomic outcomes. The Fed wants to make sure that the government can finance its deficits. That was the original purpose of central banks, and I still think it’s the one that the Fed will be held to. That is why I do not think that the Fed has either the will or the means to stop inflation in the face of persistent, high deficit spending.
perhaps a read of this might be helpful to some:
https://files.stlouisfed.org/files/htdocs/publications/page1-econ/2020/08/03/the-feds-new-monetary-policy-tools_SE.pdf
It is helpful in confirming that I don’t understand, and doubt if any of the politicians really understand, what the Fed is doing, and how it is affecting the money supply.
I think you are over-thinking it. It is contractionary because it removes cash each night from the system and keeps doing so night after night. If it weren’t for the interest on reserves and the reverse repos, banks would have to do something with all that cash deposited with them, or start charging the depositors fees for the accounts, which then means the depositors have to find something to do with the excess cash or just see it eaten away day after day, but then they buy something they think will hold or increase in value, and the seller has the cash and needs to do something with it. This is all short-circuited by the policy tools that keep the cash at the Fed for part of the day or in reserves.
Of course the policy question remains. Why is the Fed engaging in contractionary actions offsetting government intended expansionary policies?
I suspect the goal was to recapitalizate banks after the 2008 financial crisis, and after that it continued as a cushion against future financial crises. Paying interest on reserves in particular serves as a tool to encourage banks to hold reserves well in excess of hard regulatory requirements, while expansionary monetary policy around open market purchases and discount rates serves to offset the contractionary effects of reserve interest.
Another way of looking at it is that the Fed is taking on the direct risk of maturity transformation: before 2008, banks would borrow short-term in the form of demand deposits from checking-account customers and lend long-term in the form of buying Treasury and Agency bonds. Post-2008, the Fed started borrowing short term and lending long term so banks could lend substantial chunks of their balance sheets short-term to the Fed and take a safe middle-man’s profit. This, the next big financial crisis will go much easier on banks while the short end of the stick wind up with the Fed, who as a last resort can print money to stay solvent.
Paying interest on reserves doesn’t really matter for liquidity. The amount of reserves in the system are essentially determined by Fed activities (QE, reverse repo), with slow long term leakage of reserves into currency held by the public.
Separately, the large banks have to follow LCR liquidity regulations, so there’s no need to use interest rates to incentivize banks to be liquid. As I already mentioned, 0.15% is a terrible incentive anyway, as compared to pretty much any other bank investment its a terrible return.
It’s contractionary but only in a weak way. There are so much excess reserves that draining a little out of the system probably doesn’t change things all that much.
Interest on reserves are a paltry 0.15%, which might not even be higher than interest expense on deposits + marginal servicing costs. Banks already have a huge financial incentive to do something else, as high reserve balances depress net interest margin, though to get yield anywhere else involves risk. They could buy 10yr Treasuries for 1.2%, but then if rates increase 1% they lose 7% on those bonds on a mark to market basis. They could try to outbid other banks with lower yields on loans, though then they might not be properly compensated for risk.
Banks are very reluctant to inflict heavy fees or negative interest rates on depositors, probably because if the rate/liquidity environment changed it might become difficult for them to attract reasonably priced deposits. People usually stay with the same bank for a long time, and need things like large cash payments as incentives to go through the pain of switching.
Customers to some degree are like banks. Their bank accounts pay them severely negative real rates. They have a huge financial incentive to do something else with the money, though they probably don’t have great options so they accept a terrible return. If I was given a $10 per month fee to have my bank account, I wouldn’t reduce my deposit balances but I’d consolidate my bank accounts to a single account. I’d imagine most people would be the same. You’d need very severe fees, say -2% negative rates or hundreds of dollars per month for me to pull a lot of money out. But that doesn’t directly increase my personal spending, it just trades the deposit asset on my balance sheet for a cash asset. If anything, high fees/negative rates would make equities/real estate more attractive, so this would add to already rampant asset inflation.
This is a beautiful answer to the commenter’s question. You are not afraid to say that you don’t know, but then you clearly and concisely say what you do know, as well as why what you do know is not a complete answer.
On a broader view, I really appreciate the themes that seem to guide your thinking and writing: intellectual humility, courage to risk unpopularity, logical thinking, respect for facts, and solid human values. I cannot express in words how much you have taught and inspired me over the years since I first encountered your writing. Thank you!
+1
Ditto. Every word of it. : )
Yes, yes!!
If we have globalized capital markets and money is a fungible commodity…then what we are talking about should include context.
What are all the central banks doing?
Can a lone central bank have a significant impact on global capital markets?
Are money-financed fiscal programs a better approach?
The Swiss National Bank has a balance sheet equal to that nation’s GDP. But little inflation. It is an example of a lone central bank that operates in a global environment.
My guess is that orthodox monetary economics was constructed with the idea that a central bank and an economy operated on an island, so to speak.
There is some talk in orthodox monetary economics about exchange rates, but that seems quaint today.
It is too bad that MMT has become conflated with flabby liberal thinking.
If it were up to me the federal government would be cut in half.
But money-financed fiscal programs might be the proper approach to stimulating demand within a defined geographic area, such as the United States.
Since the gov’t decided to bail out the rocket scientists who failed to understand what they were doing in 2008, along with the prior bailout of Nobel prize winning founders of Long Term Capital Management in 1998, I now feel the Fed purpose is mostly to protect most of the rich, tho not always all, from suffering too much from their bad big bets.
https://www.thebalance.com/long-term-capital-crisis-3306240
Inequality will continue getting worse as long as the rich get richer faster than the poor or middle class get richer. Most wealth increases in the last 10 years has come thru asset price increases, driven by investing in those assets by the rich.
When (if??) there is a debt crisis, the rich will claim that they need to be bailed out “or else the economy will collapse!”. So they’ll be bailed out. But unlike other countries, US debt is in US controlled currency, so at any time they can, theoretically, print the currency to pay off the debt. Then the debt owners will have $30 trillion in US dollar currency, and then what? Nobody knows.
I don’t want to find out. I DO want to keep living, and maybe live to see it; so then I do want to find out.
Dow is now $35,000.
What stops it from becoming $350,000?
We could get there and keep inflation low.
Wouldn’t that be totally ahistorical?
And maybe even sort of cool.
Do the securities that the Fed lends to banks have a book value that differs from the money that changes hands? If the Fed can buy and sell securities in these transactions for amounts different from what appears on a bank’s balance sheet, that would explain a lot, and would explain how you could see counterintuitive effects of these transactions.
Are we tallking about M1 or M2. The latter includes money funds, big consumers of repo, and one fo the reasons the Fed continues to offer it (to avoid negative repo rates which would crater the MMF complex).