Tag: Federal Reserve

Greece and America — Similar crises?

Fiddling with gravity!

Financial crises can be very difficult events to understand.  Even for those who have spent a great deal of time studying such areas as finance and economics, comprehension of these disasters can be elusive.  However, analyzing shared elements in the recent American and Greek financial crises can help give even the economic layman insight into their common causes.

One word can be used to sum up the basic concept behind both of these crises – overextension.  Both the American and Greek governments attempted to take on a much heavier economic load than either could handle.  While, in both cases, this has been painted by some as a noble, humanitarian effort to help those in need, methods such as inflationary monetary policy tantamount to theft and the disguising of massive budgetary deficits (in both cases with the help of Goldman Sachs) would not justify the means employed even had these efforts been successful, and certainly should be taken to task considering the disastrous ramifications of these actions.

In both cases, many are citing unrestrained spending as the source of the problem.  For example, CNN wrote of the Greek crisis that “years of unrestrained spending, cheap lending and failure to implement financial reforms…whisked away a curtain of partly fiddled statistics to reveal debt levels and deficits that exceeded limits set by the Eurozone.”

Without suggesting that CNN was attempting to be deceptive in this explanation, as the points made certainly are important, it must be noted that things like unrestrained spending, cheap lending, and fiddled statistics are merely symptoms of the deeper disease.  Instead of asking the government to spend less, tighten lending laws, and implement financial reform, one should instead ask the deeper question – how does the government even have the power to cause such problems in the first place, and why are the results of such government power so often much more hurtful than helpful?

This deeper problem, whose symptoms we are now dealing with, is central banking.  The Federal Reserve System and its Greek counterpart, the Bank of Greece, each had a heavy hand in their respective nations’ financial collapses.  This is due to these banks’ attempts at economic manipulation – the Federal Reserve directly sets interest rates, while the Greek system uses more indirect methods to do nearly the same thing.   Note that it is due to their attempts at economic manipulation, as attempting to set economic law is about as useful as attempting to set gravity.

Consider this metaphor of setting gravity.  A man claims to be able to set the force of gravity on the earth.  He tells a stunt biker that he can set gravity to be half as much as normal.  So, the biker attempts to jump a distance that is much longer than he normally would attempt.  Upon jumping, the biker finds that, obviously, the first man never was able to set the nature of gravity at all, and he falls to the ground long before reaching his destination.

This is exactly what happened due to the actions of central banks in the cases of both the United States and Greece.  Interest rates and other natural economic restrictions were said to be more flexible than they truly were. Thus, individuals who based their actions on this information ended up engaging in activities that were far more risky than usual.  However, once they had “jumped,” so to speak, they found that, in fact, economic law was as strict as ever, and they “fell.”

However, if the answer is so obvious, why are we not hearing more about it?  Each of these financial crises is extremely complicated, and the above described scene is, it must be admitted, an oversimplification.  This is not to say that it is not accurate, but rather that this nature of the crises’ root cause is not immediately apparent to all upon examining the situation.

For example, a person who has been educated their entire life in an economic school that praises central banking, deficit spending, and government action in general would certainly seek to find another cause for the crisis, perhaps by blaming business owners for making risky investments or stating that government controls were not strict enough.  However, a person who has studied and understands the damage done by central banking and government economic controls will be quick to realize what has occurred.

People with such knowledge are becoming more and more common in both the United States and around the world.  “Even today, with an economic crisis raging, the response by our government and the Federal Reserve has been characteristic,” Ron Paul writes in his recent book, End the Fed.  “Interest rates are driven to zero and trillions of dollars are pushed into the economy with no evidence that any problems will be solved.  The authorities remain oblivious to the fact that they are only making our problems worse in the long run.”

While he may be one of the most popular adversaries of central banking, it is not just Ron Paul, or even Austrian economists, who are calling out government for its role in these financial crises.  In an e-mail to supporters, Democratic congressman Dennis Kucinich cited “the 1913 Federal Reserve Act, the banks’ fractional reserve system and our debt-based economic system” as major factors in the American crisis.

Such complex and important issues as economic crises need all the attention we can give them, and it is impossible here to provide the in-depth analysis that these situations merit.  It also must be noted that while both the United States and Greece have to an extent both engaged in central banking to their detriments, each country does have a different system.  Still, the general principles hold, always returning us to that first word – overextension.  As long as nations attempt to manipulate the laws of economics to engage in far grander pursuits than they can sustain, we can expect to see such economic crises as have been seen in the United States and Greece in the future.

By Elliot Engstrom

Unwinding $1 trillion in Toxic Assets

Ben S. Bernanke, Chairman of the Federal Reserve

Used toxic assets, anyone?

Ben Bernanke, Chairman of the U.S. Federal Reserve, announced that the Fed was likely to begin to sell some of the $1 trillion in mortgages, the so-called “toxic assets,” that it purchased over the last fifteen months to help stave off a total credit market meltdown. Those purchases essentially doubled the U.S. money supply, igniting fears of potential inflation should the underlying real economy recover before the money supply could be drawn back down. See earlier post.

Well, the process of tightening the money supply may be just around the corner. And increases in interest rates and the cost of everything purchased on credit – homes, cars, durable goods, and business capital expenditures – are not far behind. Increases in interest rates dampen economic activity, an unfortunate development given the current lethargic state of the U.S. economy. But it has to be done sometime – we cannot sustain such a huge increase in the money supply without paying an even higher price in terms of inflation and a weak dollar.

It will be interesting to see who buys the toxic assets and how much they will pay. Regardless, the sale will reduce the money supply which, if done in a slow, orderly manner, is a good thing for the economy. Getting the Fed out of the business of buying and selling private market securities will be an even better thing for the U.S. economy. Now more than ever we need a monetary authority that is focused on the best policies for our economy, not those that help Fannie Mae, the White House, or the Treasury Secretary save face.

By Sherry Jarrell

The Fed’s Exit Strategy

The Federal Reserve finally addresses how it plans to unwind trillions in toxic assets

Finally, we hear from the Federal Reserve about how they plan to unwind the billions of dollars of toxic assets they purchased over the last 18 months or so without creating further distortions in the U.S. and world financial markets (Fed lays out exit detail). This after the Fed barely acknowledged one of the most dramatic runups in the money supply in U.S. history.

Brian Sack, EVP Markets Group, Federal Reserve
The announcement came in a speech by Brian P. Sack, the executive Vice President of the Markets Group at the Fed.  I am impressed by this guy. He seems to know what he’s talking about and seems to understand how markets and fed policy interact.

In earlier posts I wondered aloud how the Fed might accomplish this tricky task. It is a very delicate balance between reducing the money supply too quickly, which would spike short term rates, and too slowly, which would increase long-term rates due to worries about inflation (which occurs when money growth is higher than the economy’s real growth, even if money growth is falling).

The Fed, the article explains, apparently intends to let $200 billion of the estimated $1.25 trillion in new money supply simply “mature” by the end of 2011 without replacing it. This represents largely toxic assets. The Fed might let another $140 billion of Treasuries it purchased during normal open market operations mature at the end of 2011, but they aren’t committing to that.  So that’s about $340/$1,250 or about 35% of the historic increase in money supply that may be vaporized over the next 21 months. What about the rest?  It would be nice to know but….

The Fed is doing the right thing by explaining its policy intentions — ANY of its policy intentions — to the markets.  Markets want, need, and deserve information from our officials, something that has been sorely lacking of late. With information, lenders and borrowers can plan, they can optimize. Without information, guessing, withdrawing from the market, and fear rule the day. Not a good environment for economic recovery.

by Sherry Jarrell

Should you invest in U.S. bonds?

Could the U.S. government default on its bonds?

I’ve been asked many times over the years for advice on investing. “What is the market going to do?” “Should I be invested in stocks or bonds?” And, especially in the last few weeks, “Should I hold U.S. or foreign government bonds?”

A U.S. treasury bill

Those are some good questions!  The answers are not as “good.”  The factors that drive the yields on treasury bills and bonds are complex and, despite Ben Bernanke’s pronouncements to the contrary, less well understood than stock returns, and I don’t have a crystal ball, but I can at least begin to frame an answer to these questions here.  I will come back to expand on this topic over time, as markets, economies, and world events evolve.

The return on both bonds and stocks is measured as the percent change between the market price today, and the cash flows received later.  The cash flows of a bond, namely coupon payments and principal, are specified in a contract; if they are not paid, the issuer is in default, and the bondholder has the right to take them to court.  The cash flows on stock, dividends and capital gains, are residual; they are discretionary, and are paid out only after debt payments and other obligations are paid.  For this reason, bonds are considered to be less risky than stocks, and the nominal yields on bonds are generally lower than those of stocks.   The risk-adjusted returns on stocks and bonds may be the same, but the nominal yields on bonds are typically lower.

There is an important distinction between the nature of the returns on bonds and stocks. With bonds, the future cash flows are known.  Movements in the bond’s yield are determined simultaneously with movements in the bond’s price. Once a bond is issued, only changes in interest rates (yield, risk) drive unexpected changes in its price.  Stock prices, on the other hand, fluctuate as either risk or residual cash flows change.  As a result, changes in a bond’s price, hypothetically at least, are a much cleaner indicator of the market’s expectations of future market rates of interest than a stock’s price.

One problem that distorts the information about expected future interest rates that is revealed by changes in the bond’s price is that bonds are less frequently traded than stocks, so the price data on bonds is less comprehensive and complete. In addition, the reported price data that form the basis of bond yield models often diverge from actual market-clearing prices, so that bond pricing models may not describe actual market behavior. Lastly, there is such a tremendous volume of economic and policy information, some of it conflicting, that is crammed into this one variable, the bond price which, given the coupon and principal, summarizes the market’s referendum on future interest rates.

by Sherry Jarrell

Next time: Sources and types of risk in U.S. and other bond prices.

Fed Funds Rate and Consumer/Business Costs

Looking more closely at the implications of changes in the Fed rate

Fed funds rate chart_img
Fed Funds rate influences consumer and business interest costs

Does the Fed Funds Rate, the rate charged by the Federal Reserve to make short-term loans to banks, directly influence the interest rate consumers and businesses pay on credit cards, mortgages, and consumer and business loans?  If you took the word of the average business news commentator, you would think not.  But the answer, of course, is yes.

One way to view the market rate of interest, although certainly not the only correct or useful way, is to think of it as a base rate that represents the risk-free rate, a rate that compensates the population for its impatience to consume the goods it would have consumed had it not lent the funds out in the first place. This risk-free rate is also influenced by the efficiency and functioning of the capital markets that bring borrowers and lenders together.

A risk premium is then added to this base rate of risk-free interest, one that varies depending on the degree of uncertainty of the lender getting repaid.  The risk of default, the risk of prepayment, the risk of political uprising, exchange rate risk, and many other sources of uncertainty — including the risk of inflation — raise the level of the risk premium commanded by lenders in the market.  As an example, over the last 100 years or so, the average annual risk-free rate in the U.S. has been about 4%, and the average annual risk premium for equity securities has been about 8%, bringing the average annual observed interest rate or rate of return to about 12% on these securities.

So what happens to the interest rate charged to consumers and businesses when the Fed raises the fed funds rate?  Basically, the level of the risk-free rate in the economy rises and, as debt contracts expire or new lending takes place, this higher base rate gets factored into the market rate of interest charged.

Overall, the demand for loanable funds falls, the aggregate demand curve for the economy falls, and equilibrium output and employment fall, RELATIVE to where they would have been without the rate increase. The bright side is that a reduction in the money supply that accompanies an increase in the fed funds rate is absolutely essential to curtailing inflation, which drives the risk premium, and represents a much greater cost to the economy.

By Sherry Jarrell

Why the Fed Raised the Interest Rate

Contractionary Fed policy in a recession?

What does it mean when the Fed raises the interest rate? It helps to first understand how the Fed raises the rate, which may surprise some people.  The Fed does not “set” the interest rate as it might, for example, by declaration or edict or by fixing prices.  No, it targets a higher interest rate by contracting the money supply until that money supply intersects the market demand for money at a higher market-clearing rate of interest.

Ben Bernanke, recently reconfirmed Fed Chairman

How does the Fed reduce the money supply? Typically by conducting open market operations, which is the purchase or sale of government securities by the Fed.  To raise the money supply, it purchases new government securities, paying for them by creating — out of thin air — reserves for the commercial banking system. To reduce the money supply, it sells securities which shrinks the amount of deposits in circulation in the economy. In other words, it reduces the liquidity or amount of credit in the system.  This is equivalent to reducing aggregate demand for the goods and services in the economy. (Yes, you heard right — a reduction in the money supply decreases the aggregate demand for goods and services by businesses and consumers.)

Raising interest rates is a contractionary policy decision.  It is designed to “slow down” the economy, reducing output and employment, and raising the equilibrium prices of goods and services in the economy.  Why would the Fed choose to contract an already anemic economy?  To head off inflation, which has it own set of insidious costs and distortions that significantly hurt the economy.

The Fed has always had to tread a very fine line between increasing the money supply enough in the short run to pump up demand and minimize the depth and length of a recession, but not increasing the money supply so much that the increase in demand outstrips the ability of the economy to produce, which creates inflation in the longer run.   Excessive money growth is what causes inflation.  And over the last two years, the U.S. has witnessed a record-shattering increase in the money supply as policymakers struggled to deal with an unprecedented financial crisis.

I have been saying for months that this behemoth money supply would inevitably lead to significant inflation unless steps were taken to shrink it.  I believe the Fed has now begun to take those steps.

By Sherry Jarrell

Fed Sets up unit to Police Itself

Foxes and hen-house?

I’m not quite sure how I feel about this yet.  The Fed recently announced that it has appointed a long-time staffer with the New York Fed to head a newly created branch to oversee the the parts of its balance sheet acquired in efforts to bail out firms like AIG.

These massive asset purchases, orchestrated by Timothy Geithner, the current Treasury Secretary and former New York Fed official, ballooned the Fed’s balance sheet from $800 billion in primarily government bonds to $2.3 trillion in toxic assets.

Now the New York Fed is overseeing the assets brought into the Fed by the Treasury Secretary as he moved from the New York Fed to the Treasury.  All while the Treasury functions are supposed to be isolated from the Federal Reserve’s role in its implementation of monetary policy.Foxhenhouse

Smacks of the fox watching the hen house….

By Sherry Jarrell

We may need a new term for Fed “Profits”

It’s more than semantics to understand what we mean by The Fed’s profits.

The Federal Reserve, it has been reported, earned record “profits” of over $46 billion in the year ending December 31, 2009.  The previous record profit was $34.6 billion in 2007. The Fed earned $31.7 billion in 2008. The financial crisis has apparently been very good for the Fed, although, as a non-profit entity, all its profits are turned over to the Treasury.  As an aside, I wonder what the Treasury plans to do with its windfall?Reduce taxes? Hmmm.

Be careful, however.  “Profits” are a bit of a misnomer for the Fed’s activities, because they pay for what they do by creating money out of thin air.  To buy a financial instrument such a treasury bill or mortgage-backed security, which is added to the left-hand-side of their balance sheet as an asset valued at cost, they create (and I do mean “create,” in the true sense of the word) an equivalent amount of deposits on the right-hand-side of their balance sheet. It does not “cost” them resources as it would you, or me, or a business.  The “expense” is deducts from revenues to arrive at this period’s profits consist mainly of employee salaries.  Fed BS Dec 2009

So if the Fed purchased a bunch of assets with reserves that they created, where do the “profits” come from?  Keep in mind, there are two major drivers of profits.  One is efficiency, or doing more with your resources. The second is pricing power, being able to charge an above-competitive price for a good or service either because you own something scarce or you make up the rules of the game.

First, two minor sources of income to the Fed are the interest and fees it charges for operating the financial system, such as check clearing and interbank electronic payments, and those it charged participants in the emergency loan programs it undertook to support credit cards and auto loans.

By far the largest source of revenue to the fed, however, came from its open market operations and the purchase of toxic assets.  The Fed had about $1.8 trillion in U.S. government debt and mortgage-related securities on its books by the end of 2009, four times the level in 2008, and the interest payments it collected on this huge pile of assets generated much of their (so-called) profits.  But interest payments are only one source of returns on financial assets. The other is “capital gains” or “price appreciation.”  If and when the Fed sells these assets, some of them considered “toxic,” there is a real risk that they will incur significant capital losses.   For example, the central bank recorded a $3.8 billion decline in the value of loans it made in bailing out Bear Stearns and AIG.

So the Fed’s profits are this period’s interest income minus the Fed’s minimal operating expenses; the capital base on which it earns income is basically “free.”  And all of these figures focus on one-period accounting entries, ignoring the huge potential negative stock of value the Fed’s activities are generating.

Don’t misunderstand. The Fed provides an invaluable service to the national and world economies, and they generally execute those services very well.  But when they begin to try to act like a business, replacing existing investment banking with their own activities, and parade around profit figures as if they meant the same thing as private industry profits, we must step back and take a moment to understand that Fed profits mean something entirely different from corporate profits.

By Sherry Jarrell

Banks are being paid to NOT LEND!

It’s a funny old world just now!

The President of the United States recently pressured the heads of the nations’ largest banks to increase lending to

Pres. Obama

small business and home-owners.  Obama claimed that the banks, as recipients of federal bailout funds, had an unusually heavy responsibility to take such measures in order to create more jobs and help nurse the economy back to health.  All of this was done very publicly and with much fanfare.  Worldwide press coverage was universally favorable.

Seems reasonable, doesn’t it?

But it is not.  You are being duped.  I can’t tell whether whoever writes this stuff for Obama knows the truth and skilfully skirts it, or just writes flowing prose with no connection to the truth that curries voter buy-in by blaming Wall Street and Corporate America for all that’s wrong in the world.

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Fractional Reserves of the U.S. Banking System Explained

What are Fractional Reserves?

The US Federal Reserve, or Central Bank, is the banking system’s bank. It is the lender of last resort.

It is through the Central Bank that banks settle their accounts with each other. The central bank serves as a clearinghouse for checks written by depositors, and it holds the commercial banks’ reserves.

Bank reserves (vault cash, and deposits by banks at the Central Bank or the Fed) are monies held out of circulation by banks to satisfy the Fed’s reserve requirements and the currency demand by the public. Excess reserves are those held above the legal reserve requirements to handle uncertain demand.  Bank deposits not held in (required plus excess) reserves are used to make loans and earn interest.

When banks make loans, they do not actually lend out the equivalent in cash but instead create on their balance sheet a loan asset and an equal liability called a demand deposit.  Such lending by banks is limited only by reserve requirements (set by the Fed) and the cash they need to satisfy cash withdrawal demand by their customers.

As these loans are then re-deposited by the borrower, the multiplier process continues as fractional reserves are held back and the balance is “lent” out again.

By Sherry Jarrell