What should the Fed do….The Treasury (for now), seems to be the primary customer/borrower.

Lending and borrowing to/from the private sector has collapsed.

All of the FED’s technical staff knows legal reserves aren’t binding. I wonder if it is just a political statement, aimed at our legislators, because money creation is an abstract concept (where the whole, is not the same as the sum of its parts). Bernanke is very smart, & he understands conventional money & central banking.
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However, the crux of the cause of our monetary mis-mangement, since 1965 (even during Volcker’s reign-the brackets were widened not removed), is the assumption that the money supply can be manged through interest rates, specifically the federal funds rate (but now IORs).

Ever since 1965 the operations of the “trading desk” has been dictated by the Federal Funds “Bracket Racket” (interest rates). This has assured the bankers that no matter what lines of credit they extend, they can always honor them, since the FED assures the banks access to more legal reserves, whenever the banks need them to cover their expanding loans - deposits.

We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treasury-Federal Reserve Accord was all about. The effect of tying open market policy to a federal funds bracket is to supply additional and excessive legal reserves to the banking system, when loan demand increases.

When the member banks operate with no excess reserves of significance, the member banks have to acquire additional reserves, to support the expansion of deposits, resulting from their loan expansion.

If they use the federal funds market, which is typical, the rate is bid up and the “trading desk” responds by putting through buy orders, reserves are increased and soon a multiple volume of money is created on the basis of any given increase in legal reserves.

This is the process by which the FED has financed the rampant real-estate speculation that has characterized the bubble years.
By using the wrong criteria (interest rates, instead of member bank reserves), in formulating, and executing monetary policy, the Federal Reserve has routinely, in the long-run, generated excessive rates of inflation.

What should the FED do? First put all banks on notice that if they need funds for expansion of loans they will individually have to liquidate some of their liquid assets, Treasury bills, etc. And the discount window will only be open for emergency borrowing.

Secondly the Manager of the Open Market Account should be instructed to regulate his operation in terms of the proper volume of legal reserves (at a level where reserves are binding), which the member banks should hold (except for temporary instances, in which support operations for the Treasury are necessary - and the excessive expansion of legal reserves can be removed after the support operations have passed).
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“Where do you think the excess reserves came from?” The source of IORs is not QE, quantitative easing, (the source of IORs within the monetary system, is other bank deposits, directly or indirectly via currency, or the bank’s undivided profits accounts).
For IORs to be offsetting, the remuneration rate on excess & required reserves, must be competitive, vis a’ vis other instruments and yields. The member banks have thus shifted their portfolio composition (earning assets), to hold IORs @.25% (rates higher than t-bills and rates which induce dis-intermediation among the non-banks).

This is why the increase in the volume the FED’s liabilities (IORs), has been deflationary. The FED has used IORs to offset (how they determine the proper volume of IORs is a mystery to me), its expansion of assets (lending facilities), on its balance sheet.

An increase in the volume of legal reserves (idle excess reserves), is functionally equivalent to an increase in reserve ratios (similar to 1937 when the FOMC doubled reserve requirements on all deposit classifications, driving the economy into a deeper depression).

I.e., raising reserve ratios does not involve QE. In 1990 & 1992, the FED reduced required reserves ratios by > 1/2 in order to stimulate lending and borrowing. So why is the FED pursuing a “tight” monetary policy compared to 1990?

As Dr. Scott Fullwiler states (contrary to Krugman):
“There is NO “liquidity effect” associated with changes in the Target Rate”

With the FED paying interest on excess reserve balances, held at the District Banks, owned by the member banks, the FOMC’s policy rate, relative to the volume of legal reserves, has become an independent variable.

Pegging interest rates through IORs will increase the probability of policy errors, as the FED will be able to hold short-term interest rates at the desired level, for longer periods of time, without increasing inflation expectations (long-term rates).

Where Bernanke demonstrates his ignorance is: commercial banks pay for what they already own, interest on their own deposits. I.e., Bernanke doesn’t understand, or demonstrate that he understands, the difference between financial intermediaries, and the commercial banking system.

- flow5

Related Posts:

• Good Read:The Real Cause of Hyperinflation
• It’s difficult to have optimism when the U.S. is piling on insurmountable debt.
• Always remember what got us into this recession!
• It is a game about relative wins, not absolute gains.
• An excellent analysis of the reasons for the banking crisis, a complex situation explained simply:

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