Wednesday, May 30, 2012

How the Federal Reserve Manipulates Interest Rates and the Money Supply

My post on the eurozone crisis and Ben Bernanke targeting of the Fed Funds rate has resulted in a number commenters asking for specifics on how it's all done. Below is a quick explanation, for a more detailed explanation I recommend Murray Rothbard's book, The Mystery of Banking.

The Federal Reserve manipulates interest rates, generally, by buying and selling Treasury bills. When they buy Treasury bills, they add reserves to the banking system. That is they issue a credit to the bank (primary dealer) that they buy the T-bills from. If the bank doesn't put the credit into excess reserves, the money becomes part of required reserves that the bank lends money out against, which increases the money supply. (The increase in money supply is actually a multiple of the added required reserves--see Rothbard)

When the Federal Reserve sells Treasury bills, the bank (primary dealer) that they sell the T-bills to pays for them with reserves, which drains reserves from the system and decreases the amount of money in the system.

Generally, when the Fed is targeting interest rates, it is doing so to keep interest rates from climbing. This is what occurred during the G. William Miller period I discussed in my earlier post.

During the Miller period, the Fed had to buy huge amounts of Treasury bills to keep rates down. This resulted in a huge increase in reserves, which resulted in exploding money supply, which resulted in soaring prices. Which resulted in higher interest rates. It was a tiger by the tail situation. When Volcker replaced Miller at the Fed, he stopped targeting interest rates and said that instead he would just slow money supply growth (to battle the price inflation)and not care about interest rates. (Rates then soared to double digit levels, some reaching 20% plus, but Volcker was successful in killing the price inflation)

At present, on a very short term basis, Bernanke appears to be targeting the key Fed funds rate at 0.15%. Because there is huge hot money flowing into the U.S. from the eurozone, the Fed has to drain reserves to keep the Fed funds rate at 0.15%. Otherwise the rate would likely drop lower. BUT, once the hot money flow stops (and possibly reverses) the pressure on rates is going to be to the upside. If the Fed keeps it's target at 0.15% for Fed funds, this means they will have to buy Treasury bills to keep the Fed funds rate from climbing higher. Thus, the Fed will be reversing from the draining of reserves to the adding of reserves. And the adding of reserves will likely mean climbing money supply.

Bottom line: A roller coaster economy brought to you by Ben Bernanke by his first draining reserves and his then expanding them is the path we are on.

13 comments:

  1. Thank you. Now to get some Excedrin...

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  2. Do you offer instructional seminars for professionals (e.g. law, medicine) who are often clueless with respect to the details of the banking system?

    I'm a big fan of your blog, and it would great to hear banking and economics explained without the cognitive dissonance and mathematical jibberish offered by the ivory tower.

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    1. Sure. Just email me about your group.

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    2. Please video tape those seminars and post on your blog par excellence. It would be helpful if a question is repeated in the event the audio fails to pick it up.

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  3. One little factoid from the history pile...

    The Supply-Sider Paul Craig Roberts stated in one of his early books that, upon entering the Treasury Department, discussions were held with Volcker and that a "Gentleman's Agreement" was made that the change in Monetary Direction would be made over a 3 year period. PCR then states that Volcker delivered the reduction in Money Supply growth over a 6 MONTH PERIOD. This guaranteed a very severe Recession.

    Conservative Economic Theory can mine a lot of data from that period - Monetarists (Demand Side), Supply Siders for what followed and the Austrian groups for analysis of what happens when rapid change occurs in the nature of money.

    Charles Wilson

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  4. Desolation JonesMay 30, 2012 at 6:49 PM

    Why does the Fed need to drain reserves? It's paying interest on reserves, which creates a floor on the federal funds rate.

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    1. Typical Desolation Jones comment, you write before you think. The Fed is paying 0.25% on reserves, yet Fed funds are at 0.15%, which means funds are being offered on the fed funds market from sources other than those who have access to the rate being paid by the Fed for reserves. Duh.

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    2. Desolation JonesMay 30, 2012 at 7:12 PM

      I was just asking a question about something I was unsure of. The horror!

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  5. Or maybe the overnight FFR is selling for .15% because the funds lent in the inter-bank market are unsecured. And a bank has to purchase maturities of 6 months or longer to obtain comparable risk-free returns on governments.

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  6. The point is not the specific risk adjusted level, but rather the fact the rate hasn't declined despite declines in other rates, which suggests a flow of hot money into the U.S.

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  7. "Volcker was successful in killing the price inflation"

    Paul Volcker (like Alan Greenspan from Oct 2002- Feb 2006) never tightened monetary policy.

    Paul Volcker’s version of monetarism (along with credit controls: the Emergency Credit Controls program of March 14, 1980), was limited to Feb, Mar, & Apr of 1980. With the intro of the DIDMCA, total legal reserves increased at a 17% annual rate of change, & M1 exploded at a 20% annual rate (until 1980 year’s-end).

    Why did Volcker fail? This was due to Volcker's operating procedure. Volcker targeted non-borrowed reserves when at times 10 percent of all reserves were borrowed. One dollar of borrowed reserves provides the same legal-economic base for the expansion of money as one dollar of non-borrowed reserves. The fact that advances had to be repaid in 15 days was immaterial. A new advance could be obtained, or the borrowing bank replaced by other borrowing banks.

    It was before the discount rate was made a penalty rate. And the fed funds "bracket racket" was simply widened, not eliminated. Monetarism actually has never been tried.

    Then came the "time bomb", the widespread introduction of ATS, NOW, & MMMF accounts at 1980 year end -- which vastly accelerated the transactions velocity of money (all the demand drafts drawn on these accounts cleared thru demand deposits (DDs) – except those drawn on Mutual Savings Banks (MSBs), interbank, and the U.S. government).This propelled nominal gNp to 19.2% in the 1st qtr 1981, the FFR to 22%, & AAA Corporates to 15.49%.

    By the first qtr of 1981, the damage had already been done. But Volcker errored again (supplied an excessive volume of legal reserves to the banking system), in late 1982-83.

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    1. So interest rates skyrocketed and commodities crashed just magically after Volcker took over the helm at the Fed?

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  8. In addition, some universalists even preserve that will Satan as well as all devils will also possibly be reconciled to The almighty unitarian

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