Wednesday, August 13, 2008

How Are Interest Rates Going Down, While Money Supply Isn't Expanding?

Money market funds, the short-term cash alternatives, grew to $2.9 trillion in June, up from $2.1 trillion a year ago, according to Crane Data. Further, those funds, in turn, have more than tripled their holdings of Treasuries and other government debt while reducing the share of their portfolios invested in somewhat riskier corporate notes, according to Vikas Bajaj .

Felix Salmon notes:

Money-market funds have gone up by eight hundred billion dollars over the past year? Yikes. To put this in perspective, the total amount of Treasury bills outstanding, according to the most recent schedule of Federal debt, is $1.13 trillion. If the money-market funds are massively overweight Treasury bills, there can't be very many left over for anybody else.

Bernanke is in kind of a Catch-22 here. Because of the fear in the markets, the real short-term rates for safe paper are below the Fed Funds rate. Thus banks do no money borrowing from the Fed to put the money in T-Bills, since it is currently unprofitable. Thus, no money supply growth. At the same time, the lack of money supply growth weakens the economy even further, creating even more fear in the markets and pushing T-Bill rates even lower.


  1. I have been thinking a lot about this issue lately. Is the risk premium on regular Treasurys higher than on TIPS? It seems to me that the market is way underforecasting future inflation, but I wonder if I'm missing the underlying patterns.

    The other thing I wonder about is the sterilization process. Suppose the Fed had been sitting on a trillion dollars in gold, and sold down that stockpile to sterilize loans to banks. How would the present situation be different? Would interest rates be lower and gold prices lower?

  2. Bob,

    I have never been big on prices as "forecaster". I think this type of thinking misunderstands Hayek's view of what prices do, in the sense that Hayek was eluding to current prices as a signal to businessmen on how to act, and not as much about futures prices.

    My guess is that the current T-Bill market reflects those whose fear is loss of principle. They aren't thinking inflation. Those who fear inflation are more likely to be buying gold than T-Bills or TIPS. TIPS will really get hot when instiutions start to fear inflation.

    That said, the 5-year T-Note is trading to yield 3.23%, while the 5 year TIPS is trading to yield 1.9%, whch suggests that a 5 year call option on inflation is priced at an anualized cost of roughly 124 basis points. (My guess is that the quants have an arbitrage that goes on between TIPS and some inflation traded instrument such as the CRB.This will keep TIPS in line wth anticpated inflation. )

    As far as gold and a sterilzation, I think there would be two factors that would put downward pressure on gold. First, the gold would be going from the Fed into hands that are more likely to sell it, indeed if the Fed itself didn't start to sell it. Second, you would probably get sizeable selling from owners of gold. Gold holders tend to have a much more sophisticated understanding of the nuances of what is going in the markets (to a degree). They would understand the downward pressure on gold from Fed sterilizaton operations. Treasury holders tend to be a lot less into the nuances. Maybe Bill Gross understands what is going on, but your average Treasury security holder, including institutional managers don't even know a sterlization is going on.

    And, if you want to get into the masses, a lot of their thinking reflects Drudge type thinking. Every time the Fed annouces the results of a TAF, Drudge runs with a post: Fed Adds Another X Billion into the Banking System, when in fact some is just a roll over of previously borrowed money and the rest is sterilized.Under this scenario, T-Bill rates would be about the same. T-Bill actors are not the same as Gold players--Maybe if you saw sizeable sell offs in gold some of that money would find its way into T-bills and put addtional downward pressure on T-bill rates.