Comment Hoists, 2008-03-10
There’s been some good conversation in the comments. I thought I’d pull out a few of my favorite bits.
The Fed’s Balance Sheet Constraint
The interesting point that no one has commented on is the existence of a Fed balance sheet constraint on limits to the outstanding TAF.
The Fed is limited by the size of the liability side. It doesn’t ‘force feed’ currency note into the system beyond the demand of the banks and the public for currency. And it has no room to expand bank reserve balances in aggregate of it wants to maintain control over the level of the funds rate. That’s why it’s ‘sterilizing’ now.
So the upper limit to TAF is essentially the size of the Fed balance sheet now, allowing for natural growth in currency demands of the banks and the public.
Beyond that, the Fed couldn’t ‘sterilize’ by selling other assets. It would have to start issuing its own liabilities, such as the sterilization bonds issued by the PBOC used to offset their foreign exchange purchases.
Looking at the March 6 Factors Affecting Reserve Balances, in addition to the already announced TAF and repo programs, the Fed could initiate somewhere between $500 and $600B more in “sterilized interventions” (as Paul Krugman first pointed out these are) before it would have to issue bonds rather than selling existing assets.
There’s more discussion of this point over at Brad Setser’s (in the comments section).
Update: The Fed announced this morning that it will use up $200B more of that capacity via a “Term Securities Lending Facility“. After the FAF expansion, repo program, and TSLF, the Fed will have between $300B and $400B in remaining sterilization capacity, unless it issues bonds directly. Paul Krugman, John Jansen, jck at Alea, Yves Smith, Michael Shedlock, Free Exchange, Justin Fox, Zero Beta (and see this!) comment.
Why the special repo program?
Why did the Fed announced the new repo program rather than just more dramatically expand TAF?
livingston guy offers an explanation:
The new repo line… is nothing more than the TAF for the brokers who dont have access to the TAF. Essentially, a Merrill wants to have the same access to liquidity as JPMorgan but doesn’t have it in the current framework of TAF which is only available to depositories. The new repo line just makes the same facility available to Merrill.
So the repo program can be looked at as a partial implementation of what Thomas Palley suggests. (In a pinch, apparently the Fed can lend directly to whomever it deems necessary, but that power has never been used. See David Wessel, “Analysts: Rate Cuts May Not Be Enough“, ht Mark Thoma.)
Update: Livingston Guy wrote on Sunday, and was referring to the expanded repo program announced Friday, not the TSLF program announced Tuesday. However, both the expanded repo program and TSLF are available to primary dealers, whereas TAF is accessible only to depository institutions.
The /Price Spiral
Len writes…
[Regarding] a widely held misconception; namely that “inflation is the debtors friend”. That IS kind of the way it worked during the Carter inflation as unions, now largely powerless due globalization, were largely able negotiate wage hikes rapidly enough to stay more or less even with inflation, creating the famous wage/price spiral which made debt an ever shrinking entity to the detriment of lenders. Nowadays we have just the /price part of that spiral, wages have been flat to negative in real terms for years. Without a means of increasing his income along with the inflating currency, the debtors debts in fact, instead of looking smaller, look ever larger as his required spending for necessities crowds out available funds for debt service, hastening insolvency.
Compare to a recent speech by Janet Yellen, President of the San Francisco Fed (via WSJ Real Time Economics):
Even so, I expect both total and core inflation to moderate over the next few years… This… assumes that inflation expectations will remain well-anchored, as they have been, and also that workers will not through their bargaining offset the real losses resulting from higher food and energy prices.
Things look different if you’re a central banker.
- 11-Mar-2008, 10:45 a.m. EDT: Added update re “Term Securities Lending Facility”. Attributed observation that these are sterilized interventions to Paul Krugman directly, rather than only implicitly via a link.
- 11-Mar-2008, 10:55 a.m. EDT: Cleaned up awkward wording introduced by reattribution in previous update.
- 11-Mar-2008, 11:05 a.m. EDT: Removed a redundant “in the comments”. Sheesh.
- 11-Mar-2008, 1:05 p.m. EDT: Added Yves Smith to list of TSLF commenters.
- 11-Mar-2008, 2:55 p.m. EDT: Added Michael Shedlock to list of TSLF commenters.
- 11-Mar-2008, 3:55 p.m. EDT: Added update explaining that LG’s comments were wrt repos, not TSLF. Added Free Exchange, Justin Fox, and Zero Beta to list of TSLF commenters.
Steve, what do you think about ANONYMOUS’ post from Setser’s blog?
“The Fed isn’t targeting treasury/agency spreads directly. The objective of the TAF operation is to ameliorate the deterioration in LIBOR/fed funds spreads. It is targeting interbank liquidity directly – not the solvency or liquidity of the agencies. To do this, it’s getting money into the hands of those banks that are having difficulty in the unsecured interbank market, but have collateral that is acceptable at the Fed under TAF requirements (essentially the same as discount window requirements). It turns out that much of this acceptable collateral is agency related.
The TAF operation is obviously very different from FX intervention. It is not the role of foreign central banks to provide US dollar interbank liquidity to the market; nor is it their role to ‘help’ treasury/agency spreads via their FX operations. The macroeconomic implications of a central bank that uses its monetary base to fund FX reserves (e.g. China) is very different than that of a CB that uses it to fund domestic intermediation (e.g. the Fed). Accordingly the analysis of materiality may be quite different. Given the short term interbank liquidity conditions that are the target of TAF, the effect of a $ 200 billion intervention may be significant in terms of short term money market liquidity conditions. Given the FX conditions that are the target of China’s intervention, the effect of $ 1.5 trillion may be significant in term of these rates, and given the mostly term instruments that are involved in the asset allocation, the result of investing $ 1.5 trillion in US and other currencies may be significant in terms of its effect on term interest rates.
But the Fed is not targeting term interest rates with TAF. It is targeting the LIBOR/Fed funds spread. There may be some moderate and welcome derivative effect on terms yields, but this is not the primary objective of the TAF exercise.
Finally, the comparison of TAF sterilization and FX sterilization is interesting, but a footnote to the TAF operation. Sterilization is a normal central bank operation, whatever the asset activity is that results in its necessity. Whether it’s the Fed extending TAF funds, or PBOC buying FX, both banks must take deliberate offsetting steps in order to avoid inadvertently increasing the level of domestic bank reserves held with them. CBs must have tight control over their liability structures and ensure their asset activity doesn’t interfere with this. Hence – sterilization – whatever the source of its necessity. One exceptional aspect – should the Fed end up increasing the size of the TAF operation beyond the size of the Fed balance sheet itself (roughly $ 700 billion), it may have to start issuing sterilization bills like the PBOC in order to switch sterilization management from the asset side to the liability side – thereby increasing the size of the Fed balance sheet while still controlling the size of the monetary base.
March 11th, 2008 at 10:01 am PDT
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In addition to the above post on Setser’s blog, I posted the following on Krugman’s blog under “anonymous from Setser’s blog”. It’s slightly convoluted in that it responds to Brad DeLong’s post on Krugman’s post, whereby I think he makes the wrong argument regarding the influence of central bank intervention on market prices. In fact, as noted above, I think central bank intervention of all types is influential, but each type has its own influence – fed funds, TAF, FX, etc. But none is as powerful as the effect of open market operations on the fed funds rate (or its equivalent for other CBs):
– DeLong’s analysis is misguided for another reason. He says: “Yet open-market operations are highly effective in changing interest rates. (Or so we believe—the late Fischer Black, Robert Rubin, and some others think that Fed open-market operations are more often a reaction to than a driver of consensus shifts in interest rates.) If most of the market is “inert”—at least in the short run—relatively small exchange rate interventions, open-market operations, and asset swaps could matter a lot—at least in the short run.”
The error here is that open-market operations are highly effective in changing the fed funds rate, but not necessarily other interest rates.
Open-market operations are positioned uniquely relative to the fed funds rate. This is because the Fed effectively forces (by law) individual depository institutions to meet their reserve requirements separately, while at the same time controlling the total reserves available to banks in aggregate. This is a closed system whereby the participants are competing for a required share of the total reserve pie. In such a competitive system, it is very easy for the Fed to change supply and demand conditions at the margin (via unsterilized open market operations at the margin), in such a way as to direct the system toward the market clearing price, which is the target fed funds rate. The proof of this is that the aggregate level of bank reserve balances held at the fed is absolutely miniscule compared with multi-trillion dollar banking system assets. The Fed’s control over the aggregate reserve level combined with enforced competition of banks for reserves results in a system whereby the Fed enjoys enormous leverage in its ability to influence the actual fed funds rate with relatively tiny adjustments to reserve levels through open market intervention.
The same thesis does not hold for LIBOR/fed funds interest rate spreads, which are the target of the TAF operation. This is because the Fed can only control one rate – the fed funds rate – via the enforced reserve system. This is simply due to the fact that the interbank rate applicable to fed funds transactions is the fed funds rate – not the LIBOR rate. LIBOR applies to transactions outside the fed clearing system. It is one step removed from fed funds in terms of both bank credit risk and the fed’s influence on the rate. LIBOR in that sense is not a regulated rate, as is the fed funds rate. The Fed cannot control a blowout in LIBOR spreads in the same way that it can control a blowout in the funds rate (by increasing reserve levels). Hence the requirement for a separate TAF facility, which is essentially targeted at LIBOR spreads. And this applies to all other market rates. No rate can be as closely influenced with such little effort by the Fed as the fed funds rate. So it is very misleading to use the case of open market operations and the fed funds rate as an index of the effectiveness of other types of intervention – TAF, FX, etc. – in affecting pricing in those other markets –
http://krugman.blogs.nytimes.com/2008/03/09/ why-sterilization-matters/#comment-28117
http://delong.typepad.com/sdj/2008/03/ small-financial.html
March 11th, 2008 at 10:50 am PDT
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The Fed official observes that “…workers will not through their bargaining offset the real losses resulting from higher food and energy prices.”
Retired folks may be under similar assault by the federal government. John Williams at Shadow Government Statistics
http://www.shadowstats.com/article/56
makes the case that the federal government is manipulating the CPI, upon which social security increases are determined, downward. He says if the CPI had been calculated since 1980 using the same methodology that was used to calculate it during Jimmy Carter’s days, Social Secuity would pay double what it does today.
March 11th, 2008 at 3:23 pm PDT
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So it all boils down to the Fed selling some treasuries to the banks, which buy it with the reserves that the same Fed loans them via repos in this TSLF, but letting them put their MBS as collateral instead of the aforementioned treasuries. This is what Paul Krugman calls a “slap in the face” to the markets, but might as well be called a ruse to deceive the markets into beleving that they are injecting a massive amount of liquidity when they are not. It’s a similar trick to the one that the ECB played months ago, as John Hussman noticed then. But will it work? By the way, I really think that the Fed is taking no real risk with this collateral: they can issue a margin call at any time.
March 12th, 2008 at 9:10 am PDT
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“anonymous from Setser’s blog” makes a lot of different points — the balance sheet constraint, targeting LIBOR/FF spreads rather than agency/treasury spreads, and the special susceptibility of the federal funds rate to Fed intervention. It seems to me that the question of which spreads are targeted isn’t an either/or thing. both spreads are disruptive when elevated, and I bet both are hoped to tighten, though afSb’s conjecture seems reasonable, the turmoil of funds overlevered in agencies is less of a dagger to the heart than loss of interbank confidence. On logical grounds, I buy the special susceptibility of interbank rates to CB intervention, but then Asian CBs have been quite effective at manipulating exchange rates as well. meaty and thoughtful and thought-provoking comments all. Thanks afSb.
DownSouth — The problem with price indices is that they can only be imperfect (there’s no such thing as the “true” inflation rate), and when very real outcomes depend on an index, necessarily arbitrary choices have significant consequences, favoring some, harming others. That’s not to excuse those choices, I do think people have a legitimate gripe when benchmarks shift adversely underneath them, and ShadowStats performs a great service by making that transparent. Fundamentally, though, price indices are bad underlyings. We can and should invent better ways of hedging purchasing power risk.
EUROLANDER — The Fed can issue margin calls at any time, if they are okay with forcing into default borrowers who can’t meet those calls. If their policy goal is to avoid high-profile, confidence-shaking failures, then their ability to require additional collateral from at least some counterparties is questionable. “Monetary policy on the asset side of the balance sheet” does not supply additional reserves, but it is not necessarily impotent either. One thing we can say for Bernanke is he is performing a lot of interesting experiments for us. I don’t know much about, and would like to know more about, the ECBs experience. from reading some of the stuff at nakedcapitalism, I wonder whether ECB isn’t holding what amounts to a great deal of Spanish bank equity.
March 13th, 2008 at 12:31 am PDT
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