In case you were wondering where the money comes from

…if banks are able to obtain 25 basis points by simply placing their funds at the Federal Reserve why would anyone be willing to lend another bank fed funds (deposits at the Fed) unsecured at less than 25 bps? The answer is actually very simple. The GSEs, consisting primarily of Fannie Mae and Freddie Mac, maintain accounts at the Federal Reserve but do not receive interest on their balances since they are not depository institutions.  So Fannie Mae and Freddie Mac are the primary suppliers of funds to the banks at rates below the “floor”. Since their return on idle reserves is zero, they are willing to lend to banks at less than 25 bps while the banks are more than willing to pick up a margin on their intermediation of GSE “loans” to the Fed.

That is Peter Stella.  There is more here (pdf), which leads to an interesting (but technical) discussion of how the Fed will unwind its current positions.  The original pointer was from FTAlphaville blog.


For the ordinary guy like me who needs to keep their piece of money safe (from wherever it came) FT Alphaville blog supplied most elevated and instructive podcast today which I tweeted: Risk-free bank deposits must not be free, but this excellent podcast is free - Admati, Coppola, & Kaminska

(1) Are Fannie & Freddie required to maintain accounts and / or a minimum deposit at the Fed by law? (2) Given enough banks willing to pick up a margin on this intermediation, won't the Fannie-Freddie below-the-“floor” rates edge very close to the Fed's 25 bps.

Pardon my naivete.

By "enough" banks do you mean more than 6?

(1) no (2) Great point and one he should have addressed; for the argument about GSEs to work, it has to be that there are a limited number of banks the GSEs are willing to deal with, and/or banks have balance sheet concerns that prevent them from doing the arbitrage trade (borrow from GSEs and deposit with Fed) and competing away the profit.

I haven't been able to keep up with economics (academic) blogosphere debates over the past year.

Since Tyler is recommending Peter Stella, can I assume that most econ bloggers now subscribe to the views (which I think have been long-held by bankers/accountants who know the mechanics of this stuff):
1) money is endogeous; banks create money (deposits) out of thin air when they loan money, they don't loan out deposits
2) banks don't loan out reserves either, and their lending is not constrained by their reserve balances

From the Stella article, page 4: "Consequently the notion that the quantity of bank reserves somehow constrains lending in a fiat money world is completely erroneous. Even in systems where legal reserve requirements are imposed on certain bank liabilities, all modern central banks allow the quantity of reserves to be demand driven in normal times...
Bank reserves are not “multiplied” by the banking system nor is such a multiplication necessary for the expansion of bank credit and monetary liabilities. If there is a single fact that illustrates this point it is that total commercial bank deposits at the Federal Reserve in 1951 ($20 billion) were larger—in nominal terms—than at end 2006 ($19 billion) while total US credit market assets rose by over 10,000 percent in nominal terms during the same time period"

I thought I read somewhere recently that Sumner still rejects this understanding of the banking system, despite - from my vantage point - the overwhelming empirical evidence.


In the mid-1970's, I dug clams for a living on the Great South Bay, LI, NY.

The issue is liquidity. Banks either "park" extra (i.e., not invested or loaned) dollars in reserves at the Fed or sell (lend) fed funds to banks needing liquidity, funds/reserves, i.e., buyers/borrowers. Overnight, 25 basis points is better than nothing. Banks also buy and sell huge amounts of repurchase and reverse repurchase agreements for securities to deploy excess, or raise needed, liquidity.

Here's the loan accounting. Bank makes a $100 loan to ABC Corp. Debit (increase) loans receiveable: an earning asset $100. Credit ABC Corp. checking account (or a certified/official check payable to someone that ABC Corp. owes), a current liability $100. Theoretically, the bank needs to hold, say 3%, reserves against the $100 liability and can lend 97% out. Ergo, the money creation/multiplier theory . . .

Here's the day-two accounting. ABC Corp. draws on the $100 check or its creditor cashes the $100 certified/official check. Debit (decrease) checking accounts, credit (decrease) cash/due from banks $100. The result the bank has a $100 loan and $100 less in the cash/due from banks account. Liquidity was exchanged for a loan: earning asset. The bank created nothing.

Banks cannot make loans unless it they have liquidity to cover. Loans are generally/histroically in the range of 66% of bank total assets, too much more and banks court liquidity problems, much less they hamper profiatbility. Banks need liquidity to economically (without incurring extra interest expenses/losses, avoid needing to sell assets at losses, or missing profit-making opportunities) cover depsitor withdrawals, operating expenses and to take advantage of investing/lending opportunities.

Real money creation. UST issues $85 billion in new US Tresaury debt securities. The Fed buys it all. Here's the accounting at the UST. Debit (increase) Fed checking account; credit (increase) Unsustainable debt. Here's the accounting at the Fed. Debit UST securities; credit UST checking account. Voila!!!

My opinion, the reserve requirement is one of them "levers" they invented for the dude in the green suit, hiding behind the green curtain. You know him. He's the dude who has never gotten it right since 1913.

Hey! Let's give a woman (Yellen Ellen) the chance to mess it up.

If I remember correctly most MM guys concede that money is short term endogenous in a fiat system with interest rate targeting. Long term endogenous money is only a position that post-keynsian types talk about. I find it crazy that false narratives like the money multiplier persist and objections are waved away as if it doesn't matter.

I'm not sure if Stella is correct, but he treats a highly technical subject with wonderful clarity.

I'd love to see some Big Brain reaction to this. A dialogue worth pursuing.

I just don't understand this part at all:

The point of credit easing policies and LSAPs is to reduce longer term interest rates plain and simple. The expansion of bank reserves is merely a technological artifact of modern payments systems combined with how all central banks pay for the assets they acquire—by crediting the reserve account of the bank where the seller maintains their settlement account. This is one of the unintended consequences of LSAPs. Banks accumulate large unwanted balances at the Federal Reserve even if they themselves do not participate in selling securities to the Fed!

If the bank is not the seller of the securities, why are the bank's reserves increasing then? I could make sense in the bank being the seller of the securities to the Fed, and its reserves increasing, but not for a third party unless that third party is simply sitting on cash or near cash equivalents, but then that doesn't really qualify as a "technological artifact".

The Primary Dealers are the sellers. For example, Jefferies LLC sells securities to the Fed, then the bank that maintains their settlement account is credited. All the Fed's LSAP transactions are with Primary Dealers.

Do you think that the non bank sellers to the FED take their money in cash? I assume they have accounts at a bank that has accounts at the FED so even if the bank is only holding the funds from the person who sold something to the FED in a QE operation. The Bank automatically will have that money put in their reserve balance.

Yeah, so what? Previously, the sellers held their funds in GSE and treasury securities. Why are they suddenly content to simply leave the proceeds in bank reserves? Why didn't they do this prior to LSAPs? One answer might be that the Fed started paying IOR, but at 25 basis points/yr, this explanation makes literally no sense to me. I can't help but believe something in this story is missing- a big something.

What do you mean before? The point of the ior policy is to provide a place to collect all the reserves of the new money created in QE. It also allows the creation of a narrow band for interest rates to float by creating a price floor with OMO and Fed commitment providing a price ceiling.

*if they go out and use the excess reserves to buy GSE's or treasuries the money will still end up in excess reserves because there is nowhere else for it to go. If I have a nice shiny GSE and I sell it to you the reserves just move from your bank to mine. (Kinda but that is the general idea). What seller out there doesn't have a bank account from a bank that doesn't have a FED account?

The only way for the money to NOT end up in excess reserves is to buy from the FED and unless you haven't heard the FED isn't selling much and is holding till maturity for the most part.

Ultimately I have been convinced that the end purpose is to raise IOR during the exit strategy to soak up any excess money without forcing the FED to sell their bonds and destroy the money and liquidity they believe their operations today let them acquire. I think the first sign of tighter policy will not be a different IR target but a raising of IOR.

What is equally liquid and yeilding above 25bp?

I will walk you through my thinking:

Before QEs, Fund X held $1 trillion in Treasuries and GSE debt, excess reserves were $20-40 billion dollars. Fed comes along and fires up QE of $1 trillion and buys Fund X's bonds by crediting fund X's bank account by a similar amount. Now, you are telling me this means excess reserves rise by this $1 trillion. I have no argument with that up to this point, but tell me this- why? Why are excess reserves basically rising in step with the QEs? Previously, excess reserves were a tiny fraction of the Fed's balance sheet (, but now are greater than 50% as big as the Fed's balance sheet. Are you seriously telling me that 1/4 of 1%/yr IOR is enough to lock up almost all the money the Fed has created to increase it's balance sheet size? I mean, the treasury has issued more debt than the Fed has bought in the last year (though that seems to be changing now). If the Fed dropped IOR to zero, would excess reserves go back to the previous 20-40 billion?

Comments for this post are closed