What's the Fed Been Up to?

The Fed's balance sheet is in a constant state of flux these days. There have been two key changes since the peak of excess reserves in mid-May. Below is the Fed's most recent balance sheet, as well as the balance sheet for May 20.

First, the Fed has been withdrawing term auction credit, which the banks were putting back on deposit with the Fed as excess reserves. That change is in red. It has no effect on the money supply or the real economy.

Second, they've reduced the sizes of swap lines with foreign central banks and instead have bought securities outright. They've also shifted some of their operations to buying securities outright. These changes are in green. Overall, the money supply is unchanged, but the policy is quite expansionary. That's because the swap lines are used to take foreign securities out of the market (they are pledged to foreign central banks by foreign banks in exchange for dollar funding), while the securities the Fed is buying instead are US Government and Agency securities. So even though the total monetary base hasn't changed much, this still represents a significant credit expansion.

The Circularity of Mark to Market Accounting

The present crisis has seen a lot of debate about mark-to-market accounting. Traders tend to favor mark-to-market, as do academics who mistrust banks' motives and accounting. Bankers and efficient market skeptics argue for more flexibility. The usual problem, of course, is that in a crisis prices can plummet for liquidity reasons, which can cause institutions to become insolvent on a mark-to-market basis, causing bankruptcies, liquidations, further price declines, and more insolvencies. Very few people are comfortable actually allowing this dynamic to play out, but it is a struggle to find a credible alternative accounting regime. For large institutions, like the banks that hold troubled mortgages, there's an even more fundamental problem with mark-t0-market accounting: it is circular and therefore not well-defined.

Mark-to-market accounting says that assets should be valued at their market prices. The market price for an asset depends on the large institution's demand for the asset -- that is well-known. But the large institution's demand depends on the market price, and if the institution is levered, its demand may in fact depend positively on the price of the asset.

So the question is: when the bank is valuing its assets, should it consider the market price including its own demand, or not including its own demand?

The problem is even more acute when there are speculators driving down the price of an asset solely because they anticipate that they will force a large, levered investor to liquidate. In other words, the market price may only be low because investors believe liquidations are coming, and those liquidations are only forced by the investors' belief. It becomes an extremely destructive self-fulfilling prophecy.

What's the right solution here?

Negative Interest Rates Again

A few months ago I commented that zero wasn't really the lower bound on interest rates, it was probably slightly below that. Well, the Swedish Riksbank today cut its deposit rate to negative 0.25%, meaning that banks will have to pay to hold excess reserves. Did the kroner collapse? Is there a run on the banking system? No and no. Why? Because holding large quantities of cash is, quite simply, a tremendous bitch.