The Fed vs. The Treasury, Money vs. Reserves, & Debts vs. Debits

Most of the nitpicking about the Federal Reserve bank over the airwaves today are variations of the same doomsday narratives that have rhymed over and over throughout time. The recent main themes are that the Fed issues too much debt / the Fed recklessly prints money that finances out-of-control federal gov’t deficit spending / the Fed is dangerously expanding the money supply, etc., that will soon lead to US Treasury bond default / the collapse of the dollar / hyperinflation, etc. Let’s take a step back from that picture and tune out the noise:


The Federal Reserve Bank doesn’t issue debt, or US Treasury securities. The Treasury issues Treasury securities, like bills, notes, and bonds, including Treasury Inflation Protection Securities (TIPs), and Floating Rate Notes (FRNs). Treasury securities make up the most liquid bond market on earth; are denominated in dollars, the world’s reserve currency of the world’s strongest economy; and why they are the global safe haven in times of economic storms. You don’t buy Treasury securities with cash, and you don’t get a physical delivery of a bearer bond anymore. You must have or open an account with a financial institution that accepts dollars, for settlement of payment in dollars for your bonds, and where your bonds will be posted, or electronically registered (because those dollars will remain within the dominion of the Fed, which wields independent power over dollars). The Fed is the banking agent of the US Treasury that settles Treasury bond auctions at initial offerings and settles Treasury bond trading between counter-parties in the secondary market, all via Fed wire. The Fed only distributes the Treasury securities.


The Fed doesn’t create money. The Fed only creates reserves. There’s a difference between money in the banking system and reserves in the banking system because money is always part of the money supply, but reserves are never part of the money supply. Reserves are like ‘pending’ money. You should think of Fed-created reserves as ‘pending’ money the same way you should think of Fed jawboning as ‘pending’ policy. For example, Open Market Operations are a frequent fine-tuning of monetary policy, but as Ben Bernanke calls it, “open-mouth operations”, or forward guidance, is more like ‘pending’ policy. The same goes for newly-created reserves, the Fed only telegraphs it’s desires.


The Fed doesn’t directly effect changes in the money supply. Everyone else directly effects changes in the money supply. The Fed only indirectly influences changes in the money supply, because reserves that the Fed prints or unprints are not part of the money supply. That’s why none of the Fed’s operations has any initial effect on the money supply. That’s also why the bond ‘kings’ and the hedge fund ‘stars’ were all wrong about extraordinarily loose Fed monetary policy automatically causing inflation. Everyone else causes inflation, not the Fed. The Fed can only indirectly influence an onset of inflation caused by everyone else, so what Professor Bernanke taught us was that accommodating Fed policy does not automatically cause inflation (but deflation, however, will automatically cause accommodating Fed policy). Whatever the Fed does, from normal open market operations, to providing backstop loans for toxic assets, to Large-Scale Asset Purchases (‘QE’), the Fed only creates new reserves, that are not money, nor part of the money supply. The Fed creates reserves and exchanges them for collateral (it always just swaps, or prints and unprints, reserves and collateral, always at the very same time and in exactly the same amounts). To accommodate the struggling US economy that is still wobbly from the 2008 Credit Crisis, the Fed is trying to accommodate the economy, which the Fed is hoping influences everyone else and causes inflation (2% to be exact). To encourage credit expansion, your creation of money, which would increase the money supply, the Fed has kept interest rates low, which has provided cheaper liquidity, but the Fed can only lead the horse (aggregate demand) to water (cheaper liquidity). Only nonfederal gov’t aggregate demand meaning you, households, businesses, local & state governments, that borrowing, that credit expansion, that conversion of reserves into newly created money; and adding to that mix, the federal gov’t also issuing newly created money from the Treasury after Congressional appropriation to provision the federal gov’t, all together, that drinking of the water, increases the money supply. Increased nonfederal govt aggregate demand and increased federal govt aggregate demand that leads to deficit spending creates money, and expands the money supply, not the Fed. In other words, everybody else creates the money, and increases the money supply. The Fed only facilitates everyone else to expand the money supply.


The Fed does not expand or contract the money supply. Everyone else expands or contracts the money supply when they print or unprint money. Thinking that the Fed prints money and expands the money supply is the same as thinking that the credit card companies print money and expand the money supply whenever you pay for a dinner with your credit card. Visa and American Express didn’t print the money and expand the money supply, you did. Visa and American Express only facilitated your printing of money and your expansion of the money supply (You ‘unprint’ that money and you contract the money supply if you pay your credit card bill in full at the end of the month). Instead of staring suspiciously at Visa or American Express, or at the Fed for ‘printing all that money’, people should step back from the picture. Your contraction or creation of money and the money supply only follows the Fed’s contraction or creation of reserves. The Fed draining or adding reserves in the banking system by itself is not the same thing as contracting or expanding money and the money supply, those are two separate things. The Fed can drain reserves from the banking system, but that isn’t contracting the money supply. If need be to achieve their dual mandate, the Fed tries to influence the contraction of the money supply, but the Fed can’t by itself, only you can. You destroy money and decrease the money supply when you deleverage, when you ‘unprint’ money that you previously ‘printed’ (i.e., paying off that credit card balance in full instead of just making the minimum payment and letting it ride). Going forward, in the unlikely but possible chance that the US economy suddenly overheats, the Fed would decide to sell those $4 trillion in Treasury bonds and mortgage-backed securities on their balance sheet, draining those $4 trillion in reserves the banks received when selling them, but again reserves are not part of the money supply. In that scenario, by draining reserves and increasing interest rates higher, the Fed only tries to slow the economy, to influence your actions, which the Fed hopes will cause a contraction of the money supply.


Instead of being a debt of gold-backed dollars like during the gold-standard era, every one of the newly created Treasury securities that the Treasury issues in the post-gold standard era is an accounting entry, a debit, that offsets a credit, or addition of newly created fiat dollars, distributed via the Fed, as instructed by the Treasury, after Congressional authorization, into the money supply. On August 15, 1971, when the gold standard officially ended, the ‘national debt’, something that had to be paid back, became the ‘national debit’, something that doesn’t have to be paid back. You have as much to worry about ‘paying back’ the amount of non-convertible fiat dollars the federal government has created and spent as you do ‘paying back’ the amount of oxygen your lungs have created and breathed. There is no ‘national debt’, no burden on your children, and no danger to the financial security of the country. Today, in the post-gold standard, modern monetary system, when the Treasury creates money, rather than adding to an outstanding debt of gold-backed dollars, it now subtracts, or debits, from the purchasing power of the outstanding national float of fiat dollars. Rather than financing the federal government’s deficit spending with our surplus of gold-backed dollars as in the past, today the federal government’s deficit spending finances our surplus savings of fiat dollars. The ‘national debit’ is a national treasure, and as long as you continue to have full faith and credit in the country, your standard of living will continue to rise for many more years to come.

Merry Christmas & Happy New Year

Those Counting On The Fed’s ‘Keynesian Experiment’ To Fail Will Have To Keep Waiting.

Traditionally, in a normal recovery, the Federal Reserve bank would start ‘normalizing’ rates with their announcement of an initial overnight Fed Funds rate hike (a ‘liftoff’) and reach, or ‘target’ that increase, that desired rate, by simply selling short-term Treasury securities (Treasury bills) to the banks (the ‘Primary Dealers’). Banks buying Treasury bills during these FOMC operations pay for the Treasury securities with their reserves held at the Fed. The more Treasury bills the Fed sells, and the more Treasury bills the banks buy, the more it ‘drains’ reserves from the banking system. As the reserves in the banking system diminish, this decrease in supply of reserves results in a greater demand, or interest rate, for the remaining reserves (the opposite of when there is a huge supply, or a glut, of reserves in the banking system, and the demand, or interest rate of the reserves, goes down). The Fed’s open market operations desk keeps selling Treasury bills, keeps pressuring prices of short-term securities in the bond market downward (which at the same time pressures short-term rates up), until the Fed’s target overnight rate is reached. However, due to the Fed’s extraordinary response to calm the 2008 credit crisis, this time it is not a normal situation. With $4 trillion in reserves now in the banking system that no one wants to borrow (or ‘the banks won’t lend out’ depending on your viewpoint), traditional FOMC draining would be like emptying a pool with an eyedropper while banks and nonbanks race to the bottom (lower yields) to compete for loan business.


Using two new programs, the Fed is employing a nontraditional way to target the overnight fed funds rate. The Fed now pays Interest On Excess Reserves (IOER) to the banks, which was legislated in the Troubled Asset Relief Program (TARP) signed into law in 2008 by President Bush. The IOER is paid to all reserves held at the Fed that are not currently lent to other banks in the Fed Funds market (where banks go for short-term financing). In addition, by adding non-banks since 2009, the Fed also expanded the eligible counter-parties that can do trades with the Fed in their Reverse Repurchase (RRP) agreement program. RRP agreements are the financial equivalent of a collateralized loan. The RRP program is effectively the same thing as paying IOER, but to nonbanks like Blackrock, Schwab, Fidelity, or Vanguard, sitting on trillions of dollars in money markets, a.k.a. the ‘wholesale funding’ markets (where corporations go for short-term financing). So instead of instructing the FOMC trading desk to sell Treasury securities to drain reserves to pressure rates up like in the past, on December 16, 2015, the Fed raised the IOER to banks (the new target overnight ‘ceiling’) to .5%; they raised the nonbanks RRP operations offer rate (the new target overnight ‘floor’) to .25%; and the Fed also announced they would accept up to $2 trillion in RRP volume (to leave no doubt that the Fed will drain every cent in reserves to slow an unlikely but sudden economic expansion and/or any sudden unwanted inflation if need be).


The world was saved from another Great Depression, thanks to the Federal Reserve Bank’s response to the 2008 Credit Crisis. Under the Fed’s leadership, the US banking system is far safer and much better able to handle a future crisis. The Fed today is now ready to step in and handle the trading volumes of the entire short-term financing, or wholesale markets, which seized during the past crisis, and widened the panic. In addition, there is no longer a regulatory blur between large banks and large non-banks as in the past. These entities can no longer maneuver around trading rules and Fed oversight. Today all large financial institutions that could pose a systemic risk to the banking system that would worsen a future crisis are now designated as Systemically Important Financial Institutions. SIFIs must now pass regular stress tests and hold greater cushions of capital against their leverage. The new ‘Volcker Rule’ prohibits SIFIs and all other entities that hold taxpayer-insured deposits from proprietary trading (speculating) with their own accounts, and also limits a bank’s connectivity to private equity firms or hedge funds that make risky bets with borrowed money. Furthermore, there will be no more controversial Fed ‘bailouts’ as in the past, because these financial institutions must now have ‘living will’ documents, or detailed instructions of their legally-binding dismantling in the event of insolvency. The US economy is slowly, but steadily going forward, and is now diverging away from all other world economies that are still stuck in neutral, a consequence of a lack of strong leadership outside the US. Despite the past progress and the continuing evidence that better days are ahead for the country, those with a conditional bias that the glass is always half empty and are still counting on the Fed’s ‘Keynesian experiment’ to fail will have to keep waiting.


eddie d