Wednesday, March 25, 2009

Bank of England "failed auction:" Some perspective



Lots of talk today about a "failed" gilt auction in the U.K. and what that might portend for the U.S. Treasury market. Many commentators saying that it's only a matter of time before the U.S. experiences what just happened in the Britain.

However, those making that prediction are ignorant of the facts. Remember, monetary policy is all about price, not quantity. The price is the interest rate. Once a central bank sets an interest rate target it is obligated to sustain a level of reserves that maintains that rate. Remember, too, that the reserves provided by the central bank are the funds used to buy Treasuries or in the case of Britain, gilts.

The Bank of England still mainains a positive interest rate of 0.5%. While this is low, it still requires reserve maintainence to keep it there. On the other hand, the Fed's overnight interest rate is zero and it has been aggressively targeting long-term rates lower as well.

This means that the Fed has been far more aggressive in boosting system reserves or, providing the money to pay for Treasuries. The Bank of England has not.

One glance at the chart below should make it clear.



While the Fed has manipulated reseve balance up by almost 8,000% in the past year, the Bank of England reserve growth has been only about 120% over that course of time and has recently dropped down significantly. If the central bank is not providing the funds to buy gov't securities (or if the British treasury is not providing the funds), then the money to buy gilts will not be there. Thus, the "failed" auction. It's the market's warning to the BOE and the British government that either interest rates must be lowered to zero or more gov't spending must be undertaken.

6 comments:

captain mike said...

When they put reserves in the system, weren't they doing that by buying treasury securities? If thats right, then they just bought treasury securities to put money in the system to sell back treasury securities?

Whats the point then..are they different maturity times?

Mike Norman said...

Cap'n:

Last week’s $150b jump in reserves was mostly due to the Fed buying mortgage backed securities (MBS) because they want to bring mortgage interest rates down and, thus, the buying of MBS. The Fed can buy anything—used cars, if they want to get the price of used cars up—and the result is the same, an increase in reserve balances. But you’re right: the Fed mostly buys Treasuries to achieve this and there are plenty of Treasuries held by the public for the Fed to buy, about $6.7 trillion at last count.

As to your question: why do they buy Treasuries only to re-sell them? At the current time the Fed is not re-selling the Treasuries it bought, however, the Federal Government is selling large quantities of new Treasuries on an ongoing basis. Some call this borrowing, but it is not, really. The government is spending all the time. It pays wages and salaries to government employees, sends out Social Security checks and other transfer payments, pays for infrastructure maintenance, defense needs, etc. Payments made by the Treasury for any of these things (and more) also result in an increase in reserves in the banking system.

If the Fed and the Federal Government, together, continued to supply new reserves to the banking system the growth in reserves would become exponential very quickly. That wouldn’t be good. So the Treasury sells securities to keep reserve growth in check and this functions to maintain the Fed’s interest rate.

On balance, the total amount of securities sold in the past year has been far less than the amount of total reserves added to the system and there is a reason for this. The Fed has decided it wants overnight lending rates at 0% and other rates sharply lower as well. Therefore, by definition, the growth in reserves has to be sufficient to sustain zero or very, very, low rates. There’s also another reason, which is, that the Fed believes high levels of excess reserves in the banking system will entice banks to lend. So far this has not worked out to their hopes, however, the Fed continues to believe that this will free up credit. We’ll see.

Ultimately, at some point down the road when the economy recovers, the Fed will raise interest rates and stop adding reserves. It could also sell some of its own Treasury holdings (currently around $480 billion) to bring the level of reserves down slowly in order to push rates back up. The ongoing sale of securities by the Treasury will function to do the same thing.

Michael said...

Mike-

Thanks for the response, it makes total sense. I often think of the Fed and Treasury as one entity, but only to simplify for understanding. In reality I see how they have to work to balance each other out.

On "inticing to lend," it seems to me that credit is constrained on the demand side too..people are too afraid to take on debt.

Mike Norman said...

Cappy:

You're right again! Lending is very constrained on the demand side. JP Morgan CEO, Jamie Dimon, has been stating this for months. There's little the Fed can do about this as reserve growth does not necessarily translate into demand growth in the economy. Only the Federal Gov't can boost demand quickly via spending more, but there is tremendous political and ideological resistance to this.

googleheim said...

in my opinion, they were gambling again on an old hand - namely the use of the bad bank to mop up the real estate problem.

so they were inflating reserves again to hedge against possible outcome of failure with the reception of this plan.

filling reserves is a safety mechanism, again part of macroeconomic elastic currency technique and theory.

Mike Norman said...

Reserve drain is coming from a belief in the U.K. that they are "out of money." They don't understand their own monetary system!! It can happen to us, too, for the same reason.