Re: Hummel Inquiry

[Warren Mosler <mosler@xxxxxxxx>]

William F. Hummel wrote:
>
> 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.
> ------------
> 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.

New loans do not change the reserve picture of the banking system
in that statement period.  in the next statement period required
reserves increase somewhat due to the new loans.  Only if the Fed
was prepared to let overnight rates fall to 0 bid until the
reserve excess was 'used up' would the above policy be left in place.

 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.

Infinitely realistic.

  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.

If the Fed, as market maker, buys bonds, clearly they can not
simply resell them without giving up the function of market
maker.  They would only be acting as broker, and would need
to let the price of the bonds float at market level rather
to follow this policy.  So when acting as market maker to peg
a bond, offsetting operating factors is generally done in the
short term market.  For example, the Bank of Japan regularly
buys long JGB's and offsets the reserve imbalance by offering
short term paper for sale.
short term paper.


  The banks could create new loans instead and
> zap the credit money supply.

Loans create deposits.  The banking system can always create new loans.
They don't need or have any use for 'deposits to make loans with.'
This is more explicit at the larger banks.  They make loans first and
then fund them.

>
> 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.

The growth in deposits, apart from those associated with the banks
purchase of securities, is a function of net loan volume.
There may or may not be any correlation with the structure of rates
and such loan volume.  Furthermore, there is the additional
question of the economic significance of the 'size' of any money
aggregate.

>
> 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.

Pretty expensive knowledge, perhaps?  I question first whether the
state should issue any long term securities at all, and instead
only pay interest on excess reserves.  For openers, the nations
top minds are being used to trade these (unnecessary?) securities
rather than curing cancer, for example.

If you want to continue please contact me off list.

Thanks,

Warren


>
> William

--
Warren B. Mosler
Director of Economic Analysis
III Finance

See:

"Soft Currency Economics"
"Full Employment AND Price Stability"
=========================
And related documents:

http://www.warrenmosler.com