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The Fed has embarked on quantitative easing – printing money to pay for securities. By itself, in normal circumstances, this would be inflationary, as it would mean a higher level of narrow money washing around the system. Indeed, this is precisely what the Fed is trying to achieve by printing money, and is the "quantitative easing" which Japan carried out until a few years ago. However, this will only work - i.e. reflate the economy - if the money is lent on by the banks.

The problem right now, of course, is not that the banks do not have money to lend, it is that they do not want to lend it: they do not want to risk having to impair their balance sheets any further by bad debt - especially as the extreme levels of uncertainty about the future make it very difficult to make lending decisions even to borrowers who today appear sound. This has meant that money which has been lent to the banks in the past has just been lent back to the Fed in the form of excess reserves. Some of that hoarding of cash was undoubtedly to provide for future claims on their balance sheets from un-drawn credit facilities, but the net effect was that the Fed was lending money to the banks who were simply lending it straight back to the Fed.

Now that the banks are being given money in exchange for debt assets instead of being lent it, there is no reason to believe that they will behave any differently. Their balance sheets may be freer than they were before, but the economy and the economic outlook have both deteriorated dramatically since the days when the banks were holding on to cash for capital adequacy reasons.

So if the effect of printing money is just going to be that the Fed gets given the money back (which, incidentally, was exactly what happened in Japan), why are they doing it? This is something that I have been trying to work out for a few days now, but I think by combining it with something else which was puzzling me, I may have the answer. You may remember that a small clause of the TARP package which Congress passed was to allow the Fed to pay interest on reserves. Ostensibly, this was to make the effective Fed funds rate equal the target rate. In a way, I think this is still true, but not in the way it has been presented so far. At the time, it appeared strange to me that the Fed was going to pay interest on the money that banks were lending to it in the form of excess reserves, when it was trying to incentivise the banks to lend money on, and not back to the Fed, but none of the commentators seemed to pick up on it. Now, I think I understand:

I believe that official interest rates in the US will be negative in the near-ish future. The way this will work will be negative rates on any money lent to the Fed in the form of excess reserves – effectively a fine for lending the Fed money. The effect of this will be to force the banks to put their money elsewhere, and some kind of restriction or penalty for buying government bonds would be a logical accompaniment to the move as a way of getting the banks to lend to non-governmental borrowers. Any negative interest rate policy (NIRP) will have to be maintained for some time and for it to be effective the banks will have to believe that it is going to be there for even longer.

If I am right - that the change regarding interest on excess reserves was a predetermined step to allow future negative rates if necessary – this shows amazing preparedness and ingenuity by the Fed. From being far behind the curve a year ago (some of you may remember me being very worried about this) to being on top of things in October, it looks to me that they still have the ability to surprise the market. This is a good thing (and yet again shows up their reactive and crusty counterparts on this side of the Atlantic). If, on the other hand, NIRP does not work for some reason, then there are still things the government can do, ending with the printing of money to pay for new government spending much as in the New Deal.

Edited by Extradry Martini

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How does a NIRP (copyright that term, EDM!) sit in the context of a nation which has to sell a lot of debt to other nations?

Peter.

It isn't so much the NIRP that a foreign investor in UST should be worried about, as the currency-adjusted interest rate – or put another way, the real interest rate. In terms of the dollar, foreign central banks have been playing their part in this sub-optimal equilibrium for a long time – keeping their currencies competitive by buying up all the revenue dollars of their exporters and investing them in US treasuries. If they did anything else, their currencies would appreciate and they wouldn’t be as competitive any more – fine if your domestic consumption growth can take up the slack but in the developing world this isn’t the case yet, so they have to keep their foreign currency reserves. On top of that, if inflation turns negative in the US, a positive yield on UST, even if small means a positive real return.

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Did it create a lot of inflation? No. It was reflationary - it helped combat the huge deflation of the time.

So I understand it was managed inflation. Ie. they managed to keep control of it.

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Does this mean I'll pay a penalty to put my money in the building society?

No, but you won't get much interest on it, which in turn will incentivise you or others at the margin to spend it.

Gold here we come?

No - quite the opposite.

How can the govt borrow the billions and billions they need without paying a decent rate?

See above.

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So I understand it was managed inflation. Ie. they managed to keep control of it.

No, it wasn't inflation at all. The deflationary forces were huge at the time and deflation averaged something like 9% (if I remember correctly) - the new deal just mitigated that, bringing it back to 0%.

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This is a global crisis EDM

suggest you rename the policy:

Trans World Interest Rate Policy.

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No, it wasn't inflation at all. The deflationary forces were huge at the time and deflation averaged something like 9% (if I remember correctly) - the new deal just mitigated that, bringing it back to 0%.

Why don't Central Banks always target 0% inflation/deflation? Then we could perpetually compare real prices.

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EDM -correct me if i'm wrong but reading your comment it sounds like the banking sector is the safest sector to be in right now in terms of employment ?

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So it depends on foreign govts buying UST?

Not really, no.

The twin deficits depend on foreign purchases of UST, yes, but they always have, what I am describing in my original post here doesn't really have anything to do with that.

Edited by Extradry Martini

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What I dont understand is how interest rates can be negative.

This is the flaw in the NIRP.

Banks wont lend with negative, they will just keep their appreciating cash mountain.

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Not really, no.

The twin deficits depend on foreign purchases of UST, yes, but they always have, what I am describing in my original post here doesn't really have anything to do with that.

Twin deficits as in the govt borrowing from year to year, plus the extraordinary circumstances?

Sorry if I cant keep up! :unsure:

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Can't see that at all - please elaborate/explain.

the recession has moved on to the wider economy ie retail and non- banking sectors - they had their bad period around sept-oct this year - with all the bailouts- reading your comment it seems the fed is feeding banks with plenty of money - but they are unable to pass this extra money on- so whilst the wider economy suffers through lack/reduced credit - the banks have plenty of it - it seems as though the banks hold all the cards at the moment.

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the recession has moved on to the wider economy ie retail and non- banking sectors - they had their bad period around sept-oct this year - with all the bailouts- reading your comment it seems the fed is feeding banks with plenty of money - but they are unable to pass this extra money on- so whilst the wider economy suffers through lack/reduced credit - the banks have plenty of it - it seems as though the banks hold all the cards at the moment.

At the moment the banks employ lots of salemen/women who have nothing to sell.

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the recession has moved on to the wider economy ie retail and non- banking sectors - they had their bad period around sept-oct this year - with all the bailouts- reading your comment it seems the fed is feeding banks with plenty of money - but they are unable to pass this extra money on- so whilst the wider economy suffers through lack/reduced credit - the banks have plenty of it - it seems as though the banks hold all the cards at the moment.

But the banks won't lend because, let's use the metaphor of a natural person in place of a company, the debtor has maxed out his credit cards, is having trouble servicing his personal loans and mortgage (which is secured on a house which if sold will not cover the debt). He is also in real danger of losing his job, either in a downsizing or because his employer might go bust. Anyone can see that lending such a debtor more money does not solve the fundamental problem which is over-indebtedness. You can't fix over-indebtedness with more debt.

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At the moment the banks employ lots of salemen/women who have nothing to sell.

Au contraire... they have plenty to sell, just much fewer qualified buyers.

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What I dont understand is how interest rates can be negative.

This is the flaw in the NIRP.

Banks wont lend with negative, they will just keep their appreciating cash mountain.

No, the banks won't lend with negative rates. The point is not to incentivise people to borrow (although very low positive rates may do that as well), it is to disincentivise the banks to lend all their money back to the Fed. If they don't lend to to the Fed and don't lend to the government via purchases of UST, they have to lend the money to the rest of the economy.

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The Fed has embarked on quantitative easing – printing money to pay for securities. By itself, in normal circumstances, this would be inflationary, as it would mean a higher level of narrow money washing around the system. Indeed, this is precisely what the Fed is trying to achieve by printing money, and is the "quantitative easing" which Japan carried out until a few years ago. However, this will only work - i.e. reflate the economy - if the money is lent on by the banks.

I think Gordon Brown solved that problem by acquiring the banks and telling them that they have to lend at 2007 levels. For example, RBS has informed that it will not start repocession proceedings for six months and agreed to keep the existing overdraft limits for small businesses.

If I am right - that the change regarding interest on excess reserves was a predetermined step to allow future negative rates if necessary – this shows amazing preparedness and ingenuity by the Fed. From being far behind the curve a year ago (some of you may remember me being very worried about this) to being on top of things in October, it looks to me that they still have the ability to surprise the market. This is a good thing (and yet again shows up their reactive and crusty counterparts on this side of the Atlantic). If, on the other hand, NIRP does not work for some reason, then there are still things the government can do, ending with the printing of money to pay for new government spending much as in the New Deal.

Being second is not always bad in business. It allows the followers to learn from the leader's mistakes. To give an example, take a look at Microsoft. Apple invented the first mass market computer operating system which was far superior to Microsoft's DOS. However, Bill Gates managed to anihilate Apple and make Microsoft as the leading choice by a country mile by learning from Apple's mistakes. There are several examples like this and empirical evidence support this view.

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