A Monetary Policy Primer, Part 9: Monetary Control, Now

Inflation Expectations, interest on reserves, interest rate targeting, natural rate of interest, QE
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Inflation Expectations, interest on reserves, interest rate targeting, natural rate of interest, QEHaving considered the Fed's pre-crisis approach to monetary control, with its emphasis on interest-rate targets reached with the help of open-market operations, we must now come to grips with the quite different methods it has been employing since, and how the switch to them came about.

The story of that switch must surely rank among the great tragicomedies of monetary history, for despite what many Fed officials have suggested, the Fed wasn't forced to abandon conventional interest rate targeting  for reasons entirely beyond its control. Instead, it was compelled to give-up old-fashioned rate targeting in part because of its own, obstinate refusal to practice such targeting responsibly.

Explaining what happened isn't easy, so brace up!

The Futility of "Unnatural" Monetary Policy

As should be evident by now, the Fed's ability to achieve any given federal funds rate target depends on that target's consistency with the underlying, "natural" funds rate. If, for example, the Fed pours fresh reserves into the banking system, by means of open-market security purchases, to combat a tendency for the effective funds rate to climb above its target, where that target is itself below the "natural" funds rate, its effort will eventually fail, because the fresh reserves will sponsor increased bank lending and investment, which will in turn increase spending on, and prices of, goods and services. The demand for credit will likewise increase, as people must borrow more to finance purchases of more costly goods. Rates will therefore tend to go up after all.

The Fed might try to keep rates from increasing through further rounds of reserve creation.  But it would only end up repeating the same process: like a dog chasing its own tail, the Fed would be engaged in a hopeless quest. And should it persist through further rounds, or (what's worse) accelerate its rate of reserve creation, it will only succeed in causing an equally persistent, if not accelerating, rate of inflation. Because persistent inflation must eventually translate into heightened inflation expectations, interest rates, instead of being lowered, will end up becoming higher than they would have been if the Fed hadn't fought the increase at all. Anyone who recalls, or has studied, what happened to U.S. interest rates during the 1970s, knows what I'm talking about.

Any Fed attempt to enforce an excessively high rate target is also bound to be self-defeating, for similar reasons. The artificially high target target will mean excessively tight money, which will in turn cause lending, spending, and prices to decline, other things equal. The slackening of demand for goods and services will have as its counterpart a like slackening of demand for credit that will defeat the Fed's efforts by pushing rates down again. Unless the Fed changes its strategy, market interest rates, instead of staying put, will end up falling even lower as deflation and expectations of its persistence take root.

Black October

It was this last scenario that played out during the last half of 2008. Because it did so against the background of an ongoing decline in real, natural interest rates, the result was that the equilibrium, nominal federal funds rate was driven to zero, and perhaps even into negative territory, compelling the Fed to completely abandon its conventional methods of monetary control.

Although the Fed lowered its federal funds rate target aggressively between the fall of 2007, when it stood at 5.25%, and early May of 2008, once the target was down to 2 percent, it resisted making any further cuts. More importantly, it refrained from making such net open-market purchases as it traditionally relied upon to assist in achieving a lowered rate target by adding to the supply of bank reserves. Instead, as part of its effort to keep the funds rate at 2 percent, the Fed auctioned-off Treasury securities to compensate for, or "sterilize," its emergency lending programs, subtracting as many reserves from the banks that bought those Treasuries as its emergency loans were supplying to other, more troubled banks.

When, starting in September 2008, the Fed ramped-up its emergency lending, it no longer had enough Treasuries on hand to keep its balance sheet from ballooning. It remained determined nonetheless to resist any monetary loosening. As alternative ways to keep its emergency lending from adding to the general availability of credit, it first arranged to have the government accumulate deposits with it, and then started paying banks to do the same. Instead of keeping a lid on the monetary base, in other words, the Fed tried to keep money tight by reducing the reserve-deposit multiplier.

But if the Fed's aim was to keep the effective funds rate from falling below 2 percent, its efforts were in vain. As the chart below shows, as market conditions worsened, the effective Fed funds rate (blue line) did in fact fall below the Fed's target (red), from which it then tended to drift further and further.


Disinflation Takes its Toll

Instead of helping to counter the tendency of market rates to decline (for longer-term interest rates were also falling at this time), the Fed's insistence on maintaining what, in retrospect at least, was an excessively tight stance, reinforced that tendency, by putting a brake on lending and spending, and by contributing thereby to falling inflation expectations. By mid-2008 and the end of that year, according to the University of Michigan's survey of consumers' year-ahead inflation expectations, the expected rate of inflation (green line) had fallen from over 4.5 percent to just 2 percent, which meant that, even had there been no downward decline in real natural rates during that time, nominal natural rates would have declined considerably.

Although, as the chart also shows, the Fed did finally cut its rate target again — twice — in October, those cuts were essentially meaningless, because they weren't accompanied by any increase in the Fed's open-market purchases. Instead, the only reserves the Fed was creating continued to be those it created as a consequence of its emergency lending. As James Hamilton observed at the time,

the [fed funds] target itself has become largely irrelevant as an instrument of monetary policy… . There’s surely no benefit whatever to trying to achieve an even lower value for the effective fed funds rate. On the contrary, what we would really like to see at the moment is an increase in the short-term T-bill rate and traded fed funds rate, the current low rates being symptomatic of a greatly depressed economy, high risk premia, and prospect for deflation.

What we need is some near-term inflation, for which the relevant instrument is not the fed funds rate but instead quantitative expansion of the Fed’s balance sheet.  …I would urge the Fed to be buying outstanding long-term U.S. Treasuries and short-term foreign securities outright in unsterilized purchases, with the goal of achieving an expansion of currency held by the public, depreciation of the currency, and arresting the commodity price declines.

But the last thing we should expect to do us any good would be further cuts in the fed funds target

You tell it, brother!

Nor did the Fed relax its efforts to prevent the reserves it did create from contributing to the overall volume of bank lending, overnight or otherwise. Indeed, it was while the Fed was making its last "symbolic" changes to its fund rate target that the reserves being piled-up by the Treasury as part of its multiplier-shrinking Supplementary Finance Program reached their peak of just under $560 billion.

Why the sham? Why didn't the Fed really ease its policy stance aggressively, as it would have had it set and seriously pursued rate targets consistent with underlying market conditions? It's here that tragedy meets comedy: Fed officials believed that, instead of countering declining inflation expectations, further easing would, by pouring more funds into the overnight market, only serve to further reduce the effective funds rate, eventually lowering it to its zero lower bound. Once it got there, the officials feared, the Fed could lower it no further, and so would find itself out of depression-fighting ammunition.

The Fed's reasoning, so far as it went, was sound enough: the initial consequence of Fed easing would include an increase in the supply of overnight funds, and a corresponding tendency for the effective funds rate to decline still further. The problem was that this reasoning didn't go nearly far enough. Fed officials failed to consider how traditional easing — meaning not just more aggressive cuts in the fed funds target, but cuts backed-up by more aggressive open-market purchases — would eventually boost both actual and expected levels of spending, and how, by doing so, it would end up buoying rates instead of suppressing them. Just as a rising tide lifts all boats, a general increase in spending, and especially an increase in the expected growth rate of spending, lifts demand schedules in all markets, including markets for all sorts of loans.

The Fed was, nonetheless, determined to keep a lid on bank lending, overnight or otherwise. When it could no longer do that by sterilizing its emergency lending, it turned, as we've seen, to other measures, including paying interest on bank reserves to discourage banks from lending them out.

From Floor to Ceiling…

Fed officials originally hoped that the interest rate on reserves, and particularly on excess reserves, would serve as a floor on the effective federal funds, because banks would have no reason to lend reserves overnight for less than they could earn by holding on to them: the rate would therefore serve to keep the effective funds rate from reaching its zero lower bound, even if it proved incapable of keeping that rate from falling below the Fed's target.

But that expectation also turned out to be mistaken: because some Government Sponsored Enterprises, including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, kept deposits at the Fed, but weren't eligible for interest payments on those deposits, they were happy to lend their Fed balances to banks overnight at rates below what the banks were earning on their own balances, and the banks were no less happy to oblige them. As the total volume of reserves continued to grow, first in response to further Fed emergency lending, and then in consequence of several rounds of Quantitative Easing, it also became unnecessary for banks themselves to borrow reserves unless they could profit by doing so on the difference between the rate they earned on deposits and the rate they paid on them. The result of all this was that, instead of serving as a floor on the effective funds rate, the interest rate paid on excess reserves ended up becoming a ceiling!

Moreover, the logic underpinning the Fed's desire to put an above-zero floor on the effective federal funds rate was tortured. To see why, suppose there had been no GSEs with Fed account balances. In that case, no bank would have lent funds overnight for less than the interest rate on reserves, so that the rate would indeed have constituted a floor of sorts. But what difference would that have made? In what sense, apart from a trivial one, would it have solved the so-called "zero lower bound" problem? Yes, it meant that Fed easing no longer posed the risk of driving the fed funds rate to zero, even in the short run. But it did so only by assuring that such easing would cease to have any repercussions, save that of adding to banks' excess reserves, as soon as the effective funds rate ceased to exceed its new, positive floor. It was as if, out of concern for would-be jumpers, the designers of a skyscraper decided to construct a broad veranda around their building's second floor, so as to prevent the jumpers from ever hitting the ground.

In any case, the Fed quickly discovered that the interest rate on  excess reserves established an upper bound to the effective fed funds rate, while its official rate target, which still hovered well above the effective rate, had become perfectly meaningless. Before the year was over, it formally abandoned that single-valued target. A brave new era of monetary control thus began.

…and from Target to Range

As the old saw goes, if life hands you a lemon, make lemonade. So far as the Fed's monetary control efforts were concerned, the months starting with Black October were one great lemon harvest. The lemonade followed, sure enough, in the shape of the Fed's switch from setting a single-value federal funds rate target that it could no longer strike to announcing a fed funds target "range" it couldn't miss, with the rate of interest on excess reserves serving as the range's upper bound, and zero as its lower one.

Considering how narrow the range was, the Fed's new approach may not seem all that radically different from traditional rate targeting. But the appearance is deceiving: in fact, the switch marked a sea change in the Fed's methods of monetary control.

How so? So long as the Fed took it seriously, the old ffr target operated as a signal to the Fed's open-market desk, instructing the manager on the required adjustments to the course of the Fed's open-market purchase. Changes to the funds target were, in other words, a mere headliner to the main, open-market events. By December 2008, that was no longer the case. The Fed's new fed-funds target range, instead of giving the open-market desk its marching orders, was one in which the effective federal funds rate was bound to fall, no matter what the open-market desk in New York was up to. To both alter the target range, and guarantee that the effective funds rate still fell within it, the Fed had only to alter the interest rate it paid on bank reserves. In its new guise, interest rate targeting, to still call it that, had become entirely divorced from open-market operations, and hence from any actual adjustments to the supply of currency or bank reserves.

In changing the rate of interest on excess reserves, and hence the funds rate target range, the Fed was, to be sure, still exercising monetary control of a sort. But it was a very different and untested sort of monetary control that worked, not by altering the supply of base money, and especially of bank reserves, but by influencing the reserve-deposit multiplier. Other things equal, a higher rate of interest on excess reserves would encourage banks to maintain higher reserve ratios, and this would be a form of monetary tightening. But just how much tightening any given increase in the rate would inspire was hard to say. Nor did the Fed  quickly put its new mechanism to the test. Instead, it left its original fed funds target range, with its 25 basis point upper and 0 lower bounds, unchanged until December 2015.

Quantitative Easing

As I've said, in replacing its traditional federal funds target with a new target range, the Fed severed the traditional connection between funds rate targeting on the one hand and open-market operations on the other. But that didn't mean that it ceased to engage in open-market operations, including long-term ones involving outright asset purchases. On the contrary: the Fed's abandonment of conventional interest-rate targeting coincided with the first of several rounds of what Fed officials referred to as "Large Scale Asset Purchases," and what the rest of the world calls "Quantitative Easing."

Despite the torrents of ink that have been devoted to theories rationalizing or otherwise assessing the workings of Quantitative Easing, in essence this "unconventional" monetary policy is nothing more than a name for central bank open-market purchases undertaken without reference to a particular fed funds rate target, that is, purchases that are not aimed at moving the effective fed funds rate to some specific level. Instead of picking a rate target and instructing the open-market desk to buy as many securities as it takes to hit the target, the Fed plans to buy some particular quantity of securities — hence "quantitative" easing.

According to the conventional reckoning, the Fed has engaged in three rounds of quantitative easing, since known as QE1, QE2, and QE3. QE1, which ran from December 2008 to June 2010, added $2.1 trillion, mainly in Mortgage-Backed Securities (MBS), to the Fed's balance sheet. For QE2, which ran from November 2010 until June 2011, the Fed bought $600-billion worth of Treasury securities. QE3, finally, began in September 2012, and consisted of an open-ended program of securities purchases, starting with $40 billion in MBS per month, and supplemented, beginning in December 2012, with monthly purchases of another $45 billion in long-term Treasury securities. In all, between December 2008 and October 2014 the Fed purchased securities worth not quite $4 trillion, or about 4.5 times its total assets just prior to the crisis.

That Quantitative Easing had nothing to do with interest targeting was made especially evident by the fact that the Fed left its original federal funds target rate range of 0 to 25 basis points unchanged throughout all three rounds of Quantitative Easing, the last of which officially ended in October 2014. The first change in the target range, and thus the first test of the Fed's new approach to interest-rate targeting, came more than a year later, in mid December 2015, when the Fed announced a new rate range of 25 to 50 basis points. Another year passed before the Fed hiked the range for a second time, to 50 to 75 basis points, where it remains as of this writing.

Overnight Reverse Repos

The upper bound of the fed funds target range is, as we've seen, simply equal to the interest rate the Fed pays on banks excess reserve balances; so to raise that the Federal Reserve Board has simply to approve and announce a new rate. Raising the lower bound above zero is another matter altogether. To do this, the Fed introduced still another novel monetary control instrument, consisting of a revamped Overnight Reverse Repo (ON-RRP) program it had been tinkering with since the spring of 2014.

 As I explained in Part 3 of this primer, repos, or repurchase agreements, had long been part of the Fed's open-market operations. But prior to the crisis the Fed made such agreements only with the small number of Primary Dealers it usually dealt with, and for the purpose of making such temporary adjustments to the supply of bank reserves as were needed to achieve its fed funds target. To temporarily increase banks' reserves, it might agree to purchase securities from one or more dealers, under the condition that they repurchase them the next day. To temporarily withdraw reserves from the banking system, it could instead resort to overnight "reverse" repos, selling securities to one or more dealers, while promising to repurchase the same securities the next day.

The post-crisis ON-RRP differed both in its scope and in its purpose. Instead of being limited to a score or so of Primary Dealers, it involved a much larger number of counterparties, including Fannie and Freddie, four of the nation's eleven Federal Home Loan Banks, and 94 money market mutual funds. For the purpose of implementing the Fed's new system of monetary control, however, it was the inclusion of the GSEs that mattered. For those institutions now had a new way to earn interest on their idle Federal Reserve deposit balances. Instead of lending them to banks overnight, in return for some share of the interest banks were earning on their own Fed balances, they could instead take part in the Fed's overnight securities sales, profiting on the difference between the Fed's sale price and the price it agreed to pay to repurchase the securities a day latter. So long as they could take part in the Fed's overnight repos, the GSEs had no reason to lend funds to banks overnight for less than the repos' implicit interest return. The Fed's new repo facility thus allowed it to set an above-zero lower bound on its federal funds rate target range, starting with the 25 basis point lower bound it announced in December 2015, which it doubled in December 2016.

So there you have it. Although we continue, as in the past, to identify monetary tightening or loosening with the Fed's determination to raise or lower "interest rates," since 2008 both the interest rates involved, and the Fed's way of altering them, have changed dramatically. Instead of endeavoring to influence a market-determined federal funds rate by reducing or increasing the supply of bank reserves, the Fed now adjusts a pair of rates determined solely by its own administrative decrees, while conducting open-market operations without any particular reference to these rate adjustments. Sometimes, a wise Frenchman might say, the more things stay the same, the more they change.

Continue Reading A Monetary Policy Primer:

  • Ray Lopez

    My gawd, another Selgin piece that hits the bulls eye! While I personally believe that money is largely short-term and long-term neutral, if there's any validity to money non-neutrality it should be market determined, as Selgin proposes, not central bank determined. And, BTW, as K. Dowd has suggested, scale back or eliminate deposit insurance. Some day Selgin, Dowd, and the other giants of free banking will be acknowledged by society; may we all live to see the day! (another way of saying may we all live to be 1000)

    • George Selgin

      Ray, that last part sounds rather like an oriental curse!

      • Ray Lopez

        We live in interesting times! BTW should I invest 100k in the bond market (short term) or wait till year end (my preference)? They say market timing is impossible, but I can't help doing it…what to do? The Trump rally is fake, like fake news, but everything is fake. Like Germany in the interwar period seems everybody is waiting for the other shoe to drop, but it hasn't yet.

    • Agree w your assessment of Selgin et al but I would prefer to only wait until I'm 500 years old. In any event, when you say non neutral, I assume you are referring to the overall or average price level, not individual prices which would be impacted depending on transmission of money in and out from the Fed or through the banking system in general.?

      • Ray Lopez

        @Milton Churchill – I suppose so. There's a paper (first draft) that discusses Fed policy shocks and finds them, on a variety of metrics, from 1959-2002, to only affect a variety of data (like GDP, employment, etc) by 3.2% to 13.2% (Google FAVAR Bernanke), also read this paper: stockman and baxter 1989, on how big nominal changes in the Fx market have no real effects. People are not stupid, if prices change they also change their expectations (no money illusion). That said, I suppose at the margin that 3.2-13.2% change might make a difference (out of 100%) since some people are locked into long-term contracts (prices, wages are a bit sticky). I wouldn't lose sleep over it, though there's a whole school of thought (i.e. monetarism) that does.

        • Well, I guess for studies like that to be conclusive one would have to run the exact same economy side-by-side with and without the Fed policy shocks to get a true read on whether those results are reliable or not. Of course, that is not possible.

          • Ray Lopez

            Yes, you're right Milton. But keep in mind Bernake's FAVAR paper is also good evidence of money neutrality. It looks at what happens after an actual Fed policy shock. It found a 3.2% to 13.2% change on something like a dozen economic variables (like GDP growth) from 1959-2001, when everybody agrees monetarism seemed to work (unlike today, when it doesn't work it seems). It doesn't sound like a lot to me (it's out of 100 percent, so if GDP changes 10%/yr then 3.2% is 0.032*10 = 0.32 to 1.32% of that 10%, not that much), but it was considered 'statistically significant'. Another example of money non-neutrality might be the Swiss central bank revaluing the Swiss franc in Jan. 2015, which caused Swiss GDP to go down for one quarter (which ended up giving them a bad number for 2015) but it was only temporary (they had a good year for 2016). But, in general, it seems to me, and to famous people like Fischer Black of Black-Scholes fame, that monetarism is an extremely weak lever. The Fed follows the market, for the most part, and talks tough. Even Japan's central bank intervening in the Yen-Dollar market is always 'cowardly' I have read. And we all know the Bank of England lost to George Soros. Central banks are giants…with feet of clay.

          • IMHO nothing is neutral, short or long term. If the government had a monopoly in car production and started producing cars at a rate to cut the cost by 50% the ordinal subjective value schedules of every individual in the impacted jurisdiction would change. People would buy more cars, what they defer, savings, a bigger house, furniture, eating out, what have you, would be dispersed or distributed according to each individuals now adjusted value scale. The impact of the new cars would not be neutral.

            Specific to money, had the Spaniards purchased more land, or chose to buy more imports, instead built bigger homes, or loaned out the silver they brought back from the new world, their decision would in no way be neutral.

          • Ray Lopez

            That's not what money neutrality is all about Milton…sorry, you need to read a bit more… the Spanish performed seigneurage with their New World Au/Ag, but in any event real wages actually went down during the time of 1350 to 1800, as is true for all of Europe, so no real changes from any seigniorage the Spanish did.

          • Ray, can I call you, Ray? Money is not neutral. If instead of monetizing bonds, the Fed monetized houses, equity shares, shoes, vehicles, gold or simply bypassed that and sent every citizen $20,000, surely real variables in the economy would be impacted. The real component variables are, would, and will always be, impacted by the transmission of money in to the economy. It is impossible, though, to conclude anything emperically as it is impossible to isolate the variables under study.

          • Ray Lopez

            'You can call me Ray, or you can call me Jay, or you can call me…' (some silly ditty from years ago). Your thought experiment goes to the heart of monetarism. It's Milton Friedman's famous "helicopter drop" and it's quite good. In a nutshell, the people of the Fischer Black 'money is neutral' school say a helicopter drop where you doubled the money supply overnight (let's say the government made it easy, and instead of a helicopter dropping money they simply decreed: 'starting tomorrow, every $1 bill is in fact worth $2') would not change real output, only double prices, while the Friedman monetarist school says that due to so-called "money illusion" a helicopter drop would cause real spending to increase (people feel richer, stupidly, and spend more; Keynes also believed this), and besides 'prices are sticky' meaning there's lots of long-term contracts so $1 = $2 would impact the real economy. That 2002 Bernanke FAVAR paper says Friedman is partly right, but only by about 3.2% to 13.2% out of 100%, a small number but 'statistically significant'. Nuff said! I probably will not reply anymore to this thread, thanks for the debate!

          • 'You can call me Ray, or you can call me Jay, or you can call me…" LOL yeah remember that myself. Yes, it has been real thank you for the debate as well!

  • Spencer Hall

    The problems stem from using the wrong criteria, interest rates, rather than member bank complicit (legal), reserves in formulating & executing monetary policy (as the use of liquidity reserves, or applied vault cash, beginning in 1959 was a precursor – the ABA, public enemy #1, being responsible). Legal reserves are a credit control device, not a liquidity provision. We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about.

    The money supply (& DFI credit or their loans and investments), can never be managed by any attempt to control the cost of credit (i.e., thru pegging the interest rate returns on government securities; or thru "spreads", "floors", "ceilings", "corridors", "brackets", IOeR, etc.).

    I.e., the Fed's monetary transmission mechanism, interest rates, is non sequitur. Interest is the price of loan-funds, not the price of money. The price of money (the Fed’s bailiwick) is the reciprocal of the price-level. And Keynes's liquidity preference curve (demand for money), is a false doctrine. The Fed's monetary transmission mechanism presumes that a “liquidity preference” curve exists which represents the supply of money. In this system, interest is the cost which must be paid, if lenders are to forgo the advantages of liquidity… all of which has little or nothing to do with the real world – a world in which interest is paid on checking accounts (elimination of Reg. Q ceilings for the DFIs).

    The demand for money is not a demand for money, per se, but a demand which reflects the advantages of spending borrowed money. Insofar as there is a relationship, it may be said that an increase in the demand for loan-funds tends to be associated with a decrease in the demand for money.

    All motives which induce the holding of a larger volume of money will tend to increase the demand
    for money – and reduce its velocity. Thus, low interest rates may induce people to hold onto their funds and not part with liquidity for such a small price.

    Reserve targeting worked well until William McChesney Martin Jr., abandoned the FOMC’s net free,
    or net borrowed, reserve targeting position approach in favor of the Federal Funds “bracket racket” beginning in c. 1965 (coinciding with the rise in chronic monetary inflation & in anticipated inflation).

    Net changes in Reserve Bank credit (since the 1951 Treasury-Reserve Accord) were previously determined by the policy actions of the Federal Reserve. Note: the Continental Illinois bank bailout
    provides a spectacular example of this practice. In other words the Fed allowed the commercial bankers to change their own operating procedure, and usurp their power to regulate properly, our money stock. I.e., the FRB-NY’s “trading desk” accommodated all requests at the pegged rate.

    That is, additional & costless excess reserves were made available to the banking system whenever the bankers and their customers saw an advantage in expanding loans. As long as it is profitable for
    borrowers to borrow and commercial banks to lend, money creation is not self-regulatory. This observation would be valid even though the Fed did not use the federal funds device as a guide to open market operations. The Fed has always been motivated by an overwhelming desire to accommodate bankers and their borrowing customers. If private profit institutions are to be allowed the "sovereign right" to create money, they must be severely regulated in the management of both their assets and their liabilities.

    The effect of tying open market policy to a fed funds bracket was to supply additional, & excessive, legal reserves to the banking system when loan demand increased, and vice versa during downswings, e.g., Bernanke’s preliminary response to the onslaught of the GR (credit easing, not quantitative easing). I.e., during upswings, the pressure is on the top side of the Fed’s plug.

    Since the member banks had no excess reserves of significance (between 1942 and Oct 6 2008), the banks had to acquire additional reserves to support the expansion of deposits, resulting from their loan expansion. If they used the Fed Funds bracket (which was typical), the rate was bid up & the Fed responded by putting though buy orders, reserves were increased, & soon a multiple volume of money was created on the basis of any given increase in legal reserves. This combined with the rapidly increasing transaction velocity of demand deposits resulted in a further upward pressure on prices. This is the process by which the Fed financed the rampant real-estate speculation that characterized the 70's.

    The fed cannot control interest rates during an economic expansion, even in the short end of the
    market, except temporarily. And by attempting to slow the rise in a policy rate, the fed will pump an excessive volume of legal reserves into the member banks. This will fuel a multiple expansion in the money supply, increase money flows – & generate higher rates of inflation — & higher interest rates, including policy rates.

    The effect of Fed operations on interest rates is indirect, varies widely over time, and in magnitude. What the net expansion of money will be, as a consequence of a given injection of additional reserves, or change in policy rates, nobody knows until long after the fact. The consequence is a delayed, remote, & approximate control over the lending and money-creating capacity of the banking system.

    The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves. The first rule of reserves and reserve ratios should be to require that all money creating institutions have the same legal reserve requirements, both as to types of assets eligible for reserves, as well as the level of reserve ratios. Monetary policy should limit all reserves to balances in the Federal Reserve banks (IBDDs), and have uniform reserve ratios, for all deposits, in all banks, irrespective of size (something Nobel Laureate Dr. Milton Friedman advocated).

  • Spencer Hall

    What originally interested me was your critique of the remuneration rate, and its level being above short-term wholesale money market interest rates. Apparently there aren't many, if any, economists who understand money and central banking. Commercial banks, DFIs, do not loan out existing deposits, they always create new money when acquiring earning assets. From the standpoint of the economy, deposits are not a source of funding.

    The idea that excess reserves are some kind of tax is inconsistent with a bank's modus operandi. An injection of central bank deposits is like manna from Heaven. It is costless to the banks and is showered on the system. Milton Friedman, an engaging person, was dimensionally confused about this.

    A brief “run down” will indicate just how costless, indeed how profitable – to the participants, is the
    creation of new money. If the Fed puts through buy orders in the open market, the Federal Reserve Banks acquire earning assets by creating new inter-bank demand deposits. The U.S. Treasury recaptures about 98% of the net income from these assets. The commercial banks acquire “free” legal reserves, yet the bankers complained that they didn't earn any interest on their balances in the
    Federal Reserve Banks.

    On the basis of these newly acquired free reserves, the commercial banks created a multiple volume of credit & money. And, through this money, they acquired a concomitant volume of additional earnings assets. How much was this multiple expansion of money, credit, & bank earning assets? Thanks to fractional reserve banking (an essential characteristic of commercial banking) for every dollar of legal reserves pumped into the member banks by the Fed, the banking system acquired about 93 (c. 2006), dollars in earning assets through credit creation.

    But that is a superficial examination of inside money. Whenever the remuneration rate’s umbrella (short-term segment of the yield curve), is greater than the savings pooled and invested through non-bank conduits, it induces non-bank dis-intermediation (an outflow of funds or negative cash flow). This destroys money velocity reducing N-gDp. Note: dis-intermediation is a term that applies exclusively to the non-banks. The last period of dis-intermediation for the commercial banks was during the Great Depression (when there were no backstops and safety nets).

    An overall expansion of bank credit isn’t predicated on the level of market clearing interest rates. It is dependent upon monetary policy, not the savings practices of the public. In fact, the commercial banks could continue to lend/invest even if the non-bank public ceased to save altogether. Even though interest is the largest expense item on a bank’s income statement, NIM for the DFIs is “fake news”.

    Interest bearing bank deposits, rather than being a source of loan-funds for the commercial bankers,
    are the indirect consequence of prior bank credit creation. The source of time/savings deposits is almost exclusively, non-interest bearing DDs (directly or indirectly via the currency route, or thru the CB's undivided profits accounts), and the growth of DDs can be largely accounted for by the expansion of bank credit.

    No, I am not exaggerating. Ben Bernanke should be doing time in Federal prison. The U.S. is headed for an economic depression.

    • joebhed

      Excellent comment,

      Your conclusion about where the US economy is headed in the future is widely
      shared. While yet to be determined, the outcome is surely leaning heavily
      toward distress indeed, without money-banking system reform.

      Looking at the results of all of those well-described 'inter-banking'
      machinations, there is more debt (monies due and payable) than there is money
      (the only thing that can settle a debt ) to pay that debt, and the only way to
      get more money is to have more debt, again, meaning more debt than money.

      We are here (*). Debt money conundrum.

      Like in the writings of Douglas, where else can a debt-based money system
      expect to end up?

      As such, I am taken to question if there isn't a more temporal identity to this
      'fractional-lending ' money system at play in terms of your positing that :

      "" Thanks to fractional reserve banking (an essential characteristic
      of commercial banking)…"", and then on to the growth of monetary
      assets as implied in the statement. But FR banking is exactly the cause of the
      problem described.""

      The fractional reserve banking system is itself vulnerable to market
      distortions that upset its ability to manage 'money', and thus cause more
      instability, both for banking and commerce. The money system can’t work because
      it is subject to the market, and not the other way around. Cowboy capitalism.

      It is, I would posit, that either a fully-reserved, or non-reserved fiat-based money system would be the superior option for enabling a more sober
      outcome to our present debt-based monetary conundrum.
      Today the FR system is indeed essential to
      maintaining the viability of the private commercial banking system. It's the system we've got.


      But private commercial banking itself is in no way less 'potential' or less
      viable, in a fully-reserved or public money lending regime. An examination
      of fiat money's benefits might find a gain to the banking industry through both
      monetary stability and decreased regulation.

      Whatever policy mechanism is chosen, it will have the characteristic of being
      essential to commercial banking. Let’s hope we can pick the one that can
      actually get the job done.

      But we're just not there yet.

  • Spencer Hall

    Historically, coming out of a recession, the commercial banks, today’s DFIs (deposit taking, money creating, financial institutions), bought highly liquid, short-term assets, pending a more profitable disposition of their legal and economic lending capacity, i.e., between 1942 and Oct 1, 2008, the CBs remained fully “lent up”, the CBs minimized their non-earning assets, their excess reserves.

    Indeed, in direct contrast to the GR, excess reserves balances actually fell during some economic recessions, 12/69 – 11/70; 11/73 – 3/75; 1/80 – 7/80; 7/81 – 11/82 (i.e., until the S&L crisis). Excess
    reserve balances never exceeded > $2b, and only for 1 month, in 1/91 (and not over $4b until 8/07, and then not exceeding that threshold until 9/08 (just before the payment of interest on excess reserve balances turned non-earning assets into commercial bank’s earning assets on 10/6/08).

    The CBs always responded (by purchasing short-term securities), without delay – to any injection of excess reserve balances, i.e., to any excess lending capacity, by the Central bank. I.e., the CB’s response was always self-correcting, or counter-cyclically (without Gov’t intervention), by expanding the money stock (buying securities, not necessarily making loans). And today, in contrast to the Great Depression, there is a surfeit of eligible collateral (viz., considering our bloated federal debt).

    The validity of the multiplier as a predictive device (UDK, 1974) is predicted on the assumption that the commercial banks will immediately expand credit and the money supply (invest in some type of earning asset), if they are supplied with additional excess reserves. The inconsequential volume
    of excess reserves held by the member commercial banks during 1942 and Sept. 2008 provides documentary proof that they undoubtedly did.

    In other words, without the alternative of remunerating excess reserve balances, it's virtually impossible for the CBs to engage in any type of activity involving its own non-bank customers without changing the money stock.

    After the introduction of the payment of interest on IBDDs, the CBs obtained higher rates of return by accepting a riskless, policy floating/chasing (when the Fed raised rates), remuneration rate. I.e., the remuneration rate “inverted” the short-end segment of the wholesale funding yield curve (destroying money velocity).

    Because the belligerent bifurcation (the mis-aligned distribution of sales and purchases of debt by the FRB-NY’s trading desk and its customers/counterparties) is largely unpredictable, so too now is the volume and rate of expansion in the money stock on even a quarter-to-quarter basis. Instead of couching its instructions in terms of reserves available for private non-bank deposits (RPDs), as the FOMC did in 1972, FOMC policy has been undermined.

    Paul Meek (FRB-NY assistant V.P. of OMOs and Treasury issues), stated objective in his 3rd edition of “Open Market Operations” published in 1974: of “gauging the general availability of non-borrowed
    (interbank) reserves in the commercial banking system (which incidentally predates Paul Volcker’s experimental and rhetorically couched approach in Oct 1979).

    Meek described how the FRB-NY's "trading desk's" used repurchase agreements (and reverse repurchase agreements), to smooth the level of reserves.

    Remunerating reserves has emasculated the Fed’s “open market power”, viz., its sovereign right to create new money and credit: at once and ex-nihilo. I.e., "pushing on a string" should have only applied prior to the nominal legal adherence to the fallacious "Real Bills Doctrine" which was terminated in 1932 – due to a paucity of eligible (hopelessly impaired), commercial and agricultural paper for the 12 District Reserve bank’s discounting purposes.

  • Dino Bingham

    600-billion not trillion -typo above
    Thanks Mr. Selgin!

    • George Selgin

      Thanks for the correction, Dino.

  • Spencer Hall

    Anyone see the bond rout in the last half of 2017?
    1/1/2017 ,,,,, 0.19
    2/1/2017 ,,,,, 0.14
    3/1/2017 ,,,,, 0.13 bonds top
    4/1/2017 ,,,,, 0.16
    5/1/2017 ,,,,, 0.22
    6/1/2017 ,,,,, 0.18
    7/1/2017 ,,,,, 0.18 rout begins
    8/1/2017 ,,,,, 0.21
    9/1/2017 ,,,,, 0.26
    10/1/2017,,,,, 0.25
    11/1/2017,,,,, 0.23

  • “the fresh reserves will sponsor increased bank lending and investment, which will in turn increase spending on, and prices of, goods and services.”

    True, but there is often a very long lag between policy and effect on prices, up to five years. That’s why the Fed has so much trouble controlling money. Any control structure must have very short feedback loops in order to keep it from spinning out of control. Any time the feedback comes as late as it does in prices, there is no way the Fed can manage it. The Fed tends to over steer and cause wrecks.

    Large corporations have been holding onto large amounts of cash since the crisis or buying their own stock shares. Doesn’t that indicate that Fed policy was impotent to change their minds about investing?

    • Spencer Hall

      @ McKinney:

      No, the effect of money on prices is not upwards of 5 years. The distributed lag effects of money are mathematical constants. They have been for over 100 years.

      The Fed's problem with controlling the money stock has to do with their monetary transmission mechanism, interest rates, and their inability to understand that DFIs create new money when they lend/invest. They never loan out existing savings (as anyone who has applied double-entry bookkeeping on a National scale should already know).

      • There is no such thing as constants in economics. And I have seen distributed lag studies show that the cpi effect can be up to five years. That creates a huge problem for them. They can't predict GDP, inflation or anything for even two quarter out, let alone five years. So they have no idea how their policies are working or which way to make adjustments.

        • Spencer Hall

          You quote Bernanke: admitting – he can't forecast for more than a few quarters in his book: "The Courage to Act".

          It's probably a celestial (solar system) induced constant. And it has economic implications. The mere fact that both the distributed lags for R-gDp and inflation are invariable allows one to make "precise" economic prognostications.

          Yeah, I discovered the Gospel in July 1979, it is worth trillions of economic $s. It should be classified as "top secret" by the CIA.

          Leland James Pritchard Ph.D., Chicago, Economics, 1933: "You have a predictive device nobody has hit on yet" – 9/8/81

          I am going to change the world (in more ways than one).

          – Michel de Nostredame

          • Spencer Hall

            Trumps' inauguration coincides with the seasonal inflection selling point (3rd week in Jan):

            01/1/2017,,,,, 0.123 sell stocks short (> 5% move)
            02/1/2017,,,,, 0.057
            03/1/2017,,,,, 0.055 buy stocks

          • Spencer Hall

            Putin is going to figure this out before Trump. All my internet traffic is from Russia.

          • Spencer Hall

            One Chinese scholar almost figure it out.

  • Spencer Hall

    The loanable funds theory of interest (that borrowing is more “elastic” at lower rates), Keynes' liquidity preference theory (demand for money), the Wicksellian Natural Neutral Rate of Interest (some presupposed and immeasurable economic pendulum / equilibrium), etc., are all full of holes (as is the Fed’s monetary transmission mechanism).

    Interest is determined by the supply of, and demand for, loan-funds’ modeled schedules, period. It is not based on the volume of savings, rather the amount saver-holders aim to allocate (proffer), or mis-allocate, towards idiosyncratic investment alternatives or marginal consumption utilities (dis-savings), i.e., investable hurdle rates, opportunity costs, viz., the Tax Reform Act of 1986 and the deductibility of mortgage interest, or “Modified Accelerated Cost Recovery System”, MACRS, etc. (Gresham’s law is apropos).

    And business expenditures depend largely on profit-expectations, and favorable profit-expectations depend primarily on cost/price relationship of the recent past and of the present. Cost/price relationships are crucial, and they are particular; they cannot be adequately treated in terms of broad-aggregates or statistical weighted “averages”.

    Investments in consumer and capital goods are deferred when demand is absent (hence productivity and incomes decline). And demand depends heavily upon money velocity (putting voluntary savings to work). I.e., N-gDp (a proxy for AD or M*Vt), has steadily decelerated since 1981.

    The fed can control changes in commercial bank credit (a Central Bank’s bank-lending: "cost-of-capital" channel approach), and by pursuing compensatory actions, control the total volume of loan-funds flowing into the financial markets. These actions can easily offset changes in the volume of
    personal, corporate, and international savings / borrowings.

    See – Speech, Chairman Ben S. Bernanke, 6/15/07:

    “The Credit Channel of Monetary Policy in the Twenty-first Century Conference”, Federal Reserve Bank of Atlanta, Atlanta, Georgia


    & also:

    Speech, Vice Chairman Stanley Fischer, 11/15/2016:

    "Do We Have a Liquidity Problem Post-Crisis?, Initiative on Business and Public Policy at the Brookings Institution, Washington, D.C.


    It is axiomatic, all domestic savings originate within the commercial banking system, today’s DFIs. I.e., the source of time (savings) deposits is other bank deposits (demand deposits), directly or indirectly via the currency route, or thru the DFI’s undivided profits’ accounts. And savers never transfer their savings out of the banking system, unless currency is hoarded. And savings can
    never be invested, unless their owners invest directly or indirectly via non-bank conduits (outside the banking system).

    The source of bank deposits is largely derived from the expansion of reserve bank credit. Time (savings) deposits, rather than being a source of loan funds for the commercial banking system, are the indirect consequence of prior bank credit creation. And the source of bank deposits can be largely accounted for by the expansion of Reserve bank credit (manna from Heaven, obviously there’s not a tax on IBDDs).

    That there is a close connection between aggregate bank credit and the aggregate volume of bank deposits can be verified by comparing the net changes in commercial bank credit to the net changes in total deposits for almost any given time period (note that as of the DIDMCA, the BOG’s commercial bank credit figures omit the S&L’s, MSB’s, and CU’s: loans and investments), viz., the
    FOMC's proviso "bank credit proxy" used to be included in its directive during Sept 66 – Sept 69).

    When DFIs grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets by initially paying for them, via the creation ex-nihilo, of an equal volume of new money – demand deposits — somewhere inside the banking system. I.e., for the CB system, the whole is not the sum of its parts in the money creating process (as anyone who has applied
    double-entry bookkeeping on a national scale should already know).

    – Michel de Nostredame

  • Philon

    You speak of the Fed's "paying interest on bank reserves to discourage banks from lending them out." But I have noticed other bloggers speaking derisively of the notion that banks can lend *reserves*; do they have a point (and, if so, would you please explain it)? And Robert Hall, in his recent conversation with Russ Roberts (EconTalk), said that the total amount of reserves is determined by the Fed — that if a bank wanted to reduce the amount of its reserves it would only be able to *transfer* some to another bank. Was that a sensible remark?

    • George Selgin

      What Hall says is true of total reserves only, not excess reserves. Banks never have to hold ANY excess reserves; they can always reduce their holdings by lending more, and thereby expanding deposits, which by raising their overall reserve _requirements_, reduces excess reserves despite unchanged total reserves. On this see https://www.alt-m.org/2016/01/05/interest-reserves-part-ii/

      As for whether banks lend reserves, the claim that they don't is a tedious semantic quibble. Of course banks make loans by first crediting borrowers' deposit accounts–voila! But were that the whole story, banking would be too good a business to be true! It isn't: the borrowers quickly write checks or otherwise draw on their borrowed balances. Checks etc. are presented through the clearing system for settlement. At the margin, new loans lead to corresponding net debits and reserve transfers, other things equal. In speaking of banks "lending" reserves, economists merely summarize this chain of events. The people who dismiss them for doing so, on the grounds that their view is naive, are in fact the ones that don't "get it."

      I only wish I had a nickel for every time I heard one of these fallacies triumphantly trumpeted!

      • Philon

        Very clear and convincing; thanks!