Re: the Fed: comment from weblog

On Tue, 26 Jul 2005 01:16:39 GMT, "sinister" <sinister@xxxxxxxxxxxxxx>
wrote:

>I'm mostly posting this to get William F. Hummel's comments:
>
>----------------------------------------------------------------------------------
>>From the *comments* to the blog post
>http://angrybear.blogspot.com/2005/07/renminbi-news.html
>(Comment itself is at
>http://www.haloscan.com/comments/angrybear/112144446650425646/#308327 )
>See also ensuing comments there
>(The stuff he quoted appears on his own website http://www.taxwisdom.org/
>under the heading "The Misunderstood Relationship Between Savings &
>Investment")
>----------------------------------------------------------------------------------
>
>Kash: "By how much will China be able to ease off on its purchases of US
>securities? What will happen to US interest rates as a result?"
>
>Answer: NOTHING is going to happen to US interest rates if the Fed doesn't
>want any change to occur.

It meaningless to talk about interest rates without specifying the
term of the loan. The only interest rate the Fed controls is the
overnight lending rate between banks, otherwise known as the Fed funds
rate. The Fed normally controls that rate to within about ten basis
points (weekly average) of its target value.

Longer term rates are a function of many things, none of which the Fed
directly controls. The most important is inflationary expectations
over the period in question. For obvious reasons, the Fed works hard
to maintain the public's confidence in regard to inflationary
expectations. It seems to have done a pretty good job of that in
recent years.
>
>Liberal economists have got to stop blindly accepting the old Classical
>Theory assumption that the SUPPLY of loanable funds that become available in
>the credit markets ALL comes from aggregate savings. It does not.

True. However the comment applies to economists in general. I don't
know what he means by "liberal" economists.
>
>"There is no limit to the amount of money The Fed can inject into the
>loanable funds market. If savers were to suddenly pull most of their money
>out of banks and put it under their mattresses instead (equivalent to a
>dramatic reduction in savings), The Fed would still be able to easily
>maintain the supply of loanable funds or even increase it by simply buying
>every sort of debt instrument offered in the credit markets. Even if The Fed
>bought up all of the nation?s debt---something that would never happen---and
>there was still a shortage of loanable funds, it could maintain/increase the
>money supply by buying buildings or land or anything else it fancies."

Misleading. The Fed cannot control the quantity of reserves it
creates without giving up control of the price of reserves, i.e. the
Fed funds rate. Theoretically the Fed has unlimited spending power.
However it cannot use that power by arbitrarily injecting reserves
into the banking system. If it did so, it would lose control of the
Fed funds rate. This important point is widely misunderstood, by
economists of all persuasions.
>
>"Whenever The Fed buys securities in the open market, it pays for them with
>money that it creates out of thin air with a keystroke. It does not draw the
>money from some reserve account that is limited in size.* It is ?new money?
>that did not exist prior to the keystroke that created it.

True.

>With any of its
>purchases of securities, The Fed provides loanable funds to banks THAT WERE
>NOT SAVED BY ANY SAVER."

Misleading. The Fed purchases (or sells) securities only as required
to maintain control of the Fed funds rate. Loanable funds are created
by the banking system, not by the Fed. If banks increase net lending
and thus require more reserves to meet the requirements, the Fed has
no choice but to supply them. It does so by monetizing the debt by
purchasing Treasury securities, which results in an increase of
reserves in the banking system.
>
>See why the question of what happens to US interest rates if the Chinese
>become net sellers of US securities is actually kind of silly? If the Fed
>buys the same number/denomination of securities from commercial banks that
>the Chinese are selling, the money supply remains unchanged.

True
>
>The Fed is the only determinant of money supply that matters.
>
Quite wrong. The money supply is determined by the public's demand
for bank loans and the willingness of banks to lend. The Fed can
influence the demand through its control of the Fed funds rate, which
is the rate banks pay to borrow funds in the money market. If it
believes that banks are lending too freely, its only response is to
raise the Fed funds rate.

Most bank loans are illiquid because they are not callable or there is
no ready market for them. If the Fed failed to provide sufficient
reserves to cover additional bank lending, one or more banks would be
unable to make payment on its depositors' checks which could cause
havoc in the payment system. Before that happened, the Fed funds rate
would soar causing much pain and confusion in the business community.
Contrary to conventional wisdom, for all practical purposes the Fed
cannot even control the amount of reserves it creates.
.

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