Re: the Fed: comment from weblog

"William F Hummel" <wfhummel@xxxxxxxxxxx> wrote in message
news:musde15k900jim6ceqancd320h98gm8in1@xxxxxxxxxx
> On 26 Jul 2005 14:29:55 -0700, "JKroeger" <james@xxxxxxxxxxxxx> wrote:
>
>>> 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.
>>
>>Don't take my word for it. Here is how McConnell & Bruce explained it
>>in their popular intro textbook:
>>
>>"The Fed actually sets neither the Federal funds rate nor the prime
>>rate; each is established by the interactiona of lenders and borowers.
>>But the Fed is the monopoly suppier of bank reserves. Wht it reduces
>>bank reserves, the Federal funds rate goes up; when it increases bank
>>reserves, the Federal funds rate goes down.
>
> The Fed sets a target for the Fed funds rate, and steers the average
> rate to its target quite closely through its open market operations,

Which just repeats what "JKroeger" said using more eliptical
terminology.

> typically within 10 basis point on the weekly average. That is the
> sense in which the Fed "controls" the Fed funds rate.
>
>>And since the amount of
>>reserves in the banking system helps determine the total supply of
>>money, changes in the supply of bank reserves affect the money supply
>>and interest rates in general."
>
> This is the standard textbook theory which fails to describe how
> things actually work. It implies that the Fed has a target for the
> money supply, and steers the money supply to its target by
> manipulating banking system reserves. The fact is the Fed long ago
> gave up targeting the money supply because it bore no particular
> relation to its primary targets -- inflation rate and unemployment.
> It now targets the overnight lending rate, and leaves both the money
> supply and banking system reserves as residuals.

This last part is probably true enough. The Fed can easily be
quite focused on the "effects" of its "open market ops" as
opposed to worrying over money aggregates. "open market"
implies that there is a market in securities where the Fed
can buy more or less new securities, or that the fed can sell
securities or redeem securities that have matured. All of this
has a direct effect on the yield of new securities and this has
an indirect effect on ALL interest rates.

>>
>>The Fed Funds rate is 'set' by buying & selling short-term debt
>>instruments.
>>
>>> Longer term rates are a function of many things, none of which the Fed
>>> directly controls.
>>
>>The Fed can easily drive long-term rates down by simply buying up
>>long-term debt. If there are long-term notes being sold on the market,
>>the Fed can always be the highest bidder if it wants to acquire the
>>debt; if it offers higher than the going market price, it will drive
>>the interest rate higher. Driving long-term rates down is a different
>>sort of challenge I've explained elsewhere; I'll go over it here if
>>asked.
>
> The Fed is constrained in what it can do to shape the yield curve by
> its need to control the Fed funds rate, i.e. the short term rate. It
> cannot arbitrarily add long term securities to its portfolio without
> selling short term securities, thus keeping the supply of reserves in
> line with the market for Fed funds. In any case, by competing in the
> market for the long term securities the Fed would lower, not raise,
> the interest rate on long term securities.

The Fed will lower the long rate and the short rate by
"competing" in the long market.. In a perfect world,
the Fed is limited in this activity by competing currencies
and by the trade deficits. The Fed could just print
money and buy T-Bills at will if it were not for the
fact that the money would become worthless. Looking
at current trade imbalances would lead one to think
that the Fed needs to be printing even more money.
The dollar appears to still be "valued" too highly by
other nations. But the other nations use these dollars
to buy American assets as opposed to American
goods.

American goods are too pricy or non existent
yet American assets seem to be a very good "value"
for the dollar when purchased by foreigners. One
wonders about the tax that foreigners pay on income
derived from US assets. Could it be that US asset
ownership by foreigners is a real profitable deal due
to our crappy tax system? Are the assets WORTH
more to the foreigners than they are to us?
Perhaps our goods cost too much because of the
heavy taxes on labor while our assets are worth a
lot more due to the lack of taxation on those
assets and the income from those assets when the
assets are held by foreigners.

>>
>>> 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.
>>
>>Well, the whole point of 'arbitrarily injecting reserves into the
>>banking system' is to CONTROL the FF rate when 'market forces' would
>>otherwise drive the FF rate above the FOMC's target.
>
> The key word here is "arbitrarily", which means without concern for
> its effects on other variables. Reserves cannot be injected
> arbitrarily. They can be added or drained only as required to
> "control" the Fed funds rate -- assuming the Fed wants to maintain
> control of the Fed funds rate, which has been its primary monetary
> policy instrument for decades.

The Fed needs to get a grip on reality and start
worrying about the value of the currency as
opposed to the rate that only Americans see.
The deficit and the loss of asset control should
be a major concern. It matters as to who _owns_
the means of production. If for no other reason,
it matters as regards who pays the taxes in this
nation that go to enforce the property rights of
the asset owners.

>>
>>>Loanable funds are created by the banking system, not by the Fed.
>>
>>When the Fed buys bonds from banks, it gives them money that was not
>>saved by any saver. The banks can lend that money because it is a part
>>of their excess reserves. I really don't understand how Hummel can
>>take that information and conclude that the Fed does not create
>>loanable funds.
>
> This is same the erroneous theory of money seen in standard econ
> textbooks. It assumes that the Fed initiates a sequence involving its
> injecting reserves, which are then loaned by banks. The sequence is
> backwards. In truth, the Fed buys bonds from banks (or security
> dealers) to satisfy the demand for reserves that banks as a whole need
> to back their net lending. The reserves themselves are not loanable
> by definition. They are what the banks must hold to back their
> lending.

A distinction without rellevance.

>>
>>> >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.
>>
>>It would actually have been more precise for me to say that the Fed is
>>the only determinant of LOANABLE FUNDS and INTEREST RATES that matters.
>
> As previously noted, the Fed only controls the short term interest
> rate. It does not determine the amount of loanable funds. The amount
> of loanable funds for any given bank is limited only by the capital
> ratio requirement, not the reserve ratio requirement. As long as
> banks have adequate capital, they can increase their lending.
> Banks can borrow funds in the money market or from the Fed to meet
> their reserve ratio requirement, but they can only grow their capital
> by retained earnings or by selling more bank shares.

So the bank loans some dough to the VP to buy
some shares in the bank. The bank has an asset
in the form of a note and the paid in capital just
grew by the amount of the loan. The bank can
now create about 10 times that amount in more
loans. Not a big problem, not a constraint. So
long as there are people that will borrow, the
bank will lend.

>> Hummel's point is well taken: It is possible for interest rates to be
>>maintained at low money supply levels if there is very little money
>>demand and at high money supply levels if money demand is high. If
>>banks refuse to lend or if firms/households refuse to borrow, then the
>>Fed will NOT be able to increase the money supply, but it will
>>nevertheless be able to drive "real interest rates" into negative
>>territory if it wishes.
>>
>>Did I miss anything?
>>
>>James Kroeger
>>

This focus on LOCAL rates is wrong headed. And
there is no real way to segregate monetary and
fiscal policies. That's my story and I'm stickin to it.

--
"I know no safe depository of the ultimate powers
of society but the people themselves; and
if we think them not enlightened enough to
exercise their control with a wholesome
discretion, the remedy is not to take it from
them, but to inform their discretion by
education." - Thomas Jefferson
http://GreaterVoice.org


.

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