Federal Reserve Paper Warns of Possible Monetary Crisis

[MachineGhost]

The money IS savings.  "Saving" is the act of not spending income.  "Savings" is the money one has saved.  Maybe we're working with different definitions here.  The fed can't change private sector savings... it can simply change its form from one to another.

If the Fed gobbles up all the at auction Treasuries leaving the public with little to none to buy, the public is forced by the Fed's actions in repairing its balance sheet or monetizing the debt to hold currency instead of debt.  Currency does not protect the public from the inflationary consequences of the Fed's actions.  So the crowding out of private sector savings should be restated more accurately as it is a crowding out of inflation-protected savings.

[MachineGhost]

I still don't see how a central bank's balance sheet can be viewed as the foundation of the value of a currency.  There's no bite there.  The value of our currency comes from a combination of taxes, "proper" lending in the banking sector (for all the complaints, a ton of lending is very legitimate and necessary, and often focused in positive areas), and government supporting an expansion of productive capacity and confidence.  To me, some nebulous fed balance sheet has little to do with it.

That may be true under MR theory, but since the monetary base and short-term interest rates have a high correlation, any upwards movement in short-term interest rates** will provoke inflation if the monetary base is not simultaneously reduced in proportion by the Fed.  The Fed can either reduce the base, do nothing and let the inflation transmit into the general price level or pull a rabbit out of their collective ass by betting on strong economic growth over two decades.  Not holding my breath here, if past history is any indication.  The Fed is always a day late and a dollar short.  If Bernanke is smart, he will get the hell out before the shit hits the fan.

** Its commonly believed the Fed sets short-term interest rates, but this is not actually true.  The Fed sets its own Discount Rate (DR) or the Federal Funds Rates (FFR) which have to do with inter-banking system loans.  Out in the real economy, T-Bill rates actually lead the Fed's actions on the DR or FFR.  Under MR, it is the primary dealers and the Treasury that colludes to set the T-Bill rate and the primary dealers respond in kind to real world economic pressures.

[moda0306]

MG,

Since when do bonds protect you from inflation?  That isn't their purpose in my portfolio, anyway. And is the fed really doing this to "repair their balance sheet" or will they ever for that purpose?  Aren't they engaging in QE to maintain their dual mandate of price stability and full employment?

But in the end I think I agree with part of what your saying.  By taking away treasuries, the fed is forcing people to take risk to get a real return out of their savings (or even keep pace with inflation).  This is the point, in a way... to keep the price floor low enough that lending to the private sector (and, conversely, borrowing from banks) become worth it for both parties... since, again, nobody would lend to a private entity for less than the federal government.  This is to promote growth, a more fluid velocity of money, and full employment.

[MachineGhost]

Since when do bonds protect you from inflation?  That isn't their purpose in my portfolio, anyway. And is the fed really doing this to "repair their balance sheet" or will they ever for that purpose?  Aren't they engaging in QE to maintain their dual mandate of price stability and full employment?

Well they do protect you against inflation, just not unanticipated inflation.  Such as the unanticipated inflation of the Fed's balance sheet not being contracted as short-term rates go higher or subpar economic growth that is not enough to increase demand relative to excess supply of "savings accounts" on the Fed's balance sheet.

I don't know if the Fed would actually buy Treasuries to repair its balance sheet, that was just my logical deduction.  The QE is to actually repair the banking system's balance sheets instead of bondholders taking a hair cut and wiping out equity holders.  That can only be done by transferring the toxic garbage to the Fed.  Price stability and full employment is just public relations B.S.. to fend off populists.

[moda0306]

I still don't see how a central bank's balance sheet can be viewed as the foundation of the value of a currency.  There's no bite there.  The value of our currency comes from a combination of taxes, "proper" lending in the banking sector (for all the complaints, a ton of lending is very legitimate and necessary, and often focused in positive areas), and government supporting an expansion of productive capacity and confidence.  To me, some nebulous fed balance sheet has little to do with it.

That may be true under MR theory, but since the monetary base and short-term interest rates have a high correlation, any upwards movement in short-term interest rates** will provoke inflation if the monetary base is not simultaneously reduced in proportion by the Fed.  The Fed can either reduce the base, do nothing and let the inflation transmit into the general price level or pull a rabbit out of their collective ass by betting on strong economic growth over two decades.  Not holding my breath here, if past history is any indication.  The Fed is always a day late and a dollar short.  If Bernanke is smart, he will get the hell out before the shit hits the fan.

** Its commonly believed the Fed sets short-term interest rates, but this is not actually true.  The Fed sets its own Discount Rate (DR) or the Federal Funds Rates (FFR) which have to do with inter-banking system loans.  Out in the real economy, T-Bill rates actually lead the Fed's actions on the DR or FFR.  Under MR, it is the primary dealers and the Treasury that colludes to set the T-Bill rate and the primary dealers respond in kind to real world economic pressures.

Why would an upwards movement of ST rates provoke inflation?  Isn't inflation stoked by negative real rates, thereby increasing lending "artificially?"

And to your ** point, isn't the fed's most impactful mechanism the purchase/sale of treasury debt?  While they may not set short overtly, they move to try to keep these rates in equilibrium with their DR nd FFR rates... at least unless I'm mistaken.

And, lastly, how is there a high correlation between ST rates and the monetary base?  Since 2008, we've had a huge increase in M0 and a massive drop in short-term rates.

I really feel like I'm missing the boat on half of what you're saying, and probably not doing a good job of debating you.  If you are up for it, I'd suggest raising some of your points at Pragcap.com and Monetaryrealism.com and get a more robust counter-debate than I can provide .

[moda0306]

Since when do bonds protect you from inflation?  That isn't their purpose in my portfolio, anyway. And is the fed really doing this to "repair their balance sheet" or will they ever for that purpose?  Aren't they engaging in QE to maintain their dual mandate of price stability and full employment?

Well they do protect you against inflation, just not unanticipated inflation.  Such as the unanticipated inflation of the Fed's balance sheet not being contracted as short-term rates go higher or subpar economic growth that is not enough to increase demand relative to excess supply of "savings accounts" on the Fed's balance sheet.

I don't know if the Fed would actually buy Treasuries to repair its balance sheet, that was just my logical deduction.  The QE is to actually repair the banking system's balance sheets instead of bondholders taking a hair cut and wiping out equity holders.  That can only be done by transferring the toxic garbage to the Fed.  Price stability and full employment is just public relations B.S.. to fend off populists.

MG,

The fed owning MBS's is the exception, not the rule.  I agree that this is to repair banks balance sheets, and that it's potentially effectively a fiscal action, but for the most part we're talking about standard fed actions... or at least I'd prefer to keep it that way so we can decide on the nature of what the fed does most of the time vs how they act during a crisis.

[MachineGhost]

Why would an upwards movement of ST rates provoke inflation?  Isn't inflation stoked by negative real rates, thereby increasing lending "artificially?"

General equilibrium theory.  If rates go higher on newly issued money, old money becomes less attractive, so a parity has to be reached for equal attractiveness.  It is the same mechanism by how long term bonds decrease in value as rates on newly issued bonds are higher.

Any kind of inflation is stoked by excess demand relative to supply.  Real rates which benefit gold is not inflation per se, it is devaluation.  There's a difference, because any kind of inflation is benign as long as nominal rates are higher or manufacturing capacity is not fully utilized (or you're not stupid and hold currency).

And to your ** point, isn't the fed's most impactful mechanism the purchase/sale of treasury debt?  While they may not set short overtly, they move to try to keep these rates in equilibrium with their DR nd FFR rates... at least unless I'm mistaken.

Beats me.  All I know is real world effects vs theory.  T-Bill rates lead the Fed.  This implies the invisible hand is at action even in a crony capitalist triumvirate between the primary dealers, the Treasury and the Fed.
 

And, lastly, how is there a high correlation between ST rates and the monetary base?  Since 2008, we've had a huge increase in M0 and a massive drop in short-term rates.

It's very high.  There's been no inflation because the short-term rates have been consistently dropping, i.e. we're in a stagnant economy with increasing demand for risk-free assets.  So long as the short-term rates go or stay down by the demand for risk-free assets, the monetary base can increase with no consequence.

[MachineGhost]

The fed owning MBS's is the exception, not the rule.  I agree that this is to repair banks balance sheets, and that it's potentially effectively a fiscal action, but for the most part we're talking about standard fed actions... or at least I'd prefer to keep it that way so we can decide on the nature of what the fed does most of the time vs how they act during a crisis.

Give me a break.  What the Fed did in this crisis was not standard.  In fact, it never does anything standard in any crisis, because it really doesn't have much clue as to what the fuck it is doing.  It flits from fad theory to fad theory under every new adminstrator.  Now put someone that understands MR in charge and I may change my tune.

The Fed should be folded into the OCC and abolished.  It is a relic of central planning no different than the politubros of the ex-Soviet Union.  We all know how well that worked out!  The only singular thing worse than the Fed is the FDA.

[moda0306]

Why would an upwards movement of ST rates provoke inflation?  Isn't inflation stoked by negative real rates, thereby increasing lending "artificially?"

General equilibrium theory.  If rates go higher on newly issued money, old money becomes less attractive, so a parity has to be reached for equal attractiveness.  It is the same mechanism by how long term bonds decrease in value as rates on newly issued bonds are higher.

Any kind of inflation is stoked by excess demand relative to supply.  Real rates which benefit gold is not inflation per se, it is devaluation.  There's a difference, because any kind of inflation is benign as long as nominal rates are higher or manufacturing capacity is not fully utilized.

And to your ** point, isn't the fed's most impactful mechanism the purchase/sale of treasury debt?  While they may not set short overtly, they move to try to keep these rates in equilibrium with their DR nd FFR rates... at least unless I'm mistaken.

Beats me.  All I know is real world effects vs theory.  T-Bill rates lead the Fed.  This implies the invisible hand is at action even in a crony capitalist triumvirate between the primary dealers, the Treasury and the Fed.
 

And, lastly, how is there a high correlation between ST rates and the monetary base?  Since 2008, we've had a huge increase in M0 and a massive drop in short-term rates.

It's very high.  There's been no inflation because the short-term rates have been consistently dropping, i.e. we're in a stagnant economy with increasing demand for risk-free assets.  So long as the short-term rates go or stay down by the demand for risk-free assets, the monetary base can increase with no consequence.

Real world effects vs theory?  If you don't know what the fed's most meaningful tools are, how can you be so sure that the real world effects you observe are so diagnosable.

I'll ask again, how can you say the correlation of monetary base to short-term interest rates is high with what's happened over the last few years?  Especially when you think of what a rise in the monetary base actually represents: the fed buying up treasury bonds to LOWER bond rates, which they seem quite successful doing (has the fed ever "failed" to reach an interest rate target (not a rhetorical question)).

Value of bonds going down is NOT equal to inflation.  That's simply the value of your bonds going down due to changes in interest rate.  And the reason short-term rates are so low, if they TRULY aren't controlled by the fed (I think this is a hasty assertion), is the stagnant economy... which is causing the low inflation.  It's the stagnant economy driving both the deflation AND short-term rates.

I can actually understand the argument that the short-term rates aren't set by the fed but are in fact managed by the market (though I have come to be much more convinced that the fed effectively sets ST rates and the market adjusts via credit and velocity of money).  However, if rates are truly managed by the market, and not the fed, then we need to stop listening to the whining of the fiscal hawks, because the MARKET is borrowing us money at rates below the rate of inflation.  It would be idiotic not to use that opportunity.  However, if you say that, guess what you hear: "The fed sets interest rates, not the market!"  (facepalm)

[MachineGhost]

Real world effects vs theory?  If you don't know what the fed's most meaningful tools are, how can you be so sure that the real world effects you observe are so diagnosable.

The means don't matter.  Only consequences.  Although I admit it helps to have theoretical framework to explain how it all comes about, but you risk getting locked into a wrong or delusionary framework which is very common with economics.  But, you don't need to know the nuts and bolts to profit from consequences.

I'll ask again, how can you say the correlation of monetary base to short-term interest rates is high with what's happened over the last few years?  Especially when you think of what a rise in the monetary base actually represents: the fed buying up treasury bonds to LOWER bond rates, which they seem quite successful doing (has the fed ever "failed" to reach an interest rate target (not a rhetorical question)).

The Fed lowers long-term interest rates with its Treasury buying, not the short-term rate that is correlated to the monetary base.

Value of bonds going down is NOT equal to inflation.  That's simply the value of your bonds going down due to changes in interest rate.

And inflation expectations.

It's the stagnant economy driving both the deflation AND short-term rates.

You got it.  Demand for risk-free assets is currently high enough to offset the dramatically increased supply that the Fed put on its balance sheet.  That would change under an improving economy or a supply shock.

However, if rates are truly managed by the market, and not the fed, then we need to stop listening to the whining of the fiscal hawks, because the MARKET is borrowing us money at rates below the rate of inflation.  It would be idiotic not to use that opportunity.  However, if you say that, guess what you hear: "The fed sets interest rates, not the market!"  (facepalm)

Yeah, it is definitely a conundrum.  Who knows what is 100% absolutely correct until after another 50-100 years to hash all the competing explanations out?

The PP is awesome in its simplicity.

[clacy]

Yeah, it is definitely a conundrum.  Who knows what is 100% absolutely correct until after another 50-100 years to hash all the competing explanations out?

The PP is awesome in its simplicity.

Best sentence in this entire thread. 

[moda0306]

A rebuttal on the Fed paper on deficits/QE and the fed balance sheet.

http://krugman.blogs.nytimes.com/2013/0 ... tractions/

Yes, it's Krugman, and his assertion that the Euro crisis is a "balance of payments crisis and not a debt crisis" is a bit much (private sector debt in Euro area countries was a huge problem).

However, for all the insane math in the paper that probably makes sense to nobody here, it seems it was really based on countries that don't control their currency.