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Now that the ECB has demonstrated how it can set term bank rates out to a year (and minimize the need for the interbank markets) the door is open to same for any maturity.

And it also paves the way for other CB’s to do the same as they inch closer to my long standing proposals.

Again, for CB’s it’s about price (interest rates), not quantity (size of operation, CB’s balance sheet, etc).

The effects on the economy are those of the resulting interest rates, and not the quantities involved in the CB’s operations.

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It is something they want but seems there is no viable plan yet.

It is harder than it sounds and what they do come up with if short of a government guaranteed market will have similar risks.

The ‘answer’ is the repo markets add no value to the real economy and therefore there is no public purpose behind creating a ‘better one.’

I would just let the banks continue to price risk for secured lending as they are doing and let the interest spreads (and disintermediation when borrowers and lenders find each other directly) fall where they may due to competitive pressures.

Fed plans repo markets revamp

by Henny Sender and Michael Mackenzie

June 21 (FT) — The US Federal Reserve is considering dramatic changes to the giant repurchase – or repo – markets where banks around the world raise overnight dollar loans.

The plans include creating a utility to replace the Wall Street banks that handle transactions, people familiar with the matter say.

The Fed’s deliberations are partly motivated by concerns that the structure of the US overnight repurchase market may have exacerbated the financial turmoil that accompanied the failure of Lehman Brothers in September last year.

Fed officials plan to meet next month with market participants to discuss reforms.

People familiar with the Fed’s thinking say it is looking into the creation of a mechanism to replace the clearing banks – the biggest of which are JPMorgan Chase and Bank of New York Mellon – that serve as intermediaries between borrowers and lenders.

“The Fed is raising questions about whether the system really protects the interests of all participants,” says one person familiar with the Fed’s thinking.

In the repo markets, borrowers, such as banks, pledge collateral in return for overnight loans from lenders, such as money market funds.

The clearing banks stand between the parties, providing services such as valuing the collateral and advancing cash during the hours when trades are being made and unwound.

Fed officials fear this arrangement puts the clearing banks in a difficult position in a crisis. As the value of the securities falls, clearing banks have an obligation to demand more collateral to avoid losses. But in doing so, they could destabilise a rival.

“The clearing banks fear the positions of the investment banks are so large that a default would be difficult for them to manage,” the person familiar with the Fed’s thinking said.

“[Everyone] is thinking about how to remove conflicts of interest of the clearing banks and the investment banks so that the investment banks aren’t vulnerable to a sudden restriction of credit.”

The system’s complications were evident during Lehman’s collapse. JPMorgan, one of Lehman’s biggest trading partners, acted as its clearing bank in the repo market and – along with BoNY Mellon – served as the clearing bank for the New York Federal Reserve’s credit facility for securities ­companies.

Lawyers for the Lehman estate and for creditors have raised questions about whether JPMorgan acted too aggressively in seizing and marking down Lehman’s collateral.

Hedge funds have bought Lehman debt on the theory that the estate can claw back some of that collateral in court.

Citing confidentiality concerns, JPMorgan declined to comment.

The Fed hopes to have a new repo system in place by October, when its credit facility for securities companies is to close.

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Central bank liquidity swaps (13) 150,282 - 15,574

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Karim writes:

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What Is Fiscally — And Politically — ‘Sustainable’?

By James K. Galbraith
Professor of Economics, University of Texas

June 11th —Chairman Bernanke may, if he likes, try to define “fiscal sustainability” as a stable ratio of public debt to GDP. But this is, of course, nonsense. It is Ben Bernanke as Humpty-Dumpty, straight from Lewis Carroll, announcing that words mean whatever he chooses them to mean.

Now, we may admit that the power of the Chairman of the Board of Governors of the Federal Reserve System is very great. But would someone please point out to me, the section of the Federal Reserve Act, wherein that functionary is empowered to define phrases just as he likes?

A stable ratio of federal debt to GDP may or may not be the right policy objective. But it is neither more nor less “sustainable,” under different economic conditions, than a rising or a falling ratio.

In World War II, from 1940 through 1945, the ratio of US federal debt to GDP rose to about 125 percent. Was this unsustainable? Evidently not. The country won the war, and went on to 30 years of prosperity, during which the debt/GDP ratio gradually fell. Then, beginning in the early 1980s, the ratio started rising again, peaked around 1993, and fell once more.

Thus, a stable ratio of debt to GDP is not a normal feature of modern history. Gradual drift in one direction or the other is normal. There seems no great reason to fear drift in one direction or the other, so long as it is appropriate to the underlying economic conditions.

History has a second lesson. In a crisis, the ratio of public debt to GDP must rise. Why? Because a crisis – and this really is by definition – is a national emergency, and national emergencies demand government action. That was true of the Great Depression, true of war, and true of the Great Crisis we’re now in. Moreover, we’ve designed the system to do much of this work automatically. As income falls and unemployment rises, we have an automatic system of progressive taxation and relief, which generates large budget deficits and rising deficits. Hooray! This is precisely what puts dollars in the pockets of households and private businesses, and stabilizes the economy. Then, when the private economy recovers, the same mechanisms go to work in the opposite direction.

For this reason, a sharp rise in the ratio of debt to GDP, reflecting the strong fiscal response to the crisis, was necessary, desirable, and a good thing. It is not a hidden evil. It is not a secret shame, or even an embarrassment. It does not need to be reversed in the near or even the medium term. If and as the private economy recovers, the ratio will begin again to drift down. And if the private economy does not recover, we will have much bigger problems to worry about, than the debt-to-GDP ratio.

It is therefore a big mistake to argue that the next thing the administration and Congress should do, is focus on stabilizing the debt-to- GDP ratio or bringing it back to some “desired” value. Instead, the ratio should go to whatever value is consistent with a policy of economic recovery and a return to high employment. The primary test of the policy is not what happens to the debt ratio, but what happens to the economy.

*****

Now, what about those frightening budget projections? My friend Bob Reischauer has a scary scenario, in which a very high public-debt-to-GDP ratio leaves the US vulnerable to “pressure from foreign creditors” – a euphemism, one presumes, for the very scary Chinese. Under that pressure, interest rates rise, and interest payments crowd out other spending, forcing draconian cuts down the line. To avert this, Bob has persuaded himself that cuts are required now, not less draconian but implemented gradually. Thus the frog should be cooked bit by bit, to avoid an unpleasant scene later on when the water is really boiling hot.

With due respect, Bob’s argument displays a very vague view of monetary operations and the determination of interest rates. The reality is in front of our noses: Ben Bernanke sets whatever short term interest rate he likes. And Treasury can and does issue whatever short-term securities it likes at a rate pretty close to Bernanke’s fed funds rate. If the Treasury doesn’t like the long term rate, it doesn’t need to issue long-term securities: it can always fund itself at very close to whatever short rate Ben Bernanke chooses to set.

The Chinese can do nothing about this. If they choose not to renew their T-bills as they mature, what does the Federal Reserve do? It debits the securities account, and credits the reserve account! This is like moving funds from a savings account to a checking account. Pretty soon, a Beijing bureaucrat will have to answer why he isn’t earning the tiny bit of extra interest available on the T-bills. End of story.

The only thing the scary foreign creditors can do, if they really do not like the returns available from the US, is sell their dollar assets for some other currency. This will cause a decline in the dollar, some rise in US inflation, and an improvement in our exports. (It will also cause shrieks of pain from European exporters, who will urge their central bank to buy the dollars that the foreigners choose to sell.) The rise in inflation will bring up nominal GDP relative to the debt, and lower the debt-to-GDP ratio. Thus, the crowding-out scenario Bob sketches will not occur.

I’m not particularly in favor of this outcome. But unlike Bob Reischauer’s scenario, this one could possibly occur. And if it did, it would lower real living standards across the board. This is unpleasant, but it would be much fairer than focusing preemptive cuts on the low-income and vulnerable elderly, as those who keep talking about Social Security and Medicare would do.

****

Now, it is true, of course, that you can run a model in which some part of the budget – say, health care – is projected to grow more rapidly than GDP for, say, 50 years, thus blowing itself up to some fantastic proportion of total income and blowing the public finances to smithereens. But this ignores Stein’s Law, which states that when a trend cannot continue it will stop, and Galbraith’s Corollary, which states that when something is impossible, it will not happen.

Why can’t health care rise to 50 percent of GDP? Because, obviously, such a cost inflation would show up in – the inflation statistics! – which are part of GDP. So the assumption of gross, uncontrolled inflation in health care costs contradicts the assumption of stable nominal GDP growth. Again, the consequence of uncontrolled inflation is… inflation! And this increases GDP relative to the debt, so that the ratio of debt to GDP does not, in fact, explode as predicted.

I do not know why the CBO and OMB continue to issue blatantly inconsistent forecasts, but someone should ask them.

Further confusion in this area stems from treating Social Security alongside Medicare as part of some common “entitlement problem.” In reality, health care costs and haphazard health insurance coverage are genuine problems, and should be dealt with. Social Security is just a transfer program. It merely rearranges income. For this reason it cannot be inflationary; the only issue posed is whether the elderly population as a whole deserves to kept out of poverty, or not.

Paying the expenses of the elderly through a public insurance program has the enormous advantage of spreading the burden over all other citizens, whether they have living parents or not, and of ensuring that all the elderly are covered, whether they have living children or not. A public system is also low-cost and efficient, and this too is a big advantage. Apart from that, whether the identical revenue streams are passed through public or private budgets obviously has no implications whatever for the fiscal sustainability of the country as a whole.

****

What is politically sustainable is nothing more than what the political community agrees to at any given time. I have been surprised, and pleased, by the political community’s acquiescence in the working of the automatic stabilizers and expansion program so far. The deficits are bigger, and therefore more effective, than many economists thought would be tolerated. That’s a good sign. But it would be a tragedy if alarmist arguments now prevailed, grossly undermining job prospects for millions of the unemployed.

Let me note, in passing, that Chairman Bernanke should please read the Federal Reserve Act, and focus on the objectives actually specified in it, including “maximum employment, stable prices and moderate long-term interest rates.” He does not have a remit to add stable debt-to-GDP ratios or other transient academic ideas to the list. One might think that the embarrassing experience with inflation targeting would be enough to warn the Chairman against bringing too much of his academic baggage to the day job.

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Please send this on to Eugenio Aleman at Wells Fargo

Thinking The Unthinkable: The Treasury Black Swan, And The LIBOR-UST Inversion

Posted by Tyler Durden

>   The below piece is a good analysis of a hypothetical Treasury/Dollar black swan
>   event, courtesy of Eugenio Aleman from, surprisngly, Wells Fargo. Eugenio does
>   the classic Taleb thought experiment: what happens if the unthinkable become
>    not just thinkable, but reality. Agree or disagree, now that we have gotten to
>   a point where 6 sigma events are a daily ocurrence, it might be prudent to
>   consider all the alternatives.

In previous reports, I have touched upon the concerns I have regarding the overstretching of the federal government as well as of monetary policy while the Federal Reserve tries to maintain its independence and its ability, or willingness, to dry the U.S. economy of the current excess liquidity.

Excess reserves are functionally one day Treasury securities.
It’s a non issue.

Furthermore, we heard this week the Fed Chairman’s congressional testimony on the perils of excessive fiscal deficits and the effects these deficits are having on interest rates at a time when the Federal Reserve is intervening in the economy to try to keep interest rates low.

His thinking is still on the gold standard in too many ways.

Now, what I call “thinking the unthinkable” is what if, because of all these issues, individuals across the world start dumping U.S. dollar notes, i.e., U.S. dollar bills?

The dollar would go down for a while.
Prices of imports would go up.
Exports would go up for a while

All assuming the other nations would let their currencies appreciate and let their exporters lose their hard won US market shares, which is certainly possible, though far from a sure thing.

Why? Because one of the advantages the U.S. Federal Reserve has over almost all of the rest of the world’s central banks is that there seems to be an almost infinite demand for U.S. dollars in the world, which has made the Federal Reserve’s job a lot easier than that of other central banks, even those from developed countries.

In what way? They set rates, that’s all. It’s no harder or easier for the Fed than any other central bank.

if there is a massive run against the U.S. dollar across the world then the Federal Reserve will have to sell U.S. Treasuries to exchange for those U.S. dollars being returned to the country, which means that the U.S. Federal debt and interest payments on that debt will increase further.

Not true. First, they have a zero rate policy anyway so they can just sit as excess reserves should anyone deposit them in a bank account, and earn 0. Or they can hold the cash and earn 0.

This means that we will go from paying nothing on our “currency” loans to having to pay interest on those U.S. Treasuries that will be used to sterilize the massive influx of U.S. dollar bills into the U.S. economy, putting further pressure on interest rates.

No treasuries have to sold to sterilize anything.
A little knowledge about monetary operations would go a long way towards not letting this nonsense be published in respectable forums.

If we add the nervousness from Chinese officials regarding U.S. debt issues, then we understand the reason why we had Treasury secretary Timothy Geithner in China last week “calming” Chinese officials concerned with the massive U.S. fiscal deficits. I remember similar trips from the Bush administration’s Treasury officials pleading with Chinese officials for them to continue to buy GSEs (Freddie Mac and Freddie Mae) paper just before the financial markets imploded.

Yes, they have it wrong, and it’s making the administration negotiate from a perceived position of weakness while the Chinese and others take us for fools.

But the situation today is even more delicate because of the impressive amounts of U.S. Treasuries s we will have to issue during the next several years in order to pay for all the programs we have put together to minimize the fallout from this crisis.

Issuing Treasuries does not pay for anything. Spending pays for things, and spending is not operationally constrained by revenues.

The Treasuries issued support interest rates. They don’t ‘provide’ funds.

Furthermore, if China and other countries do not keep buying U.S. Treasuries, then interest rates are going to skyrocket.

There’s some hard scientific analysis. They go to the next highest bidder. The funds to pay for the securities come from government spending/Fed lending, so by definition the funds are always there and the term structure of rates is a matter of indifference levels predicated on future fed rate decisions.

This is one of the reasons why Bernanke was so adamant against fiscal deficits in his latest congressional appearance.

And because on a gold standard deficits can be deadly and cause default. He’s still largely in that paradigm that’s long gone.

Of course, the U.S. government knows that the Chinese are in a very difficult position: if they don’t buy U.S. Treasuries, then the Chinese currency is going to appreciate against the U.S. dollar and thus Chinese exports to the U.S., and consequently, Chinese economic growth will falter.

Yes, as I indicated above.

The U.S. and China are like Siamese twins joined at the chest and sharing one heart. This is something that will probably keep Chinese demand for Treasuries elevated during the next several years. However, this is not a guarantee, especially if the Chinese recovery is temporary and they have to keep on spending resources on more fiscal stimulus rather than on buying U.S. Treasuries.

Again, this shows no understanding of monetary operations and reserve accounting. The last two are not operationally or logically connected.

Thus, my perspective for the U.S. dollar is not very good. And now comes the caveat. Having said this, what is the next best thing? Hugo Chavez’s Venezuelan peso? Putin’s Russian rubble? The Iranian rial? The Chinese renminbi? Kirchner’s Argentine peso? Lula da Silva’s Brazilian real? That is, the U.S. dollar is still second to none!

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Power Point I did for a conference discussion.

Financial Architecture Fundamentals

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On Wed, Jun 10, 2009 at 8:48 PM, Scott Fullwiler wrote:

(email exchange)

>   On Wed, Jun 10, 2009 at 8:48 PM, Scott Fullwiler wrote:
>   
>   Thanks, Ian.
>   
>   Warren . . . Ian was one of my students at your presentation last week . . . some people are
>   learning how this works, at least. I feel like a proud papa!

Yes, congrats!

I’m nominating this for both the stupidest article of the year and the stupidest article of all time in the category of ’statements by economic experts:’

And it was only a few weeks ago Bernanke explained the Fed/government makes payments by simply changing numbers in bank accounts and that their spending is not operationally constrained in any way by revenues.

Fed Would Be Shut Down If It Were Audited, ‘Expert’ Says

June 10th (CNBC)—The Federal Reserve’s balance sheet is so out of whack that the central bank would be shut down if subjected to a conventional audit, Jim Grant, editor of Grant’s Interest Rate Observer, told CNBC.

With $45 billion in capital and $2.1 trillion in assets, the central bank would not withstand the scrutiny normally afforded other institutions, Grant said in a live interview.

“If the Fed examiners were set upon the Fed’s own documents-unlabeled documents-to pass judgment on the Fed’s capacity to survive the difficulties it faces in credit, it would shut this institution down,” he said. “The Fed is undercapitalized in a way that Citicorp is undercapitalized.”

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Get Ready for Inflation and Higher Interest Rates

The unprecedented expansion of the money supply could make the ’70s look benign.

By Arthur B. Laffer

June 10th (WSJ)— Rahm Emanuel was only giving voice to widespread political wisdom when he said that a crisis should never be “wasted.” Crises enable vastly accelerated political agendas and initiatives scarcely conceivable under calmer circumstances. So it goes now.

Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. That’s more than twice the size of the next largest deficit since World War II. And this projected deficit is the culmination of a year when the federal government, at taxpayers’ expense, acquired enormous stakes in the banking, auto, mortgage, health-care and insurance industries.

Art knows the difference between purchasing financial assets (usually done by the Fed) and purchasing goods and services (and indirectly through transfer payments) but here elects to ignore it.

With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs — such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid — are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.

He also recognizes the demand leakages including pension fund contributions, insurance reserves, USD financial accumulations of non residents, IRA’s, other corporate reserves, etc. tend to compound geometrically and are thereby strong contractionary biases.

But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

He also knows causation runs from loans to deposits and reserves and not from reserves to anything at all.

I’ve had this discussion personally with him and I wrote ’soft currency economics’ jointly with Mark McNary who worked at art’s firm with both involved.

About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base — which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash — by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position.

Bank reserves are crucially important because they are the foundation upon which banks are able to expand their liabilities and thereby increase the quantity of money.

He knows this is not the case. He knows that lending is in no case reserve constrained, and that it’s about price and not quantity.

Banks are required to hold a certain fraction of their liabilities — demand deposits and other checkable deposits — in reserves held at the Fed or in vault cash. Prior to the huge increase in bank reserves, banks had been constrained from expanding loans by their reserve positions.

There were no banks of any consequence constrained from lending by their reserve positions that I know of.

In fact, they all had excess collateral they could have taken to the discount window as needed.

There were some banks constrained by capital considerations but that’s an entirely different story.

That’s why adding the excess reserves didn’t change anything with regards to lending.

Art knows this as well.

They weren’t able to inject liquidity into the economy, which had been so desperately needed in response to the liquidity crisis that began in 2007 and continued into 2008. But since last September, all of that has changed. Banks now have huge amounts of excess reserves, enabling them to make lots of net new loans.

Yet a chart of lending shows no changes as functions of reserve positions.

The way a bank or the banking system makes new loans is conceptually pretty simple. Banks find an entity that they believe to be credit-worthy that also wants a loan, and in exchange for the new company’s IOU (i.e., loan) the bank opens up a checking account for the customer. For the bank’s sake, the hope is that the interest paid by the borrower more than makes up for the cost and risk of the loan. The recently ballyhooed “stress tests” on banks are nothing more than checking how well a bank can weather differing levels of default risk.

Correct. And these loans are not reserve constrained.

And even if they were somehow constrained by reserves, innovations in sweep accounts have reduced reserve requirements to near 0.

What’s important for the overall economy, however, is how fast these loans are made and how rapidly the quantity of money increases.

Most important is the level of spending which may or may not be a function of the lending that creates the ‘quantity of money’ as defined by Art. And he knows that as well.

For our purposes, money is the sum total of all currency in circulation, bank demand deposits, other checkable deposits, and travelers checks (economists call this M1). When reserve constraints on banks are removed, it does take the banks time to make new loans. But given sufficient time, they will make enough new loans until they are once again reserve constrained.

He knows they are never reserve constrained.

The expansion of money, given an increase in the monetary base, is inevitable, and will ultimately result in higher inflation and interest rates. In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold.

In general the causation runs in the other direction, as he also knows.

At present, banks are doing just what we would expect them to do. They are making new loans and increasing overall bank liabilities (i.e., money). The 12-month growth rate of M1 is now in the 15% range, and close to its highest level in the past half century.

He also knows a lot of this simply replaced commercial paper issuance and other forms of non bank lending, and that total credit is the more useful indicator of lending activity.

With an increased trust in the overall banking system, the panic demand for money has begun to and should continue to recede. The dramatic drop in output and employment in the U.S. economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It’s a catch-22.

He also knows interest rates are voted on by the fed and that term rates reflect anticipated Fed moves.

It’s difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed’s actions because, frankly, we haven’t ever seen anything like this in the U.S.

He knows there are no consequences. The Fed is like the kid in the car seat with a steering wheel who thinks he’s driving.

To date what’s happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5% and inflation peaked in the low double digits. Gold prices went from $35 per ounce to $850 per ounce, and the dollar collapsed on the foreign exchanges. It wasn’t a pretty picture.

He knows that was caused by cost push from Saudi price setting that was broken by the deregulation of natural gas in 1978 that resulted in a 15 million barrel per day supply response as our utilities switched from oil to natural gas.

Now the Fed can, and I believe should, do what it must to mitigate the inevitable consequences of its unwarranted increase in the monetary base. It should contract the monetary base back to where it otherwise would have been, plus a slight increase geared toward economic expansion.

All that would do is raise rates some due to the fed selling its securities.

Or the Fed could repo its position so the banks would hold overnight collateral rather than over night reserves. Functionally that changes nothing except for creating a lot more book keeping work.

Absent this major contraction in the monetary base, the Fed should increase reserve requirements on member banks to absorb the excess reserves.

This is just plain silly.

Art knows there is no remaining ‘monetary purpose’ of reserves since we went off the gold standard, which he understands as well as anyone.

Canada and others dropped reserve requirements long ago with no consequences beyond a reduced accounting burden.

Given that banks are now paid interest on their reserves and short-term rates are very low, raising reserve requirements should not exact too much of a penalty on the banking system, and the long-term gains of the lessened inflation would many times over warrant whatever short-term costs there might be.

No penalty and no inflation consequences either.

Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with Treasury’s planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds.

Yes, yields would go higher, though not as disorderly as he forecasts.

And, as previously discussed, there’s no reason to do that unless the fed wants higher rates.

In addition, a rapid contraction of the monetary base as I propose would cause a contraction in bank lending, or at best limited expansion. This is exactly what happened in 2000 and 2001 when the Fed contracted the monetary base the last time. The economy quickly dipped into recession.

He knows the contraction of the base back then did not cause anything.

While the short-term pain of a deepened recession is quite sharp, the long-term consequences of double-digit inflation are devastating. For Fed Chairman Ben Bernanke it’s a Hobson’s choice. For me the issue is how to protect assets for my grandchildren.

The best gift he could give his grand children is to tell the story right way around as he knows is the case.

Mr. Laffer is the chairman of Laffer Associates and co-author of “The End of Prosperity: How Higher Taxes Will Doom the Economy — If We Let It Happen” (Threshold, 2008).

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Yes, as previously discussed, announcing a term structure of Fed funds levels would be far more effective in bringing rates down than securities purchases.

But that closes the door to rate hikes for that period of time, which is exactly what markets discount with the current term rate structure.

Especially with crude and commodities going up and the dollar going down, as markets discount that at some point the Fed will react to that ‘imported inflation’ with rate hikes.

Meanwhile the current ‘mercantalist’ Fed is fine with a lower dollar hoping it will help the US export its way to trend GDP growth rather than get there by domestic debt and consumption. Or at least reduce the marginal propensity to import that they fear could drain demand and abort the recovery. Unfortunately the preference for exports over domestic consumption translates to a lower standard of living via a reduction in real terms of trade.

That’s what was happening last year about this time when the great Mike Masters inventory liquidation hit and it all went bad. This time around there isn’t any excess inventory to break prices and cap utilization/employment is way down and still falling some, and rest of world economies appear too weak to absorb substantial US exports.

And the Saudis are back in control of crude prices after a very surprisingly small fall in world consumption given the size and scope of the international slowdown.

BoE’s Barker says rates could stay low for “quite some time”

MPC member Kate Barker told the Leicester Mercury newspaper that there
remained question marks over the sustainability of the recovery and that
interest rates “could stay low for quite some time”. Ms Barker echoed
Paul Tucker’s comments yesterday in saying that it would take some
months yet for the MPC to judge how robust the turnaround in activity
was: “The really important question is (whether) there’s a pick up in
the economy and if people can sustain that so it continues on to autumn.
That would be one of the most encouraging signs,” she said.

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This article gives Baum a bad name.

‘Legacy of Debt’ Gives Fiscal Stimulus Bad Name: Caroline Baum

Commentary by Caroline Baum

June 5(Bloomberg) — By the time the U.S. government unveiled its Public Private Investment Partnership in March, the toxic loans and securities clogging bank balance sheets had become “legacy assets.”

What if deficit hawks took the same tack and marketed the $787 billion fiscal stimulus as “legacy debt?”

They would be making yet another error. This is no basis for an article unless one is intent on being part of the problem rather than part of the answer.

“The $787 billion the U.S. Treasury will be borrowing or confiscating from you via taxation will saddle future generations with a legacy of debt,” the press release might read. “Your children and grandchildren can look forward to higher taxes, a lower standard of living and minimal government support in their old age.”

Wonderful, another deficit terrorist spewing counterproductive rhetoric and irresponsible journalism.

First, there is no intergenerational transfer of debt in real terms. Whatever goods and services our children produce will be consumed by whoever happens to be alive at that time. And a nominal government deficit does not keep them from operating at less than full employment.

Second, government securities function as benefits for investors, not costs. One buys them voluntarily and, at the macro level, directly or indirectly, as an alternative to holding reserve balances at the Fed. This means they are purchased at prices where they are preferred to holding balances at the Fed. Nothing is ‘taken away’ by sales of treasury securities and total (non government)holdings of financial assets remain unchanged.

Third, taxes function to reduce aggregate demand. Taxes need be raised in the future when aggregate demand is deemed too high, and not the deficit per se. That is a scenario of low unemployment and high consumption relative to available resources. Not ‘a lower standard of living’ or ‘minimal government support in their old age.’

Maybe the public would balk. And maybe some member of Congress would be bold enough to sponsor a measure to call off the still-uncommitted expenditures.

And thereby contribute to even lower output and employment.

After all, the economy appears to be recovering without fiscal stimulus.

??? The relative improvement has come only after the (non TARP) deficit got over 6% of GDP
And it has barely slowed the collapse.

The 9.4% unemployment is clear evidence aggregate demand is grossly deficient.

The rate of decline in real gross domestic product has slowed from an average 6 percent in the fourth quarter of last year and first quarter of 2009. Real GDP is expected to fall 1.9 percent in the current quarter, according to the median forecast of 61 economists in a Bloomberg News survey from early May. Less negative is the first step toward positive.

Yes, due to the ‘automatic stabilizers’ increasing the deficit, as above.

And only when GDP grows faster than productivity does the output gap fall.

And that’s before any real money gets spent. So far $36.7 billion has been distributed via various government agencies, according to Recovery.gov, the Web site that tracks where your tax dollars are going. That’s 7.4 percent of the $499 billion of outlays ($288 billion of the $787 billion is “tax relief”) and 29 percent of the funds that have been committed to a purpose or a project.

Patient, Heal Thyself

Tax relief comes in the form of larger monthly paychecks for workers and tax credits — for investment in renewable sources of energy, for first-time home buyers — that are encouraging activity now even though the benefit is in the future.

Still, it’s a trickle, not a waterfall.

So if fiscal stimulus can’t take credit for the improvement in the economy, what can? The answer is a combination of monetary policy and self-healing (an economy’s natural tendency is to grow).

Wrong. It’s been all fiscal to this point. Yes, its healed itself, via the very ugly automatic fiscal stabilizers of falling revenue and rising transfer payments with rising unemployment. This could have been avoided with proactive fiscal measures last July.
The Federal Reserve has thrown the kitchen sink at the economy, using traditional and non-traditional means to provide liquidity and credit when the banking system wasn’t up to the task.

Lower rates have drained aggregate demand as savers lost a lot more income than borrowers gained. The Fed’s portfolio alone has removed over $50 billion of annual interest income from savers and investors.

Fed’s CPR

Even before the Fed lowered the overnight interbank lending rate to 0 to 0.25 percent in December,

Savers have seen rates fall by about 5%, reducing aggregate demand, while most borrowers have seen little, if any, drop in rates as bank net interest margins widened to over 4%. And this additional bank income has a marginal propensity to consume of near 0.

the central bank was already ministering to markets and institutions outside its normal discount window customers, otherwise known as depository institutions. It was supporting the commercial paper market; had committed to purchase mortgage-backed securities and agency debt; had agreed to finance investor purchases of asset-backed securities; and had leant support to specific institutions, taking on some of Bear Stearns’s toxic, I mean, legacy, assets in March 2008 and bailing out American International Group in September.

Yes, and all of this has served to lower the term structure of rates and reduce saver’s incomes.

That’s the beauty of monetary policy. It can be implemented instantaneously. The Fed’s challenge is to be as quick on the return trip.

And, as per Bernanke’s 2004 paper, said rate cuts reduce aggregate demand via the ‘fiscal channel’ which means it reduces interest paid by government which needs to be offset by easier fiscal policy to not be a drag on output and employment.

The problem with fiscal stimulus, aside from the fact that it’s a misnomer, is that it arrives too late.

And further delayed by articles like.

Also, a payroll tax cut is instant, as would be per capita revenue sharing checks to the states.

At least that was the standard criticism prior to the enactment of the $787 billion American Reinvestment and Recovery Act of 2009 in February. The government’s tax and spending policies require the approval of a majority of the 100 senators and 435 members of the House of Representatives. And as we know, these 535 individuals sometimes confuse the people’s business with their own: getting re-elected.

True, which includes dealing with public opinion that is further jaded by unintentionally subversive articles like this one.

Preferred Stimuli

This time around, a new president with solid majorities in both Houses of Congress was able to saddle future generations with trillions of dollars of debt less than a month after he took office. The Congressional Budget Office projects the debt- to-GDP ratio rising to 70 percent in 2011, the highest since the early 1950s, when the U.S. was winding down the war effort.

You are including purchases of financial assets which is highly misleading and shows a further lack of understanding of public accounting.

If you believe, as I do, that monetary policy is the more potent of the stimuli, that fiscal “stimulus” just transfers spending from tomorrow to today and from the private sector to the government, with no net long-term gain, then maybe it’s time to stand up for the next generation.

And stand against the accounting identities.

Government deficits add directly non government savings of financial assets. To the penny.

Changes in interest rates only shift incomes between savers and investors.

And all the econometric evidence shows ‘monetary policy’ does little or nothing while fiscal policy is directly traced to changes in GDP.

Besides, where is it written that the ill effects of years of over-consumption and under-saving have to be repaired in a year? Instant gratification means future deprivation.

Over consumption? Did we consume more than we produced? No, investment remained positive during the growth years, which were years of high investment as well. That is not over consumption.

Now, with the recession and consumer pull back, is when investment is falling and we can be said to be thereby over consuming.

Word Choice

Fed Chairman Ben Bernanke used part of his June 3 testimony to the House Budget Committee to warn of the consequences of unchecked spending, even in the face of recession and financial instability.
“Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth,” he said.

Yes, sadly, he’s in that camp as well. As is the entire administration if you believe their current rhetoric.

If it takes a marketing gimmick — labeling fiscal stimulus a “legacy of debt” — to convey the message to the public and Congress, so be it.

How about taking the effort to get it right and trying to undo the damage you’ve done…

(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)

Opinions are her own, as selectively published by Bloomberg News.

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Karim writes:

Doesn’t break a lot of new ground. Forecasts appears consistent with prior statements and still casts financial markets in a fragile light despite recent run-up in equities. Makes no mention of upping asset purchases and issues longer-term fiscal warning:

*The most recent information on the labor market–the number of new and continuing claims for unemployment insurance through late May–suggests that sizable job losses and further increases in unemployment are likely over the next few months.

Agreed. And unemployment continues to increase until GDP growth outpaces productivity gains.

*Recent data also suggest that the pace of economic contraction may be slowing.

*Nonetheless, a number of factors are likely to continue to weigh on consumer spending, among them the weak labor market, the declines in equity and housing wealth that households have experienced over the past two years, and still-tight credit conditions.

*We continue to expect overall economic activity to bottom out, and then to turn up later this year.

Agreed. Deficit spending is not large enough to support aggregate demand and savings desires at levels that equate to modest GDP growth

*Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further.

Agreed. And weak overseas economies both limit export growth and bode for increased imports.

And higher crude and product prices raise nominal imports and dampen us domestic demand.

Also, state and local govt are also just now engaging in cutbacks and tax increases.

*Financial markets and financial institutions remain under stress, and low asset prices and tight credit conditions continue to restrain economic activity.

Yes, this allows lower taxes and/or higher government spending to support aggregate demand. Unfortunately, the noises from the administration are moving in the other direction, with President Obama’s latest statement that the US has ‘run out of money.’

*Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth.

I do not agree. In my book fiscal responsibility means supporting demand at desired levels of output and employment.

Financial sustainability is not an issue with non convertible currency and floating exchange rate policy, as it was when on the pre 1934 gold standard..

Non-Mfg ISM up from 43.7 to 44 but details weaker.

This indicates the slowing in the rate of decline is slowing, supporting the forecasts of nominal GDP hovering near 0 and unemployment continuing to rise.

• Employment up from 37 to 39
• Prices paid up from 40 to 46.9

There could be a rethinking of the output gap and an upward adjustment of the ‘neutral rate of unemployment if CPI continues to rise.

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As another associate quipped after reading Bernanke’s statements:

‘We are all deficit terrorists now!’

From Mike Norman who’s getting very good at this:

Mike Norman Economics

New entries on my blog today (Wednesday, May 3, 2009).

Bernanke hasn’t a clue!!

Bernanke warns on deficits as Treasury rates rise

Add Ben to the list of people who don’t understand our monetary system!

Bernanke warns on deficits as Treasury rates rise: Part II

Someone ought to tell Bernanke that the Fed sets rates. PERIOD!! END OF STORY!!!

Bernanke: start work now to curb US budget deficit

Curb the budget, reduce private sector savings. The relationship’s an identity, Ben!

I hope you enjoyed this market rally over the past three months because if the Administration follows Bernanke’s advice–and it’s likely that they will-kiss the rally goodbye and say, “Hello,” to new lows in the market sometime later this year or next year. Depends on when and how fast they “curb the deficit.”

-Mike Norman

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Karim writes:

Moving up with crude prices as reluctantly anticipated.

Back towards ‘nuetral’ levels for flat GDP

Orders expanding some from a low base as expected.

This is enough for GDP to muddle through at modest positive levels

Same

This will continue to stagnate as productivity gains will be sufficient to meet output demands

Will move back up from depressed levels

Will move up with prices

This is good for financial markers/bad for obama vision — modest growth with continuing downward pressure on wages

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From the good professor who brought us the ‘Taylor Rule’ for Fed funds:

Exploding debt threatens America

by John Taylor

May 26 — Standard and Poor’s decision to downgrade its outlook for British sovereign debt from “stable” to “negative” should be a wake-up call for the US Congress and administration. Let us hope they wake up.

And yet another black mark on the ratings agencies.

Under President Barack Obama’s budget plan, the federal debt is exploding. To be precise, it is rising – and will continue to rise – much faster than gross domestic product, a measure of America’s ability to service it.

Gdp is a measure of our ability to change numbers on our own spread sheet?

The federal debt was equivalent to 41 per cent of GDP at the end of 2008; the Congressional Budget Office projects it will increase to 82 per cent of GDP in 10 years. With no change in policy, it could hit 100 per cent of GDP in just another five years.

Almost as high as Italy and Italy does not even have its own currency.

“A government debt burden of that [100 per cent] level, if sustained, would in Standard & Poor’s view be incompatible with a triple A rating,” as the risk rating agency stated last week.

Now there’s quality support for an academic position…

I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis.

‘Believe’? Without even anecdotal support? Is that the best he can do? This is very poor scholarship at best.

To understand the size of the risk,

I think he means the size of the deficit, but is loading the language for effect.

Is that what serious academics do?

take a look at the numbers that Standard and Poor’s considers. The deficit in 2019 is expected by the CBO to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?

This presumes an unspoken imperative to bring them down. Again poor scholarship.

Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.

Ok. Inflation, if it happens as above, can bring down the debt ratio. How does this tie to his initial concern over solvency implied in his reference to the AAA rating being a risk for our ‘ability to service it?’

And still no reason is presented that 41% is somehow ‘better’ than 82%.

Nor any analysis of aggregate demand, and how the demand adds and demand leakages interact. Just an ungrounded presumption that a lower debt to GDP ratio is somehow superior in some unrevealed sense.

The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetised.

So what does ‘monetised’ mean? I submit it means absolutely nothing with non convertible currency and a floating fx policy.

That the Fed may have a difficult task reducing its own ballooning balance sheet to prevent inflation increases the risks considerably.

And the presumption that the Fed’s balance sheet per se with a non convertible currency and floating exchange rate policy is ludicrous. All central bankers worth any salt know that causation runs from loans to deposits and reserves, and never from reserves to anything.

And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar.

He’s got that math right- if prices remain where they are today in the other currencies and purchasing power parity holds. And he also knows both of those are, for all practical purposes, never the case.

Why has he turned from academic to propagandist? Krugman envy???

Americans would have to pay $2.80 for a euro; the Japanese could buy a dollar for Y50; and gold would be $2,000 per ounce. This is not a forecast, because policy can change;

And it assumes the above, Professor Taylor

rather it is an indication of how much systemic risk the government is now creating.

So currency depreciation is systemic risk?

Why might Washington sleep through this wake-up call? You can already hear the excuses.

“We have an unprecedented financial crisis and we must run unprecedented deficits.” While there is debate about whether a large deficit today provides economic stimulus, there is no economic theory or evidence that shows that deficits in five or 10 years will help to get us out of this recession.

Huh? None??? What’s he been reading other than his own writings and the mainstream tagalongs?

Such thinking is irresponsible. If you believe deficits are good in bad times, then the responsible policy is to try to balance the budget in good times.

Ahah, a logic expert!!! That makes no sense at all.

The CBO projects that the economy will be back to delivering on its potential growth by 2014. A responsible budget would lay out proposals for balancing the budget by then rather than aim for trillion-dollar deficits.

‘Responsible’??? As if there is a morality issue regarding the budget deficit per se???

“But we will cut the deficit in half.” CBO analysts project that the deficit will be the same in 2019 as the administration estimates for 2010, a zero per cent cut.

“We inherited this mess.” The debt was 41 per cent of GDP at the end of 1988, President Ronald Reagan’s last year in office, the same as at the end of 2008, President George W. Bush’s last year in office. If one thinks policies from Reagan to Bush were mistakes does it make any sense to double down on those mistakes, as with the 80 per cent debt-to-GDP level projected when Mr Obama leaves office?

The biggest economic mistake of our life time might have been not immediately reversing the Clinton surpluses when demand fell apart right after 2000. And, worse, spinning those years to convince Americans that the surpluses were responsible for sustaining the good times, when in fact they ended them, as they always do. Bloomberg reported the surplus that ended in 2001 was the longest since 1927-1930. Do those dates ring a bell???

The time for such excuses is over. They paint a picture of a government that is not working, one that creates risks rather than reduces them. Good government should be a nonpartisan issue. I have written that government actions and interventions in the past several years caused, prolonged and worsened the financial crisis.

Lack of a fiscal adjustment last July is what allowed the subsequent collapse

The problem is that policy is getting worse not better. Top government officials, including the heads of the US Treasury, the Fed, the Federal Deposit Insurance Corporation and the Securities and Exchange Commission are calling for the creation of a powerful systemic risk regulator to reign in systemic risk in the private sector. But their government is now the most serious source of systemic risk.

Finally something I agree with. Our biggest risk is that government starts reigning in the deficits or fails to further expand them should the output and employment remain sub trend.

The good news is that it is not too late. There is time to wake up, to make a mid-course correction, to get back on track. Many blame the rating agencies for not telling us about systemic risks in the private sector that lead to this crisis. Let us not ignore them when they try to tell us about the risks in the government sector that will lead to the next one.

The writer, a professor of economics at Stanford and a senior fellow at the Hoover Institution, is the author of ‘Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis’

It’s not too late for a payroll tax holiday, revenue sharing with the states on a per capita basis, and federal funding of an $8 hr job for anyone willing and able to work that includes federal health care, to restore agg demand from the bottom up, restoring output, employment, and ending the financial crisis as credit quality improves.

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(email exchange)

>   
>   Hi Warren. I heard James Grant speak yesterday. He was funny, entertaining, articulate
>   and full of historical knowledge, but I found his monetary analysis appalling. He wants
>   the U.S. (and the rest of the world) to be on a strict gold standard.
>   
>   It seems to me that the consequent reduction in flexibility and efficiency could be a
>   death sentence for hundreds of millions of people around the world. What do you think ?
>   

Agreed!

The gold standad wasn’t abandoned because it worked so well!

The gold standard panic of 1907 was so bad they created the Fed in 1913 to keep it from ever happening again.

It happened again and even worse in 1929 to the point gold was dropped domestically in 1934.

No depressions since as the supply side constraints on ‘money’ were eliminated and counter cyclical fiscal policy became viable.

They kept the Fed open anyway and gave it other things to do.

Send this along to Jim, thanks!

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Yes, he’s got that part very right!!!

>   On Mon, May 25, 2009 at 11:06 PM, Roger wrote:
>   
>   Federal Reserve Vice Chairman Donald Kohn:
>   
>   Interactions between Monetary and Fiscal Policy in the Current Situation
>   
>   [I]n the current weak economic environment, a fiscal expansion may be much more
>   effective in providing a sustained boost to economic activity.
>   Doesn’t say anything about when. Looks like it’s already too late to forestall a pileup.
>   

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Don’t Monetize the Debt

by Mary Anastasia O’Grady

May 23 (WSJ) — From his perch high atop the palatial Dallas Federal Reserve Bank, overlooking what he calls “the most modern, efficient city in America,” Richard Fisher says he is always on the lookout for rising prices. But that’s not what’s worrying the bank’s president right now.

His bigger concern these days would seem to be what he calls “the perception of risk” that has been created by the Fed’s purchases of Treasury bonds, mortgage-backed securities and Fannie Mae paper.

Mr. Fisher acknowledges that events in the financial markets last year required some unusual Fed action in the commercial lending market. But he says the longer-term debt, particularly the Treasurys, is making investors nervous. The looming challenge, he says, is to reassure markets that the Fed is not going to be “the handmaiden” to fiscal profligacy. “I think the trick here is to assist the functioning of the private markets without signaling in any way, shape or form that the Federal Reserve will be party to monetizing fiscal largess, deficits or the stimulus program.”

If he actually understood it I would expect him to say the concept is inapplicable with a non convertible currency and floating exchange rate regime.

Richard Fisher.

The very fact that a Fed regional bank president has to raise this issue is not very comforting. It conjures up images of Argentina. And as Mr. Fisher explains, he’s not the only one worrying about it. He has just returned from a trip to China, where “senior officials of the Chinese government grill[ed] me about whether or not we are going to monetize the actions of our legislature.” He adds, “I must have been asked about that a hundred times in China.”

Without knowing the right answer which is that lending is in no case reserve constrianed.
Causation runs from loans to deposits and reserves, and not from reserves to loans.

A native of Los Angeles who grew up in Mexico, Mr. Fisher was educated at Harvard, Oxford and Stanford.

Must have skipped the classes in reserve accounting.

He spent his earliest days in government at Jimmy Carter’s Treasury. He says that taught him a life-long lesson about inflation. It was “inflation that destroyed that presidency,” he says. He adds that he learned a lot from then Fed Chairman Paul Volcker, who had to “break [inflation's] back.”

Deregulating natural gas in 1978 is what broke the back of inflation as utilities switched from crude to natural gas and even cuts of 15 million barrels per day by OPEC were not enough to keep control of prices.

Mr. Fisher has led the Dallas Fed since 2005 and has developed a reputation as the Federal Open Market Committee’s (FOMC) lead inflation worrywart. In September he told a New York audience that “rates held too low, for too long during the previous Fed regime were an accomplice to [the] reckless behavior” that brought about the economic troubles we are now living through. He also warned that the Treasury’s $700 billion plan to buy toxic assets from financial institutions would be “one more straw on the back of the frightfully encumbered camel that is the federal government ledger.”

In a speech at the Kennedy School of Government in February, he wrung his hands about “the very deep hole [our political leaders] have dug in incurring unfunded liabilities of retirement and health-care obligations” that “we at the Dallas Fed believe total over $99 trillion.”

Hopefully he is worried about possible inflation and not solvency.

In March, he is believed to have vociferously objected in closed-door FOMC meetings to the proposal to buy U.S. Treasury bonds. So with long-term Treasury yields moving up sharply despite Fed intentions to bring down mortgage rates, I’ve flown to Dallas to see what he’s thinking now.

Hopefully he is concerned with the purchases possibly lowering interest rates too much for his liking and not about the size of the fed’s balance sheet.

Regarding what caused the credit bubble, he repeats his assertion about the Fed’s role: “It is human instinct when rates are low and the yield curve is flat to reach for greater risk and enhanced yield and returns.” (Later, he adds that this is not to cast aspersions on former Fed Chairman Alan Greenspan and reminds me that these decisions are made by the FOMC.)

“The second thing is that the regulators didn’t do their job, including the Federal Reserve.” To this he adds what he calls unusual circumstances, including “the fruits and tailwinds of globalization, billions of people added to the labor supply, new factories and productivity coming from places it had never come from before.” And finally, he says, there was the ‘mathematization’ of risk.” Institutions were “building risk models” and relying heavily on “quant jocks” when “in the end there can be no substitute for good judgment.”

Never does mention the role of fiscal policy. Like the massive 2003 retro tax cuts and spending increases that drove the next few years, including housing. Helped of course by the lender fraud.

What about another group of alleged culprits: the government-anointed rating agencies? Mr. Fisher doesn’t mince words. “I served on corporate boards. The way rating agencies worked is that they were paid by the people they rated. I saw that from the inside.” He says he also saw this “inherent conflict of interest” as a fund manager. “I never paid attention to the rating agencies. If you relied on them you got . . . you know,” he says, sparing me the gory details. “You did your own analysis. What is clear is that rating agencies always change something after it is obvious to everyone else. That’s why we never relied on them.” That’s a bit disconcerting since the Fed still uses these same agencies in managing its own portfolio.

Agreed. Can’t have it both ways. And now they are threatening to downgrade the US government as well

I wonder whether the same bubble-producing Fed errors aren’t being repeated now as Washington scrambles to avoid a sustained economic downturn.

He surprises me by siding with the deflation hawks. “I don’t think that’s the risk right now.” Why? One factor influencing his view is the Dallas Fed’s “trim mean calculation,” which looks at price changes of more than 180 items and excludes the extremes. Dallas researchers have found that “the price increases are less and less. Ex-energy, ex-food, ex-tobacco you’ve got some mild deflation here and no inflation in the [broader] headline index.”

Mr. Fisher says he also has a group of about 50 CEOs around the U.S. and the world that he calls on, all off the record, before almost every FOMC meeting. “I don’t impart any information, I just listen carefully to what they are seeing through their own eyes. And that gives me a sense of what’s happening on the ground, you might say on Main Street as opposed to Wall Street.”

It’s good to know that a guy so obsessed with price stability doesn’t see inflation on the horizon. But inflation and bubble trouble almost always get going before they are recognized. Moreover, the Fed has to pay attention to the 1978 Full Employment and Balanced Growth Act — a.k.a. Humphrey-Hawkins — and employment is a lagging indicator of economic activity. This could create a Fed bias in favor of inflating. So I push him again.

“I want to make sure that your readers understand that I don’t know a single person on the FOMC who is rooting for inflation or who is tolerant of inflation.” The committee knows very well, he assures me, that “you cannot have sustainable employment growth without price stability. And by price stability I mean that we cannot tolerate deflation or the ravages of inflation.”

Mr. Fisher defends the Fed’s actions that were designed to “stabilize the financial system as it literally fell apart and prevent the economy from imploding.” Yet he admits that there is unfinished work. Policy makers have to be “always mindful that whatever you put in, you are going to have to take out at some point. And also be mindful that there are these perceptions [about the possibility of monetizing the debt], which is why I have been sensitive about the issue of purchasing Treasurys.”

Yes, seems the Fed is worried about perceptions they know not to be true, but struggles to come with a way to communicate the operational realities.

He returns to events on his recent trip to Asia, which besides China included stops in Japan, Hong Kong, Singapore and Korea. “I wasn’t asked once about mortgage-backed securities. But I was asked at every single meeting about our purchase of Treasurys. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States. That seems to be the issue people are most worried about.”

As I listen I am reminded that it’s not just the Asians who have expressed concern. In his Kennedy School speech, Mr. Fisher himself fretted about the U.S. fiscal picture. He acknowledges that he has raised the issue “ad nauseam” and doesn’t apologize. “Throughout history,” he says, “what the political class has done is they have turned to the central bank to print their way out of an unfunded liability. We can’t let that happen. That’s when you open the floodgates. So I hope and I pray that our political leaders will just have to take this bull by the horns at some point. You can’t run away from it.”

Does not sound like he understands, operationally, what that is currently all about, but instead still uses gold standard rhetoric.

Voices like Mr. Fisher’s can be a problem for the politicians, which may be why recently there have been rumblings in Washington about revoking the automatic FOMC membership that comes with being a regional bank president. Does Mr. Fisher have any thoughts about that?

This is nothing new, he points out, briefly reviewing the history of the political struggle over monetary policy in the U.S. “The reason why the banks were put in the mix by [President Woodrow] Wilson in 1913, the reason it was structured the way it was structured, was so that you could offset the political power of Washington and the money center in New York with the regional banks. They represented Main Street.

Yes, there is a power struggle going on in the Fed

“Now we have this great populist fervor and the banks are arguing for Main Street, largely. I have heard these arguments before and studied the history. I am not losing a lot of sleep over it,” he says with a defiant Texas twang that I had not previously detected. “I don’t think that it’d be the best signal to send to the market right now that you want to totally politicize the process.”

Speaking of which, Texas bankers don’t have much good to say about the Troubled Asset Relief Program (TARP), according to Mr. Fisher. “Its been complicated by the politics because you have a special investigator, special prosecutor, and all I can tell you is that in my district here most of the people who wanted in on the TARP no longer want in on the TARP.”

At heart, Mr. Fisher says he is an advocate for letting markets clear on their own. “You know that I am a big believer in Schumpeter’s creative destruction,” he says referring to the term coined by the late Austrian economist. “The destructive part is always painful, politically messy, it hurts like hell but you hopefully will allow the adjustments to be made so that the creative part can take place.” Texas went through that process in the 1980s, he says, and came back stronger.

This is doubtless why, with Washington taking on a larger role in the American economy every day, the worries linger. On the wall behind his desk is a 1907 gouache painting by Antonio De Simone of the American steam sailing vessel Varuna plowing through stormy seas. Just like most everything else on the walls, bookshelves and table tops around his office — and even the dollar-sign cuff links he wears to work — it represents something.

He says that he has had this painting behind his desk for the past 30 years as a reminder of the importance of purpose and duty in rough seas. “The ship,” he explains, “has to maintain its integrity.” What is more, “no mathematical model can steer you through the kind of seas in that picture there. In the end someone has the wheel.” He adds: “On monetary policy it’s the Federal Reserve.”

Ms. O’Grady writes the Journal’s Americas column.

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This will allow them to raise rates simply by paying interest on reserves and not require them to first ‘unwind’ their portfolio as was the case in Japan.

Press Release

May 20 — The Federal Reserve Board on Wednesday announced the approval of final amendments to Regulation D (Reserve Requirements of Depository Institutions) to liberalize the types of transfers consumers can make from savings deposits and to make it easier for community banks that use correspondent banks to receive interest on excess balances held at Federal Reserve Banks.

The amendments would also ensure that correspondents that are not eligible to receive interest on their own balances at Reserve Banks pass back to their respondents any interest earned on required reserve balances held on behalf of those respondents. The Board is also making other clarifying changes to Regulation D and Regulation I (Issue and Cancellation of Federal Reserve Bank Capital Stock).

The Board has revised Regulation D’s restrictions on the types and number of transfers and withdrawals that may be made from savings deposits. The final amendments increase from three to six the permissible monthly number of transfers or withdrawals from savings deposits by check, debit card, or similar order payable to third parties. Technological advancements have eliminated any rational basis for the distinction between transfers by these means and other types of pre-authorized or automatic transfers subject to the six-per-month limitation.

The Board also approved final amendments to Regulation D to authorize the establishment of excess balance accounts at Federal Reserve Banks. Excess balance accounts are limited-purpose accounts for maintaining excess balances of one or more institutions that are eligible to earn interest on their Federal Reserve balances. Each participant in an excess balance account will designate an institution to act as agent (which may be the participant’s current pass-through correspondent) for purposes of managing the account. The Board is authorizing excess balance accounts to alleviate pressures on correspondent-respondent business relationships in the current unusual financial market environment, which has led some respondents to prefer holding their excess balances in an account at the Federal Reserve, rather than selling them through a correspondent in the federal funds market. A correspondent could hold its respondents’ excess balances in its own account at the Federal Reserve Bank; however, doing so may adversely affect the correspondent’s regulatory leverage ratio. As market conditions evolve, the Board will evaluate the continuing need for excess balance accounts.

In October 2008, the Board adopted an interim final rule amending Regulation D that directed Federal Reserve Banks to pay interest on balances held by eligible institutions in accounts at Reserve Banks. The final rule revises those provisions as they apply to balances of respondents maintained by “ineligible” pass-through correspondents–that is, entities such as nondepository institutions that serve as correspondents but are not eligible to receive interest on the balances they maintain on their own behalf at the Federal Reserve. Specifically, the final rule provides that only required reserve balances maintained in an ineligible correspondent’s account on behalf of its respondents will receive interest. Ineligible correspondents will be required to pass back that interest to their respondents. Both required reserve and excess balances in the account of an eligible pass-through correspondent will continue to receive interest and those correspondents are permitted, but not required, to pass back that interest to their respondents.

The final amendments to Regulations D and I will become effective 30 days after publication in the Federal Register. Excess balance accounts will be available for the reserve maintenance period beginning July 2, 2009.

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