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The Fed and Money Printing

As I said in the last post regarding Jon Stewart’s take on Ben Bernanke’s "60 Minutes" interview, the Fed has lost the PR war on QE2. The reality is, as Ben Bernanke said, there will likely be no appreciable increase in credit – what he calls ‘money’ in the 60 Minutes interview.

I don’t see ‘credit’ as ‘money.’ To me, any dollar credits are money. Regardless of whether you call dollar credits the Fed creates ‘money’ or credit ‘money,’ what is clear is that you need both the supply of credit to and the demand for credit by creditworthy borrowers to increase much more for the US to escape a liquidity trap. This is not likely to happen any time soon since the household sector has major balance sheet problems, especially given high rates of unemployment and underwater home values. You can goose credit by goading lenders into lending recklessly or to non-creditworthy borrowers, yes. But, a sustainable increase in credit can only come after the excesses of the housing bubble are worked through. After the 60 Minutes piece, it is clear Bernanke knows this.

The problem Bernanke is having goes to terminology and the difficulty of explaining a complex monetary system. In 2002 and again last year, Bernanke used ‘money’ to denote the reserves he is now creating to buy government Treasury securities. In the most recent interview, he backed away from this terminology in a way that simply isn’t credible – perhaps as a defensive reflex to videos like "Quantitative Easing Explained". It will cost the Federal Reserve dearly. This is a major blunder.

I have harped on this credit issue a lot. The Fed is conducting an asset swap that increases reserves and decreases Treasury securities. It’s a one-for-one swap, nothing more. This is the crux of the matter. David Greenlaw of Morgan Stanley writes up a good piece that puts this thing in terms you may understand. Below is the first snippet followed by a link to the rest of his piece. You should note that he prefers not to call the Fed’s dollar credits money and is more attuned to broader money supply aggregates.

In his recent 60 Minutes interview, Fed Chairman Bernanke denied that the Fed was printing money. This is entirely consistent with our own view (see Morgan Stanley Strategy Forum, 11/1/2010), but it appears to have generated some confusion and anxiety. In fact, a commentator on CNBC indicated that Bernanke’s denial of money printing would trigger a credibility crisis for the Fed.

QE2 departs from the textbook. The issue is confusing because all of us who took a basic undergraduate Money & Banking class learned that a central bank’s open market purchase of securities was effectively the same thing as printing money. But the experience of the last few years has taught us that this logic is not always correct. In fact, Fed officials have been reluctant to adopt the QE terminology because the impact of asset purchases is all about rates – not quantities.

In the US, the Fed pays for bond purchases by crediting the reserve account of the bank that sold it the securities. Assuming that the rest of the Fed’s balance sheet doesn’t change, this leads to an increase in bank reserves. So, the monetary base – which consists of currency plus bank reserves – goes up by the amount of the open market purchase. In every textbook written prior to 2009 that we have come across, the rise in the monetary base is assumed to be transmitted into a roughly equivalent rise in the money supply. But, as we now know, this assumption is not always valid. In the first round of Fed balance sheet expansion, which began in late 2008 and continued into 2009, the monetary base more than doubled and the money supply barely budged. In textbook terminology, the so-called money multiplier – the ratio of the money supply to the monetary base – declined by about the amount that the monetary base rose. The Fed can create excess reserves, but it can’t force the banks to turn these funds into loans or securities holdings. In this case, the excess reserves are being stockpiled in banks’ cash accounts.

Why did the monetary transmission mechanism break down? There is no easy answer, but it appears that a number of factors may be at work. First, banks seem to have a heightened need for liquidity. Second, banks are concerned about their ability to meet pending capital adequacy standards. Third, just about every bank manager who we have met with over the past couple of years has complained about a lack of lending opportunities ("the same banks going after the same deals" is the common refrain). Fourth, in the aftermath of the credit crisis, there still seems to be a general elevation in risk-aversion at financial institutions. Fifth, the Fed began paying interest on reserves in 2008, and this creates a slightly higher hurdle to lending or securities purchases than existed previously.

It’s certainly possible that the current round of asset purchases will lead to a rise in the money supply, in contrast to the situation under QE 1. But we’re not holding our breath. The Fed does not seem particularly interested in eliminating interest on reserves, or trying to engineer negative short-term rates, because of the practical complications. And the other factors that appeared to contribute to a breakdown in the transmission mechanism still appear to be very much in place. We estimate that year-on-year growth in the monetary base will hit +30% over the next few months. While this is far less growth than seen in the first round of Fed balance sheet expansion, it is astronomical from a historical standpoint. Yet, we doubt that M2 growth will get much above +5%.

Source: The Fed and Money Printing – David Greenlaw, Morgan Stanley

P.S. – this might help deciphering the terms: the monetary base is reserves and currency but most people are concerned with broader definitions of money i.e. the money supply as defined by M2 or credit. The Fed is adding reserves, but ‘money in circulation’, M2, does not necessarily increase as a result. It depends on what banks do.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

20 Comments

  1. Tom Hickey says:

    Most people think of money as something that they can spend. People cannot spend reserves. Reserves are for settlement purposes only and they never leave the FRS. While it is true that banks can exchange their reserves for vault cash, they only do this in anticipation of window demand. Claiming that the Fed is “printing money” when it exchanges reserves for tsys is misleading and is just confusing the issue. It is generating the fear that the Fed is doing something that is inherently inflationary when this is patently not the case, even on the expectations level.

    • Certainly that’s your view and you’re entitled to it. But my view is that reserves are money. And obviously a lot of people have this same view. It’s not misleading because it concentrates one on the fact that the Fed is expanding it’s balance sheet and that’s something worthy of focus.

      We can debate this until the cows come home. Marshall and the other MMT’ers make the same arguments. I don’t share those views because they boil down to promoting an activist Fed. To me THAT is misleading – acting as if the Fed isn’t distorting the economy by injecting $600 billion in reserves into the system.

      I don’t want the Fed expanding its balance sheet – except to provide liquidity in crisis.

    • Gabriel says:

      If Fed’s creating just the reserves and uses it to drain the treasuries out of the market, how does this help in creating more jobs and boost the economy? I’m not challenging you, just trying to understand how this astronomical increase in reserves play out in the real world economy!

      • Gabriel, they don’t boost the economy or jobs. This is the problem.

        Unless the Fed can induce a shift in private portfolio preferences i.e. the risk-on trade or a preference for longer-dated treasuries, its not doing anything that has any tangible affect on rates or the real economy. They need to target the rate, not the quantity of reserves as a vehicle for QE. This has been my problem all along. And the reason no one likes this or understands it is because it just doesn’t work. I don’t want to overstate this. Maybe, it could shift preferences. It did have a tremendous effect when announced after all. But, that effect has dissipated.

        • Gabriel says:

          Ed, I completely agree with what you’re saying, but our friend tjfxh seems to think differently, so that’s why I was replying to tjfxh and requesting for a descriptive rationale.

          I think it will be helpful if one can address the issue in a logical way.

          1. Fed is increasing money, because that’s what they’re saying: quantitative (meaning = quantity of money) easing (meaning = increase). It’s a simple English language translation. No smoke, no mirrors.

          2. Fed then denies the increase in money supply. Mish has recently written about Bernanke’s lies where he brushes on money supply issue too. So, we need to ask which one is it? Is it quantitative easing or is it not?

          3. If it’s not quantitative easing (looser money supply), then what’s the rationale for QE? How is it supposed to help? What is the objective? I’m sure someone has a good idea of what exactly this increase in Fed balance sheet is going to accomplish.

          4. We need to map the path between point A and point B, where point A is Fed’s increase in reserves and point B is the ultimate objective of increasing these reserves. What is that clearly defined objective, the point B? How will we get to point B?

          • traffic says:

            Gabriel, as to question #1, I am not sure if the fed is calling its asset purchase program quantitative easing. It is easier and catchier for people to write, however.

    • traffic says:

      People can’t spend reserves, but banks can lend out excess reserves and they will spend that. Banks aren’t lending out their excess reserves (in fact they are getting 25 bps not to) currently, but at the ponit they decide to that is when money supply begins to grow.

      • Tom Hickey says:

        Traffic, banks are not reserve constrained. The Fed stands by to make reserves available to banks that need them to settle. Normally, banks lend and borrow reserves from each other at the ovenight rate set by the Fed (FFR), but if a bank comes up short at the end of the settlement period, then the Fed provides the reserves to settle and charges the discount rate. There is no transmission of reserves to loans. Reserves are obtained ex post not ex ante.

        • traffic says:

          tjfxh, I agree with you that banks are not reserved constrained. It seems to me the opposite is true now: banks have excess reserves. Am I wrong in assuming that reserves are cash on the asset side of a banks balance sheet and held on deposit at the Fed? And that if you hold excess reserves (earning 25 bps) above the regulated amount at the Fed, you can readily change those reserves from a cash asset to a loan asset (or any other asset)? Looking for clarity on this issue.

          • Reserves can’t be lent out. Think of them like a checking account at the
            Fed which can only be lent out to other banks in interbank market. But since
            they already hold trillions in reserves, there is little need to give them
            more via QE2.

            And banks don’t need extra reserves to induce them to make loans. In normal
            times the banks make loans and then obtain the reserves that are required
            to be held against the resulting deposit. They first go to the Fed funds
            market to borrow reserves; if there are no excess reserves in the system as a
            whole, this will cause the Fed’s rate to be bid up. Because the Fed
            operates with a reserve rate target, it will intervene to maintain the rate by
            providing the necessary reserves.
            Second, given that the banks already have trillions in reserves, they
            certainly already have adequate quantities on hand (even before QE2) to make the
            loans and have sufficient reserves to cover the resultant deposits.

            And remember, the Fed can always drain excess reserves at any time from the
            system by unwinding its own portfolio. This can be accomplished by selling
            its assets back into the banking system; for each bond it sells, it will
            debit bank reserves dollar for dollar. The process can continue until the
            banks have no further excess reserves.

            In a message dated 12/8/2010 6:54:19 P.M. Mountain Standard Time,
            writes:

            traffic (unregistered) wrote, in response to tjfxh:

            tjfxh, I agree with you that banks are not reserved constrained. It seems
            to me the opposite is true now: banks have excess reserves. Am I wrong in
            assuming that reserves are cash on the asset side of a banks balance sheet
            and held on deposit at the Fed? And that if you hold excess reserves
            (earning 25 bps) above the regulated amount at the Fed, you can readily change
            those reserves from a cash asset to a loan asset (or any other asset)? Looking
            for clarity on this issue.

            Link to comment: http://disq.us/u9es4

  2. Tom Hickey says:

    My point is that “printing money” is not helpful in this debate. OK if you understand what you are talking about and are using the term loosely, but most people don’t understand, even supposedly “sophisticated” people. Moreover, ordinary people, including the media, completely misunderstand “printing money” as the Fed printing and distributing cash.

    • I don’t know how you get around this. I think the E Explained Video sums up my experience on this issue. When I ask people if they know anything about Quantitative Easing I get blank stares. It’s only when I say the Fed is effectively printing money that they understand. QE is a meaningless technocratic expression meant to obscure. While printing money may be pejorative it is certainly what Bernanke was saying just 21 months ago.

      How else would one say it? “Injecting liquidity,” “stimulating rates lower?” Seriously, I have tested all of these. It just doesn’t come over. I understand your squeamishness but the fact is the Fed is expanding its balance sheet by creating dollar credits. The Jon Stewart video shows you that people see this as money printing as do I.

      • Tom Hickey says:

        Yes, this is all a bit complicated, but if it is not explained to the public in terms they can understand, then the country is going to continue down the road that ignorance ( and, I suspect, some disingenuousness) is leading. People don’t have to understand reserve accounting in any detail, but they do need know the basics of how the FRS works. The Fed is going to be a huge issue over the next two years, and most of what is being bandied about is fantasy.

        The people need to hear the truth from their leaders and experts rather than the myths they are now being fed, so that they can make informed decisions in the electoral process rather than flail about in the dark, voting against their own interests and often against the interests of the country, too. Warren has written a book debunking these myths. It’s a good start.

        It’s the job of the media to understand this first and then walk the people through it. Each of us has to explain it our friends, and if we blog, explain it through the net. For example, look at those animated videos about the Fed and QE side by side. Both simple and understandable. One right and one wrong. Guess which one went viral.

        Right now the media is getting it wrong because most experts, Bernanke included apparently, have it wrong. For example, according to Warren, the people that actually do the operations at the Fed understand it, but many of the people at the top who are isolated from the ops do not. Same goes for Treasury. So the country is mired in ignorance and is paying the price. Unless a lot of us cooperate and coordinate on reversing this misapprehension (and possible disingenuousness), the country is headed in a bad direction.

  3. Rob says:

    As interest rates ramp up, and they will (since the bond market will eventually stop digesting the Federal government’s $1.5-2 Trillion deficits), Bernanke will have to take a major capital loss on his purchases. Those losses will be effectively the same as “printing” money.

  4. Jl3793 says:

    If one is confused or perplexed or dismayed with all the terminology used about central bank accounting then consider the whole connundrummm from a bank’s position. The bank has simply sold some of its government bonds (and maybe even other junk assets) to the Fed. The bank gets paid by an increase in its Receivable-from-the-Fed account. End of story. What the Fed wants is now for that bank to go out and make a real commercial loan. Then the bank converts that Receivable-from-the-Fed into a commercial loan receivable. The question is why would a bank do the sale to the Fed if it’s going to end up with a Receivable-from-the Fed? Why do you sell any asset? Cause you got a good price for it! And o in this case the banks are getting excellent prices for that bonds they are selling to the Fed. But that still doesn’t make it any easier to find someone, anyone, any live moving body that is a good credit risk to make a commercial loan. That’s where this whole scheme falls flat. The constraint on commercial lending at a bank isn’t the availability of money it’s the scarcity of decent commercial customers. To prove that just ask yourself how many people are lining up to get another mortgage?