Money Creation And The Fed

Mrswing.com reports about money creation and the Fed.

(emphasis mine) [my comment]

Money creation and the Fed
Mar 28, 2009
James Hamilton

[This is the best and clearest explanation of the fed's money creation and the monetary base that I have found.]


A lot of people have seen this picture of the recent behavior of the monetary base and wondered what it means.


Figure 1. Adjusted monetary base. Source: FRED.

To understand the explosion in the monetary base since September, let's begin with a little background. The Federal Reserve has the ability to purchase assets or make loans with funds (money) that are created by the Fed itself. To buy a billion dollars worth of assets, the Fed doesn't show up with new cash in a wheelbarrow. Instead the Fed pays for any assets it purchases or loans it extends by crediting the funds that the recipient bank has in an account with the Fed, known as reserve deposits. A bank can later withdraw those deposits in the form of green currency, if it chooses, and that's the point at which an armored truck from the Fed would be involved with physical delivery of cash.

The monetary base is essentially the sum of (1) the currency that's been withdrawn from private banks and is being held by the public, (2) the currency that's sitting in the vaults of private banks that could potentially be withdrawn by the banks' customers if they wanted, and (3) banks' reserve deposits, which you could think of as electronic credits for currency that the banks could ask for from the Fed any time the banks choose. Historically, newly created reserve deposits have usually shown up pretty quickly as currency withdrawn by banks and then by the public. Choosing a pace at which to allow that supply of currency to grow so as to accommodate the increased currency demands from a growing economy without cultivating excessive inflation is one of the main responsibilities of the Fed.

Figure 2 below plots the assorted "factors absorbing reserve funds" from the Fed's H41 release during the halcyon period from 2003 to the middle of 2007. At that time, currency held by the public was by far the biggest component in the liabilities side of the Fed's balance sheet, with the currency supply increasing 20% over these 5 years and with temporary seasonal bumps to accommodate the annual Christmas surge in currency demand. Reserve deposits (the sum of the "reserves" and "service" components in Figure 2) were quite minor relative to total quantity of currency in circulation.
[Remember, 70% of currency in circulation is held overseas.]


Figure 2. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 7, 2003 to June 27, 2007. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

With this increase in newly created money, the Fed was over this period acquiring assets primarily in the form of short-term Treasury securities, which holdings grew 25% over this 5-year period. The Fed at that time used short-term repurchase agreements as a device for adjusting the supply of reserves on a temporary basis. Note that for each date the height of the components in Figure 3 below (essentially the asset side of the Fed's balance sheet) is exactly equal, by definition, to the height of the liabilities portrayed in the previous Figure 2.


Figure 3. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 7, 2003 to June 27, 2007. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.


Beginning in September 2007, the Fed began a process of systematically changing the nature of its asset holdings
[Key point]. Over the course of the next year, the Fed sold off over $300 billion in Treasury securities (about 40% of its holdings of Treasury securities), and replaced them with $150 billion in direct bank lending in the form of term auction credit, $60 billion in loans to foreign central banks in the form of liquidity swaps, and $100 billion in repurchase agreements, used now not for temporary adjustments but instead as a device to create a market for MBS by accepting alternative assets as collateral.



Figure 4. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to August 27, 2008. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.


Because the Fed funded those measures through August 2008 by selling off its holdings of Treasuries, there was little effect on either currency in circulation or the monetary base through that time.



Figure 5. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to August 27, 2008. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.


Beginning in September of 2008, the Fed embarked on a huge expansion in its lending efforts and holdings of alternative assets. The biggest items among assets currently held are $469 billion in term auction credit, $328 billion in currency swaps, $241 billion leant through the CPLF, and $236 billion in mortgage-backed securities now held outright.



Figure 6. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.


Where did the Fed get the resources to do all this? In part, it asked the Treasury to borrow on its behalf, represented by the pale yellow region in Figure 7 below, and a sum that last week amounted to a quarter trillion dollars. Note that magnitude is not part of the monetary base drawn in Figure 1. Some of the Fed expansion has shown up as additional currency held by the public, which made a modest contribution to the explosion of the monetary base seen in Figure 1. But by far the biggest factor was a 100-fold increase in excess reserves, the green region in Figure 7. These excess reserves mean that for the most part, banks are just sitting on the newly created reserve deposits, holding these funds idle at the end of each day rather than trying to invest them anywhere.
[Excess reserves are safer than short term treasuries and they pay better too.]



Figure 7. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.


That idleness, as I read the situation, was something the Fed initially actually wanted, and deliberately cultivated by choosing to pay an intere st rate on excess reserves that is equal to what banks could expect to obtain by lending them overnight. As long as banks do just sit on these excess reserves, the Fed has found close to a trillion dollars it can use for the various targeted programs.

But what would happen if those electronic credits start to be redeemed for actual cash? Then we would have a concern, and the Fed would need to call the reserves back in by selling assets or failing to renew loans. But that presents a potential problem, as noted by Charles Plosser, President of the Federal Reserve Bank of Philadelphia:

It is true that a number of the Fed's new programs will unwind naturally and fairly quickly as they are terminated because they involve primarily short-term assets. Yet we must anticipate that special interests and political pressures may make it harder to terminate these programs in a timely manner, thus making it difficult
[impossible] to shrink our balance sheet when the time comes. Moreover, some of these programs involve longer-term assets--like the agency MBS. Such assets may prove difficult to sell for an extended period of time if markets are viewed as "fragile" or specific interest groups are strongly opposed, which could prove very damaging to our longer-term objective of price stability.

Last Monday's joint statement by the Treasury and the Fed indicated that the plan is for the worst of the Fed's assets (reported as "Maiden Lane" and part of the "AIG" sums in Figure 4) to be taken over by the Treasury, and Plosser for one wants the Treasury to take all the non-Treasury assets off the Fed's balance sheet. But as the Fed has declared its intention to raise its MBS holdings to $1.25 trillion it seems the current plan calls for more, not less of non-Treasury assets. And the following clause in the joint Fed-Treasury statement suggests that perhaps the Fed intends this, like most of the previous balance sheet changes, to not be allowed to impact total currency in circulation:

the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves.

John Jansen (hat tip: Tim Duy) construes that clause to mean that the Fed is going to request the ability to borrow directly as well as for exemption of any borrowing done by the Treasury on behalf of the Fed from the congressional debt ceiling. Also via Tim, FRB San Francisco President Janet Yellen offers this elaboration:

As the economy recovers, the Fed will eventually have to reduce the quantity of excess reserves. To some extent, this will occur naturally as markets heal and some programs consequently shrink. It can also be accomplished, in part, through outright asset sales. And finally, several exit strategies may be available that would allow the Fed to tighten monetary policy even as it maintains a large balance sheet to support credit markets. Indeed, the joint Treasury-Fed statement indicated that legislation will be sought to provide such tools. One possibility is that Congress could give the Fed the authority to issue interest-bearing debt in addition to currency and bank reserves
[This is what China is doing to sterilize its currency interventions]. Issuing such debt would reduce the volume of reserves in the financial system and push up the funds rate without shrinking the total size of our balance sheet.

In other words, if the Fed decides that, as a result of inflationary pressures, it needs to undo some of the expansion in its liabilities at a time when it is not prepared to unwind its asset positions, Plan B is for the Fed to borrow directly from the public.

Which brings me back to the original question. Does the explosive growth of the monetary base in Figure 1 imply uncontrollable inflationary pressures? My answer: not yet, but stay tuned.
[Yes it does.]

My reaction: Good explanation of money creation and the Fed. I have been meaning to post this for while and only got around to it now.


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5 Responses to Money Creation And The Fed

  1. Hugo says:

    The strategy of having the FED issuing bonds is a good idea (from a thief point of view).

    The FED allways wants some inflation, but not extremely high inflation, because then the peasants would protest. If the robbery is made slowly then it goes unnoticed. And that has allways been the FED objetive.

    By selling bonds the FED dealys the effect of inflation, wich is exactly what they want to do.

    But this would just make the ponzi US economy even more ponzi. Its just buying time.

  2. Dread says:

    Eric, have you viewed Money as Debt? For the ~50 minute presentation, nothing to date matches the simplicity of explaining the FED, and central/fractional-reserve banking, with exception of The Money Masters (which is a three hour series)

    Not sure if you have caught this yet, concerning China, gold and the IMF. Glenn Beck explains this quite well for the layman, and the fact that we have already lost this in a "war game" scenario should raise many an eyebrow or two.

    Finally, it may be high time, to brush up on the little French that one might know, and especially their Boétie

  3. Anonymous says:

    Hi...thank you for all your good research. With the excessive supply of money from the FED, which will spark inflation and hyperinflation, it would seem that when this inflation occurs that hte FED will try to remove some of the money from circulation. What methods or options do they have at their disposal to accomplish this feat, and how effective will they be? I'm thinking that this would provide an understanding of how long the inflationary period may be.

  4. Mark says:

    @fooser77: regarding the "Money as Debt", let us consider a tax-by-inflation scheme for a moment: at a first glance it seems like great solution, maybe even to solve the cold progression problem (inflation stealth tax). But giving it a second thought, I'm not sure how that would play out in practice. For example: wouldn't one try to avoid holding such money? Wouldn't in the end the state be forced to enforce the use of such a currency? I would hold and trade gold currency if the state collects taxes by devaluing its own currency... as cool as it seems at first sight, would it be a fair taxation? What real-world implcations would it have? Simple solutions often sound great, but almost always fail to deliver when put to work.

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