Bank Fed Borrowing Doesn’t Mean Rapidly Rising Money Supply


Do me a big favor. Don’t be this guy.

“Banks’ borrowing at the rate climbed to a daily average of $13.9 billion in the week ended July 16 from $7.84 billion three months earlier.”

So currently banks are borrowing about $417 billion per month from the Fed? Where did the Fed get trillions of dollars to makes these loans?

If this rate of borrowing continues for the next 6 months will they will borrow 2.5 trillion? Against what assets?

Is this the biggest money give-away of all time? (and completely illegal/unethical as well)

If this money keeps flowing we should see massive inflation soon. Perhaps this is why the Fed stopped reporting M3 and why the CPI has been monkeyed with so much.

What do you guys think?

This is from a post on Trade2Win after the poster had read this story: Bloomberg.com: Worldwide.

What you read above is about as solid an example of being ignorant of the facts as you’re likely to fine. The author here clearly either doesn’t realize or had failed to take into account the fact this borrowing being done from the Fed is generally short-term in nature. Sometimes the term is as quick as overnight. It’s like a revolving line of credit. While there might be some net increase in the borrowing, as the numbers indicate, the loans are being rolled over. You cannot aggregate the into the massive figures noted above.

I particularly love how the poster then spins it into a conspiracy angle. The increasing money supply angle he’s playing there is wrong too.

The fact of the matter is that banks have to put up collateral when they borrow from the Fed. At a minimum they have to put up approved securities of equal value. In many cases the Fed requires more collateral value than what they will lend out if the posted securities are of a higher risk of a decline in value. What this means is that at best when a bank borrows from the Fed it’s a simple asset swap and there is no net increase in assets in the system. Since some of the collateral is of lower quality, though, it’s really a negative asset situation because the Fed is providing assets of lesser value than the ones it receives.

What the Fed is doing with this lending is creating liquidity thing because it’s taking in some less liquid assets (like some mortgage securities) and providing more liquid ones (like Treasury securities). Since these are not long-term loans, any impact on money supply is temporary and automatically reversed once the bank repays the loan.

The point I want to make here is that you need to understand all the facts before you make any conclusions – especially ones with investment/trading implications. Do not trust what you read on the web. I see examples of folks operating on unconfirmed or plain incorrect information so often that it becomes laughable at times. Confirm and verifying from alternate, reliable sources.

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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
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  • Tyro

    Bah. The Fed issues $1 then the banks issue $100 so what do people do? Scream that the Fed’s actions are inflationary. Yeah right. With such a great ‘conspiracy’ in banking, I don’t know why people obsess about the Fed – probably too government-y, I guess. Anyway…

    I’m not sure what you are getting at when you say “What this means is that at best when a bank borrows from the Fed it’s a simple asset swap and there is no net increase in assets in the system.” On paper, the act of borrowing doesn’t increase or decrease assets, that’s true. But the reason that the banks need to borrow in the first place is because they have too much issued credit which can be supported by their current reserves. Issuing credit does increase the money supply and when the Fed loans cash-equivalent securities to banks, they are supporting this, so the writer does have a sort of point and I don’t know how your reply addresses this. It’s retroactive support of actions by banks that were inflationary and so the loans are there to prevent a large contraction in the money supply, but I think the point is valid.

    There’s also the fact that there’s collateral and then there’s collateral. By swapping mortgage collateral for high quality Fed Funds, the banks boost their reserves and can either increase their loans or maintain their current levels which does have a direct impact on money supply.

    In general you are right that Fed loans are temporary, often overnight and that rolling them together is wrong, but lately the Fed has been acting as a lender of last resort and worse, with their Term Auctions, they’ve been offering “loans” directly to individual depository banks not part of the Fed, something brand new for them. These aren’t overnight and the total amount has grown to over $500 billion dollars, so it is increasing. http://www.thestar.com/Business/article/427999

    I don’t know enough details about how the values of the collateral for these loans are calculated, but it wouldn’t surprise me if the Fed was accepting mortgages as collateral using their book value not market value which would help to push off the full magnitude of the problem.

    My economic knowledge is probably a decade out of date but it doesn’t sound like this guy is as laughably wrong as you imply. Maybe I’m also wrong?

  • Tyro

    BTW: I’m not defending this guy. I think he’s wrong on a bunch of issues, but I don’t think your comments are quite right either. I’m probably misunderstanding some things.

  • http://www.theessentialsoftrading.com John

    Tyro,

    The laughably wrong part is the idea that the Fed will be lending anyone $2.5 trillion over the next six months. That article you linked did exactly the same thing the poster did. The writer aggregated the term auctions when they have terms of 28 days. That means they have to be rolled each month, and it’s not like the Fed does these things every other day. There isn’t $500 bln of that stuff outstanding.

    But to some of the specifics of you comment…

    My point is that essentially the banks are giving the Fed (as collateral) $X in notional value of securities and recieving $X-$h back where $h is the haircut the Fed is requiring in the valuation of the collateral securities to reflect their relative quality vis-a-vis the Treasury securities that the Fed is providing the bank. The Fed is definitely not lending the banks more than the marked value of those securities. It’s lending them less from what I understand. Even during normal circumstances the Fed haircuts on its lending, even on high quality collateral so there is basically no risk the Fed gets caught out. That’s what I mean by the fact that assets (marketable ones) in the system are actually at best held level and at worst reduced during the term of the loan.

    You’re right. The received Treasury securities becomes a source of reserves. It’s all about replacing illiquid securities (like the mortgages) with liquid ones. As such, they could be used to make loans. Not being a part of the funding desk for one of those banks I can’t be sure what’s going on, but my guess is that those funds are more being used to keep existing loans covered with the required reserves than to initiate new business.

    The bottom line is this, though. Banks with surplus reserves have become less or unwilling to lend those reserves via the Fed Funds market to other institutions because of the perceived risk. That is a money supply contracting circumstance and deflationary. What the Fed has done is basically stablize that situation, allowing those who need the reserves to continue their lending to do so because otherwise they’d blow up like Bear Sterns. Because, however, the banks are required to post collateral above and beyond the value of what they are receiving, the system never has the full flow of reserves it had previously.

    In other words, lending has to be reduced, which contracts money supply. We know anecdotally that’s going on, though I’d like to see some figures.

  • Tyro

    John,

    Thanks for the feedback. Having the Fed lend directly to banks looks like a new thing (since Dec/Jan?) and I don’t know much about it. If what you say is right, it looks like a lot of news articles are getting it wrong but I know even less than they do :)

    So if I understand this right, swapping mortgages for fed funds does expand the money supply but currently these loans are just counter-balancing the contracting effect of declining housing prices, defaults and other problems.

    Seeing things like this really burns me up since it looks like a prelude to yet another bailout. As a Canadian, our federal bank, the Bank of Canada, is fully owned by the federal government so any profits that it makes is a profit for Canadians. But instead of taking advantage, the governments of the last 50 years have slashed the reserve ratio massively (topping 250:1) so virtually all Canadian money gets ‘printed’ by the banks and when the government wants to do anything, it borrows from commercial banks instead of the Bank of Canada. This means our federal debt is held by private banks which get billions each year in interest payments. We could be paying interest to the BoC and getting virtually interest-free loans if the government hadn’t let banks make off like counterfeiting bandits.

    It boggles my mind to think of the amount of billions that get funnelled from taxpayers into banks. How much federal debt would disappear if the reserve ratio was pulled in… The windfall profits from banks would shrink dramatically, but deposits would be safer, federal deficits would shrink and Canadians in general would prosper. With this backdrop, it’s hard to summon much sympathy for the plight of banks.

    Heh, sorry ’bout the rant. There are so many legitimate issues with banking it’s bizarre that people should resort to making up their own conspiracy theories :)

  • http://www.theessentialsoftrading.com John

    Tyro,

    I was actually stunned to see that really the only deposits in the banking system which require reserves are basically checking accounts (demand deposits). CDs, money markets, and all the rest of the stuff doesn’t. That does basically mean the fractional reserve part of the system is nearly zero. Sounds like a recipe for dissaster. Our whole financial system is based on confidence. We’ve seen what’s happened when a bit of that confidence vanished. Imagine if that expanded.

    But to your point about your central bank holding the gov’t debt, I think you miss the larger picture. There would be no gov’t debt (or at least a lot less) if the gov’t could maintain a balanced budget. Talk about legitimate issues! :-)