It is a game of chicken the Fed is playing. I think they will lose, because securities valuations in the bubble were far beyond real intrinsic value. Those values will not come back.

Yes, the TAF auctions are sterilized. The proof is that the monetary base remains relatively unchanged. I would describe the effect not so much as a forced transfer, but as a centrally brokered redistribution of reserves.

The core problem induced by the credit crisis that the Fed must deal with directly as lender of last resort is the maldistribution of aggregate banking system reserves across individual banks. This could be categorized more broadly as a liquidity distribution problem, as opposed to an aggregate liquidity supply problem – although the term liquidity is sufficiently malleable that it is virtually meaningless without a specific context, making its use redundant anyway.

The system isn't working because it is not clearing the positions of all willing buyers and sellers of Fed funds, despite the fact that the Fed has supplied sufficient adequate reserves for the system to clear in a normal environment. Willing buyers of funds can't get them if other banks perceive the buyers as bad credits. Willing sellers will keep pushing their funds positions out provided that they can find good credit banks to buy them, or if they can use the funds as underlying payment for something else like treasury bills. But even if individual banks find treasury bills to buy, this doesn't guarantee that the resulting underlying redistribution of reserves will move toward the banks that ultimately need them. No matter what the aggregate supply of bills, even with an adequate supply of aggregate system reserves relative to system requirements, some bank(s) must end up with unwanted excess reserves so long as there are banks with deficient reserves that can't get them because of credit perception or lack of liquid assets to sell.

The implied dual of the problem of maldistribution of reserves therefore is a corresponding “maldistribution” of liquid assets to sell (such as treasury bills), in the sense that those banks who can't get other banks to sell them Fed funds directly also don't have sufficient high quality liquid assets to sell or finance in order to replenish their reserves in that way. Therefore, their last resort is the discount window - that is until the Fed created a “stigma-free” TAF.

Thus, the problem expressed in terms of either reserves or t bills is one of distribution rather than aggregate supply.

TSLF allows dealers to get collateral financing with bills when they can't get it in the market with the collateral they end up pledging at the Fed. It's a solution to the dual problem noted above in the case of dealers, who don't have direct accounts with the Fed in order to access either the discount window or TAF.

Either way, the Fed needs to supply government paper to the market to facilitate both TAF and TSLF – for sterilization in the case of TAF and substitution in the case of TSLF. The Fed is limited by the amount of bills and bonds it has on its balance sheet to do this. That's why it can't exceed the size of its balance sheet with these programs as currently structured.

However, in the case of TAF, the Fed is now about to get the authority to pay interest on bank reserves. That will allow them to increase the size of TAF virtually without limit. I described how this works in my final comment on the April 9 post. Paying interest on some portion of excess reserves is another means of sterilizing the effect of the Fed asset purchases that created those excess reserves. Paying interest on reserves will also allow the Fed to switch some of their current use of government paper from TAF sterilization to TSLF substitution, so they would be able to use more of their current balance sheet specifically for TSLF.

This will all end when the markets normalize, which could take years – as long as it takes the housing and mortgage markets to clear. The alternative right now is for the Fed to give up and go home and forget about the markets and targeting the funds rate.

Resetting the target funds rate is not a problem that would interfere with maintaining these programs. The Fed can still adjust excess reserves at the margin as it does normally via repo or reverse repo, which affects the prevailing funds rate directionally according to the corresponding marginal change in the supply of funds. The Fed does need to maintain an inventory of government paper for the purpose of draining excess reserves when necessary. Therefore they can't TAF sterilize or TSLF substitute all of their good paper, but the required inventory level for draining excess reserves will always be quite small relative to their balance sheet size.

The effectiveness of an intended correction to an aberrant trading level for the actual Fed funds rate relative to an existing target rate depends only on marginal economics and not on the general level of the target rate.

Resetting the target funds rate is a matter of announcing the intended new level and then using intervention tools as necessary to keep it on course. There is no change in the supply-demand dynamics for individual banks in the sense that they remained constrained to meeting their individual reserve requirements at the new rate level, and will be affected by availability of aggregate reserves in exactly the same way as at the old level. The actual rate will move immediately toward the new target rate because of this. The same marginal economics will then work at the new rate level as did at the old.

My earlier comment (April 9th post) regarding the Fed's plan to pay interest on bank reserves:

They want a contingency plan to expand their funding of private credit, if deemed necessary. They've already used up a fair portion of their balance sheet. This would be a plan to increase the size of the program further by facilitating a 'non-disruptive' expansion of their balance sheet. They can't monetize the additional assets with normal bank reserves, because they need to control the level of non-interest paying bank reserves in order to control the funds rate. Otherwise, banks would drive the funds rate to 0 with any kind of significant excess reserve setting. So they pay interest on excess reserves at a rate that would effectively put in a lower bound for the funds rate. The discount rate is a sort of upper bound. This puts an administered economic collar on the funds range. As to why they would want to do this for $ 2 trillion, for example, as opposed to $ 900 billion (their current balance sheet size), that horse is out of the barn. The only natural upper limit to this arrangement would be the size of total private sector credit. I doubt their contingency plan goes that far. This plan would not increase the market float of treasuries, as they are limited to their current balance sheet holdings. Instead, banks would be stuck with low interest paying reserves, forced upon the system by the Fed, which could still control the funds rate. In addition to increasing the monetary base (including interest paying reserves), balance sheet expansion would also increase broad money supply (not a factor in the current treasury substitution program), which is another risk.

Paying interest on reserves allows virtually unlimited expansion of the TAF program. The Fed auctions reserves to banks that can't get them otherwise at the Funds rate. The rest of the system, which by definition includes “healthy” banks who don't need TAF originated reserves, operates normally in terms of the willingness of those banks to trade with each other at the funds rate. Because TAF injections will no longer be sterilized by system repos or sales, some of those banks will end up with excess reserves. They will seek to sell funds at the funds rate so long as the funds rate is somewhat higher than the administered interest rate paid by the Fed for reserves. Because these remaining banks are “healthy”, it shouldn't take much of a rate differential to incentivize them to seek to sell at the funds rate. The funds rate will tend to move toward the administered rate, and there will be a point where banks just leave their balances with the Fed instead. Given the unlimited TAF supply for “non-healthy” banks, and the effective neutralization of that credit risk for the rest of the system, the resulting equilibrium differential should be quite narrow. The “level of distrust” to which you refer should be substantially immunized by a sufficient supply of TAF originated reserves.

As the Fed funds rate approaches 0, it will force the Fed rate for excess balances to 0 as well. But once the Fed funds rate gets sufficiently close to 0, the Fed is no longer concerned about losing control over the funds rate on the downside, because 0 is the lower bound for rates. Since control over the funds rate is the cause for the concern about balance sheet expansion in the first place, the issue becomes moot.

I think you're right. I'm presuming the Fed won't tighten, or at least won't tighten at a sufficiently rapid pace, that it will be counterproductive in terms of creating further dysfunction related to the kinds of problems that TAF and TSLF are now attempting to address. At the end of the day, the Fed is in control of the decision to tighten. They won't be ‘forced' to tighten, if they think the consequence will be worse than in the event they stay put. My personal view is that the credit dysfunction is a deflationary force at the margin, and this should be considered as a (partial) offset to both short and long term inflation risk.

Good point. I would view that as market tightening rather than Fed tightening. The market has a direct vote in monetary policy out the curve beyond the Funds rate.

Good point again - although its the Fed's ultimate choice on the degree or pace to which they follow the market signal for the desired path of the Fed funds rate. On the other hand, there have been times when they've actually wanted to the market to do some tightening for them, and it hasn't (e.g. the "conundrum").

JKH & RTD — Excellent discussion.

JKH writes, "[T]he Fed is now about to get the authority to pay interest on bank reserves. That will allow them to increase the size of TAF virtually without limit."

They have only signaled their intent to ask. They've not received. You'll perhaps be unsurprised to hear that I've posted this graph as prelude to a rant on why they should not be given this authority, unless some strong strings are attached.

AK — If you are right that the losses that must be taken are inevitable and too large to be finessed, I think it's too easy to say that "the Fed" will lose. This process we are going through is precisely about determining the distribution of those losses. Who will have one and who will have lost if the Fed fails to keep everything seeming mostly okay, but succeeds at redistributing losses from private borrowers, lenders, and financial intermediaries to taxpayers and those paid in nominal dollars? Perhaps the Fed "loses" in this case, but a lot of the constituents to whom the Fed seems particularly responsive would have won.

My understanding is that the Fed's TAF and TSLF are not expanding the money supply. Rather, the Fed is substituting for the currently dysfunctional repo and money markets. Is this correct?

In this case, money supply expansion has to come from new borrowing. But who's borrowing? It seems that on the whole, credit supply is shrinking. Yes, you have some homeowners drawing down their HELOCs, some individuals drawing on their credit cards, and a few corporations drawing on their revolvers. But net, individual and corporate credit supply seems to be shrinking. So it would seem the inflation we are seeing is not driven by USD money supply expansion. But maybe its partially driven by money supply expansion in countries pegged to the dollar, who are seeing credit expansion?

@JKH

Well, I think it depends on what you mean by "US monetary phenomenon". It would seem that US monetary policy, by fueling foreign money growth in countries pegged to the greenback, is driving global inflation. I think as soon as it becomes clear that global inflation is slowing, the speculators will run for cover.

So if you buy this view, the question becomes, what will slow global inflation? It seems there are several possibilities:
1. Fed raises rates significantly
2. Major countries drop their peg, or re-peg at a different level
3. Economic slowdown in countries like China such that foreign money growth decelerates

What could drive each of those possibilities?
1. US economy stabilizes and Fed starts hiking
2. Inflation gets out of control in certain countries and they are forced to drop their peg
3. US recession becomes more severe, potentially tanking major export economies that are currently pressuring commodities (China).

Agreed, although it's the decision of foreign CBs to peg to the dollar that drives foreign inflation, not US policy per se.

Does this mean that the dollar will go up from here? If CB's are increasing money supply (which they are) does this not mean that the dollar will go up because US money aggregates are not?