Re: Hummel Inquiry

[wfhummel@xxxxxxxxxxxxxx (William F. Hummel)]

Warren,

Thanks for your reply to my questions.  I think there are issues
that still need to be resolved.  I'll use some of your comments
to address them.

Hummel:
>Why would the banks wind up holding the bonds?

Mosler:
>When individuals sell bonds to the Fed, and add to their
>bank deposits, the banking system has a reserve excess.
>If the only offset the Fed offered was bonds, the banks
>would have to buy them or leave their $ in non-interest
>bearing reserve accounts.  If the Fed provided other sources
>of interest, such as repos, the banks would end up either
>holding the repo collateral (bonds) as short term investments
>or the bonds themselves-their choice.
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You make a good point about banks using their excess reserves to
buy interest bearing accounts, and thus ending up with the bonds
(or equivalent).   However that is not their only option.  The
excess reserves could also be used to write new loans, which
would of course further increase the credit money supply.  If the
public had sold the bonds to the Fed in the first place because
the yield was too low, it seems likely that the banks would not
settle for that yield by buying the bonds, but would opt to make
loans which normally offer much higher interest rates.

Hummel:
>It seems to me that the Fed itself would have to be the buyer, in
>effect making a (one-way) market at the pegged price.  In other
>words, as Basil has said, the money supply would rip.  Until the
>public had sold to its satisfaction, the overnight rate would be
>out of the Fed's control.

Mosler:
>No such thing.  The Fed can offer unlimited access to interest
>bearing accounts (such as securities) to 'drain' excess reserves.
-----------
While this is strictly true, I have to wonder how realistic it
is.  It appears to me that there is a big leak in the scheme you
describe, one that could result in an excessive growth in the
credit money supply.  I alluded to it above.

Consider the case where the public owns a large supply of bonds
whose price has been pegged at par, and the public wants to cash
in.  Let's assume the direct buyer is the Fed, and the banks
receive the deposits creating a system wide excess reserves
problem.  The Fed could absorb those reserves by selling the
bonds to banks if the banks were willing to buy them.  Under
normal conditions, without a price peg on the bonds, the Fed
could always lower the price enough to induce the banks to buy
the bonds.  But with the assumed peg, that game doesn't
necessarily work.  The banks could create new loans instead and
zap the credit money supply.

Unless I have overlooked something in this scenario, it appears
to me that pegging both the overnight rate and the bond rate by
the Fed does not preclude an excessive growth in deposits.
Further the growth would likely continue as long as the public is
net selling those pegged bonds.

Further questions.  Do you feel the Fed should in fact peg any
interest rates besides the overnight rate?  If so, for what
purpose?

Comment:  It seems to me that doing so would not only create a
troublesome arbitrage problem, but it would deny the Fed a very
important piece of information, namely a knowledge of the
inflation risk premium at various terms.

William