Fed's Interest on Reserves and Inflationary Spirals

Discussion in 'Economics' started by Daal, Feb 17, 2010.

  1. Daal

    Daal

    I fail to see how raising the IOR will prevent the money supply from rising creating a inflationary spiral. Lets say they hike from 0.25 to 1%, lending interest rates should rise by a similar amount(why wouldn't they), maintaining the spread, thus the banks will be exposed to the same amount of profit potential before or after the hike. UST bill yields will also rise, creating the possibility that banks would switch from deposits at the fed to USTs, likely increasing M2 in the process

    This tatic will only work if the spread contracts for whatever reason, that is if lending rates do not adjust
     
  2. I don't understand... Are you suggesting that the absolute level of rates in the economy doesn't matter, daal? Specifically, suppose FF effective is still 10-15bps below the IOR rate, when the latter is hiked to 1%. Would tightening not occur as a result of FF effective going to 90bps? Or you don't think that this tightening will exert downward pressure on inflation?
     
  3. Daal

    Daal

    I suppose it will have an impact as it changes the levels of real interest rates making it hard to borrow. However how does the Fed knows a higher level of real interest rates will have a stronger impact than reverse repos or asset sales(as Bernanke seems to suggest when he says IOR is the main tool)?
     
  4. Daal

    Daal

    Also I routinely hear that the reason they will hike the IOR is to encourage banks to 'sit on their reserves', but as I argue that will only happen if the spread doesnt adjust

    If inflation is indeed set to fall this year, the people calling for a rate hike this year are essentially saying that the FOMC does not want to see net credit growth this year(which seems pretty crazy in the middle of a credit crunch), thats what would likely happen if the real rate went up. The reverse repos in the other I can see it happening this year
     
  5. The real reason the fed needs interest on reserves as a tool, is because they have lost control of the federal funds rate. Does anyone remember in the fall of 08, the fed couldn't control the fed funds rate due to the huge demand for cash. The rate was all over the place, spiking up, and dropping erratically. Now, with quantitative easing in place, the fed has 2 trillion on the balance sheet. Imagine trying to control the fed funds rate with that level of liquidity sloshing around. The interest on reserves tool is now their new fed funds rate. It will allow the fed to effectively create a peg to the ff rate. Otherwise, they are up shit creek without a paddle if they try to control the fed funds rate without selling massive amounts of assets, creating deflation.
     
  6. I don't think it's the question of the tightening impact, to be honest. It's just a matter of which is the lesser evil and what is likely to work. They definitely would want to avoid asset sales, if at all possible, for fear of killing the housing mkt. For repos, it's a matter of making sure that the mkt plays ball, which ain't necessarily going to happen. Raising IOR could be the easiest thing to do, in their view.
     
  7. Daal

    Daal

    Maybe IOR, repos, Fed CDs, SFP are all the same thing. They all seem to attempt to lock monetary base in exchange for financial compensation to the private sector in the form of interest payments
     
  8. Yep, as long as they drain cash from the system, it's all the same in the end... However, there all sorts of questions about the side effects.
     
  9. All are attempts at Central Planning and all will fail in one way or another. The trader just has to figure out how, when, and where.
     
  10. Daal

    Daal

    Almost all societies in history had activities centrally planned, such as the military, the police, justice, etc
    Who is to say that allowing the money supply to fluctuate according to the demand and supply for gold in jewlery and teeth is better than a independent central bank with an inflation target?
    The evidence presented by Bernanke in his book makes a quite compelling case that the money supply should not be in the hand of market forces but it should be with the state even if that brings occasional inflationary periods. I'd take the 70's over the 30's anyday
     
    #10     Feb 17, 2010