Will the Fed end up Losing a Boatload of Taxpayer Money on its QE Programs?

I copied that title from the Washington Post.  It’s an important question and one that I keep seeing over and over again.  I think the answer is rather simple and the Washington Post doesn’t provide an entirely accurate answer.  The article states:

“Eventually, the Fed will likely need to shrink its balance sheet and/or raise interest rates to undo its easy money policies and prevent inflation from getting out of control. And when that day comes, the Treasury bonds and mortgage securities it owns will probably be worth less (when interest rates are higher, the old securities with low interest rates become less valuable).”

The Fed doesn’t really have to shrink its balance sheet to tighten policy.  So it doesn’t have to shrink its balance sheet to raise rates.  The reasoning here is simple.  The Fed is currently paying interest on reserves.  So the Fed Funds Rate that we all think about is rather irrelevant.  That is, the IOR rate is now the de facto FFR.  If the Fed were not paying interest on reserves the reserves would put downward pressure on overnight rates and the Fed wouldn’t be able to support the Fed Funds Rate.  But the IOR solves that problem. In other words, it allows the Fed’s balance sheet to expand while also keeping control of rates.

The implications here are basic.  If the Fed wants to tighten policy they don’t have to shrink their balance sheet (though I guess they could).  Instead, they’ll just raise the rate on reserves.  And that means there’s no urgency about shrinking the balance sheet.  And that likely means the Fed can ease out of its current holdings over a very long time or it can simply let them mature on the balance sheet.   Either way, I don’t see huge risks to the Fed losing money unless they mismanage the portfolio.  They own government guaranteed paper and can afford to hold it to maturity.  Losing money on that portfolio would take a truly brain dead trader….

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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  1. I can’t believe people are still asking this question. Cullen, you need to start figuring out a way to spread the word better. You’ve been saying this for years and yet it seems like no one listens.

    • No one reads these articles. I don’t know why. Maybe if I talked about how a nuclear bomb was timed to go off inside the Fed when QE ends then everyone would read. Of course, I’d be lying about everything, but at least the word would get out. Instead, I write about the operational reality and it’s like screaming into an empty hole.

        • MR needs some marketing whizzes. Who wants to read blogs named Pragmatic Capitalism and Monetary Realism, when there are blogs out there like zerohedge, testosterone pit, implode-explode, and infectious greed all with fancy logos and slogans that are available on t-shirts! What’s MR’s banner slogan, “The backbone of private sector equity is zzzzzz” BOOOORIIING!!!

          Just kidding, love this site.

        • Cullen, you are so fundamentally mistaken and confused about such a basic concept as this, that it seriously calls into question just about everything else you claim.

          It’s simply remarkable how completely and utterly wrong you are.

          The Federal Reserve not only can, but is likely to lose INCUR SIGNIFICANT LOSSES based on the composition of existing balance sheet (let alone the nearly inevitably much larger and more impaired balance sheet it will possess a year from now).

          It’s Friday, it’s late, and I don’t have time at the moment to debunk your tragically flawed statements and conclusions line-item style, but I will provide a link to a Bloomberg article citing an excellent summary of how this can (and probably will) take place that was written by former U.S. Federal Reserve Governor Frederic Mishkin (now an economist at Columbia University), David Greenlaw (chief U.S. fixed income economist for Morgan Stanley), James D. Hamilton (professor of economics at the University of California in San Diego) & Peter Hooper (chief economist at Deutsche Bank Securities Inc.).

          http://www.bloomberg.com/news/2013-02-22/economists-warn-fed-risks-losing-control-amid-budget-deficits.html

          • Tragic, very, very, nice find ! I wonder why the WAPO even needed to use a question mark ?

            • Even assuming Mishkin is someone not credible (which is essentially an ad hominem attack since you fail to respond to the specifics of what the paper that he CO-WROTE states), which seems to be your weak rebuttal to what is a thorough dismantling of everything you claimed about how the Fed somehow can’t lose money (let alone a lot of money, let alone have this lead to horrific, knock-on macroeconomic effects), are you going to impugn the 3 other co-authors of the paper that will be presented?:

              “The conclusion from economists, including Frederic Mishkin, a governor at the central bank from 2006 to 2008 and an academic collaborator with Bernanke before that, will be presented at the U.S. Monetary Policy Forum in New York. Their paper serves as a high-profile warning to an audience including Boston Fed President Eric Rosengren, Fed Governor Jerome Powell and St. Louis Fed President James Bullard.”

              ““This unfavorable fiscal arithmetic might tend to push the Fed toward delaying its exit from the extraordinary easing measures it has taken in recent years; it could even affect decisions this year about how much further to expand the Fed’s holdings of longer-term government securities,” the authors said. “The Fed could cut its effective drain on the Treasury significantly by putting off asset sales and delaying policy rate increases. But such a response would presumably feed rising inflation expectations.”

              The U.S. Monetary Policy Forum is sponsored by the Initiative on Global Markets at the University of Chicago Booth School of Business.”

              “Hooper and Greenlaw are both former Fed economists, while Hamilton’s research on bond yields has been cited by Bernanke as justification for the Fed’s policies.”

              • His record speaks for itself. Mishkin is a neoliberal in the worst sense of the word. He has contributed to misunderstandings and poor policy in more ways than one. If you think that’s an ad hominem then so be it. A man contributing so directly to so much pain and suffering should be called out for his errors. I won’t apologize for pointing out the fact that someone’s bad calls have resulted in terrible pain and suffering. If you want to be his apologist then be my guest. I rarely point out such ad hominem flaws, but Mishkin is literally one of the very causes of our current predicament. I’m sure he’s a fine man, but his ideas are wrong, wrong, wrong,

                That paper you cite is wrong on several counts. For instance, its opening line is patently absurd when applied to the USA:

                “Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates which in turn make the debt problems more severe.”

                The USA is a sovereign currency issuer. There are no bond vigilantes in the USA. We are not Greece who has delegated currency control to a foreign central bank. We are not “running out of money” and cannot run out of money. These myths have been spreading for years and everyone who spreads it looks like a fool. The debt of the USA is denominated in a currency it can always procure. Further, interest rates on that debt are a function of the economy and the Fed’s perception of that economy. They are the monopoly supplier of reserves to the banking system. There is no such thing as the lenders deciding they don’t want to hold US debt for fears of default. Any trader making such an error should let me know in advance so I can separate a fool from his money. I’ve been saying all of this in real time for years. The hyperinflation, bond vigilante, default nonsense. It’s all been wrong. These are tired lies. They are destructive lies. And you should do your homework before defending them.

                http://pragcap.com/understanding-modern-monetary-system

                http://pragcap.com/why-the-usa-isnt-going-bankrupt

                http://pragcap.com/the-fed-and-interest-rates-the-details

                http://pragcap.com/what-happens-if-and-when-the-interest-rate-rises

                • Did you even read the Bloomberg article?

                  Are you planning on reading the co-written article after it’s presented at:

                  “The U.S. Monetary Policy Forum, sponsored by the Initiative on Global Markets at the University of Chicago Booth School of Business.”

                  It seems you’re obsessing over Mishkin, while completely ignoring the other 3 co-authors of the study:

                  “Hooper and Greenlaw are both former Fed economists, while HAMILTON’S RESEARCH ON BOND YIELDS HAS BEEN CITED BY BERNANKE as justification for the Fed’s policies.”

                  Maybe you should delve deep into their analyses before mounting a counterfactual (it’s just a humble suggestion).

                  I don’t say this in snark, but I think your narrow focus on endogenous money and the who of the issuance of currency if preventing you from seeing the forest for the trees.

                  I’ve gotten much more of substance and a rational framework as to how the Fed could not only lose money on its holdings, but lose control of its policy, from reading what are now essentially cliff notes of the paper that these 4 economists (all former Fed officials, too) are to be soon presenting in Chicago.

                  In very layman terms, the Fed has bit off quite a lot to chew thus far, has its pedal to the metal for the foreseeable future, and is headed right for the mountainside; and no one at that illustrious body can drive the General Lee quite so well.

                  No one is perfect. If it turns out that you missed some significant issues or overlooked critical dynamics (and I, for one, think that it looks as if you may have), it could turn into a great teachable moment.

                  This is how we all learn.

                  • I read the actual paper instead. Its mostly nonsense. Like the Reinhardt paper about how the USA was going bankrupt and how the 90% debt to GDP level would destroy the USA.

                    The USA isn’t at risk of bond vigilantes and running out of money or becoming Greece. The whole paper is a fearmonger piece based on misunderstandings. See the references above if you’re truly interested in understanding this from my view. No harm if you decide not to….

                    • Mr Roche, how does a nation with $20 trillion in debt at a nominal interest rate of 5%, pay the 1 trillion dollars in interest let alone reducing the balance ?

                      When did a sovereignty with no debt ever go bankrupt ?

                      Which is better to possess, assets or debts ?

                      Any other governmental statistic is welcomed to answer the questions….

                    • The US gov does have lots of assets though too. Sometimes those are overlooked (Federal lands, highways, etc.).

                • Indeed,the threat is not to the Feds’ balance sheet.It is,if anything,to the purchasing power of the US consumer via the imported inflation channel The FED can control rates ad infinitum.What it can’t control to the same degree is the effect on currency.The UK is the best example of this scenario of gilt rates and currency.

                  • Stephen,

                    Interest rates and the sterling exchange rate are related. Specifically, the policy rate and the exchange rate are correlated: sterling devalued by over 25% when the Bank of England cut the base rate to 0.5% in 2009. The exchange rate is also related to gilt yields, although this relationship has been distorted by QE: now that gilt yields are rising due to UK’s poor economic performance and the absence of QE, guess what – sterling is falling. It’s all the same thing, and therefore nonsense to say that the central bank doesn’t control the exchange rate.

                    The imported inflation in the UK is almost entirely due to the actions of the UK Government and the Bank of England. Government, for raising taxes that impact headline CPI (notably VAT) and failing to control above-inflation rises from privatized utilities. BoE, for devaluing sterling and contributing to global commodity price rises through its QE program.

                    • Frances,

                      Why do you say that gilt yields are rising due to UK’s “poor economic performance”? I’m not too familiar with the UK situation but I do know that, in general, longer-term bond yields are a function of shorter-term ones. Therefore, my assumption would be that the UK bond market has increased the odds of a BOE hike happening earlier than previously expected. To me, that would indicate more confidence in the UK economy (and the global economy as it is not just UK yields that have been on the rise).

                • When you say that the U.S. can always procure fund and can never run out of money, you are not even bothering here to insert the usual disclaimer that inflation is the constraint. (There are other constraints, too — political (if we flood the world with money, then others will respond) and psychological (if we act irrationally then trust will erode.)
                  Obviously the Fed’s reserves are infinite in theory, but not in reality.
                  You seem to take great delight in pointing out that we have a printing press, but that doesn’t eliminate the danger of debt rising faster than growth. Or does it?

                  • Johnny, calling reserves “infinite” is a bit of an exaggeration. If you are talking about creating reserves to purchase Treasury securities, there are only a limited amount of those, i.e. around $16 trillion.

              • All of which seems to make fiscal policy the more attractive way to limit inflation increases.

                By the way if IOR is greater than say 1 year gov’t rate then gov’t can’t issue except at a premium to IOR, and if things are looking good then inflation in a few years is more of a threat so 10 year needs a premium to 1 year etc.

                The only way to prevent a bond rout (at lest in mark to market terms – but we don’t have that any more, do we?) is to take current rates as the new normal and use fiscal policy to reduce the money supply by increasing taxes/reducing spending to keep inflation at the new normal low rates (or at least limit the pace of blowout of inflation and rates so that the quantum of damage is reduced).

                Seems to me that this is what the replacement for sequestration (or sequestration itself) will do.

                In 5 or 10 years when the deficit has turned into a surplus and debt to GDP ratio has started improving the Fed and Gov’t will need to consider raising interest rates a bit faster, but until then a bond rout is avoided by very slow interst rate increases (5% pa – ie from eg 2 to 2.1%) in conjunction with fiscal consolidation being the main policy tool to stop inflation if it starts to break out.

                It doesn’t matter to the real world how money is created but a big bond rout from raising interest rates too far too fast would be a disaster.

                The big question is who gets affected and by how much? Is it unemployment benefits and health care or defence and the FIRE sector, the rich or the poor and by income tax or consumption taxes? (It will be a mix of many things but that’s politics!)

        • Cullen,
          Your posts are really good. MR is enlightening. Thanks for everything. I would love to have Pragcp “APP” from iphone/iPad!

        • Hello Cullen,

          The reason that interest rates are at or near zero is because the Federal Reserve has flooded bank reserves with mountains of cash, almost $2 trillion since 2008.

          Its a supply and demand issue. At present because of Fed meddling, enlarging the supply of money by ungodly amounts, demand for funds by banks is quite small indeed. That is why interest rates are at or near a bottom.

          To use up $2 trillion in reserves will require with a 10% reserve ration the creation of $20 trillion in loans.

          And the reason for this oversupply is because the Fed is buying all sorts of mortgage assets and Treasuries at their almost maximum price, with inflation running about 5%.

          Now if those now buying Treasuries decide to pass, then all hell is going to break loose. Prices for Treasuries will decline, putting the Fed in a hell of a spot. If it dumps Treasuries, then prices collapse. If they sell tardily or not at all, then the Fed takes huge losses, damning the US to a Japanese banking system problem of many years.

          The US Government is now 25% of the US economy. Add in state and local, and government is now 45% of the economy.

          That is the big problem. And big government only squanders more money. More of the products and services none or few want, Government’s, at the cost of less of the products and services all or many want, private sector’s.

          By the way, how is the Fed going to pay 3% on reserves that yield less than that?

          GM

      • Cullen, take it easy on yourself man. Believe me, lots of people read your site and find it very helpful. One of the hardest parts of being an active investor is sifting thru all the junk that is available on the net and trying to figure out who is worth reading and who is just wasting your time. I check this site every day and its been really good to me. THANKS–

        • I’m just kidding around. I made a decision years ago that I wouldn’t sell out to the traffic whoring competition. It’s just unfortunate that people prefer to read nonsense online as opposed to informative stuff. The internet is both our best friend and our worst enemy in that regard. It is what it is.

          • What is it they say? A lie gets half way around the world before the truth has got its boots on…

      • “Maybe if I talked about how a nuclear bomb was timed to go off inside the Fed when QE ends then everyone would read.”

        I wonder how long a drive it is from the FBI’s San Diego office to your house? Yeah, don’t do that. :o)
        Apparently the Soviets snuck an A-bomb one piece of time (Johnny Cash-style)into their embassy in DC.
        Time magazine reported this with a source at the very highest levels.
        http://www.time.com/time/magazine/article/0,9171,1001206,00.html

      • I’m reading and very much appreciate the education. I will think twice, however, about clicking on one of Tom Brown’s youtube links after watching how to make kitten pie.

    • People that understand how the system actually works will in the long run make more money. That is how this information will spread. I think the strength of the market since 2009 shows that a lot of smart people do understand the creation of money, federal debt, and QE. Glenn Beck may be stuck in his bunker protecting his gold, but the smart money isn’t.

      • 1. There’s no way “everybody” can make money on the market, even though they all may be loyal readers of this site and followers of authors MMT theory.
        2. We’ll see about other things. It was barely 3 years ago that you almost got wiped out and you’re already smarter than the average investor. I’m (not) impressed.

        • This isn’t an MMT website. We started MR because of disagreements with certain components of MMT. And it’s really quite simple to understand. In MMT the govt is central to everything. Money starts with the govt, taxes “drive” money, public purpose is more important than private purpose. In MR, it’s the opposite. Money is created by banks, money is “driven” by production, and private purpose is the primary reason a money system exists.

          Maybe see here if you’re confused still. http://pragcap.com/mmt-critique

  2. It’s just titles for clicks on these sites now that have been bleeding money.

    One was “Do you need to protect your investments from Cyber-Terrorists?”

    It’s a bunch of schlock.

    Or as you say, Cullen, you know you could probably get more ad traffic if you posted about Apple and Gold speculation all day.

    Cheesy fear question headlines… it’s sad.

  3. Great post, Cullen. Very helpful. You mention that the Fed owns government guaranteed paper and can afford to hold it to maturity. I assume you’re referring to the Treasury bonds, notes, and bills. What about the MBS purchases? Different level of risk? Do I have that wrong?

  4. Paying more interest on reserves is still going to cost tax payers, because it would otherwise be remitted to the Treasury at the end of the year, right?

    • Yeah, but that’s assuming they don’t earn more than they charge. Which, if they hold to maturity would be really difficult to imagine since the yield curve is steep and likely to remain so….

  5. Anyway, it’s a free lunch for banks being served by the Fed. I suggest you could have been more clear and not act as a wise man. Eg say explicitly, the Fed pays interest on excess reserves, which helps the banks make money without actually lending them out to the real economy. Either way, it’s money alchemistry being played between the banks and Fed, so that the banks profit without lending anybody. Am I correct?

    • Free lunch for the taxpayer. The Fed took in $90B in profits last year. That’s $90B that could have been private sector interest earnings. I haven’t checked the expense report, but I would guess the Fed probably paid out about 10% of that to the banks. So net of fees the Fed is actually taking interest out of the financial system, remitting it to Tsy who is then spitting it out in various forms. Net interest margins on banks are getting slammed in recent years. I don’t think it’s quite the free lunch you imply. You have to look at both income AND expenses. The banks lose a lot of potential income via QE and have to hope to make it up on the lending spread.

    • Banks don’t lend excess reserves.

      They are exchanging a risk free asset for another risk free asset, hardly a free lunch. Banks will have an extremely hard time making any profit just collecting interest on reserves and employing all those people to just do nothing. Are you familiar with the metric banks use call the efficiency ratio?

      • “Banks don’t lend excess reserves” … well, except to other banks, correct?

        • correct, his comment specifically said lend to the real economy. That’s not how it works as you and I know.

    • “Fed pays interest on excess reserves, which helps the banks make money …”

      the banks were making money on the treasuries they held before they sold them to obtain the excess reserves. What the conspiracy theorists ignore is that these reserves haven’t been given to the banks, the banks have sold treasuries to obtain them. Whether this increases or decreases a banks revenue stream depends on the differential between the amount earned on treasuries vs the 0.25% earned on excess reserves.

  6. I haven’t worked my argument out in detail, but something looks fishy about this. You’re response to the concern that the Fed might lose money on it’s QE holdings is to point out that its giving away money to banks through IOR? Isn’t this just another channel via which its financial position can deteriorate? A mere detail as to how, not whether, the Fed would lose money?

    “Free lunch for the taxpayer. The Fed took in $90B in profits last year. That’s $90B that could have been private sector interest earnings.”

    It seems to me that they just pay the interest upfront through capital appreciation to bond holders. The bond holder by definition has nothing to complain about, because s/he sells to the Fed at a rate that s/he estimates to be a better deal than the interest income otherwise gained.

  7. This round of QE includes MBS. So even when you find conspiracy theorists who acknowledge that “swapping” treasuries for excess reserves is benign they will claim that the Fed is buying toxic MBS at way above market value etc.

    Unfortunately I have never seen any charts that show market values of these MBS before and after the Fed entering the market. Does anyone know where this information can be found. It seems like the last piece of the data jigsaw the rebut the tin foil hat brigade.

    • SI, they claim buying these instructive (MBS) would drive interest rate lower…But they know it is only a ruse to cloud the real issue of repairing a very badly damage banking industry. The FDIC was running out of funds and would have had to be reliquefied.

      Not only this, but by removing these assets, it creates a shortage for this securities and help drive future demand…This is an artificial stimulus for both the housing and banking sector, both considered a very high priority for the Central Bank…

      http://www.newyorkfed.org/markets/ambs/ambs_faq.html

      WARNING; GL, in finding a rational common cent explanation for the taxpayer…

      Tens of thousands of smart investors lost money in these MBS, butt the brains at the FBS will generate a profit…LOL

      • I am seeking information. I am not claiming to have it. My understanding was that QE1 was a bail out, i.e. the MBS you have referred to were 5hit. But since the 5hit was removed, these MBS have been trading on the open market right? This is where the Fed is buying them, not in some private back room deal. So my question, as yet unanswered, is what evidence is there that the Fed is paying above market rate?

        • Start with the Nov 15th H.4.1, where the Fed revised MBS values (to current values) down to $322B from $696B.

  8. Please, with hundreds of billions in MBS on their BS, they will not lose any money ?

    The banks own the FBS, which is currently bailing them out with FedZero and the buybacks of all of those near worthless MBS…

    The good news, however, is like ALL federal agencies, the Central Bank can not go bankrupt either…

    • my question immediately above was what data is there to support your claims that these MBS are near worthless?

      Since you say they are near worthless what has the Fed been paying and how much were they trading for on markets over the previous couple of years?

      • Good luck getting an honest, fact-based answer to that question from Cullen or any other Fed sympathizers…..its the elephant in the room everyone ignores. Another one…..if the primary dealer cash for treasuries and treasuries for reserves, which are supposedly unavailable for use by the primary dealer for purposes like speculation….if this is the complete story as claimed here, it would eventually lead to a depleted cash state within the primary dealers…..and that is not the case…..so what is the rest of the story? And if the answers to these questions were of tax payer benefit don’t you think the answer would be out by now?

      • A bank support strategy, that is HARMFUL to banks, if we are to believe what we read here is the complete story, defies logic.

      • Excellent questions, SI…No one knows what they paid but it may be possible that they (MBS) where never reduced to mark-to-market.

        We all known the default issue with these securities and there is no chance with these bulk purchases, that the Central Bank will not loss money (us)….

        Of course, why should they really care, as they issue credit (out-thin-air) and receive an asset…

        “A second key determinant of MBS pricing is the default risk
        of those securities. Falling house prices, rising foreclosures, and
        increasing inventory in the housing market all contribute to a higher
        default probability for the underlying mortgages. As we described
        above, the Federal Reserve’s purchases were limited to the market of
        mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac,
        and Ginnie Mae. The default risk of these agency-insured MBS is
        thus not only affected by the default risk of the underlying mortgages
        but also by the perceived probability that the insuring entity will not
        be able to fulfill its insurance pledge. While Ginnie Mae securities
        are the only MBS that carry the full faith and credit guarantee of the
        U.S. government, many market participants believed that there was
        also an “implicit guarantee” for the MBS guaranteed by Fannie Mae
        and Freddie Mac. In section 2.2 we discuss a number of approaches
        we take to control for the default risk of agency-insured MBS.”

        They run the risk of defaults as well as interest changes…What is rather puzzling is that many knew, that their objective, to drive interest lower of fail and fail badly. A twenty year model existed in Nippon for all to see.

        I personally believe this is nothing more than a balance sheet scheme for US and foreign banks, badly hurt be the 2008 govcession and their possession of MBS.

        • Interesting……the underlying has collapsed in value, but are listed above par on Fed balance sheet, which is probably an indication of what they paid the primary dealers for them…….I guess its Christmas year-round for the primary dealers!! Why am I not surprised.

        • Of course the information is out there. My post is just asking the question about where to find it, whether it has been written about, data aggregated etc. It is only the tin foil hat brigade who seem to see this as a secret mission.

          You link refers to what is probably called QE1 ending 3 years ago. I was asking about QE3 *now* and MBS purchases by the FEd on the open market. If you have a link can you post please. thanks

        • My clients owned Fannie Maes trading at 60 cents on the dollar at the bottom of the market. Once the Fed started buying them, they traded at par again right away. The Fed only had to buy a few of them and that drove the price back to par.
          I’d say the same thing works with the MBS. Once the Fed enters the market, just a statement is enough to drive the prices back to par. It seems like the Fed is paying market price for them, but the Fed is setting that price by its intent to buy them.

    • Already priced in – had been expected since November. It’s the biggest yawn ever. Sterling reacted to the announcement, but by Monday everyone will have worked out that it makes no difference at all and sterling will be back to its normal status – slow decline. Ratings agencies are irrelevant for a sovereign like the UK whose economic performance is a matter of public record.

  9. “it can simply let them mature on the balance sheet”

    Exactly. And the trend of currency held outside the banks has been up ever since 1930. An expansion of currency held by the non-bank public absorbs excess reserves. So the Fed doesn’t have to offset these 2 factors – which will allow it to exit.

  10. Taxpayer’s money is wasted by paying the banks not to lend. Contrary to Milton Friedman, reserves were never a tax in the first place. Reserves aren’t a tax because of fractional reserve banking: based upon an injection of clearing balances the member banks are able to create a multiple volume of new money & credit & acquire a concomitant volume of additional earning assets. When the CBs pay for additional earning assets (from a system standpoint) they pay with newly created money.

    The tax was the elimination of Reg Q ceilings. CBs pay for what they already own. From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, & probably its costless legal reserves & thereby it’s lending capacity. But all such inflows involve a (1) decrease in the lending capacity of other commercial banks (outflow of cash & due from bank items) or (2) is a consequence of an expansion of Reserve Bank credit. Hence, all CB liabilities are derivative.

    • No one’s paying them not to lend. They make a few billion cumulatively on QE. The idea that this is some great handout to the banks is absurd.

      • I thought this reply, by JKH, to Morgan Warstler, captured your sentiment here very well Cullen:

        http://monetaryrealism.com/krugman-on-says-law/#comment-15559

        Here’s the key quote:

        “Excess reserves are now, what: $ 1.5 trillion give or take? Interest of 25 basis points a year on that amount is $ 3.75 billion pretax, which is probably around $ 2.5 billion after tax. Do you really think it’s conceivable that a banking system that makes $ 100 billion plus per year after tax is going to knock the lights out with aggressive new lending just because it loses $ 2.5 billion in reserve interest?”

  11. In 1961 money center NYC banks began issuing large denomination negotiable CD’s. Its use enabled these large banks to draw funds out of banks all over the country & indeed the world. By late 1965 market interest rates had risen to levels that no longer made 4 ½ per cent CD’s attractive. Consequently as they matured they could not be replaced, the issuing banks had large outflows of funds & faced a liquidity crisis.

    The effect of the 5 ½ per cent ceiling was to dry up the non-banks, especially the savings & loan associations, which paralized the housing industry.

    The solution was to reverse the flow of funds (divert savings from being impounded within the CBs), to encourage their flow through the NBs. Reg Q ceilings were twice lowered for the CBs thus forcing savings to flow through the S&Ls, & MSBs.

    Increasing the volume of savings being transferred through the NBs increased the number of mortgages these institutions were able to make, but did not impact the composition of loans & investments the CBs were making. I.e., disintermediation can only occur within the NBs, but not the CBs.

    True, Bank of America may end up losing deposits to JP Morgan Chase (& they may have to sell some of their liquid earning assets in the process), but these are simply replaced by the other bank.

    Same applies to the contractionary IOeR policy.

  12. How can you lose money when you can create money?!
    Just wish people would recognize the Fed is monetizing federal spending. Not saying it’s good or bad, it just is. If we did that, maybe we could talk about better ways of using that printing press than financing speculation.

    • Mr Evans, if this is the case, why does not the FBS simply purchase ALL federal government debt ?

      • It almost is……last year 70-90% of the 10yr and higher maturity issuance……that issuance with the most interest rate risk….was soaked up by the Fed. (I gave range because I’ve read both figures.) Lower maturity issuance can serve other purposes than investment and will probably always have a deeper secondary market.

      • Countries that are in trade surplus with the USA need to be able to buy treasuries.

        • Why?
          Treasuries are just interest bearing cash, so you can understand why people hold them.
          But if we didn’t offer them Treasuries for cash, wouldn’t they have to find some other use for the money — maybe increase their own imports, for example.

          • They don’t exclusively use all the cash they accumulate to buy treasuries but the bond market is the deepest market in the world. That is where most of it goes.

  13. The more things change, the more they stay the same.

    Here’s a snippet from my local paper from 150 years ago today:

    “A Paper Currency, Present and Past.

    The public debt is the slow canker which is gnawing at the heart of the nation. The worst evil of our present condition is the repletion of our paper currency; the greatest danger which threatens our national existence is the prospective insolvency of the government. There are only two results which can follow from the load of indebtedness under which we are struggling – taxes or prostration, and repudiation”

    Doom and gloom sells!

    http://blog.pennlive.com/gettysburg-150/2013/02/gettysburg_150_patriot_union_-_16.html

    • Hahahaha! That’s great! Your are so right. What am I doing working for a living? I should start a doom and gloom cult.

      • Tom,

        That would be work too. Dishonest work, though. But it would pay the bills! Always has, always will.

    • Ossified optimism always sells too. I still have the Dow 30K book and my Dow 10K hat (bought the last time it was below 8K), etc.

  14. “When the Fed first announced that it would buy agency debt (that is, debt issued by Fannie Mae and Freddie Mac) and agency mortgage-backed securities in November 2008, the rate on the 30-year fixed-rate mortgage was 6.69 percent. Last year, when the Fed started hinting at another round of buying mortgages, the rate was above 4 percent.

    Today, the 30-year is down to 3.55 percent. Meanwhile, home prices in a majority of major U.S. markets are rising once again. This may mean that the effectiveness of a Fed mortgage-buying program could be quite limited. Rates likely won’t fall too much further and home prices don’t seem to need the stimulus they once did.

    What’s more, the Fed already owns a tremendous portion of the mortgage market. Credit Suisse analysts pointed this out in a note last fall:

    “The Fed currently owns roughly 15% of all Agency MBS, and just over 20% of fixed-rate conventional pass-throughs. If the Fed were to buy $500B of MBS as part of QE3, the numbers would jump to 25% and 34%, respectively,” Credit Suisse wrote.”

    • For all you swappers, ask yourself what these QEs does for the mortgage public…

      Interest rates have been reduced by nearly 50% [whether it is a cause and effect or not remains to be determined] but what happens to the underline price of the product ?

      Really, what is the net effect? For buyers of MBS and other related mortgage products and net savers, this results in very marginal returns…

  15. Was a bit confused about what your were saying here, I’m not really sure why we are worried about a decrease in the Fed’s balance sheet anyway. But I found this fed paper that basically agrees with Cullen’s logic:

    Interest on Excess Reserves as a Monetary Policy Instrument:
    The Experience of Foreign Central Banks
    http://www.federalreserve.gov/pubs/ifdp/2010/996/ifdp996.pdf

    Another great piece on the feds reserves from the Fed itself is here:
    http://libertystreeteconomics.newyorkfed.org/2012/08/interest-on-excess-reserves-and-cash-parked-at-the-fed.html

    “What determines the size of the monetary base? As with any other institution’s balance sheet, the Fed’s dictates that its liabilities (plus capital) equal its assets. The Fed’s assets are predominantly Treasury and mortgage-backed securities, most of which have been acquired as part of the large-scale asset purchase programs. In other words, the size of the monetary base is determined by the amount of assets held by the Fed, which is decided by the Federal Open Market Committee as part of its monetary policy.”

    In other words, loans create deposits.

  16. Lack of financial education isn’t so bad. It allows others to take advantage of the asymmetric information.

  17. Well, dear pragmatic capitalist, with all due respect this can hardly be called capitalism. No doubt the Fed and the banks create money or so called profit, but it doesn’t repesent wealth in terms of output of valuable goods and services for odinary citizens anywhere in the world.

    Cullen, I appreciate you thourogh analysis of Fed’s actions, but for me it’s really a very confusing brainer: who is making money, how, interest to who and so on. Please explain the purpose of these QEs and how they are relevant to the people on the main street and the unemployed.

    I think anybody can agree with me, that the economy grows by production. Say’s law is correct, if you create goods and services valuable by market consumers, you grow rich, if not – you are poor. All I can make out so far that these money dealings of the Fed and banks has nothing to do with capitalism, it’s crony capitalism. Even Jamie Damon said in Davos not to try to understand how banks make profit. It’s really outrageous! We must not follow money, it’s growth doesn’t represent wealth for ordinary people, but for banksers connected with the government. It’s also wrong saying that taxpayers’ made money – these moneys will be wasted by politions as handouts of priviliges to their cronies. Profits must be made out of production. All other methods are fraud and must be banned altogether!

    • Cullen has never advocated QE. He’s stated that on numerous occasions. He has pointed out what it is, an asset swap, rather than the money printing many people mistake it for. It’s funny that you’re a promoter of Say’s Law… so are the Market Monetarists, who agree with you on that 100%… while at the same time advocating a more aggressive QE-4-Ever as the key part of their NGDPLT plan. A plan, I take it, which they think essentially makes our system more precisely like barter.

      • Mr Brown, could the FBS do that with all of the federal debt ? Perhaps the fed could do a 15 trillion dollar asset swap..

        Problem solved and America is debt free…

        • That’s the plan, imo.
          Whether it creates unforseen problems is the $15 trillion question.
          I have two problems accepting that the QE programs are a routine swap.
          First, can you see the swap going in reverse? Can you see the Fed selling back the debt? Logically, that only works if you accept the a T-bill is the same as cash. So if the Fed wants to sell me back the bond, sure, I’ll do that with my savings. It’s all the same to me, after all. Federally backed money is the same no matter what the form. But once you accept that, you have this problem — the Fed has a $5 trillion or whatever of debt (money) in its pocket in an economy in which 50 percent of Amerca has no money — that can’t be a good thing.
          Second, can you see the Fed exchanging reserves for stocks, real estate or other assets? When the Bank of Japan proposed doing just that, MR proponents hit the roof.

        • Well if it was a one-time swap, Treasury would still have to pay the principal on Treasury bonds held to maturity at the Fed, and thus it wouldn’t actually be debt free. Technically it has to pay the interest too, although I’ll grant you that is mostly remitted back to Treasury.

          Now if it’s the Fed’s stated policy to ALWAYS buy ALL Treasury debt forever, and they could buy the bonds directly, then you are right: that amounts to monetizing the debt. The Treasury would continue to sell more and more bonds to pay off the principal for the last round and to fund new government deficit spending. That still doesn’t preclude the government from raising a surplus of revenue though, and actually start to pay down the debt. And perhaps that would be useful at some point (to put the brakes on inflation, for example).

          However, Treasury has no such stated policy, and furthermore it does not coordinate it’s policy with the Treasury (they are not one in the same), and it does not purchase gov debt directly. Does that make a difference? I think so regarding government “plans” for deficit spending (as if there’s any planning going on, ha!), and regarding the impact on the institution of private banking.

          As I understand it, such coordinated activity between the Fed acting in lock step with Treasury to purchase every Treasury bond, would amount to the M M T world wherein Fed and Treasury are really the same thing. That would be very different than our current system.

          I suppose you could argue it’s a matter of degrees, and that because the Fed does buy Treasury debt, even though it only buys it on the secondary market, and it only buys a fraction of it, and it doesn’t buy it in accordance with some joint Treasury/Fed plan, that still it has moved us along the spectrum somewhat towards “monetizing the debt.” How much has the Fed purchased now? About 10% of all outstanding gov debt? Is that correct?

          Still, I think the ultimate constraint is inflation, whether it’s deficit spending in the world we have now, or the hypothetical world wherein the Fed always buys all gov debt.

          It’s also true that the Fed could cause inflation all by itself without any government deficit spending, especially if they were legally allowed to purchase anything at all. They could simply purchase enough items making up the basket of goods in the CPI so as to raise the inflation rate to anything they wanted. I think for that to work though, they’d have to destroy those goods or keep them locked up, right?

          So in that sense, whenever the Fed purchases anything (as long as they make sure nothing useful is done with what they purchase) it is “money printing.” It’s not really a helicopter drop though. I personally think a helicopter drop would be much more effective! … i.e. a debt jubilee.

          Thought experiment: What if the Fed decided to start purchasing cars, but it didn’t buy every car, just a fixed quota each year, And instead of destroying them it just gave them away on a first come first serve basis. What effect would that have on the market? I don’t know, I’m asking. A whole industry would probably develop in hiring people to wait in line to get free cars. I wonder if this would actually affect the price of cars at all?

          • “However, Treasury has no such stated policy,…” should read “However, the Fed has no such stated policy,…”

          • What if the Fed came to the city of Detroit and bought 1,000 10-seater vans and gave them free of charge to any city resident with a clean driving record and gave him a license to transport people on a route of their choosing.
            That would create a business and serve the public. It would generate tax returns.
            It would cost less than a public busing system, in which the government would have labor and maintenance costs. Buses are also far more efficient than rail, in that bus routes, or in this case, van routes, can be more flexible.
            Would that create inflation? I don’t see how.
            The interesting thing about MR, in my view, is that if inflation is the constraint, it frees us up to create money for all sorts of things, with the only criteria being does it help the public and does it create inflation.
            If we could get to the point where we could spend this money without creating debt, well, that would be an interesting thought experiment. My biggest issue with deficit spending is that it creates a future obligation to the debt holders.

            • I don’t know if it would create inflation. I don’t have a good way to reason this through. Sometimes I feel like a mathematical model would be useful. And it seems like that model would have to include a behavioral model for what people would do. Then we could play with the assumptions in the model at least.

              I wrote out a reply to my own question but then erased it because I really don’t have a basis for my conclusion. But briefly, I figured that if the Fed purchased some commodity (like cars, or vans, as you suggest), and let’s say they restrict it to newly manufactured ones, and then distributed them somehow (perhaps randomly, by SS #, or in the manner you suggest)… well I thought perhaps that’s very similar to a helicopter drop, which I think would be inflationary to the economy as a whole. For the particular commodity in question, however, it may well be deflationary. People might hold off buying a car in hopes of getting a free one, or buying one (obtained free from the Fed by someone else) at a discount. I’m at the limits of my ability to reason with words here… I need some formulas!

              I’m pretty confident that if the Fed were to destroy the commodity it purchased, then it would be inflationary for the whole economy and especially for the commodity in question. But that doesn’t make much sense does it?

              • You might study a commodity that the federal government already buys for people. Maybe start with some kind of medical procedure that is most often paid for by Medicaid.
                For example, Medicaid will pay for long-term care for the elderly poor. You have to pay down all your assets to qualify.
                How does that affect the quality and cost of long-term care for those who can afford it?

                I would still suspect that cash payments would be the least inflationary and disrupt markets the least. For example, Social Security gives the recipient the relative freedom to use the check however he wants. It’s basically a subsistence level, but there are still choices within that insofar as housing primarily goes.
                But if you gave a Social Security check or payment to a working person, it might induce him to stop working, which would be negative.

      • No, I’m in favor of Say’s law which states that production of goods creates demand for other goods. Ultimate payment is via goods, no money supply increase is necessary for wealth creation. money is just a medium of exchange.

        • Well here’s a Market Monetarist, who’s also a Say’s Law advocate, but is (by definition of being an MMer) in favor of aggressive unlimited Fed QE type operations to make NGDP grow at 5% a year:

          http://www.themoneyillusion.com/?p=19358

          And here’s a bit by JKH (an MRist) on the same subject of Say’s Law (and Krugman’s discussion of it):

          http://monetaryrealism.com/krugman-on-says-law/

          So you see, you can be for aggressive Fed QE-4-ever (MMer) and still love Say’s Law! Whereas you can be against or at least highly skeptical of QE (MR) but not necessarily buy into Say’s Law.

          MMer’s might say, you need that 5% growth in NGDP (which could, on any given year, work out to be 5% pure inflation) every year to remove the “illusion of money” and return to a more perfect barter economy (that’s where I’m guessing Sumner got the title of his blog… he’s certainly a barter model advocate, from what I can tell! He’s definitely NOT in favor of the balance sheet recession concept nor is he in favor of including banks in macro theory). He also claims he’s a “libertarian”… so there you have it! Libertarians can be MMers or Austrians… two very different stripes!

    • http://articles.marketwatch.com/2013-02-06/finance/36936876_1_bubble-bailout-money-god

      And on the eighth day God looked down on his planned paradise and said, “I need someone who can flip this for a quick buck.”

      So God made a banker.

      God said, “I need someone who doesn’t grow anything or make anything but who will borrow money from the public at 0% interest and then lend it back to the public at 2% or 5% or 10% and pay himself a bonus for doing so.”

      So God made a banker.

      God said, “I need someone who will take money from the people who work and save, and use that money to create a dotcom bubble and a housing bubble and a stock bubble and an oil bubble and a commodities bubble and a bond bubble and another stock bubble, and then sell it to people in Poughkeepsie and Spokane and Bakersfield, and pay himself another bonus.”

      So God made a banker.

      God said, “I need someone to build homes in the swamps and deserts using shoddy materials and other people’s money, and then use these homes as collateral for a Ponzi scheme he can sell to pensioners in California and Michigan and Sweden. I need someone who will then foreclose on those homes, kick out the occupants, and switch off the air conditioning and the plumbing, and watch the houses turn back into dirt. And then pay himself another bonus.”

      God said, “I need someone to lend money to people with bad credit at 30% interest in order to get his stock price up, and then, just before the loans turn bad, cash out his stock and walk away. And who, when asked later, will, with a tearful eye, say the government made him do it.”

      God said, “And I need somebody who will tell everyone else to stand on their own two feet, but who will then run to the government for a bailout as soon as he gets into trouble — and who will then use that bailout money to help elect a Congress that will look the other way. And then pay himself another bonus.”

      So God made a banker.

  18. “They own government guaranteed paper and can afford to hold it to maturity. Losing money on that portfolio would take a truly brain dead trader”

    This is a really important point. Many investors forget that in thinking buying and holding bonds to maturity is the same as buying a bond ETF or mutual fund.

    • I agree. But the byproduct is that they have reached a point where the policy becomes a one-way street….

      They can not reverse policy and shrink the balance sheet…..interest rates would go up and they WOULD lose on the holdings.

      They can not freeze their balance sheet and stop absorbing the longer maturity issuance, because interest rates would then rise to something the secondary market would require to hold something for 10-30 yrs, which blows up our govt budgets.

      The only thing that seems possible now is persistent issuance and rollover of very short term maturity paper.

      All the fed governor BS about debate over ending or reversing policy is nothing but a charade…….they can’t, they’ve gotten in so deep that any change now means terrible outcomes that they aren’t likely to accept.

    • Sure, the Fed cannot lose money even if the value of its holdings fall (besides, as noted in another post, the Fed can peg its MBS holdings at par and avoid the issue of declining principal value entirely.
      However, if a major institution sees the value of its bond holdings fall, there could be negative consequences, as many of these holdings are either leveraged or used to shore up the balance sheet. Remember that it only took a slight decline in housing market to decimate the the value of leveraged-MBS holdings and trigger a collapse in the credit markets.
      There was a great moment before the crisis when some key investors realized that even a normal default rate would bankrupt many holders of MBS.

      • The issue of distorting pvt markets is separate and a very serious concern of mine. I have never been an advocate of QE. But the idea that the Fed might lose money or contribute to some sort of mythical govt insolvency is just absurd….

      • But as one blogger recently had in their headline “all monetary policy is dangerous”. 100 years from now, they will look at 1980-2007, the great moderation, as an abberation. People get use to monetary policy and then start to game it, just like bacteria will adapt to antibiotics. At the consumer level, we’ve gotten used to it, we almost expect it; big financial players game it … there’s nothing a poker player loves than a guy that has tells and a preannounced strategy.

    • 26, not true, since any for of paper can and will go bad..

      Then you have no par nor maturity as well…

  19. Hi Cullen,

    I love your blog. Please carry on being educational and wonkish. Even if you do like dogs better than cats. :)

    We have the same “unwind” problem in the UK, of course: the BoE has currently holds I think around 40% of the total gilt stock, so returning those to the private sector will be quite a headache. Personally I’m not convinced we will ever return more than a small percentage of them: the UK is in for a very long slump, I suspect (not least because of idiotic government policy), so draining excess reserves is going to be economically unjustifiable for years to come. But we do interest remittance differently: unrealised mark-to-market losses on gilts will be borne by the Treasury in the form of reduced quarterly interest remittance, rather than by the Bank of England. It’s sort of a cash margin scheme. So the Bank of England will be fully protected from losses on the gilt portfolio when it unwinds, and the Treasury will fund future losses by borrowing now (while it is cheap) rather than when they are realised (when borrowing will be potentially more expensive). Rather clever, I thought.

    • Hi Frances,

      Very clever indeed – if I understand it correctly – the Bank of England basically builds up a retained earnings/loss reserve equivalent to unrealized losses – so that it is unconstrained in an institutional accounting sense from selling bonds at a loss. And the hold back of the ‘reserve’ forces Treasury to issue more debt now at low rates to cover the budget deficit.

      I think a good part of the eventual exit for both the Fed and the BoE will consist of maturing bonds instead of selling them. Realized and unrealized losses end up being zero on that component.

      That said, the Fed certainly faces a measure of risk from potential interest margin compression due to short funding (there’s that word funding again). The starting spread and running profit rate as well as the portfolio of permanent zero cost currency funding is a hedge for most if not all of that erosion though. Bank interest rate gaps can be slow moving over time – but have a habit of coming up and biting you very suddenly. But I think the Fed is particularly well protected, because it doesn’t face the same kind of customer liability optionality that commercial banks do. And rates may remain low for a long time. But it is interesting that they’re taking a very sizeable interest rate position at the institutional level – gargantuan in fact. My expectation is that they’re running risk scenarios and profit simulations constantly on this stuff, and that it’s very well managed from that perspective. The combined effect of accrual bond interest, reserve short funding costs, zero cost currency, and any realized losses on bonds will determine the Fed profit trajectory over time. And they do care about the profit result profile, even though it has no bearing as a consolidated government “solvency” concern.

  20. If the fed continues believing it can create as many reserves as it needs, due to the ability to print as much moneys as it needs to keep interest rates low, then in fact rates can never rise. Soon the feds balance sheet will be 100% of GDP and the duration mismatch of their portfolio will not even allow for a 25 bp jump before causing the fed to have to print money to pay its own loses as interest received on its massive portfolio will not make up for interest is has to pay on reserves. This would be highly inflationary, but they will not be able to stop because inflation would force rates up and then force larger losses and more inflationary pressures. The entire reason we are in this box is because economists thought they found a loop hole in the law of physics where they could create more currency than there was money and by removing outside factors by sovereignty. Unfortunately , we are seeing why being a currency issuer has no greater benefit than a currency user other than a bit more time before external forces pressure the same outcome. When you create more currency than money stock you can generate a moderate level of inflation for an extended period of time. This inflation is moderate over a given period of time due to that only the excess not invested chases the goods we consume. Since creation is exponential in nature, the quality of investment declines to to scarcity. Since investment quality declines over time due to the forces of supply and demand, the exponential created currency units chase lower and lower quality investment, otherwise known as mal-investment. Once the cycle hits critical mass, it folds in on itself. The ignorant claim the solution is obvious. The obvious being more currency, they believe it is a balance sheet issue that can be solved with further expansion and government spending to replace the private sector demand component. The real problem is the lack of money not currency units. The economy needs to grow through real creation. Going forward on the path of MR, which is not a path but a mere explanation for our current system, is nothing more than speeding up the demise of the system itself. We will continue to see upward pressure on nominal pricing instruments, downward pressure on employment numbers, upward pressure on real goods such as gas and food, this can be seen in nominal prices or quality of same merchandise, increase in government spending to remain status quo of more and more dependency as higher prices feed through and destroy more purchasing power. The fed can never end QE and never will, right up into the final day. The sick part of the joke is that anyone with an understanding of high school physics could see how this system couldn’t work forever. We are in the first inning here, fortunately the play book is obvious going forward, as we know the inputs. garbage in garbage out