Tag Archive for 'Interest rates'

Paying interest on (excess) reserves (Updated)

Published on 28 July 2010 in Economics, Finance and USA. Tags: , , , , , , , , , . 0 Comments

The U.S. Federal Reserve is currently paying 0.25% interest on the reserve accounts of depository institutions.  This is therefore, at present, the primary rate of policy concern (as opposed to the Fed Funds rate):  if a bank can’t get a rate of return that, when adjusted for risk, is greater than 0.25%, they will stick their money in their reserve account at the Fed.  Among others, Scott Sumner [blog] has called this policy a mistake.

There is an economic cost to the policy.  0.25% isn’t much, but it’s the risk-free aspect that complicates things.  If banks’ risk aversion or their perception of the risks associated with investments are high, then a truely risk-free 0.25% could look quite attractive.  With the interest rates on US treasuries so low, there’s certainly reason to believe that risk aversion is still abnormally high at the moment.  Whether the demand for loans is coming from particularly risky projects, or is perceived to be, I don’t know (is there any way of knowing?).

So why have it at all?  I suppose I support the paying of interest on required reserves.  The banks don’t get a choice with them, so it seems only fair that they be compensated.  But for excess reserves, there would need to be an offsetting benefit to justify the policy.  One benefit will be that the interest is paid with new money, so it’s a way of quietly helping banks improve their balance sheets.  There’s currently about US$1 trillion in excess reserves, so that’s about US$2.5 billion per year.  That may be a lot of money to you and me, but it’s not much more than a rounding error to the US banking system as a whole.  Still, it’s something.  Another benefit, depending on your point of view, is that by attracting all that money into excess reserves, the Fed sterilised the QE they engaged in last year.  If you feel that the sterilised QE has caused lower long-term interest rates and hold that those rates are the ones that most significantly drive the economy and distinctly dislike inflation, then you’d probably judge the affair to have been a success [I include the weasel words because I am no longer certain].  A third benefit, which is really a further justification of the second, is that there is evidence that the Fed’s QE appears to have lowered not just US rates, but foreign rates as well.  In that case, then you probably want to sterilise the fraction going to other countries (bad enough, one might think, that America is fixing the rest of the world; it would be unthinkable if America also had to suffer inflation by doing so).

Anyway, all of that is by way of getting around to this point:  via Bruce Bartlett, I’ve just discovered that Sweden also pays interest on reserve deposits, normally 0.75 percentage points lower than their repo rate.  But, crucially, their repo rate is currently only 0.50%, which means that their deposit rate is negative, at -0.25%.

For myself, I tend to think that the interest rate on excess reserves should be lowered.  My argument is similar to what I imagine Scott Sumner would say, so I should also explain his view a little, to the extent that I understand him.  With nominal GDP at US$14 trillion, the US$1 trillion sitting in excess reserves is a very, very large amount of money.  If it were released into the economy, it would be a huge stimulus (even if the money multiplier/velocity of money is temporarily low).  By choosing to sterilise their QE (presumably out of fear of inflation), the Fed has turned what could have been a tremendously effective stimulus into a mediocre one at best.  Scott is rather more sanguine about inflation in general than I am (he favours targeting NGDP; I suspect that this graph would make him want to tear his hair out), but even if the Fed wishes to target inflation of, say, the near-universally accepted benchmark of 2%, then with actual current inflation down at 0.5% and expected future inflation below 1.5% for most of the next 10 years and falling, the sterilisation has been excessive.

Update 6 Aug 2010:

The FT’s Alphaville has gathered the arguments for and against.  Here are three arguments (and their counter-arguments) for keeping the Interest on Reserves (IoR) unchanged:

First, from Ben Bernanke himself, made in recent congressional testimony:

The rationale for not going all the way to zero has been that we want the short-term money markets like the federal funds market to continue to function in a reasonable way because if rates go to zero there will be no incentive for buying and selling federal funds, overnight money in the banking system, and if that market shuts down … it’ll be more difficult to manage short-term interest rates, for the Federal Reserve to tighten policy sometime in the future. So there’s really a technical reason having to do with market function that motivated the 25 basis points interest on reserves.

I think this is silly. It’ll be more difficult to manage short-term interest rates in the future only if, following an effective shut-down of the federal funds market, it becomes costly to start it back up again. I seriously doubt that the banks are going to take their existing staff, processes and infrastructure dedicated to this and throw them out the window. Heck, in a Q&A session after his testimony, Mr Bernanke stated that lowering the interest rate on reserves is a (serious) option in the event that the FMOC decides that further stimulus is warranted:

But broadly speaking, there are a number of things we could consider and look at; one would be further changes or modifications of our language or our framework describing how we intend to change interest rates over time — giving more information about that, that’s certainly one approach. We could lower the interest rate we pay on reserves, which is currently one-fourth of 1%.

A second viewpoint, put forward by Dave Altig (of the Atlanta Fed) and Joseph Abate (of Barclays Capital), is that

If banks didn’t get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn’t see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum.

I think that Jim Hamilton’s response to this is excellent, so let me just quote it in full:

But Dave doesn’t quite finish the story. If I as an individual bank decide that a repo or T-bill looks better than zero, and use my excess reserves to buy one of these instruments, I simply instruct the Fed to transfer my deposits to the bank of whoever sold it to me. But now, if that bank does nothing, it would be left with those reserve balances at the end of the day on which it earns nothing, whereas it, too, could instead get some interest by going with repos or T-bills. The reserves never get “shifted into short-term, low-risk markets”– instead, by definition, they are always sitting there, at the end of the day, on the balance sheet of some bank somewhere in the system.

The implicit bottom line in the Abate story is that the yields on repos and T-bills adjust until they, too, look essentially to be zero, so that banks in fact don’t care whether they leave a trillion dollars earning no interest every day.

The essence of this world view is that there are two completely distinct categories of assets– cash-type assets which pay no interest whatever, and risky investments like car loans that banks don’t want to make no matter how much cash they hold.

But I really have trouble thinking in terms of such a two-asset world. I instead see a continuum of assets out there. As a bank, I could keep my funds overnight with the Fed, I could lend them in an overnight repo, I could buy a 1-week Treasury, a 3-month Treasury, a 10-year Treasury, or whatever. Wherever you want to draw a line between available assets and claim those on the left are “cash” and those on the right are “risky”, I’m quite convinced I could give you an example of an asset that is an arbitrarily small epsilon to the right or the left of your line. Viewed this way, I have a hard time understanding how pushing a trillion dollars at the shortest end of the continuum by 25 basis points would have no consequences whatever for the yield on any other assets.

Finally, back with Dave Altig, there is the argument that:

the IOR policy has long been promoted on efficiency grounds. There is this argument for example, from a New York Fed article published just as the IOR policy was introduced:

“… reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.

“… it is important to understand the tension between the daylight and overnight need for reserves and the potential problems that may arise. One concern is that central banks typically provide daylight reserves by lending directly to banks, which may expose the central bank to substantial credit risk. Such lending may also generate moral hazard problems and exacerbate the too-big-to-fail problem, whereby regulators would be reluctant to close a financially troubled bank.”

Put more simply, one broad justification for an IOR policy is precisely that it induces banks to hold quantities of excess reserves that are large enough to mitigate the need for central banks to extend the credit necessary to keep the payments system running efficiently. And, of course, mitigating those needs also means mitigating the attendant risks.

But, to me, this really sounds like an argument for having higher reserve requirements, not an argument for encouraging excess reserves.  I’m all for paying interest on required reserves and setting the fraction required at whatever level you judge necessary to ensure the operation of the payments system.  But don’t try to shoe-horn that argument into keeping interest payments on excess reserves.

On interest rates

Published on 23 November 2009 in Economics, Finance and USA. Tags: , , , , , . 0 Comments

In what Tyler Cowen calls “Critically important stuff and two of the best recent economics blog posts, in some time,” Paul Krugman and Brad DeLong have got some interesting thoughts on US interest rates.  First Krugman:

On the face of it, there’s no reason to be worried about interest rates on US debt. Despite large deficits, the Federal government is able to borrow cheaply, at rates that are up from the early post-Lehman period … but well below the pre-crisis levels:

DESCRIPTION

Underlying these low rates is, in turn, the fact that overall borrowing by the nonfinancial sector hasn’t risen: the surge in government borrowing has in fact, less than offset a plunge in private borrowing.

So what’s the problem?

Well, what I hear is that officials don’t trust the demand for long-term government debt, because they see it as driven by a “carry trade”: financial players borrowing cheap money short-term, and using it to buy long-term bonds. They fear that the whole thing could evaporate if long-term rates start to rise, imposing capital losses on the people doing the carry trade; this could, they believe, drive rates way up, even though this possibility doesn’t seem to be priced in by the market.

What’s wrong with this picture?

First of all, what would things look like if the debt situation were perfectly OK? The answer, it seems to me, is that it would look just like what we’re seeing.

Bear in mind that the whole problem right now is that the private sector is hurting, it’s spooked, and it’s looking for safety. So it’s piling into “cash”, which really means short-term debt. (Treasury bill rates briefly went negative yesterday). Meanwhile, the public sector is sustaining demand with deficit spending, financed by long-term debt. So someone has to be bridging the gap between the short-term assets the public wants to hold and the long-term debt the government wants to issue; call it a carry trade if you like, but it’s a normal and necessary thing.

Now, you could and should be worried if this thing looked like a great bubble — if long-term rates looked unreasonably low given the fundamentals. But do they? Long rates fluctuated between 4.5 and 5 percent in the mid-2000s, when the economy was driven by an unsustainable housing boom. Now we face the prospect of a prolonged period of near-zero short-term rates — I don’t see any reason for the Fed funds rate to rise for at least a year, and probably two — which should mean substantially lower long rates even if you expect yields eventually to rise back to 2005 levels. And if we’re facing a Japanese-type lost decade, which seems all too possible, long rates are in fact still unreasonably high.

Still, what about the possibility of a squeeze, in which rising rates for whatever reason produce a vicious circle of collapsing balance sheets among the carry traders, higher rates, and so on? Well, we’ve seen enough of that sort of thing not to dismiss the possibility. But if it does happen, it’s a financial system problem — not a deficit problem. It would basically be saying not that the government is borrowing too much, but that the people conveying funds from savers, who want short-term assets, to the government, which borrows long, are undercapitalized.

And the remedy should be financial, not fiscal. Have the Fed buy more long-term debt; or let the government issue more short-term debt. Whatever you do, don’t undermine recovery by calling off jobs creation.

The point is that it’s crazy to let the rescue of the economy be held hostage to what is, if it’s an issue at all, a technical matter of maturity mismatch. And again, it’s not clear that it even is an issue. What the worriers seem to regard as a danger sign — that supposedly awful carry trade — is exactly what you would expect to see even if fiscal policy were on a perfectly sustainable trajectory.

Then DeLong:

I am not sure Paul is correct when he says that the possible underlying problem is merely “a technical matter of maturity mismatch.” The long Treasury market is thinner than many people think: it is not completely implausible to argue that it is giving us the wrong read on what market expectations really are because long Treasuries right now are held by (a) price-insensitive actors like the PBoC and (b) highly-leveraged risk lovers borrowing at close to zero and collecting coupons as they try to pick up nickles in front of the steamroller. And to the extent that the prices at which businesses can borrow are set by a market that keys off the Treasury market, an unwinding of this “carry trade”–if it really exists–could produce bizarre outcomes.

Bear in mind that this whole story requires that the demand curve slope the wrong way for a while–that if the prices for Treasury bonds fall carry traders lose their shirts and exit the market, and so a small fall in Treasury bond prices turns into a crash until someone else steps in to hold the stock…

For reference, here are the time paths of interest rates for a variety of term lengths and risk profiles (all taken from FRED):

interest_rates_1monthinterest_rates_3monthsinterest_rates_30years

To my own mind, I’m somewhat inclined to agree with Krugman.  While I do believe that the carry trade is occurring, I suspect that it’s effects are mostly elsewhere, or at least that the carry trade is not being played particularly heavily in long-dated US government debt relative to other asset markets.

Notice that the AAA and BAA 30-year corporate rates are basically back to pre-crisis levels and that the premium they pay over 30-year government debt is also back to typical levels.  If the long-dated rates are being pushed down to pre-crisis levels solely by increased supply thanks to the carry trade, then we would surely expect the quantity of credit to also be at pre-crisis levels.  But new credit issuance is down relative to the pre-crisis period.  Since the price is largely unchanged, that means that both demand and supply of credit have shrunk – the supply from fear in the financial market pushing money to the short end of the curve and the demand from the fact that there’s been a recession.

The contradictory joys of being the US Treasury Secretary (part 2)

Published on 16 November 2009 in Economics, Finance, Politics, Trade and USA. Tags: , , , , , , , , , , , , . 0 Comments

In my last post, I highlighted the apparent contradictions between the USA having both a “strong dollar” policy and a desire to correct their trade deficit (“re-balancing”).  Tim Geithner, speaking recently in Tokyo, declared that there was no contradiction:

Geithner said U.S. efforts to boost exports aren’t in conflict with the “strong-dollar” policy. “I don’t think there’s any contradiction between the policies,” he said.

I then said:

The only way to reconcile what Geithner’s saying with the laws of mathematics is to suppose that his “strong dollar” statements are political and relate only to the nominal exchange rate and observe that trade is driven by the real exchange rate. But that then means that he’s calling for a stable nominal exchange rate combined with either deflation in the USA or inflation in other countries.

Which, together with Nouriel Roubini’s recent observation that the US holding their interest rates at zero is fueling “the mother of all carry trades” [Financial Times, RGE Monitor], provides for a delicious (but probably untrue) sort-of-conspiracy theory:

Suppose that Tim Geithner firmly believes in the need for re-balancing.  He’d ideally like US exports to rise while imports stayed flat (since that would imply strong global growth and new jobs for his boss’s constituents), but he’d settle for US imports falling.  Either way, he needs the US real exchange rate to fall, but he doesn’t care how.  Well, not quite.  His friend Ben Bernanke tells him that he doesn’t want deflation in America, but he doesn’t really care between the nominal exchange rate falling and foreign prices rising (foreign inflation).

The recession-induced interest rates of (effectively) zero in America are now his friend, because he’s going to get what he wants no matter what, thanks to the carry trade.  Private investors are borrowing money at 0% interest in America and then going to foreign countries to invest it at interest rates that are significantly higher than zero.  If the foreign central banks did nothing, that would push the US dollar lower and their own currencies higher and Tim gets what he wants.

But the foreign central banks want a strong dollar because (a) they’re holding gazzilions of dollars worth of US treasuries and they don’t want their value to fall; and (b) they’re not fully independent of their political masters who want to want to keep exporting.   So Tim regularly stands up in public and says that he supports a strong dollar.  That makes him look innocent and excuses the foreign central banks for doing what they were all doing anyway:  printing local money to give to the US-funded investors so as to keep their currencies down (and the US dollar up).

But that means that the money supply in foreign countries is climbing, fast, and while prices may be sticky in the short term, they will start rising soon enough.  Foreign inflation will lower the US real exchange rate and Tim still gets what he wants.

The only hope for the foreign central banks is that the demand for their currencies is a short-lived temporary blip.  In that case, defending their currencies won’t require the creation of too much local currency and they could probably reverse the situation fast enough afterward that they don’t get bad inflation. [This is one of the arguments in favour of central bank involvement in the exchange-rate market.  Since price movements are sluggish, they can sterilise a temporary spike and gradually back out the action before local prices react too much.]

But as foreign central banks have been discovering [1], free money is free money and the carry trade won’t go away until the interest rate gap is sufficiently closed:

Nov. 13 (Bloomberg) — Brazil, South Korea and Russia are losing the battle among developing nations to reduce gains in their currencies and keep exports competitive as the demand for their financial assets, driven by the slumping dollar, is proving more than central banks can handle.

South Korea Deputy Finance Minister Shin Je Yoon said yesterday the country will leave the level of its currency to market forces after adding about $63 billion to its foreign exchange reserves this year to slow the appreciation of the won.
[...]
Brazil’s real is up 1.1 percent against the dollar this month, even after imposing a tax in October on foreign stock and bond investments and increasing foreign reserves by $9.5 billion in October in an effort to curb the currency’s appreciation. The real has risen 33 percent this year.
[...]
“I hear a lot of noise reflecting the government’s discomfort with the exchange rate, but it is hard to fight this,” said Rodrigo Azevedo, the monetary policy director of Brazil’s central bank from 2004 to 2007. “There is very little Brazil can do.”

The central banks are stuck.  They can’t lower their own interest rates to zero (which would stop the carry trade) as that would stick a rocket under domestic production and cause inflation anyway.  The only thing they can do is what Brazil did a little bit of:  impose legal limits on capital inflows, either explicitly or by taxing foreign-owned investments.  But doing that isn’t really an option, either, because they want to be able to keep attracting foreign investment after all this is over and there’s not much scarier to an investor than political uncertainty.

So they have to wait until America raises it’s own rates.  But that won’t happen until America sees a turn-around in jobs and the fastest way for that to happen is for US exports to rise.

[1] Personally, I think the central bankers saw the writing on the wall the minute the Fed lowered US interest rates to (effectively) zero but their political masters were always going to take some time to cotton on.

The contradictory joys of being the US Treasury Secretary

Published on 16 November 2009 in Economics, Finance, Politics, Trade and USA. Tags: , , , , , , , , , . 0 Comments

Tim Geithner, speaking at the start of the G-20 meeting in Pittsburgh:

Sept. 25 (Bloomberg) — Treasury Secretary Timothy Geithner said he sees a “strong consensus” among Group of 20 nations to reduce reliance on exports for growth and defended the dollar’s role as the world’s reserve currency.

“A strong dollar is very important in the United States,” Geithner said in response to a question at a press conference yesterday in Pittsburgh, where G-20 leaders began two days of talks.

Tim Geithner, speaking in Tokyo while joining the US President on a tour of Asian capitals:

Nov. 11 (Bloomberg) — U.S. Treasury Secretary Timothy Geithner said a strong dollar is in the nation’s interest and the government recognizes the importance it plays in the global financial system.

“I believe deeply that it’s very important to the United States, to the economic health of the United States, that we maintain a strong dollar,” Geithner told reporters in Tokyo today.
[...]
Geithner said U.S. efforts to boost exports aren’t in conflict with the “strong-dollar” policy. “I don’t think there’s any contradiction between the policies,” he said.

Which is hilarious.

There is no objective standard for currency strength [1].  A “strong (US) dollar” is a dollar strong relative to other currencies, so it’s equivalent to saying “weak non-US-dollar currencies”.  But when the US dollar is up and other currencies are down, that means that the US will import more (and export less), while the other countries will export more (and import less), which is the exact opposite of the re-balancing efforts.

The only way to reconcile what Geithner’s saying with the laws of mathematics is to suppose that his “strong dollar” statements are political and relate only to the nominal exchange rate and observe that trade is driven by the real exchange rate.  But that then means that he’s calling for a stable nominal exchange rate combined with either deflation in the USA or inflation in other countries.

Assuming my previous paragraph is true, 10 points to the person who can see the potential conspiracy theory [2] implication of Nouriel Roubini’s recent observation that the US holding their interest rates at zero is fueling “the mother of all carry trades” [Financial Times, RGE Monitor].

Hint:  If you go for the conspiracy theory, this story would make you think it was working.

Nov. 13 (Bloomberg) — Brazil, South Korea and Russia are losing the battle among developing nations to reduce gains in their currencies and keep exports competitive as the demand for their financial assets, driven by the slumping dollar, is proving more than central banks can handle.
[...]
Governments are amassing record foreign-exchange reserves as they direct central banks to buy dollars in an attempt to stem the greenback’s slide and keep their currencies from appreciating too fast and making their exports too expensive.
[...]
“It looked for a while like the Bank of Korea was trying to defend 1,200, but it looks like they’ve given up and are just trying to slow the advance,” said Collin Crownover, head of currency management in London at State Street Global Advisors

The answer to follow …

Update: The answer is in my next post.

[1] There better not be any gold bugs in the audience.  Don’t make me come over there and hurt you.

[2] Okay, not a conspiracy theory; just a behind-the-scenes-while-completely-in-the-open strategy of international power struggles.

[1] There better not be any gold bugs on this list.  Don’t make me
come over there and hurt you.

[2] Okay, not a conspiracy theory; just a behind-the-scenes-while-
completely-in-the-open strategy of international power struggles.

Money multipliers and financial globalisation

Published on 8 January 2009 in Economics, Finance, UK and USA. Tags: , , , , , , , , . 0 Comments

Important: Much of this post is mistaken (i.e. wrong).  It’s perfectly possible for America to have an M1 money multiplier of less than one even if they were an entirely closed economy.  My apologies.  I guess that’s what I get for clicking on “Publish” at one in the morning.  A more sensible post should be forthcoming soon.  I’m leaving this here, with all its mistakes, for the sake of completeness and so that people can compare it to my proper post whenever I get around to it.

Update: You can (finally) see the improved post here.  You’ll probably still want to refer back to this one for the graphs.

Via Greg Mankiw, I see that in the USA the M1 money multiplier has just fallen below one:

M1 Money Multiplier (USA, Accessed: 7 Jan 2009)

M1 Money Multiplier (USA, Accessed: 7 Jan 2009)

At the time of writing, the latest figure (for 17 December 2008) was 0.954.  That’s fascinating, because it should be impossible.  As far as I can tell, it has been made possible by the wonders of financial globalisation and was triggered by a decision the US Federal Reserve made at the start of October 2008.  More importantly, it means that America is paying to recapitalise some banks in other countries and while that will help them in the long run, it might be exacerbating the recessions in those countries in the short run.

Money is a strange thing.  One might think it would be easy to define (and hence, to count), but there is substantial disagreement of what qualifies as money and every central bank has their own set of definitions.  In America the definitions are (loosely):

  • M0 (the monetary base) = Physical currency in circulation + reserves held at the Federal Reserve
  • M1 = Physical currency in circulation + deposit (e.g. checking) accounts at regular banks
  • M2 = M1 + savings accounts

They aren’t entirely correct (e.g. M1 also includes travelers cheques, M2 also includes time/term deposits, etc.), but they’ll do for the moment [you can see a variety of countries' definitions on Wikipedia].

The M1 Money Multiplier is the ratio of M1 to M0.  That is, M1 / M0.

In the normal course of events, regular banks’ reserves at the central bank are only a small fraction of the deposits they hold.  The reason is simple:  The central bank doesn’t pay interest on reserves, so they’d much rather invest (i.e. lend) the money elsewhere.  As a result, they only keep in reserve the minimum that they’re required to by law.

We therefore often think of M1 as being defined as:  M1 = M0 + deposits not held in reserve.

You can hopefully see why it should seem impossible for the M1 money multiplier to fall below 1.  M1 / M0 = (M0 + non-reserve deposits) / M0 = 1 + (non-reserve deposits / M0).  Since the non-reserve deposits are always positive, the ratio should always be greater than one.  So why isn’t it?

Step 1 in understanding why is this press release from the Federal Reserve dated 6 October 2008.  Effective from 1 October 2008, the Fed started paying interest on both required and excess reserves that regular banks (what the Fed calls “depository institutions”) held with it.  The interest payments for required reserves do not matter here, since banks had to keep that money with the Fed anyway.  But by also paying interest on excess reserves, the Fed put a floor under the rate of return that banks demanded from their regular investments (i.e. loans).

The interest rate paid on excess returns has been altered a number of times (see the press releases on 22 Oct, 5 Nov and 16 Dec), but the key point is this:  Suppose that the Fed will pay x% on excess reserves.  That is a risk-free x% available to banks if they want it, while normal investments all involve some degree of risk.  US depository institutions suddenly had a direct incentive to back out of any investment that had a risk-adjusted rate of return less than x% and to put the money into reserve instead, and boy did they jump at the chance.  Excess reserves have leapt tremendously:

Excess Reserves of Depository Institutions (USA, Accessed: 7 January 2009)

Excess Reserves of Depository Institutions (USA, Accessed: 7 Jan 2009)

Corresponding, the monetary base (M0) has soared:

Adjusted Monetary Base (USA, Accessed: 7 Jan 2009)

Adjusted Monetary Base (USA, Accessed: 7 Jan 2009)

If we think of M1 as being M1 = M0 + non-reserve deposits, then we would have expected M1 to increase by similar amounts (a little under US$800 billion).  In reality, it’s only risen by US$200 billion or so:

M1 Money Supply (USA, Accessed: 7 Jan 2009)

M1 Money Stock (USA, Accessed: 7 Jan 2009)

So where have the other US$600 billion come from?  Other countries.

Remember that the real definition of M1 is M1 = Physical currency in circulation + deposit accounts.  The Federal Reserve, when calculating M1, only looks at deposits in America.

By contrast, the definition of the monetary base is M0 = Physical currency in circulation + reserves held at Federal Reserve.  The Fed knows that those reserves came from American depository institutions, but it has no idea where they got it from.

Consider Citibank.  It collects deposits from all over the world, but for simplicity, imagine that it only collects them in America and Britain.  Citibank-UK will naturally keep a fraction of British deposits in reserve with the Bank of England (the British central bank), but it is free to invest the remainder wherever it likes, including overseas.  Since it also has an arm in America that is registered as a depository institution, putting that money in reserve at the Federal Reserve is an option.

That means that, once again, if Citibank-UK can’t get a risk-adjusted rate of return in Britain that is greater than the interest rate the Fed is paying on excess reserves, it will exchange the British pounds for US dollars and put the money in reserve at the Fed.  The only difference is that the risk will now involve the possibility of exchange-rate fluctuations.

It’s not just US-based banks with a presence in other countries, though.  Any non-American bank that has a branch registered as a depository institution in America (e.g. the British banking giant, HSBC) has the option of changing their money into US dollars and putting them in reserve at the Fed.

So what does all of that mean?  I see two implications:

  1. Large non-American banks that have American subsidiaries are enjoying the free money that the Federal Reserve is handing out.  By contrast, smaller non-American banks that do not have American subsidiaries are not able to access the Federal Reserve system and so are forced to find other investments.
  2. The US$600+ billion of foreign money currently parked in reserve at the Fed had to come out of the countries of origin, meaning that it is no longer there to stimulate their economies.  By starting to pay interest on excess reserves, the US Federal Reserve effectively imposed an interest rate increase on other countries.

Negative interest rates on US government debt and Brad DeLong (Updated)

Published on 10 December 2008 in Economics, Finance and USA. Tags: , , , , , , , . 0 Comments

The interest rates on US government debt has turned negative (again) as a result of the enormous flight to perceived safety.  I guess they’ll be able to fund their gargantuan bailouts more easily, at least.

Brad DeLong has written a short and much celebrated essay (available on Cato and his own site) on the financial crisis and (consequently) why investors currently love government debt and hate everything else.  I’ll add my voice to those suggesting that you read the whole thing.  Here is the crux of it:

[T]he wealth of global capital fluctuates … for five reasons:

  1. Savings and Investment: Savings that are transformed into investment add to the productive physical — and organizational, and technological, and intellectual — capital stock of the world. This is the first and in the long run the most important source of fluctuations — in this case, growth — in global capital wealth.
  2. News: Good and bad news about resource constraints, technological opportunities, and political arrangements raise or lower expectations of the cash that is going to flow to those with property and contract rights to the fruits of capital in the future. Such news drives changes in expectations that are a second source of fluctuations in global capital wealth.
  3. Default Discount: Not all the deeds and contracts will turn out to be worth what they promise or indeed even the paper that they are written on. Fluctuations in the degree to which future payments will fall short of present commitments are a third source of fluctuations in global capital wealth.
  4. Liquidity Discount: The cash flowing to capital arrives in the present rather than the future, and people prefer — to varying degrees at different times — the bird in the hand to the one in the bush that will arrive in hand next year. Fluctuations in this liquidity discount are yet a fourth source of fluctuations in global capital wealth.
  5. Risk Discount: Even holding constant the expected value and the date at which the cash will arrive, people prefer certainty to uncertainty. A risky cash flow with both upside and downside is worth less than a certain cash flow by an amount that depends on global risk tolerance. Fluctuations in global risk tolerance are the fifth and final source of fluctuations in global capital wealth.

In the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion. Savings has not fallen through the floor. We have had little or no bad news about resource constraints, technological opportunities, or political arrangements. Thus (1) and (2) have not been operating. The action has all been in (3), (4), and (5).

As far as (3) is concerned, the recognition that a lot of people are not going to pay their mortgages and thus that a lot of holders of CDOs, MBSs, and counterparties, creditors, and shareholders of financial institutions with mortgage-related assets has increased the default discount by $2 trillion. And the fact that the financial crisis has brought on a recession has further increased the default discount — bond coupons that won’t be paid and stock dividends that won’t live up to firm promises — by a further $4 trillion. So we have a $6 trillion increase in the magnitude of (3) the default discount. The problem is that we have a $20 trillion decline in market values.

Some people have criticised Brad for his characterisation of the liquidity discount, suggesting that he has confused it with the (pure) rate of time preference.  I don’t think he is confused.  Firstly because he’s a genuine expert in the field and if he’s confused,  we’re in big trouble; and secondly because the two concepts are interlinked.

The liquidity discount is that an inability to readily buy or sell an asset – typically evidenced by low trading volumes and a large bid/ask spread – reduces it’s value.

The pure rate of time preference is a measure of impatience.  $1 today is preferred over $1 tomorrow even if there is no inflation. [Update: see below]

The two are linked because if you want to sell assets in an illiquid market, you can either sell them at a huge discount immediately or sell them gradually over time.  The liquidity discount is (presumably) therefore a monotonically increasing function of the pure rate of time preference for a given level of liquidity.

Minor update:

A more correct illustration of the pure rate of time preference would be to say:

Suppose that you could get a guaranteed (i.e. risk-free) annual rate of return of 4% and there is no inflation.  A positive pure rate of time preference says that $1 today is preferred over $1.04 in a year’s time.

More on the Effective Funds Rate versus the Target Rate

Published on 20 November 2008 in Economics, Finance and USA. Tags: , , , , . 1 Comment

Without comment, here are some more links on the gap between the target and effective federal funds rates:

Is there $100 lying on the ground? (Updated)

Published on 12 November 2008 in Economics, Finance and USA. Tags: , , , . 0 Comments

There’s an old joke among economists:  Two economists are walking along when one of them notices $100 lying on the ground and bends over to pick it up.  The other one says: “Don’t bother.  If there were really $100 on the ground, someone would already have taken it.”  It’s about things like the Efficient Market Hypothesis and the Coase Theorem.  In short, that opportunities for arbitrage ought to disappear quite quickly because their existence represents free money. [1]

James Hamilton is wondering if he’s staring at $100 lying on the floor of the US Federal Reserve.

On the 5th of November, the US Fed announced that starting on the 6th, any depository institution (e.g. a regular bank) with reserves at the fed would be paid the Federal Funds Target Rate (which is what gets splashed all over the news) on both required and excess reserves.[2]  On the face of it, that would appear to set the target rate as a floor for inter-bank lending.  Why would any bank lend money to another bank for less than the target rate and a little bit of risk when they could put the money in their federal reserve account to get the target rate with no risk?

The mystery, then, is why the effective rate (a volume-weighted average of actual lending rates) really is below the target rate:

The latest data at the time of my writing this was for the 7th of November.  The effective rate was 0.27% while the target rate was 1.00%.

At first, James thought that the reason must be the 75 basis-point charge made by the Federal Deposit Insurance Corporation (FDIC) for guaranteeing the repayment of any federal funds borrowed, but then he realised that the charge doesn’t apply to any borrowing made before the 13th of November.

So we’re still left with the mystery.

It’s probably got something to do with the non-depository institutions that play in the fed funds market (e.g. the G.S.E.s like Fannie Mae and Freddie Mac).  Those institutions don’t receive any interest on cash held at the Federal Reserve, so if they want to make a return on it they need to lend it out.  But why aren’t the depository institutions snapping it up?  They can borrow from a G.S.E. at 0.27%, put it in their reserve account with the fed and get 1%. Since the FDIC has waived all charges for guaranteeing fed fund borrowing until the 13th of November, it’s also risk-free at no extra cost.

[1] The joke also says something about economists:  That we need to make up jokes about other economists is pretty sad. :)

[2] Strictly speaking, the rate paid on excess reserves is the minimum target rate over a two-week period, but since it’s (reasonably) safe to assume that the Fed won’t lower rates again in the next week, we can operate as above.

Update: The only idea that I can come up with sounds like a conspiracy theory (and I therefore consider it highly unlikely): that fund managers at the G.S.E.s are not seeking the best rate of return for their cash, but instead voluntarily accepting a return well below the target rate.  Since Fannie and Freddie are 79.9% U.S. government-owned now, what are the odds that there is a depository bank out there that is struggling mightily and the government is using its control of the G.S.E.s to give that bank free money?

A prediction: Only Bear Stearns will fall; Lehman Brothers is safe

Published on 17 March 2008 in Finance and USA. Tags: , , , , , . 0 Comments

The “orderly liquidation” of Bear Stearns is certainly dramatic, but I think that it will be the only US investment bank to fall from the current mess. The reason can be found in this press release from the Federal Reserve:

Release Date: March 16, 2008

For immediate release

The Federal Reserve on Sunday announced two initiatives designed to bolster market liquidity and promote orderly market functioning. Liquid, well-functioning markets are essential for the promotion of economic growth.

First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.

Second, the Federal Reserve Board unanimously approved a request by the Federal Reserve Bank of New York to decrease the primary credit rate from 3-1/2 percent to 3-1/4 percent, effective immediately. This step lowers the spread of the primary credit rate over the Federal Open Market Committee’s target federal funds rate to 1/4 percentage point. The Board also approved an increase in the maximum maturity of primary credit loans to 90 days from 30 days.

The Board also approved the financing arrangement announced by JPMorgan Chase & Co. and The Bear Stearns Companies Inc.

You might argue that this should have been in place a while ago, but now that it’s in place, I doubt that any more US investment banks will fall. You can safely assume a 50bp drop in the base rate in the next week, I think. As with the previous drops, I think that we will see little, if any drop in longer-term paper. That increased gradient in the yield curve, combined with the effectively-intentional inflation (their liabilities are largely nominal and a fair fraction of their assets are real), should be enough to recapitalise the banks over time. The new lending facility from the New York Fed seems designed explicitly to give them that time.

See also this comment from Deutsche Bank’s Mike Mayo (HT to Calculated Risk):

Lehman is Not Bear. 1) It has more liquidity, 2) It has support among its major counterparties, evidenced by an extension on Friday of a $2B working capital line with 40 banks (one issue w/Bear Stearns [BSC] seems to be that counterparties pulled in lines). 3) Its franchise is more diversified given almost half outside the US and an asset management business that is more than twice as large relative to its size (BSC was more plain vanilla). 4) It has a seasoned and experienced CEO (Bear’s CEO was new). We maintain our Buy rating given a belief that LEH will weather this storm and our estimate of a price to adj. book value ratio of 83%.

The industry issue seems more liquidity than solvency, and LEH protected itself more fully after it’s problems similar to BSC in 1998. At year-end, it had $35B of excess liquidity combined with $63B of free collateral, implying $98B available for liquidity, or $70B more than needed for $28B of unsecured short-term debt (which includes the current portion of long-term debt). While it also has $180B of repo lines, we take comfort that 40 banks extended credit on Friday and believe that some of the repos are likely to be termed at least to some degree.

Why is the US Fed lowering interest rates?

Published on 15 February 2008 in Economics and USA. Tags: , , , , , . 0 Comments

Continuing on from my previous wondering about how panic-driven and effective current US (monetary) policy is, I notice these two posts from Paul Krugman …

Ben Bernanke has cut interest rates a lot since last summer. But can he make a difference? Or is he just, as the old line has it, pushing on a string?

Here’s the Fed funds target rate (red line) — which is what the Fed actually controls — versus the interest rate on Baa corporate bonds (blue line), which is probably a better guide to what matters for actual business spending.

It’s pretty grim. Basically, deteriorating credit conditions have offset everything the Fed has done. Doubleplus ungood.

INSERT DESCRIPTION

… and Brad DeLong …

Further cuts in the federal funds rate are on the way. Ben Bernanke is talking about how we are in a slow-moving financial crisis of DeLong Type II: one in which large financial institutions are insolvent–”pressure on bank balance sheets”–and in which lower short-term interest rates and a steeper yield curve are a way of providing institutions with the life jackets they need to paddle to shore.

Larry Meyers has pointed out that the BBB yield is no lower than it was in July–that all the easing has had no effect on the cost of capital that the financial markets feed to the “real economy,” and hence that Fed policy today is no more stimulative than it was last summer.

I’m more inclined to agree with Brad’s assessment than Paul’s implicit prediction of gloom, although it depends on what you think the Fed should be looking at.  Paul is clearly hoping for a decrease in long-term rates so-as to stimulate the real economy, while Brad is simply noting that steeper yield curves, manifested here through a drop in base rates and no movement in longer-term paper, are pumping up banks’ profit flows, which will help them deal with the hideous losses from the sub-prime mess, the monoline insurer implosion and all the other nasties out there.

This seems like pretty clear “Bernanke put” behaviour to me.  The banks need the short-term increase in profit flows in order to stay solvent in the medium-term.  Whether Mr Bernanke is pushing down the base rate because the banks can’t lift the yields on long-term debt or because he doesn’t want them to (since that would hit the real economy) is a moot point.

This doesn’t change the fact that Bernanke is slopping out the good times to save the industry from its own mistakes.  It’s probably safe to say that there’ll be no more knuckles rapped (except maybe those of the ratings agencies), so the real question is whether they’ll be allowed to make the same mistakes again …