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« Weighing the Week Ahead: An Avalanche of Data | Main | January Employment Report Preview »

January 31, 2012

Comments

Pmp Pmp

Dude, this is horrible analysis. GDP growth is a joke, did you even bother to look at the deflator they were using? Your analysis of the Greek situation is typical of that of the mainstream media. The European banks are insolvent,get a clue. Until they are forced to mark to market , you and I know have no clue how much toxic crap is on the financials. Want to bet PNB Paribus is your next Lehman? The only end game is the complete wipe out of debt.BTW, if you understood economics ,you would know you can't have a good economy without a good financial system.

Angel Martin

David, i'm not an expert on central banking but isn't it the case that a fed funds rate target increase will be swamped by the 1 trlllion plus excess reserves that are already out there?

http://www.economist.com/blogs/freeexchange/2009/12/the_truth_about_all_those_exce

this economist article makes the point better then i can.

David Pearson

Angel,
Again, the banking system does not need Excess Reserves to "lend out". In a rate targeting regime, the following sequence of events occurs:
-loan demand increases; banks make loans, creating new deposits out of thin air
-as banks bid for reserves to support new deposits, the Fed Funds rate rises
-the Fed supplies reserves through OMO to keep the rate at target

Banks don't "lend out" excess reserves. They create deposits when they make loans; these deposits are nothing but accounting entries; they require reserves to back them up as a means of clearing inter-bank payments.

Excess Reserves are not inflationary. They may create losses for the Fed if it raises interest rates, and that might be inflationary if it keeps the Fed from raising rates.

Angel Martin

Jeff, this is great article that explodes a lot of bogus anti-Fed lines of argument.

However, i do think there is a risk to what the Fed has done, and what the ECB is doing right now. One could argue that it is unlikely to occur (especially in the US), but the downside if it does occur is really huge.

Yes, the balance sheet expansion for either the Fed or the ECB has ended up as excess reserves, and not in M2 - so no inflation.

But there is always the risk, especially for europe, that a confidence shock could cause a big fall in the currency. A big devaluation causes some inflation, which itself can accelerate money velocity. With inflation, the incentive becomes greater to lend out excess reserves at positive real interest rates, rather than have real losses by keeping them in zero interest excess reserves at the ECB.

If that sequence of events were to start, the ECB would really be in a bind, as they need to keep interest rates very low to support a faltering eurozone economy and eurozone banks, and the ECB needs to be able to expand it's balance sheet to support the PIIGs.

The risk is that the ECB will choose hyperinflation rather than raise interest rates and sell assets.

The same sequence of events is also possible with the US and the Fed. In my view it is less likely because unlike the euro, there is no question of the future the dollar.

I'm not arguing that the Fed did the wrong thing in 2008. Bernanke is the expert in depression era monetary policy - not me. My case is that there is a huge downside if things go wrong, and the probability is not zero.

David Pearson

Jeff,
"Anyway, I think that if M2 starts to move higher, the Fed will sell assets pretty quickly."

This is an incorrect view of the role of Excess Reserves in money creation. Under a Fed Funds Rate (FFR) targeting regime, the Fed supplies unlimited reserves to the system at any given FFR. Technically speaking, the supply of reserves is, "perfectly elastic". Therefore, it doesn't matter one bit to M2 whether ER's are $1 or $10tr. The system does not need ER's to induce the Fed to create reserves: it merely bids up the FFR above zero, forcing the Fed to engage in OMO to bring the FFR back to zero.

So "selling assets pretty quickly" would do nothing to stop M2 from rising. Raising the FFR (and IOR) would.

The only significance of ER's is that they create duration risk for the Fed. The only reason for the Fed to sell assets is to eliminate that duration risk.

oldprof

ZIRP -- I often read Krugman, but not nearly as much as my academic friends.

In a humorous aside, when I started tweeting, I followed him. I immediately got a message that he was following me! I forwarded this to friends who were quite impressed. Sheesh!

Anyway, I think that if M2 starts to move higher, the Fed will sell assets pretty quickly. Bernanke has said as much.

This is certainly the right question to ask.

Jeff

oldprof

GenXCynics -- You are on your own for that article! I am more pragmatic. I understand that helping society and the economy involves helping specific groups and institutions.

When it comes to strengthening the financial system, it is difficult to come up with a practical plan (something I doubt you have thought about) without involving banks.

When it comes to housing....

When it comes to autos.....

So you have a choice. You can refuse to accept the reality of the American political system, with all of its warts, and make your investments somewhere else.

Or you can join me in being a political agnostic -- willing to make money no matter who is in power and what they are doing.

Good luck with your investing!

Jeff

oldprof

Alex -- Basically, I think there is some merit, but I don't feel like doing a full review in the comments.

Here is a link from a Kauffman colleague whom I respect, David Beckworth: http://macromarketmusings.blogspot.com/2011/12/market-monetarist-mmt-and-austrian.html

Most investors should keep in mind the most dangerous words -- "self-taught in Austrian economics."

More-- eventually.

Jeff

ZIRP

"Essentially, the Fed has stepped in to (temporarily) take up the slack in the money supply."

curious to know the Krugmanite definition of temporarily?

GenXCynics

Jeff, you should write a blog on how the Fed expansion of balance sheet via QE programs help cleansing up and proping up banks' assets, and thus ease up the credit market. You should write something about the Fed and Treasury using Fannie and Freddie as the dumping ground for bad mortgages. You should also educate the readers on the channels through which Fed's policies can exert their effects (all through banks). Credits are several multiples of monetary base in nominal values and our economy is now a full-blown credit based, asset based one; so using M2 (deposits and CD's of common men) to explain our economy is insufficient and misleading.

Alex H.

"This happens when reserves are created for participating banks and they make additional loans. This has not been happening. Essentially, the Fed has stepped in to (temporarily) take up the slack in the money supply."

Jeff, what are your thoughts on the MMT interpretation (or I guess pragcap.com) of the Fed's role in using reserves to induce bank lending?

Mike C

The critics of the Fed -- and now the ECB and other European banks -- have an easy path to page views and affirmation by readers who never took the class in Money and Banking.

This has the usual result. Anyone who is willing to spend a little time while keeping an open mind can gain a significant investment advantage.

What is the actionable investment advantage based on these myths? Should investors/traders short gold?

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