Fed Offers New CD; Chairman Bernanke is still confused

By L. Randall Wray

As reported in the NYT yesterday, the Fed has decided to offer banks an interest-paying CD. So far, so good. However, the argument offered by the Fed to justify this “innovation” is that it needs to start mopping up reserves in order to prevent inflation:

The Federal Reserve on Monday proposed allowing banks to park their reserves at the central bank, a move aimed at weaning the economy off extraordinary infusions of cash and curbing inflation. The Fed would create the equivalent of a certificate of deposit that pays interest to banks for keeping some of their reserves — which are currently estimated at more than $1 trillion — for up to one year. That would help offset some of the $2.2 trillion the central bank has fanned out into the economy during the financial crisis. It also would allow the Fed to quickly entice banks to take more money out of circulation in case inflation emerged as a serious threat in the near future. The proposal was the latest sign the Fed is intensifying its efforts to scale back the vast amounts of money it pumped into the economy at the height of the crisis.

This blog has published a number of pieces explaining why there is no need to worry about the trillions of dollars of reserves and cash created by the Fed to deal with the run to liquidity set-off by this crisis (see here and here). As and when banks decide they do not want to hold reserves, they will retire their loans at the discount window and will begin to purchase higher-earning assets. As this pushes up asset prices (reducing interest rates), the Fed will begin to unwind its balance sheet—selling the assets it purchased during the crisis. Retiring discount window loans plus purchases of assets from the Fed will eliminate undesired reserve holdings. It is all automatic and nothing to worry about or to plan for. And it will not set off a round of inflation. The old “money multiplier” view according to which excess reserves cause banks to lend, which induces spending, which causes inflation, was abandoned by all serious monetary theorists long ago. Chairman Bernanke ought to abandon it, too.

However, there is nothing wrong with offering longer-maturity CDs to replace overnight reserve deposits held by banks at the Fed. Banks are content to hold deposits at the Fed—safe assets that earn a little interest. They are hoping to play the yield curve to get some positive earnings in order to rebuild capital. If they can issue liabilities at an even lower interest rate so that earnings on deposits at the Fed cover interest and other costs of financing their positions in assets, this strategy might work. That is what they did in the early 1990s, allowing banks that were insolvent to work their way back to profitability. The Fed could even lend to banks at 25 basis points (0.25% interest) so that they could buy the CDs, then pay them, say, 100 or 200 basis points (1% or 2% interest) on their longer maturity CDs. The net interest earned could tide them over until it becomes appropriate for them to resume lending to households and firms.

Finally, note that these new CDs are equivalent to Treasuries: government debt that pays interest. However, no one has castigated the Fed for proposing to bankrupt our grandchildren by running up debt. Apparently, this is because economists and policymakers recognize that the Fed is just substituting one kind of liability (reserves) for another kind of liability (CDs). But that is exactly what a sale of a Treasury bond does: it substitutes one government liability (Fed reserves) for another government liability (Treasury bonds). Operationally, it all amounts to the same thing. Once this is recognized, the Treasury can stop issuing debt, we can all stop worrying about our grandchildren, and our nation can get on with ramping up fiscal policy to get out of this economic crisis.

7 responses to “Fed Offers New CD; Chairman Bernanke is still confused

  1. 1. What do you mean when you say "one government liability (Fed reserves)"?Why are the reserves of the Fed a government liability – just because they are $USD, like the shadow-banking $Trillions?Is the Fed part of the government?2. If the Treasury can stop issuing debt(bonds), because they have the sovereign right to issue money, it seems we could eliminate the national debt and there would be no 'Treasuries' as debt.If there yet there remains a 'fractional-reserve-system' at the central bank, then what becomes the foundation for the money supply?Is this covered somewhere?

  2. Yes, Fed is a "creature of congress", a part of the government. It is able to create govt liabilities (reserve deposits as well as the green paper money we use). Private "money" IOUs leverage govt liabilities; bank checkable deposits for example are convertible to govt currency (Fed liabilities or Treasury liabilities) on demand. That remains whether or not govt decides to stop issuing ONE type of liability. LRWray

  3. Isn't this called "concealed greenbacking"? Does this presume that there is a "free lunch"?

  4. Term-Deposits have several advantages over the current volume of IORs (Dec 16, $1,089,691 trillion) held by the member banks (or the interest paid on their excess reserve balances).The FOMC can calculate and sell whatever volumes, durations, rates of interest, at whatever auction times, or to individual banks (small, medium, & large), & whatever other explicit covenants, it wants to target. I.e., the FED can use a systematic, measured technique, to unwind IORs.I.e., Term-Deposits will give the "trading desk" all the flexibility it requires to keep the member bank's required reserves, and the banking system's excess reserve balances, at the FOMC's desired level, and at the proper non-inflationary path. (i.e., the money supply can never be managed by any attempt to control the cost of credit).Member banks should initially have the option to convert, or substitute, some proportion of their IORs, currently held at their District Banks, into Term-Deposits. A conversion privilege would smooth the transitioning and unpredictable, and vacillating, demand of competing IORs.Delimiting the volumes should be confined to a percentage of bank capital adequacy ratios (up to 100%), or some percentage of the current volume of IORs now held. The idea is that the provision should not retard the growth of new money and bank credit (as IORs, which caused disintermediation among the non-banks, and shifts in member bank earning assets, essentially retiring commercial-bank owned investments, or acted as decidedly deflationary forces, have done). IORs compete with other short-term, money market instruments, & yields.Term-Deposits should be eligible collateral for both Securities Lending & the TSLF (which have a non-reserve impact), to assist the Treasury in government market support operations???Term-Deposits have more advanced monetary management characteristics as compared to IORs, which in the long-run, Term-Deposits will replace. The ECB has always been one step ahead of the FED. Term-Deposits act exactly like raising reserve ratios (a credit control device, by raising the volume of outstanding legal reserves), as a measure to drain legal reserves, as opposed to the unpredictable, and surging, demand for IORs. Fixed volumes, for fixed maturities (no early withdrawal privileges), will make Term-Deposits, less volatile, and more predictable. It makes it easier for reverse repurchase agreement transactions (& other tools), to complement and balance Term-Deposit purchases, rollover, & runoff.

  5. Hi Flow:Yes free lunches abound when there are unemployed resources. Sovereign govt can put them to work.Req'd reserve ratios don't constrain anything, but act as taxes on banks. If that reduces lending, it is very indirect.

  6. Au Contraire, Anonymous: Legal reserves are costless to the commercial banking system. While today the member banks are unencumbered in their lending operations, prior to removing reserve ratios as a credit control device, an expansion coefficient did exist (and monetarism has never been tried, esp. considering Paul Volcker foul-ups).A brief “run down” will indicate just how costless, indeed how profitable – to the participants, is the creation of new money. If the Fed puts through buy orders in the open market, the Federal Reserve Banks acquire earning assets by creating new inter-bank demand deposits. The U.S. Treasury recaptures about 97% of the net income from these assets. The commercial banks acquire “free” legal reserves, yet the bankers complain that they are not earning any interest on their balances in the Federal Reserve Banks.On the basis of these newly acquired free reserves, the commercial banks can, and do, create a multiple volume of credit and money. And, through this money, they acquire a concomitant volume of additional earnings assets. How much is this multiple expansion of money, credit, and bank earning assets? Thanks to fractional reserve banking (an essential characteristic of commercial banking) for every dollar of legal reserves pumped into the member banks by the Fed, the banking system can, and does, acquire about 208 dollars in earning assets through credit creation (this is now outdated). But to label bank reserves as a tax is strikingly wrong.

  7. This nonsense where the banks make loans and later acquire reserves from the FED to satisy their reserve requirements is an operational error. Most of the inflation since 1964 was due to an irresponsible easy monetary policy. Since 1964, the operation of the trading desk has been dictated by the federal funds “bracket racket or its equivalent, pegged rates”. This has assured the bankers that no matter what lines of credit they extend, they can always honor them since the Fed assures the banks access to costless legal reserves whenever the banks need to cover their expanding loans – deposits. Our monetary mismanagement has been the assumption that the money supply can be managed through interest rates. We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about The effect of tying open market policy to a fed Funds rate is to supply additional (and excessive free gratis legal reserves) to the banking system when loan demand increases.Since the member banks have no excess reserves of significance, the banks had to acquire additional, free, legal reserves to support the expansion of deposits resulting from their loan expansion. That's not the way a responsible monetary authority acts.