How the modern financial system works, the mechanics of the central bank's balance sheet and how the Fed turned from being profitable to unprofitable to being broke
Spectacular! Question for you- IYO why cant the Feds just use reverse repo and control for new loan growth vs controlling front facing rates and hurt Americans who already own mortgages?
You have brought about a very thoughtful point. I would need to look into it and I will get back to you soon. Stay tuned and thanks for your continued support
Hi Sully, I apologize for the delay in getting back to you. You had raised a fantastic question. So, as per my understanding, technically the Fed can use Quantitative Tightening to sell off their bonds, draining bank reserves and therefore liquidity from the system. This can happen in a 0% interest rate environment. What this should ideally do is steepen the yield curve, which naturally tightens the economy. This will impact mortgage rates at the same time. In my opinion, this should have been the first action that the Fed should have taken in 2021. But they were living in the "inflation is transitory" narrative. Also, the Fed generally performs QT first, before raising rates, so as to reduce/eliminate interest rate risk on their asset durations.
In this cycle, it is different. The Fed is doing QT and raising rates at the same time. Of course, that has created the negative operating income (that I have addressed in this post). In my opinion, the magnitude and force with which inflation showed up, forced aggressive action on the Fed's part. Also, now their credibility was on the line. So, they are doing both, which is severely tightening bank lending and starting to squeeze consumers. With mortgages, people who have fixed rate mortgage are not affected in this, but you can see that people who already owned homes from before, are not selling. Existing home market has come into a gridlock. It is the new home buyers who are affected by the rising mortgage rates, and we can see that mortgage applications are falling fast. Ultimately, the Fed "kind of" has dug its own grave this time. They should have started QT in 2021, but they were complacent. Now, they are doing QT and rate hikes, thus severely contracting bank lending and operating in net income (when bank lending was not the culprit of inflation this time). At this point, if the Fed even backs off from rate hikes with effective communication and continues with QT, the market is not likely to believe and there might be speculative attack on the dollar, which would again be inflationary. Please let me know if this helped. Happy to answer any other questions you may have.
Hi Amrita. I find this topic fascinating. How do you think the Fed policy and the whole financial system are affected by the elimination of reserve requirements (effective March 26, 2020)?
"Effective for the reserve maintenance period beginning March 26, 2020, the 10 percent required reserve ratio against net transaction deposits above the low reserve tranche level was reduced to 0 percent, the 3 percent required reserve ratio against net transaction deposits in the low reserve tranche was reduced to 0 percent. The action reduced required reserves by an estimated $200 billion."
Hi Gianni, thanks for reading my post and posting a very insightful question. To answer your question on how reduction or elimination of reserve requirements affect the Fed and the financial system, this is my take: Commercial banks are required by law (after GFC 2008) to park their reserves at the Fed, where the reserves earn an interest overnight, set at the Fed funds rate. When interest rates are low, reserves earn lower interest, when interest are high (such as low), reserves earn a lot more interest. Now, during the pandemic, along with the Fed setting interest rates at 0%, they also lowered the reserve ratio (which is the ratio of how much capital the bank needs to have in reserves vs. the loan amount). This essentially means commercial banks are incentivized to create a higher number of loans, i.e. increase lending. And lending is a direct way to create real economy money. At 0% interest rates and reserve ratio lowered, banks and people are encouraged to start lending and borrowing, turning the economic flywheel around. This process is designed to drive growth and healthy inflation. Of course, during the 1970s, bank lending had spiked to such a degree that it led to a spiralling of inflation. Unfortunately, during this episode, we did not see a sizable increase in bank lending, as people had received checks (also real economy money) from the government and borrowing did not go up. While inflation certainly ballooned, driven by the fiscal stimulus, bank lending did not contribute as much. Hope this answers your question? Let me know if you have any further questions.
I was not very familiar with his work, but I quickly read through a couple of his blog posts on Creditism. I would fully align with his stance that creditism, while it can cause inflation, has also driven growth and reduced poverty. And a reversal of credit can be disastrous. That is exactly what we are seeing in the US, however, which is in a late stage debt cycle, is that inflation is being driven not by credit, but by government spending (which creates real economy money). Obviously, government spending is not projected to go down, in fact the deficit is expected to double as per projection. While this can work in a low rate environment, in a high inflation, high rate environment, this further widens deficit as interest payments balloon. And to quell inflation, the Fed chooses to raise rates which just destroys credit. Not the best tool, but the Fed hasn't much of a choice either.
Spectacular! Question for you- IYO why cant the Feds just use reverse repo and control for new loan growth vs controlling front facing rates and hurt Americans who already own mortgages?
You have brought about a very thoughtful point. I would need to look into it and I will get back to you soon. Stay tuned and thanks for your continued support
Hi Sully, I apologize for the delay in getting back to you. You had raised a fantastic question. So, as per my understanding, technically the Fed can use Quantitative Tightening to sell off their bonds, draining bank reserves and therefore liquidity from the system. This can happen in a 0% interest rate environment. What this should ideally do is steepen the yield curve, which naturally tightens the economy. This will impact mortgage rates at the same time. In my opinion, this should have been the first action that the Fed should have taken in 2021. But they were living in the "inflation is transitory" narrative. Also, the Fed generally performs QT first, before raising rates, so as to reduce/eliminate interest rate risk on their asset durations.
In this cycle, it is different. The Fed is doing QT and raising rates at the same time. Of course, that has created the negative operating income (that I have addressed in this post). In my opinion, the magnitude and force with which inflation showed up, forced aggressive action on the Fed's part. Also, now their credibility was on the line. So, they are doing both, which is severely tightening bank lending and starting to squeeze consumers. With mortgages, people who have fixed rate mortgage are not affected in this, but you can see that people who already owned homes from before, are not selling. Existing home market has come into a gridlock. It is the new home buyers who are affected by the rising mortgage rates, and we can see that mortgage applications are falling fast. Ultimately, the Fed "kind of" has dug its own grave this time. They should have started QT in 2021, but they were complacent. Now, they are doing QT and rate hikes, thus severely contracting bank lending and operating in net income (when bank lending was not the culprit of inflation this time). At this point, if the Fed even backs off from rate hikes with effective communication and continues with QT, the market is not likely to believe and there might be speculative attack on the dollar, which would again be inflationary. Please let me know if this helped. Happy to answer any other questions you may have.
Ah! Yes! QT still moves in the shadows of the financial world unseen while we all are focused on interest rates. Thanks you, Amrita!
Yes, what goes up, comes back down faster.
A brilliant and enlightening analysis, Amrita.
Really appreciate your feedback. Stay tuned for Part 2.
Hi Amrita. I find this topic fascinating. How do you think the Fed policy and the whole financial system are affected by the elimination of reserve requirements (effective March 26, 2020)?
"Effective for the reserve maintenance period beginning March 26, 2020, the 10 percent required reserve ratio against net transaction deposits above the low reserve tranche level was reduced to 0 percent, the 3 percent required reserve ratio against net transaction deposits in the low reserve tranche was reduced to 0 percent. The action reduced required reserves by an estimated $200 billion."
Thank you very much for your insights
Hi Gianni, thanks for reading my post and posting a very insightful question. To answer your question on how reduction or elimination of reserve requirements affect the Fed and the financial system, this is my take: Commercial banks are required by law (after GFC 2008) to park their reserves at the Fed, where the reserves earn an interest overnight, set at the Fed funds rate. When interest rates are low, reserves earn lower interest, when interest are high (such as low), reserves earn a lot more interest. Now, during the pandemic, along with the Fed setting interest rates at 0%, they also lowered the reserve ratio (which is the ratio of how much capital the bank needs to have in reserves vs. the loan amount). This essentially means commercial banks are incentivized to create a higher number of loans, i.e. increase lending. And lending is a direct way to create real economy money. At 0% interest rates and reserve ratio lowered, banks and people are encouraged to start lending and borrowing, turning the economic flywheel around. This process is designed to drive growth and healthy inflation. Of course, during the 1970s, bank lending had spiked to such a degree that it led to a spiralling of inflation. Unfortunately, during this episode, we did not see a sizable increase in bank lending, as people had received checks (also real economy money) from the government and borrowing did not go up. While inflation certainly ballooned, driven by the fiscal stimulus, bank lending did not contribute as much. Hope this answers your question? Let me know if you have any further questions.
Thanks a lot for your reply.
Regarding the topics of these 2 posts, I have read much of Richard Duncan’s work and what he defines as creditism.
I was not very familiar with his work, but I quickly read through a couple of his blog posts on Creditism. I would fully align with his stance that creditism, while it can cause inflation, has also driven growth and reduced poverty. And a reversal of credit can be disastrous. That is exactly what we are seeing in the US, however, which is in a late stage debt cycle, is that inflation is being driven not by credit, but by government spending (which creates real economy money). Obviously, government spending is not projected to go down, in fact the deficit is expected to double as per projection. While this can work in a low rate environment, in a high inflation, high rate environment, this further widens deficit as interest payments balloon. And to quell inflation, the Fed chooses to raise rates which just destroys credit. Not the best tool, but the Fed hasn't much of a choice either.
https://www.cbo.gov/publication/58946
Very nicely explained.
Thanks Drew for your feedback!!