Why the modest inflation?

[Danan]

The reason quality of assets on Fed's Balance Sheet matters is because if those assets couldn't be sold off at least at par & if they can only be sold at enormous losses as is likely to occur then those losses will have to be borne by Treasury.

Ever heard Ron Paul saying, "Why is Fed buying all these BAD ASSETS, why are they putting this on taxpayers' tab?". etc etc. It's precisely because as & when these losses occur, Treasury will have to bear them since despite all the talk of Fed being "private", it really is just another arm of the government & just as Fed hands over its profits to Treasury, it must also bear Fed's losses, which means that essentially it's the taxpayers that are on the hook!

I'm aware that this would "cause losses". But to be honest, in reality those losses already occured at the time they purchased those papers above market value. It's just a matter of accounting at this point, because real wealth doesn't care for financial years.

But that's not the "problem" I was talking about. Of course it would hurt, but I was more interested in the monetary consequences of a shrinking balance sheet. Because ironically if the balance sheet of the Fed roughly represents the amount of the currency in circulation, then the value of the Dollar would have to up , due to it's higher scarcity.

So would a giant devaluation of the Fed's mortgage backed securities (or even a partial default of the US government) cause the price of the Dollar to go up? That sounds a little bit counter-intuitive.

 

[gonegolfin]

Brian, thank you for your in-depth explanations here. I feel like I'm finally filling the most crucial gaps in my understanding, even if every answer leads to a new question.

You are welcome ... glad I can help.

Wow...the "interest on all reserves" part sounds extraordinarily shady, even by the Fed's standards. It essentially sounds like free money for banks based on how much money they already hold in reserves, which grossly distorts the meaning and purpose of the term "interest."

Yes, it is a method used by central banks to sequester reserves while still providing some incentive for lending/investment. But given the extreme level of bank reserves, the Fed is also using it as a tool to recapitalize the banks. It is the first time the Fed has used it (to my knowledge), but not the first time it has been used by central banks. Obviously it is now being done on an unprecedented scale.

However, I'm now quite confused about something: The fact that interest is paid on all reserves - not just excess reserves or those on deposit with the Fed - seems to defeat the purpose of IOR, because if banks get the "interest" payments from the Fed regardless of how they're using their reserves, doesn't that limit the effectiveness of IOR in regulating interest rates and lending? After all, "interest no matter what, as long as you don't bleed reserves" seems like a poor way of incentivizing any particular lending behavior. Clearly I'm misunderstanding something here...fill me in?

Thank you for asking this question, I was hoping someone would. This illustrates that you are paying close attention and trying to understand what the Fed is doing ... keeping your eye on the ball ... unlike some others that continue to ignorantly argue a position because the truth does not meet their preconceived notions (positions they would like to be true) learned from faulty propaganda/writings. After a while, those folks simply need to visit the ignore list.

#1 Being that the primary goal of the Fed in all of this to recapitalize the banking system, this is more completely done by paying interest on all reserves. They also want to keep interest rates low for obvious reasons, which is why they are not paying more than 25 bps and using IOR as the short term market rate.

#2 Paying something on reserves (instead of nothing at all) is still somewhat of a disincentive to lend, even if that interest is being paid on all reserves. It becomes a decision of whether to sit on those excess reserves and earn 25 bps (play it conservative) ... or invest some excess reserves, thus creating more required reserves (and still earning interest on RR+ER), but now taking on more risk with the investment. This allows banks to construct a more balanced portfolio with respect to risk (risk management).

#3 Despite the added investment risk noted above, paying interest on all reserves still provides enough incentive to move some of these excess reserves into the economy. The banks cannot survive on 25 bps alone (though it certainly helps) and will look for opportunities to employe some of those excess reserves (and we can track that directly). Meanwhile, if the Fed paid interest on only excess reserves, in really hard times it would create the possibility of a liquidity trap as a side effect. It does not want that ... and we are currently nowhere close to that ... despite the opinion of the Seeking Alpha article I commented on (and provided direct evidence as to why this is not the case) this week that postulates we are presently in a liquidity trap.

It is a balanced approach in the context of managing the monetary base and money supply, with the primary goal of recapitalizing the banking system.

The Fed views interest paid on the required reserves portion of IOR as compensation for what is considered a "tax" on depository institutions. That is, depository institutions are required to hold a certain amount of reserves (required reserves) and are unable to earn anything on those funds (the Fed views this as a tax as this money is in limbo). I do not agree with this notion as I view it as a cost of doing business ... I view it as necessary collateral for conducting operations. But the much bigger issue is interest paid on excess reserves.

From the perspective of a fiat money system propped up by legal tender laws and petrodollar hegemony, why is the composition of the Fed's balance sheet so important? Granted, the Fed needs to possess valuable assets instead of junk if it plans on extinguishing money by selling its assets back on the open market, but is there a reason related to the value of the dollar that I'm not seeing?

This is precisely the reason (you have read/understood my articles). This may be much more important than you realize and is directly related to the value of the US Dollar. If the Fed experiences losses in its portfolio (whether via asset quality or interest rate movements), it is then hampered in its ability (based on the degree of the losses) to execute monetary policy. This could mean, for example, the inability of the Fed to reign in excess reserves it would like to extinguish (because of monetary inflation that is taking place). The inability for the Fed to do this would stoke more inflation fears. This would also prompt the banks to do something with their excess reserves (protecting themselves) as the dollar fell ... and this would ripple to other dollar holders. There would be one of several responses by authorities, but each would have their own set of ramifications for the dollar. One response might be for the Fed to obtain approval from Congress to issue its own interest bearing debt. And yes, this would be interesting because this debt would compete with US Treasury debt in the marketplace. This interest bearing debt would be sold by the Fed to extinguish reserves. And yes, the Fed would be holding its own debt as an asset on its balance sheet. Another response (if required) might be a Fed recapitalization effort via the US Treasury.

Is it really necessary for the system to be inflationary just to survive though? I understand that the human element virtually guarantees inflation as an inevitable result of fiat money, but in theory, couldn't the Fed technically seek to maintain a stable monetary base under all conditions, thereby mimicking a gold standard (without any new gold mined)?

That cleared up a LOT for me. Thanks.

In theory, you may be correct. In practicing, mimicking a gold/valued asset standard (without actually implementing a gold/commodity/valued asset standard) would be extraordinarily complex to do. As big as banker egos are, I am not even sure they would think it is feasible. And then (still in practice) you still have the politicians. They would apply pressure to bleed the system away from the light of day. This happened under our Gold standard that ended under Nixon. We were cheating and the world called us on it.

Brian

 

[gonegolfin]

I guess what he's implying is that against popular belief banks cannot get significant amount of loans for zero or near zero percent interest, neither directly through the Fed nor indirectly through it's policies. The only market to which this often mentioned interest rate does apply is miniscule in size and unimportant at this point in time. I guess he further suggests (though I don't want to put words in his mouth) that in fact banks do have to finance themselves through the market for savings and loans, which you suggested would only be true in absence of the Fed.

I'd like to know if I described gonegolfin's position correctly. It's certainly a very interesting point of view.

Yes Danan, regarding this topic your summary is accurate, but a few more specifics should be provided. Some of the below you address above ... and some of the below is adding to your summary.

1) The Fed does not loan to the commercial banking system in any capacity, except via the primary credit facility (discount window) and some of the specialized lending facilities they put into place during the recent "financial crisis". These facilities are now defunct.

2) As far as indirect is concerned ... before 2009 the Fed managed the federal funds rate by buying/selling treasuries, agency debt, and agency MBSs from/to its primary dealers. The sole purpose was to manage the supply of reserves to achieve the desired federal funds rate in the context of daily demand of reserves. This was not a mechanism to push reserves into the system that could then be used banks for lending. First, half the time the Fed was removing money from the system. Over time (even short periods of time), the net amount of reserves pushed into the system is zero (it is presently at -$94 billion). We are also not talking about much money here. Second, the maturity of these Fed operations is typically one to several days (and funds borrowed by the banks from other banks in the federal funds market ... are overnight). It is nonsensical to believe that such a maturity of operations could be used as the basis/foundation for bank lending and investment.

3) The Fed has had $0 in repurchase agreements on its weekly balance sheet since the beginning of 2009. As I stated, the Fed is actually net negative with respect to reserve creation via TOMO operations.

The reserves supplied by the Fed to the banking system for operations (lending/investing) and non-operations (squatting) have been provided through outright asset purchases (Fed balance sheet expansion). Not loans.

This very detailed in-depth analysis of specific policies could certainly be useful in order to dismiss common myths, such as, "Banks get newly created money for almost 0% interest and can then invest it or put it for more interest in Fed-accounts!" (That is, if I understand Bryan correctly and if what he says is also actually true - but he seems quite knowledgeable.)

Precisely.

Brian

 

[gonegolfin]

As "gonegolfin" has said, all of these myths & conspiracy theories just discredit the liberty movement; yes there are issues with Fed & many other things but that doesn't mean that any fallacious against them is necessarily true; I wish more people would actually spend time on learning the philosophy of liberty & sound economics than looking out for the next big conspiracy theory!

Well said.

Brian

 

[Brian4Liberty]

Once again, without getting into the lowest levels of detail, how is the Federal spending and Federal debt being financed?

When the Fed purchases treasuries (as well as Agency debt and Agency MBSs) via traditional trading desk open market operations (either temporary or permanent), the Fed conducts these purchases through its primary dealers. Ownership of the treasury securities are simply transferred to the Fed and kept as assets on their balance sheet. If the primary dealer is conducting the sale on behalf of a commercial bank (frequently the case), the Fed simply credits the reserves account of that commercial bank when it receives the treasury securities.

Is the Fed doing this in trivial amounts, or large amounts? Is the Fed enabling the process of Federal debt?

Yes, it sells. The treasury holds auctions when they issue debt. You can find out more at treasurydirect. I will never in my life buy a government bond so I don't care to know more.

The last figures on China I've seen are from 2011, they held about $1.3 trillion. Country specific figures for private foreign holders are nebulous guesses though.

For the latest figures on ownership of treasury securities you'll want to look at the flow of funds release from the fed here: http://www.federalreserve.gov/econresdata/statisticsdata.htm
Click on (Flow of Funds Accounts of the United States - Z.1). You want levels, not flow, of treasury securities which is L.209 and you can jump there by going to page 104 in the full release.

Total liabilities of presumably the treasury are listed as $11 trillion.

The Fed holds about $1.6 trillion ~ 15%
Foreign holders about $5.3 trillion ~ 48%

You can look at the breakdowns listed in the release there if you want to know more. Keep in mind that figures such as this and the categories used can be defined in a myriad of ways.

The National Debt clock is now at over $16 trillion. Is the difference between 16 and 11 due to additional debt created since your figures were reported, or is there an additional debt mechanism other than the Treasury issuing debt?

So we have a figure of $1.6 trillion or 15% in direct Federal Reserve purchases of Treasury debt. (Not a trivial amount).

So what other mechanisms are used by the Federal Reserve to help finance the debt? We know that the Federal Reserve is purchasing toxic debt from Wall St. Is some of that money turned around and invested in Treasuries? How much money would that entail?

 

[Brian4Liberty]

As "gonegolfin" has said, all of these myths & conspiracy theories just discredit the liberty movement; yes there are issues with Fed & many other things but that doesn't mean that any fallacious against them is necessarily true; I wish more people would actually spend time on learning the philosophy of liberty & sound economics than looking out for the next big conspiracy theory!

Well said.

Brian

We need to be a little more specific, but not too detailed!

What are the (untrue) myths and conspiracy theories?

 

[TheTexan]

As far as indirect is concerned ... before 2009 the Fed managed the federal funds rate by buying/selling treasuries, agency debt, and agency MBSs from/to its primary dealers. The sole purpose was to manage the supply of reserves to achieve the desired federal funds rate in the context of daily demand of reserves. This was not a mechanism to push reserves into the system that could then be used banks for lending. First, half the time the Fed was removing money from the system. Over time (even short periods of time), the net amount of reserves pushed into the system is zero (it is presently at -$94 billion). We are also not talking about much money here. Second, the maturity of these Fed operations is typically one to several days (and funds borrowed by the banks from other banks in the federal funds market ... are overnight). It is nonsensical to believe that such a maturity of operations could be used as the basis/foundation for bank lending and investment.

Considering that reserves have very obviously gone up since the Fed was created, I'd say it's very difficult to say the net amount of reserves pushed into the system over time is zero.

All funds are fungible. Any funds that enter the system can be used for anything. And considering the proximity of the bankers to the printing press, I think it's fairly unlikely that the money the Federal reserve adds to the market isn't being used for primarily loans* and investments.

Unless the Fed has some policy of making sure the PD's spend all their money on home-made products, of course.

(*Taking interest on reserve is also a loan, but is not called a loan. Because they are getting paid to keep reserves, they are essentially loaning that money to the Fed. Its no different than loaning it to the Fed, except the money stays on the bank's books.)

 

[Aurave]

The National Debt clock is now at over $16 trillion. Is the difference between 16 and 11 due to additional debt created since your figures were reported, or is there an additional debt mechanism other than the Treasury issuing debt?

Those figures are from last Friday. The difference is intragovernmental debt. Stuff that cant be sold on the market, most of it, or a lot of it, is in the social security "trust fund". Debt the government owes to itself (lol?)

 

[TheTexan]

Those figures are from last Friday. The difference is intragovernmental debt. Stuff that cant be sold on the market, most of it, or a lot of it, is in the social security "trust fund". Debt the government owes to itself (lol?)

I think social security is a legitimate debt owed to the American people... which makes it a shame it will never be paid back

 

[Brian4Liberty]

Those figures are from last Friday. The difference is intragovernmental debt. Stuff that cant be sold on the market, most of it, or a lot of it, is in the social security "trust fund". Debt the government owes to itself (lol?)

So it's money "borrowed" from the SS trust fund?

 

[furface]

"Why the modest inflation?" Because very few people have any money. The Fed keeps printing money, but it just gets pissed down the government toilet on its way to the elite banking sewer. A real stimulus would be when money ends up in the hands of ordinary people and they start spending it. That's when you would have inflation if you didn't implement other policies to stop it.

 

[Aurave]

So it's money "borrowed" from the SS trust fund?

It really functions more like part of the actual budget than being "borrowed". If there are surplus payroll taxes they are "invested" into government debt, by an arm of the government. Which really isn't savings, or investment, at all- anymore than moving money from your savings account into your checking account and then spending it on air jordans is somehow an investment on your part, or a debt to yourself.

Sure, if you wanted to really to be stubborn with the idea you could say that you actually have an extra $100 in your savings account because your checking still owes it $100. But in the end the only way that $100 is going to appear in any account is for you to actually work for it...which would be the exact thing you would have to do anyway if that $100 "debt/investment" never existed in the first place. It is just a semantic retardation, a fallacy of composition.

 

[TheTexan]

Helpful illustration:

source: http://www.federalreserve.gov/datad...label=include&layout=seriescolumn&pp=Download

(Link may or may not work, if not go to the Data Download Program and select excess reserves)

 

[heavenlyboy34]

One thing that can offset the counterfeiting is defaulting on debt.

Still it is hard to see inflation up close for me. I'm guessing its been over 8% a year most of my life. I think once some time passes and we look back at the last few years we will be able to see it was alive and well. Actually I have been thinking the last year we had a nice break and had some counterfeiting easing.

Anyway if you look long term it looks heavy duty. Not like the figures they dish out anyway.

Printing money, by its nature, is a type of default.

 

[Paul Or Nothing II]

What's the difference, they own it~

No, they don't! That's just more conspiratorial garbage for the simple-minded!

Government created & sustains the system because government itself is its biggest beneficiaries, although there may be other INCIDENTAL beneficiaries, all the wealth that government rakes in with the prevelant system isn't going to them, it certainly does NOT hand it over to the banks but rather government uses all that wealth on ITSELF!

 

[Paul Or Nothing II]

I'm aware that this would "cause losses". But to be honest, in reality those losses already occured at the time they purchased those papers above market value. It's just a matter of accounting at this point, because real wealth doesn't care for financial years.

But that's not the "problem" I was talking about. Of course it would hurt, but I was more interested in the monetary consequences of a shrinking balance sheet. Because ironically if the balance sheet of the Fed roughly represents the amount of the currency in circulation, then the value of the Dollar would have to up , due to it's higher scarcity.

Government not being able to sell those securities at par in itself will be problem when the arrives. When those losses become due, how do you think Treasury is going to pay them? Treasury doesn't even have enough money to pay its "regular" expenditure, which it pays by selling Treasuries! Well, Treasury will simply have to sell "additional" debt to raise enough money to pay off Fed's losses

And then Fed Balance Sheet will essentially go something like this :

(continued from this link - http://www.ronpaulforums.com/showth...-liabilities&p=4405329&viewfull=1#post4405329)

Case 3 : Fed sold MBS at a loss

Liabilities                                         Assets
Currency in circulation - 1 trillion                   Treasuries/US debt - 2 trillion
All banks' reserves - 1.5 trillion                      Losses/Treasury A/c - 0.5 trillion

Treasury meets the losses by selling additional Treasuries to the market

Liabilities                                         Assets
Currency in circulation - 1 trillion                   Treasuries/US debt - 2 trillion
All banks' reserves - 1 trillion                        Losses/Treasury A/c - 0.5 trillion
Profits/Treasury A/c - 0.5 trillion

Losses written off

Liabilities                                         Assets
Currency in circulation - 1 trillion                   Treasuries/US debt - 2 trillion
All banks' reserves - 1 trillion

Fed buys equivalent amount of Treasuries in order to prevent interest on Treasuries from rising & choking US government

Liabilities                                         Assets
Currency in circulation - 1 trillion                   Treasuries/US debt - 2.5 trillion
All banks' reserves - 1.5 trillion

When the losses become due, Treasury will either give debt-securities worth the amount to Fed or Treasury will simply sell them to Primary Dealers & Fed will immediately buy from them but one way or another, more or less of those losses will "replace" more debt-securities on Fed's Balance Sheet.

So there will be no "shrinking" of Fed's B/S that you are talking about. In fact, the real "problem" is the fact that if Fed can't sell those bad securities at par then it will become even harder for them to shrink their B/S & that will set up stage for higher inflation!

So would a giant devaluation of the Fed's mortgage backed securities (or even a partial default of the US government) cause the price of the Dollar to go up? That sounds a little bit counter-intuitive.

The more money government needs > the more debt they issue > more of the debt will have to be bought by the central-bank to keep down interest on debt to prevent government-bankruptcy > the more central-bank buys > the more money is created > higher future inflation

 

[TheTexan]

No, they don't! That's just more conspiratorial garbage for the simple-minded!

Are you seriously trying to tell me that the banks don't pick our candidates nowadays? "Conspiracy garbage" ok

Government created & sustains the system because government itself is its biggest beneficiaries, although there may be other INCIDENTAL beneficiaries, all the wealth that government rakes in with the prevelant system isn't going to them, it certainly does NOT hand it over to the banks but rather government uses all that wealth on ITSELF!

Ya, the banks huge profits over the last decades was surely incidental, I'm sure they had zero influence in making sure that free money chopper was at full capacity. You're selling to someone who just isn't buying, sorry.

 

[Paul Or Nothing II]

Once again, without getting into the lowest levels of detail, how is the Federal spending and Federal debt being financed?

Well, at the most fundamental level through taxes & debt........

I'm not sure but I'm assuming you want to know how Fed enables the system & helps out the government.....

If that's indeed the question then -
1) Interest saved - All the interest Treasury "pays" to Fed on Treasuries held by Fed is eventually handed BACK to the Treasury when "Fed's profits" are given back to Treasury. If somebody else had held these Treasuries then money would GO OUT of US government but having Fed there means that much interest essentially goes nowhere & remains with the US Treasury so that it can spend it where it wants.

2) Seigniorage on Coins & Notes -
US Treasury sells coins to Fed at face value to circulate into the economy through 12 regional Fed-banks, as per the communication received from commercial banks about the public-demand for coins; so the difference between cost of production & face value of coins is profit for Treasury.
Just like with coins, as public-demand for notes increases, commercial banks ask for more notes from the 12 regional Fed-banks, these Fed-banks have to buy Treasuries to issue notes into circulation, which they buy from Treasury. Again, the interest saved on these Fed-held Treasuries benefits government.

3) Lower cost of borrowing (interest on Treasuries) - The most significant benefit Fed (all central-banks really) offer to the government is that without a central-bank, government would have to pay much higher interest for borrowing money from the market but with central-banks' virtually unlimited capacity to "create money", they create additional demand for Treasuries & drive down interest on Treasuries/debt, which means government can borrow & spend more than it could have without the existence of a central-bank. Without Fed, US government would probably have bankrupted itself by now but the existence of Fed has enabled it to prolong the inevitable by a few decades at the least.
Without a central-bank, governments' borrowing habits would have to be curtailed significantly or the system would collapse a lot faster so central-banks almost stand to legitimize high government spending & borrowing!

4) Higher taxes - As inflation hits & prices rise, income rise subsequently, so do taxes!

We need to be a little more specific, but not too detailed!

What are the (untrue) myths and conspiracy theories?

There are too many perhaps but a couple would be that "banks get money for free" or that "Fed is private"; it's alright to agitate people with such statements to get them to want to know what Fed & government is doing but that's all should be its utility because as has already been pointed out, neither do banks get "free money" (since they have to repay their loans with interest) nor is Fed run like a truly "private" company (since it's just another arm of the government & hands over its profits to Treasury).

So it's money "borrowed" from the SS trust fund?

Except they would call it money "invested"! You know because all the wise people in government have chosen to "invest" our money in government-debt as it's the "safest" instrument out there since government will never default on its obligations (it's beside the point that they will just devalue it )

 

[Paul Or Nothing II]

Are you seriously trying to tell me that the banks don't pick our candidates nowadays? "Conspiracy garbage" ok



Ya, the banks huge profits over the last decades was surely incidental, I'm sure they had zero influence in making sure that free money chopper was at full capacity. You're selling to someone who just isn't buying, sorry.

Are you in the habit of getting off-track?

The original point of contention was - who's the BIGGEST beneficiary of the system?
You'd said it was the banks & I'd contended that government is the biggest beneficiary of the system & I still stand by that.

Again, banks would be pretty profitable whether borrowing-rates were at 0.XX% while lending-rates being 2-3%, or whether borrowing-rates were at 4-5% while lending-rates being 7-8%, they'd still make good money so long as there was demand for their services, which there usually is in productive societies; but without Fed, government wouldn't be able to borrow at such discounted rates that it does!
Banks are intermediaries, they borrow from one side & lend from the other while they make the spread for providing their services so the rates of interest don't directly affect them but the rates directly affect the ACTUAL borrowers/spenders & lenders/savers.

A libertarian attacks the Fed & the government while a liberal would attack the whole banking industry & anyone that seems to be making a lot of money!

I don't think I could ever convince anyone who relies on conspiracy theories so I don't even try but I just choose to post for those few who might be interested in facts!

 

[Travlyr]

So I still stand by the statement banks are NOT necessarily the biggest beneficiaries of the system, GOVERNMENT IS!

Are you serious? The Rothchild Family is worth $Billions upon $Billions.

Sure, the small bankers are not necessarily raking in as much dough as they would like, but they are participating in the theft of America too. Fractional reserve banking is a theft scheme ... plain and simple.