Fed's Interest on Reserves and Inflationary Spirals

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

  1. wave

    wave

    Everything feeds off interest rates. The government will try to keep them low for as long as they can. However, the mother of all unintentional consequences will pop up when private and government pensions start having cash flow problems due to the 0.5% yield they are getting from treasuries. That will put a hurting on many companies and citizens.
     
    #11     Feb 17, 2010
  2. It is an interesting point you make that Fed funds an IOR are essentially pegged to each other. Any banker who has to make choice to lend to the Fed vs. the Fed Funds market will take a higher IOR rate versus a lower Fed funds rate. The bank Fed funds bid will disappear if Fed pays higher IOR than Fed funds.


    Which means that if the Fed were to lend at different rates on Fed Funds (lets say .25%) and 1.25% with IOR, it would have to actually print more money to keep a gap going (since no banker in their right mind would take .25% over 1.25%). This would keep an arb opportunity going where the bank can borrow from the Fed funds market (discount window in disguise) at .25% and lend it back to the Fed at 1.25%. Doubt they'll let that happen, simply because it actually ramps -up- money supply. Let's pick an absurdly wide tightening: 8% interest on reserves against 1% fed funds. No bank will bid at less than 8% on fed funds when it can loan to the Fed at 8%. So then Fed will have to fill the gap and provide an unlimited bid for the Fed funds market to accomodate an enormous risk free arb demand. To me, this looks more like an underhanded way to recapitalize banks.

    And no way the Fed raises short term rates to 8% amid this type of job market. Remember also, that if they raise rates like this, they are effectively increasing the duration of their 1T+ agency MBS portfolio to 20+ yrs. Essentially helping with self-reinforcing inflation expectations (now that the money supply will be permanent).

    The more I think about it, the Fed may not have as much control over this as they are expecting. A dump of agency MBS and/or a one time inflationary move may be just what comes out of this (likely the latter).

    Conclusions:

    1) IOR and Fed Funds rate are two rates that must implicitly remain relatively the same, otherwise an arb opportunity will be created that increases money supply and recapitalizes banks.

    2) Because of this, any large increase in IOR (to ratchet down the money multiplier) will force Fed funds up (OR go back to #1, and result in MORE money printing and liquidity) an equal amount. That increases the permanence of the 1T+ agency MBS portfolio (as people will not prepay as early and have no incentive to refinance), as the investor required rate of return on this portfolio will also rise.

    3) (disclaimer: not a banker, so correct me if I'm wrong about this:) How will reverse repos be possible far away from market interest rates? If done en masse, it may send a signal to banks to raise the rates they are willing to take for lending cash. Extreme example, a banker lending its cash overnight will not take .25% or 1% if it knows the Fed might come in and pay 4% (or some other rate) on that money. I imagine reverse repo and fed funds (and thus IOR) are intrinsically tied together, and any large deviation or expectation in either will result in an arb (which ends up again having unexpected expectations of increased money supply, as Fed funds may stay fixed). ie, expectations of the substantial Fed involvement in the reverse repo market will likely drive the the rate further from Fed funds rate, maybe even making it illiquid and an unattractive source of funds (ie, why would a bank borrow at 3% on the reverse repo when it can borrow from other sources for less $$$? I imagine it would put pressure on Fed funds to rise and/or force the Fed to print more $$$ to keep it pegged. Now I am not taking into account collateral restrictions and Fed funds borrowing limitations, so perhaps someone more familiar with this can correct me or introduce more reality into my points.)
     
    #12     Feb 17, 2010
  3. zdreg

    zdreg

    you don't have the luxury of choice.
    volcker put a stop to the 70's inflation. also inflationary periods are associated with high unemployment and low levels of capital formation.there is no such thing as a central bank with a successful inflationary target. they are subject to political forces. you end up with maybe short term gain and guaranteed little long term growth. in addition you destroy the middle class.
     
    #13     Feb 17, 2010
  4. Daal

    Daal

    I believe this might be right, the reverse repos would be essentially a deposit facility where banks will park their short-term money, draining those reserves should put upward pressure on short-term rates, including the t-bills as they seem like competing products
    So it might be all the same in end, there might be some differences in the settlements of eurodollar and fed futures contracts between the different types of exits and thats where my interest is on
     
    #14     Feb 17, 2010
  5. Daal

    Daal

    So does the gold standard, devaluation and going off gold are two tatics that were routinely used by govermnents. At the end of the day if the goverment wants to mess things up they can always do, regardless if they print the money themselves or if the supply is set by the needs of dentistry
     
    #15     Feb 17, 2010
  6. zdreg

    zdreg

    what do the needs of dentistry for gold or silver have to do with the topic?
     
    #16     Feb 17, 2010
  7. I should add 4th conclusion:

    4) Since reverse repo, IOR, and 'Fed CDs' have a similiar effect to outright Fed funds movement, the Fed only has 3 options:

    a. Sell MBS. (crater the mortgage market?)
    b. Raise Rates / Suck the Money up.
    c. Let inflation run its course and then clean up the mess to manage forward expectations.

    This is going to be a giant poker game with huge stakes. Since GDP recovery depends on labor market recovery and a solid housing market, I'll bet on c. See you at $5000 gold.

    a and b are profoundly deflationary as well as horrible for government budgets / GDP prospects as well as the labor market. It is so hard to bet on a and b when Fed policy includes employment targets and politicians have angry voters to satisfy.
     
    #17     Feb 17, 2010
  8. In a gold standard, money supply is dictated by gold supply/demand fundamentals, not merely central bank interest rate policy. So if there is a shortage of flouride in the water, there is less gold on the market and thus less money supply (deflation).
     
    #18     Feb 17, 2010
  9. Daal

    Daal

    #19     Feb 17, 2010
  10. Didn't we have stable prices throughout the 19th century, without central banks ? There were also periods of deflation I believe and worse than the Great Depression , but not in terms of social impact, meanwhile prices remained affordable for everybody. It's striking that the worst economic decline took place under the Fed watch. IMO inflation is way worse than economic declines, people who have saved and have no debt can manage during recessions, of course the overleveraged and profligates take the plunge.
     
    #20     Feb 17, 2010