Banking On Failure: Open Market Operations, Quantitative Easing & Interest On Reserves

WORLDWORKS by Joe Pimbley

Editor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book;“Banking on Failure” co-authored by Laurel McDevitt.

The previous excerpts for Chapter 8 discussed “History of Central Banks,” the “Stated Mission of Central Banks” and some monetary policy tools

THE MOST EFFECTIVE monetary policy tool over the longest period of time in the U.S. has been “open market operations” (OMO).[1] It’s an obscure name for a practice that one might call “fiendishly clever” or “too clever for its own good.” In OMO in the U.S., the Fed buys or sells (U.S.) Treasury debt securities from or to designated “primary dealers.”[2] Why and how? When the Fed buys Treasuries, the “cash” it pays adds to the money supply in the form of increased bank deposits. All else equal, the increase in deposits will foster more bank lending which acts to increase both price levels Banking on Failureand economic activity. The Fed’s net buying of Treasuries also pushes up the price of these debt securities. Since the higher price of debt is equivalent to lower yield of the debt, the Fed’s OMO purchase of Treasuries forces Treasury yields lower. Typically, lower Treasury yields result in lower interest rates more broadly which should also boost prices and activity by increasing borrowers’ demand for loans since the loans will have lower interest cost.

Thus, the purpose of the Fed’s OMO purchase of Treasuries is to stimulate the economy and prod inflation higher. Conversely, if the Fed wishes to suppress inflation it will sell some or all of the Treasuries it has accumulated. As it sells these debt holdings, the Fed drains money out of the economy and thereby discourages lending. General interest rates rise as a consequence of this “Fed tightening.”

Where does the Fed get the money to purchase Treasuries in OMO? Or, when it sells Treasuries, where does the Fed put the money it receives? The Fed creates money to buy and destroys money when it sells. The conventional description is that the Fed “prints money” even though electronic transfer of funds eliminates the need for literal paper currency.

Prior to 2008, the Fed focused its buying and selling on the shortest maturity debt instruments known as “T-bills” (Treasury bills). As calibration and determination of whether to buy or sell T-bills for OMO, the Fed set a target level for the “Fed Funds” interest rate.[3] The Fed Funds rate is the rate at which one bank lends reserves to another bank with overnight (i.e., one-day) maturity. Since Fed Funds lending is extremely short-term, it was reasonable that the Fed’s OMO purchases and sales would focus on short-term T-bills to guide (or one could say “manipulate”) the Fed Funds rate.

But OMO transactions need not stop with T-bills. Beginning in 2008, the Fed included longer-term (maturities out to thirty years) Treasury notes and bonds with the explicit goal of controlling longer-term interest rates.[4] In an “OMO-to-the-max” extension, the Fed also added mortgage-backed securities (MBS) and other debt of the Federal National Mortgage Association (also “Fannie Mae” or FNMA), the Federal Home Loan Mortgage Corporation (also “Freddie Mac” or FHLMC), the Government National Mortgage Association (also “Ginnie Mae” or GNMA), and other quasi-government entities to the list of permissible assets for OMO transactions. “Quantitative easing” (or QE) is the term that the market applies to OMO purchases of financial assets other than Treasury debt securities.

If there’s a “method to the madness” of QE, it is that the Fed’s direct purchase of MBS and other Fannie Mae / Freddie Mac / Ginnie Mae debt will lower mortgage interest rates. In addition to the overall goal of OMO purchases to boost economic activity and inflation, the selection of mortgage-related debt attempts to focus price inflation on the housing market. All else equal, if mortgage rates are lower and mortgage loans more plentiful, then house prices rise. Though targeting increased house prices is arguably closer to “public policy” than “monetary policy,” the Fed anticipates a “wealth effect” in which homeowners will presumably increase their spending when they believe their houses have greater value.[5]

As one additional wrinkle of OMO, the Fed may choose repurchase (“repo”) and reverse repurchase (“reverse repo”) transactions in lieu of purchases and sales. Generally, repo transactions are a form of borrowing. For the Fed’s OMO, however, a repo acts like a purchase of Treasury securities “today” followed by a sale of the same security (i.e., “repurchase” by the counterparty) at a fixed future time. During the period of the repo, the Fed has increased the money supply just as if it had purchased the Treasury securities. In the opposite manner, a reverse repo is equivalent to the Fed withdrawing cash from the economy “today” and then pushing the cash back to the market at the maturity of the reverse repo.[6]

Let’s pause briefly to consider a skeptic’s view. Harken to George Orwell: “Some ideas are so stupid that only intellectuals believe them.” Although OMO traces its history at least as far back as the 1920’s when the U.S. remained on the gold standard,[7] one wonders whether OMO under today’s fiat money regime signifies nothing, or worse, at its core. When the Fed creates cash to buy Treasuries, it may as well simply pay the cash to the U.S. government. That is, imagine an investor purchasing a T-bill by paying cash to the U.S. Treasury. The next day, the Fed buys this T-bill from the investor. The net result is equivalent to the Fed simply paying cash to the U.S. government in return for an electronic IOU (the T-bill). In fact, there are occasions on which the Fed literally skips the middle-man and buys debt straight from the U.S. Treasury.[8]

As we noted in the earlier fleeting reference to the Weimar Republic, the first duty of a central bank is to refuse to create money at the behest of its government merely to enable the government to pay its obligations without raising legitimate revenue (such as taxes) or issuing legitimate debt. Is it Orwellian to believe that OMO and Weimar-style money printing have nothing in common?

A defender of today’s monetary policy methods would likely agree that “money printing” is wrong for the purpose of papering over government fiscal problems. But she would then add that conventional OMO targets monetary policy rather than fiscal policy. The skeptic then likely rejoins with the complaint that identical activities with different stated motives remain identical activities.

Returning to our descriptive task, we consider a final tool of monetary policy in the U.S. The Fed began paying interest on banks’ reserve balances in 2008.[9] In prior years, banks rarely held reserve balances significantly above the reserve requirement. With the advent of the new Fed policy, however, the “excess” reserve balances jumped to, and sustained, levels more than ten times greater than required balances.[10] Just as the government pays farmers in some situations not to grow crops as “agricultural policy,” the Fed effectively pays banks not to lend their excess reserves. Stated differently, when the Fed wishes to discourage bank lending in the conduct of its monetary policy, it will raise the rate it pays on bank reserves. The banks then have incentive to stop lending to real borrowers at interest rates below the rate the Fed pays and to raise lending rates. The banks’ loans to the Fed (i.e., the reserve deposits) are risk-free. Thus, all real borrowers will need to pay a higher rate than the Fed.

For purposes of controlling bank lending, Fed adjustment of this interest rate it pays on reserves is highly effective. If and when the Fed chooses to push general interest rates back to “normal levels” from today’s prevailing levels, it may well choose to increase the interest rate on reserves rather than sell its large accumulation of Treasury and mortgage-related debt.[11] Yet this potential action paints an odd picture. The Fed, a government entity, will maintain large holdings of Treasury and government agency debt while paying banks high, risk-free interest. One could say the banks lend trillions of dollars to the Fed so the Fed can buy government debt.

In the next excerpt, we explain and dissect the Balance Sheet of two Central Banks.

[1] See, for example, http://www.federalreserve.gov/monetarypolicy/openmarket.htm .

[2] See, for example, http://www.federalreserve.gov/faqs/money_12851.htm .

[3] The Federal Open Market Committee (FOMC) of the Fed is the deliberative body that makes formal decisions of this sort. The FOMC meets at least eight times annually and issues public policy statements following each meeting. Investors and economists pay close attention to these statements. See, for example, http://www.federalreserve.gov/faqs/about_12844.htm .

[4] See, for example, http://www.federalreserve.gov/monetarypolicy/bst_openmarketops.htm .

[5] See, for example, B. S. Bernanke, “Aiding the Economy: What the Fed Did and Why,” Washington Post, November 5, 2010.

[6] What the Fed calls “reverse repo” transactions are in reality repo transactions by conventional definition. The Fed labels “repo” or “reverse repo” based on the opposing party’s position rather than its own. We provided the description above with the Fed convention rather than market convention. We consider market convention to be “correct” and less confusing, but it’s hard to fight the Fed! See, for example, http://www.newyorkfed.org/markets/rrp_faq.html .

[7] See, for example, http://www.federalreserveeducation.org/about-the-fed/history/ .

[8] See, for example, this link to the website of the Federal Reserve Bank of New York with this comment on Treasury debt auctions: “Within minutes of the auction deadline, the Treasury … [announces] … the quantity of securities awarded to the Fed, the quantity awarded to foreign and international monetary authorities for noncompetitive bids made through the Federal Reserve Bank of New York, and the quantity awarded to other noncompetitive bidders.”

[9] See, for example, http://www.federalreserve.gov/monetarypolicy/reqresbalances.htm . Other central banks instituted similar practices. See D. Bowman, E. Gagnon, and M. Leahy, “Interest on Excess Reserves as a Monetary Policy Instrument: The Experience of Foreign Central Banks,” Board of Governors of the Federal Reserve System International Finance Discussion Papers, Number 996, March 2010.

[10] See, for example, the Federal Reserve Bank of San Francisco’s “Dr. Econ” column of March 2013 at http://www.frbsf.org/education/publications/doctor-econ/2013/march/federal-reserve-interest-balances-reserves . See also T. Keister and J. McAndrews, “Why Are Banks Holding So Many Excess Reserves?,” Federal Reserve Bank of New York Staff Reports, no. 380, July 2009.

[11] In fact, this was precisely the Fed’s mechanism for its December 2015 rate hike. The Fed now pays 0.50% per annum on reserve deposits from banks. See, for example, “The Federal Reserve’s New Approach to Raising Interest Rates,” FEDS Notes, February 12, 2016.

Joe Pimbley
Joe Pimbleyhttp://www.maxwell-consulting.com/
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.