More from Jackson Hole
David R. Kotok,
July 15, 2013



We thank readers for their emails and questions following our original report from Jackson Hole (July 13). Let’s use a metaphor and advance the discussion with this commentary.

On the Jewish holiday of Passover, we ask four questions. The first is “Why is this night different from all other nights?” Following the Jackson Hole visit, meetings, conversations, roundtable discussions, and presentations,

it seems to me that a similarly probing set of questions can now help us to explore the significance and ramifications of current monetary policy.

The first Passover question we might borrow has already been answered: the post-2008 monetary policy is different. Very different! And its deviations from conventional monetary policy are widely identified. But three other critical questions follow:

(1) How do we manage this issue of excess reserves?

(2) What about the issue of extraction of duration from the market as part of the transactions within the Fed’s balance sheet expansion?

(3) What is the size and meaning of the Fed’s (Federal Reserve) balance sheet?

Let’s take those in order.

Excess reserves are not required of the banking system. They are created by the Fed’s process of purchasing Treasuries and federally backed mortgage securities. Right now they are at an unprecedented size in the banking system and are on deposit back at the Fed. The Fed currently pays 0.25% (25 basis points) to banks that deposit excess reserves with it. The banks deposit these excess reserves because that is, at this time, the most prudently profitable way to deploy them.

The big future concern is this: what happens when the excess reserves leave the banking system for other assets? What happens when there are loans and investments? Is there a multiplier? Does too much stimulus result? Will inflationary impacts ensue? Will asset bubbles form? The answer to all of those questions is … yes and no. Remember, that for a given single transaction, most of the transfer between agents is of excess reserves from one bank to another: I buy something from you; my bank settles the transaction; and the total amount of excess reserves held by my bank is reduced, while the total amount of excess reserves held by your bank is increased. It takes a loan and credit expansion to increase the amount of required reserves.

What can the Fed do with this issue of large excess reserves? My colleague Bob Eisenbeis has written about the fact that they could raise the reserve requirement, such that the excess reserves become required reserves. Furthermore, they could change the amount of required reserves as needed in order to neutralize the impact of what is currently a large overhang of excess reserves.

Another option is that the Fed could change the interest rate on excess reserve payments. They have said that they could use this tool. At Jackson Hole there were discussions of these options, with lots of possibilities, combinations, permutations, and incantations. The bottom line is that the Fed has not figured out what it is going to do, or when, or how. The fact is that the Fed has these tools and can use them when and if it is ready. Markets seem to ignore this. My personal view is that if the Fed were to use one of these tools, the markets would respect the Fed’s decisive intervention; their response would actually flatten the yield curve; and long-term interest rates would fall.

Let’s get to the question regarding the size of the Fed’s balance sheet. Just how big is it? This is another serious issue. In the old days, the balance sheet was big enough to create enough reserves to meet the requirements of the banking system, plus fund the need for currency. The size of the Fed’s balance sheet was roughly $900 billion before the failures of Lehman Brothers and AIG (American International Group, Inc.).

The asset side consisted mostly of holdings of short-term Treasury securities. The liability side entailed the required reserves on deposit with the Fed plus currency in circulation worldwide. That is what the balance sheet looked like then.

Now that balance sheet contains a couple trillion more dollars and is growing every day. Doesn’t that make a difference? The Fed buys securities and creates excess reserves by paying for them, and three hours later those excess reserves are back on deposit at the Fed. They generate no multiplier now, sitting where they are as excess reserves, but they are high-powered money. So, they can potentially multiply with extensions of credit and they can have a stimulative effect when interest rates tick upward or when loan demand improves.

Under the present circumstances, credit multiplication is not happening – or if it is, it is doing so in a very small way. What happens now? The Fed buys more government-backed securities, and a few hours later the excess reserve balance is higher than it was the day before. The Fed holds the securities; the balance sheet and excess reserves are increased; and very little economic impact occurs. There may be a psychological impact. That is, the Fed may have seeded the notion that it is going to continue with stimulus until the economy becomes more robust. All of those things are true; however, the impact of the single transaction is negligible.

The third question concerns the duration of the assets the Fed holds. In the old days, the Fed held mostly short-term Treasury securities. Think of it as holding 90-day Treasury bills. Now the Fed is buying Treasury notes and bonds. Let’s look at two transactions. In the first, the Fed buys $1 billion worth of 90-day Treasury bills. In the second, the Fed buys $1 billion worth of 30-year Treasury bonds. In the first transaction, the amount of duration withdrawn by the purchase of the 90-day Treasury bills is negligible. It is a speck, a tiny amount. In the second transaction, the Fed has taken the duration of a 30-year Treasury bond out of the market. That is long duration. That is a lot.

The size of the Fed’s balance sheet does not change, whether it buys a 90-day Treasury bill or a 30-year Treasury bond. Using balance sheet size as a determinant of the outcome of Fed policy is not equal even though it measures the same.

Then what is the impact of buying the 30-year bond? It is that the Fed has extracted long duration from the market and put it on its own balance sheet. It has said to the market, “We are going to take duration away from you and keep it.” Therefore the market has had to adjust its duration outlook. Duration is a key ingredient in the pricing of home mortgages, bonds, corporate finance, and long-term finance of any type. By its action, the Fed has reduced interest rates in the long and intermediate sections of the public market.

That is what the Fed wanted to do. It wanted to bring down home mortgage interest rates and make longer-term financing more palatable to investors, speculators, businesses, and all sorts of agents that care about the duration of their own holdings. It wanted to say, “Look, you can play in the game now. We are backstopping the world, and there will not be another Great Depression.”

What happens if the Fed reduces the duration of its portfolio? What happens if it does not reduce its duration and the portfolio size stops growing? What happens if it does either of those things in the context of a federal deficit that is getting smaller versus one that is getting larger? Can the Fed reduce duration by buying fewer long-term bonds even as the federal government is issuing fewer long-term bonds in order to shrink the deficit? These are the types of questions we cannot answer. But we debated them in Wyoming.

The research literature does not help us here. It focuses on eras when we did not have this wild, exciting, and very different construction of these reserves. All this is new. Meaningful research will be done many years from now. Today we are throwing the textbooks in the trash and starting over.

Our view is from the bottom line. The interest rate of importance is going to be the short-term rate, which is the target of the Fed. It is near zero and is going to be there for the next two years or more. It is bullish for assets. We believe spread product in the bond market is a desirable thing to own. We particularly like municipal bonds. Stocks, real estate, and other asset classes are likely to rise in price as long as this current policy is in place, which will likely be, at least, a couple more years.

The latest reports on retail sales and manufacturing only affirm this outlook. We remain fully invested.


David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors

Category: Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

8 Responses to “More from Jackson Hole”

  1. Greg0658 says:

    ask BR for picture permission (as in whats in it for me other than)
    and if BB doesn’t stay – does another venue get picked for years to come? or has JH got the stuff onward?
    I nominate the pretty Chicago skyline (oh – jinxed it)

  2. DeDude says:

    “Can the Fed reduce duration by buying fewer long-term bonds even as the federal government is issuing fewer long-term bonds in order to shrink the deficit?”

    That is a very critical issue not being talked about much. The federal governments deficit has gone from about $100 billion per month to about $60 billion per month at the end of this year. That means they will be issuing about $40 billion less of treasuries per month. So if the Federal reserve bank stops purchases of about $40 billion per month of treasuries, it should have no effect whatsoever, if you just account for market forces. If it has any effect, and it did, that would all be from panic (lemmings running one direction or another). Benny is just allowing the private participants to absorb the same amount of new debt as before; it’s not “tightening”, it’s a failure to losen further.

    Try to look at a plot of monthly excess issues (above redemptions) of treasuries vs. rates. Market forces of supply and demand show all their predicted effects in treasuries. The Fed purchases initially drove rates down, but a lot more down-movement came as the government failed to issue as much debt as before.

  3. Greg0658 says:

    watching TreaSec Jack Lew with SteveL
    @ Deliver’g Alpha

    great spread in NYC too – swear the repeal of GlassSteagall was
    paperpusher re-employment act to spread it into finer roundAbouts

    cash air is every Laborer’s – break up the beaver dams
    dissolve this old world invention of cash while there is still an inhabitable planet

    (was watching the spanking live on cTv57 but BB released a statement hense outrank in circle)

  4. flow5 says:

    The IOeR policy was designed as an IQ test. See the bad guys:

    The savings-investment flow is as follows: “CB lending expands the volume & directly effects the velocity of money – whereas NB lending directly affects only the velocity of money. The lending capacity of the CBs is determined by monetary policy, not the savings practices of the public. The lending capacity of NBs is almost exclusively dependent on the volume of monetary savings placed at their disposal. The CBs, on the other hand, could continue to lend if the public should cease to save altogether. NBs lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the CBs lend no existing deposits or savings: they always, create new money in the lending & investing process. Whereas monetary savings received by NBs originate outside the intermediaries, monetary savings held in the CBs (time deposits & the saved portion of demand deposits) originate, with immaterial exceptions, within he CB system. This is demand deposits constitute almost the exclusive net source of time deposits. The NBs can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the CBs, as a system, can make loans (if monetary policy permits & the opportunity is present ) which amount to several times the initial excess reserves held. Monetary savings are never transferred from the CBs to the NBs; rather are monetary savings always transferred through the intermediaries. The funds do not leave the commercial banking system” L.J.P. – Ph.D, Chicago, Economics 1933, M.S. Statistics, Syracuse

    To wit, the CBs pay for what they already own (both reserves & the money stock are endogenous & impounded within the system). Whereas dis-intermediation hasn’t been predicated on interest rates for the CB system since right before Roosevelt’s “banking holiday” in 1933, dis-intermediation for the NBs today (where the size of the NBs shrink, but the size of the CB system remains unaffected), is predicated on the remuneration rate on excess reserves. It’s the 1966 S&L crisis redux.

    The CBs have the FDIC (& the NBs use “specials”).

    The problem is that IBDDs are remunerated & the IOeR return exceeds all money market (wholesale funding), or borrow-short to lend-long business-model costs. I.e., the CBs are being paid not to lend by our Federal Gov’t. This is quite clear as excess reserves grow pari passu with POMOs (though lending by the CBs is inflationary, and lending by the NBs is non-inflationary (ceteris paribus)).

    The NBs do not (indeed cannot), compete with the CBs. For non-accountants, the NBs are the CB’s customers. But the Fed’s policy making arm incentivizes the CBs to out bid the NBs for loan-funds & collateral (how odd?).

    “Although collateral backed credit does not increase the money supply, it impacts real sector and monetary policy transmission (Claessens et al, 2012)” See: The Changing Collateral Space” – Manmohan Singh

    Drop the CB’s compensation &:

    (1) the CBs will then buy “specials” from the NBs (& not sell them to the FRB-NY),
    (2) the money multiplier will rebound
    (3) velocity will rebound
    (4) the money stock will quickly ratchet higher
    (5) savings will be transferred to the NBs where they are “put to work” (matching voluntary savings, with ideally, real & not financial-investment).

    Reversing the flow of savings would increase aggregate demand. Without safeguards (e.g., raising reservable liabilities or reserve ratios), it would increase inflation. But it would re-establish the concept that the utilization of bank credit to finance real investment or government deficits does not constitute a utilization of savings, since bank financing is accomplished through the creation of new money. And unspent savings (non-use) represent a leakage in National Income Accounting.

  5. flow5 says:

    Bernanke’s exit strategy testimony in 2/10/10 footnoted:

    “Section 13(3) of the Federal Reserve Act authorizes Reserve Banks to lend to individuals, partnerships, and corporations in “unusual and exigent circumstances” as determined by the Board of Governors. The Federal Reserve invoked Section 13(3) on two occasions during the 1960s to establish lending facilities for savings associations; however, no credit was extended through either facility”

    Just as in 1966 S&L crisis, Bernanke fails to understand the difference between money & liquid assets. In 1966 the Fed turned the economy around by getting the CBs out of the savings business (reversed Reg Q ceilings). This escaped economic analysis. This course of action did not reduce the size of the CB system, the volume of earnings assets held by the CB system, the income received by the CB system, nor the opportunities of the CBs to make safe & profitable loans.

    To the contrary. By promoting the welfare & health of the most important lending sector of the economy (the NBs), the health & vitality of the whole national economy improved. The aggregate demand for loan funds expanded, the volume of CB “bankable” loans grew, & so did the CB system.

    I.e., net changes in Reserve Bank credit (since the Treasury-Reserve Accord of 1951) are determined by the policy actions of the Federal Reserve, not the savings practices of the public. But Bernanke acts as if the CBs are intermediaires between savers & borroweers: “The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which IMPOSE COSTS and DISTORTIONS on the banking system”. Never are the CBs intermediaries in the savings-investment process.

    From a system’s viewpoint, commercial banks (DFIs), as contrasted to financial intermediaries: never loan out, & can’t loan out, existing deposits (saved or otherwise) including transaction deposits, or time deposits, or the owner’s equity, or any liability item.

    When CBs grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets by initially, the creation of an equal volume of new money – demand deposits — somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around.

    Bernanke thinks reserves are a “tax”. A brief “run down” will indicate just how costless, indeed how profitable – to the participants, is the creation of new money. If the Fed puts through buy orders in the open market, the Federal Reserve Banks acquire earning assets by creating new inter-bank demand deposits. The U.S. Treasury recaptures about 98% of the net income from these assets. The commercial banks acquire “free” legal reserves, yet the bankers complained that they didn’t earn any interest on their balances in the Federal Reserve Banks.

    On the basis of these newly acquired free reserves, the commercial banks created a multiple volume of credit & money. And, through this money, they acquired a concomitant volume of additional earnings assets. How much was this multiple expansion of money, credit, & bank earning assets? Thanks to fractional reserve banking (an essential characteristic of commercial banking) for every dollar of legal reserves pumped into the member banks by the Fed, the banking system acquired about 93 (c. 2006), dollars in earning assets through credit creation.

    In short, Bernanke’s IOeR policy emasculated the FRB-NY’s “open market power” & destroyed the intermediaries.

  6. flow5 says:

    It’s Keynes’s “optical illusion”: In the General Theory, John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor & his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

    In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term financial intermediary in order to make Keynes’s statement correct.

    That’s why the CBs pay for what they already own (elimination of Reg Q ceilings). That’s why the Fed’s research staff doesn’t know the difference between money & liquid assets. That’s why the Fed turned 38,000 financial intermediaries into 38,000 CBs (DIDMCA of March 31st 1980). That’s why Friedman & Bernanke think reserves “impose costs & distortions on the banking system”. That’s why the BOG introduced the payment of interest on excess reserves. That’s why there’s a collateral shortage. That’s why the regulators want to backstop the shadow banks (turn them into CBs too).

    The fundamental misconception is epochal. As Einstein said “History is full of bad jokes” (& bad equations). It’s no radical conceptual leap. It’s not prejudicial. The pundits have learned their catechisms. We are being intellectually poisoned. It’s a “competition in laxity” & a global “race to the bottom”.

  7. flow5 says:

    Transaction based bank deposits represent our “means-of-payment” money supply. 93%-96% of all demand drafts cleared thru these deposit classifications (despite numerous financial innovations).

    Legal (required) reserves serve as a proxy for this “means-of-payment” money. They are based upon transaction deposit classifications 30 days prior. Thus roc’s in RRs reflect the FOMC’s degree of ease or restraint.

    I.e., “high powered money” does not equal the MB. Legal reserves are the base. The reserve ratio is the constraint. And the money multiplier reflects the “hot potato” effect (reserve velocity).

    Reserves & the money stock are endogenous & impounded (we have a managed currency – not a fiat one). And whereas savings are used or unused (S may or may not = I), depending upon where they are held (by the CBs or the NBs).

    Remember that lending by the CBs is inflationary (expands both the volume & directly effects the velocity of money). And lending by the NBs is non-inflationary (effects only the velocity of monetary/voluntary savings), ceteris paribus.

    FRB theory has evolved from bad politics: from using the CB’s liabilities as a credit control device to inadvertently using capital & liquidity coverage ratios to control the volume & rate of expansion in CB credit.

    Therefore the Fed never intended to provide continuous, timely, & conforming data for econometric modeling (as reserves allegedly “impose costs and distortions on the banking system”). I.e., esp. during the 1990s, the BOG’s data points were fundamentally statistical outliers.

    Nonetheless, the a posteriori evidence for the last 100 years demonstrates that the lag effect in money flows (our “means-of-payment” money times its transactions rate-of-turnover) have been mathematical constants (the zig & zag of an unbroken continuum).

    Using a heuristic approach, in July 1979, I discovered that the 10 month rate-of-change in required reserves is a proxy for real-output. And that the 24 month rate-of-change in required reserves is a proxy for inflation, ceteris paribus.

    Therein a “tight” money policy is defined as one where the roc in monetary flows is no greater than 2-3% above the roc in the real-output of goods & services. And inflation is the consequence of “too much money chasing too few goods & services”.

    I.e., FOMC policy didn’t necessarily “tighten” in May (but aggregate monetary purchasing power temporarily rose). You have to differentiate between the roc’s in the 2 metrics. Until Oct, the roc in MVt (economic activity), will decelerate.