Fed's Actions: Less Than Meets the Eye

I’ve been puzzling about the recent Fed actions, and I think there is less there than meets the eye. Don’t get me wrong, the Fed has acted. It is changing the composition of its balance sheet in the short run, absorbing MBS, and pushing out Treasuries. But it is not expanding its balance sheet. After several novel policy initiatives, it should be painfully obvious to Fed-watchers that the lack of increase in the monetary base is intentional.

The Fed is trying to influence financing in the residential mortgage market versus Treasuries, in the short run. It is not trying to stimulate the economy through expanding the monetary base.

The short-run aspect of the program hobbles it to some degree. The Fed can say that they will continue to finance in the short term indefinitely, but nothing says that louder than expanding the terms from 28 days to two years. If it’s in the agreement, the expanded length of financing will get a much bigger result than a rolling four week window. Think of it this way: the Fed might want to continue the short-term financing indefinitely, but there have been times in the past where the Fed has felt forced to abandon a plan because of global macroeconomic events (think 1986-7, when the dollar fell, then the bond market fell, then the stock market fell…). Promises are one thing, contractual terms are another.

I’m not a fan of central banking, but if we are going to have central banking, this is a time when the monetary base should be expanding, at least modestly. I think the Fed in this case is being “too clever” and needs to do a permanent injection of liquidity. If they don’t want to do that, well, let’s move back to the gold standard, and privatize monetary policy.

Comments

[Tony Soprano]

"I think the Fed in this case is being “too clever” and needs to do a permanent injection of liquidity. If they don’t want to do that, well, let’s move back to the gold standard, and privatize monetary policy."

Good Golly Miss Molly your comments are about as conservative and sane as Little Richard's music.

The Fed is doing just fine and their timing yesterday was impeccable. Sandy Koufax could not have thrown a better curve ball at the markets. Their is no silver bullet but only patience.

[Jack Yetiv]

I wondered about the 28-day period as well. I can think of two reasons for it.

First, some people even doubt whether the Fed has the authority to take the action it did. Therefore, from a legal perspective, the Fed does not want to be bound to perform for 2 years things it may not be allowed to do at all.

Second, the Fed knows that to rescue the credit markets, it has to act quickly, so it is instituting either a "time-out" (if you have children) or a 28-day "automatic 362 stay" (if you are a bankruptcy lawyer). However, at the end of the 28 days, after it has some time to sort out the collateral it gets, the Fed wants to be able to NOT roll-over some of the credit it extends on assets that don't deserve it so as to decrease the hit to the taxpayers.

Jack Yetiv

[lex]

bernanke is just making up for lost time, since every time he testifies he gets an earful from the senators for not being proactive enough. the truth he doesnt no how to solve the problem. this time next year we will have a new Fed chairman, a bust housing mkt and a full blown depression. maybe bernanke bought a whole load of index futures before annoucing the move. thats the only way he will get paid.

[cyberman]

The fed has become the pawn shop of last resort. Unfortunately as taxpayers we own the shop. And a 9 year old is in charge of the shop. Its name is: Junior's Proactive Pawn Shop

He just extended your credit to a very uncreditworthy persons who convinced him the world would collapse if he did not accept two bags of sand in exchange for billions of your dollars. He was told there were a few flakes of gold in them thare bags.

Good luck taxpayers. Just get ready to buy more bags of other people's mistakes. Taxpayer bailout or those who probably belong in jail. Put an out of business sign on the pawn shop. Chain the doors shut.

[flow5]

People who don't know anything about money & central banking pontificate that the monetary base [sic] is a base for the expansion of money & credit. But in today's world, neither the monetary base, "free gratis" legal reserves, or an expansion in the Federal Reserve's balance sheet are indicative of a "restrictive"... or "binding" FOMC policy.

The "base" for the expansion of money, the "money multiplier", the supply of our "means-of-payment... and monetary flows (MVt) are all unknown and unknowable.

[warrenmosler]

mostly agree with flow 5

with today's non convertible currency fed action is about 'price' (interest rates) and not 'quantity.'

nothing they do alters net financial assets.

unfortunately even the fed doesn't quite get it, or, for example, they wouldn't set quantities for the taf or have an auction. they would just announce a target rate and clear all takers at that rate.

and, as above, net system wide reserves would not change.

[iThinkBig]

They would have been better off dumping $200 B in the Small Business Administration to oversee banks/loans for small businesses.

The fattest cat bankers are still in charge, almost no firings and it's disgraceful. May as well give it to the small guy because to him, it's do or die out there right now and investors were waiting for the next Google and parking money. So you have a ton of fantastic entrepenuars with no way to get funds.

I have been under this pressure before as a business owner and entrepenuar. Nothing like performance when it's all or nothing and you're families butt is on the line. Plus, 80% of this economy is small business.

[lex]

Hey Tony Saprano...how u doing now DJ futures down big.

[Tony Soprano]

Here is an analogy ...your teenager has maxed out their credit cards and is to a point they can no longer make payments. You step in as a co-signer and get the limits on the cards doubled.

Is this the right decision? This is what the Fed did for the banks yesterday. from Mr. NoFate

______________________...


It’s a good simple story and to a large degree I agree with your story. Here is my view of the story.

The son does use a credit card but instead of spending it on himself he wants to lend out the money and become loan shark. His idea is to lend out as much money that he can. In the mean time people that he is lending out to all live on an island. The island depends on a dike system to keep the island from going underwater. The dikes take an enormous amount of power to run. The islanders are taxed a lot to keep the power going..

The loan business is slow starting and the son wants it to grow much faster. His rich daddy is still backing him up and thinks his son is remarkable. The son's new business plan offers loan owners interest in a new waterfront country club if they barrow more. They see it as a steal and it makes them feel rich so they barrow more. His new business plan is a success for many years. The new country club is well under construction. Most of the people on the island are happy and think they have it made. The son pockets a good deal of wealth but he always wants more and more.

As more time passes, the cost of the power to run the dikes starts to increase rapidly. Sadly some of the islanders become sick. The doctors on the island suspect the Avian virus. Some even die and others cannot work. Unemployment starts to rise dramatically and the power for the dikes continues to rise.

Not all of the islanders owe money to the son. Many are still wealthy and never liked what the son has done and they are very much concerned about the rising cost to power for the dikes. More time passes and construction cost for the country club increases as well. Construction on the project starts to slow down. Many on the island start to become angry.

Taxes receipts to pay for the power for the dikes starts to diminish. Some of the islanders want to raise taxes to pay for the power. The islanders that are sick are not paying taxes. A meeting is called. The meeting is a failure and the son goes into hiding. However, the islanders come up with another plan but still many on the island do not like the newer plan as well

The newer plan requires the islanders to barrow more money but from the mainland. The wealthy on the island do not like this plan because it will require them to pay more taxes in the future. However, some of the middle class people on the island become restless and crime increases.

The islanders are at a serious crossroad. Damned if they do and damned if they don’t. Many on the island say the island will sink completely underwater if new monies are not borrowed. Others do not agree and feel the island will be on okay without the additional debt.

I’m not going to finish this story. I will let your imagination do the rest.

But my point is we can let GM or Ford go under and we will still have cars. However, we cannot take this chance with the banks. Banks are the corner stone, hence the island metaphor, of our capitalism. If the banks sink we all sink. We cannot afford to take the slightest chance that this will spread further and sink us all. At the same time it’s a shame that a lot of our mortgage companies, brokerages firms and money center banks let this happen.

[flow5]

It isn't within the power or responsibility of the Federal Reserve to hold unemployment or even Gross Domestic Product to "tolerable" levels. In fact, to assume that the Federal Reserve can solve our unemployment problems is to assume the problem is so simple that its solution requires only that the Manager of the Open Market Account buy a sufficient quantity of U.S. obligations for the accounts of the 12 Federal Reserve banks. This is utter naivete.

[flow5]

Stop the Bullshit:

Flawed as the AMBLR figure is (Adjusted Member Bank Legal Reserves), it is still far superior to the Domestic Adjusted Monetary Base (DAMB) figure, which is generally cited. The DAMB figure includes AMBLR plus the volume of currency held by the nonblank public (Milton Friedman’s “high powered money”).

Since the public determines its holdings of currency an expansion or contraction of DAMB is neither proof that the Fed intends to follow an expansive, nor a contractive monetary policy. Furthermore any expansion of the nonblank public’s holdings of currency merely changes the composition (but not the total volume) of the money supply. There is a shift out of demand deposits, NOW or ATS accounts into currency. But this shift does reduce Member Bank Legal Reserves by an equal or approximately equal amount.

Since the member commercial banks operate with no excess legal reserves of consequence since 1942, any expansion of the publics holdings of currency will cause a multiple contraction of bank credit and checking accounts (relative to the increase in currency outflows from the banks) ceteris paribus. To avoid such a contraction the Fed offsets currency withdrawals by open market operations of the buying type. The reverse is true if there is a return flow of currency to the banks.

Since the trend of the non-bank public’s holdings of currency is up (ever since the 1920’s), return flows are purely seasonal and cannot therefore provide a permanent basis for bank credit and money expansion.

In our Federal Reserve System, 90 percent of MO (domestic adjusted monetary base) is currency. There is no money multiplier for currency And the currency component of MO is so prominent, and the proportion of legal reserves so negligible (and declining); that to measure the rate of change in currency held by the non-bank public, to the rate of change in M1 (where 54% is currency), is, yes, to measure currency vs. currency (cum hoc ergo propter hoc); in probability theory and statistics, not a cause and effect relationship.

Complicating the measurement of the monetary base is the fluctuation in the percentage of foreign currency circulation to domestic currency circulation (estimated at ½ to 2/3 of all U.S. currency). I.e., the domestic monetary source base equals the monetary source base minus the estimated amount of foreign-held U.S. currency. Inflows and outflows of foreign-held U.S. currency (seldom repatriated) are related to political and price instability, as well as seasonal flows; and all are immeasurable in the short run...

The “shipments proxy” estimate of foreign-held U.S. currency uses data on the receipts and shipments of currency, by denomination, at the Federal Reserve’s 37 cash offices nationwide (note: > 80 percent of foreign-held U.S. currency are $100.00 bills). Because of its influence on the DAMB, quarterly estimates of foreign-held U.S. currency are reported in the Feds “Flow of Funds Accounts of the United States” & in the BEAs estimates of the net international investment position of the United States.

The volatility of the K-ratio (publics desired ratio of currency to transactions deposits), and the volatility in the ratio of foreign-held to domestic U.S. currency, both influence the forecast of the (1) cash drain factor, and (2) the movement of the domestic currency component of the DAMB. This causes unpredictable shifts in the money multiplier (MULT – St. Louis), [sic], for M1 and thus M2.

The Federal Reserve Bank of Chicago uses legal reserves (“t”-accounts), exclusively, to explain the creation of new money in the booklet “Modern Money Mechanics”. The booklet is a workbook on bank reserves and deposit expansion. The stated purpose of the booklet is to “describe the basic process of money creation in a "fractional reserve" banking system” The monetary base plays no such role.

It is therefore both inaccurate in practice, and incorrect in theory, to refer the DAMB figure as a monetary base [sic]. The only base for an expansion of total bank credit and the money supply is the volume of legal reserves supplied to the member banks by the Fed in excess of the volume necessary to offset currency outflows from the banking system. The adjusted member bank legal reserve figure is that base.