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Beyond the horse race to lead the FED

Sarah Binder is a professor of political science at George Washington University and a senior fellow at the Brookings Institution, offers some thoughts on the FED and its changing role ( re-posted with authors permission, for the complete post go to original):

Beyond the horse race to lead the FED

…As the horse race for Fed chair continues, I thought I’d take a second stab at trying to put the campaign for the Fed into perspective. I offered a few thoughts the other day; here are a few more observations.

First, keep in mind that advice and consent for the chair of the Fed is a relatively new phenomenon.  The now familiar four-year term for the chair of the Federal Reserve Board of Governors dates to reform of the Federal Reserve Act in 1935.  But requiring Senate confirmation of the president’s nominee for service as chair is a product of Democratic-led reforms of the Fed in 1977, which included the imposition of the Fed’s dual mandate (directing the Fed to maximize both employment and price stability).  Requiring confirmation of the chair provided an avenue for the Senate to try to indirectly influence the course of monetary policy.   But given the newness of the requirement and given multiple terms for recent Fed chairs, there are relatively few chair “contests” against which to judge this open contest: there have been just four chairs since the reform in 1977.  And of course, even if there were more cases, it would be tough to compare the selections over time given the expansion and change in the Fed’s responsibilities over the past three plus decades—let alone the rise in political conflict over the Fed’s unconventional policies.  (As I suggested the other day, though, the public nature of the “campaign” is unprecedented.)

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The Fed, Primary Dealers, and the Ineffectiveness of Monetary Policy

by Mike Kimel

The Fed, Primary Dealers, and the Ineffectiveness of Monetary Policy

The Federal Reserve’s primary tool for monetary policy is buying or selling securities, in particularly US notes, bills and bonds.

But… it doesn’t buy and sell bonds to you and me. Instead, it deals with primary dealers – the complete list is here. The list includes reputable and scandal-free companies such as Citigroup, Bank of America (actually, it’s subsidiary Merrill Lynch, Pierce, Fenner & Smith Incorporated), Goldman Sachs, and UBS. What does it take to get removed from the list? Well, the most recent change to the list occurred when MF Global was removed on October 31, 2011. By coincidence, that was the day that MF Global declared bankruptcy after making almost $900 million of other people’s money disappear. Bear Stearns came off October 1, 2008, four months after the company imploded and sold itself to JP Morgan. Lehman came off a week after it declared bankruptcy.

Other past luminaries include Countrywide, Drexel Burnham Lambert, Continental Illinois and Salomon Brothers, which makes for an interesting list if you tend to be the kind of person who remembers financial scandals of times past. I have no idea what criteria the Fed uses in picking its primary dealers – clearly controlling massive quantities of financial assets is a requirement, but financial viability and being off the public dole are not.

In fact, being a primary dealer is a way of being on the public dole. When the Fed confers the primary dealer designation, it confers a large, recurring financial gift on the designee. Remember, the Fed won’t engage in securities transactions with the public, just with primary dealers. So if the Fed is planning to sell bonds for $X, and you want to purchase bonds for $X + $Y, the Fed won’t just sell you those bonds. Instead, the Fed sells the bonds to Bank of America, and making the perhaps unreasonable assumption that Bank of America is able to execute without massively screwing something up, the bank then turns around and sells you the bonds, pocketing $Y.

This convoluted and inefficient way of doing business made sense in the 1960s when the scheme was cooked up. Now, its just another infusion of cash from you, me, and the Fed to many of the same institutions that took a good run at taking down the world economy, and which regularly require other infusions of cash to survive. These days we have computers – any halfway decent programmer could set up an auction system for the Fed that wouldn’t require regular transfers from the rest of us to Goldman Sachs and UBS. Heck, I can do it and I’m not a halfway decent programmer.

Of course, if you give it some thought, there is no particular reason the Fed’s way to conduct monetary policy has to involve buying and selling Treasuries. It could just as easily be funding social security benefits, placing money in the bank accounts of each American, flinging it from trebuchets or buying geraniums. Buying and selling securities is an inefficient way to adjust the money supply in this day and age, even if it made sense in 1913 when the Fed was established.

What do I mean when I say that buying and selling Treasuries is an inefficient way to conduct monetary policy? Well, its simple. As noted above, the Fed’s current process is a way to transfer funds from you and me to the primary dealers. By selecting how money is put into and taken out of the system, the Fed selects how monetary policy affects the economy.

The haves are less likely to spend an extra dollar of income than the have nots (in economic parlance, the wealthy have lower marginal propensity to consume than the poor), and when the haves do spend money, they generally don’t do it as quickly as the have nots (in economic-ese, the velocity of money is slower when wealthy people have it).

The reason it matters… during a recession, people and companies become more cautious and reduce their spending. That leads to less stuff being produced, less people working, etc., making the economic downturn worse. By pumping money into the economy, theoretically the Fed makes money cheaper, which in turn leads to more money being spent. That’s the theory, anyway.

But because the Fed’s way of increasing the money supply is designed to place more of it in the hands of the primary dealers, the process often doesn’t work very well even leaving out the fact that periodically, another member of this august group turns out to be corrupt, antisocial or incompetent. The money the Fed has been putting into the economy has not been getting spent. Since it isn’t getting spent, it isn’t doing any good for the economy. Rather, its been accumulated, in large part by the very same sectors of the economy that played so big a role in causing the crash. I believe that’s what Lloyd Blankfein was talking about when he said he was doing God’s work.

It is long past time to change the way the Fed operates.

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Who Determines Short Term Interest Rates?

Do you think it’s the Fed?

It’s not.

The market determines short term interest rates.


The Federal Funds Rate, which is set by the Fed, FOLLOWS 3 month T-Bill rates.  It does not lead the economy.  Here are some looks.  First the whole data set, going back to 1954, presented in Graph 1.

Federal Funds data from FRED.

T-Bill rates from a different Federal Reserve site

These are tabulated monthly values.  But the T-Bill rate is set in a weekly auction, and the Fed Funds rate is set by the Fed Open Market Committee, on an arbitrary schedule, at their discretion. 

Graph 1  Fed Funds and 3 Mo. T Bill Rates, 1954-2011

Not exactly lock step, but they are a couple of clinging vines.  At this scale, it’s pretty hard to tell who leads and who follows.  Let’s look closer at the last few decades.  First, the all-time highs of the early 80′s, in Graph 2.

Graph 2  Fed Funds and 3 Mo. T Bill Rates, 1978-84

Here, the Fed Funds are in green and the T-Bill rate in orange, with the moves off of tops and bottoms highlighted in other colors.  Fed Funds tend to run a bit above T-Bills.  From this data, T-Bill rates generally change direction in the same month or the month prior to a Fed Funds change.

Graph 3  Fed Funds and 3 Mo. T Bill Rates, 1978-84

Same story in Graph 3: either concurrent motion or T-Bills are slightly ahead.  For the two downward moves at the beginnings of 1990 and 1995, they are three to four months ahead.

The story is similar for the most recent decade, shown in Graph 4.

Graph 4  Fed Funds and 3 Mo. T Bill Rates, 2000-2008

Looks like the Fed is a close follower of T-Bill rates, usually within a month or so.  Coming off a diffuse top, the lag can be a little longer.

Graph 5 shows a close up of 2001-5, without the odd colors.  T-Bill leadership is easily seen.

Graph 5  Fed Funds and 3 Mo. T Bill Rates, 2001-05

Two questions present themselves:

1) Does the Fed have any real power to influence interest rates?
2) What would happen if they attempted to move counter to the market?

In my mind, this casts serious doubt on the usefulness of interest rate manipulations as a monetary policy lever.   What do you think?

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ECB policy is tightening – has been for some time

Update: Nouriel Roubini front pages this post on Euromonitor here.

The ECB dove in and hiked its policy rate by 25 basis points to 1.25%. I had the pleasure of listening to Wolfgang Munchau on Thursday, and he reiterated what I reluctantly understood: the ECB’s strict inflation target is ridiculously simple for such a complex region; but more importantly, the Governing Council is just itching to tighten.

Eurointelligence blog highlights the various interpretations of the ECB’s shift in policy: Thomas Mayer at Deutsche Bank suggests that the ECB’s normalization is appropriate, while David Beckworth and others (links at Beckworth’s site) are more sympathetic to the impact on the Periphery. They highlight that relative price fluctuations could facilitate the much-needed redistribution of capital flows (i.e., the current account); and furthermore, that ECB policy is even too tight for the core (a google translation of Kantoos Economics). Yours truly has written extensively about this – among others, here’s one, another, and another. Who’s right? Ultimately time will tell.

But I do suspect that we haven’t seen the end of this crisis. The ECB is squeezing out liquidity when more liquidity is needed. Furthermore, the core remains subject to export shocks via external demand; and there’s building evidence that global growth will slow (see this excellent post on global PMIs by Edward Hugh).

It’s ironic, too. While the ECB is currently being heralded or chastised for raising rates, monetary and financial conditions in Europe have been tight for some time, both on a relative and stand-alone basis!
(read more after the jump!)

First, the ECB’s bond purchase programs, the Securities Market Programme and the Covered Bond Purchase program, amount to just 1.4% of 2010 Eurozone GDP. In stark contrast, the size of the Fed’s program broke 16% (and is rising) and the Bank of England’s purchase program remains firm at around 13% of GDP.

The asset purchase programs are emergence liquidity programs and are not normal monetary policy tools. But while the Fed and the BoE do not sterilize their flows, the ECB does. And my interpretation of ECB rhetoric and policy as of late is that they want out of the secondary-bond purchase business. For example, they’ve slowed their SMP purchases markedly in 2011 (see the ad-hoc announcements here).

Second, Eurozone financial conditions have been tightening since August 2010, while those in the US and England loosened up. Goldman Sachs constructs a financial conditions index, which is comprised of real interest rates (long and short), real exchange rates, and equity market capitalization. I love this index (subscription required), as it represents a broad measure of monetary policy pass-through.

Even though the ECB just started its rate-hiking cycle, they’ve been effectively tightening for some time.

I would say that Eurozone (as a whole) growth prospects are seriously challenged at this time, especially by comparing monetary policy to that in England and the US. We’ll see if the ECB’s able to push its target rate back to 2.5-3% through 2012 – I suspect that may be just a pipe dream, as tight liquidity and a slowing global economy drag economic growth.

The ECB’s actions imply to me that they still do not understand the following: Europe faces a banking crisis not a fiscal crisis!

Rebecca Wilder

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Comparing the Fed, the ECB, and the BoE before policies diverge

The coming week is G4 central bank week. The Federal Reserve Bank (Fed) announces its policy decision on November 3; the European Central Bank (ECB) and the Bank of England (BoE) will make policy announcements on November 4; and the Bank of Japan pushed forward its November 15-16 meeting to be held now on November 4-5.

At this juncture, G4 ex Japan monetary policy is likely to diverge sharply: the Fed is expected to announce an extension of its asset purchase program, while the ECB and BoE are not expected to increase theirs. In fact, the policy wedge between the three central banks is already wide. Despite the ECB’s enacting its covered bond purchase program, the amount is small, roughly 1.4% of Eurozone GDP (see chart below), and the central bank is sterilizing the flow – sterilizing the operation means that the ECB performs equal and opposite monetary operations to reduce bank reserves by the amount of the bond purchase program.

The chart above illustrates the size of the bond purchase programs (assets sitting on the central bank balance sheet) as a share of 2010 GDP (IMF forecast). Ostensibly, and from a bank-lending point of view, Eurozone financial conditions appear to be “healthier” than those in the UK or US.

The chart above illustrates total bank lending in the Eurozone, UK, and the US; but this may change as austerity measures in some European countries infect the stronger economies via a tightly integrated trade relationship.

Policy is already much tighter in the ECB compared to its US and UK counterparts. This discrepancy is expected to diverge, as the Fed moves into QE2 mode this week.

Rebecca Wilder

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