Friday, March 16, 2018

A Flawed Monetary Transmission Mechanism

Summary

•Interest is the price of loan-funds.

•The price of money is the reciprocal of the price-level.

•Keynes' "liquidity preference curve" is a false narrative.

1.Thrust is applying a robust force.

“In economics, robustness is the ability of a financial trading system to remain effective under different markets and different market conditions, or the ability ofan economic model to remain valid under different assumptions, parameters and initial conditions.”
1.A governor, a credit controldevice, restricts a force.

A restrictive monetary policy is when the Federal Reserve slows economic growth by restricting the growth of money and credit (not demarcated by a change in interest rates).

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Given no change in the Fed’s policy rate, it’s monetary transmission mechanism (interest rate manipulation), economic activity should remain unfettered, impervious to any disequilibria, any volatility, as measured by any outsized deviationin CBOE Volatility Index (^VIX).

According to Wikipedia, “VIXrepresents: a colloquially referred to as the fear index or thefear gauge.”

What is the one truistic policy instrument, the one that is responsive, predictable and impactful? May 7th 2018 will become documentary proof. Any equity decline prior to Mondaymight parallel “Black Monday”. The newspeak is now catching up to the prior economic deceleration.

Whereas using a price mechanism (pegging interest rates), to ration Fed credit is non-sense. The effect of current open market operations on interest rates(now via the remuneration rate), is indirect, varies widely over time, and in magnitude.

The Fed has capriciously emasculatedit’s “open market power”, its sovereign right to create new money and credit: at once and ex-nihilo (by remunerating IBDDs). Unlike Treasury issuance, because the belligerent bifurcation [themis-aligned distribution of sales and purchases of debt by the FRB-NY’s trading desk and its counter-parties] is largely unpredictable, so too now is the volume and rate of expansion in the money stock on even a quarter-to-quarter basis. FOMC policy has now been undermined by turning excess reserves into bank earning assets (a monetary policy blunder that prevented a V recovery). The BOG has inadvertently thereby eviscerated all semblance of a“money multiplier.

And the money multiplier is predicated on the assumption that the commercial banks will immediately buy some type of earning asset with their “Manna from Heaven”, IBDDs. This they always did between 1942 and Oct. 6, 2008’s enactment.

But by mid-1995 (a deliberate and misguided policy change by Alan Greenspan), legal (fractional) reserves ceased to be binding– as increasing levels of vault cash/larger ATM networks, retail deposit sweep programs (c. 1994), fewer applicable deposit classifications (including allocating "low-reserve tranche" & "reservable liabilities exemption amounts" c. 1982) & lower reserve ratios (requirements dropping by 40 percent c. 1990-91), & reserve simplification procedures (c. 2012), combined to remove reserve, & reserve ratio, restrictions.

See the pundit Dr. George Selgin: “I myself don't oppose IOR as a means for limiting the implicit reserve requirement tax [sic]. IBDDs, reserves: excess, borrowed, non-borrowed, required, etc. are not a tax, they are “Manna from Heaven”, costless viz., a “helicopter drop”.

Interest on Excess Reserves: The Hobie Cat Effect - Alt-M

Past Chairman Paul Volcker thought the member banks should be paid interest on reserves "based on rounds of equity” - WSJ 1983. No joke.

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

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

See SA contributor: “Bank Reserves and Loans: The Fed Is Pushing On A String” - Charles Hugh Smith

Bank Reserves And Loans: The Fed Is Pushing On A String

See: “Quantitative Easing and Money Growth: Potential for Higher Inflation” – FRB-STL’s Dr. Daniel L. Thornton, Vice President and Economic Adviser

bit.ly/2viavlS

And there never has been any mention in the FOMC’s deliberations concerning money velocity.

What the net expansion of new money will be, as a consequence of a given change in policy rates, nobody knows until long after the fact. The consequence is a delayed, remote, & quasi-control over the lending and money-creating capacity of the banking system.

Economists should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about.

Net changes in Reserve Bank credit (since the 1951 Treasury-Reserve Accord) are predetermined by the policy actions of the Federal Reserve. Note: the Continental Illinois bank bailout provides a spectacular example of William McChesney Martin Jr.’s “bartending”.

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

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

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

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

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

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


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

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

But history was re-written (and Dr. Richard Anderson fudged the reconstruction of legal reserves, many times the Fed does not keepthe initial iterations). Paul Volcker told Congress:

"He advised the congressmen to watch the non-borrowed reserves -- "Watch what we do on our own initiative." The Chairman further added --- "Relatively large borrowing (by the banks from the Fed) exertsa lot of restraint" [sic].

Paul Volcker targeted non-borrowed reserves when at times 10 percent of all reserves were borrowed.One dollar of borrowed reserves provided the same legal-economic base for the expansion of money as one dollar of non-borrowed reserves. The fact that advances had to be repaid in 15 days wasimmaterial. A new advance could be obtained, or the borrowing bank replaced by other borrowing banks. That's before the discount rate was made a penalty rate on 1/2003 (a penalty rate is one where the Fed fights inflation - not deflation, which was what the GFC was all about). I.e., Walter Bagehot's dictum should not have applied to the GFC. And the fed funds "bracket racket" was simply widened, not eliminated. Monetarism has never been tried.

See also: Lawrence K. Roos, Past President, Federal Reserve Bank of St. Louis & past member of the FOMC (the policy arm of theFed) as cited in the WSJ April 10, 1986 "...I do not believe that the control of money growth ever became the primary priority of the Fed. I think that there was always & still is, a preoccupation with stabilization of interest rates".

By using the wrongcriteria (interest rates, rather than member bank legal reserves) in formulating and executing monetary policy, the Federal Reserve will invariably continue to be behind any: “supply and demand for money” curve. Why? Because interest is the price of loan-funds (what the free markets dictate), the price of money is thereciprocal of the price level (the Fed’s bailiwick).

See again, George Selgin: The Hobie Cat effect can be illustrated formally using a diagram showing the supply of and demand for bank reserves or federal funds under a floor system. The supply schedule for federal funds is, as usual, a vertical line, the position ofwhich varies with changes in the size of the Fed’s balance sheet. The reserve demand schedule, on the other hand, slopes downward, but only until it reaches the going IOER rate, here initially assumed to be set at 25 basis points. At that point the demandschedule becomes horizontal, because banks would rather accumulate excess reserves that yield the IOER rate than lend reserves overnight for an even lower return.

For the initial stock of reserves R(1), starting at the equilibrium point “a,” a slight reduction in the IOER rate would suffice to get the banking system back onto the sloped part of its reserve demand schedule, at point “b,” where reserves are again scarce at the margin. But once the stock of reserves has increased to R(2), it takes a much more substantial reduction in the IOER rate — perhaps, as the move in the illustration from “c” to “d” suggests, even into negativeterritory — to make reserves scarce at the margin again, and tothereby make switching to a corridor system, by a modest further reduction in the IOER rate, possible without any need for central bank asset sales.

Interest on Excess Reserves: The Hobie Cat Effect - Alt-M

There is "no fool in the shower". Interest isthe price of loan funds. The price of money is the reciprocal of the price level.

Friedman conflated stock with flow. From Carol A. Ledenham’s Hoover Institution archives): Friedman pontificated that: “I would (a) eliminate all restrictions on interest payments on deposits, (b) make reserve requirements the same for time and demand deposits”. Dec. 16, 1959.

Since time depositsoriginate within the banking system, there cannot be an “inflow” of time deposits and the growth of time deposits cannot per seincrease the size of the banking system.

George Selgin (who just testified before Congress) said:

“None of this would matterif the Fed acted as an efficient savings-investment intermediary, as commercial banks are able to do, at least in principle.” And: “This is nonsense, Spencer. It amounts to saying that there is no such things as 'financial intermediation,' for what you claim never happens is precisely what that expression refers to."

Or take Martin Wolf, chief economics commentator at the Financial Times writing in his book: “Charles Goodhart of the London School of Economics, doyen of British analysts of finance, responds to such suggestions as follows:

A problem with proposals ofthis kind is that they run counter to the revealed preferences of savers for financial products that are both liquid and safe, and of borrowers for loans that do not have to be repaid until some known future distant date. It is one of the main functions of financial institutions to intermediate between the desires of savers and borrowers, i.e., to create financial mismatch, to make such a function illegal seems draconian."

Take Daniel Thornton:
Re my comment: “Savings are not a source of "financing" for the commercial bankers”
Dr. Dan Thornton’s response:
Thu 3/9, 2:47 PMYou
See the graph below.
Large Time Deposits, All Commercial Banks

No, savings never equals investment. Take the “Marshmallow Test”: (1) banks create new money (macro-economics), andincongruously (2) banks loan out the savings that are placed with them (micro-economics).

Not only are the Fed's econometric models wrong, but their macroeconomic concepts reflect this. These McCarthyites have learned their catechisms, that there is no difference between money and liquid assets (the Gurley-Shaw thesis).

You will soon see the difference.

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