How does the fed add liquidity to the economy?

[morganist]

Actually government issued, fiat money, like the U.S. dollar for example, is backed by at least three things: productivity, taxes and faith. ( taxes give money value in the sense that it is the only currency the government will accept toward payment of taxes. You will need to pay your taxes if you want to stay out of jail.)

Are the assets the central bank holds on its balance sheet not seen as being of value? All of the treasuries and risky commercial bank assets they buy through OMOs etc? Are these not considered valuable assets the central bank owns?

 

[piezoe]

See, I find this image pretty unsettling:

We know the fed is pumping money into the market, but my question is HOW MUCH are they doing it? Are they making up for 50% of the volume? That sounds absurd, but imagine the fed being the only buyer in the market that matters now. The dollar is getting destroyed as a result.

Even more unsettling, is the fed the only buyer in the fixed income market now? Who else would buy with negative real rates? We'd end up with a Japanese situation where the CB owns 70% of the national debt.

It does seem as though the fed is pumping up the market. but me mustn't forget that short term equity prices are largely emotion driven and the market, most of the time, is irrational. The fed does not buy equities, so the notion of the fed pushing up the market by buying stocks is wrong. However some of the money that the government spends into the economy, as authorized by Congress, will of course be used by the private sector to buy equities.

We are currently experiencing stepped up inflation in a number of sectors in the economy (building materials for example). Inflation also drives up nominal earnings, especially foreign earnings converted to dollars, as it drives down the value of the dollar relative to other currencies. Both of these latter factors, on top of social behavior (fueled by advertising), drive up equity prices.

The fed does not make fiscal policy. It must react to changes in economic conditions created by fiscal policy and events. At the moment we are experiencing unemployment typical of a very deep recession that would likely have become a depression had the Congress not acted to head it off. Congress is spending trillions into the private sector economy. The fed is the conduit for this, because the Treasury's reserve account, like other banking reserve accounts is at the fed. Once the pandemic is past and people go back to work. the fed will withdraw excess dollars from the economy by selling bonds. In the meantime, in addition to stepped up federal assistance to individuals and businesses, the fed has adopted an easy money policy (a little too easy in my opinion) with the intention of making credit very inexpensive. They do this by buying bonds which swells commercial bank reserve accounts and forces the funds rate rapidly down toward zero. They can put a low floor under the funds rate by agreeing to pay a small interest on excess reserves.*

Once this crises is over you will see the fed as a net seller of bonds which will drain excess reserves. This is all "outside" money that the fed directly controls. It is important to recognize that this process works in both directions, and not only can the fed swell reserve accounts and force interest rates down, but it can also drain reserves and force interest rates up. And the fed has other tools as well such as altering the maturity of the bonds it holds on its balance sheet. It does this by buying bonds of one maturity and selling those of another. The interest rate on the maturity it sells is pushed up a bit and that on the maturity it buys down a bit.

A important thing to understand, that unfortunately most people don't, is that the government always money finances its operations. What this means in practice is that if the Treasury's reserve account balance is not sufficient for it's current obligations, the fed will simply add to the Treasury's reserve account as needed.

The Treasury does not go out and borrow money by selling bonds before it can spend. In reality, the Treasury does not have to borrow at all. The Treasury selling bonds gives the outward appearance of borrowing. In our modern, fiat money system however, bonds serve an entirely different purpose than raising money so the government can spend beyond its tax revenue. This is why the annual fight in Congress over the deficit and debt ceiling is so utterly ridiculous. It's only purpose, it would seem, is to keep the public completely in the dark regarding government finances and make the public think the government must borrow to finance deficit spending. It is impossible for the government to go bankrupt, your social security dollars will always be there unless they are removed by statute. But they could be made virtually worthless by government mismanagement.

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*Beginning March 26th, 2020, the fed reduced its formal reserve requirement to 0% consistent with its current "adequate reserve policy." https://www.federalreserve.gov/newsevents/pressreleases/monetary20200315b.htm Under this policy the interest rate the fed pays on reserves becomes the low bound of the fed funds rate.

 

[piezoe]

Are the assets the central bank holds on its balance sheet not seen as being of value? All of the treasuries and risky commercial bank assets they buy through OMOs etc? Are these not considered valuable assets the central bank owns?

It is impossible to discuss any of these topics with you in a productive manner because your knowledge, such as it is, is a half century out of date.

 

[morganist]

It is impossible to discuss any of these topics with you in a productive manner because your knowledge, such as it is, is a half century out of date.

So the central banks don't make money from holding assets they purchase from the commercial banks when the assets' values appreciate? Isn't that what they said happened. Are these assets not worth anything? Surely these assets hold some value which the central bank owns/controls.

I feel it is more your position that is outdated with the lack of appreciation of the whole industry of Open Market Operations and repos that can generate a profitable business operation for the central banks. Buying risky assets when they are undervalued then selling them when the market stabilises generates price appreciation and a profit.

 

[piezoe]

So the central banks don't make money from holding assets they purchase from the commercial banks when the assets' values appreciate? Isn't that what they said happened. Are these assets not worth anything? Surely these assets hold some value which the central bank owns/controls.

I feel it is more your position that is outdated with the lack of appreciation of the whole industry of Open Market Operations and repos that can generate a profitable business operation for the central banks. Buying risky assets when they are undervalued then selling them when the market stabilises generates price appreciation and a profit.

Your responding to someone other than me perhaps? Since you brought it up however, I guess I could mention that the U.S. Central bank is not a "business." The Central bank does not need to make a profit, as a business would, and any incidental profit, after operational expenses, flows directly to the U.S. Treasury.

 

[longshort]

Actually government issued, fiat money, like the U.S. dollar for example, is backed by at least three things: productivity, taxes and faith.

The Fed's lending isn't backed by actual savings as it's the case with private lending. "Lending" newly printed digits amounts to redistribution and causes distortion, which was my point. Just ask yourself whose productivity is it and who pays the taxes. The private sector can lend on its own if it makes economic sense, thereby setting proper rates that prevent misallocation.

The fed does not buy equities, so the notion of the fed pushing up the market by buying stocks is wrong.

The Fed certainly enables the stock bubble through artificially low interest rates and QE infinity. All the recent gains in tech stocks come from multiple expansions, i.e. P/E ratios getting worse.

Congress is spending trillions into the private sector economy.

The government can't support the people, it's always the other way around. The money the government spends, be it from taxation or inflation, comes from the private sector. There's no other source. Without the huge increase in government spending that has taken place in the U.S. over the last decades, people would have the savings to deal with a crisis.

Once this crises is over you will see the fed as a net seller of bonds which will drain excess reserves. This is all "outside" money that the fed directly controls. It is important to recognize that this process works in both directions, and not only can the fed swell reserve accounts and force interest rates down, but it can also drain reserves and force interest rates up.

Sell them to whom? Private investors? That would necessitate a rise in interes rates which won't happen because the debt is too big, now that the can has been kicked down the road too many times. See how the Fed tried to raise rates the last time and failed. Ten years after the financial crisis at merely 2.25% and quickly had to be dropped again starting July 2019, long before the Corona impact.

 

[piezoe]

The government can't support the people, it's always the other way around. The money the government spends, be it from taxation or inflation, comes from the private sector. There's no other source. Without the huge increase in government spending that has taken place in the U.S. over the last decades, people would have the savings to deal with a crisis.

Of course you're right. Productivity or GDP comes mainly from the private sector. We turn over responsibility for creating money to the government however, because we don't trust the private sector to do that. When we tried it, we eventually got into a big mess. So we made the government the source of money, with the private sector being the source of most of its value.

Savings are an interesting thing because when it is determined that the people should save more, the government must run a deficit to provide the additional money for increased savings. If you think about this a while you will see that this is correct. It can be understood this way: The government spends money into the economy and removes it via taxation, or temporarily via bond sales. When the government sells bonds, money that was in the private sector is transferred to the central bank and a treasury liability, i.e, the bond sold, replaces the money that was in the private sector. If the government budget is perfectly balanced the government will remove from the economy, via taxation, exactly what it spends into the economy. There will be no net change in the amount of outside money in the economy.

On the other hand, if it is decided that the people should save more the government must spend more into the economy than it removes, it must run a deficit to do that. If it later happens to sell bonds to the private sector in an amount exactly equal to the amount of the deficit, those bonds, once in the private sector, become the vehicle for additional savings. The bonds serve as an interest bearing store of money. Thus deficits are intimately related to increased private sector savings.

Let us recognize that a lot of the recent large deficits were in response first to a war, then to the threat of financial collapse and a depression, and recently in response to a pandemic.

Even so, apparently, by the foregoing reasoning, it isn't exactly true that.

"Without the huge increase in government spending that has taken place in the U.S. over the last decades, people would have the savings to deal with a crisis."

It is a very hard thing to accept that as populations an productivity grow, or in the event of a crisis, the government must put additional money into the economy by spending more into the economy than it removes via taxation. Thus it must run deficits -- maybe not every fiscal year, but nevertheless quite often. If it doesn't do this, the economy will be thrown into recession and/or deflation, exactly as would happen were the government to start running surpluses year after year.

This way of thinking is foreign to most of us because we have been wrongly taught that government should run just like a private sector business and manage its finances just like you and I manage ours. But, of course, on close examination of the role required of government as the source of our money, this is impossible.

That said, there is certainly plenty of room for debate on the proper size of deficits, the role of government, and spending priorities.

 

[morganist]

It is impossible to discuss any of these topics with you in a productive manner because your knowledge, such as it is, is a half century out of date.

Your responding to someone other than me perhaps? Since you brought it up however, I guess I could mention that the U.S. Central bank is not a "business." The Central bank does not need to make a profit, as a business would, and any incidental profit, after operational expenses, flows directly to the U.S. Treasury.

OK I agree with you that it does not have to make a profit. However it whether intentionally or not does. In the UK the central bank was started by taking over the operations of the wholesale banks that specifically traded in the industry of supplying debt to commercial banks. This industry is what started the Bank of England and is still in operation today. I can't see how it is possible for the central bank to not make profits, have assets and to be able to use them to back up at least to some extent the value of the currency. Even if the profits and assets they hold are generated by fluke or accident they will still be made.

 

[piezoe]

It is a very hard thing to accept that as populations an productivity grow, or in the event of a crisis, the government must put additional money into the economy by spending more into the economy than it removes via taxation. Thus it must run deficits -- maybe not every fiscal year, but nevertheless quite often. If it doesn't do this, the economy will be thrown into recession and/or deflation, exactly as would happen were the government to start running surpluses year after year.

My comments above relate specifically to the United States. It is interesting to note, however, that there are examples drawn from socialist governments and absolute monarchies, where the government is permitted to own means of production or assets that produce significant profits from exports. It then becomes possible for the government to operate over long periods without producing a significant net deficit. Norway would be an example. These governments can, under favorable circumstances, produce surpluses in their budgets without starving their domestic economies of the money needed for commerce, and therefore without throwing their domestic economies into recession.

 

[morganist]

My comments above relate specifically to the United States. It is interesting to note, however, that there are examples drawn from socialist governments and absolute monarchies, where the government is permitted to own means of production or assets that produce significant profits from exports. It then becomes possible for the government to operate over long periods without producing a significant net deficit. Norway would be an example. These governments can, under favorable circumstances, produce surpluses in their budgets without starving their domestic economies of the money needed for commerce, and therefore without throwing their domestic economies into recession.

What about the government being involved in free market operations, especially when it trades with other nations.