Fed capitulates: the central bank is broken

Financial Times

For it appears that the US Federal Reserve has given up on the idea of easing stress on interbank and wholesale lending and is resigned to being the central bank-come-market-maker of last, first and every resort.

For some time now there’s been a debate about the direction of the Fed’s policy. Would we see target rates come down further? Quantitative easing? Massive T-Bill issuance in the open market?

From the Fed yesterday:
The Federal Reserve Board on Wednesday announced that it will alter the formulas used to determine the interest rates paid to depository institutions on required reserve balances and excess reserve balances.

What is the Fed doing to the interest rates? Why, it's going to pay banks even MORE interest to hoard their stockpile of money! See, banks are required to keep a certain amount of "cash" (in electronic form) on reserve to cover their obligations - everything from paying salaries and keeping the lights on to guaranteeing loans they have made.
As of October 6th, these reserves can be lent to the Fed, who pays the bank interest on the amount it borrows.
Banks can keep additional reserves over the required amount lent out to the Fed at interest as well. These are called, fittingly enough, excess reserves.

Originally, banks were paid interest on excess reserves in the form of the Federal Funds Rate (FFR) minus 75 basis points (bp) - or .75% One hundred bp equals 1%.
Just over two weeks later, on October 22nd, the interest rate paid was increased to FFR minus 35bp.
As indicated in the article at the top of this post, on Nov 7 that amount became the straight FFR.

So what is this Federal Funds Rate we're talking about?
It's the rate you hear about on the news when you hear about the Fed "cutting rates."
As of this posting, the current rate is 1.0%. It was lowered on Oct 29th from 1.5%. It was lowered before that from 2% on October 8th.

Look at the timing on those dates compared to the dates of interest paid on excess reserves.

When this initiative started on Oct 6th, banks were paid 2% - .75%, or 1.25%.
That only lasted for a week (10/1-10/8); the FFR was lowered to 1.5%. At the same time, the interest adjustment was reduced as well; banks were then paid 1.5% - .35%, or 1.15%.
With the FFR cut again on 10/29, the interest adjustment was completely eliminated. Banks are now paid whatever the FFR is set at for their excess reserves: currently 1%.

So how much are we talking in excess reserves?
Well, our answer comes thanks to the Financial Times article above, courtesy of Michael Cloherty at Bank of America:

...a normal level of reserves held at the Fed is $7.5bn, where last Wed there was $420bn. With that many excess reserves, funds should trade soft. Now, rather than lend to another bank at a sub-target rate, we should just see banks leave the $ in their account at the Fed. Volumes in the Fed funds market are likely to drop dramatically.

$420 BILLION are held in excess reserves. FIFTY SIX TIMES the normal amount.

Do you like charts? I love charts, and here's a chart that shows how much money is pouring into the Fed's credit line:

Keep in mind that this chart, as of this posting, is current through Oct 1, 2008. You'll need to imagine that the line continues to shoot straight up to the (not yet printed) 420 line.

Yeah.

So what does it all mean?
It's quite simple, actually.
Those excess reserves aren't being used to make non-Fed loans. Why should banks make loans to other banks, to companies, to people when they can get a guaranteed return by loaning the money to the Fed? I mean, it's more likely that Startup Company X will default on a loan than the federal government, right? So why bother lending the money to start new companies, help existing companies grow (or even stay afloat), or help Joe Public get a mortgage?

I know what you're thinking, and you've got a point. Look at all these foreclosures and defaults. All this talk about credit spending. Credit bubble. Credit crunch. The banks SHOULD reign it in, right?
Right. It would have been nice if they'd reigned it in 10 years ago, but they're doing it now. Unfortunately that means people are losing jobs because companies can't get loans, which causes even more foreclosure and default, which means the banks wind up losing even more money....

But where is the money coming from?
IDK, my BFF capital injection??

....wait. Hang on a second.
These banks are getting capital injections from the Treasury. Their excess reserves suddenly start going through the roof (as seen in the above chart). The Fed is suddenly paying interest on excess reserves.

So the banks are getting money from the Treasury and loaning it to the Fed.
Ever hear of check kiting?

Why?
Maybe because the Fed is leveraged 50:1 according to it's most recent balance sheet?
Lehman Bros was leveraged 30:1 mere weeks before it collapsed. A healthy commercial bank has about 10:1 leverage - that is, about $10 owed for every $1 it has in capital.

Food for thought, even if that food is a bowl of lentils.

Thanks for posting this information.

Part of what it demonstrates is that greed and poor business practice have no bounds.

Guess it is time for the average person to be cut out of the dream and possibly living itself.

This is why the Establishment wanted Obama in power.
It gives them an easy target to blame after the looting traitors have finished rooting the economy.

So many people, even on this board, will blindly point their fingers at Obama in their racist belief that the ****** must have done it.

excellent information and well explained, thank you

So as the tax payer money is used to prop big banking institutions backed up by the fed and treasury department they are now monopolizing their hold on the smaller banks and bankrupting them so they can by them from pennies on the dollar.

That is what the fat rats are doing.

Now they are creating a new revolving debt base on deception and the scamming of the American people.

Originally posted by marg6043
So as the tax payer money is used to prop big banking institutions backed up by the fed and treasury department they are now monopolizing their hold on the smaller banks and bankrupting them so they can by them from pennies on the dollar.

That is what the fat rats are doing.

Now they are creating a new revolving debt base on deception and the scamming of the American people.

Well, not quite, marg, at least not by my interpretation.

I think the Fed is overleveraged, possibly near insolvent.
It's money laundering, check kiting...the taxpayers give money to the banks via Treasury bailouts, the banks loan the money to the Federal Reserve in the form of excess reserves, the Fed pays interest to the banks, the banks borrow money from the Fed's discount window at a lower interest rate than they're paid for loaning their excess reserves, meanwhile the Fed is leveraging those loans with the excess reserve deposits it's borrowing from the banks.

Say I have $1000. I'm Goldman Sachs. You, marg, are the Federal Reserve.
I loan you my $1000 with the agreement that you'll pay me 1% interest on that loan. You now have $1000. You pay me $10 in interest.
I come back to you and say "Hey, I need to borrow $1000. We signed this agreement that you'll loan me that money at .35% interest through your discount window. Gimme."
So I "borrow back" the money. I pay you $3.50 in interest when I pay it back.
Repeat cycle over and over.

The same $1000 is being passed back and forth, except I, as the bank, am making $6.50 profit on each thousand dollar cycle due to the disparity in interest rates.

The more the Fed has on their books in excess reserves, the more they can lend out to the same banks via the discount window.

They're not doing it to bankrupt smaller banks; they're doing it to be able to afford all the loans they're making via the discount window.
You are correct, however, in that "they are creating a new revolving debt base on deception and the scamming of the American people."

Who do you think is paying for that $6.50 (or whatever the disparity is on any particular day) in interest the bank is getting?

Until today the credit is still frozen as the big banks are refusing to loan money to small banks, what is Paulson doing when he is investing with bail out money the big banks and global banks that are more solvent?

They are also bailing countries in South America and Asia.

None of the money has gone to buy out the toxic debt caused by the housing defaults.

The entire thing remind me back in the 80s when it was a cash check scam where you will open as many bank accounts as you could open in different banks and then getting check books from all the banks and then you will make checks as many as you could and deposit them from one bank to the other without having the funds to cover them

That was a very popular scam back then until the debt started to pile up and you were all in default and ending in Jail.

Originally posted by marg6043
The entire thing remind me back in the 80s when it was a cash check scam where you will open as many bank accounts as you could open in different banks and then getting check books from all the banks and then you will make checks as many as you could and deposit them from one bank to the other without having the funds to cover them

That was a very popular scam back then until the debt started to pile up and you were all in default and ending in Jail.

That's exactly right, marg - what you've described is the very definition of check kiting, and it IS a crime if you or I were to do it. We'd go to jail for passing bad checks.

Now imagine that same scam but on a $420 billion scale! Only in this case it doesn't look like anyone is going to jail for it.....

*******************************************

I've been kicking this whole thing around in my head for nearly 24 hours now, trying to sort out what sort of effects this could have on the US in the long term.

Kicking aside the obvious issues of the massive bill the taxpayer will have to pick up for a generation or three to come, is this deflationary or inflationary?

When I first began studying these numbers (and others related), I hypothesized that this was severely inflationary in the long term, but mildly inflationary in the short - meaning that we are currently in a deflationary environment due to the money destroyed in the credit implosion, and that all this money was being used to try and hold off that deflation. Since the amount of money is so huge, once this mess passes, the money is likely to freely enter the day to day economy and act in a very inflationary manner.

Now I'm not so sure. I think this is intended to be mildly inflationary for the above reasons, but it's turning out to be even more deflationary as banks hoard the extra cash.

Bear with me here.
We've been operating under fractional reserve banking for a long time.
I discussed FRB in some length in this thread from September - in short, banks all over the world, including here in the US, only keep a small portion of your deposits in reserves. The rest of the money is lent out.

By lending out the money, the banks actually CREATE money that isn't there. This increases exponentially as the money is used. For example, if I deposit $1000 with Bank A, Bank A will (in normal times) be able to create a loan to another party of say $800. That loan for $800 is used to buy a box of Widgets. The company selling the Widgets takes the $800 and deposits it into Bank B. Bank B can then take that $800 deposit and make a loan to someone else of $640. This goes on down the line, each loan creating more money.
The process reverses when the loans are paid back. If the loans aren't paid back, the bank suffers a loss and the money remains in the wild.

Okay, so now that we have that down...what does it have to do with deflation? Why are some Congresscritters so up in arms about the money not being loaned out to "Main Street?"
Because Fractional Reserve Banking isn't happening. All that 'created money' isn't being created at the normal rate. Look at all those excess reserves on the chart up there - those are dollars that have, in the past as evidenced by the chart, been lent out to various entities. Obviously, thanks to capital injections, there is more money involved than there otherwise would be, but we're looking at fifty six times the "normal" amounts being hoarded by the banks.

If the banks aren't lending, people aren't spending. In addition, if banks aren't lending, temporary money creation isn't happening to expand the economy. More money created = inflation. Controlled inflation is the mark of a normal economy.
By removing not just the first-tier money from credit spending but also all the successive tiers of fractional reserve banking, money is being effectively sucked out of the economy faster than anyone can keep up with.

THIS is deflationary, and significantly so.
Not only is it deflationary, but it's sending us towards a deflationary spiral - less money is in the system, so there is less spending, which leads to prices falling, which leads to loss of production, which leads to job loss, which leads to less spending, which leads to prices falling more, which leads to more loss of production, which leads to even more job loss, which leads to less spending some more, which leads to ever lower prices, which leads to further reduced production, which leads to even more job loss, which leads to.....and on it goes.

Think of home prices over the past 8-10 years. They started to grow slowly, then picked up steam, then they were EXPLODING to massive highs, and they kept growing as more and more people speculated in real estate, until....BOOM.
This is the inverse. It started getting crappy pretty slowly, but as more things went wrong it got crappier faster and faster until we are where we are now, with bad news getting worse seemingly by the day.

Is called revolving debt that is what got us in the big problem we are right now and rather than fixing the problem our geniuses behind the fed and the treasury are starting to create another revolving debt, because the first one was actually very profitable before it came crashing.

It is deflationary as long as the tier banks are hoarding this cash. Anachryon, do you think they are planning on releasing it into the wild and if they do, do you think Hyper-Inflation will occur?

Originally posted by Anonymous Avatar
It is deflationary as long as the tier banks are hoarding this cash. Anachryon, do you think they are planning on releasing it into the wild and if they do, do you think Hyper-Inflation will occur?

That's my understanding as well - as long as the banks are hoarding the cash, it's deflationary and very much so. I contend that these capital injections and other "bailout bucks" were intended to combat the deflation that had slowly started, at least in the sense that the deflation would affect the banks. It's up for debate whether the broader deflationary effect on the general public was intended, and if not, if action will be taken to stop it.

Do I think they'll release it into the wild? Eventually, in some form, yes. As long as it's profitable and safe for the banks to make their loans to the Fed, I think it'll stay tied up. Besides, they're making a killing in the interest disparity. It'll stay tied up until something else comes along that may not be as safe, but is tremendously more profitable for the banks. Another housing bubble, dot-com bubble, something like that.
OR it'll stay tied up until the government forces them to lend it out, which I can't see happening because a) there's no requirement in the bailout that they do so and b) if I'm right, this is what's keeping the Fed's balance sheet solvent.

If the money is released in measured amounts, I think that it would actually be an orderly, somewhat "normal" type of inflation. We need inflation to get out of deflation.
If it's a manic sort of release, something like another "bubble," well...no, that wouldn't be ideal. The excess reserves alone are something like 3.5% of our estimated 2008 GDP. That's a huge amount of money. If it were all released in a short amount of time, with the FRB money creation multiplier....well, my mind is having a hard time calculating exactly how much we're talking about. Math time!!

Considering banks are under a zero reserve requirement thanks to the bailout, IN THEORY an infinite amount of FRB money could be created. Let's say that banks are working under a 10% reserve, which would be a smarter thing for banks to do rather than zero reserve (though not as smart as a higher reserve, but I digress)... that would be....
M = 1/.10, so the multiplier would be 10, which means based on the current excess reserves alone, that would be
$420,000,000,000 x 10

Which means that $4.2 trillion could enter the economy via fractional reserve banking loans based just on EXCESS reserves, not counting the normal reserves which are right now about $52 billion.
At 20% reserve, that number is "only" $2.1 trillion.
$4.2T is a whopping 30% of our est. '08 GDP; $2.1T is 15%.

SO! If the money comes in slowly, like over the course of years - yeah, it's a lot of money, but it's not devastating.
If the money were to be released at once, like all at the same time - that's pretty damn hyperinflationary. I might consider it near-catastrophic.
To answer your question, it could lead to high- or hyper-inflation. If the current deflation continues its spiral and the money is released in measured amounts, it could balance out.

That leaves the issue of the Fed's potential solvency, though. When/if those excess reserves leave the Fed....what happens then?

reply to post by anachryon


This is an interesting scenario. That is we know the desired end result. That is a one world currency controlled by current owners of the central banks. However what is not known is how they plan to achieve this? I mean the controlled economic collapse is obvious as is the consolidation of the large banks. I have been waiting to see just how they are going to kill the dollar and sell the world currency to the American citizen.

I suppose I have been expecting to see either hyper-inflation or deflation, but this provides an interesting alternative. The crash of the Federal Reserve? In your mind is this possible to achieving the desired outcome of 'the bankers?'

The Fed creates its own money, they are not borrowing money from anybody. Where would anybody get the ideal that they would need to, that just doesnt even make any sense. The Federal Reserve has nothing to do with the Federal Government and they have long planned out this collapse for the world economy. The government borrows from the Fed and if anything the treasury is paying them for debt owed by the government.





[edit on 9-11-2008 by seek4 truth]

Originally posted by Anonymous Avatar
I suppose I have been expecting to see either hyper-inflation or deflation, but this provides an interesting alternative. The crash of the Federal Reserve? In your mind is this possible to achieving the desired outcome of 'the bankers?'

Assuming there's a concerted effort to rock out with a "One World Bank & Currency" type thing, the only real, effective way to do it would be, in my opinion, the collapse of either the currencies themselves or the central banks that manage said currencies.

Take the Euro. Why hasn't it caught on in more countries? Why hasn't the UK adopted it? Well, there's no real need to. The public didn't want it. The GBP has been strong enough to continue to support the British economy. The UK doesn't have to cede control over its currency to a third party (even if they have a position in said party, they don't have sole control) - why would they want to give it up with what has been a strong currency and a stable-on-the-surface economy? C'mon, you know no one goes into politics to help people. They do it for control. They don't want to control LESS if they don't absolutely have to.

So how else can you get all the major governments of the world (and all the people involved!!) to agree on a single currency and a single central banking entity?
Either the currencies have to go or the central banks have to go.

Again, this is assuming that there's a concerted drive to create a one world bank of some sort. I'm still more inclined to believe that we're looking at a mixture of greed and lack of common sense, though greed is the bigger factor!

reply to post by anachryon


Interesting. Why do you not believe there is a concerted effort? Even with the forums happening on the 15th with the Europeans pushing for a one world currency?

Originally posted by Anonymous Avatar
Interesting. Why do you not believe there is a concerted effort? Even with the forums happening on the 15th with the Europeans pushing for a one world currency?

Well, I said I was "more inclined to believe" that greed is what's driving the issue we're discussing - I didn't say I DISbelieved the One World aspect. I tend to keep many options in mind.

Bretton Woods didn't create a singular currency, and on the surface it appears that the G20 meetings are geared towards something like a new Bretton Woods - even though the IMF is denying it. I will readily admit that I've missed any admissions by Europe pushing for a one world currency. I know Britain was pushing for it during Bretton Woods v1.0 in the form of an anchor currency other than the Dollar. Do you have any links about this?

Originally posted by seek4 truth
The government borrows from the Fed and if anything the treasury is paying them for debt owed by the government.

You might want to do a little reading whilst you seek truth, my friend.

...an unprecedented action.

Originally posted by anachryon
I will readily admit that I've missed any admissions by Europe pushing for a one world currency. I know Britain was pushing for it during Bretton Woods v1.0 in the form of an anchor currency other than the Dollar. Do you have any links about this?

Right here in the Global Meltdown Forum... =)

Here you go

i don't see the demand or will for banks to unload these dollars to induce an inflation into the "real economy". there seems to be tremendous deflationary pressures from deleveraging and these i think the biggest misconception people are still hanging on to is that the "recovery" will be somewhat V shaped, as opposed to an L.

in other words i don't see enough credible borrowers demanding more loans, and i don't see the big banks finding enough credible borrowers to decide "hey i should go out and lend now" since our service sector economy is particularly vulnerable to a reinforcing cycle of lower consumer spending and high unemployment, making the chance for defaulting on loans higher than it has been in awhile.

wage pressures will not support higher inflation, the wall street securitization business (cdo's) model is broken, and mortgage debt issuance has also slowed dramatically. I don't see stimulus check being written for 15,000$ yet so i'm not sure how this inflation is supposed to happen. Most economists seem married to the notion that a reflation is inevitable, either because they are gold bugs, or they believe Ben B and the politicos won't let deflation happen here. I think they both overestimate bernanke's own confidence in being able to recognize and treat severe deflationary pressures minus

1. large scale debt forgiveness (debt jubilee) but that seems unlikely to me

2. and/ or a major revaluation in the currency to monetize debt (make it more serviceable)


also i would like to note the FED chairmen are not ignorant of the past hundred fiat currency's that can be found in the Financial system's graveyard. with this in mind, they are always looking for ways to extend the current fiat's life expectancy, thru implementing ways that they can use to effectively stem the early threat's to the currency system's legitimacy ( you see dollar's are not intrinsicaly worth anything other than the paper they are printed on) and in order to maintain the purcashing power/legitamicy i.e (avoid hyperinflation/worthlessness) of the dollars, the fed and other central banks had had to resort to an exponential growth in DERIVATIVES i.e intrest rate derivatives and gold derivatives to occasionally take DOWN THE PRICES of the metals too keep the safe haven's in paper (gov't debt) instead of PRECIOUS METALS to maintain the confidence game that is finance. The smart money understands this and often "invests" /collects/ purchases luxury items like boats, fine art, fine furniture, fine cars that will be

1 repriced upward when any fiat collapses / is devaluead/monetized

2 also more immune to fed orchestrated take downs of competition in there "paper confidence game" i.e precious metals

3 not subject to be "confiscated"

we have all witnessed how fast the price of certain commodity's (oil) can go up when a large amount of money (relavitely) flows into an asset class (that is relatively small) . Watch how fast gold would soar when gov't bond market is no longer seen as a safe haven ........exponential increases in money flows into precious metals "market" from the bond market would cause exponential rises, even now the current spot price of gold at 725 (or so) is a joke, considering many people are reporting that in the real world they have to pay near 1000 an ounce for physical delivery. it would also seem gold could go from 750 to 5000$ minus any increase in inflation (at least in terms of total money in the system) it would merely take a shift in the current money in the system from having a home of many trillion in gov't debt to moving to physical gold. but the fed's will fight this with there derivatives. One path for the end game i see is continued Debt deflation even outright deflation followed by U.S treasury DEFAULT (they care much less about paying back there foreign creditors lol) followed by Currency devaluation (so that they can pay back millions of american's social security and medicare payouts with devalued dollars) this would beat defaulting on citizens debt's and facing a angry and armed mob. to repeat Deflation Default then Devaluation.


[edit on 9-11-2008 by cpdaman]

[edit on 9-11-2008 by cpdaman]

Originally posted by cpdaman
i don't see the demand or will for banks to unload these dollars to induce an inflation into the "real economy". there seems to be tremendous deflationary pressures from deleveraging and these i think the biggest misconception people are still hanging on to is that the "recovery" will be somewhat V shaped, as opposed to an L.

Very nice post, cpdaman!

I agree, the demand for and will of loans isn't there now, not like it was a year ago or five years ago. The demand is there for those that are desperate - companies struggling not to go under, people nearing foreclosure, etc - but those are higher risk loans. The banks wouldn't have the will to lend to them when they're guaranteed a return from the Fed.

I'm working under the assumption that recovery will happen. Maybe not V-shaped, maybe a wide U or an upside-down candy cane. L isn't something I'm ready to consider in a research sense. It's possible, and my gut takes it into consideration, but my brain is expecting eventual recovery.

When new companies start up to take advantage of the next bubble, whatever that may be, whenever that may be, the demand will be there and the will won't be far behind as the money starts to flow. That hoarded money will come out sooner or later unless there's a complete collapse of the U$ a la the Papiermark.