Author Topic: How can the Fed unlimited QE be deflationary?  (Read 7376 times)

Spekulatius

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Munger_Disciple

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Re: How can the Fed unlimited QE be deflationary?
« Reply #51 on: June 22, 2020, 10:58:11 AM »
A good op-ed piece in Bloomberg by Bill Dudley, former President of the Federal Reserve Bank of NY:

https://www.bloomberg.com/opinion/articles/2020-06-22/fed-s-balance-sheet-heads-to-10-trillion-to-support-u-s-economy

Dudley's description of the inner workings of the Fed parallels the posts by wabuffo. He seems to imply that despite the rapid expansion of the Fed balance sheet, it can control the inflation by raising the interest rate paid on bank reserves. Does this mean the Fed will drive the ST treasury bond yields to 0% while at the same time raise the rate paid on bank reserves to control inflation if needed? Seems weird.

wabuffo

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Re: How can the Fed unlimited QE be deflationary?
« Reply #52 on: June 22, 2020, 12:12:50 PM »
Dudley writes in a clear manner about the Fed's monetary operations.  Here's another article he wrote in January after people were claiming the Fed's resuming repo operations and expanding its balance sheet was leading to a stock bubble at the end of 2019.

https://www.bloomberg.com/opinion/articles/2020-01-29/fed-s-repo-response-isn-t-fueling-the-stock-market
Quote
“…when the Fed buys T-bills and increases the amount of reserves in the banking system, that liquidity can’t go elsewhere.  It can move from bank to bank as households and businesses shift where they hold their bank balances.  The only exception is if bank customers decide to increase their holdings of currency.  But if they do that, that reduces the amount of excess reserves in the banking system.

If one always remembers the quote above from Dudley every time some TV talking head blames the Fed's growing balance for one problem or another, one will experience less confusion about monetary policy.

wabuffo
« Last Edit: June 22, 2020, 12:16:19 PM by wabuffo »

Munger_Disciple

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Re: How can the Fed unlimited QE be deflationary?
« Reply #53 on: June 22, 2020, 01:15:37 PM »
Dudley writes in a clear manner about the Fed's monetary operations. ....
.
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If one always remembers the quote above from Dudley every time some TV talking head blames the Fed's growing balance for one problem or another, one will experience less confusion about monetary policy.

wabuffo

+1

wabuffo

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Re: How can the Fed unlimited QE be deflationary?
« Reply #54 on: August 02, 2020, 08:06:33 AM »
I wanted to revisit this thread to outline a recent simple real-world example that illustrates how US monetary operations work.  It took place during Q2, 2020 and involves MetaBank (ticker: CASH) and the recent spending by the US Treasury under the CARES Act – specifically, the Economic Impact Payment (EIP) program.  This program sent money directly to all US individuals who qualified either via direct deposit, check, or in some cases, pre-paid debit cards.  The US Treasury engaged MetaBank (a US leader in prepaid debit cards) in the debit card creation and distribution part of the program.

Specifically, the US Treasury transferred to MetaBank $6.42B so they can create and issue 3.6 million prepaid debit cards to individuals across the US.  MetaBank is a small bank with only $5.8B in total assets and $4.0B in deposits – so adding $6.4B to that asset and deposit base really expands its balance sheet. What would be a rounding error to JPMorgan Chase or Bank of America is a “pig in a python” to MetaBank.  You can see it in the quickie table I drew up based on quarter-end balance sheet data from MetaBank’s regulatory filings (Quarterly Call Reports) for March and June quarter-ends. Of note, look at what happened to MetaBank's cash assets - almost all of which are bank reserves ("Balances due from Federal Reserve (F.R.) Banks").

         

These quarter-end amounts understate how much MetaBank’s balance sheet probably expanded at the exact moment the total funds were transferred.  If one adds the entire $6.42B to the total asset balance at the end of March, MetaBank's total assets would’ve reached $12.3B at that point in time.
   
Now let’s follow this funds flow through the US Monetary System via the Federal Reserve’s payment system (click on table below to expand to full size view - amounts are in $000s USD).  Step 1, the US Treasury issues a payment order to its “bank” (the Federal Reserve) to deposit $6.42B at MetaBank.  The next step (Step 2) is that the Federal Reserve shifts reserve balances from the US Treasury’s General Account to MetaBank’s reserve account.  This transfer of reserves at the Fed creates both a new asset for MetaBank and a new deposit liability electronically in Step 3.  The final step 4 is for MetaBank to issue the 3.6m prepaid debit cards to individuals, thus creating new financial assets for all of these debit card holders.  Of course, as these debit card holders spend their balances, the banks that represent merchants who are receiving those funds settle with MetaBank and the Federal Reserve starts shifting funds from MetaBank's reserve account to the other banks' reserve accounts (eg, JPM, BAC, WFC, USB, Citi, etc...).  MetaBank's reserve balance at the Fed is then reduced by those amounts presented for payment at the Fed by the other banks.



There are some important observations to make here:
1)   MetaBank’s cash asset on its balance sheet is really an amount on deposit in a “checking account” at the Fed.  The reality is that this “cash asset” is a settlement balance and Meta can never withdraw it from the Fed.1 It can only use the balance in this account at the Fed to settle payments with other banks (as prepaid cards get spent) or with the US Treasury.
2)   US Treasury deficit spending creates new private sector financial assets.  Look at the debit and credits at the bottom of each organization’s balance sheet.  The Fed and MetaBank end up at zero change to their net asset position.  It is the debit card holders that have new financial assets.
3)   If the US Treasury is constantly net deficit spending (spending exceeding tax receipts), then why aren’t bank reserves, in aggregate, for the entire US banking sector continuously growing to astronomical sums?  That’s because the US Treasury issues debt.  When it issues a bond, the process flow goes into reverse.  Reserve balances move from the banks to the US Treasury’s general account and the private sector receives a new asset.  This asset (unlike bank reserves) ends up in the hands of the private sector and thus is a more liquid asset and more marketable.   Thus, debt issuance by the US Treasury is a reserve maintenance activity, and not a funding activity for the Federal government.  (This fact is not well understood and tends to blow people's minds.)
4)   Similarly, the Federal Reserve through its payment clearing and lending does not create new financial assets in the private sector (contrary to much of the economic commentary).  It manages the payments between banks and between the US Treasury and banks.  The Fed can also buy assets from/sell assets to the private sector.  But it always exchanges reserves for those assets when it does so.

This last point is important to remember when we think about the Fed.  Currently, the Fed is talking about moving to a new program of yield curve control.  This program would attempt to “pin down” long-term Treasury yields by having the Fed buy enormous amounts of US Treasury debt (possibly a majority of what's outstanding).  Right now, the Fed owns on its balance sheet approximately 20% of the total amount of US Treasury debt issued to the private sector (which is a normal amount for the Fed’s history going back forty years or so).   

If the Fed wants to own a majority of US Treasury debt (say 65%), it would have to increase bank reserves by another $9T or so.  This is because it would buy a Treasury bond and exchange it for a bank reserve balance.   But unlike Treasury spending, this asset swap doesn’t increase the size of US commercial bank’s total assets, it would just convert more and more of their total assets into deposits held at the Fed (and no increase in their deposit liabilities - unlike US Treasury spending).  As we’ve seen in the MetaBank example this would really distort the aggregate balance sheet of the US commercial banking sector ($11T+ of cash at the Fed vs $20T of total assets if the Fed moved to 65% from 20% ownership of US Treasury debt o/s).

Anyhoo - just thought the MetaBank real-life example was interesting and illustrative (and probably too Fed-geeky).

wabuffo

1 - technically, a bank can exchange reserves for bank notes and currency.
« Last Edit: August 02, 2020, 08:46:10 AM by wabuffo »

Spekulatius

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Re: How can the Fed unlimited QE be deflationary?
« Reply #55 on: August 02, 2020, 08:31:17 AM »
^ Wabuffo, thanks for the illustrative example. I think we slowly come around the fact that buying treasuries will lead to more bank reserves, which isn’t really good news for banks at all (since they have a larger and larger percentage of low yielding and risk free assets on their balance sheet).

It would become a disaster (for banks) if we get negative interest rates, also the Fed officials so far vehemently  refuted negative interest rates  so far.
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Munger_Disciple

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Re: How can the Fed unlimited QE be deflationary?
« Reply #56 on: August 02, 2020, 11:17:51 AM »
wabuffo,

Thanks for the Meta example; it is very helpful in understanding how the Fed operates. Your posts and Bill Dudley's op-ed pieces have been quite educational to me.  Does this mean that the main risk to inflation comes from US government spending as opposed to the large Fed balance sheet?

MD

 

KJP

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Re: How can the Fed unlimited QE be deflationary?
« Reply #57 on: August 02, 2020, 11:52:42 AM »
I wanted to revisit this thread to outline a recent simple real-world example that illustrates how US monetary operations work. 

Great post!  A few questions:



Thus, debt issuance by the US Treasury is a reserve maintenance activity, and not a funding activity for the Federal government.  (This fact is not well understood and tends to blow people's minds.)

How do assets (i.e., the account that's debited at Step 1 of your MetaBank example) get into the U.S. Treasury's Fed account to begin with?  If I understand your point later in the post, the issuance of debt by the Treasury reverses the flow and ends up crediting that Treasury account.  So why isn't that debt issuance "funding" Treasury spending?

This last point is important to remember when we think about the Fed.  Currently, the Fed is talking about moving to a new program of yield curve control.  This program would attempt to “pin down” long-term Treasury yields by having the Fed buy enormous amounts of US Treasury debt (possibly a majority of what's outstanding).  Right now, the Fed owns on its balance sheet approximately 20% of the total amount of US Treasury debt issued to the private sector (which is a normal amount for the Fed’s history going back forty years or so).   

Unless forced to do so by increases in reserve requirements, why would banks choose to sell any Treasury to the Fed that has a higher yield than the interest on its Fed reserves?  So is "yield control" simply the Fed paying a high enough price to drive all Treasury rates down to the rates it pays on reserves?  If that happens, what forces private market buyers to purchase Treasuries yielding essentially nothing?  In other words, why don't Treasury auctions fail?   



Spekulatius

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Re: How can the Fed unlimited QE be deflationary?
« Reply #58 on: August 02, 2020, 01:05:07 PM »
Life is too short for cheap beer and wine.

wabuffo

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Re: How can the Fed unlimited QE be deflationary?
« Reply #59 on: August 02, 2020, 01:06:30 PM »
Does this mean that the main risk to inflation comes from US government spending...

Yes - this is my working theory.  In fact, inflation (and the political ramifications of that) are the only constraint to US government spending (so long as it is USDs).

wabuffo