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Michael Salemi, Professor EmeritusUNC—Chapel Hill

NY Times First Draft, Jan 28, 2015

₡ “The two Republican Senators introduced the Federal Reserve Transparency Act ….”

₡ “Republicans have questioned the Fed’s moves to stimulate the economy … arguing that the expansion of its balance sheet will create economic instability.”

₡ “In 2011, Gov. Rick Perry called the Fed’s monetary policies potentially ‘treasonous.’”

₡ “Janet L. Yellen, …said … she would ‘forcefully’ oppose any attempt to audit the central bank that might infringe upon its independence.”

NY Times First Draft, Jan 28, 2015

1. What is the Federal Reserve?2. How does the Fed conduct monetary

policy in normal times?3. How did the Fed conduct monetary

policy during the Great Contraction?4. Was Fed Great-Contraction policy

irresponsible?

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$ M0 (the monetary base) is the sum of currency in circulation and reserve balances held by banks at the Fed.

$ M1 is the sum of currency held by the public and transaction deposits (like checking account balances) at depository institutions such as commercial banks.

$ M2 is M1 plus savings deposits, small-denomination time deposits and retail money market mutual fund shares.

What is the Fed?

Money Dec 2007 Dec 2010 Dec 2014Billions of U.S. Dollars

M0 837 2,017 3,934M1 1,394 1,871 2,973M2 7,478 8,831 11,715

What is the Fed?

What is the Fed?

$ In 2007, ratio of M2 to M0 was 8.9. For every one dollar of base money there were nine dollars of private institution deposits that functioned as money.

$ Since 2007, the Fed has allowed base money to grow by 470% and the ratio of base money to GDP has increased from 5.8% to 22.6%.

$ But since 2007, M2 has grown by only 157% and the ratio of M2 to GDP has increased from 52% to 67%.

What is the Fed?

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Money Dec 2007 Dec 2010 Dec 2014Percent of GDP

M0 0.058 0.135 0.226M1 0.096 0.125 0.171M2 0.517 0.590 0.672

What is the Fed? What is the Fed?

$ Commercial Banks are financial institutions that accept deposits and use deposited funds to make loans.

$ Commercial Banks are required to hold reserves to guarantee they can redeem their deposits on demand.

$ Deposits at commercial banks are insured by the Federal Deposit Insurance Corporation.

What is the Fed?

Balance Sheet of the US Commercial BanksDecember, 2007

Assets Billions Percent Liabilities Billions PercentSecurities 2455 22 Deposits 6681 61Loans 6843 62 Borrowings 2363 22Cash 304 03 Other 772 07Other 1350 12 Total 9816Total 10952 Residual 1136 10

What is the Fed?

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₡ The core function of banks is to lend. In 2007, 62% of bank assets were loans.

₡ Banks hold relatively little cash—only 3% of assets were cash in 2007.

₡ Banks obtain most of their funds from depositors—61% of assets in 2007.

₡ Bank capital amounts to the difference between the value of assets and the value of liabilities. Bank capital was 10% of assets in 2007.

What is the Fed? What is the Fed?Eccles Building, DC

₡ Commercial banks have accounts at the Fed—the balances in those accounts are legal reserves.

₡ By law, depository institutions must hold reserves in the form of either vault cash or deposits at the Fed.

₡ The Fed makes loans to banks by allowing banks to re-discount securities thus converting the value of those securities to reserves.

What is the Fed?

Balance Sheet of the Federal ReserveDecember, 2007

Assets Billions Percent Liabilities Billions PercentU.STreasuries

755 81 Currency 829 87

Loans 67 07 Reserves 5 01Gold 13 01 Other 95 10Other 94 10 Total 929Total 929

What is the Fed?

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₡ In 2007, the great majority of Fed assets were US Treasury securities.

₡ The small gold holdings of the Fed are an artifact of the past gold standard.

₡ The chief liability of the Fed is US currency.

₡ Banks hold deposits at the Fed which count as legal reserves.

What is the Fed?

$ In order to evaluate Federal Reserve policy during the Great Contraction (after 2007), it is necessary to understand how the Fed conducts policy in “normal times.”

$ The Great Contraction was not a normal recession—it involved both a financial crisis and a recession.

$ In normal times, Fed policy attempts to counteract two undesired outcomes--recession and inflation.

Fed Policy in Normal Times

₡ The Federal Funds rate is the interest rate that depository institutions pay to borrow reserve funds from one another.

₡ Banks that need reserves to meet their legal obligations borrow from banks that have more reserves than the law requires.

₡ Loans of Federal Funds are just long enough for the borrowing banks to satisfy their legal obligations.

Fed Policy in Normal Times Fed Policy in Normal Times

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Before and during recessions, the Fed lowers the federal funds rate.

As economic growth rises, the Fed raises the federal funds rate.

Fed Policy in Normal Times

₡ To Stimulate the Economy, the Fed:Buys US Treasury Securities on the Open MarketThereby Increasing the Supply of Federal Funds (Reserves)Thereby Lowering the Federal Funds Rate

₡ The policy is effective because other interest rates decrease as the Federal Funds rate decreases.

₡ Lower interest rates create incentives for spending by businesses and households.

Fed Policy in Normal Times

Fed Policy in Normal Times

₡ To Cool the Economy, the Fed:Sells US Treasury Securities on the Open MarketThereby Decreasing the Supply of Federal FundsThereby Raising the Federal Funds Rate

₡ The policy is effective because interest rates increase along with the Federal Funds rate.

₡ Higher interest rates create dis-incentives for borrowing and spending.

Fed Policy in Normal Times

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Fed Policy in Normal Times

$ The Great Contraction was a financial crisis coupled with a recession. The US had not experienced the two together since the Great Depression of the 1930’s.

$ During the Great Contraction, Commercial Banks preferred to hold the additional reserve dollars that the Fed created rather than to loan them out.

Fed Policy—Great Contraction

Commercial Bank Balance Sheet Before and After the Onset of the Great Contraction

Year 2007 2009 2007 2009Assets Percent Liabilities PercentSecurities 22 20 Deposits 61 66Loans 62 57 Borrowings 22 16Cash 03 10 Other 07 07Other 12 12 Residual 10 11Total 10952 B 11,666 B

Fed Policy—Great Contraction

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₡ The normal chain that connects Fed stimulus to economic activity was broken…

₡ Because banks held the additional funds created by the Fed rather than increasing loans.

₡ The Federal Funds rate went to zero and could fall no further.

₡ Private individuals could not respond to the stimulus of low interest rates because they could not borrow.

Fed Policy—Great Contraction Fed Policy in Normal Times

$ In 2008, the Fed provided secured loans to institutions offering commercial paper and money market mutual funds.

$ The Fed provided loans to institutions that were deemed too important to the financial system to allow them to fail.

$ The Fed supported securitization of consumer and business loans.

$ The Fed provided extraordinary stimulus by buying longer maturity bonds.

Fed Policy—Great Contraction

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Fed Policy—Great ContractionFawley and Neely, Fed St. Louis Review, Jan 2013

The Composition of Fed AssetsApproximate Percentages

2007 2009 2012Lending to Financial Firms 10 75 10Holdings of Government Agency and Mortgage Backed Securities 32

Short Term Treasuries 30Long Term Treasuries 60 25 53

Fed Policy—Great Contraction

Was Fed Policy Responsible?

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$ Those who believe that Fed policy was irresponsible argue (for the most part) that:

Large increases in base money will cause inflation.

$ Those who believe that Fed policy was responsible argue (for the most part) that:

Large increases were necessary to stimulate the economy and will not cause inflation.

Was Fed Policy Responsible? Was Fed Policy Responsible?

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Money Mischief: Episodes in Monetary History, 1992

Was Fed Policy Responsible?Milton Friedman

$ There is robust evidence that nations which permit more rapid growth in their money supplies are nations which experience higher inflation rates.

$ Inflation erodes the value of the dollar and transfers value from creditors to debtors. The biggest debtor in the U.S. is the federal government.

Was Fed Policy Responsible?

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Was Fed Policy Responsible? Was Fed Policy Responsible?

The very large increases in the money base did not cause large increases in M2 because banks were unwilling to lend during the Great Contraction.

Milton Friedman criticized the Fed of the 1930’s for allowing the money supply to fall during the Great Depression.

Was Fed Policy Responsible?

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Was Fed Policy Responsible? Was Fed Policy Responsible?

Was Fed Policy Responsible? Was Fed Policy Responsible?

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Was Fed Policy Responsible?NY Times First Draft, Jan 28, 2015

$ House Republicans Intensify Attacks on Federal Reserve (NYT, Feb 25, 2015)

$ Rep. Jeb Hensarling backs legislation requiring the Fed to announce a set of rules it would follow in setting its benchmark short-term interest rate.

$ Yellen responded: “I don’t believe that the Fed should chain itself to any mechanical rule,” she said. “I did not believe that in 1995. I do not believe it now.”

What Do You Think?

Was Fed Policy Responsible?

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