The Fed and Interest Rates – The Details

Dr. Krugman has another good smackdown of the inflationistas on his blog today.  But his explanation is lacking in the details that definitively prove the inflationistas wrong.  So let’s round out the details.

First, the Fed sets rates by manipulating rates HIGHER.  This isn’t the case sometimes.  It is the case ALL THE TIME.  If the Fed didn’t set the rate on reserves by paying interest (as they do today) the banking system would be flooded with reserves and the rate would naturally be driven down to zero as banks would attempt to get rid of these reserves in the overnight market.  Because the banking system as a whole cannot control the amount of reserves, the process inevitably ends at zero.  That is, the overnight rate is zero without Fed intervention.  So, the Fed ALWAYS manipulates rates HIGHER in trying to achieve an interest rate target.  And it does so by manipulating the amount of reserves or by setting a floor on the rate as they do today via IOR (interest on reserves).  So, get over the whole “Fed manipulation” meme.  The Fed always manipulates rates higher.

Since the overnight rate has obviously hit a floor at the current target of 0-.25% the Fed has been forced to implement policy in unusual ways.  But don’t mistake fiscal policy for monetary policy (as many have done in recent years).  What the Fed is doing at the long end of the curve via QE is what they always do at the short end.  In other words, the Fed is manipulating the amount of reserves in the banking system to try to influence interest rates.  This isn’t nearly as unusual as many people will make you think.  For instance, in 2006 the Fed flooded the banking system with $50B in reserves and no one cried about “monetization” or anything like that.  In the case of QE, since they can’t manipulate short rates lower they are targeting other rates on the yield curve.  And they’re doing this like they always do – by altering reserves in the banking system.

But the most important piece of this puzzle is understanding the difference between primary and secondary markets in implementing monetary policy (not fiscal policy).  The Fed is buying bonds on the secondary market.  This is a lot like you buying shares of stock in your brokerage account.  This is a simple exchange.  Who really buys the bonds that fund the Treasury’s spending?  Not the Fed.  It’s the banks via their Primary Dealers.  The Dealers bid in the primary market at auction as they’re REQUIRED to do.  In other words, the funding has already been allocated and purchased before the Fed ever does anything.  Whether they were buying or not the funds would get spent and the bonds would get bought.  Don’t confuse the Fed’s monetary policy for fiscal policy.  They’re two distinctly different things.

In addition, as Paul Krugman rightly notes, there was no decline in Treasury demand auctions following QE2.  So the idea that the Fed is backstopping the Treasury markets has been proven wrong.  Many of us who understood this called it in real-time and said that famous investors like Bill Gross would be wrong about how this would play out. That was definitively correct and proved, without a doubt, that the Fed’s buying on the secondary market was not backstopping the Treasury market.

Anyways, long rates are ultimately a function of current economic conditions.  The Fed sets short rates based on expectations of future economic conditions and long rates are an extension of short rates.  In fact, if the Fed wanted to pin the 10 year t-bond at 0% it would just do it, but that’s a different matter).   And bond traders front-run the Fed in trying to outguess the future economic conditions.  So, it’s best to think of this whole relationship like a person walking a dog through traffic.  The Fed walks the bond market around and the bond market tries to steer the Fed by guessing where traffic is headed.  But the Fed can always control the rate and the leash if they want.  The dog ultimately knows this and so doesn’t steer too far from its master (though it doesn’t want to be behind its master!).  So it’s all a delicate guessing game because there’s no telling when the traffic might become faster or slower than we expect.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. Krugman’s problem is that he doesn’t understand banking so he can’t actually explain why he’s been right. You’ve been right because you actually understand the operational details. He’s been right because he’s close to understanding the operational realities.

  2. Today BLV (long-term bond term bond ETF) gapped massively down, hence suggesting higher interest rates ahead. Furthermore, BLV violated a significant trend line on Dec 18. Technically, long-term bonds are becoming little by little long term bearish. For the time being, gold’s weakness is preventing further deterioration of BLV. However, if the BLV/GLD ratio turns bearish (stronger gold), then we could see significant weakness in bonds. In any instance, bonds are now at technical crossroads, as it is depicted here:

    http://www.dowtheoryinvestment.com/2012/12/dow-theory-special-issue-revisiting.html

    Regards

  3. The Fed isn’t backstopping the Treasury markets, they’re (mostly) controlling them.

    I’ve maintained for year that the Fed’s daily Securities Lending Open Market Operation is by far the most under valued and under appreciated stat of the entire Fed. The high control (or that eeeeeeeevil m word – manipulation) shown over rates is incontrovertible.

  4. Would you please explain this further: “What the Fed is doing at the long end of the curve via QE is what they always do at the short end. In other words, the Fed is manipulating the amount of reserves in the banking system to try to influence interest rates. ”

    Wouldn’t buying in the open market directly push bond prices up and therefore directly push rates down? I am confused why you state that this mechanism works via manipulating reserves instead?

  5. The Fed implements policy in the open market by purchasing bonds in exchange for reserve balances. So, before QE the banks have bonds. Afterwards, they have reserve balances. The SOMA desk does the same thing in the overnight market when it needs to clean up their rate target.

  6. But in your article you state that the Fed can only ever drive interest rates “HIGHER” – I.e. up. Yet later in the article you state that the Fed could set the 10 year bond to 0% – I.e. down (lower).

    Buying bonds drives down interest rates, regardless of who does it. So how can the Fed’s buying of bonds drive up (set ‘HIGHER’) interest rates?

    Wouldn’t the correct statement be that the Fed can always control the short rate, both higher and lower? When rates are too high it buys bonds on the open market. When rates are too low it sells bonds at the open market or pays a higher interest for balances at the reserve window (which necessarily puts a new floor on short maturity bond rates).

  7. And the Fed’s current “QE buying” is that of long maturity debt: 3 years and longer. That drives down long interest rates in addition to and more directly than their repeated guidance/promise of low interest rates “for an extended period of time”.

    So what the Fed is doing now is to lower interest rates at pretty much any maturity – to help grow the economy.

    Meeting reserve requirements are an afterthought: there’s trillions in excess reserves currently, deposited at a large bank that pays 0.25% for it: the (NY) Fed.

    This seems to contradict your article – so one of us must be wrong! :-)

  8. The Fed puts a floor on the overnight rate because it’s flooded the interbank market with reserves. That’s them keeping the rate above 0%. So, they’re manipulating the overnight rate HIGHER, which subsequently puts natural pressure on long rates since long rates are an extension of short rates. So the overnight is always manipulated higher. But QE is intended to target other parts of the yield curve because the Fed isn’t setting a target rate on long rates. They’re letting price float (unlike setting a target rate as they do at the short end). If the Fed were to set a target rate at the long end the rate would decline to that rate. So we’re really talking about two different rates. The Fed, as policy is currently implemented, controls the short end 100%, but lets the market currently steer price to some degree. Hence my dog on a leash analogy. The dog can walk out, sideways, etc.

  9. Ok – but the difference between 0% and 0.25% is minimal: 2.5 billion dollars per 1 trillion dollars of reserves. Total reserves are slightly above 1.4 trillion:

    http://m.research.stlouisfed.org/fred/series.php?sid=EXCRESNS

    So we are talking about a 3.5 billion dollars per year effect (any other bank could achieve that by spending that much money to attract the overnight deposits).

    The Fed’s effect on long bonds on the other hand is massive: it has bought more than 2 trillion dollars worth of MBS and Treasury bonds. Those actions have, all other things equal, lowered long yields.

    No other bank is even close to be able to increase its balance sheet to such a degree.

    So in general the more accurate characterization of current Fed policy is that it is lowering rates across most maturities – except the really short ones. Given that the Treasury does not issue overnight bonds – the net effect on Treasury is that of the Fed lowering borrowing costs for the Treasury, i.e. effectively buying federal debt on the secondary market, I.e. monetization.

    The bond vigilantes are hiding, because, 1) as long as the Fed guarantees easy financing for the Treasury, there’s always a bank willing to buy the debt, to resell the bonds to the Fed at a slightly higher price. 2) holding existing Treasuries to maturity is more profitable than selling them, as long as the Fed keeps short rates down. 3) Should any big selling in Treasuries start, the Fed soaks it up.

    No MMT effects here: just the regular effects of a really, really large bank buying government debt.

  10. “the fed is a man walking a dog through traffic.” yes, and a blind man at that.

  11. Cullen,

    Are the banks subject to duration risk on the bonds they hold? Or do they somehow flip them or swap away the interest rate risk?

    I am not quite clear on what risks they face by being required to purchase bonds as Primary Dealers.

    So IOR is what we should be paying attention to when we are trying to assess the future direction of interest rates. Is that correct?

    Thank you.

  12. CW, Cullen replied about this in a Q&A session here:

    “CR: a) QE is just an asset swap. The banks trade bonds for reserves. Had the bank not entered into this arrangement with the Fed they would have likely held the bonds to maturity at which point they would have had to find some other interest bearing asset to replace them. If the Fed sells the bonds back to the banks then they’ll just hold the bonds to maturity at which point they’ll likely just roll it over into a new bond (or on-sell the bond to the public). If The Fed lets the bonds mature on their balance sheet then the same thing will still happen. The US govt will re-issue bonds and the banks will buy them as they always do. At which point, assuming the economy is normalized, excess reserves will have to go down.”

    Hope that helps.

  13. This isn’t MMT or MR or anything else. This is just how it works. In targeting the OVERNIGHT rate, the Fed must manipulate rates HIGHER if there are excess reserves in the banking system. Once it sets IOR the Fed can try to manipulate other rates on the curve lower.

    I also don’t agree with your description regarding “Fed guarantees”. I think that question was solved when QE2 ended and yields FELL. There was obviously no backstop in demand….

  14. Banks hedge their exposure here pretty aggressively. In addition to on-selling most of their inventory they also hedge their holdings.

    And yes, IOR is a de facto Fed Funds Rate now.

  15. He pretty much showed that your statement that the Fed sets rates by manipulating them ‘higher’ is not true.
    The Fed is manipulating rates lower.

  16. No, he showed no such thing. Excess reserves in the banking system drive the overnight rate to zero. That’s an irrefutable fact. There is no proving that wrong. It’s as real as gravity. When overnight rates are at zero long rates are naturally lower than they otherwise would be. From there, there Fed must support the overnight rate by paying IOR to keep it above 0%. At the longer durations, the Fed has less control (as per my dog on a leash explanation) and so must exercise a more precise policy approach in keeping rates low at the long end.

    Maybe I wasn’t clear enough about this in the original post….

  17. Introducing excess reserves into the system is the mechanism that brings interest rates lower. So stating that the Fed always manipulates interest rates higher is complete nonsense. The purpose of open market operations and QE (when credit conditions call for it) is to swap treasuries for reserves, thus reducing the rate that banks pay on an increased pool of reserves. How could you possibly state that the Fed never manipulates interest rates lower? This (at times) is their primary objective! It’s creating the excess reserves in the first place that actually brings rates down lower. You know this — not sure how you are missing this.

  18. @ Stephen,

    If the government didn’t sell bonds there would always be excess reserves in the banking system. The government’s sale of bonds in the first place eliminate this possibility. The overnight rate on government debt would otherwise always be zero.

  19. I would phrase it differently than Mosler does. I say that the creation of the Fed created excess reserves by definition. In other words, without a required reserve rule all reserves are excess reserves to banks. Banks would prefer not to hold any reserves at all. They’d prefer to go back to their days of rogue banking before the Fed ever existed. But the existence of the Fed means there are reserves. And the existence of reserves means the banks will naturally try to get rid of their reserves which drives the overnight rate to zero.

    So, bond sales are not a “reserve drain” as MMT states. It’s the creation of the Fed that creates reserves which automatically drives the overnight rate to zero. If the Fed wants to implement policy going forward they have to drive the rate higher.

  20. You really have to understand the impact of the Fed’s big mouth. The Fed doesn’t usually need to flood the system with reserves (or remove them) to implement policy. The NY Fed can usually clean up any target rate discrepancy with relative ease. The Fed usually drives rates by announcing the rate. In other words, when the Fed says the price is X the price goes to X. Why? Because bond traders know the Fed will drive the rate there if they don’t take it there. For instance, if the Fed announced the 10 yr was 1% tomorrow the rate would go there in an instant. Why? Because bond trades know the NY Fed’s SOMA desk will come in and smack a few traders into the ground. I’ve traded fixed income for years now and the saying “don’t fight the Fed” is 100X more applicable to FI traders than equity traders. You just don’t mess with a bank that has a bottomless pit of money (which is what the Fed is). So, it doesn’t really tell you much to look at excess reserves and nothing else. It’s probably MORE important to understand how the Fed communicates with the market.

  21. But the Federal Reserve doesn’t really have a bottomless pit of Inside money, it only has a bottomless pit of Reserve Creation or outside money so is outside money more powerful force than Inside money when Inside money is the actual economic backbone of a nations credit worthy productivity?

  22. The Fed has a bottomless pit of outside money. In theory, outside money could be more important if the state actually exercised its powers to crush the banks and their creation of money. That’s obviously not happening. In fact, the Fed’s entire existence is designed around supporting the existence of inside money.

  23. Funny thing is, in the end, the only money that matters is the money that Mom can use to keep her household.
    If mom is happy, everyone is happy :)

    With that being said, the FED’s coexistence for the mere support of inside money is a good thing I think. However, how this support arises in our economy is the argument of men who sit on both sides of the coin.

  24. Yes, when you actually understand the history of the Fed and its intended purpose, it’s a rather brilliant construct as it maintains private competitive banking while leveraging the strength of the government. It’s by no means a perfect entity and I disagree with a lot of what they do, but it’s better than nationalized banking or pure rogue banking….

  25. In reading Mosler’s take on the natural rate of interest being zero, I’ve come across a comment that just does not make sense IMO. Perhaps some one (Cullen) can explain?

    “Note that, from inception, and as a point of logic, in order to actually collect taxes, the government, as the monopoly issuer of the currency, must, logically, spend (or lend) first. Note that it would be logically impossible for the government to collect more than it spends (or run a budget surplus) unless it had already previously spent more than it collected (past budget deficits).”

    Why is this true? Why can a government as described above not collect taxes unless it spends/lends first? I’m not following the logic here.

  26. The actual daily record of the Securities Lending OMO (the way the “SOMA desk” actually implements actions) shows that rates go both ways, although way more down than up the last few years.

  27. That point is wrong. It’s one of the major reasons why I disagree with MMT. They start with the state theory of money and claim that all money is essentially an extension of the state’s money. I say the US govt has outsourced money creation to the private sector in the form of an oligopoly of banks. So, MMT starts with the state and MR starts with the banking system.

    Mosler makes a really brilliant point in that piece on the natural rate, but he arrives at his conclusions in the wrong way. The reality is that the existence of the Fed creates a reserve system that otherwise would not exist. You don’t have to create MMT’s convoluted “reserve drain” theory to arrive at the conclusion that the natural rate is zero. You just have to understand that, without the reserve system, the natural rate would be zero because it wouldn’t exist!

  28. So let me try to clarify the point you make in this article by presenting a few brief questions. You state:

    “Because the banking system as a whole cannot control the amount of reserves, the process inevitably ends at zero.”

    Does this process inevitably end at zero as a result of government deficit spending?

    As Mosler states, “When the government realizes a budget deficit, there is a net reserve add to the banking system. That is, government deficit spending results in net credits to member bank reserve accounts.”

    Why is this? I was under the impression that only the central bank can create reserves within the system as part of an asset swap (reserves for treasury securities).

  29. Stephen,

    The very existence of the Fed means there are reserves. That’s the whole point of the Fed after all – to create a central clearing market for interbank payments. So, by definition, all reserves are excess reserves. Of course, we create requirements which creates a distinction, but the natural state of the banking system is to have no reserves and a zero overnight rate (because this wouldn’t exist). Many systems are already there. Canada, for instance, has no reserve requirement.

    So, it’s not deficit spending that causes excess reserves. It’s the existence of the Fed that causes excess reserves. Mosler and MMT do not have this point right. The state theory of money does not fully apply to a system with privatized money creation as we have in the USA.

  30. You’re saying that the Canadian banking system operates without reserves? How then does the Bank of Canada target its banking system’s overnight interest rate? I believe it is 1% today.

  31. Sorry to drag this on, but I still find myself disagreeing with your statements above:

    “If the Fed didn’t set the rate on reserves by paying interest (as they do today) the banking system would be flooded with reserves and the rate would naturally be driven down to zero as banks would attempt to get rid of these reserves in the overnight market.”

    What is natural about this process? The reason that the banks are flooded with reserves in the first place is that the Fed created these reserves as a byproduct of large scale asset purchases (QE).

    The Fed was not required to initiate QE — it was a policy decision. That decision resulted in the creation of excess reserves, which in turn led to banks attempting to get rid of these reserves in the overnight market, pushing rates down towards zero.

    To state that the Fed never manipulates rates lower is crazy to me — it is the Fed that decides to create/increase reserves which is the mechanism that lowers rates.

  32. The natural state of the banking system is to want to hold no reserves. So, without reserve requirements the banks would try to shed themselves of all reserves. The only thing that props up the rate is the required reserve ratio or paying interest on reserves. In essence, the Fed has to disincentivize banks to try to get rid of their reserve balances which naturally drives the overnight rate down. Make sense?

  33. Yes, that makes perfect sense.

    But I am still confused as to how you can say that there are never scenarios in which the Fed wants to manipulate rates lower.

    How then would you explain every instance that the Fed has lowered the FFR? Is this the Fed simply reacting to/catching up to market forces rather than deliberately lowering the rate?

  34. I don’t say there are “never” scenarios where the Fed drives down the rate. In fact, that’s precisely what the fed did in 2008 by flooding the system with reserves. So I am kind of confused by your question? Could be the Xmas day rib roast hangover. :-)

  35. Bernanke told us in his speech over the summer in Jackson Hole:

    “After nearly four years of experience with large-scale asset purchases, a substantial body of empirical work on their effects has emerged. Generally, this research finds that the Federal Reserve’s large-scale purchases have significantly lowered long-term Treasury yields. For example, studies have found that the $1.7 trillion in purchases of Treasury and agency securities under the first LSAP program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points. The $600 billion in Treasury purchases under the second LSAP program has been credited with lowering 10-year yields by an additional 15 to 45 basis points.12 Three studies considering the cumulative influence of all the Federal Reserve’s asset purchases, including those made under the MEP, found total effects between 80 and 120 basis points on the 10-year Treasury yield.13 These effects are economically meaningful.

  36. “First, the Fed sets rates by manipulating rates HIGHER. This isn’t the case sometimes. It is the case ALL THE TIME…. So, get over the whole “Fed manipulation” meme. The Fed always manipulates rates higher.”

    How much rib roast was consumed at the Roche residence this Christmas?

  37. I was not specific enough there. I should have said the overnight rate. The Fed is always keeping the rate from falling to zero. So, it lowers rates by letting the natural process occur, but propping it up. Kind of like saying that a ball will fall to the ground if you let it go. If you want to prop it up you support it. If you want it to decline you just let gravity do its thing.

  38. Now that makes sense…I appreciate your patience here, keep up the good work!

  39. Cowpoke:

    “Can anyone explain why there is virtually no excess reserves for 40 years”

    Coming out of the Great Depression the CBs didn’t become fully “lent up” until 1942 at which time the volume of excess reserves became more releated to its need for interbank clearing balances (like vault cash is needed for currency withdrawls). Bank managers strived to minimize non-earning assets to maximize profits.

    Since Oct 9, 2008 interbank demand deposits have become bank earning assets. The Fed has with this “tool” [sic] effectively emasculated its power to control the money stock.

  40. Thanks flow5, I was trying to grasp how or if there is a relationship in excess reserves and the funds rate when in the past it was hard to tell because of the differing data.