Reading thru this article, how does all this affect the average middle =
class bozo like myself?
http://econ-opinion.blogspot.com/2008_03_01_archive.html
Tuesday, March 25, 2008
Fed facing a 'Money Trap'=20
John Maynard Keynes suggested that, when interest rates are very low, =
monetary policy does not work, there is a so-called "liquidity trap". =
Speculators anticipate that interest rates will go up and bond and asset =
prices will fall. Therefore, speculators transform their wealth holdings =
into the most liquid asset, money (cash), rendering monetary policy =
ineffective. It is often argued that a liquidity trap occurred during =
the Great Depression. Between August 1929 and March 1933 the Federal =
Reserve Bank (Fed) increased the monetary base (money in circulation =
plus bank reserves) by 41% and yet the money supply (M1) decreased by =
29% as people started hoarding cash because of bank failures.
So, in a financial crisis such as today, where large banks fail =
seemingly overnight, and the Fed is responding by lowering the rates, =
one would think that a liquidity trap could occur. Instead something =
different is happening, call it a money trap.=20
As insightfully pointed out by Michael Shedlock, Treasury Bills =
(T-bills) yields are falling because investors (company treasurers, =
mutual funds, local government treasurers, etc) prefer them to money. =
Money amounts above the FDIC $100 000 limit are not safe, and are quite =
costly too keep in cash and to dispense with (who uses cash anyway). A =
similar effect was also observed during the Great Depression, by the =
way.=20
In a liquidity trap speculators want to get rid of bonds and obtain =
cash. Thus, the demand for money shoots up. In the current crisis, =
individuals and firms with large amounts of short-term savings want to =
get rid of cash and obtain safe liquid assets. This happens because =
market after market has been failing and cor****ations, local =
governments, investment funds, and wealthy individuals need security on =
their short-term asset holdings. The only safe liquid assets available =
are short-term T-bills, as they protect against the risk of bank =
defaults. So demand for T-bills is very high, the price of T-bills is =
rising and their yield falling to levels similar to those observed =
during the Great Depression.
The Fed has been trying to address the problem, to no avail thus far, by =
means of outright sales of T-bills. The Fed's aim is to drive the =
short-term T-bill yields closer to the federal funds target rate. Its =
holdings of T-bills have fallen by 37% ($90bn) since the end of 2007 =
(see the Fed's H.4.1 Release). Yet, the yield on the 3-month T-bill has =
fallen to a low of 0.26% last week, nearly two percentage points lower =
than the discount rate, although it has since recovered to 1.2%.
Why is this a problem? Because it means that the Federal Reserve Bank is =
unable to conduct monetary policy, its main function in the current =
macroeconomic policy making framework, since it currently does not =
control short term rates other than the federal funds rate.=20
The Fed targets the short term federal funds rate, currently at 2.25%, =
through open-market operations. These operations are used to exchange =
money (cash) by securities and vice-versa between the Fed and the banks, =
and occur regularly through tem****ary repo operations but in relatively =
low volumes. For example, one year ago, Fed repos plus other loans to =
commercial banks amounted to just $32bn. As of March 19th, these Fed =
assets had risen to $160bn including the TAF (Term Auction Facility) and =
PDCF (Primary Dealer Credit Facilty), still a small amount in the grand =
scheme of things. In normal cir***stances, the yields on the 3- and =
6-month T-bills, as well as the yields on the interbank rates (Dollar =
Libor rates), where trillions of dollars of money and securities are =
exchanged between private agents, follow the federal funds target rate =
fairly closely. Therefore, the federal funds rate "guides" the =
short-term market rates to "an equilibrium". Currently, however, the =
yields on the 3-month T-bills are one percentage point lower and the =
yield on the 1- and 3-month Libor rates about 35 basis points higher =
than the federal funds target rate.=20
The Federal Reserve has taken unprecedent measures (lowering the =
discount window rate, the Term Auction Facility, the Primary Dealer =
Credit Facilty, and starting March 27th the new Term Securities Lending =
Facility - TSLF) in order to lower the Libor rates to the current =
levels, which are closer to but still above the federal funds target =
rate, and to try to reduce the squeeze on T-bills and bonds that has =
occurred as their prices have risen in the flight to safety. These =
measures in effect subsidize commercial banks and primary dealers with =
tax-payers funded liquidity and Treasury securities.=20
However, despite the Fed's intervention, private savings holders don't =
want to hold cash and prefer the safety of T-bills with much lower =
yields. In fact, demand for T-bills is so large that at last week's rate =
of intervention the Fed holdings of T-bills would be depleted in 5 =
weeks. Alas, given that T-bills are zero cupon bonds, it is quite likely =
that we will observe negative short-term yields on the T-bills in the =
near future, for the first time in history (negative rates on T-bills =
repos occurred already on March 20th). This means investors will be =
paying more to the U.S. Treasury than what they will get after 3- or =
possibly 6-months, just in order to ensure that their money is safe. It =
is like paying taxes they don't actually owe to Uncle Sam, and in =
addition let Uncle Sam hold on to their cash, just because the investors =
don't trust the private financial system.
What is happening is that the demand for money (cash) by savings holders =
is falling. If the Fed had maybe over a trillion dollars of T-bills on =
its balance sheet it might be able to keep the yield on the T-bills =
close to the federal funds target rate, by means of outright sales of =
T-bills. But as of March 19th it just had $150 billions of T-bills left, =
so it is unable to push the T-bills yield higher.
Outright sales of T-bills by the Fed decrease the monetary base, clearly =
something it does not want to happen in the middle of a financial crisis =
as it would be strongly contractionary. Therefore, the Fed has had to =
sterilize these sales of T-bills to maintain the monetary base. It =
accomplished this by making tem****ary purchases of other securities =
(e.g., mortgage based securities), namely through the new facilities =
(TAF, PDCF), while maintaining roughly constant its permanent holdings =
of Treasury notes (2- and 5-years) and bonds (10- and 30- years). The =
Fed has also maintained the monetary base quite stable, which is very =
surprising given the stresses in the system. At this point, it seems =
very likely that the Fed will have to significantly increase the =
monetary base, i.e., print more U.S. Dollars, like it did between 1929 =
and 1933, to ameliorate the effects of the upcoming steep contraction in =
money supply.
The Fed has been trying to solve a crisis for which it lacks the =
instruments, and in the process, is damaging its credibility. Holders of =
short-term savings and banks correctly perceive that the risk of default =
by banks is very high. Thus, there is a large spread between 3-month =
T-bills and the 3 month Libor rate (the TED spread), and rightly so. The =
market is functioning. There is no inherent problem in having a large =
TED spread, although it may result in further failures of weaker banks. =
Still, if policy makers decide intervention is required to reduce the =
TED spread, the market is also telling who should act: the US Treasury, =
either through blanket coverage of deposits, bank bailouts, or =
nationalization of insolvent banks.=20
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