On Treasury, Fed, financial stimulus, interest rates & MMT

The Treasury Dept and Federal Reserve Bank are responsible for smoothening economic cycles by managing economic fluctuation. Treasury oversees Fiscal Policies which deals with the management of government spending and taxation to achieve targeted aggregate spending. Fed handles Monetary Policies which primarily seeks to maintain price stability, ie inflation.

There are tools the agencies use to tweak policies during normal and crisis times. The mechanisms are somewhat complicated which leads to conspiracy ideas, claims of unfair bailout of fat cats, and blames on failing systems. Some claim that MMT (modern monetary theory) has in fact been partially practiced since the Fed is already ‘printing’ money, why not go full-throttle the AOC-Bernie Sander’s way (which is what, exactly?).

What I like to share here is the mechanisms Treasury and Fed use to pursue their policies, why certain aspects are critical, why the central bank balance sheets matter, and there is no MMT at work at the moment.

Treasury Department

The Treasury is like any consumer. It has a checking account and it makes all govt payments out of this account. This account is the TGA (Treasury General Account) with the Federal Reserve Bank of New York (There are 12 Fed banks).

Where does Treasury get the money to deposit into the TGA? From tax collection and debt. Treasury raises debts by issuing Tbonds, Tnotes and Tbills . These are govt securities of different terms. Let’s call them bonds collectively. These bonds are sold by public auction on a regular basis.

So what happens when Treasury wants to provide more financial aid, or free services, when needed, whether during normal or crisis times. Well, it can raise more taxes or dig a deeper hole by issuing more bonds.

Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, Treasury provides :

• Economic Impacts Payment Programme – Treasury pays to qualifying citizens $1,200 each.
• Coronavirus Relief Fund — Treasury funds state, local and tribal governments for qualifying expenditures.
• Paycheck Protection Programme – qualifying SMEs can borrow from participating lenders to pay salaries and some other expenses.

(1) & (2) are paid out and borne directly by Treasury.
(3) Treasury uses participating non-bank lenders to lend to qualifying borrowers. These loans are guaranteed by Treasury. The loans are free of interest or fees. lenders earn a fee from Treasury. Borrowers that use the funds for qualifying purposes have the loans forgiven (Treasury reimburse lenders).

These disbursements are borne by Treasury and impact its Income & Expenditure Account. Treasury pays out using its TGA checking account with Fed NY.

In addition, Treasury guarantees some loan programmes run by the Fed. In other words, risks and losses in these Fed financial assistance programmes are borne by Treasury.

There is no money creation by Treasury because that is not their territory. Its cash outlays are all funded by tax and debt. That is, tax payers foot the bill. The US national debt is the aggregate of these bonds which now stands at a whopping $23T. Years of deficit budgeting prevented the govt from making repayment on these loans. The practice of rolling over these bonds and never paying on it (except during the Clinton administration), has made some Americans, and MMT crowd, believe this is really not a debt. These folks should try to explain to pensioners that the bonds their pension funds are holding are not really assets.

The Federal Reserve

The Fed does its job by managing its balance sheet. Let’s look at an abridged balance sheet to understand how it works.

The TGA is the checking account of Treasury Dept. The Fed is the govt’s banker, honouring payments when there are funds in the account. Fed has nothing else to do with it.

The Bank Reserve accounts are the operating accounts of all banks in US. All US$ transactions, whether local or anywhere in the world, through correspondent banks and clearing house systems, end with the Fed crediting one bank and debiting another in these reserve accounts. Each day, banks are required to maintain a balance in these accounts that is not less than 10% of their deposit base.

When a deposit is made with a bank, it gets credited into its reserve account, which it then lends out and trigger off fractional banking. A reserve requirement of 10% can cause a $1,000 deposit to end up creating $10,000 in the economy. Thus the Fed can create more money in the economy by reducing the reserve requirement, or putting more money into reserve accounts. Managing this liability influences money supply or liquidity and short term interest rates.

By simply crediting these bank reserve accounts, the Fed puts money into the coffers of the banks. So the ‘keystroke’ analogy is born. But that’s only half the story. The Fed takes on the liabilities, where are the assets. The Fed puts money in Banks reserves and debits the following assets :

• Fed buys Govt bonds in the market – it debits Govt bonds account
• Fed makes loans in the Repos market – it debts Corporate bonds account
• Fed loans to banks through the Discount Window – it debits loans a/c
• Fed loans to banks under the Term Auction Facy in 2007 crisis — it debits loan a/c
• Fed loans to banks / SVP under under the various special facilities – it debits loan a/c

Buying govt bonds and releasing liquidity into the economy is called Quantitative Easing which is an expansionary policy. With liquidity in the market, interest rates go down, lending cost is cheaper, business expands and more people get employed.

When economy overheats and there is inflation, the Fed does the reverse by selling bonds. Bank reserve accounts are reduced (debited) and liquidity is sucked out of the market. This is contractionary policy called Quantitative Tightening.

Buying govt or selling govt securities to pump or withdraw liquidity in the market is called open market operation. It is not a Fed novelty, central banks in other countries do the same stuff.

Monetising Debt

During a crisis, such as the present corona virus pandemic, what does the Fed do by way of financial stimulus?

The anatomy of a financial crisis is basically a liquidity crunch. Everybody in the economy is connected in a network of inter-indebtedness. Some entities within the network tank, causing a contagion effect. If you cannot pay someone, that person has’nt got the funds to pay someone else. It goes up and down the line. Exacerbating the situation is a concurrent credit crunch as lenders pull back in the face of heightened risks. So the Fed tries to pump huge amount of liquidity into the market. It is more or less like QE.

Imagine you lend someone some money. You went into some financial difficulties and you needed the money back from your friend. Unfortunately, he cannot oblige and you have no one to borrow from because your credit rating sucks. An enterprising beer buddy, for a small cut, takes over the loan and gives you the cash you desperately needs. In legal lingo, this is debt assignment, in financial high fallutin, that’s monetising debt.

Central banks are all monetising their national debts in QE programmes to manage the liquidity in the economy.

During a financial crisis, the Fed applies the same debt monetisation across a wider risk asset spectrum. It purchases corporate bonds.

In addition, the Fed rolls out various special loan programmes, each designed for a class of specific target borrowers, with different lending mechanisms, securitisations, maturity, rates etc. For eg, Fed has established for coronavirus stimulus programmes:

• Primary Market Corporate Credit Facility (PMCC)
• Secondary Market Corporate Facility (SMCP)
• Term Asset-Backed Loan Facility (TALP)

These programmes use SVP (Special Purpose Vehicles). The PMCC & SMCC will provide credit of $750B and Treasury will put in $75B in equity in the SVP. Fed will loan the SVP to provide $100B credit lines for TALP, with Treasury underwriting $10B of losses. These loans are securitised, and often with guarantees by Treasury. When the SVP lends to a qualifying borrower or buys corporate bonds, it draws on these facilities with the Fed. By keystroke, Fed credits the SVP banker’s (say Citi) reserve account at the Fed, and debits asset (Special facilities a/c). Citi credits the funds to SVP’s a/c and the lending vehicle disburses the loans.

TALP facility came from the 2007 financial crisis playbook. It was guaranteed by Treasury’s TARP facility and collaterised with all sorts of mortgage securities. So the same mechanism is now used for corona virus stimulus package.

Why guarantees by Treasury? Because this business of lending is not the Fed’s normal function. Losses are carried by Treasury. Not doing so is to put Fed’s equity at risk and with it the confidence in the central bank.

Is the public sentiment of tax-payers bailing out fat-cats a fallacy?

Treasury CARES support packages mentioned above are freebies, but they are not for fat-cats. They are meant primarily to ensure the working class gets paid , SMEs get some band-aid, local govts can run some health programmes . Are tax payers footing these? Yes because they are funded by debts.

Fed facilities are credit mechanisms that allow corporations to draw on, the loans collaterised by various securities such as bonds or other mortgage instruments. This means when the crisis clears, the Fed can hold on to the securities till maturity, or sells them in the open market. Some of these facilities are guaranteed by Treasury, so tax payers foot the bill only to the extent of realised losses.

And here is the good news. The Fed did not loose a single cent on the disposal of their billions of $ of TALF 2007 securities. This is hardly surprising as bond prices had increased sharply since 2007. There were some abuses, but the reality is, no fat-cats got bailed out. No freebies were given to them.

Do you see MMT in all these?

In summary, stimulus packages in a financial crisis is the same as in normal times to the extent that Treasury funds itself from debt, whereas Fed creates money by ‘keystroke’ a credit to bank’s reserve account and debiting an asset account for debts purchased.

This brings me to MMT. Proponents say money is free and the way the Fed is ‘printing’ money by a keystroke is the euraka. However, nothing above describes free money. Treasury took on debt to get the funds for its TGA checking account. Fed creates money to buy assets but corporations take on debt to get Fed funds via SVP.

MMT proponents are long on theories and short on details. Reaction to criticisms is condescension — you are ignorant, antiquated, you should embrace the new ideas. Requests for details are met with a dose of high octane theories, sans the info you are seeking. MMT proponents are in the same crowd as social justice warriors in social media. They decry status quo and say we should move to yonder hills where the sun shines bright, but will not tell you the steps to take. It matters, because the steps may be laced with mousetrap glues.

MMT is no universal theory, there are disagreements within the camp. I am in no position to posit on this, but there are a couple of points where they have been specific, and on these, I will touch on below.

Interest rates

“Our preferred position is a natural rate of zero and no bond sales. Then allow fiscal policy to make all the adjustments” (MMTer William Mitchell)

At the heart of an open market economy beats the interest rates. It is the wage of capital. Interest is the cost of using the $. And like all things sold in an open economy, the market decides what the price is.

Interest rate is the tool of choice by Fed to tame inflation. It fine tunes the interest rate to manage inflation to a preferred level which is about 2%.  Sounds contradictory here, since interest rate is a market function and yet the Fed can tweak it? Here’s how it works.

There are interest rates of all sorts of maturities out there – overnight, a week, a month, 3 months …. 30 years. This is known as the yield curve. There are interbank rates (banks borrowing and lending each other with no spreads) and Prime rates which are rates that banks lend to their best customers.

Then there is the Fed Funds Rate. This is the rate the Fed uses to influence the economy in the US. Without a doubt, the Fed Funds Rate is the most important interest rate not just in the US, but in the world. It is the benchmark rate for all spheres of business activities — credit cards, mortgage loans, banks’ prime rates and thus all consumer loans, etc and rate setting in international banking centres such as LIBOR, SIBOR, HIBOR, SHIBOR, EURIBOR. Last but not least important, it also impacts the yield curve. And when these rates move, it impacts foreign exchange, commodities, derivatives markets all over the world. We are all inextricably tied together.

Remember all those bank reserve accounts? Each day cash flows through these accounts to settle deals done for the day with same day values, plus forward-dated deals done in the past that has matured. At the close of business, banks must have balances that meet their reserve requirements. Excesses are lent out, shortfalls are covered by borrowing. Banks lend/borrow each other overnight in the Interbank Money Market. The rates are negotiated rates and its called the Interbank O/N Rate. If market is tight, banks borrow from Fed through the Discount Window facility which is more expensive.

Fed computes a weighted average of these Interbank O/N Rates daily and post it on their website. This is called the Fed Funds Rate because the depositors money lying in all those bank reserve accounts are called Fed funds.

Notice that the Fed does not set the Fed Funds Rate. It is market driven. What the Fed does is to set a Targeted Fed Funds Rate. To heat up the economy, they reduce the targeted rate, to cool the economy, they raise the rate. It takes about 12 to 18 months for the impact of rate change to be seen in the economy.

The Interbank O/N Rates always gyrate towards the Targeted Fed Funds Rate. Decades of practice have made the Fed an expect in predicting the economy and rate setting. It does this by using algorithms and all sorts of monetary aggregates, and managing those monetary metrics to get the economy to where it wants.

The FOMC (Federal Open Market Committee) meets 8 times a year. Monetary policy decisions are made and announced. This is when the Targeted Fed Funds Rate is announced. Investors and all financial markets and central bankers in the world pay great attention to what’s said here. Every word, every nuance, is studied carefully.

“… auction philosophy, …, are just arbitrary rules. Those are not etched in stones or, for that matter, obeying the natural laws of the universe.” ( Micha)

So the Targeted Fed Funds Rate impact the short-term overnight rates. How about the longer term rates? This is the function of the auction of bonds by the Treasury. There are issues of market power, but generally, auction is one of the most efficient means for price discovery in an open economy. There is ‘no natural laws of the universe‘, but it bows to the truism that the market gets what the market wants.

Treasury sells its bond issues in the Primary Market by auction which the Fed, by law, cannot participate. This is to ensure independence of the central bank and open market price determination. Treasury bonds have maturities ranging from 1 month to 30 years and its auction establishes the interest yield curve for a risk free asset. Long term deals are benchmarked to the yield curve. Without this, there is no valuation for all sorts of assets like futures, options, foreign exchange arbitrages, and other derivatives, there is no basis for pricing long term loans, there is no actuarial science, and a host of other application.

Interest rates lie at the very core of the economy, but MMTers wave them away and suggest it be done by fiscal policy adjustment. Exactly how, is the question.

Fed balance sheet matters

Interest rate was the tool of choice for Fed to manage inflation and promote full employment. After 2007 crisis, the Fed Fund Rate has dropped to near zero, which means there is very little room left to manoeuvre. It had to use more open market operations to pour more liquidity into the market. The purchase of govt bonds became the new tool and it got so pronounced the QE term was born.

The Fed went on a buying spree of govt securities and corporate securities to generate liquidity and took on loan assets in the stimulus programmes during the crisis of 2007 and the conora virus pandemic. To generate liquidity, the Fed has been building up its balance sheet. Just prior to the 2007 crisis, total assets was $870B. At about the time of normalisation of 2007 crisis, total asset had increased to $3.7T. Today it is $5.3T and still growing. It is predicted before the virus pandemic credit squeeze is normalised, the Fed’s balance sheet will grow to an astounding $10B, a frightening 43% of the US economy! Think about what each extra $1T will be after fractional banking and the scope of money supply after that.

The US is not alone in this. G7 central banks are in similar situation – near zero interest rates and a bulky balance sheet. G7 central banks are more precarious because they have also gobbled up higher risk ETFs in equities market. The Fed does not purchase in the stock markets although there had been some talk about the possibility. There are implications in the size of central bank balance sheets. The huge liabilities side indicate the vast sum of liquidity that impacts both short and long term interest rates which affects asset prices. The huge assets side puts central bank capital at risk when assets are marked-to-market. Deflating the books after the crisis is over carries with it a different whole series of risks for the economy because it's a contractionary exercise.

Summary

I set out to show what the Treasury and Fed does both in normal times and crisis and hope to convey the view that there is method in their complexities and there is no MMT in play.

To those who ask, with all the national debt built up and QE of the last decade, why the liquidity did not bring about an inflation in the US, the answer lies in the Fed balance sheet. If you had been observant, I have already answered it. The increase in the money supply did not spill into the real goods and services and thus prevented real inflation. All those liquidity pumped into the economy has to go somewhere and it did. It went into the asset market. Just before the virus debacle, Dow Jones US real estate index was higher than before the subprime crisis, Dow Jones Industrial index was 120% over 2007 heights. Decline in yields raised bond prices to new heights. Inflation in the asset market allowed the Fed to dispose assets acquired in 2007 crisis without incurring any losses.

The Fed fights inflation with interest rates as the main tool. Its Targeted Fed Funds Rate is proactive in nature as its impact is felt 12 to 18 months later. MMTers have consensus that taxation is their weapon to fight inflation. This is reactive, and imagine the legislative process it requires to reach implementation.

In it’s essence, MMT transfers monetary policy making to the Treasury. It throws to the trash bin the jewel in the capitalist open economy, the independence of the Fed. MMTer’s regard for the need for integrity of the Fed is summed up in Micha’s comment “central bank independence is exactly the narrative that the private banking mafia want to perpetuate.” I shall end with this poser:

Without actually understanding all the MMT theories, and you have to choose, would you trust politicians to handle the intricate task of fine-tuning the monetary aggregates for a $23T economy, or would you prefer non-partisan, seasoned technocrats to run the show?