Wednesday, December 9, 2015

Exploring Central Banking

In response to my most recent post regarding the Fed and interest rates, I receive an email query.  Having received permission to publish the email, here it is (with my thoughts / comments interspersed):

Thanks for today's article. I've been waiting for someone to address IOER for a long time.

Please consider putting your mind to this as it may benefit those of us trying to navigate the storm ahead.  In reality, the Fed's dual mandate is:  (1) to maintain and preserve the US dollar hegemony/monopoly here and abroad; and (2) keep alive the US federal government, its benefactor and protector.  In short, the Fed's primary goal is control and keeping the wheels on the money cart…

This seems to be as good a job description as any – better than the publicly available mumbo-jumbo.

…it doesn't care about profits or losses of its MBS portfolio.  The Fed could (and may) take the trillions of worthless MBS securities on its balance sheet and simply throw them in the furnace or hit the digital "delete" button. 

There are a couple of points I would raise: first, I am not sure what it means if a central bank was to have a negative equity position on its balance sheet; let’s just say I have never come to a settled view on the ramifications of this.  Certainly, if the mortgage securities are / were not worth what the Fed paid for them, this possibility becomes real.  However, I believe the Fed values its (claimed) gold holdings at $44 or some such.  Properly valued, this could offset any negative positions on the securities.

In any case, I don’t know if a negative equity position matters at all for the Fed. 

But the “throw them in the furnace” part is something I have thought about for some time.  The Fed holds government securities, government backed securities, and securities the government would bail-out if necessary.  At the same time, after covering a few billion dollars of expenses, the Fed returns (off the top of my head) $50 - $70 billion per year to the treasury – interest income and the like.

The Fed holds the bonds; the Fed returns the interest to the creditors.  Neither principal repayment nor interest is expected from the debtor.  Doesn’t this suggest that the debtor (the government) has in essence defaulted on the bonds being held by the Fed?

I am not sure what this means, but it means something.  As long as price inflation is politically tolerable, I continue to wonder why the Fed would ever shrink this portfolio – and in fact why not keep buying.  Borrowing without repaying, paying no interest, defaulting without embarrassment for the US government.  This seems to me to be the current situation for at least $4 trillion of US obligations.

It doesn't need to "unwind" anything, as it is not a market player and doesn't care about its own losses or bad purchases.  It is a monopoly game banker that will do anything within the confines of maintaining monetary control.  Wondering what the Fed will do with its balance sheet may therefore be a red herring. 

In many ways I agree.  I only began exploring this topic because I became curious about the mechanism of how the Fed would raise rates – it always struck me as an issue for the Fed to be able to raise rates with today’s level of excess reserves.  I wanted to understand the mechanisms and possibilities, nothing more.

So, what it to prevent the Fed from:  (1) raising its interbank/overnight rate 25 basis points (or even more); (2) delivering helicopter money/inflation to mainstreet by, instead of paying IOER, charging rent, thereby forcing banks to lend; and (3) tempering the mass inflation potentially caused by 2 by raising reserve ratios?  

Don’t 2 & 3 offset or neutralize each other?  Setting this question aside, I think helicopter money is possible, even likely if price inflation continues to remain tame.  Let’s see if commodities push ever higher in price – it seems we have seen this bust and it isn’t clear that anything on the near horizon will change this.

I suspect the reason it can't do this is that it will negatively affect treasuries and potentially kill the US gov's ability to borrow but I don’t' know how or why. 

I have not figured out what ends this game as long as price inflation stays politically acceptable.  We have had significant expansion of central bank balance sheets around the world – and not all of the expansion is sitting in excess reserves; trillions of dollars of central bank expansion globally, and no price inflation to be found anywhere.  Why can’t the game continue – with further central bank balance sheet expansions and returning the interest income to the Treasury?  The Fed increased its balance sheet to over $4 trillion.  Why not $8 trillion?  $12 trillion?  Default without embarrassment.

It is possible that the game doesn’t end until we reach a point where the shrinking productive class can no longer support the growing non-productive class.  (This post is two years old, so I won’t vouch for every word, but it will give some idea of what I am getting at.)

Think about the inclusion of Mexico, China, India, Eastern Europe, etc., into the division of labor economy.  Yet, we have not seen corresponding price deflation (as should have been expected); instead the added productivity billions of newly-productive people has been consumed, introduced as feedstock for the non-productive class.

Consider the almost unbelievable advances in technology and communication – perhaps as valuable to productivity as the industrial revolution.  Where is the corresponding price deflation?  Again, consumed by the non-productive.

Someday this must end…I think.  But when and why?  The best answer might be found in demographics.  This says we are still decades away.

Also, helicopter money may be pushing on string because average joe is tired of debt and won't take the bait this time. 

It doesn’t have to be debt.  Why not just deposit $1000 per month for every individual over 18?   Why not charge demurrage to encourage spending?  Again, until price inflation picks up, why not?

Further, Repos and reverse repos sound like de minimus/at the margins monetary tools.  IOER (and ROER, rent on excess reserves) are the big guns and for some reason the fed hasn't used them to put money on main street. 

From my understanding, the problem with IOER is that it doesn’t touch enough players – money market funds, etc.  This is why they have to go also to reverse repos.

Why hasn’t the Fed charged the banks – forcing the banks to lend?  I think for the reason I have earlier offered: the main objective was to ensure liquidity in the system.  But if inflation stays tame, they could do this (of course, after further growing the balance sheet).  There is a cost (negative interest) to holding money in other countries at the moment – Switzerland comes to mind – yet price inflation remains low.

Thanks again for your analysis.  

I hope I helped.

I know others, like Wenzel, believe we are on the cusp of significant price inflation.  I certainly will not argue with him, and I certainly do not study the data the way he does.  If, a year from now, price inflation moves to 4% or higher, it wouldn’t shock me.  

But I look around and wonder why this game cannot continue for some time.  I have yet to find a reason.


  1. THis back and forth NAILED IT....IOER IS THE CANNON THAT THE FED can unleash to stop any kind of of monetary deflation and unleash it they will!
    And...yes...this game can go on for many years to come and the dollar will still be the reserve currency of the world. There is no rival to the dollar as far as the eye can see. Too many reasons to list but suffice to say that our economy may have some friction to it but Europe Japan China India Brazil etc etc....are totally bound up and absolutely dysfunctional compared to good ole America

    1. What I have learned about IOER is that its effectiveness could be limited due to the limited number of institutions that will have access. Of course, the Fed could change those rules, I suppose.