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Lawrence J. Kramer

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  • What Does A Central Bank Do When A Central Bank Can't Do Anything? [View article]
    "Does the Fed's underwriting quality lessen when it issues more of its liabilities into the system? "

    Not necessarily, but maybe. So long as the Fed is buying Treasuries, its underwriting standards remain unaffected. Once it starts relying on values and credit - with RMBS, say - its underwriting risk increases, but the quality of its underwriting does not necessarily fall. Everything can be priced for; bad underwriting means inadequate pricing, not a decline in quality of credit.
    Sep 19 11:45 AM | 1 Like Like |Link to Comment
  • What Does A Central Bank Do When A Central Bank Can't Do Anything? [View article]
    "Are interest rates tied to underwriting quality in some form, e.g. if the underwriting quality goes down, does it require higher interest to compensate for the extra risk? "

    Interest rates are always as high as the market will allow. Lower underwriting quality would result in lower bank profits, loss of capital, loss of capacity, and, perhaps, then, higher rates. But I don't believe the dominoes would be allowed to fall that far...
    Sep 19 11:27 AM | 1 Like Like |Link to Comment
  • The Worst Call Of The Last 5 Years [View article]
    "But every serious economist (not trader) should be interested in what will happen when the fed starts to increase rates and sells assets to draw liquidity and how this will affect the economy."

    And so they are. But they are interested in the conditions that will prompt the Fed to raise rates. How much stronger will the economy be? What will tax revenues look like? Unless you put the board in motion and look at the situation dynamically, you cannot draw any inferences about outcomes. Fed rates should always be a non-event, an exercise in leading from behind by anticipating where the market "wants" rates to be, i.e., by putting rates where they will not prevent modest, predictable inflation from occurring.

    "Isn't this monetizing debt in your view?"

    The "money supply" is only a useful stat to the extent it correlates with the aggregate propensity to spend. Otherwise, why would we want to know it? The correlation between the money supply and the propensity to spend arises from the opportunity cost of holding money. The more it costs to hold money, either in lost interest or lost value, the more readily we can infer from someone's holding money that he is about to spend it. When interest rates and inflation are both low, the opportunity cost of holding money drops, and the signal flashed by the money supply becomes unreliable.

    Some economists make the same point through the concept of "moneyness." Low-paying treasury debt is already "almost money" in the minds of many who hold it. Such instruments are the first thing one sells if one needs some cash. Thus "monetizing" such debt has very little effect on aggregate demand. So, yes, the Fed is monetizing debt, but the more debt it monetizes, the less effect the monetization has on the national propensity to spend.

    It also makes a difference whether the debt is being "bought" by the Fed or "sold" by its owners. If prices of financial instruments are rising because the Fed has gone on a buying spree, we can infer less about aggregate demand from the liquidation of holdings than if prices are falling because people are getting liquid in order to spend. In either case, the Fed monetizes debt, but the inferences to be drawn are completely different.

    In short, the "money supply" is only a proxy for aggregate demand, and it is only as good a proxy as varying circumstances permit. Today, it's not worth much as an indicator. If and when interest rates rise, it will be more useful.
    Sep 19 11:08 AM | 1 Like Like |Link to Comment
  • What Does A Central Bank Do When A Central Bank Can't Do Anything? [View article]
    "The Fed’s new authority gave policymakers another tool to use during the financial crisis. Paying interest on reserves allowed the Fed to increase the level of reserves and still maintain control of the federal funds rate."

    Yes, it said it, but you are misreading it. The new tool was IoER, which enabled the Fed to buy more bonds to lower long-term rates without losing control of the overnight rate. There is no implication that the reserves were the goal. The ability to pay interest ON the RESULTING reserves was what mattered. At least, that seems to me a fair enough reading that merely quoting the language gets you nowhere. (I agree with Sleek's rewording as more accurately expressing the speaker's intent, and I agree with the speaker's decision not to waste his breath saying what Sleek says he meant.)

    I don't deny that QE 1 was about creating liquidity when the markets froze. The target there was to create reserves so that banks would not have to borrow from each other. But after the liquidity crisis passed, Operation Twist et al. created even more reserves, and those were not a Fed purpose. If you are referring to early QE, I agree with your position.
    Sep 19 10:21 AM | 1 Like Like |Link to Comment
  • What Does A Central Bank Do When A Central Bank Can't Do Anything? [View article]
    "What if the Fed did not pay the IoER? Would that make interest rates go up?"

    No, it would make the underwriting quality go down.

    Deposits are a source of funds. Unless a bank needs funds to honor withdrawals from the accounts created by its loans, it does not need deposits. Thus, a bank that is not making loans provides depository services at a cost to the bank. To recover the cost, the bank can charge depositors for holding their money, or the bank can make loans that require deposits and pay interest. But a bank does not have an unlimited supply of loans it can make. In "normal" times, the bank turns to the Treasury and "lends" Uncle Sam some money by buying T-Bills. That enables the bank to accept deposits without losing money on the cost of servicing them.

    Now comes the Fed and buys up all the T-bills. As Mr. Mason asks, what's a central banker to do? Turn down deposits? Make stupid loans? Some banks may not even be able to make sound loans if their capital is too thin. The cause of this mismatch between deposits and available safe loans is that the amount of deposits has grown enormously thanks to QE.

    If I own a Treasury bond, and the Fed makes me an offer I cannot refuse, one consequence of selling the bond is that my bank balance goes up. Do I rush out and buy another bond? Even if I do, someone has to sell it to me, so HIS bank balance goes up. Somewhere in the banking system, the Fed's purchase has increased the amount of Fed liabilities owned by some bank. The bank's liabilities have increased by the amount of the deposit it accepts, and its assets increase by the amount of Fed obligations it is holding. The account costs money to maintain, and the Fed obligation pays nothing in interest. So, the banker is in a bind.

    The Fed knows that the banks are forced to hold unremunerative deposits when the Fed buys up safe assets. So the Fed "remunerates" the banks for the "excess" depository services they provide, in a sense subsidizing depositors so that money will reside in the banking system, where it can be transacted easily, rather than under mattresses, where it is not so readily accessed.

    The so-called "excess reserves" are really just "excess deposits" by bank customers, i.e., deposits that the banks don't want. The Fed pays interest on excess deposits HELD by the banks as a result of the Fed having given people money in exchange for their Treasury and RMBS investments.

    I would liken IoER to medical marijuana. The patient gets cancer, takes chemo, becomes nauseated, and smokes pot. The banking system gets sick, takes QE, gets excess deposits, and takes IoER. Just as the patients needed to change the law to get the cannabis, the banks needed to change the law to get IoER. Just as the doctor might say "I will prescribe cannabis for the nausea I am creating" the Fed says "I will pay interest on the excess reserves (i.e., deposits) I am creating." To say that the Fed had the creation of excess reserves as a goal is like saying that the oncologist had nausea as a goal.
    Sep 19 09:08 AM | 1 Like Like |Link to Comment
  • What Does A Central Bank Do When A Central Bank Can't Do Anything? [View article]
    "My point is the Federal Reserve Bank (FRB) was clearly targeting excess bank reserves as a policy objective. "

    I understand your point, but I disagree with it.

    There is no point in creating the level of excess reserves that the Fed created. They outstrip banks' current capital constraints and so add no firepower to the system. They are instead the amount of reserves that results from putting interest rates where the Fed wanted to put them.

    The policy is called ZIRP for a reason: it targets rates. The reserves are merely a consequence, one that the Fed needed authority from Congress to neutralize with interest payments. In essence, IoER is a banks-only replacement for the T-bills that ZIRP sucked up. It was a coping mechanism, not a strategy.
    Sep 19 01:23 AM | 1 Like Like |Link to Comment
  • What Does A Central Bank Do When A Central Bank Can't Do Anything? [View article]

    The Fed clearly knew that its policies would deprive banks of the opportunity to buy bonds and would leave them with uninvested funds. So the Fed sought permission to pay interest on excess reserves. Is there a basis for inferring that the request was more than prophylactic?
    Sep 18 09:16 PM | Likes Like |Link to Comment
  • What Does A Central Bank Do When A Central Bank Can't Do Anything? [View article]
    David -

    I did not mean to suggest that the Fed was unaware that it had created reserves or that the reserves would support undue lending. I said only that the Fed did not have the creation of reserves as a purpose.

    Now that the banks have more reserves than they need, there is a risk that they will lend more than the economy can stand, but (i) capital constraints on banks will make that possibility slow to emerge, and (ii) banks will still need to borrow from each other, and the Fed intends to pay higher interest on excess reserves (and do repos with non-banks) to raise the overnight rate. If that does not dampen lending, the Fed can raise reserve requirements, thereby making overnight lending more necessary.

    I'm not in a position to say that all of these steps will prevent inflation when the time comes, but I suspect the Fed's arsenal is more potent than many believe, and, again, my issue was the Fed's intention in doing QE and ZIRP, not the difficulties of unwinding them.
    Sep 18 07:13 PM | Likes Like |Link to Comment
  • What Does A Central Bank Do When A Central Bank Can't Do Anything? [View article]
    I believe that Mr. Mason is looking through the wrong end of the telescope. The Fed is not "pumping liquidity" into the banks. The Fed is lowering interest rates. The liquidity is an unimportant by-product. That's why the excess reserves are not converted to required reserves by additional lending. No one cares about the liquidity. Everyone is reacting to interest rates.

    The whole concept of "effective" monetary policy is misguided. The question is whether monetary policy is optimal, not whether it is effective. The optimal risk-free interest rate is the lowest non-inflationary rate, by which I mean the lowest rate at which the rate of inflation is not unacceptably high. What happens at that rate is not the central bank's concern, as there is no better rate it can set.

    If setting the risk-free rate at the lowest non-inflationary rate does not result in prosperity, then there is no monetary solution to the slowness. But that does not mean that the central bank is not doing its job as well as it can be done. Any test based on anything other than the rate of inflation in goods and services (not in financial assets) simply asks the wrong question, so the answers produced don't tell us anything about monetary policy that we should want to know.

    Of course, monetary policy CAN have an effect, when interest rates do matter to users of credit, and in that case, a policy change TOWARD optimal will be "effective." But the fact that effective monetary policy is good does not imply that good monetary policy must be effective. Effectiveness is evidence of correctness; ineffectiveness is evidence of nothing.
    Sep 18 02:34 PM | Likes Like |Link to Comment
  • FOMC Statement And The New Normal [View article]
    "The Committee intends that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively, "

    I wouldn't worry about that. The Fed doesn't now, nor should it ever, hold more Treasury securities than necessary to implement monetary policy efficiently and effectively. The other securities - RMBS - are not related to monetary policy. They are there because the secondary RMBS mortgage market was severely damaged by the misbehavior of its largest players. I suspect that the Fed will unload these mortgages (including by repayment) if, as, and when the secondary market is willing to take them off its hands, i.e., "in the longer run."
    Sep 18 09:06 AM | Likes Like |Link to Comment
  • Yellen Speaks Softly, Market Overreacts [View article]
    "I think 1% interest rates will be far better for the economy than 0% rates."

    Sep 18 08:27 AM | Likes Like |Link to Comment
  • The Worst Call Of The Last 5 Years [View article]
    "So, there are two ways to create a lot of money in the economy. First is by commercial bank lending, the second is government borrowing from the financial markets and spending it. "

    Bull's eye! Money does not cause inflation. SPENDING causes inflation, and then only to the extent supply cannot keep up.

    The Fed can remove interest rates as a barrier to spending. It cannot DO spending, and it cannot COMPEL spending. Thus, Fed policy matters to the extent that the amount of spending that occurs depends on the amount of spending that higher interest rates would prevent, and the Fed can cause inflation only to the extent that it could, but doesn't, make the inflation-causing spending too expensive.
    Sep 18 08:20 AM | 2 Likes Like |Link to Comment
  • The Worst Call Of The Last 5 Years [View article]
    "Also importing to understand that many exchange rates are not at all free (as the term of 'free floating' implies), since central banks heavily intervened since 2008."

    Exactly how does a central bank NOT intervene? Would it never buy its government's bonds? Would it never operate a discount window? Why would it exist? Would it BE a central bank if it didn't do anything that could be called "intervening."

    What people today call "intervening" is really just the Fed intervening DIFFERENTLY from how it was intervening before. Before ZIRP, there was a Fed Funds rate, there were open market operations, there was an inflation target. If the Fed had raised interest rates in 2005 to cool the mortgage market, would that have been the Fed NOT intervening? There simply is no benchmark, because there is no such thing as a non-intervening central bank. It's like a switch that is neither on nor off, a thermostat that is set to no temperature.

    A central bank IS an intervention. The idea that the Fed is doing anything qualitatively different now from what it has always done makes as much sense as a four-sided triangle. It is an impossibility. Yet one cannot swing a dead cat at SA without hitting someone who thinks the Fed should not have intervened, or that interest rates would be higher if the Fed had not intervened, when what they mean is if the Fed had not changed how it was intervening.
    Sep 17 11:39 PM | Likes Like |Link to Comment
  • Yellen Speaks Softly, Market Overreacts [View article]
    "and looks very bad for the Fed (their QE was useless)."

    My burglar alarm has not caught a single burglar. What a "useless" piece of crap.
    Sep 17 05:44 PM | 1 Like Like |Link to Comment
  • The Worst Call Of The Last 5 Years [View article]
    Terms like "ex nihilo" give off far more heat than light. To the extent credit is backed by an asset, the money is not created "ex nihilo." That extent is not always measurable, so people are tempted to think it does not exist. But if one sets up the right (not-necessarily-GAAP) T-accounts, one can create an asset for every expenditure, and we can then argue about what the asset is actually "worth." The binary concept of "ex nihilo" just doesn't help.

    When the Fed buys a bond, it does not create reserves; it SUBSTITUTES a claim against itself for a claim against the Treasury. Sound banking requires that banks have sufficient liquid assets to service deposits. Bankers and their regulators call these assets "reserves." Only certain assets qualify as "reserves." Demand deposits at the Fed so qualify; time deposits do not. Thus, if the Fed "bought" bonds by issuing 2-year CDs, it would not be creating "reserves" at all; it would be creating 2-year CDs. Would a swap of a Fed 2-year CD for a 2-year Treasury be "ex nihilo?" Would it be worth mentioning? As it happens, the Fed creates demand deposits that pay interest to the extent the holder is a bank with already adequate reserves. These deposits happen to count as reserves, but they are no more or less "ex nihilo" than would be any other deposit at the Fed.

    The interesting and important thing about the Fed's purchases is that they remove a term instrument from the marketplace, thereby lowering term interest rates. That the deposit qualifies as "reserves" is wholly beside the point, and whether the deposit is created "ex nihilo" turns entirely on what the government got for the money it spent, something we cannot infer from the mere creation of the deposit.
    Sep 17 12:39 PM | 3 Likes Like |Link to Comment