Why the modest inflation?

[Mini-Me]

Brian, thank you for your in-depth explanations here. I feel like I'm finally filling the most crucial gaps in my understanding, even if every answer leads to a new question.

And regarding your IOR sentence above ... the bank does not deposit those reserves. Those reserves have already been credited by the Fed. And yes, the Fed is paying these banks interest on their reserves. In fact, they do not pay interest for just excess reserves (and just reserves on deposit with the Fed) ... they pay interest on all reserves. This includes required reserves as well as vault reserves.
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Maybe I am not the right person to ask as I have repeatedly written in my Financial Sense articles that I think this is part of the Fed's plan to stealthily recapitalize the banking system. It takes time, but it is time they have. A long, slow, painful process that benefits the banks.

The interest payments are simply additional reserves credits issued by the Fed.

Wow...the "interest on all reserves" part sounds extraordinarily shady, even by the Fed's standards. It essentially sounds like free money for banks based on how much money they already hold in reserves, which grossly distorts the meaning and purpose of the term "interest."

However, I'm now quite confused about something: The fact that interest is paid on all reserves - not just excess reserves or those on deposit with the Fed - seems to defeat the purpose of IOR, because if banks get the "interest" payments from the Fed regardless of how they're using their reserves, doesn't that limit the effectiveness of IOR in regulating interest rates and lending? After all, "interest no matter what, as long as you don't bleed reserves" seems like a poor way of incentivizing any particular lending behavior. Clearly I'm misunderstanding something here...fill me in?

You are really asking what happened on Day 1, right? To get a fiat currency central bank managed monetary system jump-started, you need to buy an initial round of assets. These assets traditionally fall into two categories ... sovereign debt and Gold. This is how the Federal Reserve system got started. The quality of assets are important because these are the securities that back the currency and money supply. This is why I harp on the declining composition of the Fed balance sheet ... both in terms of asset quality and maturity (asset risk and interest rate risk). Meanwhile, the financial media seems to be fixated on only the size of the balance sheet. Both are important. Agency debt and Agency MBSs, unfortunately, have become a core holding of our central bank. Meanwhile, average duration continues to rise and is at unprecedented levels.

From the perspective of a fiat money system propped up by legal tender laws and petrodollar hegemony, why is the composition of the Fed's balance sheet so important? Granted, the Fed needs to possess valuable assets instead of junk if it plans on extinguishing money by selling its assets back on the open market, but is there a reason related to the value of the dollar that I'm not seeing?

After all, it's not like the dollar is backed by gold in the sense of being redeemable for any fixed amount. That bygone policy previously gave the dollar value as a proxy for gold (which also led to expectations that it wouldn't be inflated). If FRN's were redeemable on demand at the Fed for a fixed quantity of some asset on the Fed's balance sheet (let's handwave the vague meaning of "quantity" for assets that aren't commodities like gold ), then the composition of those assets would obviously contribute to the value of the dollar, but as it stands, I'm having trouble seeing any real connection. In the absence of any kind of redeemability, the "backing" of the currency by the Fed's balance sheet just seems way too abstract (and disconnected from what the currency can actually be exchanged for) to matter, in and of itself.

Then again, taking the long view that the dollar is doomed to fail in the first place, I suppose the Fed's balance sheet composition might matter from the standpoint of switching over to another currency system. If another state-sponsored gold standard were ever implemented (which could be a terrible idea for a number of reasons), it would certainly matter whether the Fed's reserves at the end of this current system were composed of gold or toxic MBS's (and depending on the situation, I might be liable to value Treasuries closer to the latter ). The same might apply to any kind of switch to a regional or global fiat currency (God forbid), since the Fed's balance sheet could play a role in determining exchange rates and/or the US's stake in such a currency.

Over long periods of time, the Fed engages in asset purchases (at considerably lower levels than that of post September 2008). These asset purchases increase reserves in the banking system (liability side of the balance sheet) and obviously add to the asset side of the balance sheet. Increased reserves means increased monetary base. Over time, some of these reserves become currency in circulation. These types of systems rely on continued inflation (even if it is modest) to survive. This is how it is achieved. From the period of summer 1996 to summer 2006, the monetary base increased from $443 billion to $804 billion. In 1959 it was $40 billion.

Is it really necessary for the system to be inflationary just to survive though? I understand that the human element virtually guarantees inflation as an inevitable result of fiat money, but in theory, couldn't the Fed technically seek to maintain a stable monetary base under all conditions, thereby mimicking a gold standard (without any new gold mined)?

All systems start from scratch ... but that does not mean that the government did not already have assets to use as backing for the central bank and currency. It did (Gold). The Fed "purchased" them and as such, hold them as asset and liability entries on its balance sheet. The government also issued debt which the central bank purchased.

Brian

That cleared up a LOT for me. Thanks.

[Danan]

Are you really getting on my ass because I said 0% instead of 0.25%?

I guess what he's implying is that against popular belief banks cannot get significant amount of loans for zero or near zero percent interest, neither directly through the Fed nor indirectly through it's policies. The only market to which this often mentioned interest rate does apply is miniscule in size and unimportant at this point in time. I guess he further suggests (though I don't want to put words in his mouth) that in fact banks do have to finance themselves through the market for savings and loans, which you suggested would only be true in absence of the Fed.

I'd like to know if I described gonegolfin's position correctly. It's certainly a very interesting point of view.

This very detailed in-depth analysis of specific policies could certainly be useful in order to dismiss common myths, such as, "Banks get newly created money for almost 0% interest and can then invest it or put it for more interest in Fed-accounts!" (That is, if I understand Bryan correctly and if what he says is also actually true - but he seems quite knowledgeable.)

But it obviously fails to describe the greater scheme of things. How does the existence of the Fed (and also Federal Deposit Insurance, etc.) influence the loanable funds market? What are the implications for the banking sector? Are they profiting from it and if yes how and by how much? How loses? Are there implications of what Bryan states for the Austrian Business Cycle Theory (if the Fed wouldn't alter the market for loanable funds at all, only Fractional Reserve Banking would start the Business Cycle, which could theorectically also exist without the Fed)?

[bxm042]

If there aren't many loans happening at a near zero rate, it doesn't mean near zero loans aren't available. It just means they don't need the loan. If any of these banks offered to pay "near zero + .01"... I'm sure another bank would be happy to oblige them.

[Danan]

From the perspective of a fiat money system propped up by legal tender laws and petrodollar hegemony, why is the composition of the Fed's balance sheet so important? Granted, the Fed needs to possess valuable assets instead of junk if it plans on extinguishing money by selling its assets back on the open market, but is there a reason related to the value of the dollar that I'm not seeing?

After all, it's not like the dollar is backed by gold in the sense of being redeemable for any fixed amount. That bygone policy previously gave the dollar value as a proxy for gold (which also led to expectations that it wouldn't be inflated). If FRN's were redeemable on demand at the Fed for a fixed quantity of some asset on the Fed's balance sheet (let's handwave the vague meaning of "quantity" for assets that aren't commodities like gold ), then the composition of those assets would obviously contribute to the value of the dollar, but as it stands, I'm having trouble seeing any real connection. In the absence of any kind of redeemability, the "backing" of the currency by the Fed's balance sheet just seems way too abstract (and disconnected from what the currency can actually be exchanged for) to matter, in and of itself.

I wrote a whole paragraph on why I believe it matters. But I deleted it, because after further thinking about the subject, it starts to make less sense every minute.

My first explanation was that a massive contraction of the Fed's balance sheet, due to defaults on poisenous assets like mortgage-backed securites, would rapidly increase the scarcity and thus the price of the currency.

However I have a few problems with that theory. Why does it matter if the Fed or private banks are holding these assets at the time they have to be written off the books? Obviously if the Fed has to write something off their balance sheets it was a "bad investment" to purchase it at this price and they make losses on these papers (of course they've known that in advance). Bad those losses are not really the point. It's the contraction of the money supply due to the contraction of the balance sheet that I don't really understand.

Once the Fed owns these papers, a default means that the money supply shrinks, but if private banks own them, a defauld only results in big losses, but the money supply remains unchanged? I fail to see how that makes any sense.

If the Fed didn't buy these assets and the banks had to write them off the books, would this in any way be reflected on the Fed's balance sheet too? I don't see how, to be honest. Do the balance sheets of private banks influence a different money base (like M3, or whatever) and if yes, what's the difference? How does it change the value of the currency differently if the central bank has to contract it's balance sheet or if a private bank has to do the same thing?

I guess what it comes down to is: Can a private bank increase the money supply without having the Fed as some kind of a proxy (I've seen people arguing on whether a newly created loan is actually an increase in the money supply) and if yes, how is this different than if the Fed increases the money supply by purchasing assets out of thin air?


The economy could be so easy to understand without governments. =/

[Danan]

If there aren't many loans happening at a near zero rate, it doesn't mean near zero loans aren't available. It just means they don't need the loan. If any of these banks offered to pay "near zero + .01"... I'm sure another bank would be happy to oblige them.

The way I understand it, they couldn't finance their business by those loans, because they are extremely limited, only lend out for liquidity purposes and have to be secured by assets.

It's not that I approve of them. I don't want to see a central bank at all (obviously). It's just that it doesn't seem that these specific loans are anywhere near as important as the other crimes the Fed is committing.

And the, "Banks get money for 0% interest rates!"-meme seems to be a distraction. It doesn't explain why banks would bother to get new depositors (and pay them interest).

[Brian4Liberty]

To keep it simple. one of my main questions revolves around Federal government debt (and deficit spending). My assumption is that all of that debt must be sold by the Treasury (T-Bills, Bonds and Notes). Who is buying that debt? What percent of the debt is eventually being purchased by the Federal Reserve? Rumor has it that most people don't want to buy US Treasury debt anymore (China, for instance).

So with our latest version of QE, the Federal Reserve is purchasing toxic debt from Wall St. Is there an agreement that Wall St will turn around and purchase US Treasuries with that money? How is the debt being financed?

[Paul Or Nothing II]

Collectively, yes. Individually, the bankers are making the big $$$. BIG $$$. Huge incentive to keep the status-quo.

If one banker takes 10% out of 10 trillion, and distributes the other 9 trillion relatively equally across everybody (in reality it isn't evenly distributed but that's not the point), the primary benefactor is the banker.

Everybody else, didn't really earn much. Their small fraction of the 9 trillion was diluted through inflation. They do benefit, but they do not have nearly as much incentive to keep this system up and running as the bankers.

You don't seem to grasp that whatever banks earn thru lending is what market gives them for their services & whatever they earn thru buying/selling Treasuries is what they earn for being market-makers to government for their debt.

Right now, they borrow at 0.XX% & lend at 2-3% or whatever, without Fed they'd be borrowing at let's say 4-5% & lending at 7-8% or whatever, the point is that they earn for providing a service & markets decide how much they earn & that depends on supply & demand of credit, & the more the credit expands the less they earn per loan while they earn more per loan when credit is limited so they'll be pretty profitable under any system & anyone who believes in capitalism should have little problem with anyone making money by providing goods/services. So I still stand by the statement banks are NOT necessarily the biggest beneficiaries of the system, GOVERNMENT IS!

As for the system, as I've said before, we live in a majority-rule society so any system that exists, can only exist with majority-consent & majority clearly aren't interested in stopping the government or the Fed, they are too busy collecting welfare & robbing others for it through socialism.

[Paul Or Nothing II]

why is the composition of the Fed's balance sheet so important?

Once the Fed owns these papers, a default means that the money supply shrinks, but if private banks own them, a defauld only results in big losses, but the money supply remains unchanged? I fail to see how that makes any sense.

If the Fed didn't buy these assets and the banks had to write them off the books, would this in any way be reflected on the Fed's balance sheet too? I don't see how, to be honest. Do the balance sheets of private banks influence a different money base (like M3, or whatever) and if yes, what's the difference? How does it change the value of the currency differently if the central bank has to contract it's balance sheet or if a private bank has to do the same thing?

The reason quality of assets on Fed's Balance Sheet matters is because if those assets couldn't be sold off at least at par & if they can only be sold at enormous losses as is likely to occur then those losses will have to be borne by Treasury.

Ever heard Ron Paul saying, "Why is Fed buying all these BAD ASSETS, why are they putting this on taxpayers' tab?". etc etc. It's precisely because as & when these losses occur, Treasury will have to bear them since despite all the talk of Fed being "private", it really is just another arm of the government & just as Fed hands over its profits to Treasury, it must also bear Fed's losses, which means that essentially it's the taxpayers that are on the hook!

I'd had a discussion with someone explaining him about how Fed's Balance Sheet works but he'd bought too much into conspiracies & therefore he wasn't being objective with respect to Fed & how it ACTUALLY works but may be you guys might be interested in this - http://www.ronpaulforums.com/showthr...=1#post4405329

As "gonegolfin" has said, all of these myths & conspiracy theories just discredit the liberty movement; yes there are issues with Fed & many other things but that doesn't mean that any fallacious against them is necessarily true; I wish more people would actually spend time on learning the philosophy of liberty & sound economics than looking out for the next big conspiracy theory!

[bxm042]

banks are NOT necessarily the biggest beneficiaries of the system, GOVERNMENT IS!

What's the difference, they own it~

[Aurave]

My assumption is that all of that debt must be sold by the Treasury (T-Bills, Bonds and Notes). Who is buying that debt?

Yes, it sells. The treasury holds auctions when they issue debt. You can find out more at treasurydirect. I will never in my life buy a government bond so I don't care to know more.

What percent of the debt is eventually being purchased by the Federal Reserve? Rumor has it that most people don't want to buy US Treasury debt anymore (China, for instance).

The last figures on China I've seen are from 2011, they held about $1.3 trillion. Country specific figures for private foreign holders are nebulous guesses though.

For the latest figures on ownership of treasury securities you'll want to look at the flow of funds release from the fed here: http://www.federalreserve.gov/econre...isticsdata.htm
Click on (Flow of Funds Accounts of the United States - Z.1). You want levels, not flow, of treasury securities which is L.209 and you can jump there by going to page 104 in the full release.

Total liabilities of presumably the treasury are listed as $11 trillion.

The Fed holds about $1.6 trillion ~ 15%
Foreign holders about $5.3 trillion ~ 48%

You can look at the breakdowns listed in the release there if you want to know more. Keep in mind that figures such as this and the categories used can be defined in a myriad of ways.