Friday, August 10, 2007

I'm Ben Bernanke, I'm here to rescue you!

My post from Monday caught a lot of flak from commenters, but I'm feeling quite vindicated today. I argued there that the Fed would be paying close attention to illiquidity in the bond market, and they would do well to express a willingness to cut rates if need be to restore liquidity.

They didn't say as much as I had hoped, but it appears events may force their hand. Yesterday's collapse of liquidity in Europe and the disturbing announcement from Countrywide are forcing central banks around the world to pump liquidity into the financial system.

First, a clarification what is meant when the media reports that the Fed (and ECB, BoJ) were adding liquidity yesterday. The Fed adds liquidity almost every day, so the fact that they injected some money isn't surprising. What happened yesterday was so many banks wanted to borrow that it pushed the trading level of Fed Funds well above the Fed's target of 5.25%. This is unusual, and therefore the amount of reserves the Fed added was much larger than usual.

Second, a not-so-bold statement, that I'm sure many will disagree with: the Fed will not let Countrywide fail solely because they are denied access to the debt markets.

For those who don't believe me, particularly those who argue that the Fed is a bunch of hard core inflation hawks, I ask you to read Bernanke's academic work from before he was with the Fed. He did a ton of work on the Depression, and his belief is that the Depression was basically a result of a liquidity crunch. After joining the Fed, he famously told Milton Friedman "Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

What's happening with Countrywide is very similar to a bank run. And the Fed has the power to inject enough liquidity to stem the run. Mark my words, they will do it. The futures now price in a cut for September. Many are saying there will be an emergency cut before then. Whether the emergency cut happens will depend on how events unfold, but don't let the inflation hawk rhetoric fool you. Ben Bernanke will not risk another depression by sitting on his hands. Not when he has the tools to address the problem now.


Anonymous said...

Agreed, We're seeing absolutely no trading in cash markets (other than a spurt around the new issuance calendar 2 days ago). The commentary posted on that previous post was completely off base. We've been trying to move some bonds and every time we call for a bid on a posted 5 point market, the traders either refuse to actually bid or back their bids up a few points.

My thesis is essentially that corporates and siv's have all run their revolvers to their limits and are hoarding cash. We're seeing huge inflows into cash funds which reflect this. That's been going on for two weeks. We've reached the point now where banks have run out of ready reserves to carry these (loss making) loans. Essentially a good old bank run.

What is interesting is that liquidity in derivative (cashless) products is normal to slightly below normal with good volumes.

Anonymous said...

How exactly does a rate cut prop up the markets you discuss in the short term? If buyers do not exist at 5.25%, will they at 5%, or are you (bond market people calling for a rate cut) calling for something eye catching, say to 4.5%? And then do we just prop up another asset bubble with inflation still strong only to bust when the Fed has to pick either growth or inflation to tackle?

Now, as it happens, I agree that it would be unwise for the Fed or the Treasury, or whoever's court the decision actually falls, to let Countrywide fail solely due to a liquidity crunch as long as their books are otherwise sound. That would be the wrong message and the wrong policy.

Looking from the outside, and quite appreciative of the insight into the bond market by the way, it just looks to me like it is only a few weeks. It is August when more than half of Europe is on vacation anyway and judging by my commute here in San Antonio today half of this city is as well. Other than specific instances, like countrywide, the fed taking rate action now seems hideously premature to me.

Greenspan got old and loony and forgot that Inflation is the Enemy. Hopefully the Fed is now in better hands.

Anonymous said...

Not exactly the most boring corner of the financial world any more, is it?

Unknown said...

I thought fixed interest was boring until I found your blog about 2 weeks ago. Its been non stop action ever since. Thanks, great blog.

Anonymous said...

have you considered changing your header...

A bond market blog? Seriously? Yes, from the most boring corner of the investment world, its Accrued Interest, a blog about the bond market.

it's really fun reading your blog... from the view of the individual investor, little peeks into the dark rooms I've never invited to are most enlightening



Anonymous said...

Ya think Paulson could have put the Chinese on notice that Bernanke was preparing for helicopter drops, and they're not to happy about it, hence the threat? I have to think his visit, their threats, and these repos are related.

If there is one thing the Fed can do, it is to print the dollar into oblivion. No debate, no vote, no Constitutional amendment. Unilateral power. I believe it shifts the balance of power to the Executive branch far in excess of what the framers of our Constitution had in mind.

Great blog, btw, don't have to agree with what's posted; food for thought is all I look for, and I get plenty here. Thanks

Anonymous said...

Great blog! In 1987, I had many option calls. I remember how the buzz was that the fed had to lower rates. And the Tuesday prior to the crash they raised rates. Over the years, I’ve tried to figure out why they did this and I've come to the conclusion that killing runaway inflation was the purpose of 1987. It is interesting how the xau and xoi tanked in 1987 along with everything else. As a guess, the trigger to kill inflation this time was when oil reached close to $80. I think the fed has stepped in to prevent a bank run but will step in adequately to end the downslide after those indexes backs are broken.
Since I have no facts to back this theory and you obviously are much more knowledgeable in this area, do you think this is at all plausible?

Anonymous said...

Add me to the crew who think a rate cut in the near or intermediate term is absolutely out of the question. Accepting MBSs as repo collateral, sure, nothing unusual about that except the size of the transaction(s) needed.

But it is an open hand with liquidity that stems bank runs, not a cut in interest rates, and given what a rate cut would mean for the $USD, moral hazard, and a bunch of other heavy-duty stuff, the Fed won't do it if their collective integrity means anything at all (even though I have no doubt their arms are being twisted off by everyone from Goldman Sachs to my congress-critter).

Salmo Trutta said...

(1) For an economy to have the inherent resiliency to recover from a recession presumes certain requisite conditions: sufficient competitiveness in the price structure to insure that decreased demands will result in across-the-board downward flexibility in prices...this applies to the price of houses, which have appreciated on average, over 80% in the last 6 years.
(2) The Fed cannot control interest rates, even in the short end of the market except temporarily. By attempting to slow the rise in the federal funds rate the Fed will pump an excessive volume of free legal reserves into the member banks.
(3) The Federal Reserve Bank of New York's "trading desk" -- injected 35 billion of Mortgage Backed Securities on Fri Aug. 10th.
(4) If it is decided to maintain excess reserves at a higher level, i.e., to follow an easier (or less restrictive) monetary policy, this is presumably undertaken to counteract recessionary tendencies in the economy.
(5) Since the annualized 2nd quarter 2007 real-gdp grew at 3.4% and the core PCE was at the top of the target range, it is likely that the temporary injection of legal reserves will eventually be "washed out" by the Manager of the Open Market Account

David Merkel said...

There is no risk of depression from the current crisis. Recession, maybe. The losers from all of the bad lending are typically hedge funds and fund-of-funds, and will not affect the average person much at all.

Fortunately, the Fed is doing almost nothing. Temporary injections of liquidity do nothing to affect long-term conditions.

Monetary policy, when loosening, only stimulates healthy portions of the economy; it is totally ineffective at curing the problems of those with bad balance sheets.

Superbear said...

I think markets maybe totally off the mark in thinking that the rate cut will save us from the impending crisis. One has to differentiate between the root causes of the credit crunch. The current crunch is due to the unwillingness of the buyers to put a bid as opposed to their inability to bid. This second type of crunch can be overcome by a rate cut, not the first type - which is where we are now.

On another note, in spite of his academic work, he will find that theoretical knowledge is not much useful in practice. If he drops the rates, the dollar will take a dive - reigniting the inflation, and worse, hiking the long-end of the yield curve. So, he will end up with even worse real estate market.

This Fed is in a severe danger of getting into what Keynes called as a 'liquidity trap', i.e., inability of low rates to revive the economy (Japan for example? And there is a tremendous debate on this issue.)

I think the damage has already been done. And all that Helicopter Ben can do is to clean up the mess as quickly as possible - this includes letting Countrywide fail. (And unless the Fed is willing to lend directly to Countrywide, I m not sure what it can do to save it.)

The options before the fed are choosing between inflationary depression or deflationary depression.

If Helicopter Ben really starts dropping the $s from the sky, then instead of studying the Great Depression, he should be brushing up on economic history of Germany, or of current Zimbabwe.

Best luck.

Accrued Interest said...

OK Lots to respond to. I'll do a couple at a time.

Derivatives trading better than cash: I think that tells you that fast money is the only thing trading. Real money doesn't like to do a lot of price discovery.

Rate cuts "proping" up the market: I don't like the word "prop" here. By cutting rates the Fed will create more liquidity in the banking system. This will leave banks more able to deal with a lack of liquidity in the bond market. I know the blogging world tends to be pretty young, but that's exactly what happened in 1998. I argue that this market is very similar to the post LTCM period. The Fed was tightening policy prior to the crisis, they cut during the crisis, and by June 1999 they were hiking again.

Accrued Interest said...

Fixed income boring? Maybe based on the last couple weeks I should change my banner. Anyway, doing this blog is a labor of love. All I want to do is stimulate conversation, which makes all of us better traders.

Accrued Interest said...

I am too young to have been in the market in 1987. I will say that I don't think the Fed had as much credibility then on inflation as it does now. The credibility allows the Bernanke Fed to cut rates once or twice without the market concluding that they don't care about inflation.

Accrued Interest said...


You might be right that just pumping enough liquidity to keep FF at 5.25 is enough. But I really think the Fed will send a message by cutting rates soon.


I don't think anyone disagrees that money is neutral in the long run and that hedge funds failing doesn't effect the average person. However, if Countrywide goes bankrupt all because there is no bid for jumbo prime MBS, that's a major problem for the economy. Illiquidity is a problem that the Fed can impact in the short run. I hate to invoke Keynes, but in the long run we're all dead.

Accrued Interest said...

Flow5: I love your comments, although I'm never sure how to respond.

Accrued Interest said...


All we need to improve liquidity in the bond market is to find the right price for risk. But while that's going on, the Fed cannot allow a good company like Countrywide to go bankrupt merely because they can't securitize residential loans of any kind.

If the Fed is willing to keep cash pumping into the system, they buy time for firms like Countrywide. If Countrywide is going to have to warehouse loans longer than expected, they need a source of capital to do so. If the debt markets are shut down, the Fed has the power to provide this capital.

I hate to keep bringing up 1998, so I'll give another example. 9/11/01. Fed funds went to zero. Some people outside financial markets don't realize this, but the trading level of fed funds that day went to zero. The Fed literally gave reserves away to make sure fear didn't turn into a liquidity crisis.

Anonymous said...

Hi, a basic query really. Isn't the Fed Funds rate decided at 5.25%? or is it market driven? I may have mitaken that it stays 5.25% as decided by the Fed.

rdinges said...

It has been interesting reading here since I had just stumbled onto this bond trading blog earlier this morning. I am the owner of a mortgage broker in Ma. From the perspective of one on the street, I can tell you this issue is a bit more severe than most realize.

Subprime and non-agency Alt-A have accounted for only about 5% of our past volumes. Though we are still affected since we are now seeing Fannie and Freddie tighten up their guidelines over the past 8 months. When other financing alternatives becoming extinct, the Agencies will get more requests and therefore must approve a lower percentage of those requests. We are now at the point where it is extremely difficult to refinance a perfectly performing subprime/ Alt-A borrower (650-700 fico, no mortgage or credit lates, no cashout)with higher LTV's. They are hitting their adjustments and will have their budgets obliterated with the increased home cost. The crazy part of this is I can qualify many of the same borrowers through the Agencies to purchase at 100% financing. Without the portfolio caps being lifted for the Agencies, they will continue to tighten resulting in a significant increase in foreclosures. This is going to get worse.

The caps on the Agencies need to be lifted so we can work on the street to keep families in their homes. We all know the Agencies portfolios are performing strongly. Allow them to open the guidelines back to where they were prior to 2007. A rate decrease may also help in stabilizing the housing market. There are many home buyers on the sidelines, since nobody wants to buy on the down slope of home values.

A choice needs to be made. Does this issue get resolved by letting these bad loans get purged out of the system via foreclosures or a combination of refinances and purchases. The banks are now beginning to hoard funds, because we are on the foreclosure path at the moment.

Salmo Trutta said...

The financial press reported that the “fed funds rate rose as high as 6 percent on Friday” (above the Federal Reserve’s target rate off 5.25 percent) and that this “prompted the central bank to inject temporary” free legal reserves into the banking system. Unfortunately, these publications continue to circulate outdated explanations for FOMC operating objectives and procedures.
And if you look back at the range fluctuation data (the Federal Funds Bracket Racket), the “trading desk” allowed fed funds rate to be traded as high as 6% on 7 different days during the last month. But no previous rate rise was the consequence of a panic-stricken marketplace.
The FOMC establishes monetary policy and directs the FRBNY Open Market Desk to execute it. Each day the FRBNY Open Market Desk sets a one-day-repo rate on Treasuries, or the one-day-cost-of-carry on government bonds. This is the true policy instrument – and it affects huge amounts of money (essentially, the one-day-return on all government securities). Federal Funds transactions are trivial in comparison.
In the last 28 days, the highest trading rate for repo’s was 5.28%. In the last 28 days, the highest trading rate for mortgage backed securities was 5.32%. These rates were well below the highs for federal funds.
The FRBNY conducts open market operations (selling & purchasing, reselling & repurchasing, & lending) U.S. Government securities. The FRBNY holds all dollar denominated assets (except for securities purchased under agreements to resell) in the System Open Market Account (SOMA).
Interest rates are headed lower. (1) The Federal Budget Deficit is declining,(2) Real-gdp is now declining, (3) inflation is declining.

Salmo Trutta said...
This comment has been removed by the author.
Salmo Trutta said...

"brilliance of Friedman and Schwartz's work on the Great Depression"

It's my considered opinion neither Friedman nor Schwartz knew much about money & central banking. Bernanke is a little different & he will be able to pull us out of this mess.

Don't know if this is proper to publish, so if need be, I'll delete it.

Great Depressions presume catastrophic financial events: not just a panic on Wall Street, but the actual collapse of the U.S. monetary system.
The Great Depression was the first depression ever experienced by this country which required government fiscal intervention to nullify the forces of contraction and deflation and turn the economy around. The “mind set” of government and business, and economists, assumed that financial panics, recessions, and depressions were natural and inevitable events and that time alone would solve the problems of excessive debt, excessively high and distorted prices, and widespread unemployment. Up to 1929 they were right.

It took almost four years of ever worsening economic contraction before the people running this country would accept the fact that the Great Depression had ushered in a new era. By that time unemployment and under-employment had exceeded half the work force, the private money system had totally collapsed, and a highly interdependent economy was being forced to retreat to a self-sufficient economy. For example, farmers found it necessary to use ear corn, rather than coal, for fuel. Both Roosevelt and Hoover in 1932 ran on platforms calling for balanced budgets.

The “primary” postwar depression of 1920-21 was the last of the self-correcting business cycles. Recovery, in fact, was attained in spite of the federal government’s fiscal policy. From the beginning of 1920 to the end of 1921 the national debt was reduced from $25.6 billion to $23.1 billion.

For an economy to have the inherent resiliency to recover from a depression presumes certain requisite conditions: (1) sufficient competitiveness in the price structure to insure that decreased demands will result in across-the-board downward flexibility in prices; (2) the absence of a high degree of economic interdependence; (3) the retention of sufficient faith in the nation’s monetary system to preclude a wholesale failure of the commercial banks; and (4) the introduction, or continued development, of broad based capital-consuming, work-creating industries. All of these conditions were present in the 1920 economy.

In the 1920-1921 period the decline in prices was surgically sharp. Compared to the 1929 economy there was much less monopoly and oligopoly in business and industry; family-sized farming constituted a much greater proportion of the economy; there was, consequently, less interdependence, and the financial crisis was largely limited to small banks in rural areas. But the principal force that propelled the economy bank to prosperity was the continued introduction of numerous innovations and inventions in the automobile industry. Thanks largely to the competitive imitative of Henry Ford, prices were low enough to insure that cars were mass produced and mass sold. For the first time the worker on the assembly line could buy what he was fabricating.
In the Great Depression, people everywhere were attempting to convert their demand and time deposits into currency. Thousands of towns and cities throughout the country were attempting to finance their daily commerce without a single operating bank. And by March, 1933, just before Roosevelt’s “banking holiday” there were even entire states without a single operating bank.
Before the New Deal, widespread bank failures were epidemic even in so called prosperous times In the 1921-29 period 5,411 banks failed; 8,812 in the 1930-33 period; but only 336 insured banks failed in the 28 year span from 1934-1962.

In the first 20 years under the Federal Reserve Act of 1913, there were over 20,000 bank failures. The intention of the framers of the Act was to establish a unified banking system under 12 central banks. There were many flaws in the original Act, one being the establishment of 12 rather than one central bank. The fatal flaw was not making membership in the System compulsory for all money creating institutions. And had not Franklin Roosevelt declared a “banking holiday” in March 1933, the lack of confidence in the banking system would have resulted in the failure of virtually every bank in the United States.
Some unprecedented things have been happening since the coming of the “New Deal” in 1933. On a year-to-year basis, Federal Reserve Bank credit has always expanded. The same applies to commercial bank credit, and the means-of-payment money supply. The consumer price index has fallen on a year-to-year basis in only two years, 1937 and 1949. The chief factor affecting the level of long term interest rates since the early 1950’s is inflation expectations, not the level of business activity.
We now actually have a central bank. It is called the Federal Reserve Bank of New York. An amendment to the Federal Reserve Act in 1933 established The Federal Open-Market Committee and gave it the power to control Total Reserve Bank Credit. The Fed can now buy an unlimited volume of earning assets. (With the federal debt at over 8.9 trillion, and expanding, and billions of dollars of “eligible paper” available, the term “unlimited” is not an exaggeration in terms of any potential needs of the Fed.) In the process of buying Treasury Bills etc., new Inter-Bank Demand Deposits (IBDDs) are created. These deposits can be cashed by the banks into Federal Reserve Notes, without limit, on a dollar-to-dollar basis.
Today, the public, seeking to cash their deposits, would soon have a surfeit of paper money. A general run on the banks is impossibility. Where the Federal Deposit Insurance Corporation cannot handle the situation (Continental Illinois, for example), the Fed will guarantee the liquidity of the bank’s deposits. In other words, a liquidity crisis leading to the wholesale failure of commercial banks is impossible. Where banks are allowed to fail, or are absorbed into solvent banks, customers never suffer losses if their deposit does not exceed $100,000. The fed intervened in the Continental case because many corporations, foreign and domestic, had deposits far in excess of $100,000.
These institutional changes plus the numerous “safety nets” now provided business and consumers preclude a recurrence of a “Great Depression”.
In the period from 1929 – 1932 stocks were spiraling down, unemployment was becoming endemic, businesses were failing in increasing numbers, bank failures were accelerating, and millions of people were suffering severe malnutrition, there was not a single piece of legislation passed by Congress or action taken by the administration which had any significant effect in stemming the tide of economic disaster.

The “New Deal” programs, initiated in 1933 and subsequently, were sufficient to staunch the hemorrhaging of the economy, but never sufficient to lift the economy out of the depression. Bank and Savings and Loan failures were virtually ended after 1935, but the government had to remain employer of last resort on a very large scale. To provide direct relief to the unemployed and a modicum of sustenance to the unemployable, the Federal Emergency Relief Administration was organized. Emergency Relief Commissions were set up in each state, and a network established for direct distribution of relief.

In 1935, in an effort to put the unemployed to work, various work programs were added. The Civil Works Progress Administration and the Public Works Administration confined their clientele to the relief rolls. No means test was required for employment on projects managed by the Civil Works Administration or the Public Works Administration.

To arrest foreclosures and bankruptcies and assist business and agriculture, the New Deal put in place numerous agencies including: The Reconstruction Finance corporation, the National Farm Mortgage corporation, the Agricultural Adjustment Administration, the Federal Housing Administration, the Rural Electrification corporation, the Federal Deposit Insurance Corporation, The Federal Savings and Loan Insurance Corporation, the Bank for Cooperatives, the Export-Import Bank, etc., etc.

In retrospect, the answers to the depression seem simple. We needed a central bank that could and would pump IBDDs into the commercial banks in a volume sufficient to satisfy the public’s demand for currency, specifically paper money (currency is an asset the Fed does not, should not, and cannot control). In the control of the monetary aggregates, the monetary authorities are completely dependent on their power to control the volume of bank credit. They have no power over the volume of the Treasury’s General Fund Account or the currency holdings of the public.
It was not until 1933 that we began to unshackle our paper money from the numerous and unnecessary restrictions pertaining to its issuance. With the numerous types of paper money in circulation at the time, this would seem to have been a non-problem. Here is the list: gold certificates, silver certificates, national bank notes, United States notes, Treasury notes of 1890, Federal Reserve Bank notes, and Federal Reserve notes. With that array of paper money there should have been plenty to meet the liquidity demands placed on the banks by the public. But the volume of each type that could be issued was so circumscribed by restrictions that even the aggregate group could not begin to meet the panic demands of the public.
Today we have only the Federal Reserve Note, and there is only one restriction placed upon its issuance. No Federal Reserve Note can be put into circulation unless there is a prior transaction involving the relinquishing by the public of an equal volume of bank deposits, and an equal diminution of the holdings of IBDDs on deposit with the Federal Reserve Banks; In other words, the issuance of our paper money contains no inflationary bias. Its issuance does not increase the volume of money. It merely substitutes one form of money for another form
The last vestige of legal reserve and reserve ratio requirements against the Federal Reserve Note, demand deposit, and inter-banks demand deposit liabilities of the Reserve banks was eliminated in 1968. Today the Federal Reserve Note has no legal reserve requirements, and the capacity of the Fed to create IBDDs has no legal limit. These IBDDs are owned by commercial banks; they are bank legal free reserves and can be converted dollar-for-dollar into Federal Reserve Notes. The volume of IBDDs is almost exclusively related to the volume of Reserve Bank credit. When Federal Reserve Banks expand credit, for example by buying U.S. obligations, the balance sheets of the Banks reflect an increase in earning assets and an equal increase in IBDD liabilities, i.e., legal free reserves
Actually the issuance of Federal Reserve Notes is deflationary, other things being equal, since the issuance diminishes the clearing balances and legal free reserves of the commercial banks. The Fed recognizes this fact and uses its open market power to replenish bank free reserves and prevent any unwarranted contraction of bank credit.
In 1933 the Federal Reserve Note had to be collateralized by at least 40 percent in gold bullion or coin, and the remaining collateral had to consist of eligible comer paper, principally Trade and Banker’s Acceptances. The problem was the banks had practically no eligible collateral.
The first tentative step was to reduce the gold requirement to 25 percent and allow U.S. government obligations to provide the remaining collateral. The framers of the Federal Reserve Act did not believe that the credit of the U.S. government was inferior to that of the Federal Reserve Banks and the short term commercial paper of business; they merely believed that the volume of paper money should rise and fall with the level of business activity. They also had the naïve belief that this country was so big, so diverse in its commercial needs, that it needed twelve central banks.
Had the present Federal Reserve System been in place at the beginning of the Great Depression, there would have been no Great Depression. We were not reduced to practically a barter economy because the banks were insolvent; we needed that condition because perfectly sound banks could not meet the liquidity tests imposed upon them by a panic-stricken public.
One of the preconditions the U.S. needed in 1929 was a much larger national debt, and a willingness on the part of the Congress, the Administration, and the business community to tolerate an adequate expansion of the national debt. In 1929 the national debt was less than $17 billion, and the banks held only a small proportion of that amount. We needed a larger debt and a much more rapidly expanding debt in the 1930’s, not only to “prime-the pump”, but to meet the monetary management needs of the Fed. Note: Both Roosevelt and Hoover in 1932 ran on platforms calling for balanced budgets.
The open market operations of the Fed require a depth of market that will enable the Fed to buy or sell billions of dollars worth of treasury bills on any given day without deeply disturbing the bill rates. Another of the many lessons from the Great Depression was the realization that if a financial panic is allowed to reach crisis proportions, monetary policy becomes useless, totally ineffective.
For all of the Great Depression legal reserve management was impossible even though the Banking Act of 1933 provided for the coordination of all open market operations through the New York Reserve bank. (that is to say, before 1933 one FRB could be conducting operations of the buying type -- expanding credit, creating bank free reserves and laying the foundation for a multiple expansion of money, while another FRB was doing the opposite, -- conducting open market operations of the selling type) Before April 1933 any excess free reserves in the system were quickly wiped out by the massive “runs” on the banks.
But even after bank failures were brought under control business confidence remained so traumatized the expansion of legal free reserves remained to a large extent excess free reserves. There were not enough credit worthy borrowers in the private sector (according to the bankers), and in the public sector there was an insufficient volume of government debt to absorb excess bank lending capacity. From 1933-1942 the centralization of the open market power was of little consequence. It was not until about 1942 that the member banks operated with no excessive amount of excess free reserves.

After 1933, after we had a central bank and a coordinated Fed credit policy, the Fed pumped billions of dollars of free reserves into the banks; and nothing happened. There were years during this period when the excess legal free reserves held by the member banks were larger than the volume of required free reserves. The exercise of Fed policy was likened “to pushing on a string”. Note: before 1942, and before the federal debt became a controlling economic factor, demand deposits fluctuated up and down with the business cycle. Commercial banks were commercial banks and when business demand for loans increased, demand deposits increased, and vice versa. Now the banks always remain fully “lent-up”, they hold no excessive amount of excess legal lending capacity to finance business (or consumers), it is now used to acquire a piece of the national debt or other creditor ship obligations that are eligible for bank investment.
World War II changed this and since 1942 the member commercial banks have operated with no significant amount of excess legal free reserves. Excess free reserves were, and should be, made equal to total free reserves minus the product of all deposit liabilities times the reserve ratios.
By the end of 1940 the national debt had risen to $44.8 billion as a consequence of a deficit that averaged $2.6 billion annually. Not surprisingly GDP, which had been $103.8 billion in 1929 and $55.3 billion in 1932, had only risen to $101.4 billion by 1940. All of these New Deal agencies, in terms of fostering increasing demands for goods and services, were of such modest proportions that we had, in 1937-38, a sharp recession within a larger depression.

In the four years approximating the span of World War II, from the end of 1941 to the end of 1945, the net debt rose from $56.3 billion to $252.7 billion, an average annual deficit of $49.1 billion. Government expenditures on goods and services peaked in 1944 at a level approximating $100 billion or approximately 50 percent of nominal GDP. The deficit, at $57.5 billion, also peaked

Relative to nominal GDP we had the highest deficits during WWII and interest rates approximating the lowest levels of the Great Depression. Interest rates on Treasury obligations ranged from less than on percent on TBs to 2 ½ percent on long term bonds. This was accomplished by the Fed pegging the rates on all governments through the unlimited use of their open market power. If the market pushed any rate above the predetermined “peg level” the Fed entered the market on the buying side, etc. This resulted in a vast increase in m1, bank credit and commercial and reserve bank holdings of governments.

At the same time due to rationing and the absence of available goods transactions velocity of demand deposits fell from around 20 to 13. The production of houses and automobiles was virtually stopped and credit rationing severely reduced the demand for all types of goods and services not directly connected to the war effort this plus controls on prices and wages kept the reported rate of inflation down. Financing nearly 40 percent of WWII’s deficit through the creation of new money laid the basis for the chronic inflation this country has experienced since 1945. Interest rates, especially long-term, would have average much higher had investors foreseen this inflation.

Not only were World War II deficits an unprecedented proportion of GDP; about 45 percent of the debt was monetized; that is $9=6.4 billion of the $216.4 billion increase was bought by the Federal Reserve Banks and the commercial banks. The Fed’s contribution was $22.5 billion of “high powered money” – the legal reserves of the commercial banks.

It should have come as no surprise that we did not have a “primary” post-war depression; our problem was excess demand and inflation, not deflation and depression. By the end of 1942, unemployment was no longer a problem, and the bankers had fully regained their confidence; the banks no longer held excessive legal reserves. Massive deficit financing had ended the Great Depression.

Today, the monetary authorities use two tools to control the money supply, legal free reserves and reserve ratios. Furthermore, the reserve assets that all money creating institutions are required to hold, should be of a type the monetary authorities can quickly ascertain and absolutely control. The only type of bank asset that fulfills this requirement is interbank demand deposits in the Federal Reserve Banks owned by the member banks. This was the original definition of the legal free reserves of member banks in the Federal Reserve Act on Dec. 23, 1913 –(Owen-Glass Act) and it is still the only viable definition (pre-Dec 1959 requirements pertaining to assets). The time is long past for the Congress to require that balances (IBDDs) in the Federal Reserve Banks be the sole legal free reserves of all banks. If this reform is not made all other reforms will be of little consequence.
Similarly the monetary authorities have to have complete discretion over changes in reserve ratios. Note: required free reserves were 20 percent of demand deposits (for central reserve cities) in 1958 and are 10 percent today. This is essential since under fractional reserve banking (the essence of commercial banking) these ratios determine the minimum volume of legal free reserves a bank must hold against a specified volume and type of deposit liability
Note :deposit classification for reserve ratio purposes is based on the false premise that the purpose of legal free reserves is to provide bank liquidity. As a consequence of the abuse and laxity now surrounding the administration of monetary policy, commercial banks since 1994, have been permitted to arbitrage –that is to sweep (reclassify), checking accounts into savings accounts, overnight to circumvent required free reserves.
Rather than discipline the member commercial banks the reserve authorities have become increasingly lenient, resulting in many undesirable forms, including allowing member banks to count vault cash as a part of their legal free reserves, thus confusing liquidity (liquid assets to meet seasonal and other “extra” demands on their clearing balances) and legal free reserves and making the Fed’s job of monitoring the volume of legal free reserves more difficult to predict.. Required reserve balances at the Federal Reserve Banks are now only 15 percent of their level at the end of the 1980s. Today 85 percent of commercial bank legal free reserves is now applied vault cash. Since the beginning of the 1990s IBDDs at the Reserve Banks have declined by 83 percent, and lagged reserve requirements have replaced contemporaneous reserve requirements as a result (see numerous reserve figure revisions and bankers inability to determine requirements pertaining to assets ).
The monetary authorities have long recognized that the volume of bank legal free reserves, combined with the reserve ratios applicable to various class of bank deposits, determined the limits and, since 1942, the amounts of bank credit creation (Member commercial banks have maintained negligible excess free reserves since 1942) Bank credit creation is a “system” process. No bank or minority group (from an asset standpoint) can expand credit (and the money supply) significantly faster than the majority group are expanding. Prior to the DICMCA of 1980 member banks held only 65 percent of total bank assets, (after holding 85 percent in the late 1950’s), thus creating the need for new legislation to reign in the state chartered banks that had lower reserve requirements.
With deposit classifications reduced, reserve ratios reduced, non-bound CBs, and a 30 day lagged reserve maintenance; this all adds up to a legal reserve apparatus that the Fed cannot monitor, much less control, even on a month-to-month basis. And the Fed cannot know, in a meaningful administrative sense, the current volume of depository institution legal free reserves. What the net expansion of money will be, as a consequence of a given injection of additional free reserves, nobody knows until long after the fact. The consequence is a volatile, delayed, remote, and approximate control over the lending and money-creating capacity of the banking system. The rationale for this particular form of “accommodation” originates from the Fed’s technical staff, by adhering to the false Keynesian theory – that the money supply could be properly controlled through the manipulation of interest rates (specifically the federal funds “bracket racket”) – lost control of both the money supply and the federal funds rate. The Fed cannot control interest rates, even in the short end of the market except temporarily.
The first order of business should be to require all banks to have the same legal reserve requirements, both as to types of assets eligible for reserves and the level of reserve ratios. The Fed should limit all reserves, to balances in the Federal Reserve banks, and have uniform reserve ratios, for all deposits, in all banks, irrespective of size.
From a systems viewpoint, commercial banks as contrasted to financial intermediaries, never loan out existing deposits (saved or otherwise) including existing DDs, or TDs or the owner’s equity or any liability item. When CBs grant loans to or purchase securities from the non-bank public (which includes every institution and every person except the commercial and the reserve banks), they acquire title to earning assets by the creation of NEW money-DDs.
From the standpoint of the individual banker his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, and probably its legal reserves – and thereby its lending capacity. But all such inflows involve a decrease in the lending capacity of other banks, unless the inflow results from a return flow of currency to the banking system or is a consequence of an expansion of Reserve Bank credit.
It was true, as the Keynesians insisted, that monetary policy didn’t matter; fiscal policy was everything. No more. Never will we allow a financial panic to get out of hand, and never will we have another Great Depression. That does no mean the future is rosy. The future holds the prospect of sharply declining levels of consumption for the vast majority of the American people, who will be facing years of stagflation. It is probable that we will never be able to dig ourselves out of the present morass of debt and still operate the economy within the framework of a free capitalistic system.

John G. Black said...

I have no idea who flow5 is but that post was the most lucid piece I've read on the current banking system.

Keep up the interesting writing.

John B

Salmo Trutta said...

The discount rate was intended to be a penalty rate. And it was presupposed that the penalty rate would be invoked during periods of rising inflation to discourage borrowing except in unusual circumstances. The current discount rate for banks eligible for primary credit is 6.25%. The discount rate for secondary credit is 6.75%.

(1)“The primary credit program is the principal safety valve for ensuring adequate liquidity in the banking system and a backup source of short-term funds for generally sound depository institutions.”
(2) “Secondary credit is extended on a very short-term basis, typically overnight, at a rate that is above the primary credit rate. Secondary credit is available to meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution.”

The interest rate criteria for primary & secondary credit during a period of market illiquidity coinciding with a decline in the rate-of-change in real-gdp is counterproductive. The discount rate should be set below the federal funds rate. It should be set at the same level the “trading desk” sets the repurchase agreement rate.

Accrued Interest said...

Flow 5 is like my guest blogger. I don't know who he is either, but he sure knows his stuff.

Anyway, fed funds is a traded rate between banks. The Fed merely buys or sells FF to manipulate the rate up or down on a given day. Its rare that FF actually trades materially away from the target, so when it does, its news.

Accrued Interest said...


Your story is exactly like Countrywide. There is no bid for non-agency MBS. So there is no liquidity for an originator underwriting a solid loan. At any price! Even if you were willing to take a loss on the loan to get it off your balance sheet, you can't.

I will be completely shocked if Fannie/Freddie loan limit isn't raised in the very near future. Its such a no-brainer.