Download US Fed: the water rate addendum 140923

US Fed: the water rate addendum
23 September 2014
Economics
US Fed: the water rate addendum
DBS Group Research
23 September 2014
• Three QE programs have made the Fed funds rate obsolete as a policy
rate
• Banks are sitting on $2800bn of excess reserves that they are free to
deploy – or add to – any day they wish
• The only way to control whether banks move funds into or out of this
reserve poos is to raise or lower the rate paid on them – the water rate
• The official name for the water rate is “interest rate paid on excess reserves”. Either way, it’s the new policy rate
• Congress may not like paying banks for ‘doing nothing’ but they got
paid even more when they held Treasuries instead of Fed deposits
In “US Fed: the water rate” (16Sep) we discussed why the Fed funds rate has become
irrelevant as a policy tool and will likely be replaced by the “interest rate on excess
reserves” or what we call the water rate, for short. The repo/reverse repo rate(s)
will support the new policy rate as it supported Fed funds in the past.
The message there was that Fed funds had been made obsolete by the failure of
QE to “inject liquidity” into the economy as was hoped and as traditionally occurs
when the central bank conducts open market operations / buys bonds. For the
most part, Fed ‘injections’ continue to sit idle on bank balance sheets in the form of
excess reserves. The magnitude of these reserves ($2800bn at last count) and the
fact that banks are free to tap them – or add to them – any day they wish, means
that the rate paid on excess reserves is the only one that matters when it comes to
monetary stimulus / constraint.
US Fed – balance sheet (liability side)
QE3
Sep12 - Oct14
US$bn
4,500
All those QE ‘injections’ went nowhere
but into the Fed’s
basement in the form
of excess reserves
4,000
QE1
Dec08-Mar10
3,500
QE2
Nov10-Jun11
3,000
2,500
Excess bank reserves
at the Fed
2,000
1,500
Deposits and capital
1,000
Currency in circulation
500
0
Mar-06
Mar-07
Mar-08
Mar-09
Mar-10
Mar-11
Mar-12
Mar-13
Mar-14
David Carbon • (65) 6878-9548 • [email protected]
1
US Fed: the water rate addendum
More formally
That the Fed ‘injected’ $3.5 trillion into the economy
through its QE programs is one of the most enduring conventional wisdoms of the past five years. But it is a myth:
nothing was injected into the economy, the stock market,
foreign emerging markets or anywhere else. In “The water
rate” we explained why this is so using simple language and
a simple model where the Fed purchased its bonds solely
from banks. While many appreciate the simplicity, some
have asked for a more precise / technical treatment that,
additionally, includes QE purchases from the public rather
than banks alone.
This addendum attempts to address these issues. Explicit
balance sheet examples are offered and asset / bond purchases are extended to individuals. None of the conclusions
about injections and/or the need for a new policy rate are
altered. However, in the initial paper we hypothesized that
Congress might become upset with a new policy rate that
pays interest on excess reserves and rewards banks for ‘doing nothing’. On further reflection, discussed below, it is
clear these payments are simply received in lieu of what
would have been earned on their Treasury holdings had
they not been sold to the Fed. Whether Congress recognizes this fact or not remains to be seen.
Monetary injections – the good old days
The best place to start with ‘liquidity injections’ is how they
used to work. Called ‘open market operations’, the central bank would buy a bond and the effects would ripple
through the economy in circular fashion until the money
supply had grown by perhaps 10x and loans had grown by
9x. This ‘money multiplier’ was the essence of the fractional
reserve system and explains why any banking system today
is, to a greater or lesser extent, a ‘house of cards’.
23 September 2014
Table 1: Typical money / loan expansion
in fractional reserve banking system
Step 0: starting point
Bank A
Assets
Reserves
Required
Excess
Loans
10
10
0
100
Deposits
100
Capital
10
Total
110
Total
110
Step 1: Fed buys $50UST from client
who holds acct at Bank A
Bank A
Assets
Bank A now has $45 of excess reserves which it is free to
loan out. Since excess reserves pay almost no interest and
the economy is doing well, the bank lends out the entire
$45 of excess reserves. This is shown in Step 2. On the asset
side, bank loans rise by $45. On the liability side, deposits
also rise by $45. This reflects the fact that the borrower
dispenses his loan as intended and whoever receives those
funds deposits them with their bank.
Although Bank A thought it had loaned out all its excess
reserves, the new deposits mean it once again has surplus
reserves that may be lent out. Loans are once again extended. Deposits are once again received. With a 10% required
reserve ratio, this process continues until deposits expand
Liabilities
Reserves
Required
Excess
Loans
60
15
45
100
Deposits
150
Capital
10
Total
160
Total
160
Step 2: Bank lends out excess reserves
Bank A
Assets
Liabilities
Reserves
Required
Excess
Loans
60
19.5
40.5
145
Deposits
195
Capital
10
Total
205
Total
205
The process is illustrated in Table 1. Bank A represents the
banking system overall and its initial balance sheet is shown
in Step 0. On the liability side, the bank has $100 of deposits and $10 of capital. On the asset side, it holds $10 of
required reserves and $100 of loans. The reserve requirement is assumed to be 10% of deposits. Total assets equal
total liabilities.
In Step 1, the Fed purchases a $50 Treasury bond from a private citizen who we’ll call Bob. It pays for the bond by crediting the reserves of Bank A by $50. Bank A credits Bob’s
deposits by the same amount.
Liabilities
Steps 3, 4 etc etc…
Final equilibrium: excess reserves
are exhausted by lending
Bank A
Assets
Liabilities
Reserves
Required
Excess
Loans
60
60
0
550
Deposits
600
Capital
10
Total
610
Total
610
Total change due to $50 Fed UST purchase
Bank A
Assets
Liabilities
Reserves
Required
Excess
Loans
+50
+50
0
+450
Deposits
Total
+500
Total
Capital
+500
0
+500
2
US Fed: the water rate addendum
23 September 2014
by 10x and loans expand by 9x the initial bond purchase. In this example, a $50 bond purchase by the central
bank has led to a $450 increase in loans and $500 increase in deposits. Total reserves have risen by $50. Excess
reserves have returned to zero. Everything that can be lent out has been lent out.
Failure to launch 1.0
One may note that in the ‘successful’ loan creation example above, the central bank did not have to purchase the
$50 bond from the bank in order for bank reserves to rise.
Although the bond was purchased from a private citizen,
banks’ reserves still grew by $50 and loans grew by 9 times
that. In a similar manner, as we’ll see below, it will make
no difference whom the bond is purchased from when loan
creation fails – when banks do not lend out their excess reserves.
In this ‘failure’ scenario, consider first a Fed bond purchase
from a bank. Changes in the balance sheet are clear and
make it easy to assess other scenarios. Initially, Bank A holds
assets and liabilities of $110. The liability side is the same
as before. On the asset side, it holds $10 of reserves, as required. Other assets include $50 each of loans and Treasuries.
The Fed then purchases $50 of Treasury bonds from Bank A,
paying for them with $50 of reserves. Reserves rise by $50.
Securities holdings fall by $50. Assets and liabilities remain
unchanged at $110. Importantly, Bank A extends no new
loans.
In this example, the Fed ‘injected’ $50 of reserves into Bank
A. Bank A ‘injected’ them back into the Fed in the form of
excess reserves. All that has occurred is an asset swap: the
public now holds reserves at the Fed instead of Treasuries.
If those Treasuries had been 3-month T-bills, then one shortterm government liability would simply have been swapped
for another. Few would expect this to have any impact on
the economy. The Fed of course has aimed to purchase longer-term Treasuries from the public. Although there is still
no net ‘injection’ into the economy, the hope is that longerterm interest rates would fall modestly and this would have
a stimulative impact. The extent of that impact remains
subject to debate. The liquidity ‘injected into the economy’
is not subject to debate: it is zero.
Table 2: Fed buys $50 UST from bank
banks fail to lend excess reserves
Starting point
Bank A
Assets
Liabilities
Reserves
Required
Excess
Loans
Securities
10
10
0
50
50
Deposits
100
Capital
10
Total
110
Total
110
Fed buys $50UST from bank
Bank A
Assets
Liabilities
Reserves
Required
Excess
Loans
Securities
60
10
50
50
0
Deposits
100
Capital
10
Total
110
Total
110
Total changes due to Fed purchase
Bank A
Assets
Reserves
Required
Excess
Loans
Securities
Total
Liabilities
+50
0
+50
0
-50
0
Deposits
0
Capital
0
Total
0
Failure to launch 1.1
Put Bob back into the calculus above and nothing material changes. The Fed now buys $50 of UST from Bob.
The Fed credits Bank A with $50 of reserves and the bank credits Bob’s deposit account for $50. Assets and
liabilities of Bank A rise by $50. Again though, for one reason or another, the bank refuses to lend out its
excess reserves, holding them instead with the Fed. Loans remain unchanged.
Once again there has been no net injection of liquidity into the economy. An asset swap has taken place as
before, except now it has occurred between the Fed and Bob, rather than between the Fed and Bank A. As
before, the public now holds $50 of deposits at the Fed, earning 25 basis points per year. The Fed now owns
a $50 government security, earning whatever it earns. Out of these earnings, the Fed pays Bank A 25 basis
points per year for its reserves held there. Bank A passes this to Bob, less its usual fees.
Bank in the middle
Some general principles should be clear. Through its QE/Open market operations, the central bank determines the quantity of total reserves in the banking system. Reserves are created irrespective of whether the
central bank purchases a bond from a bank or a private citizen.
Banks and banks alone, however, determine how many of those reserves sit idle at the Fed [1]. If banks do not
lend the excess reserves that the Fed creates for them, there is no net injection of liquidity into the system.
3
US Fed: the water rate addendum
23 September 2014
Again, this is irrespective of whether a bank or private citizen sold the bond to the
Fed.
The bottom line is clear: the Fed lays out the water bowl, the banks decide whether
and how much to drink from it.
The water rate
The easiest way to
control whether
banks move funds
into or out of this reserve pool is to raise
or lower the rate
paid on them – the
water rate
Since December 2008, banks’ excess reserves have grown to $2800bn from zero. As
in the examples above, banks are free to lend them out any day they wish. They
are also free to do the opposite – to add to them if they thought that would be
profitable. The easiest way to control whether banks move funds into or out of this
reserve pool is to raise or lower the rate paid on them – the water rate [2].
For example, if the Fed felt they were lending too freely into economy, it could raise
the water rate. This would ripple across the rest of the economy because banks
are free to sell their existing assets – like government securities or, indeed, loans to
businesses – and deposit the payments as excess reserves at the Fed. The reverse
would also apply. Thus, the broader constellation of interest rates prevailing in the
economy could be raised or lowered by altering the water rate.
Exit Fed funds
Why can’t Fed funds serve this purpose any more? Two main reasons: First, because
the Fed funds rate is a market rate and there is no market any more. Fed funds is
the rate at which banks lend to one another when they have too many or too few
reserves at the Fed at the end of the day. No one has too few any more. Everyone
has too many. The only way for the Fed to balance supply and demand would be
to effect quantitative changes in bank reserves – to alter / unwind its three QE programs. The water rate – the rate paid on excess reserves – is not a market rate; it is
dictated autonomously by the Fed.
That’s a technical consideration, if an important one. The bigger reason why Fed
funds won’t do the trick any more is simply the bigger numbers involved – a $2800bn
pool of reserves is difficult to control indirectly. Why fool around with indirect controls anyway? If this giant pool of excess reserves is what matters to the economy
– and in terms of monetary policy, it is – then it only makes sense to control the pool
directly. Hence the water rate becomes the new policy rate.
Congress and subsidies
In our 16Sep note, we hypothesized that politicians might become upset with paying banks 2% or 3% per year on $2800bn of reserves sitting risk-free in the Fed’s
basement. At a 3% interest rate, this would amount to the Fed paying banks $84bn
each and every year for ‘doing nothing’.
While Congress may still get upset, the balance sheet examples above make it clear
that such emotions would be unwarranted. QE amounts to an asset swap – the
Fed receives a Treasury and a bank (or private citizen) receives a deposit at the Fed.
The Fed pays the bank with the earnings from its Treasury bond. The bank (or private citizen) receives only what he/she would have received before the bond was
swapped. Probably a bit less in fact.
There’s no free lunch, apparently, even when it comes to the QE ‘printing press’.
Which is why QE hasn’t kicked up growth or inflation in the five years that the program has been in place.
Notes
[1] Plainly, loan demand / the strength of the economy is important too.
[2] The other way of course would be for the Fed to conduct open market operations
/ buy and sell bonds / unwind its QE programs. This will no doubt be part of a
longer-term monetary policy / strategy. But for shorter-term policy, controlling the
interest rate would be far simpler and smoother.
4
US Fed: the water rate addendum
23 September 2014
Sources:
Data for all charts and tables are from CEIC Data, Bloomberg and DBS Group Research (forecasts and transformations).
5
US Fed: the water rate addendum
23 September 2014
GDP & inflation forecasts
GDP growth, % YoY
CPI inflation, % YoY
2011
2012
2013
2014f
2015f
2011
2012
2013
2014f
2015f
US
Japan
Eurozone
1.6
-0.5
1.6
2.3
1.4
-0.7
2.2
1.5
-0.4
2.1
1.2
0.6
2.6
1.0
0.9
3.1
-0.3
2.7
2.1
0.0
2.5
1.5
0.4
1.3
1.7
2.9
0.5
1.9
1.5
0.8
Indonesia
Malaysia
Philippines
Singapore
Thailand
Vietnam
6.5
5.1
3.6
6.0
0.1
5.9
6.2
5.6
6.8
1.9
6.4
5.0
5.8
4.7
7.2
3.9
2.9
5.4
5.4
5.9
6.4
3.0
1.6
5.4
5.9
5.2
6.4
3.6
4.0
5.7
5.3
3.2
4.7
5.2
3.8
18.6
4.0
1.7
3.2
4.6
3.0
9.3
6.4
2.1
2.9
2.4
2.2
6.6
6.0
3.0
4.4
1.5
2.1
4.8
5.8
3.2
4.1
2.8
3.3
5.8
China
Hong Kong
Taiwan
Korea
9.3
4.9
4.2
3.7
7.7
1.5
1.5
2.3
7.7
2.9
2.1
3.0
7.5
2.6
3.5
3.5
7.5
3.0
3.7
3.8
5.4
5.3
1.4
4.0
2.6
4.1
1.9
2.2
2.6
4.3
0.8
1.3
2.7
4.4
1.4
1.5
3.2
4.0
1.3
2.5
India*
6.7
4.5
4.7
6.1
6.6
9.0
7.4
9.5
8.1
7.0
* India data & forecasts refer to fiscal years beginning April; prior to 2013.
Source: CEIC and DBS Research
Policy & exchange rate forecasts
Policy interest rates, eop
Exchange rates, eop
current
4Q14
1Q15
2Q15
3Q15
current
4Q14
1Q15
2Q15
3Q15
US
Japan
Eurozone
0.25
0.10
0.05
0.25
0.10
0.05
0.25
0.10
0.05
0.25
0.10
0.05
0.25
0.10
0.05
…
108.8
1.285
…
105
1.28
…
106
1.27
…
108
1.26
…
109
1.25
Indonesia
Malaysia
Philippines
Singapore
Thailand
Vietnam^
7.50
3.25
4.00
n.a.
2.00
6.50
7.50
3.25
4.00
n.a.
2.00
6.50
7.50
3.50
4.00
n.a.
2.00
6.50
7.50
3.50
4.00
n.a.
2.00
6.50
7.50
3.50
4.25
n.a.
2.25
6.50
11,989
3.25
44.5
1.27
32.2
21,205
11,750
3.20
43.3
1.26
32.3
21,200
11,750
3.18
43.1
1.25
32.1
21,200
11,750
3.17
42.9
1.24
32.0
21,200
11,750
3.16
42.7
1.23
31.9
21,200
China*
Hong Kong
Taiwan
Korea
6.00
n.a.
1.88
2.25
6.00
n.a.
1.88
2.25
6.00
n.a.
2.00
2.25
6.00
n.a.
2.13
2.50
6.00
n.a.
2.25
2.75
6.14
7.75
30.2
1039
6.10
7.76
29.6
1025
6.07
7.76
29.5
1020
6.04
7.76
29.4
1015
6.01
7.76
29.3
1010
India
8.00
8.00
8.00
8.00
8.00
60.9
61.3
61.6
61.9
62.3
^ prime rate; * 1-yr lending rate
Market prices
Policy rate
Current
(%)
US
Japan
Eurozone
10Y bond yield
Current
1wk chg
(%)
(bps)
FX
Current
1wk chg
(%)
Index
Equities
Current
1wk chg
(%)
0.25
0.10
0.05
2.56
0.54
1.01
-3
-4
-6
84.7
108.8
1.285
0.5
-1.5
-0.9
S&P 500
Topix
Eurostoxx
1,994
1,331
3,096
0.5
1.3
0.9
Indonesia
Malaysia
Philippines
Singapore
Thailand
7.50
3.25
4.00
Ccy policy
2.00
8.22
3.94
4.38
2.50
3.67
-8
-5
-2
-5
0
11977
3.25
44.5
1.267
32.2
-0.1
-0.6
-0.6
-0.6
-0.1
JCI
KLCI
PCI
FSSTI
SET
5,220
1,846
7,280
3,297
1,590
1.5
-0.5
1.1
-0.5
0.7
China
Hong Kong
Taiwan
Korea
6.00
Ccy policy
1.88
2.25
…
2.28
1.73
2.99
…
22
-2
-5
6.14
7.75
30.2
1039
0.0
0.0
-0.5
-0.1
S'hai Comp
HSI
TWSE
Kospi
2,290
23,955
9,135
2,039
-2.1
-1.6
-0.9
0.2
8.46
-4
60.9
0.4
Sensex
27,207
1.5
India
Source: Bloomberg
8.00
6
US Fed: the water rate addendum
23 September 2014
Recent Research
US: the water rate addendum
23 Sep 14
SG: On liquidity and property
30 May 14
IN: Forging global ties
19 Sep 14
TH: more downgrades
23 May 14
US Fed: the water rate
16 Sep 14
SG: SGD – unappreciated 22 May 14
Qtrly Economics-Markets-Strategy 4Q14
11 Sep 14
India elections: Quick review
16 May 14
IN: Market too dovish
25 Aug 14
IN: Four key post-election priorities
9 May 14
KR: Housing recovery
21 Aug 14
Asia: Gamechangers
5 May 14
IN: Increasing resilience
20 Aug 14
CN: Consumption opportunities in the rebalancing process
28 Apr 14
SG: Competitiveness matters
23 Apr 14
EZ: Time to bite the QE bullet?
22 Apr 14
ID: The to-do list
21 Apr 14
TW-CN services trade: 4 questions
17 Apr 14
CNH: “Through-train” coming 15 Apr 14
Asia cyclical dashboard: praise Europe! 11 Apr 14
IN: Assessing the El Nino threat
11 Apr 14
US: Unfrozen, just
10 Apr 14
ID: Beyond 2014
8 Aug 14
CN: SOE reform challenges
6 Aug 14
Asia cyclical dashboard: EU disappoints
25 Jul 14
US: The inflation non-problem
23 Jul 14
SG: Downgraded
23 Jul 14
KR: Unleashing services
17 Jul 14
US: The search for a new policy rate
14 Jul 14
India Budget: hits and misses
11 Jul 14
UST: 10Y yields downside limited
8 Jul 14
3 Jul 14
CN: Defaults, liberalization and new market benchmarks
8 Apr 14
India budget: setting its sights longer
ID: Fiscal prudence still warranted
2 Jul 14
KR: Decoding ‘474’
1 Apr 14
JP: Abe’s reform plan, V2.0
MY: Foot on the brake
Qtrly: Economics-Markets-Strategy 3Q14
27 Jun 14
PH: Bond yields to continue north
31 Mar 14
27 June 14
IN: Election is about the economy,
not just markets
28 Mar 14
ID: Consumption doubts unfounded
27 Mar 14
CNH: Fructifying trade finance activities
25 Mar 14
KR: Rate hikes not priced in
17 Mar 14
Qtrly: Economics-Markets-Strategy 2Q14
13 Mar 14
12 Jun 14
CNH: Offshore loans set to grow
4 Jun 14
JP: Looking beyond the volatility
30 May 14
CN: In search of a new consensus
30 May 14
Disclaimer:
The information herein is published by DBS Bank Ltd (the “Company”). It is based on information obtained from sources believed to be
reliable, but the Company does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or
correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein
does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee. The
information herein is published for the information of addressees only and is not to be taken in substitution for the exercise of judgement
by addressees, who should obtain separate legal or financial advice. The Company, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages
of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise)
or further communication thereof, even if the Company or any other person has been advised of the possibility thereof. The information
herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Company and its associates, their directors, officers and/or employees may have
positions or other interests in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking and other banking or financial services for these companies. The information herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation.
7