Friday, December 12, 2008

What do Fed policy and the commercial paper market have in common?

Normally nothing. But we are not in normal times – whatever that may mean – and the Fed is propping up the commercial paper market via its new liquidity facilities, the Commercial Paper Funding Facility (CPFF) and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (ABCP MMMF). In just seven short weeks, the Fed has added 69% of the entire third quarter’s loss in net-issuance of commercial paper. Some would say that the Fed IS the commercial paper market right now.

The Fed released its flow of funds statistics yesterday, and I listed my initial findings in this post. Furthermore, the report indicates that the commercial paper market is struggling.

The chart illustrates the quarterly total net new issuance of (flow) and total outstanding (stock) commercial paper over the last six years, 2002:Q3 to 2008:Q3. This includes all types of commercial paper, nonfinancial and financial. The size of the commercial paper dropped in the third quarter to $1.56 trillion and the total net issuance over the quarter fell $508 billion.

The Fed is single-handedly propping up the commercial paper market

In response to a shrinking credit system, the Fed initiated several new liquidity facilities over the year – eight to be exact - including those for the commercial paper market, CPFF and ABCP MMMF. The new facilities increased the Fed’s balance sheet by $1.4 trillion to $2.2 trillion, where the magnitude of the liquidity facilities are are massive (you can view the balance sheet here):

  • The Term Auction Facility (TAF) currently stands at $448 billion, or 20% of bank reserve credit (size of the Fed’s balance sheet). The size of the TAF rivals the Fed’s stock of Treasuries, which has dwindled to just 22% of the Fed’s balance sheet.
  • Other Federal reserve assets, which is mostly comprised of currency swaps is now $628 billion, or 28% of the balance sheet.
  • The Commercial paper facilities (CPFF + ABCP MMMF) have extended a net $349 billion, $41 billion under the ABCP MMMF and $309 billion under the CPFF, which is 16% of the Fed’s balance sheet.

The chart illustrates the Fed’s net purchase of commercial paper through the CPFF and ABCP MMMF liquidity facilities since October 29, 2008 (the beginning of the liquidity programs). On December 10, 2008, the Fed had increased their net holdings of commercial paper by $349 billion. In just 7 short weeks, the Fed has offset 69% of the $508 loss net-issuance of commercial paper over the third quarter of 2008.

The Fed is ostensibly shoring up the commercial paper markets. I imagine that the Fed will continue to intervene in this market until the CPFF’s termination date, April 30, 2009. It is obvious, though, that credit markets still have a ways to go until they are considered healthy.

Rebecca Wilder


  1. "When the Federal Reserve System was established in 1913, lending reserve funds through the discount window was intended as the principal instrument of central banking operations"...that's what Ben's team is doing.

  2. As Bernanke understands, and has demonstrated, one of the obstacles that faced the FED during 1929-1933was that the commercial banks lacked sufficient discountable “eligible paper” (i.e., commercial paper, principally trade and bankers’ acceptances).

    The FED neither had sufficient gold, nor the banks "eligible paper", to meet the liquidity demands of the public for currency.

  3. Hi Flow5,

    Thank you - as always - for your comments. I agree; the Fed is doing the right thing right now by supporting the commercial paper. Bernanke is making the right decision. But without the Fed, the commercial paper market is not likely to stand on its own.


  4. In the area of economics I don't think one can be too negative, but that doesn' mean you let the non-professionals pre-empt the field. Memorable article, i.e., those who can't write, I can't remember.

  5. The Fed’s introduction of the payment of interest on excess & required reserves has proven more difficult than expected.

    The Fed’s technical staff can’t quantify / calculate the correct remuneration rate on excess reserves.

    With the Fed issuing it’s own debt, its balance sheet expansion lending/discount operations) could be “mopped up” on a dollar for dollar basis.

    However, the Fed cannot offset these advances on a very large scale - without destroying the Treasury’s capacity to manage the national debt.

    Bernanke has "eased" as the economy has receded. I.e., his staff's analysis are ex-post.

    Monetary flows (MVt)are ex-ante.


    The transactions concept of money velocity (Vt) has its roots in Irving Fischer’s equation of exchange (PT = MV), where (1) M equals the volume of means-of-payment money; (2) V, the rate of turnover of this money; (3) T, the volume of transactions units.

    The “econometric” people don’t like the equation because it is impossible to calculate P and T. Presumably therefore the equation lacks validity.

    Actually the equation is a truism –to sell 100 bushels of wheat (T) at $4 a bushel (P) requires the exchange of $400 (M) once (V), or $200 twice, etc.

    The real impact of monetary demand on the prices of goods and serves requires the analysis of “monetary flows”, and the only valid velocity figure in calculating monetary flows is Vt.

    Income velocity (Vi) is a contrived figure (Vi = Nominal GDP/M). The product of MVI is obviously nominal GDP.

    So where does that leave us? In an economic sea without a rudder or an anchor. A rise in nominal GDP can be the result of (1) an increased rate of monetary flows (MVt) (which by definition the Keynesians have excluded from their analysis), (2) an increase in real GDP, (3) an increasing number of housewives selling their labor in the marketplace, etc.

    The income velocity approach obviously provides no tool by which we can dissect and explain the inflation process. Income velocity was espoused by Friedman .

    To the Keynesians, aggregate demand is nominal GDP, the demand for serves (human) and final goods.

    This concept excludes the common sense conclusion that the inflation process begins at the beginning (with raw material prices and processing costs at all stages of production) and continues through to the end.

    But we do know that to ignore the aggregate effect of money flows on prices is to ignore the inflation process.

    And to dismiss the concept of Vt by saying it is meaningless (that people can only spend their income once) is to ignore the fact that Vt is a function of three factors: (1) the number of transactions; (2) the prices of goods and services; (3) the volume of M.

    Inflation analysis cannot be limited to the volume of wages and salaries spent. To do so is to overlook the principal "engine" of inflation - which is of course, the volume of credit (new money) created by the Reserve and the commercial banks, plus the expenditure rate (velocity) of these funds.

    Also overlooked is the effect of the expenditure of the savings of the non-bank public on prices. The (MVt) figure encompasses the total effect of all these money flows.

    Some people prefer the devil theory of inflation: “It’s all OPEC’s fault.” This approach ignores the fact that the evidence of inflation is represented by "actual" prices in the marketplace.

    The “administered” prices of the world's oil producing countries would not be the “actual” market prices were they not “validated” by (MVt)


    The Financial Crisis and the Policy Responses:

    An Empirical Analysis of What Went Wrong

    John B. Taylor*
    November 2008


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