Re: Fed open market operations, reply-comment on Mossler

["ÁÎ×Ó¹â HenryC.K.Liu ¹ù¤l¥ú" <hliu@xxxxxxxxxxxxxx>]

Warren Mosler wrote:

> >
> > Or the banks go to the repo market.  The repo market reduces the >relevance of
> the discount rate.
>
> Repo within the private sector may move reserves (clearing balances) around but
> the net stays the same.  Repo with another private sector agent is not a
> substitute for 'getting' reserves from the Fed.

Discount-window lending, open market operations to effect changes in reserves to set
Fed funds rates, and reserve requirements are the three main monetary policy tools
of the Federal Reserve System. Together, they influence the cost and availability of
money and credit.

Usually, the discount rate is less than the federal-funds and other
money-market interest rates. However, the Fed does not allow banks to borrow at the
discount window for profit. Thus, it monitors
discount-window and federal funds activity to make sure that banks are not borrowing
from the Fed in order to lend at a higher rate in the federal funds market.
During periods of monetary ease, the spread between the federal funds and discount
rates may narrow or even disappear briefly because depository institutions have less
of a need to borrow reserves in the money market.
Under these conditions, the Fed may adjust the discount rate in order to reestablish
the accustomed spread.  Discount window loans are granted only after Reserve Banks
are convinced that borrowers have fully used reasonably available alternative
sources of funds, such as the federal funds market and loans from correspondents and
other institutional sources.

Usually, relatively few depository institutions borrow at the discount
window in any one week. Consequently, such lending provides only a small fraction of
the banking system's total reserves. All depository
institutions that maintain reservable transaction accounts or
nonpersonal time deposits are entitled to borrow at the discount window.

Changes in the discount rate often lag changes in market rates. Because banks are
looking at these alternatives as ways of raising cash, there will be a tendency for
rates to move together. If the funds rate is high, but the repo rate is low, then
banks will be more likely to
raise cash by doing reverse repos than by borrowing funds. This will
tend to move those rates together. Similarly with cd rates. Thus if the
FED is able to raise or lower the repo rate, this should have an impact on the funds
rate in the same direction (It also should impact the cd rates through similar
reasoning). The FED is likely to be able to control the federal funds rate if it can
control the repo rate.
Most observers seem to feel that the FED can routinely control the daily federal
funds rate because the FED, in their eyes, can control the repo rate.

The notion of a repurchase agreement was a legal/regulatory fiction dreamed up to
minimize the impact of such transactions on bank and broker-dealer capital
requirements. If these transactions had been called loans, then banks (and
broker-dealers) would be required to set aside cash (or perhaps other capital if a
broker-dealer) against such loans. By inventing the fiction of calling what is
actually a loan by some other name, banks and broker-dealers were able to reserve
less cash/capital against such activities. Convertible bonds are another type of
loan that can be incurred by corporation off the books.  Repos obviously increase
systemic risk in the banking system, particularly when the daily repos volume has
grown to $2.5
trillion and rising by the week.

To raise cash, a commercial bank normally sells so-called secondary
reserves consisting of treasury bills and other short term debt assets,
before resorting to other more drastic measures like the liquidation of
loans, selling fixed assets of the bank and so forth.
Or a bank can borrow by borrowing reserves directly from other
commercial banks in the federal funds market. The rate for such
borrowings would be the prevailing federal funds rate that follows the
law of supply and demand set by Fed open market operations.
Or a bank can do reverse repos. Mechanically, it would send out
secondary reserves to some third party in exchange for a cash loan. When the loan
terminates, the bank will receive back its secondary reserves that had been pledged
for the repo.  Such transactions will occur at the prevailing repo rate.  A default
will saddle the creditor with a loss equal to the spread between the old and new
prevailing repo rate. Or a bank can issue commercial deposits to the public (which
will simultaneously increase reserves and deposits). Such issuance (sales, really)
will be transacted at the prevailing cd rates corrected for the credit quality of
the issuing bank.
Or a bank can borrow from the FED at the Federal Reserve Discount
Window. This type of borrowing takes place at the FED discount rate, an announced
rate that the FED changes from time to time.
The term "discount rate," although widely used, is actually an
anachronism. Since 1971, Reserve Bank loans to depository institutions have been
secured by advances. Interest is computed on an accrual basis and paid to the Fed at
the time of loan repayment.  The interest rate charged by a Federal Reserve Bank on
short-term loans to depository institutions is referred to as the discount rate. The
discount rate is important for two reasons: (1) it affects the cost of reserves
borrowed from the Federal Reserve and (2) changes in the rate can be interpreted as
an indicator of monetary policy.  Increases in the discount rate generally reflect
the Federal Reserve's concern over inflationary pressures, while decreases often
reflect a concern over economic weakness or in recent times, deflation.
Discount-window lending, open market operations to effect changes in reserves to set
Fed funds rates, and reserve requirements are the three main monetary policy tools
of the Federal Reserve System. Together, they influence the cost and availability of
money and credit.
However, this influence has been steadily eroded by the repo market, as Greenspan
has discovered.

>
> ?  You had ended by stating that was not what you had meant.  Now you are back to
> that point?  Anyway, there still is no such thing the way you previously
> introduced it.  And, at the macro level, the above is not a profitable arbitrage,
> but more like a game of 'chicken' for the banking system.

I never said anything about arbing the spread between the discount rate and fed
funds rate, although a strategy can be designed to do that when the spread get
abnormal, but its not the most rewarding.  I said
arbs regularly exploit the target fed funds rate and the market rate for profit.

For example, fed funds target rate was set at 5.75% effective 2/2/00.  On February
24, ff rates were 5.78% high, 5.5% low, 5&3/8 near closing bid, 5&1/2 offered.

Overnight repo rate was 5.64% (Feb. 24)

These relationships change daily.  Some traders profit while others lose when they
bet on the movements.

Henry