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Demand Deposits 1,500,000

So, by purchasing securities on the open market worth $50 million, the central bank set a chain of events in motion that increased the money supply by $500 million-$500 million of new money was created. The exact reverse would happen if the central bank sold securities in open market operations.

I want everyone who is reading this to understand that this is a simplified ver sion of what actually occurs, not only with the Federal Reserve System, but with every central banking system in the world. The actual workings are more complex; but I could show in a more detailed discussion how, no matter how many banks

are involved, the potential impact on the supply of money and credit is virtually identic al to what I just described in the hypothetical country of Newmoney. For you doubters out there, its a good mental exercise.

In net effect, when the Fed purchases securities, it creates, on paper, the money with which it buys those securities-it simply writes a check on itself. That new money, in tum, enters the banking system and may be used to increase reserve assets held by the banking system. The increase in reserves assets creates the potential for an increase in the money supply through credit expan sion equivalent to the reserve increase divided by the net average reserve ratio. When you leave Newmoney and enter the real world, things then start to get a little more complicated.

If you look back at Table 10.1, you will see that reserve ratios in the Federal Reserve System currently vary from 0 to 12% depending on the type of liability. If you buy a 10-year, $10,000 certificate of deposit from your bank for cash which has been stuffed in your mattress, the reserve ratio is 0 for that item (it is a time deposit with over 1 2 years to maturity), and the banking system as a whole can potentially expand its loans by $10,000/.12, or $83,000! When the Fed buys securities, the exact same thing can happen.

The net reserve ratio-an equivalent ratio which would give you required reserves for deposits as a whole-depends on where the market chooses to place its money. But to give you an idea of the relationship of required reserves to depository liabilities as a whole, the data in the May 7,1990, issue of Barrons shows the broadest measure of the money supply, M3, at $4.066 trillion, while total reserves deposited in Federal Reserve District banks equalled only $60.3 billion. Of that 4 trillion plus number, actual currency equaled only $228.4 billion, which means that the rest consists of deposits (liabilities) in accounts of one form or another at various institutions.

So the ratio of reserve assets to monetary deposits as a whole is almost 1 to 70. Even assuming that M3 is not an accurate measure of the total mon ey supply, the same issue of Barrons reported that the Fed then held $233,966,000 in govemment securities. Assuming a net average reserve ratio of 10%, that gives the 12 men who make up the FOMC the power to add over $2.3 trillion in potential credit availability to the system-over half of M3!

Are you beginning to understand why open market operations are such a pow erful tool of monetary policy?

Plato, the Greek philosopher, believed that the common man was incapable of goveming his own life and affairs. Ideally, he thought that philosopher kings should mle the world. In a sense, Plato got his wish. The members of the FOMC are the philosopher kings of the U.S. economy, and as the sovereigns of the most powerful industrial nation on earth, they wield eno rmous power over the world economy as a whole. They are the kings, and the markets are the subjects-free to act only within the confines of sovereign dictate.

Just 12 men on the FOMC-the members of the board and five district bank presidents -vote to set policies which critically constrain and alter free market ac-

tion. They set objectives in terms of and take action based upon broad, aggregate economic statistics such as unemployment figures, capacity utilization, the Consumer Price Index (CPI), the Producer Price Index (PPI), the growth and rate of growth of the money supply (as measured by MI, M2, and M3), the trade balance figures, indices of the money supply (MI, M2, and M3), reserve balances, and many other

indicators. They constantly monitor these macro indicators and alter their strategy-in secret at the FOMC meetings-according to what they agree, by consensus, is needed to better achieve their policy objectives.

Now Ive simply got to put in an aside here. When the FOMC meets, they purposefully withhold their decisions from the market. Yet, the 12 members of the committee all bring aides to the meeting. Most of the committee members are married and have families, as are most of the aides. In addition, secretaries and staff must type up and duplicate the minutes. Now, in a country where the National Security Council cant sneeze without the press getting wind of it (no pun intended), do you really think the decisions in the meeting stay completely a secret? I dont. And in fact, that gives me an i dea.

Instead of raising taxes and doling out welfare, why doesnt the govemment secretly distribute the minutes of the FOMC immediately after the meeting to committees responsible for the development of depressed areas of the country. They could train these committees to trade in the markets and use the secret knowledge to get a jump on the rest of us who trade govemment securities. You could virtually end poverty in depressed areas! Of course, Im not serious, but in my opinion, a select few are getting the jump anyway!

Who holds the pump and who holds the needle? Without a doubt, the Fed does, in the form of Open Market Operations and the other policy weapons available to them to control the supply of and demand for money and credit. In order of increasing importance, the Fed has three principle tools of monetary policy: setting reserve requirements, setting the discount rate, and performing open market operations.

As a speculator, you need to understand the nature of these tools and how the Fed uses them in order to accurately assess the likely direction of future market movements. Let me discuss each of these weapons in tum.


In terms of the mechanical workings of reserve requirements, little more needs to be said than what I brought out in my discussion of the Newmoney banking system. But it is important to understand the different ways banks can achieve their reserve requirements and how the Fed uses its hand within this context both to affect the supply of money and credit and to monitor the activity of lending institutions.

The Board uses reserve ratios to establish reserve requirements that can only be met by holding sufficient reserve assets-vault cash and deposits with the Fed

eral Reserve District banks. Because money is constantly moving in and out of individual lending institutions, a particular institution may have a deficit or surplus of reserve assets in the short term. In the case of a deficit, a bank or lending institution ha s one of two choices: either it borrows the excess reserves of another institution on a short-term basis, or it can borrow from the discount window at the Federal Reserve bank in its district.

The market for borrowing the excess reserves of other institutions is known as the Fed Funds market, and the prevailing interest rate charged is known as the Fed Funds rate. This "borrowing from Peter to pay Paul" market and the interest rate which accompanies it is very important to watch. Although it is ostensibly designed to facilitate banks with a short-term reserve deficit, what it actually does is enable the system as a whole to stay loaned up to the fullest extent possible.

In fact, it is such an important market that until 1979 the Fed based its open market ope rations primarily upon trying to achieve a target Fed Funds rate, thinking that the interbank interest rate would determine the ease or tightness of borrowing for reserves, which would in tum set the standard for the credit market as a whole. But if you review the Carter years (197(-1980), youll find near runaway inflation, followed by interest rate controls, followed by a credit crunch, followed by deregulation and 22% interest rates!

Obviously, targeting a particular level of the Fed Funds rate was a totally inadequate tool for controlling credit availability. Like any other item in the marketplace, supply and demand determines how much credit expansion will occur. In the Carter years, people willingly borrowed and banks willingly loaned money at high interest rates because they thought rates might go still higher. In late 1990, however, there were plenty of excess reserves in the system, but banks simply werent making


Until 1979, in addition to trying to control the Fed Funds rate, the Fed also attempted to use the discount rate as means to control credit expansion. The discount rate is the interest rate that the Federal Reserve District banks charge lending institutions for borrowing reserves directly from the central bank. In theory, the discount rate was supposed to be set by the board of each Fed District Bank, subject to review and approval by the Federal Reserve Board. In practice, however, the discount rate is now uniform throughout the system and is established by the Federal Reserve Board with District banks automatically approving the Boards "recommendation" as a formality.

There are several differences between the discount rate and the Fed Funds rate. First and foremost, discount window borrowing is inflation of the most blatant form. When a bank borrows from the discount window, the Fed writes a check against itself, creating money that then serves as new reserves for the borrowing bank.

The borrowing bank pays interest (the discount rate) on the borrowed reserves and the system as a whole is able to expand loans by approximately 10 times the amount borrowed. The discount rate is always lower than the market rate of interest so, just like I used to do when I started trading options, the borrowing bank "makes

the middle" when it makes new loans secured by reserves borrowed through the discount window.

But there is a catch. Borrowing from the discount window flags the borrower as being possibly overextended. No one wants a federal agency breathing down its throat and monitoring its activities, so lending institutions are limited in the number of times they can go to the discount window. Basically, when they borrow from the discount window, they are given a silent, but not so subtle message, "Clean up your act, bad child, and provide the reserves you need from your own sources."

By comparison, the Fed Funds market is much more free. As long as banks can successfully "make the middle" and pay off their loans to fellow banks, they can borrow reserves in the Fed Funds market. During the late 70s, Fed credit was running amuck because the board was reluctant to sell enough securities to make the Fed Funds rate rise to a level that discouraged interbank borrowing for credit expansion.

It was all Volcker could do to get the Board to approve a V2-point raise from 10 Y2 to 11 % in the discount rate (a 4 to 3 vote), much less encourage open market securities sales to increase the Fed Funds rate.

What the Fed failed to realize during the 70s is that interest rates arent the sole determinant of the supply of and demand for money and credit. It goes right back to Von Mises explanation of the three components of the gross market rate of interest and how they change during the boom/bust cycle.

If, during an expansionary period, originary interest is lo w because of rising prices, if the price of the premium component is perceived by the market as being a bargain because interest rates are continuing to rise, and if the entrepreneurial component (no matter how high interest rates are nominally) is perceiv ed as surmountable in profioss calculations, then the markets will borrow as much money as they can!

In other words, no matter what the actual interest rate number is, if both the supply of and demand for credit exists, money will be loaned and the ere dit expansion will continue. Another reason the Fed couldnt quell the credit expansion of the 70s was that only Federal Reserve member banks were subject to reserve requirement restrictions. This meant that unregulated lending institutions could create money, which in tum ended up as new deposits in Fed member banks, further fueling the credit expansion. In addition, the foreign liabilities (such as Eurodollars) of member banks and other institutions were exempt from the same reserve restrictions as domes tic liabilities, and dollars created abroad were entering the system and further stimulating the growth in the money supply.

We were in the latter stages of a boom fueled by credit expansion, prices were rising in every sector, and the sentiment was that prices would continue to rise indefinitely. People were making paper fortunes in real estate, the commodities markets, stocks, you name it, and there was no end in sight; simultaneously, the average worker on fixed income was infuriated by the govemments inability to put a lid on rising prices. It was Laws Mississippi Scheme on a grand scale.

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