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Posts Tagged ‘monetary policy’

Is The Fed Giving a Pass on Sovereign Debt?

Part of the role of the Federal Reserve (the Fed) is to provide oversight to their member banks.  Approximately one-third of all U.S. commercial banks are members of the Federal Reserve.  All national banks are required to be members, and certain state chartered banks can choose to become a member.

Fed oversight involves a variety of bank operations.  Recently, the Fed conducted stress tests of the large national banks.  The purpose was to assess the strength of the bank and their ability to withstand another major economic calamity, like what happened throughout 2008.  One of their goals is preventing any bank from becoming “too big to fail.”

Bank capital is one of the measures regulators use to measure bank strength and stability.  Bank capital requirements are intended to guarantee a bank is able to withstand certain losses in its investment and loan portfolio and still meet the withdrawal demands of its depositors.

The following article describes a Citigroup analysis which discovered a recent trend in the U.S. and Europe regarding bank capital requirements and sovereign debt.  The Citigroup study revealed that bank regulators at the Fed and their European counterparts were not counting sovereign debt as part of the bank capital requirements.  The Citigroup analysts concluded the primary reason for excluding the sovereign debt was to help guarantee a market for sovereign bonds.

The United States and European countries are currently experiencing huge budget deficits.  In order to keep their respective governments operating, the nations’ treasuries and central banks are issuing new government bonds on a daily basis.  Thus, there is a constant need for someone to purchase these bonds.  If the market for a particular nation’s bond were to disappear, catastrophe would quickly follow.  Consider what would happen in the U.S. if investors stopped buying the additional $100 billion of new bonds it takes to keep the U.S. government operating each month.

Just imagine what would happen to inflation and the U.S. economy if investors are reluctant to purchase U.S. Treasuries.  You only have to look at the current problems in Europe.  Spanish 10-year bonds issued this past week carried an interest rate in excess of 6% while 10-year U.S. Treasuries were selling around 1.75%.  If the U.S. had to pay interest on our $15.8 trillion debt at a 6% rate, the annual interest cost would be near $1 trillion.  Think that might negatively impact the economy?

The Fed and European Central Bank are largely responsible for the monetary policy of their respective nations.  Interest rates and inflation are critical factors affecting monetary policy and economic results.  Consequently, you can see the vested interest the Federal Reserve and European Central Bank have in making sure there is a steady market for sovereign debt.   As a result, it appears these institutions are willing to give favorable treatment to sovereign debt when measuring bank capital.

I’m not implying there is collusion amongst the bankers.  Contrary to what some people believe, I don’t there is some grand conspiracy.  With a few exceptions, most of the people involved are honest people doing their best in a very difficult economic and political environment.  Central bankers are given tremendous responsibility for a nation’s economic health, yet they are seldom the people making important decisions on taxes, spending and debt, which greatly impact the economy.

My primary purpose in writing this article is sharing information.  I haven’t seen many articles addressing this topic, so I thought it was worth discussing.  Additionally, I think it’s another indication of the long-term problems of deficit spending and huge national debt.   Without realizing it, policy makers can make poor decisions in order to encourage people to buy sovereign debt, because it will be catastrophic if it ever stops.  It’s like a house of cards that’s growing and requires more effort to keep it from collapsing.

Time will tell, but it seems like exempting sovereign debt from bank capital requirements might be one of those decisions.

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Quantitative Easing: Out of Nothing

Quantitative Easing is a monetary policy used by a nation’s central bank to stimulate the economy.  The central bank buys its own government’s bonds on the open market, thereby increasing the money supply. This additional money is supposed to stabilize or lower interest rates, and make it easier to borrow money.

So where does the central bank get the money?  It prints it.

Last week, the U.S. Federal Reserve (the Fed) decided to engage in another round of quantitative easing.  Over the next eight months, the Fed will purchase $600 billion of US government bonds. This will be in addition to the $1.7 trillion of U.S. bonds the Fed purchased between January 2009 and March 2010.  Thus, by the end of June, the Fed will own $2.3 trillion of U.S. debt. The Fed is expected to print up to $900 billion of new money to fund these purchases. 

In a Wall Street Journal article defending the decision, Fed Chairman Ben Bernanke has justified the action as part of normal monetary policy.  He stated that “We see an economy which has a very high level of under utilization of resources and a relatively slow growth rate.”

However, quantitative easing is not without risks.  A spike in inflation is one of the primary concerns.  Printing money creates assets ex nihilo (out of nothing).  Since no additional value is created, pumping more money into the system devalues the existing dollars, which often leads to inflation.  The ability to print money ex nihilo is why the U.S. government will never go bankrupt.  All it needs to do is print more money to cover its debts.  However, this technique usually results in hyperinflation.  History is full of nations that have inflicted financial ruin on themselves by using this type of monetary policy.

Apparently the Fed believes that a lack of liquidity is the cause of anemic economic growth.  I’m not an economist nor as smart as the Chairman, but something doesn’t seem to add up.  We’ve been hearing for months that banks and corporations are currently sitting on approximately $2 trillion of cash. Their reluctance to invest this money is hindering the economic recovery.  If there is already $2 trillion of excess cash, what is the benefit of creating $600 billion of additional liquidity?  Lack of demand and uncertainty of the future seems to be a greater hindrance to economic growth than a lack of money.

The first round of quantitative easing didn’t seem to have much of an effect on the economy. Time will tell if Chairman Bernanke is correct in his assessment of round two.  Hopefully it does as he expects and the economy grows.  More importantly, let’s hope it doesn’t backfire and spark a significant rise of inflation.  If so… we could easily return to the days of stagflation in the late 70’s and early 80’s.

Controlling Economic Growth with the Federal Reserve Discount Rate

The Federal Reserve (the Fed) is charged with managing the U.S. money supply and keeping inflation in check.  Increasing the money supply (i.e., printing money) is intended to spur economic growth.  Additional money is supposed to make it less expensive to borrow, thereby encouraging investment and growth. It also devalues the dollar against other currencies, which should increase exports by making American goods less expensive to buy internationally.

The Conference Board includes the Federal Reserve money supply as part of its composite index of leading economic indicators.  Bankers, economists, currency traders and exporters are particularly tuned into the supply of money in the financial system.    

The discount rate is another primary tool the Fed utilizes to achieve its objectives.  The discount rate is the interest rate the Fed charges other banks to borrow from it. 

If banks are in the business of lending money, why are they borrowing from the Fed?  It’s called leverage.  Being able to borrow money from the Fed allows banks to leverage their deposits and loans.  Banks only keep a fraction of the money deposited to them on hand.  The rest is loaned out.  However, if you want your money, they have to be able to pay you when you to withdraw it.  The ability to borrow from the Fed allows banks the ability to keep fewer reserves and lend more money. Consequently, the discount rate affects the interest rate banks charge you to borrow money.

In general, the Fed increases the discount rate when the economy is doing well.  Raising the interest rate slows growth, which is intended to keep inflation in check.  Furthermore, in good economic times, people don’t need as much of an incentive to take risks or borrow money and are willing to pay a higher interest rate to access capital.  Conversely, in recessionary times, the Fed will reduce the discount rate to lower lending rates and spur economic growth. 

If you study the history of the Fed discount rate, you’ll see increases during periods of economic prosperity and rate cuts during recessions.  The size and timing of the rate cuts or increases are indications of the economic conditions. 

This is evidenced in the Fed discount rate over the past two years. The Fed dropped the rate seven times in 2008, reducing the rate by 0.75% three times.  The rate was 0.5% at the end of 2008, and hasn’t been that low in over 30 years.  This is an indication of the severity of the current recession, as if you needed another sign.

The Fed raised the rate 0.25% in February 2010, on signs the economy was strengthening.  However, the Fed has indicated that it doesn’t expect any rate increases for an extended period of time.  With rumblings that the recovery is slowing, the Fed may be pushed to lower the rate once again, but it doesn’t have much further it can go.

You don’t have to wear yourself out trying to understand monetary policy, money supply and inflation factors.  If you want to get a quick synopsis of the Fed’s current view on the economy, just watch their action on the discount rate.  No change means you can expect things to stay the same for a while.  A reduction is a sign of trouble, and an increase is an indication that things are getting better.

With the Fed saying that they expect to hold the discount rate static for an extended period of time, you can expect the economy to continue to slog along.  It may not be great, but hopefully it doesn’t get worse.

Paper Money and the Gold Standard (The Value of Money – Part III)

If you’re unfamiliar with the principles of a gold standard currency vs. fiat money, About.com:Economics has a great article you can read.  As Mike Moffatt, stated in this article, it’s unlikely that the U.S. will return to a gold standard for currency any time in the near future. 

One of the primary benefits of a gold standard is that it tends to keep inflation in check, but it can also restrict government monetary policy because the government can’t print money that is not backed by value of the gold it controls.  This may be one of the reasons that President Franklin D. Roosevelt  pushed to remove the gold standard in 1933, which was part of his economic plan to move the country out of the Great Depression.

For most of us, it doesn’t matter too much whether our money is backed by gold, so long as we can buy what we want.  Since inflation has been relatively low for the past 30 years, we have yet to experience the loss of purchasing power resulting from government monetary policy gone awry.

I recall being in Romania in 2001 and 2002. The exchange rate was about 32,000 Romanian Lei to $1 U.S. in 2001.  A year later, the exchange rate was nearly $36,000 Romanian Lei to $1 U.S.  The inflation rate was about 10% per year.  Not the worst in the world, but definitely not great either.   In 2001, the Romanian government had just begun printing the 500,000 Romanian Lei bill (the equivalent of about $13.89), because of the large amounts of cash people were required to carry.  Those 500,000 bills came in handy when paying the dinner tab for our group, which could easily exceed 10,000,000 Romanian Lei, and trust me, we weren’t eating in posh places.  On July 1, 2005, the Romanian government revalued their currency for the fourth time.  It was revalued at 10,000:1.

If you don’t live in Romania, you may wonder what this has to do with you.  The point… any government (including the U.S.) can print as much fiat money as it wants. The question is… what’s it worth?

The Federal Reserve System of the United States (the Fed) controls the monetary policy of the U.S.  In order to help stimulate the economy and prevent the financial markets from collapsing in 2008, the Fed increased money supply by approximately $1 trillion.  How did they do that?  Since it is fiat money, all they needed to do was crank up the printing presses.  The money then entered the financial system through the discount window and by the Fed’s purchase of bonds.  With a federal deficit of $1.42 trillion for the year ended September 30, 2009, who do you think bought some of those U.S. Treasury Bonds?

Still seem like it doesn’t matter to you.  Maybe it won’t, but maybe it will.  The challenge now facing the Fed is the how to reduce the money supply.  That could result an increase in the interest rate at the discount window, which will likely cause a tightening of credit and higher interest rates for borrowers.  It could also slow down the economic recovery.  Alternatively, leaving the money in the system for too long could cause a significant rise in inflation.  The Fed may find that it’s a lot easier to print $1 trillion, than it is to get back $1 trillion.

The Fed controls the U.S. monetary policy, and there is little you can do about it.  However, by paying attention to the Fed, you can keep tabs on the value of your money.  Under a fiat money system, your dollar literally may not be worth what it used to be.

Your Money vs. Other People’s money will be the topic of The Value of Money – Part IV.