Federal Reserve creates Term Deposit Facility as tool for withdrawal

[brian0918]

Can anyone help explain this more clearly? The way I understand it, party A loans party B money that cannot be withdrawn for a fixed period, after which the the money is paid back with interest - like a CD.

Now I can't figure out if the Fed is party A or party B. Who is lending the money, and who is paying it back with interest.

From reading the whole article (esp. the part stating that the money cannot be withdrawn at the end of the term, or ever), it sounds like the Fed is party B, and the financial institutions are effectively throwing their money into an abyss and getting a little bit back in interest - in other words, a Ponzi scheme. My first question would be - what financial institution would be willing to do that, to throw their money into a CD that they knowingly will never be able to withdraw it from? And how low could the financial institutions be willing to bid the interest rate? Assuming they're not willing to go to single digit interest rates, doesn't that mean we will have double-digit inflation?

Assuming I am completely wrong, and the Fed is actually party A, then essentially the Fed would be giving the financial institution more magic money in order to withdraw a little bit in interest. But that seems like it would only exacerbate inflation - those institutions would use that additional money to try to make a profit, which means trading it in the market, no?

Thanks in advance to anyone who straightens this out.

Edited December 29, 2009 by brian0918

[Jake_Ellison]

Here's how I see it:

These institutions are legally obligated to have some of their funds as reserves (as cash, or as "reserves", with the Fed). The amount varies depending on the bank, but it's often 10 %. When an institution issues a loan (or does something else that makes it not have 10% reserves), it needs to get those reserves from someone else. It can borrow some, from someone who already has say 11%, at a rate that is negotiated between the two parties.

When Bernanke announces a change in the interest rates, he is referring to that rate (its average), and he is setting a target for that rate, which the Fed then needs to manipulate into existence (I won't go into how). This rate is called the federal funds rate, in the media (quite misleadingly) referred to as the Fed interest rate.

Another option a bank has, is to borrow money from the Fed directly, at a rate that is higher than this federal funds rate I described above, at something called the Discount Window. Borrow money to be kept in reserve, that is, to meet the 10% requirement. Quite dodgy, if you ask me. Anyway, this isn't used very often, because it's more expensive. This lending is also done on an overnight basis, and only to institutions who meet certain conditions. (but the names of the institutions aren't public, so it's safe to assume it's a lax system)

Long story short, I think this suggestion would be just like these overnight lending schemes, on the part of the Fed, to beef up the reserves banks have, except for a given term, after which the bank (presumably) has to get the money from elsewhere. I would assume they would either be easier to give out (meaning more institutions could get them), or the rates would be lower (closer to the federal funds rate). There really is no reason to be in favor of it, for Objectivists, since it's an expansion of the Fed's powers.

As for the " these never ever leave the Fed", sure. That's because it's not really money, as much as written permission from Uncle Sam to lend money, cause he'll back you up for 10% of it if push comes to shove. (I'm talking strictly about the "reserves" borrowed from the Fed, not the actual reserves traded among banks, and held by the Fed).

Edited December 29, 2009 by Jake_Ellison

[softwareNerd]

The background is that the Fed has created a large volume of "high powered money" during the last year, but customers aren't too keen to borrow from banks. (In conventional terms the "multiplier" is low.)

The fear is that when fear recedes, the "multiplier" will return to its standard levels. In other words, the banks will start to lend money, that too much credit will be created.

The "tool" described in the article is where the Fed will become a borrower. The banks will "lend" money to the Fed, and the Fed will pay interest. If the Fed offers a good enough rate, a bank could be better off lending to the Fed, since that is "riskless". The idea is that banks will lend some to the Fed, thus cutting down what they lend to the economy as a whole; therefore credit will be kept from booming.

That's the most generous way of explaining it. In reality, the whole situation is so convoluted that it'll knot one's brain. A loan to the Fed would be like buying a short-term govt. bond. So, this would be the equivalent of the Fed off-loading its holding of short-term government bonds, in order to mop-up "high powered money".

As I understand it, they intend to pilot a small version of this, to get the mechanism right, in case they decide to really use it when the boom times come!

Edited December 29, 2009 by softwareNerd

[brian0918]

Hmm, it appears you both have contradicted eachother. According to Jake, the Fed would be lending money to the banks. According to sNerd, it's the other way around.

Edited December 29, 2009 by brian0918

[softwareNerd]

This new scheme is definitely banks lending to the Fed (at least if we retain conventional terms -- i.e. the Fed's own terms -- and don't spiral into "there's no real money to lend" etc.)

In 2008, the Fed started to lend a lot of money to banks, foreign-central banks, etc. When banks borrow short-term, they cannot lend out the money that easily; they have to calculate if the Fed will continue to lend to them short term -- thus making the loan effectively medium-term. In the midst of survival fears, the banks were in no mood to lend anyway.

Starting Feb 2009, the Fed pulled back this short-term lending and started to create new money by buying bonds. Basically, the Fed is creating money and lending it to the US government, to Fannie and Freddie and to institutions behind mortgage loans. This process, "quantitative easing" is quite different from the earlier phase. Firstly, the loans are longer term than the previous phase of "repo lending". Secondly, the route the money takes is different (e.g. Fed buys bonds that you hold, and you take this new cash and put it in the bank). This type of money creation let's banks lend the money (create credit). However, right now, people are in no mood to borrow.

In Q1-2010, the Fed hopes to stop buying these bonds. They hope that business will be returning to normal by then; i.e. low, but moving upward.

At some point after that, they hope business will have risen for enough months that businesses and individuals will start to borrow again. At this point, the Fed would like to reverse some of the previous quantitative easing by taking the money back from banks. Typically, they would start to sell the bonds they previously bought. It appears that they're wondering: "if we stop buying and then start selling who will buy from us?" Well, there's always a buyer -- at the right price. Problem is, the price pretty much is the interest rate. The Fed would like to keep interest rates of mortgages and US bonds as low as possible; but, that is contrary to their need to sell those bonds.

So, they've come up with this new scheme where they will do something similar, essentially selling "Fed-Reserve bonds" (no such thing really) rather than US treasury bonds. Since this will not be offered generally, but only to the banks etc. that usually borrow from them, they probably hope that they can create a divergence of interest rates. If the deal were open to all, there's no reason a "Fed-Reserve bond" should trade differently from a US-govt. Bond of similar duration. It appears that the Fed intends this to happen, because of the barriers to entry. They're probably doing it with "honestly statist" intentions. However, in effect, it will be a sweetheart deal for the banks who can lend to the Fed at rates higher than anyone else can lend to the US government. (Expect another "Chinese premier screwed" SNL video!)

Obviously, the Fed does not really know how things are going to play out. When they stop buying bonds in Q1 2009, they will be interested in seeing what that does to long-term interest rates. Also, they can be surprised on what happens to the economy. A lot of this will be play-by-ear, which is normal Fed policy. However, they're making these plans and prototyping them, to get the mechanics right, and also to float the trial-balloon.

There's another angle to this. The Fed probably realizes that they cannot sell their US bonds as expensively as they bought them. So, when all is said and done, and one sees all they bought (since Feb 2009) and all they sold (till whenever their dream comes true), they would have lost a few billion. The other side of this loss is extra money in the economy that the Fed has no way to pull back. However, if they have their own bonds, they can go into debt themselves and pull the money out. I'm sure they'd be loathe to do so; I'm sure they hope that the net effect will be a few hundred billion in extra money that they can voters will live with. Still, they're experimenting to keep that option open.

Edited December 29, 2009 by softwareNerd

[brian0918]

What about the repeated line in the story that, "Once lent to the central bank, the money cannot be withdrawn." Ever? So a bank deposits $100M to the Fed, and can never get it back, but after the term is up, they get the "interest" back? Am I understanding this right? How else can you interpret the sentence I quoted? If I'm right, this is simply a Ponzi scheme, no?

[C.W.]

What about the repeated line in the story that, "Once lent to the central bank, the money cannot be withdrawn." Ever? So a bank deposits $100M to the Fed, and can never get it back, but after the term is up, they get the "interest" back? Am I understanding this right? How else can you interpret the sentence I quoted? If I'm right, this is simply a Ponzi scheme, no?

This is just poor reporting. They are trying to point out a difference between a CD and what the Fed wants to do. If you put your money into a bank CD, you can withdraw the money before the end of the term (maybe with a certain warning period and a penalty). What they are saying here is that the "loan" to the Fed can't be withdrawn during the term. It can be at the end of the term. That is part of the problem. This money will still be floating around and the Fed will still be trying to "sop it up".

[brian0918]

This is just poor reporting. They are trying to point out a difference between a CD and what the Fed wants to do. If you put your money into a bank CD, you can withdraw the money before the end of the term (maybe with a certain warning period and a penalty). What they are saying here is that the "loan" to the Fed can't be withdrawn during the term. It can be at the end of the term.

Thanks for the clarification.

That is part of the problem. This money will still be floating around and the Fed will still be trying to "sop it up".

With interest, on top of that! I wouldn't be surprised if they refuse to give the money bank at the end of the term, and get backing by the government, or if they somehow change the rules after banks have already lent them the money.

And what are the chances the Fed won't use the lent money for anything themselves? That seems extremely unlikely, even if it will completely work against what they're trying to accomplish. Obama is already recommending something similar - spending the bailout "savings" - which isn't actually savings at all.

Edited December 29, 2009 by brian0918

[Jake_Ellison]

So this would be a scheme by the Fed to drive interest rates up, in the middle of a boom, by competing with the average citizen for loans from banks? (Collecting money from the market without having to sell their assets-and drive down the price of those assets?)

Wouldn't that simply allow the government to get and spend that money itself, through the issuing of more bonds of its own? (which wouldn't be possible if the Fed was selling them at the same time, which is the reason why the current way of fighting inflation works in the first place)

[softwareNerd]

So this would be a scheme by the Fed to drive interest rates up, in the middle of a boom, by competing with the average citizen for loans from banks?

Yes. Not that they want to send rates up, as such, but they would view it as a necessary evil in order to slow down credit-creation.

Wouldn't that simply allow the government to get and spend that money itself, through the issuing of more bonds of its own? (which wouldn't be possible if the Fed was selling them at the same time, which is the reason why the current way of fighting inflation works in the first place)

It's as though the Fed is going into competition with the Treasury in issuing bonds. If the Treasury were running a budget-surplus, I can somewhat see how this could "work", but if the Fed is going to stop buying Treasuries, and then get banks to buy Fed bonds, I can't see how medium/long rates can be kept in check. (Which is not to say rates will rise, as such; but, only that they will rise in any situation where the Fed decides to use this new "tool" in a big way.)

Today, Economist James Hamilton wrote an Econobrowser post about this new "tool". He points out that this is a type of reverse-repo. He also points out that the Fed already has an ultra-short term variant of this in place, since they started paying banks interest on "deposits".

[C.W.]

... but if the Fed is going to stop buying Treasuries, and then get banks to buy Fed bonds, I can't see how medium/long rates can be kept in check. (Which is not to say rates will rise, as such; but, only that they will rise in any situation where the Fed decides to use this new "tool" in a big way.)

Do you think that the Fed is getting a little worried as to how their going to get out of their mess? Everyone is saying that as soon as the Fed starts to pull out is massive funding that there will be a void and long-term rates will rise, apparently more than the Fed wants to see. I think that they are going to come up with as many little tools as they can, plus smoke and mirrors, press releases, lots of public appearences, appeals to love of country, and bake sales.

I am reading, or trying to, this crap is tough to choke down, In Fed We Trust. Aren't you happy that we have such a hero as Bernanke to rely upon!

I have finished Meltdown by Woods. I highly recommend it. I will write some about it here soon. I am also working on a review.

Edited December 31, 2009 by C.W.

[softwareNerd]

Do you think that the Fed is getting a little worried as to how their going to get out of their mess?

Yes, I guess Bernanke must be worried that he'll end up being cursed, just like Greenspan. He truly has no great options when the government shows no sign of fiscal discipline, and voters show no understanding of why they cannot have their cake and eat it too. Not that I pity him... nobody forced him to take the job!

Looking forward to reading your reviews, C.W.

[John McVey]

I think sNerd is right on it being a variant of the reverse repo idea, but there is a difference. In RR's the fed would sop up liquidity by compelling the banks to buy assets (usually Treasury instruments) at above-market prices, which is the counterpart to increasing liquidity by the Fed buying them from the banks at above-market prices, where in either case the termination of the repo is the opposite transaction at lesser prices. However, if the loans are going to be competitively priced then this is not going to sop a blessed cent and just move the issue for the future to deal with. It's like trying to deal with an over-full tank by blowing some of the liquid from one side to the other away from the level-sensor - as soon as you stop blowing the liquid level is going to go right back to where it was at the outset.

If higher compulsory reserve ratios are out of the question then there is no way to permanently reduce liquidity without either taxation, repudiation, or compulsory overcharging to get the money in permanently so that it can be retired.

JJM

Edited December 31, 2009 by John McVey

[softwareNerd]

It's like trying to deal with an over-full tank by blowing some of the liquid from one side to the other away from the level-sensor - as soon as you stop blowing the liquid level is going to go right back to where it was at the outset.

Ha ha! and using the lowered level near the sensor to fill the tank a little more.

Yes, its about kicking the can down the road, and Bernanke is probably thinking that if Japan could kicks its problem for twenty years, maybe the U.S. can do the same.

[brian0918]

Yes, its about kicking the can down the road, and Bernanke is probably thinking that if Japan could kicks its problem for twenty years, maybe the U.S. can do the same.

The difference, though, is that Japan had a high savings rate, and was a net creditor nation, so even if their financials went bad, they had something to fall back on. We have no savings and are a net debtor nation. Combine that with massive nanny-state programs about to default and a huge deficit - how could Bernanke possibly mistake our situation for Japan's in the 90s? If he thinks that, isn't he just deluding himself?

Edited December 31, 2009 by brian0918

[softwareNerd]

The difference, though, is that Japan had a high savings rate, and was a net creditor nation, so even if their financials went bad, they had something to fall back on. We have no savings and are a net debtor nation. Combine that with massive nanny-state programs about to default and a huge deficit - how could Bernanke possibly mistake our situation for Japan's in the 90s? If he thinks that, isn't he just deluding himself?

Yes, Bernanke probably does not hope to see the U.S. at Japan's absolute levels. Indeed, if our CPI and long-term rates went down to their absolute levels, he'd probably be surprised and would encourage more money-creation. Rather, the argument would go something like this: if Japan can run up 100% Debt-to-GDP while keeping the 10-year bond at 1% and CPI near zero, the the U.S. could get away with the same, keeping the 10-year bond near 5% and the CPI around 3%.

Note that hoping that the U.S. follows Japan (at a different absolute level) means hoping for some pretty bad times: for long multi-decade stagnation, particularly hard on those who in their first few years of joining the workforce. (Employed Japs save about 25%, and after it's all spent on the oldies etc., the country's saving rate is under 4%).

BTW: Japan's saving rate is not much above the U.S. (it's in the ballpark of 4% vs. 2%). Also, Japan's demographics and social-security type problems are pretty bad. As for being a net debtor nation, that depends on what one means, since the U.S. owns more than it owes.

[brian0918]

BTW: Japan's saving rate is not much above the U.S. (it's in the ballpark of 4% vs. 2%).

Has their savings rate gone down since the 60s/70s/80s? What was it back then? Schiff has repeatedly referenced their past high savings rate as one of the reasons they were able to make it through the 90s. It could certainly be lower now, but that doesn't affect his argument.

Edited December 31, 2009 by brian0918

[softwareNerd]

Has their savings rate gone down since the 60s/70s/80s? What was it back then? Schiff has repeatedly referenced their past high savings rate as one of the reasons they were able to make it through the 90s. It could certainly be lower now, but that doesn't affect his argument.

According to this paper, the rate was around 15% at the start of the 1990s (twice the US rate at that time). From another paper, my best guess is that their savings rate averaged about 16% from the 1960s all the way to 1990. It drifted slowly downward, and then (post 1998) sharply downward. The Japanese government has repeatedly attempted fiscal stimulus, but to no avail. Basically, all the past saving has made Japan a very rich nation, so they can weather a lot. The U.S. is a rich nation too, though, having built this wealth over more than a century.

[brian0918]

According to this paper, the rate was around 15% at the start of the 1990s (twice the US rate at that time). From another paper, my best guess is that their savings rate averaged about 16% from the 1960s all the way to 1990. It drifted slowly downward, and then (post 1998) sharply downward. The Japanese government has repeatedly attempted fiscal stimulus, but to no avail. Basically, all the past saving has made Japan a very rich nation, so they can weather a lot. The U.S. is a rich nation too, though, having built this wealth over more than a century.

Well, the Japanese "riches" were actual cash, right? That is what savings is. Our riches are certainly not cash. What are they? And how easily could they be converted to cash if we hit hard times and need staple goods?

[softwareNerd]

Well, the Japanese "riches" were actual cash, right? That is what savings is. Our riches are certainly not cash. What are they? And how easily could they be converted to cash if we hit hard times and need staple goods?

Savings is the total GDP less the total consumption expenditures and total depreciation. It comes in the form of homes, infrastructure, businesses and durable assets. The Japanese riches are real, much like those of the US. When you say "cash" I assume you mean claims on foreign holders of assets (i.e. foreign exchange). The Japs do have a huge holding of foreign exchange; however, they also have a huge debt. So, one can either view them as having a huge Debt, or one can net out their foreign exchange holdings and they still have a pretty large net debt (as % of GDP). The future does not look good for Japan. Check out the figures in this article.

Basically, if one were to extrapolate current trends in a near-straight line, things don't look good either for Japan or for the U.S. Of the two, I would bet on the U.S. breaking out of that trend -- for good or for bad -- because I see voters in the U.S. as being more ideologically restless than those in Japan. If I were to bet for my great grand kids, I'd say the U.S. will break out on the top; but that doesn't do me any good. For my own lifetime, I expect the ride to be bumpy.

[softwareNerd]

Reading a couple of blog posts, I realized that the main question is not whether this particular mechanism can work (i.e. undo quantitative easing) and to what extent. Rather, the main question is: will the Fed have the nerve?

former NY Fed economist, Richard Alford, says:

...the Fed is attempting to reassure the markets that it has the tools to drain the reserves that it has recently pumped in to the system. However, the markets’ concern has not been “does the Fed have the tools to drain the reserves”, but rather does the increasingly politicized Fed have the confidence, the will, the confidence in its forecast and the fortitude to take the politically unpopular step and begin to drain in a timely fashion. Fed officials assert that they will, but the open-ended commitment to maintain a highly accommodative stance for an extended period of time, i.e. until after the recovery is assured, strongly suggests that the Fed will again remain too loose for too long. (emphasis added)

As Yves Smith points out: "... the Fed will lose its nerve and abandon its efforts to withdraw from quantitative easing, despite noises now to the contrary"

[brian0918]

When has the Fed performed one responsible act? ... Lowering interest rates in response to bubbles, thus fueling further bubbles and causing greater recessions....Stimulating people to spend when their every inclination is to save... They are continually fleeing from the consequences of their actions.

Edited January 4, 2010 by brian0918

[softwareNerd]

Sure, and it not just the Fed that acts irresponsibility. Really, the Fed is not the prime driver of problems; it is an accomplice in the problems created by the legislature and executive. If voters were to require those two to get their act together, the Fed would not be a major problem. Irresponsible voter want to have cake and eat it. The legislature and the executive go along, pretending to deliver. The Fed helps with the charade. Then, the illusion of the boom, turns to bust.

Then we cycle again!

Edited January 4, 2010 by softwareNerd

[brian0918]

Then we cycle again!

Surely, the cycle can't keep going forever. We'll eventually have to suffer the consequences of the Fed's actions, no? We've previously been able to hide behind interest rate reductions, and borrowing from other countries, but you can't go any lower than zero, and countries can't lend to us forever. The next bust will be huge, and sustained.

[C.W.]

On one point, I agree with you sNerd, the question is what is the Fed going to do and when. Not only will they have to have the will to see interest rates rise, they will also first have to convince themselves that taking money out of the economy is actually a good idea. Even when interest rates start rising, how high are they willing to see them go? I mean, short-term rates are next to zero. Long-term rates are higher because of inflation scares. The Fed is going to have to go a ways to break the inflation fears, but by then rates may have gone up a lot. I also don't think they have the nerve, especially when B.O. and the Congress start seeing their interest costs going up and start complaining.

Bernanke has made clear in many ways that he is a "put more money in to solve all problems" kind of guy. His take on the Great Depression, as a academic student of that period , is that it was all the Fed's fault because in 1930 and 1931 the Fed did not flood the country with money. I don't think that he really wants to take money out of the economy, no matter what he says.

He made a speech this week in which he said that the rise in house prices was just coincidental with his policy of low interest rates. Those low interest rates were necessary because of the 9/11 shock, apparently for more than 5 years. The guy just wants low interest rates and lots of money flowing which is all good. How he thought house prices rose continually as much as they did would be interesting to learn (in a purely pshchological sense).

I don't think we need to worry about the next bubble, at least not yet. We are a long way from being out of this bubble's bust: housing will still go down, unemployment is really still rising, banks are not lending, the dollar will continue to fall, the government is taking every available saved dollar out of the system, the money supply is growing fast. The only bright spot that I can see is that business are doing all they can to be profitable. We are now over a year into the recession and although the government has declared it over, the actual recovery has yet to finish. I think 2010 is going to be bumpy.

Regarding the Fed's role, I am not sure I agree with you, sNerd. I think that whether the Fed is the driver or not depends upon the chairman. Greenspan kept the money flowing while the Pres and Congress were in surplus during Clinton's second term. He fueled the tech stock boom. The problem with the Fed is that they have no constraints. It is purely rule by man, not by law. They can do whatever they want.

Brian, if Bernanke continues to throw money around has he has, you are probably right, the swings will blow us out of the water. This "recovery" and "stimulus" program is about as extreme, spur of the moment, reality defying as to be beyond what anyone could imagine. It was a set of circumstances that a somewhat unusual, but our economy is complicated enough that other industries could have similar effects if they were to blow up, too.