Its often easy to dismiss progressive chattering about "full employment" as another fuzzy liberal pipe-dream. An its even easier for neoliberal economists to define full employment as simply a number that seems "good enough" (of course, the official unemployment rate is a joke, as is the traditional definition of "good enough.)
But full employment means more than just a number. It means that our nation is reaching its best. It means that everybody who is willing and able to contribute to society and solidify some meaning in their lives can do so. A job isnt just about what goods and services you produce, although that is important. Jobs give us things to do with our minds and bodies and give us a sense of accomplishment. A good day at work can give us confidence we might not otherwise have. And even a bad day at work can serve to take our minds off of personal struggles we may be having.
Tuesday, April 14, 2015
This long post will discuss Regulations D and Q, their history, purpose and effect on the banking system. It elaborates on modern monetary policy operations and recent developments that have further removed the necessity for the anachronistic reserve requirements established in Regulation D.
Regulations D and Q were written to clearly demarcate between highly liquid transaction accounts and less liquid savings accounts/ bank CDs. Their purpose was only relevant under the gold standard. Under the gold standard, demand deposits (checking account deposits and physical currency) could be exchanged for gold at a fixed rate, whereas time deposits (savings accounts/CDs) could not.
Therefore the banking system needed to control the flow between the percentage of the money supply that was not convertible into gold (savings/CDs/bonds) and that which was (checking/cash). Reg Q’s purpose was to allow banks only to pay interest on non-convertible time deposits as a way to incentivize customers to put their deposits into these accounts, and therefore limit the banking system’s exposure to gold convertibility risk. To further delineate time and demand accounts, Reg Q also prohibited the payment of interest on demand deposits until 2011.
Regulation D then, required banks to hold a certain percentage of central bank money (reserves or vault cash) against certain types of deposits. The classes of reservable deposits has changed over time, and now only net transaction accounts, (demand deposits/checking accounts) must be reserved against:
As an another matter, Reg Q also capped the interest rate that banks could pay on savings deposits, in order to prevent banks from “reaching for yield” (competing for lower quality (more expensive) loans which would then have been used to fund the higher rate paid to depositors. Another objective of capping interest rates on deposits was to increase bank profits by limiting the competition for deposits. Congress at the time felt that competition for deposits not only reduced bank profits by raising interest expenses, but also have might cause banks to acquire riskier assets with higher expected returns in attempts to limit the erosion of their profits.
Congress thought unpredictable movements of deposits among banking institutions in response to interest rate competition made some banks vulnerable to failure. Another related reason was that big money center banks could pay higher interest rates for deposits than smaller banks, and thus could bid deposits away from smaller regional banks. Larger banks frequently made more speculative loans, such as for buying shares in the stock market. Lawmakers believed that this competition for deposits misallocated financial resources away from productive to speculative uses.
Regulation D is written to limit the liquidity of savings accounts by only allowing a certain amount of monthly withdrawals from time to demand accounts. Reg D also imposes reserve requirements on depository institutions, which was intended as a tool for managing the supply and price of bank money. These requirements created a continuous demand for central bank money (reserves) above and beyond what was needed for interbank payment settlement. Therefore by creating demand, the Fed as the monopoly supplier of reserves could control the price of these reserves and therefore the profitability of bank lending.
Before 1971 when the Federal Reserve’s own liabilities were convertible to gold, it had an incentive to restrict the amount of its reserves that backed the credit created by the banking system. So once this gold convertibility ended, the Fed slowly began to ease its reserve lending facilities, since it no longer faced any convertibility risk of its own. The 2003 amendments to Regulation A, which established the discount window Primary Credit Facility as a “no questions asked” liquidity facility were perhaps the first demonstration of this change.
Technically however, the US left the gold standard in 1933, with only dollars in foreign central banks convertible into gold during the Bretton Woods era which ended in 1971. Nevertheless, during this time and to some degree up to the present, the Federal Reserve and economics profession have not fully understood the monetary policy implications of the removal of the gold constraint.
Since the Fed both imposes reserve requirements, and requires a positive end of day balance in all Fedwire accounts, it has no choice to provide reserves to the banking system, at its target rate. These reserves can be provided through open market operations/Repos, through intraday credit through the Daylight Overdraft facility, or finally through the discount window at a penalty rate. The demand for these reserves is completely inelastic, much like a diver at the bottom of the ocean needs an air supply. Not providing reserves at any price would result in either a shortage of clearing balances or shortage of required reserves, both of which would cause banks to bid up federal funds above the FOMC’s target rate. Therefore, the Fed as the monopolist, has no choice but to provide reserves in unlimited quantities at its target rate in order to defend the payment system and ensure all reserve requirements can be met without bidding up the federal funds rate.
If banks were left on their own to obtain more reserves no amount of interbank lending would be able to create the necessary reserves. Interbank lending changes the location of the reserves but the amount of reserves in the entire banking system remains the same. For example, suppose the total reserve requirement for the banking system was $60 billion at the close of business today but only $55 billion of reserves were held by the entire banking system. Unless the Fed provides the additional $5 billion in reserves through some facility, at least one bank will fail to meet its reserve requirement. The Federal Reserve is, and can only be, the follower, not the leader when it adjusts reserve balances in the banking system. Perhaps the best example of the irrelevancy of reserve requirements is that the Fed has not changed them since April 1992, the month when I was born! However, it is important to keep in mind that the reserve requirement itself does not matter. If reserve requirements are 10% or 100%, either way the Fed must provide reserves at its target rate, as explained above.
Once Richard Nixon ended what was left of the gold standard in 1971, neither of the restrictions from Regulations D or Q became necessary. Since neither demand nor time deposits were convertible to gold (or anything else at a fixed rate) after 1971, the banking system faced no convertibility risk and therefore did not need to differentiate between deposit accounts or pay interest on time deposits to reduce such risk. Other than issues relating to funding stability, from the banks perspective checking and savings accounts became essentially the same. The regulatory atmosphere finally caught up to this post-gold standard reality in 2011 when the Federal Reserve repealed the last remaining part of Reg Q which prevented banks from paying interest on demand deposits (see side note).
While Reg D still exists, it is also less relevant than ever. The movement of much of the deposit base to money market mutual funds, and allowing banks pay interest on both checking and money market accounts, makes Reg D’s limit on time deposit withdrawals largely irrelevant. Further, over the past several decades most banks have become able to effectively avoid reserves requirements through the use of sweep accounts. These sweep accounts are set up to automatically sweep most of a banks reservable deposits (demand) into non-reservable deposits (time) at the end of each 14-day reserve maintenance period, which reduces most of a banks reservable deposits.
Sweeps surged between 1995 and 2000. All charts from the Federal Reserve.
The proliferation of sweep accounts has significantly reduced the percentage of banks required to maintain reserve balances.
Many depository institutions seek to meet most of their reserve requirements through holding vault cash. Since vault cash is necessary for the everyday business of meeting ATM/window withdrawals, banks figure they might as well use cash to meet reserve requirements as well. So what banks do (or at least did before IOR) is to meet as much of the reserve requirement through vault cash, and then adjust their reservable deposits so the RR would be met by what they already had in cash. This is the opposite of what the old fashioned, textbook version of reserve requirements would suggest.
Required reserve balances declined sharply in the 1990s as vault cash holdings rose.
Further, the trillions of excess reserves in the banking system resulting from three rounds of quantitative easing have left the banking system with enough reserves to meet even these minimal requirements for decades into the future. Much of the Federal Reserve’s own literature has supported both of these points.
All of this all dramatically changed during the financial crisis of 2008. As the financial crisis was worsening the Fed faced a conundrum. Through its various new/expanded crisis- lending facilities (discount window, TALF, Corporate paper facility, etc), the Fed was adding trillions of dollars of reserves to the banking system, but it still had an overnight interest rate target above zero. Having run out of unencumbered Treasury securities to sell off its portfolio in order to drain these added reserves and support its interest rate target, the Fed needed a new tool (during this time the Fed actually had to rely on Treasury to conduct a special purpose bond offering with the sole purpose of draining reserves, known as the Special Financing Program or SFP).
The Financial Services Regulatory Relief Act of 2006 had authorized the Federal Reserve Banks to pay interest on balances held by or on behalf of depository institutions at Reserve Banks, subject to a rulemaking by the Board of Governors, to be effective October 1, 2011. The effective date of this authority was advanced to October 1, 2008 by the Emergency Economic Stabilization Act of 2008, and a rule amending Regulation D was finalized just a week later.
So in October of 2008 the Fed gained the ability to pay interest on reserve balances, a power which it previously did not have. This allowed the Fed to establish a non-zero overnight interest rate without having to conduct any POMOs or Repos. With the floor of interest rates now solidly in place, the Fed could continuing lending emergency reserves into the banking system while simultaneously maintaining a nonzero federal funds rate. Interest on Reserves (IOR) changed the game in the federal funds market, and trading volume decreased significantly, by about 75%.
The 2008 changes to Regulation D effectively eliminated the need for reserve requirements. Since the Fed now has the ability to pay interest on reserve balances, it can “sterilize” a certain percentage of the monetary base simply by incentivizing banks to move balances out of the federal funds market and into interest bearing reserve accounts, known as “excess balances accounts”. It can also do this in a more limited fashion with its new Term Deposit Facility (neither of these facilities are available to the GSEs or FHLBs, so some trading in federal funds remains, which is why the effective federal funds rate is slightly below the 25 basis points paid on reserves). In this way, the rate paid on reserve balances serves as a floor to short term interest rates, and the rate charged for institutions that borrow reserves from the Discount Window or through overdrafts represents a ceiling on short term rates.
So with this monetary incentive in place, there is no need to require banks to hold a certain amount of reserves through regulation. Under the IOR system, no regulatory requirement is needed to create a demand for reserves (although even with no IOR banks would still need to hold reserves to meet payments).
This is the way the Bank of Canada has implemented monetary policy since 1999. Canada eliminated its reserve requirements in the 1990’s. Since then, it has set a floor for the overnight rate through the interest it pays on settlement (reserve) balances, known as Deposit Rate, and set the ceiling through the rate it charges for overnight loans (discount window), known as Bank Rate. Deposit rate and Bank rate are usually set 50 basis points apart, just like the IOR rate and Discount rate are in the US. The overnight rate therefore trades in the band between these two rates, and the Bank of Canada sets the midpoint of these two rates as its target rate. This can be expressed as: Bank Rate>Target Rate>Deposit Rate.
Concerns that implementing monetary policy by increasing the rate paid on reserves represent an increased cost to the government are unfounded. While it is true that the interest the Fed pays on reserves is subtracted from what it would otherwise remit to the Treasury, the Treasury ends up ‘paying’ either way. If the Fed were to raise interest rates by selling off part of its Treasury portfolio, as it has done in the past, then its earnings, and therefore remittances to the Treasury, would decrease by about the same amount, and the yield on new Treasury offerings would rise. (In fact, it is likely the case that banks end up earning less under the IOR scenario, since the spread earned by Primary Dealers banks acting as middlemen between Fed and Treasury operations was likely higher than the current 25 basis points paid on all reserve balances). Therefore the size of the Fed’s payments to the Treasury depend on the size of its portfolio, not on the method used to raise interest rates. Either way, the Federal Reserve’s earnings represent a tax on the economy, since the dollars that it earns and remits to the Treasury would have otherwise remained in the economy and distributed to savers, bondholders, or bank shareholders.
QE merely represent a swap of governmental assets. When the FRBNY purchases Treasury and Agency securities, is removes the Treasury/agency liability and replaces it with its own liability (reserves). Deposits merely shift from securities accounts at the Fed (saving) to reserve accounts at the Fed (checking). This is identical to moving money from a savings account to a checking account. Concerns that this rise in reserve balances could lead to inflation stem from a misunderstanding of the post gold standard banking system. Since the start of QE, many lawmakers and banking analysts have express concern that this increase in reserves will lead to an explosion in new money creation through bank lending ,that could put upward pressure on prices (needless to say, these people have been completely wrong.) However, even before QE, as described above, the Fed, as the monopolist of reserves, had no choice but to provide reserves to the banking system in unlimited quantities, at its target rate. Now, as before, the Fed can only influence the marginal cost/profitability of making a loan, not a bank’s ability to do so. Bank lending is not constrained by any quantity of reserves; it is the price of reserves that influence the marginal cost of making a loan.
When banks make loans, they are not “loaning out reserves” as is often portrayed. Reserves are simply a liability of the central bank that can only exist in central banks accounts, known as reserve accounts. Reserves cannot be lent “out”, or leave the banking system (except as withdrawals of physical currency, which is not a matter of monetary policy). In reality, banks create credit, which Reg D then requires to be backed by a certain amount of central bank money; they do not “lend out” anything. The textbook money multiplier model only applies to countries on a fixed exchange rate where the central bank itself faces a convertibility risk. In most countries with floating currencies, the money multiplier model does not apply, as the Bank of England demonstrated in this paper and video last year. Most of these countries have appropriately eliminated reserve requirements after recognizing that they are no longer necessary.
During the “bubble” of the 2000’s when ostensibly too much lending was going on, there were only a few billion of excess reserves in the banking system. Now with $2.5 trillion of excess reserves, there is arguably “not enough” lending going on. Clearly there is no correlation between quantity of reserves and lending. It’s about marginal price, not quantity.
Bank lending merely represents the creation of a new demand deposit balance for the borrower (the banks liability) and a corresponding creation of a new bank asset of equal value (the borrower’s liability). This is accomplished through simple dual-entry accounting, and done completely independently of a bank’s reserve position. Loan officers do not have to check with the CFO to see if they “have the money” to make a loan! Once the borrower pays back the loan, both the bank’s liability and the bank’s asset cease to exist, wiping out both sides of the balance sheet. Therefore, eliminating Regulation D’s reserve requirements (as was done in Canada many years ago) will have no tangible effect on bank lending, economic growth, or inflation.
In any case, the Federal Reserve cannot control the money supply, as the failed efforts of the monetarists in previous decades has demonstrated. The money multiplier is simply the ratio of the broad money supply to the monetary base (mm = M/MB). Changes in the money supply cause changes in the monetary base, not vice versa. The money multiplier is more accurately thought of as a divisor (MB = M/mm). Failure to recognize the fallacy of the money-multiplier model has led even some of the most well- respected experts astray. The inelastic nature of the demand for bank reserves leaves the Fed no control over the quantity of money. The Fed controls only the price, which has not been changed by QE or IOR, and would not be changed by eliminating reserve requirements.
Side note: now that banks are allowed to pay interest on checking deposits, theory indicates that checking account balances at banks would rise, since they no longer represent a lost interest opportunity to the depositor. However, an increase in checking account balances also means an increase in demand deposits, which banks have to hold reserves against. Normally, an increase in reservable deposits (in absence of sweeps of course) would constitute a larger “tax” on the bank, since holding more unremunerated reserves would impose a marginal cost to the bank. However, now that the Fed pays interest on both required and excess reserves, the higher cost of holding more reserves against larger checking account balances can be mitigated.
Posted by The Just Gatekeeper at 5:09 PM
Friday, April 3, 2015
(Wall St. analyst and frequent CNBC guest Christopher Whalen wrote and interesting Op-Ed in American Banker today, focusing on how QE's effects are not as the mainstream believes them to be. In this article, Walen takes on a few MMT talking points, focusing on how the Fed's asset purchases remove interest income from the economy and are therefore more biased towards the deflationary side. The article is pasted below, with my comment in italics. )
Former Federal Reserve chairman Ben Bernanke argues in a new blog post that low interest rates are a reflection of the state of the economy and that a zero interest rate policy will somehow improve economic growth and employment. But he forgets the warnings of economists such as Walter Bagehot and John Maynard Keynes about the dangers of keeping interest rates too low for too long.
I assume those dangers are taken to be "misallocated prices or resources"? Seems to forget that rates were low during 40s, 50s, and 60s.
In fact, both zero rates and quantitative easing, or QE, are actually making deflation worse. (Although the Fed officially ended its bond-purchasing program in October 2014, it continues to reinvest proceeds from the bonds it already owns.)
These policies are also causing a precipitous decline in consumer demand, which is visible in lower prices for key commodities such as copper, oil and natural gas. And they come at a long-term cost to individual investors and financial institutions.
Obviously we have weak aggregate demand right now, which QE makes worse. But blaming low commodity prices only on QE goes to far IMO. Its really global austerity that is to blame for weak demand.
In the fourth quarter of 2014, the total cost of funds for all U.S. banks was just $11 billion, versus over $110 billion in 2008. Meanwhile, as Kroll Bond Rating Agencyobserves in a research note, banks earned $119 billion in gross interest income in the same quarter — illustrating the huge wealth transfer from savers to debtors occurring under the Fed’s policy of financial repression.
Ok, but what were bank gross interest incomes before QE? He doesnt say, so that $119 billion figure is out of context. And if banks are earning so much interest income, why are their earnings and share prices still so low? Also, I am hearing the opposite from the Credit union/ community bank world....they are saying that net interest margins are tighter than ever. Maybe it is different for mega-banks? True that whatever number it is demonstrates a shift of income from savers to debtors, but in a nation where most of the populace are net debtors, this is a GOOD thing. Lower rates on home mortgages, auto loans, consumer loans, student loans, etc. Most savers are the wealthy who are doing fine anyhow.
Savers and investors do not live in the theoretical world of “equilibrium interest rates.”
Of all the theoretical worlds, I dont think one with 'equilibrium rates' is the one I'd chose. Something more like Middle Earth perhaps ;)
Net interest income for U.S. banks is higher than ever in dollar terms. But the negative impact of low interest rates is clearly reflected in falling returns on earning assets. U.S. banks earned $108 billion in net interest income in the fourth quarter, just 0.69% of the $15 trillion in total assets, versus 0.80% in 2010, when system assets totaled just $13.3 trillion, according to the Federal Deposit Insurance Corp. In other words, bank assets increased by 12%, but income per dollar of assets fell almost 10%.
Yes, but those asset prices have been propped up by QE...so the returns post QE will obviously be lower. When asset prices go up, rates go down. So while interest income streams may be lower, bank assets are also worth more, which boosts their capitalization which is arguably more important. This is especially true now that capital requirements and testing have gotten more stringent.
Bank earnings and asset returns are likely to continue experiencing pressure through 2015 and beyond as institutions try to offset declining net interest income with efforts to boost fee revenues and reduce operating costs.
True. Banks now relying more on checking account fees/overdrafts for income.
But more importantly, the steady decline in bank asset returns provides a striking illustration of why the Fed’s policies of zero interest rates and quantitative easing are not working.
Depends what "working" is supposed to mean! If it working means stimulus, then yes.
The decrease in banks' interest expense comes directly out of the pockets of depositors and investors. John Dizard of the Financial Times wrote recently that it has become mathematically impossible for fiduciaries to meet beneficiaries’ future investment return target needs through the prudent buying of securities.
Right, but borrowers save an equal amount that is lost to savers. Again most of the country are borrowers, not savers/investors so this is a net positive for most of the populace. Interest rates are like a see-saw since every dollar borrowed is a dollar saved: Raising rates hurts borrowers, lowering rates hurts savers-- in equal amounts, except for the $17 trillion in Treasury securities which are a NET asset for the economy. Lower rates on Treasury securities do represent a net loss for the economy, since the "savings" from lower Treasury rates just disappear into the Treasury General Acount ie reduce the deficit.
Since many pension funds are required to purchase mainly Treasuries I can see how lower rates hurt them. They may need to shift into riskier investments/change their prospectuses to meet growth targets in the future, since the Fed has corned the market of safe Tsy debt. But this shift in portfolio allocation means more capital directed towards private business, which actually need funds, unlike the US government which is the issuer of dollars.
The stated goal of the Fed's policies is to boost economic growth and employment. But in practice the policies fall short of the mark, because zero interest rates are taking trillions of dollars in income annually out of the global economy.
Agree with the theory, but I don't see how trillions are removed. At most, the Fed sends about $100 billion back to Treasury. The rest is reflected in savings for borrowers, which is not a loss to the economy. Any macro difference would be due to difference in propensity to spend between savers and borrowers.
While the Fed pays banks 25 basis points for bank reserve deposits, the remaining spread earned on the Fed’s massive portfolio of Treasury and agency securities purchased via quantitative easing is still being transferred to the U.S. Treasury. This policy does nothing to support private credit creation or job growth.
Agree completely. This is a dumb policy that acts as a tax. But it does reduce TEH DEFICIT, which is supposed to increase confidence and job growth duh!!
Indeed, the Fed should increase the rate paid on bank reserves immediately and thereby neutralize transfers to the Treasury.
This would require raising IOR which means increasing the FFR target, something that may happen later this year but gradually at best. I dont see the public purpose of raising rates just to boost bank income... Remaining transfers to Treasury should be offset by payroll tax cuts in any case, or at least be credited to the SS Trust Fund.
Moreover, zero rate policy as practiced by the Fed and now by the European Central Bank is actually depressing private-sector economic activity by taking money out of the hands of consumers and businesses.
Only those that are NET savers/fixed income, which is minority.
And by using bank reserves to acquire government and agency securities via QE, the Fed has been artificially pushing up the prices of financial assets around the world even as income and GDP stagnates.
Only because Treasury has been selling its "debt" at a discount in the first place. No public purpose to this. Treasury only issues long term debt because private investors want it, not because it needs to. Therefore, the Fed purchasing Treasury debt =just as if it had never been issued in the first place.
Public companies are using low interest rates to fund stock buy-backs instead of making new investments.
But QE has lowered rates all through the term structure, making it cheaper for business to borrow money/issue their own securities, which is a good thing! No reason for US government to be competing in the capital/paper markets with private businesses which actually need the money! The fact that companies are using these funds for buybacks and not new capital investment is because aggregate demand/sales remain low, so no reason to make real investments at this time.
Higher asset prices due to purchases by the Fed and ECB under QE are clearly a temporary phenomenon. Without a commensurate increase in national income — impossible with zero interest rates — the elevated asset prices resulting from QE cannot be validated and sustained.
Not entirely true. Ever heard of fiscal policy? We can easily boost national income by just spending more/taxing less! Appropriate fiscal policy can support any level of asset prices.
Thus with the end of QE in the U.S. and the possibility of higher interest rates, global investors face the decline of valuations for both debt and equity securities. This reality is already weighing on global financial markets.
Except rates have continued to go down post QE, and weak growth means this will likely continue...
Zero rate policy and QE do not address the core problems of hidden off-balance-sheet debt that caused the 2008 financial crisis. That is, banks and markets globally still face tens of trillions of dollars in on- and off-balance-sheet debt that has not been resolved.
True. Does anyone know what happened to all those CDOs?
Bad debt is a drag on economic growth, from German banks' loans to Greece to underwater mortgage loans in the U.S. Governments in the U.S. and EU refuse to restructure the bad debt because doing so would force banks to take losses and incur further expenses for already cash-strapped governments.
Eurozone governments are cash strapped, ours is not!
But no matter how low interest rates go and how much debt central banks buy, the fact of financial repression in which savers are penalized to the advantage of debtors has an overall deflationary impact on the global economy.
"Financial repression" is a loaded term. With a fiat currency with a natural rate of zero, any rate above zero is a subsidy to passive savers that only occurs because of central bank intervention to support this rate in the first place! So the Fed's current ZIRP is just the end of a subsidy, not repression of any sort. However, it is obvious that the public's understanding of this has not kept up, which is a political problem.
To be clear, the Fed was right to aggressively lower interest rates after the 2008 crisis. But continuing with zero interest rates and quantitative easing for seven years after the crisis is in conflict with the goal of increased employment and growth. By robbing individual savers and financial institutions of income, and artificially boosting asset prices, the Fed and ECB are unwittingly creating the circumstances for the next financial crisis.
Nothing is 'artificial' about one public policy versus another. Both are just policy choices--see my previous blog post on Bernanke! Savers aren't being robbed, just no longer subsidized. People who have saved in the stock market instead of bank accounts/CDs are doing very well.
The Fed and ECB should therefore abandon zero rates and quantitative easing and move to gradually increase interest rates to restore cash flow to the financial system. Mr. Bernanke and his former colleagues on the Federal Open Market Committee ought to recall Adam Smith's famous dictum that the “great wheel of circulation" is the means by which the flow of goods and services moves through the economy. If the Fed really wants to fight deflation and eventually hit a 2% inflation target, then we must embrace policies that make the proverbial wheel turn faster, not slower. We can do this by gradually ending financial repression and restoring balance to global monetary policy.
So we agree that QE does not help the economy, but dont agree on way forward. I think ZIRP should be made permanent, and economic growth should be run through fiscal policy, which not only works better but is more closely in line with our Constitutional principles (spending for the "general welfare").
Posted by The Just Gatekeeper at 1:23 PM