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 can only distribute the Treasury securities.

The Fed doesn’t create dollars outright. The Fed creates dollars (reserves) only if part of a swap with a counterparty. Unlike dollars that are in the money supply, Fed-created dollars (reserves) are like ‘pending’ dollars because reserves are always part of the monetary base. For example, when you pay federal taxes, your dollars are ‘converted’ from dollars in your commercial bank to reserves in a Treasury account at the Fed, and those reserves are subsequently ‘converted’ back to dollars that go right back into another commercial bank for federal gov’t surplus spending. This a contentious issue with some MMTers who see federal taxation as a dollar ‘destruction’ only (which is technically correct), however old processes from the gold standard era still remain in place. For example, the federal accounting (albeit from the bygone era) rule is that federal taxation amounts are credited to the Treasury General FUNDS Account, the exact same account from which the federal gov’t pays its bills, and by US law this account must be “funded” by “revenue”. “Funded” by “revenue” is in quotes because the federal gov’t issues its own pure fiat currency (not convertible to gold and free floating) now, so “revenues” are no longer needed to “fund” federal gov’t spending (they serve a far more important function in the modern monetary system). Semantics aside, the point being, you should look at reserves as being dollars regardless if they are reserves in the monetary base or dollars in the money supply, better to just see them all as being ‘dollars in the banking system’. The easy way for me to see reserves, I just think of reserves as ‘pending’ dollars that are not in the money supply (in circulation), same as when you look at your bank account balance, right after making a deposit, there’s an ‘available’ balance (available for ‘circulation’) which is smaller than the ‘actual’ balance because of those other ‘pending’ dollars that haven’t cleared yet. You could also think of Fed-created dollars (reserves) as ‘pending’ dollars the same way you should think of Fed jawboning as ‘pending’ policy. For example, Open Market Operations (OMO) done by the Fed are a frequent fine-tuning of monetary policy. Ben Bernanke likes to call Fed OMO ‘open-mouth operations’, because just like Fed ‘forward guidance’, it is more like ‘pending’ policy. The same goes for reserves that are newly-created by the Fed for any monetary policy actions, they can only influence what the Fed desires. The Fed can only telegraph its 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. 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 Open Market Operations, to providing backstop loans for toxic assets, to Large-Scale Asset Purchases (a.k.a. ‘QE’), the Fed only creates new reserves, that are not part of the money supply. Meaning those newly-created reserves are not circulating throughout the economy, they are not chasing goods and services, they are not causing inflation. Newly-created reserves by the Fed do not cause inflation because they do not add net financial assets to the banking system. Every time the Fed creates reserves it is never an outright creation (a net addition of assets in the banking system), it is always part of a swap (no net addition). The Fed creates reserves and exchanges them for collateral (it ‘prints’ reserves to a counterparty and at the very same time, in exactly the same amount, ‘unprints’ collateral from them). 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 your deficit spending, your creation of dollars (another swap between you and your lender), which unlike Fed creation of dollars, does increase the money supply, the Fed has kept interest rates low. The Fed does this to encourage your deficit spending, to encourage credit expansion. However, just because the Fed provides cheaper liquidity, the Fed can’t outright cause us to deficit spend, the Fed can only try to influence us to create dollars (to expand credit creation). 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; and adding to that mix, the federal gov’t (Treasury) also issuing newly created dollars after Congressional appropriation for federal gov’t spending, 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 dollars, and expands the money supply, not the Fed. In other words, everybody else to increase the money supply and causes inflation. The Fed only facilitates everyone else to increase the money supply and cause inflation.

The Fed does not expand or contract the money supply. Everyone else expands or contracts the money supply when they print or unprint dollars. Thinking that the Fed prints dollars (reserves) and expands the money supply is the same as thinking that the credit card companies print dollars and expand the money supply whenever you pay for a dinner with your credit card. Visa and American Express didn’t print the dollars and expand the money supply, you did. Visa and American Express only facilitated your printing of dollars and your expansion of the money supply (You ‘unprint’ those dollars 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 dollars and the money supply only follows the Fed’s contraction or creation of reserves. The Fed draining or adding dollars (reserves) in the monetary base is not the same thing as you or I draining or adding dollars in the money supply, those are two separate things. The Fed can drain dollars (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 dollars and decrease the money supply when you deleverage, when you ‘unprint’ dollars 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 those reserves nor those bonds 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 dollars, 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 (just how much the inflationary bias of newly-created dollars actually causes inflation depends on prevailing economic conditions). 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.

Thanks for reading,