People who focus on monetary statistics often forget the underlying data may be more robust than is captured by these aggregates. In the current situation there are people who point to the fact that the monetary base hasn't grown much or has even fallen for a few month over month periods in recent times thereby justifying low inflation expectations and the need for the fed to combat an apparent deflationary downside risk.

The problem with this analysis is over simplicity. The factors missed out by the statistics include a qualitative view of the quantities, a theoretical interpretation of the data over broad times, and an assessment of the recent market demand for money and loanable funds. I'm gonna try split these into three posts to keep them short and to the point. For this one, I will focus on the qualitative view of the quantities.

The Federal Reserves' ability to effect the money supply is the key to their power and influence. All policy is essentially enacted by means of this tool. The current monetary structure is arguably the Feds' most powerful environment over its history and this is partially the result of several big pushes towards providing more elasticity and therefore control over the money supply. Under a gold standard compared to today, the fed could contract the money supply more powerfully than expand, while today they have a stronger ability to expand than contract. Thus far, under the post-Nixon Fed, they have had a reasonably strong power to do both as they please but the means to effect the downside may become increasingly constrained due to macro changes and risks and changes in the quality of the Fed's balance sheet.

To see this, one must simply realize, that once the things the Fed buys to effect an increase in the money supply are not scarce, there is little to no limit to how high this can go. On the other hand, selling those same things will depend on the demand for these items in terms of how much the money supply can be effected on the downside. Default risks also threaten the ability of just letting an agreement or loan expire. Note that there is little external to the Fed that is necessary to control the upside of the money supply, however, factors beyond the Fed can disturb their ability to bring the supply down.

Consider the situation now a days where the Fed generally mostly holds high quality debt paper. The reason the fed has in the past been discriminating over the quality of paper they hold is because they want to retain control of their ability to sell and or collect on these assets if need be. Should they lose this ability, they simultaneously lose their ability to effect the money supply on the downside and inflationary risks are increased all else equal.

Over the last year the Feds' balance sheet has undergone quite a makeover (see image below) yet the value quantities of assets hasn't changed much. One reason this is more serious than the money base aggregates suggest is because the Fed has been replacing higher quality assets with comparatively lower quality assets. The fed went from assets that have little no to risk of default before expiring and are generally very liquid to loans backed with questionable credibility and liquidity. This may then effect the Feds' ability to unload these assets at significant value if need be and consists of a debasement of the Fed's creditability. In all, this is one reason to why what the Fed holds matters very much so and explains a deeper picture than is captured in a simple aggregate.

I could have made the same argument using half as many words

sometimes a little background and extended emphasis helps avoid later problems. i can explain it one short sentence otherwise.

Didn't the fed change how it does its accounting or something?

they make changes and additions every so often so depends which change you're referring to. how they've classified the new facilities they've started may be what you're referring, but maybe you can be more clear.

what do you assess as the probability of the fed needing to unload the securities of lesser liquidity/credit quality? ... i.e. what would you assess as the probabiliity that one of the member/loaned banks default.

Barron

well due to the limited information about who is specifically bidding for what its hard to know, but the probability is certainly greater than the treasury defaulting. Liquidity of their "collateral" backed debt is obviously an issue by virtue of the fact that the firms desperately need loans from a government institution under extenuating circumstances.

also to assess what you're asking you need to be clear about a default. If a firm is about to default the fed may prevent the process by monetizing more of their debt for as long as it likes. like i said, there is no limit on the upside of inflation because there is no scarcity to debt. no firms need to ever default technically and this is apparently the position the fed is taking. in essence a primary dealer already did fail, but my guess is you're not counting that.

qualitative view of the quantities


lololololololololol

do i have a funny accent?

Cliff Notes:

1. The Fed prints money to buy stuff.
2. Printing money causes prices inflation because it increases the money supply.
3. It is good that the Fed has more control over the money supply since the dollar is no longer linked to gold.
4. However, if the Fed wanted to decrease the money supply, they may not be able to because people may not want to buy the stuff the Fed bought in 1. This reduces the Fed's control over money supply, which is bad.
5. Item 4. is happening now, which is important to very few people, but shouldn't be.

i never made a value judgment about whether control over the supply was good or bad.

the real danger here in practice, whether or not this was clear, is if the lower quality assets come to represent the overwhelming part of their portfolio they will not be able to continue an offsetting mechanism as easily as they do with treasuries now if the loans need to persist. This means either an uncontrollable growth in their assets and therefore the money aggregates or the failure of major institutions.

This is just not true. The reason that the Fed shouldn't buy credit assets has to do with wanting to keep capital allocation in the private sector (and not have tax payers shoulder credit losses) and nothing to do with loss of control over the money supply. In the event that the Fed's balance sheet is impaired, they can directly issue debt, or have the Treasury turn over t-bills to them, or even increase reserve requirements. The Fed is normally ridiculously profitable that this just isn't an issue. Another way of looking at this is that basically all major banks will have to fail for the Fed to be impaired significantly (the Fed isn't directly buying credit assets in any of the transactions - they are mostly lending to major banks/b-d's) and bank failures are so extremely deflationary that inflation is likely the last thing they'd be worrying about.

this is another reason and they've tried to avoid it but they are doing this right now even if while grinding their teeth. Aside i dont care about their motives. The fact is they are losing control, whether they like it or not.

also, what i said "The reason the fed has in the past been discriminating over the quality of paper"

The risk is that their balance sheet no longer has treasuries to do this with. Sure they can issue debt but if they are very impaired this wont be very successful. Increasing reserve requirements would be their best option but they are still more limited than they were before hand. They would have to face up to a massive unwinding still if they take this last option.

if the fed lets the banks fail i agree inflation wont be a problem hence why i said either a systematic collapse or inflation will be the choices they may confront.

YESSS Another epic Zygote-Phone Booth debate....Popcorn please.

The quality of paper determines whether the Fed gets stuck with losses, which basically means less income for the treasury. The Fed has to constantly pump money back into the system just for the monetary base to stay even.


The Fed debt would be backed by the printing press. It's as sure as the treasuries. And nothing whatsoever stops the treasury from issuing debt directly to the Fed without taking the proceeds.


But this has nothing whatsoever to do with the Fed buying bad papers. The point is that monetary contraction is within the powers of the Fed, regardless of their balance sheet, since their balance sheet can be repaired at will by the Treasury.

well it will be important for them to find foreign demand if they didnt want to really feel the crunch at home. Also these will only take away from demand for treasuries and not much will have changed.

this is an interesting point but the treasury will need to cooperate in diluting their ability to borrow.

for one even treasuries may suffer a sever drop in quality so they're out of means to repair then. i agree there are a lot of thing the government and fed can still do beyond this the point is just that they become more vulnerable and less credible.

Well if treasuries are not acceptable, then we already have monetary contraction due to higher interest rates. What I'm saying is that assets failing itself is a problem, not whether the Fed holds them. Buying those assets is inflationary, but that's true whether foreign governments do it, the Treasury does it, or the Fed does it.

but this contraction is out of their control. it also doenst necessarily imply an overall contraction.

very much agreed. there isnt much point with the fed providing loans collaterally backed by failing assets.

interesting Volcker speech:

quote from bloomberg article, "The Bernanke Fed may have already seized too much power and has abandoned historical principles, says Paul Volcker, who was Fed chairman from 1979 to '87. ``The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers,'' Volcker, 80, told the Economic Club of New York on April 8. ``A direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time- honored central bank mantra in times of crisis: lend freely at high rates against good collateral. It tests it to the point of no return.''"

vidoe of the speech:

part 1
part 2
part 3
part 4
part 5