Posts Tagged ‘Fed’

They told us that they told them to lend

April 1, 2009

James Hamilton in a brilliant post discusses the recent expansion of the monetary base.

As it stands, the Fed has bought an array of securities from the banks, of a varying degree of toxicity. They did not go to the bank headquarters with a truckload of money, they, sort of, wrote a check or an IOU.

Every bank is required to keep some reserves with the central bank. In that way they force banks to keep some of their assets in cash form, thereby reducing the risk of banks over-leveraging themselves (or at least that was the principle). In order to buy these dodgy assets, the Fed did not actually pay for them, they just extended the reserves of the corresponding banks, without the banks putting any money themselves.

To make things more concrete, say that Pitibank is required to keep USD50 with the Fed as reserve. Also, say that the Fed decided to buy from them a bunch of mortgages (of face value USD300), but which they agree to buy at USD200. These are “toxic” because if the bank sold them in the market, then at the moment they cannot find a buyer that will pay more than USD30.

The Fed gets these mortgages from Pitibank, and instead of paying in cash, they just increase Pitibank’s reserve to USD250. It is essentially the same thing, since Pitibank can draw from these reserves if they want to (down to the requirement of USD50). The Fed will then essentially “print” money to give Pitibank when asked.

What politicians are telling us, is that they want banks to start lending again. This essentially means that they want Pitibank to ask for these reserves and lend the money to individuals, small businesses and each other.

But banks don’t appear to be doing that. They prefer to let the money in their reserves with the Fed. Why do they do that? Are they keeping good money idle? Well not really, because the Fed has decided to actually pay interest on these reserves. This increases the opportunity cost of lending the money to you and me, and acts as a dis-incentive for Pitibank.

Does that make sense? Well, no matter what the politicians are saying, central banks are having nightmares of all that money reaching the consumers and sparking inflation. As J Hamilton points out, doubling the monetary base will eventually translate into 100% inflation: all prices will double.

It seems to me that with that interest rate on the reserves, the Fed is trying to control how fast this huge amount of money reaches the real economy. And they don’t seem to be very keen for this to happen.