Monday, January 5, 2009

The Fed's message: We're not the Bank of Japan

The Fed is increasingly discussing its monetary policy goals, and it’s about time. But I have noticed that the Fed is being very careful not to use the term quantitative easing (QE) when describing its current policy measures. If not read carefully, one might assume that the Fed is not engaging in a policy of quantitative easing, when in fact, it is.

What the Fed is trying to say is this: we are pursuing a QE policy, but differently than did the Bank of Japan earlier in the decade because; we are not growing the liabilities side of our balance sheet. This seems little silly, as the Fed may very well start printing currency if prices continue to decline. Note: See this post for a discussion of quantitative easing, the Fed’s creation of reserve balances, and the “printing of money.”

The Fed finally stated its intentions

1. The Fed had its big coming-out monetary policy party when it announced a near-zero interest rate policy on December 16. Before that, one could only speculate as to what the Fed’s intentions really were. In the Fed’s announcement of its intentions to use any means necessary to promote economic growth and price stability, the word quantitative was not used, except to refer to the purchase of “large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets”. No mention of quantitative easing, when in fact, that is exactly what the Fed is doing.

2. In a press conference directly following the Fed’s announcement, the Wall Street Journal reported:
But the senior Fed official said the central bank’s approach is distinct from quantitative easing and different from what the Japanese did. The Fed’s balance sheet has two sides, the official explained: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan’s quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed’s focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. That’s designed to improve credit-market functioning, the official said. By expanding the balance sheet by making loans, the official explained, the focus is not on excess reserves but on the asset side. That securities-lending approach directly affects credit spreads, which is the problem today — unlike Japan earlier, where the problem was the level of interest rates in general, the official said.
3. And then Janet Yellen, President of the Federal Reserve Bank of San Francisco, said this (hat tip, Mark Thoma):
On the surface, it may seem appropriate to equate the Fed's use of its balance sheet to stimulate the economy with the quantitative easing policy pursued earlier by the Bank of Japan. But as I noted at the outset, the differences outweigh the similarities in my opinion. The main similarity is that the Fed, like the Bank of Japan, has increased the quantity of excess reserves in the banking system well above the minimum level required to push overnight interbank lending rates to the vicinity of zero. The creation of such a large volume of excess reserves, in the Fed's case, results from the enormous expansion in the Fed's discount window lending, foreign exchange swaps, and asset purchases. In the Bank of Japan's case, the expansion in excess reserves resulted from the deliberate adoption of an explicit numerical target for them. The theory underlying the Bank of Japan's intervention was that banks might be encouraged to lend by replacing their holdings of short-term government securities with excess cash.
The Fed is pitching the same line: our policy is different from the Bank of Japan’s (BoJ) policy measures earlier in the decade. Janet Yellen went as far as to imply that the Fed is not engaging in a QE policy. But Bernanke himself defines QE as “providing bank reserves at levels much greater than needed to maintain a policy rate of zero” (page 5 of Bernanke, Reinhart, and Sack), whichis exactly what the Fed is doing.

The Fed IS engaging in QE policy, but somewhat differently than did the Bank of Japan.

Like the BoJ, the Fed is growing its balance sheet through reserve creation. The Fed has been quite explicit about this, citing the funding of the MBS purchase program and GSE debt through reserve creation.

This should be a familiar chart by now. It illustrates the Fed’s various lending policies listed in its balance sheet. The Fed has increased the credit extended to the commercial banking system by $1.35 trillion in just one year, mostly through the creation of reserves.

The Bank of Japan targeted commercial bank reserves – through the printing of currency and creation of reserves – to a level of 30-35 trillion yen. The Fed has made no such target.

Unlike the BoJ, the Fed's liabilities are falling.

The chart illustrates the liabilities side of the Fed balance sheet. As you can see, with the unwinding of the TSP account (see this post ), the liabilities of the Fed are falling rather than rising. And furthermore, the Fed is not growing its currency stock in bulk. The BoJ’s liabilities would have been rising precipitously, as it flooded the banking system with yen (printing currency).

So the Fed isn't printing hard currency. I find this to be a rather mute point, as the Fed would probably like to see a little inflation right about now. James Hamilton argues that the Fed should consider increasing bank cash holdings to create some inflation. Inflation would lower the real debt burden of households and firms, ensuring that debts at least could be paid off. In the Wall Street Journal, Kenneth Rogoff argues: that "a little inflation would be a good thing".

The Fed said that it will “employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability"; that certainly doesn’t preclude the printing of currency. I wouldn’t be surprised if the Fed started to print currency soon (it has already increased the currency stock by $44.5 billion since October 8) to promote a little inflation.

Rebecca Wilder


  1. Sorry, Chairman Ben S. Bernanke, But Quantitative Easing Won't Work.

    In a Liquidity Trap although Saving (S) is abnormally high investment (I) is next to 0.

    Hence, the Keynesian paradigm I = S is not verified.

    The purpose of Quantitative Easing being to lower the yield on long-term savings and increase liquidity it doesn't create $1 of investment.

    In a Liquidity Trap the last thing the Market needs is liquidity.

    Quantitative Easing does diminish the yield on long-term US Treasury debt but lowers marginally, if at all, the asked yield on long-term savings.

    Those purchases maintain the demand for long-term asset in an unstable equilibrium.

    When this desequilibrium resolves the Market turns chaotic.

    This and other issues are explored in my tract:

    A Specific Application of Employment, Interest and Money
    Plea for a New World Economic Order


    This tract makes a critical analysis of credit based, free market economy, Capitalism, and proves that its dysfunctions are the result of the existence of credit.

    It shows that income / wealth disparity, cause and consequence of credit and of the level of long-term interest-rates, is the first order hidden variable, possibly the only one, of economic development.

    It solves most of the puzzles of macro economy: among which Unemployment, Business Cycles, Under Development, Trade Deficits, International Division of Labour, Stagflation, Greenspan Conundrum, Deflation and Keynes' Liquidity Trap...

    It shows that no fiscal or monetary policy, including the barbaric Quantitative Easing will get us out of depression.

    A Credit Free, Free Market Economy will correct all of those dysfunctions.

    The alternative would be, on the long run, to wait for the physical destruction (through war or rust) of most of our productive assets. It will be at a cost none of us can afford to pay.

    A Specific Application of Employment, Interest and Money

    Press release of my open letter to Chairman Ben S. Bernanke:

    Sorry, Chairman Ben S. Bernanke, But Quantitative Easing Won't Work.

    Yours Sincerely,

    Shalom P. Hamou
    Chief Economist & Master Conductor
    1776 - Annuit Cœptis.

  2. Shalom P. Hamou:
    S has never equaled I. I.e, the utilization of bank credit to finance real investment or government deficits does not constitute a utilization of savings since financing is accomplished thru the creation of new money. I.e., savings are impounded within the CB system (now almost every bank).

  3. The "legal base" for the expansion of new money & credit is given by the Board of Governors "required reserves" figure (H.3).

    It should be the most accurate proxy for the banking system's money stock. Then the "expansion coefficient" would be (commercial bank credit) divided by (required reserves).

    now 40204
    dec 40947
    jan 42398
    feb 41050
    mar 39724
    apr 41645
    may 43069
    jun 41627
    jul 42101
    aug 42086
    sep 42472
    oct 46936
    nov 50366
    Dec 53749

    Note: neither "interest rate targets" nor "legal reserves" are "binding"!

    Note also: The Board of Governors figures do not compensate for changes in the growth of ATM networks, nor sweep-accounts, etc.

    In that respect, Richard Anderson reconstructed excess, required, & total reserve figures account for these changes (St. Louis has always been the maverick bank).

    For example those figures definitely explained the 1987 and the Feb 2007 crashes. While the FED denied any responsibility, they were the guilty party.

    Now, excess reserves are simply parked, and the banks have no incentive to lend when the renumeration rate is above a policy target, e.g., repo stop-out rate.

  4. "the Federal Reserve Bank of New York today began purchasing fixed-rate mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae"

    The FED can raise the renumeration rate on excess and required reserves and monetize a very large chunk of securities.

  5. Great report Rebecca.

    That Janet Yellen comes across as a Greenspan-esque gas bag.

    In short, she tried to say this:

    Through discount window lending, foreign exchange swaps, and asset purchases, the Fed has increased member bank reserves without setting a target amount. The Bank of Japan relied upon a target amount.

    While Fed Res liabilities seem to be falling, the shallow slope on the graph shows a slow descent. Also, compared to the period between 01-02-2008 to 09-10-2008, the amount of liabilities stands as an outrageous mountain.

    Oh, someone should inform Fed Res bankers that reserves does not equal lending, hence credit-money growth over money outside banks(inflation).

    Commercial bankers seem to be waiting to lend. Perhaps they plan to lend to contractors who shall get contracts awarded from Obama's New Deal.

  6. Smack McDonald: "reserves does not equal lending" true, but,

    That's the beauty of required reserves, because (lending) is exactly what the growth in required reserves implies.

    There are some assumptions: that the distribution of accounts in varying deposit classifications remain approxiately the same.

  7. Rebecca,

    As John Taylor said, the Fed's asset-side focus is more industrial policy than monetary policy. Of course, as long as liabilities match assets, the Fed is easing quantitatively.

    But the important point is this: the Fed is essentially targeting credit spreads (rather than targeting a quantity of reserves). Should spreads again widen, this "asset-side" focus will appear to have failed. The Fed will then have to turn to a liability-side focus. What's ironic is that every previous Fed attempt to manage credit spreads has failed. Why would they expect this one to succeed?

  8. Hi David,

    To be sure, the MBS, GSE, and potentially Treasuries purchase programs were set in place to lower longer-term lending rates. And given that the Fed is accepting rather risky debt as collateral for TSLF and other lending programs, that also implies that the Fed is targeting credit spreads.

    But the Fed's objectives were certainly not stated clearly until it finally admitted its policy goals and objectives on December 16. Simultaneously, the Fed must keep the money supply afloat, which to me, implies some sort of monetary target, which is somewhat separate from the issue of lowering interest rates.

    Thanks for your comments, Rebecca