Sunday, February 8, 2009

Reserve balances down $200 billion from peak



For all those alarmists like Dick Morris who worry about hyperinflation because the Fed has been "pumping massive liquidity" into the system, they should have a look at reserve balances. In the past month reserves have declined by 25% (over $200 billion), indicating that the Fed is actively working to bring them down. Ongoing Treasury sales will sustain this process.

In addition, President Obama's executive compensation cap may unwittingly add to the contraction in reserve balances as companies that don't want to come under this restriction scramble to pay back government funds. This flow of funds, from the private sector to the Fed will result in downward pressure on reserves. This could complicate monetary policy as the Fed may not want reserves to fall that fast given the weak economy and still-fragile credit markets.

9 comments:

googleheim said...

so there is a way to mitigate the inflation risk.

Vince Rowe's encore saturday program had someone who incorrectly said that USA faces becoming like "Argentina" if USA borrows too much and does not produce anything. More bogus supply side concerns and bogus analogies.

Argentina is still an export power house who has never sustained a foreign trade debt - monetary maybe - but not trade since they make enough food for 300 million people but they are only 30 million people.

Executive compensation cap is a reaction tendency to tidy things up akin to balancing a budget. We know that is a no-no, right ?

Krugman points out today that food stamps have been cut out of the stimulus - the item that Norman showed has the biggest amplifier effect for stimulus.

Again, our currency is indirectly pegged to a devalued China yuan. If the Chinese float the yuan, then USA is in trouble, right ?

googleheim said...

Maybe the Federal Reserve does not any longer see the threat of banking runs.

This is a function of an elastic currency. Where in the world is there not an elastic currency - China, Euro?, and any other peggers. Argentina was pre2002.

Elastic currency

One way to prevent bank runs is to have a money supply that can expand when money is needed. The term "elastic currency" in the Federal Reserve Act doesn't just mean the ability to expand the money supply, but also to contract it. Some economic theories have been developed that support the idea of expanding or shrinking a money supply as economic conditions warrant. Elastic currency is defined by the Federal Reserve as:[12]

Currency that can, by the actions of the central monetary authority, expand or contract in amount warranted by economic conditions.

Monetary policy of the Federal Reserve System is based partially on the theory that it is best overall to expand or contract the money supply as economic conditions change. In practice, the Federal Reserve has never contracted the monetary supply since the Great Depression, on the fear that contracting the money supply may cause a deflationary recession, and because according to the operating theory of the Federal Reserve, monetary supply should expand as the economy expands to accommodate larger volumes of transaction.

Mike Norman said...

Yes, that view is pervasive, unfortunately. It's totally flawed, as you know.

I find the Senate's stimulus compromise to be very disappointing. They cut out practically all aid to states, which is totally necessary because to a large degree whatever the Federal Gov't does will be offset by states cutting back. Support the states and give a 2-year payroll tax holiday and it would be over.

The risk is that an insufficient stimulus finally emerges. Then six months or one year down the road when the economy is tanking again, Republicans and other fiscal conservatives will blame the stimulus and there will be a militant reaction against any more spending. I really think we could see the U.S. back on a gold standard at some point.

Obama should not have left this up to Congress, but he should have fashioned his own plan then enlisted supporters in Congress to get it passed.

Matt Franko said...

Mike,
Perhaps that the reserves are falling with the reduction of the amount of foreign currency swaps that the fed has on the balance sheet. The amount lately is just below $400B and previously as high as just over $600B, so about the $200B difference. I have read an old paper on the FRBNY website I found that does indicate that swap lines can increase reserve balances.
http://www.newyorkfed.org/research/quarterly_review/1977v2/v2n4article5.pdf
Wouldnt it be ironic if the inflation hawks who point to recent reserve increases as cause to sell the US fearing inflation are actually looking at the accounting record of the US bailing out foreign central banks!
Ill look into it further and would appreciate your and STFs comments.
Resp,

Mike Norman said...

Matt,

From my understanding foreign currency holdings are not one of the "Factors affecting reserve balances." They do affect reserve balances of foreign CBs but not domestic reserve balances.

-Mike

STF said...

Hi Matt and Mike

I thought I had heard something along the lines of what Mike said, too. However, I've also noticed that these swap arrangements result in a Fed asset when drawn upon, so unless there's something added to the liability side other than rbs, it has to add to rbs by definition.

So, I'm looking through the NY Fed's annual report on OMOs and chart 2 on page 8 clearly shows currency swaps adding to rbs.

Then, I'm looking at the Fed's weekly "factors affecting Rbs," and swaps fell about 78b for the week, which was the main change to assets, and rbs fell about 81b, and there were no other significant changes to liabilities.

It thus appears that the unwinding of swaps is reducing rbs. I'm not exactly sure what reserve account these swaps are being drawn upon . . . perhaps the foreign cbs have an account at the Fed (actually, they do, but didn't know it was a reserve account that functioned like this, if that's the case). Haven't spent as much time on these operations (they didn't matter much at all until a few months ago) as I have on other parts of their ops.

Hope that makes some sense.

Scott Fullwiler

Matt Franko said...

Scott thanks for your analysis.

This is an excerpt from the 1978 report I found at the FRBNY site by Kubarych.
"Swap drawings on the Federal Reserve by foreign central banks:
From time to time, foreign central banks have drawn on their swap lines with the Federal Reserve either to finance intervention sales of dollars or to augment official reserves. For instance, the Bank of England, Bank of Italy, and Bank of Mexico all made swap drawings as recently as 1976. In an example in which a drawing was made to finance intervention, there would be an initial expansionary effect on member
bank reserves. It would occur as the foreign central bank's dollar account is credited with the proceeds of the swap drawing and then debited to make payments to one or more commercial banks in the United States. As a result, member bank reserves would rise, but that increase would also be neutralized, given the way the Desk operates. Another of the group of factors influencing reserves would have changed. In this case, the Federal Reserve's holdings of foreign currencies would have gone up, as the System is credited with the countervalue of the foreign central bank's drawing of dollars under the swap line. That factor represents an increase in member bank reserves. Other things equal, the domestic Trading Desk would respond by absorbing reserves. In this way, the initial expansionary effect on reserves of the foreign central bank's swap drawing would be offset and the monetary impact neutralized."
I take that unless the Trading Desk at the NY fed makes specific adjustments, the member bank reserves will remain elevated. Also perhaps the exchange value of the foreign currencies received by the Fed sits in the banking system in accounts that count as reserves?
If you look at the bottom of the weekly H.4.1 report, the swaps account is distributed all throughout the regional districts (not just NY) perhaps in commercial banks?
Resp,

Mike Norman said...

Matt, good find!

Scott, it appears you are right. I see offsetting liabilities (equal to total outstanding swaps) at the FRBNY and FRB Philly and their increase or decrease has pretty much matched the increase and decrease in swap lines. The foreign CBs must have their accounts there. Thanks guys!

STF said...

Matt and Mike

Yes, good find. Sounds like it works a bit like how a Eurodollar works, with the actual deposit (in this case, reserve) remaining in the US, yes?

Scott