Friday, 7 August 2009


RebelEconomist values the NakedCapitalism blog for providing a digest of financial news and commentary, and admires its writer Yves Smith for her productivity and independence, but I am afraid that Yves got hold of the wrong end of the stick in her criticism today of Zero Hedge’s report of Chris Martenson’s observation that the Fed has been buying very recently issued treasuries in its open market operations (actually, this story had already been covered by Brian Benton a couple of days earlier). Maybe the Zero Hedge and Martenson posts are a bit sensational, but they do raise an important point.

The main reason why central banks are generally not allowed to buy government debt in the primary market is that the central bank is supposed to buy assets at market prices (to protect its ability to re-sell them when it chooses to tighten monetary policy without depleting its capital and therefore its independence from government). Although the Fed does buy treasuries at auction, it does so only to roll over its existing holdings. So when the Fed buys a large proportion of a new treasury issue from the primary dealers very soon after the auction, it raises the question of how meaningful the auction process actually was in determining a fair market price for the bonds. And, as Chris Martenson notes, the apparently successful sale of a larger volume of treasuries to the private sector gives the impression that demand remains robust despite the massive increase in supply.

I have not been involved in the US treasury market for a few years, but it does strike me as strange that the Fed would buy such a recently issued bond. Normally, the most recently issued (so-called "on-the-run"; "hot-run" if you trade with J.P.Morgan) treasuries are the most expensive on the yield curve as their liquidity (ie still lots of bonds in loose hands with active trading) gives them extra utility (eg for hedging purposes). Although John Jansen has offered the ingenious explanation that the Fed might buy the most recently issued treasuries because the off-the-run issues tend to be priced with reference to the on-the-runs and would therefore also be raised in price, I am sceptical. In my experience, the treasury market does re-price the off-the-runs to allow for the idiosyncrasies of particular on-the-runs (eg for repo squeezes). And contrary to John Jansen's response to the Zero Hedge post, I could believe that a tacit understanding between the key players could be reached that the primary dealers can bid up for the bonds in the auction with the reassurance that the Fed will endeavour to – ie with no firm guarantee – offer a modestly profitable outlet a few days later. After all, the Bank of England reputedly used to be able to discreetly (and unattributably) signal its view of the conduct of British banks by a mere twitch of the Governor's eyebrow.

Yves Smith incorrectly relates the issue to whether the Fed is adding or draining liquidity. In fact, the quantity of liquidity that the Fed adds (or withdraws) is determined by the monetary value of bonds it buys (or sells). In this case, the issue is about how the Fed adds the liquidity, and the impact of its operations on relative prices in the treasury market.


Charles Butler said...

Agreeing that it is possible and verging on likely given all the smoke and mirrors that have characterized responses to the crisis... would be tremendously interesting if someone with a grasp of the material that extended beyond having memorized the jargon in order to impress a gullible audience were to take the matter up.

The problem here is that the messenger is interfering with the message, not the message itself.

To paraphrase ZH's motto: On a long enough time line, if one says enough things some will turn out to be correct.

My dark suspicion is that ZH is a setup to discredit the critics of current policy.

RebelEconomist said...

Charles, I only read ZH when prompted by the blogs I normally read (eg Naked Capitalism), so I could not comment on its style, but in the ZH posts I have read I have not seen anything that suggests a lack of understanding of how fixed income markets and Fed open market operations work. Anyway, in the absence of any whistleblower actually involved in the discussions between the Treasury, Fed and primary dealers, I doubt that any evidence of collusion other than circumstantial evidence would emerge. That may well be enough for regulators to investigate private sector relationships though.

Charles Butler said...


Like I said, I don't think he's necessarily wrong. But I know that he is not the guy you want to be right.

Read more ZH, starting here...

And make sure you click through to the source to catch my drift.


Brian said...


I think you are dead on here and I tried to make the same or simimlar point in an article that actual pre-dates the Martenson piece. I covered this in a Tuesday morning (8/4) story at Financial Sense ... Hopefully you think it is a bit less sensationalistic than the Martenson/Zero Hedge version.

One of the main points I made in my article is that it has gotten to the point where the Fed is essentially lending directly to the Treasury … which is explicitly disallowed by a section in the Federal Reserve Act. As you know, the Fed can only purchase securities at auction that are maturing in its SOMA portfolio. This is reported in the “SOMA” line of the Treasury Auction Results report (I commented on this in Martenson's blog ... which was one of the mistakes in his story). But when the Treasury can auction large amounts of debt and have the Fed support that auction by purchasing some of those same securities on the day of issuance (as illustrated in my article) or within a short period of time, this in my opinion is violating the aforementioned section of the Federal Reserve Act ... or at least the spirit of that rule.

My other principal point is that there should have been no surprise last week concerning the success of the 7-year auction on Thursday (even after poor 5-year and 2-year auctions) and I illustrated the reasons why.


RebelEconomist said...

Ah, I see what you mean Charles! The link no longer works, but turnerradionetwork does seem a dubious source. The adverts and donation link suggest that Zero Hedge is a commercial venture, so I guess that its sensational style is aimed at attracting readers. To be fair, it does, although judging by Zero Hedge's comments, some of them are nutters. You make a good point that the poorly informed and unselectively targeted noise on such sites is easily dismissed by the establishment, which makes them look good and drowns out the more challenging criticism.

RebelEconomist said...

Well done Brian! It is clear from your fsu post that you had this sussed a couple of days before Chris Martenson, and in your post you specifically mentioned the point that the Fed is not supposed to lend directly to the Treasury. You also steered his commenters to seeing that the key point was not the monetisation of treasuries but the proximity of the purchases to the auction. I will edit the post to mention your fsu piece.

RebelEconomist said...

Note to self:

The restriction on the Fed to buying US government debt only in the "open" market appears in the Federal Reserve Act, Section 14b(1).

A current list of primary dealers appears on the FRBNY's website.

Anonymous said...

And why, with a $ 2 trillion Fed balance sheet, are any of these minor details relevant or significant in the larger picture of monetary policy?

RebelEconomist said...

Anonymous at 11 August 2009 19:53

Although the significance of this issue now is small in terms of dollars (ie the illusion of a well-covered auction may slightly raise the price that the US Treasury can get for its next bond issue), the principle involved and its potential financial implications is large, because it affects both monetary and fiscal policy. In fact, as I shall explain, it matters most when the central bank's balance sheet is being expanded by quantitative easing (QE). The principle involved is the financial independence of the central bank (CB) from government.

The near-term concern mentioned in my post is that, when supplying base money, the CB should try to avoid buying assets that fall in value. Inevitably some of the assets will lose value, but if they are purchased at market prices, a gain should be as likely as a loss (more likely if the assets generate some income). This matters because if the CB subsequently judges the stock of money to be excessive, it may wish to re-sell assets to withdraw some (I described in detail how QE works in a previous post). If the CB's saleable assets are worth less than the excess amount of money, they may be insufficient to allow the excess to be withdrawn by selling assets (the CB may even be technically insolvent, although in a fiat money system in which money cannot be redeemed for hard assets like gold, insolvency does not present an immediate problem). In this case, the CB may need to resort to either increasing reserve requirements to immobilise the excess money or else asking the government for a grant of marketable debt to fill the hole in its balance sheet, both of which may incur a political cost to the CB. For example, in return for amending legislation or recapitalising the CB, the government can extract some favour, such as persuading the CB to buy, say, car manufacturers' debt. If the CB refuses to pay this political price and is unable to withdraw the excess money, it will have to accept unwanted inflation.

When the CB is conducting conventional monetary policy operations, the bulk of the base money stock comprises banknotes rather than bank reserves and the CB's liabilities typically amount to in the order of a few percent of GDP, so it hardly matters if the CB tends to lose money on the assets it buys, as banknotes are rarely redeemed and interest rates can be raised by just a marginal contraction of reserves. QE, however, involves a larger expansion of reserves which is supposed to be temporary, and the exit strategy may well involve selling assets, in which case it does matter if the CB overpays for assets and exposes itself to a higher probability of sustaining losses when they are sold.

A longer-term concern is that the CB buying a large fraction of a government debt issue, shortly after an auction in which the bidders may have been influenced by a tacit understanding that the CB will provide a profitable outlet for the bonds, represents an intermediate step towards direct CB lending to the government. At some point, it would no doubt be suggested that the CB might as well cut out the middle man and lend directly. In the light of the experience of inflationary episodes like the 1970s, many countries have a constitutional prohibition on their CB lending to their government. Naturally, any CB purchase of domestic government debt means that the CB is effectively lending to its government, but at least when this is done at genuine secondary market prices, the transaction is public and the government is subject to market discipline over the terms of its borrowing. When the government can borrow direct from the CB at potentially off-market terms though, it may well be tempted to abuse that position, with inflationary consequences.

In conclusion, the issue matters not so much because it affects the terms of one treasury auction, but because the principle involved represents a step on the road to Weimar Germany / Argentina / Zimbabwe!

Anonymous said...

The fact is that the Fed already committed to buying Treasuries for the purpose of influencing mortgage rates. That's public knowledge. It really doesn't matter what their tactics are in pursuing this public policy.

The Fed balance sheet is published weekly, for all to see. Whether government debt comes from an auction or from the market or from Mars doesn't matter. It's all opportunity cost in terms of economics - Fed holdings versus public holdings. And the size of the monetary base is open for all to see.

These details you discuss here are all a tempest in a teapot. Great for keeping bloggers busy, but not important otherwise.

RebelEconomist said...

Anonymous at 15 August 2009 02:14

Ah, I thought your previous comment (I assume that you are the same anonymous) was probably rhetorical!

Forgive me if your opinion already takes account of the point, but you did not mention the distinction between nominal and market value. I believe (although the FOMC statements are not precise in this regard) that the quantity of treasuries that the Fed has undertaken to buy is specified in nominal terms. While the Fed's tactics in executing the purchase operation will not affect this quantity, they will affect the amount of liabilities – bank reserves in the first instance – that the Fed incurs in the process. Since the Fed's liabilities are largely of very short duration, their market value will be practically the same as their nominal value. The market value of the bonds purchased, however, may well differ considerably from their nominal value, depending on how far their coupon differs from current coupons for bonds of similar duration.

Although as you say, the Fed's balance sheet is published (ie Fed statistical release H.4.1), it comprises nominal or "face" values (as stated in note 2 to table 1 in the August 13 2009 report). As bonds are purchased by the Fed, any mismatch between their nominal value and the price paid (corresponding to the resulting increase in Fed liabilities) will be absorbed in the "other liabilities and capital" line (and note that buying old, relatively high coupon bonds would reduce the size of this capital item, which may be another reason why the Fed has been buying recent issues). Any difference between the price paid and the market value of the bonds at the time, and any subsequent changes in their market value will not show up in the Fed's balance sheet, so if the bonds purchased tend to fall in value, the resulting depletion of the Fed's true net worth will not be obvious (although the New York Fed does publish details of the Fed's treasury holdings - but not their MBS portfolio - so it would be possible to calculate any difference between the nominal and current market value of the Fed's treasury portfolio with a bit of effort).

MW said...

"And why, with a $ 2 trillion Fed balance sheet, are any of these minor details relevant or significant in the larger picture of monetary policy?"

Because the market thinks they are, and the market still sets (some) rates!

Anonymous said...

The market (i.e. "Mr. Market") is an ass about monetary policy. Inflation today, deflation tomorrow. Here today, gone tomorrow.

g said...

Hello Rebel,

Are you the Rebeleconomist that posted on Rowe's website recently. I found your skeptical comments on monetary policies and central bank powers well put.

If you are, there is a bit of a debate going on on Mosler's website about what powers central banks or in this case the Fed actually have.

You may find it interesting. Look to the bottom and here is the link....

RebelEconomist said...

g, I am indeed the same RebelEconomist; I presume you are Gary Marshall.

I read the paper discussed in the Warren Mosler post you refer to, but I do not think that it would be fruitful for me to participate in that discussion, because the ideas of Mosler and his disciples are based on a belief - that governments control the issue of money - which they consider undeniable but which I would argue does not normally apply.

Briefly my view is as follows: I agree with Mosler et al that governments typically establish fiat money and encourage its use by requiring taxes to be paid in that currency and by declaring it legal tender for the settlement of debts. I recognise that governments are effectively the beneficial owners of the fiat money issuing business since they appropriate the seigniorage revenue from the central bank. And I accept that in a desperate situation, the value of money can be underpinned by government recapitalising the central bank or exploited by directing the central bank to lend to the government. But I disagree that governments do or should behave as the issuer, rather than the user, of money in normal economic conditions. Unless the government is prepared to nationalise the taking of demand deposits, it is hard to see how a government can induce its public to hold more base money without generating inflation. And past experience of inflation has suggested that it is disruptive, motivating constitutional monetary policy independence for central banks that would be politically costly to rescind.

g said...

Hello Rebel,

Sorry. It was me and I forgot to identify myself. It was quite late.

From what you say, you and I are almost in complete agreement.

I have many difficulties with economists in monetary debates because they are driven by theory rather than by the events they see about them.

I see that you have experience in banking, so you have a good grounding in how things actually work. The economists assign great magical powers to the central banks and interpret any sign or utterance as a mystic might.

Nick Rowe is comfortable with his classroom gadgets and prefers them to what truly is happening.

Currency is a central bank's only lever and it is a lever exercised on a demand basis only. The central banks cannot buy bonds with it because the currency would come right back to them the next day for redemption. If it does not redeem, then inflation of a magnitude 20 times the rate of inflation for ethereal money results.

Currency creation is a blessing, but it comes with heavy constraints. In truth, the central banks are just small marginal lenders. They do not have the power to control interest rates.

The real money, strangely, is that which exists only in bank records, having no physical form. It is the only money that can earn interest. It is the money created through the loans process. As the central banks do so little of it, the money is actually proprietary to the private banks and lenders.

I have yet to hear back from Mosler, Baird, Fulwhiler, and whoever else on my latest post.

I do not think they know what to say. If they agree, then whatever they believed counts for nothing.

I have often said I may indeed be crazy, and that all anyone need do is show me why.

I am not welcome on Rowe's site anymore. I am described as a boor. Well, it certainly takes one to know one. Calling a very astute bank economist ignorant in a national newspaper certainly qualifies.

Gary Marshall