Sunday, April 26, 2020

Explaining the Federal Reserve’s Coronavirus Policy Response Part 5: Is Runaway Inflation Inevitable?

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6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff ponders the likeliness that the Federal Reserve’s aggressive coronavirus easing will spark runway inflation.

Monetary Velocity: 2008-2015

Note: This analysis applies fundamental principles concerning the effects of money, output, and velocity on prices and inflation. For a primer on the basics of inflation go to:

Since mid-March the Federal Reserve has flooded the financial system with new liquidity more quickly than during the depths of the 2008 financial crisis. Newly created reserves are being loaned out by commercial banks and multiplied into higher demand deposit balances.

So won’t all this new money spark massive inflation? Is our money doomed to go the way of the Venezuelan bolivar and become toilet paper?

In the Economics Correspondent’s opinion, the short answer is “very unlikely” although he won’t rule out a mild increase particularly in the near term—but not Weimar Republic Germany or Robert Mugabe’s Zimbabwe.

Some of the new money will spill over into asset markets, driving up the value of stocks and other securities which—while introducing a different set of risks longer term—have little effect on consumer prices and aren’t measured in official inflation statistics.

However the greatest counterbalance to the Fed’s monetary inflation will be falling monetary velocity which the Correspondent believes the Fed already considers a fait accompli.


There is no question the Federal Reserve is aggressively creating new bank reserves through extremely large asset purchases. In the March 11 to April 22 period total commercial bank reserves held at the Fed have risen from $1.72 trillion to $3.1 trillion, an increase of 80% in 42 days and a new record eclipsing the $2.8 trillion set in July of 2014 (see table 1, "Reserve balances with Federal Reserve Banks").

The monetary base is also in record territory (see graph).

Incidentally the rate of increase of both has slowed considerably from the operations’ frantic opening days.

The broader M1 aggregate, which reflects currency and commercial bank demand deposits (themselves the product of banks lending out reserves) has risen from $4.07 trillion to a record $4.52 trillion or up a more modest 11%.

The even broader M2 aggregate has risen by $1.2 trillion during the same period from $15.66 trillion to $16.87 trillion, up even slower: 7.7%.

But as we’ve already reviewed in the previous chapter on the Equation of Exchange (mv = py), final prices are influenced not only by changes in the money supply, but also by fluctuations in economic output (real GDP) and monetary velocity.

As we enter a major recession due to government social-distancing shutdowns and consumer fears of coronavirus infection, real output is sure to fall. Given that prices move in inverse proportion to output, a decline in real GDP will trigger an increase in prices.

So if, for example, the next quarterly GDP report reflects an epic annualized decline of 40%, then all things being equal the actual drop for the quarter itself (when not extracted on an annual basis) of 11.2% will propel a price inflation of 12.6% for the quarter alone.

Unnerving indeed. So why the downplayed inflation concerns?

Because—and this is a key concept—a fall in monetary velocity produces the opposite effect, a decline in prices. We have a recent example.

During the financial crisis single-year period 2Q2008 to 2Q2009 monetary velocity fell by 17% (see graph).

A 17% decline in velocity, all things being equal, will deflate prices by 17%. And applying the Equation of Exchange (mv = py) a 17% decline in velocity paired with an 11% increase in M1 and an 12.6% decline in output actually translates to a final inflation rate of 3.7%.

Now of course this is just a mathematical hypothetical using apples and oranges—a full year’s deflation, a quarterly GDP contraction, and a 42 days change in money supply. We don’t know yet what the M1 and GDP numbers will be by the end of the year, but the Economics Correspondent believes the Fed anticipates an even larger drop in velocity than 17% for 2020 and that the decline will easily outpace GDP’s in ensuing years as GDP resumes growth more rapidly than velocity.

The reasons aren’t hard to fathom.

Starting with a baseline of the 2008 financial crisis and its single-year 17% decline we can start making adjustments accounting for the more extreme economic conditions of the coronavirus crisis.

1) With nearly all of America under shutdown, consumers can’t spend on discretionaries and even some consumer staples, even if they have the means to do so.

2) Tens of millions of Americans will lose their jobs in the short-term. The lack of income will drive velocity down further.

3) Even when the lockdown restrictions are loosened, those Americans who still have jobs will forgo spending to bolster their savings as they worry about job security.

4) Even when the lockdown restrictions are loosened, Americans will be less willing to spend on most goods and services than before. Spending on travel, hospitality, restaurants, sporting events, many brick-and-mortal retail stores, personal fitness clubs, movie theaters—the list goes on and on—will fall to depressed levels until a cure or vaccine is widely available.

It doesn’t stop with consumers.

5) Firms have borrowed heavily and built liquid cash cushions to ride out the slump. However those reserves will be spent at a slower rate than before. With demand down across the board firms will be paying fewer workers, cutting back on operations, and abstaining from large capital investment projects.

The federal government is attempting to prop up spending and velocity with its $2+ trillion “life support” package, but borrowing and handing out trillions of dollars every month is unsustainable.


What about when the economy recovers?

Recent history shows in recessions GDP always bottoms out and recovers before velocity does.

In the 2008-09 recession, GDP bottomed out at about -5% in 2Q2009 before resuming growth at a very modest pace. However velocity’s fall remained persistent. By the end of 2015 velocity had declined by a whopping 44% and as of this article’s writing has still never reached a trough (see graphs).

Once again we can apply the Equation of Exchange.

Had the money supply remained constant from 2008 to 2015, prices would have fallen by 50% resulting in widespread bankruptcies as borrowers found it twice as difficult to earn the dollars needed to pay back fixed nominal debts.

In the 2000-01 recession, GDP bottomed out at less than -1% in 3Q2001 before turning around. However velocity continued to fall for two more years before bottoming out in 2Q2003, down 6.5% from the pre-recession peak.

So even though spectacular headlines of GDP contraction will dominate the news for a few quarters, the Economics Correspondent believes velocity will also contract and remain depressed for a longer period.

Hence the Fed’s aggressive quantitative easing and liquidity programs are designed to offset declining velocity. This doesn’t even include the Fed’s more publicized goals of ensuring firms have access to liquid dollar loans to survive, and at reasonable interest rates (rates would skyrocket is new reserves weren’t available—simple supply and demand).

The Fed hasn’t made many public statements announcing the velocity rationale for monetary expansion, but it has repeatedly reaffirmed its goal of “price stability and the 2% inflation target.” Obviously if velocity falls 40% over several years while GDP falls 10% or 20% and rebounds, price stability and a 2% inflation target won’t be achieved without adjusting the money supply.

Ironically, Austrian economist F.A. Hayek—possibly the most free market economist ever to win the Nobel Prize—advocated the same policy response in the early 1930’s and he also used the Equation of Exchange to reach his conclusion. Hayek argued mv (what he called “the flow of spending”) must be kept constant by central banks and that declines in spending—which the central bank had little control over—must be “offset” by expansion of the money supply.

However most central banks, most notably the 1929-1933 Federal Reserve, did the opposite. The Fed sat idly by and refused to make emergency liquidity loans to member banks. As 10,000 U.S. banks failed the money supply, far from expanding to offset declines in velocity, contracted by one-third in what would mark the darkest period of the Great Depression.

Ultimately Hayek gave up on his “flow of spending” proposals, not because he believed they were invalid, but because he lost confidence that central bankers were competent enough to carry them out. Later in his life Hayek ultimately came to believe a complete separation of money and state (free banking) was the best policy.


The Fed’s strategy of offsetting declines in velocity with monetary expansion sounds good in theory, but carrying out the policy is a fine balancing act that requires constant monitoring of prices and the economy in general.

So what’s the Fed to do if it miscalculates and prices start to accelerate beyond its 2% inflation target? Is it powerless to restrain prices once they start to rise?

No, it has tools.

Since 2008 the Fed has used Interest of Excess Reserves (IOER) policy to control the quantity of bank reserves that are loaned out into the real economy. IOER is the interest rate the Fed pays member banks to sequester their reserves instead of lending them.

Since IOER interest is risk-free, safer than U.S. Treasuries since the Fed simply creates the interest paid out of thin air, banks are prone to sequester their reserves so long as the rate is attractive enough discounting for its zero-risk premium.

During the entire post-2008 period the Fed consistently paid a higher IOER rate than banks could earn on competing safe, short-term securities like 1-week, 1-month, or even 3-month Treasuries. This achieved its goal of loading banks up with trillions of dollars in reserves during the crisis to enhance their liquidity positions while preventing those reserves from being unleashed on the real economy and sparking runaway inflation.

The Fed will use the IOER rate as its primary policy tool during and after the coronavirus crisis as well. If the Fed sees inflationary pressures building, it will raise the IOER rate to impel banks to moderate lending enough to restrain the inflation rate.

Over the next several quarters the Economics Correspondent will monitor increases in monetary aggregates and compare them against changes in real GDP and velocity. While unwilling to bet his life's savings on it, he anticipates:

-Higher monetary aggregates

-An initial sharp GDP contraction followed by a slower recovery (although rapid compared to previous recoveries due simply to the size of the initial contraction)

-An even sharper contraction in velocity that persists long after GDP bottoms out.

Thursday, April 23, 2020

Paul Krugman in 2008: Higher Oil Prices Won't Spur Shale Oil Production

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With WTI May oil futures dipping briefly to negative $35 a barrel this week, the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff found this gem from New York Times columnist and New Keynesian economist Paul Krugman arguing it looks like the world has reached peak oil—back in 2008 (see link).

"Peak oil, that is — a dismal theory that keeps getting more plausible."

Krugman also mocked anyone who predicted 2008's high oil prices might bring unconventional oil sources like shale oil online.

"I spent many hours with Bureau of Mines publications containing firm estimates of the price of shale oil and oil-from-coal, all of which said that huge alternative supplies should be arriving any day now..."

"Well, people say that — but they’re always saying something like that..."

"Seriously, don’t believe the hype: history says that these things always fall short of expectations."

h/t to Nick Shaw's personal comment thread that referred me to this aging addition to the endless list of Krugman blunders.

Monday, April 20, 2020

Explaining the Federal Reserve’s Coronavirus Policy Response Part 4: A Primer on Inflation

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5 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff will consider the inflationary repercussions of the Federal Reserve’s coronavirus easing operations—starting with a prerequisite primer on the general subject of inflation for anyone seeking a better understanding of the subject.

Disclaimer: It’s no secret that the Economics Correspondent is no fan of the Federal Reserve which he views as an instigator of asset bubbles and boom-bust business cycles, bureaucratic central planner of monetary policy, interest rate price-fixer, persistent inflation machine, and facilitator of endless government deficit spending.

That said, he reserves judgment on the Fed’s latest expansionary operations. While the Correspondent doesn’t hesitate to critique monetary and fiscal policies during traditional financial crises and business cycles, the current government-engineered hard stop to restrain a pandemic is unlike any recession anyone has ever seen.

However there are some universal relationships between money, GDP, velocity, and prices that apply in any economy and will certainly play out in this recession as well.


Economists and scholars have pondered the nature of prices going back for centuries. By the early 19th century British economist David Ricardo and later John Stuart Mill had begun publishing judiciously on the effects of changing money, output, and velocity on prices although their theories were denoted via written prose.

In 1911 American economist Irving Fisher produced the first mathematical expression of those relationships known today as the Equation of Exchange (also referred to as the Quantity Theory of Money).

Now before objecting that “I don’t want to deal with math!” keep in mind this simple equation can serve the layman for a lifetime with a broad and comprehensive understanding of the forces that drive inflation and deflation.

In its simplest form the Equation of Exchange is expressed as…

mv = py


m = the money supply

v = monetary velocity (the number of times dollars change hands each year)

p = the general price level, and

y = real GDP… or output… or technically the monetary value of all economic transactions.

(Sometimes the formula is expressed as mv = pq or mv = pt where GDP is expressed as “q” for quantity of all goods/services produced or “t” for total monetary transactions, but we will use “y” which is the standard economic variable for GDP)

The Equation of Exchange isn't some pie-in-the-sky abstract theory. It has not been overturned for more than a century and is accepted by virtually every major school of economic thought, even if some schools disagree about the ultimate policy implications of the formula or apply it with varying degrees of frequency.

The Equation of Exchange is also considered a tautology, a statement that is true by necessity or by virtue of its logical form (such as two nickels equals one dime, or four quarters equals one dollar). After all, it’s not the expression of a natural scientific law but rather one of human invention: mathematical monetary flows.

Going back to the formula, isolating p (prices) helps the student better understand the forces that drive the overall price level and inflation in general. Dividing both sides of the formula by GDP (y) gives us:

p = mv/y

From here it’s fairly straightforward to understand the impacts of all inputs on prices.

1) All other factors being equal, if the money supply (m) rises then prices rise proportionally. If the money supply contracts then prices fall proportionally.

This is the most obvious and intuitive relationship understood by most people.

2) All other factors being equal, if monetary velocity (v) rises then prices rise proportionally. If velocity falls then prices fall proportionately.

3) All other factors being equal, if real GDP (y) rises then prices fall inversely. If real GDP falls then prices rise inversely.

The real GDP relationship is also somewhat intuitive since most people understand that the same number of dollars chasing fewer goods translates to higher prices. Likewise the same number of dollars chasing more goods (ie. a growing economy) translates to lower prices.


Nobel Laureate and economist of the Monetarist School Milton Friedman famously said “Inflation is always and everywhere a monetary phenomenon” which is true under most conditions. He also drove around with an MV = PY bumper sticker on his car.

The most universal truth of the two expressions is the latter: the Equation of Exchange.

MONEY: Starting with money, most readers intuitively "get it."

If the central bank produces money faster than the real economy grows—either by printing lots of high denomination banknotes, creating new reserves and crediting them directly into the central government’s account, or by buying large quantities of assets with newly created reserves and forcing interest rates down—prices are going to rise.

If the central bank produces money even faster hyperinflation can result as it famously did in Weimar Germany or recently in Zimbabwe and Venezuela.

However GDP/output and velocity also influence prices.

OUTPUT: If real GDP—the value of all goods and services produced in the economy—rises, there are more goods and services to be purchased with the same quantity of money and prices fall. If real GDP falls there are fewer goods and services to be purchased with the same quantity of money and prices rise.

However changes in output alone very rarely produce hyperinflations or rapid deflations. The reason is simple: real output would have to rise at impossible rates to create rapid deflation.

For example, to achieve an annual 20% fall in prices real GDP alone has to grow 25% a year, impossible in either a developed or even developing economy.

And a huge share of economic output would have to be destroyed to create hyperinflation. To achieve 1,000% annual inflation the real economy would have to contract by 91% in a single year.

It is theoretically possible for 50%, 70%, or 90% of a real economy to be destroyed in a single year during wartime, but typically a government losing that badly in a war will already have resorted to hyperinflationary money creation to further commandeer resources for the military.

Incidentally under the classical gold standard of the late 19th century, the U.S. economy grew very quickly even as the money supply grew due to new gold supplies produced via mining. However, since the economy was consistently growing at a faster rate than the supply of gold, output (y) outstripped money (m) and the result was a gentle, benign fall in prices (p) year after year.

That’s right, the United States along with every other industrialized nation experienced consistent and mild deflation even as their economies grew rapidly. So don’t let any Keynesians or central bankers tell you that the moment prices start to fall 0.5% the result will inevitably be another Great Depression.

VELOCITY: Finally there’s the more complex variable of velocity. The old economists of the Monetarist school and Quantity Theorists (which included Irving Fisher) assumed velocity was more or less constant. However we now know that’s not true although velocity tends to change very slowly—during normal times.

However in times of depression, financial crisis, and rapid inflation velocity tends to change more quickly.

Some examples: the easiest to follow is rapid inflation. Once the inflation rate breaks a high enough level, people start spending their cash frantically. They know the longer they hold their money the more value it will lose.

At the extremes workers in Weimar Germany received their pay at lunchtime and quickly handed it to their wives waiting at the factory gates to spend it all before the day ended. Prices were rising that quickly, doubling every 3.7 days and even changing midday.

So in a cruel spiraling effect, when rapid inflation sets in, velocity rises rapidly too which in turn raises prices even faster. The central bank usually responds by upping the rate of monetary creation to fund exploding budget deficits and the vicious cycle continues. This phenomenon explains why hyperinflations not only drive prices up quickly, but also accelerate with the inflation rate itself rising higher and higher.

Falling velocity, which applies closest in the coronavirus economy, is the most complex scenario.

Obviously consumers are an important driver of velocity. Healthy consumer spending is a large factor in maintaining dollar velocity.

However it’s not just the consumer who influences velocity. Firms have an even greater effect. Corporations are large spenders of money via not only worker salaries, but also capital investments and spending on operations (such as an airline spending on fuel or aircraft maintenance or a general contractor spending on steel, concrete, and heavy equipment).

If consumers and firms both cut back on spending and hoard their income as savings, one necessary condition arises for falling velocity.

But the largest mediator of velocity is banks and other financial institutions. Because most money is deposited in a bank, the bank’s propensity to lend or not lend serves as a conduit or chokepoint for monetary velocity.

So if consumers and businesses cut back on spending and save more, those savings are usually deposited at a bank of other financial firm. If the bank lends those savings out, the hoarded savings change hands and the hoarding-induced fall in velocity is moderated.

But if the bank sits on the funds and refuses to lend, as banks tend to do when their balance sheets come under strain due to recessionary bad loans or during financial crises, the hoarded savings get stuck in the banking system and all the necessary precursors are in place for a significant decline in velocity.

In the final installment we’ll apply the lessons of the Equation of Exchange to determine if the Federal Reserve’s aggressive monetary policy is conducive to rapid price inflation.

Friday, April 17, 2020

Left Coast Correspondent: Taiwan and the Coronavirus. With Enemies Like China, Who Needs Friends?

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3 MIN READ - The Cautious Optimism Correspondent for Left Coast Affairs and Other Inexplicable Phenomena goes back to an August 2019 story and reveals how Taiwan’s acrimonious relationship with communist China spared the island the worst ravages of the coronavirus pandemic.

Taiwan has received global acclaim for its rapid response to the coronavirus crisis and keeping the spread far better contained than most other countries.

Although Taiwan sits only 81 miles off China’s coast and shares many cultural ties to the mainland, it benefits from being an island and a relatively small nation.

(I call Taiwan a “nation” although its sovereign status is disputed by China, the United Nations, most world governments, and even the KMT opposition party within Taiwan itself)

Taiwan also has few ports of entry from outside. Similar geographic and size advantages can be said for other small Asian nations/regions that have so far fared relatively well: South Korea, Hong Kong, and Singapore.

Those countries also gained from being victims of the 2002 SARS epidemic, learning valuable lessons from the difficulty of being at the epicenter of that earlier coronavirus crisis.

But what’s less well known is that Taiwan secured a huge safety advantage by virtue of its longstanding acrimonious relationship with mainland China.

Taiwan and China have been at odds since 1949 when Chiang Kai-Shek’s Guomingdang Party (KMT) government retreated to the island after losing the civil war to Mao Zedong’s communists. For over half a century few ties existed between the two antagonists, and only a slight thawing appeared in the late 2000’s decade under Taiwan’s KMT President Ma Ying-Jeou.

Over time the KMT sought a modestly reconciliatory stance with Beijing, the two sides agreeing with the “One country, two systems” framework and joint declaration that “There is only one China, and Taiwan is part of China.”

A handful of direct flights between Taiwan and China were approved for the first time and Chinese tourists were allowed to visit the island. The KMT government welcomed tourism dollars brought from its increasingly rich neighbor.

However everything changed with the 2016 election of Taiwan’s current president Tsai Ing-Wen. Tsai, whose Democratic Progressive Party (DPP) has long considered Taiwan an independent country and opposed the KMT’s overtures, felt that her predecessor was getting too close to Beijing.

The moment Tsai was elected, Beijing predictably ratcheted up pressure on Taiwan attempting to isolate it. War games were conducted near Taiwanese waters, and China has tried to impose economic pressures on the island in a bid to depose Tsai in the next election.

Famously the world now knows the same isolation strategy included severing all direct communication between The World Health Organization (WHO) and the Taiwanese government.

And in what wasn’t understood at the time to be a critical development, Taiwan itself further stoked tensions by voicing support for the 2019 Hong Kong pro-democracy protests. In what would prove to be a bizarre twist of fate China responded by “punishing” Taiwan with new restrictions.

On August 1st the communist government ended permits for most Chinese tourists wishing to visit Taiwan and banned many flights between the two countries. The idea was to cut off tourist revenue from Taiwan's economy and further hurt Tsai Ing-Wen's re-election chances. And the Taiwanese public’s initial response was alarm: hotels and tour companies braced for economic pain.

Read detailed CNN story at:

As 2019 progressed, Beijing cut off more and more travel to the island in an attempt to ratchet up the pressure.

But now in early 2020 it's clear in hindsight that China’s “punishment” turned out to be an epic blessing.

Before the travel ban, approximately 82,000 Chinese tourists visited Taiwan every month. But with most cross-strait visitor traffic already cut off—even before the Wuhan outbreak— Taiwan was spared a late 2019/early 2020 mass influx of Chinese tourists who would have brought the coronavirus with them.

Taiwan’s initial view of the 2019 travel ban was negative, but today Taiwanese thank Beijing for punishing them. If China were to offer to lift the travel ban now, Taiwanese would surely respond “No thank you, we like our punishment just the way it is."

The strained relationship with China helped Taiwan in other ways.

When the Wuhan coronavirus outbreak started in late 2019, Taiwan’s requests for information from the WHO were met with silence. What little word it received was channeled through Beijing since the WHO officially considers the Chinese Communist Party to be the legitimate government of Taiwan which, also consistent with China’s position, it views as a Chinese province.

Taiwan’s DPP government, which has never trusted China, didn’t believe what few propagandized and flowery outbreak reports it received from the communists and assumed the worst. It quickly moved to quarantine the island and place strict restrictions and health inspection measures on what few entry conduits remained for Chinese nationals to visit and Taiwanese nationals to return to the island.

And of course recent reports confirm that Taiwan warned the WHO in late 2019 of human-to-human transmission of the novel coronavirus, but the international body ignored them and chose to adopt Beijing’s official narrative that the outbreak was under control and posed no threat to global health.

In retrospect, Taiwan’s strained relationship with China gave it the edge it needed to manage the spread of the virus to its shores.

1) Taiwan adopted a stance of great caution in light of the information blackout from the WHO.

2) Taiwan’s DPP government, which has never trusted any “information” coming out of Beijing, assumed the rosy reports of a small, nonthreatening Wuhan outbreak to be baseless propaganda.

3) Taiwan, isolated from China by Beijing’s travel ban, was spared the influx of hundreds of thousands of potentially disease-spreading visitors from the mainland.

So with enemies like China, who needs friends?

Monday, April 13, 2020

Explaining the Federal Reserve’s Coronavirus Policy Response Part 3: International Liquidity

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4 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff continues reviewing the Federal Reserve’s unprecedented monetary policy response to the coronavirus crisis, this time with its overseas dollar liquidity operations.

Note: This installment applies central bank vocabulary and operations mechanisms previously defined in Part 1 of this series. Readers who are not familiar with monetary theory and central banking terminology can find a primer in Part 1 at:


It’s not just U.S. firms and financial institutions that are rushing to bolster cash positions for uncertain times. The need for dollars is equally great overseas.

As a reminder, the U.S. dollar is the preeminent world reserve currency for settling international balance of payments. Overseas companies need dollars to buy from and sell to firms in other countries. They borrow, invest, spend, and repay debt both with dollars as well as their own domestic currencies.

Consequently international banks that lend to such firms also require dollars, and their own central banks maintain dollar holdings as well.

As the issuer of the world’s reserve currency, the Federal Reserve has long accepted its responsibility of de facto central bank to the world, at least to keep the wheels of international commerce well-oiled.

As it has become increasingly clear that social distancing measures to stem the spread of the virus will strain the economies of the world, overseas firms have also scrambled to stockpile dollars as a hedge against uncertain times—in some cases by selling assets but primarily through borrowing.

Hence overseas banks have seen a huge demand for dollars and they in turn have tried to monetize paper assets in their portfolios through their own central banks to bolster liquidity.

But foreign central banks aren’t authorized to issue dollars, only the Federal Reserve. So consonant with its international responsibilities the Fed has launched large scale asset purchases in open market operations with not only its domestic primary dealers but also its long-established foreign ones.

Those include Bank of Nova Scotia (Canada), BMO Capital Markets (Canada), BNP Paribas (France), Barclays Capital (UK), Daiwa Capital Markets (Japan), Deutsche Bank Securities (Germany), HSBC Securities (UK), Mizuho Securities (Japan), NatWest Markets (UK), Nomura Securities (Japan), RBC Capital (Canada), Société Générale (France), and UBS Securities (Switzerland).

The Fed has also boosted its dollar currency swap lines with standing participant central banks such as the Bank of England, Bank of Canada, ECB, Bank of Japan, and the Swiss National Bank.

A currency swap line is a facility by which the Fed accepts currencies of other countries and provides dollars in return.

Both of these lists (overseas primary dealers and foreign central banks) are missing a lot of countries. So on March 19th, seeing soaring demand for dollars from other regions, the Fed established new currency swap lines with the central banks of Australia, Brazil, Denmark, South Korea, Mexico, New Zealand, Norway, Sweden, and Singapore.

These countries also had temporary swap lines with the Fed during the 2008 financial crisis which were allowed to expire at crisis end.

If the Fed doesn’t supply reserve dollars to the world during a time of crisis-level demand, the imbalance of high demand and low supply will naturally result in a higher price (interest rate). Not only will some firms not be able to raise dollar balances to survive uncertain times, but those that do will pay punitive interest rates.


There’s one more less publicized but equally important international dollar crisis the Fed attempts to head off by making more dollars available: the threat of rising dollar exchange rates to foreign firms and their economies.

As foreign banks and firms initially rushed to accumulate dollars, the dollar’s exchange rate against foreign currencies rose sharply.

Under normal conditions overseas firms would gain an export advantage since their products would become cheaper for U.S. consumers.

However there’s a downside as well. Since foreign firms borrow and repay much of their debt in dollars, a stronger dollar becomes much more expensive for them to obtain. Many firms generate revenues domestically in their own currencies, exchange them for dollars to conduct overseas business, and repay their dollar-denominated debts.

A sharp rise in the value of the dollar means revenues earned in the domestic currencies exchange into fewer dollars, placing greater strain on their ability to service dollar-denominated debt.

This phenomenon is particularly crushing for developing countries since a great deal of investment in their economies comes from overseas dollars. A sharp fall in the exchange rate value of their domestic revenues will result in foreign investors pulling out as dollar-denominated losses begin to pile up.

Normally this exchange rate phenomenon would be somewhat offset by higher exports (which in turn would send dollars back to the exporting country), but with the world locked down and entering a global recession overseas buyers (consumers and businesses) are on strike. So foreign firms are getting little export benefit and plenty of dollar-debt liability.

By issuing more dollars via open market operations and currency swaps, the Fed is attempting to moderate the exchange rate rise of the dollar to prevent foreign economies from being sunk by their own rush for dollars.

One can see the obvious movements of the dollar exchange rate against several currencies in the following charts. The dollar strengthens in mid-March as the crisis unfolds and international institutions rush for dollars. Then the dollar falls as the Fed makes its own rush to provide global dollar liquidity.






So after reviewing all the reasons the Fed is taking such dramatic and unprecedented steps to increase dollar liquidity and dollar holdings—both domestically and overseas—readers might ask one very logical question:

“Fed operations might be doing a good job of accommodating demand for dollars, but won’t all these new dollars spark massive inflation and make our money worthless?”

The short answer is probably not, which we’ll explain in the final installment.

Monday, April 6, 2020

Explaining the Federal Reserve’s Coronavirus Policy Response Part 2: Domestic Liquidity

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4 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff moves forward to the Federal Reserve’s specific policy programs to counter the rapid coronavirus economic downturn.

Overall system reserves rise sharply in March of 2020
Note: This installment applies central bank vocabulary and operations mechanisms previously defined in Part 1 of this series. Readers who are not familiar with monetary theory and central banking terminology can find a primer in Part 1 at:

Also, this article is not a full endorsement of Federal Reserve policy by the Economics Correspondent, only an explanation of the Fed’s recent liquidity operations and strategic policy objectives countering today’s unprecedented economic shutdown.


As it becomes clearer to U.S. financial institutions, companies, and households that a sharp recession and economic uncertainty are coming fast, everyone is naturally trying to bolster their dollar holdings as a cushion to ride out the storm.

Banks want a larger liquid reserves balance as a cushion against higher loan losses. The good news is banks are already loaded up with trillions of dollars in reserves from successive Fed quantitative easing programs (QE1, QE2, QE3) in 2008, 2011, and 2013 (see link for chart):

So banks, while not invulnerable, are already highly liquid. The same can’t be said for all firms and households.

In a sudden economic downturn companies with low cash balances will run out of money very quickly if they can’t access loans. But many companies still have access to credit because in exchange for new loans they have large capital assets to pledge.

Unfortunately most companies are also rushing to borrow lots of rainy day dollars at once and driving up interest rates. For example, ExxonMobil, which is reeling from $25 oil and the Saudi-Russian oil price war, quickly moved to bolster its cash position even as it had already lost its AAA debt rating and was forced to pay an unheard of 60 basis points higher rate than Pepsico on its corporate notes. But in the words of Diamond Hill Capital Management CIO Bill Zox “In an environment like this, it’s all about access to capital, not cost of capital.”

That pretty much sums it up.

So the Fed has moved quickly to make more dollar liquidity available which in turn will also prevent interest rates from skyrocketing.

1) On March 15th the Fed announced it was immediately launching an open market operation to purchase $500 billion in Treasury securities and $200 billion in agency-backed mortgage securities to boost bank reserves. It moved to lower the Fed Funds rate to a 0%-0.25% range, and it dropped the rate it pays on the excess reserves of banks from 1.60% to 0.10%.

Raising bank reserves, lowering the Fed Funds rate, and lowering the rate banks receive on excess reserves are all designed to encourage more lending and raise M1 demand deposit balances.

In the same announcement the Fed lowered the regulatory bank reserve ratio from approximately 10% to zero. To the Economics Correspondent’s knowledge, a zero reserve ratio is unprecedented in the Fed era although pre-Fed suspensions of the gold standard (War of 1812, Civil War Confederacy) could be a rough parallel.

In theory a zero reserve ratio requirement could result in an infinite quantity of demand deposit money created via bank lending, but banks are still disciplined by the threat of customer withdrawals, the Fed can adjust the IOER rate to motivate banks to hold onto a higher level of reserves, and banks are hardly in the mood to lend out 100% of their reserves in the coronavirus economic environment.

Finally the Fed lowered its discount window rate (the rate at which banks can borrow from the Fed directly and which the Fed controls completely) to 0.25% and encouraged banks to use it. In the past banks have been reluctant to approach the discount window during financial crises for fear they will be identified as troubled institutions leading to rapid customer withdrawals (a classic bank run) and failure.

However the current environment is not one of financial crisis, at least not yet, so the Fed has encouraged banks to utilize the discount window without fear of stigma. The Fed’s announcement text is at the following link:

In its March 15th announcement the Fed indicated it would consider other tools to increase liquidity, and it quickly made good on its promise.

2) On March 17th the Fed created an unprecedented Commercial Paper Funding Facility (CPFF) to provide liquidity to lending institutions via purchase of investment grade commercial paper.

3) On March 17th, seeing strains in money markets, the Fed announced the creation of the Money Market Fund Liquidity Facility (MMLF) to purchase high-quality assets from money market funds to provide liquid cash. The MMLF was not entirely novel as a similar facility operated from 2008 to 2010 to support distressed money markets during the financial crisis.

4) On March 20th the Fed announced it would expand the MMLF to make liquid loans to money market funds secured by state and tax-exempt municipal securities. The expansion is not only designed to increase liquidity to the money markets, but also to support borrowing efforts by state and local governments.

5) On March 23rd the Fed announced it was raising its March 15th $700 billion QE program to “unlimited” in a nod to financial institutions that it would do whatever it takes to make liquid dollars available.

And in the widest expansion of its operations into previously untouched credit markets, it also named a wide range of new purchase and lending facilities (too many to name here) that expanded asset purchases to corporate bonds as well as lending operations collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. It even announced it would begin buying corporate bond exchange traded funds (ETFs).

Monetizing corporate assets and lending to institutions using consumer and small business loans as collateral marks a huge step outside the Fed’s traditional asset class boundaries (reminder: before 2008 the Fed only dealt with U.S. Treasury securities).

All these efforts were designed to ensure that in their rush to bolster cash balances to ride out the economic storm, financial institutions, corporations, and to a lesser degree small businesses and households would find no shortage of dollars available provided they meet lending standards

In recent days the Fed has seen money markets stabilize and has reduced its rate of Treasury asset purchases from $75 billion per day, to $60 billion, to $50 billion. It evidently feels its policies are having a moderating effect.

The one group that has always been somewhat left out of the liquidity programs is households. Households with low cash balances are also rushing to boost their reserves but primarily through saving—assuming they still have income. But unlike banks they don’t hold huge quantities of paper assets to sell to the Fed (although if they hold stocks and bonds they can sell them in the open market to raise cash). And households have few large assets they can use to secure large cash loans—typically just a primary home and cars. And cars depreciate and banks are reluctant to lend against them other than for their purchase.

Indeed, on the FOMC’s March 15th conference call Chairman Jay Powell conceded that “About households, it’s true we don’t have the tools to reach individuals… …and people who may be out of work.”

So although the Fed has tried to supply liquidity to banks, money markets, and bond markets to in turn provide cheaper loans to corporations, the process of supporting household liquidity falls more into the domain of unemployment insurance or Congressional stimulus packages.

In Part 3 we’ll discuss the Fed’s less publicized policy response to accommodate the rush for international dollar liquidity.

Saturday, April 4, 2020

Left Coast Correspondent: Biden Campaign Backs Trump China Air Travel Ban—64 Days Later

Click here to read the original Cautious Optimism Facebook post with comments

A brief update from the Cautious Optimism Correspondent for Left Coast Affairs and Other Inexplicable Phenomena:

Yes, this CNN article and Biden's campaign announcement are both dated April 3rd.

Trump announced the China travel ban on January 31st, and by the time of the Biden campaign's announcement 278,913 Americans had tested positive for Covid-19 with 7,127 deaths.

Left Coast Correspondent: Chilean Leftist Trapped in Cuban Quarantine Learns Misfortunes of Socialism

Click here to read the original Cautious Optimism Facebook post with comments

Chilean actress and Communist activist Carolina Cox during better times

The Cautious Optimism Correspondent for Left Coast Affairs and Other Inexplicable Phenomena detours to the left coast of South America to follow an actress’ hard lesson about real life under communism.

"Washing hands with soap and water is the best way to avoid the spread of the coronavirus (COVID-19), a luxury that is not possible in Cuba, as soap is scarce... ....Although advocates of the communist regime advertise it as a medical power, the reality is that since December, for example, there are no sanitary pads for the menstrual cycle ."

"Cox calls for help, since several of the Chileans stranded in Cuba need medication, thus breaking the myth that everything on the island is free. The reality is that even with resources, there is no access, as credit cards do not serve them on the island."

(Read full PanAm post here. When clicking the link be sure to accept Google's offer to translate to English)

The Left Coast Correspondent doesn’t know whether to criticize or feel sympathy towards Carolina Cox, the young Chilean actress and communist activist presently stranded in Cuba.

After vising Cuba to document how superior communism is to the Chilean system she has routinely criticized, international travel was locked down to prevent the disease from spreading and her stay in paradise has been extended indefinitely. Dreary details of her living conditions can be read in the attached article.

If, heaven forbid, she gets sick one wonders how much the Cuban medical system can do for her. She doesn’t have Michael Moore and a film crew to win government access to Havana’s sole world-class Potemkin Village hospital and would have to use the same facilities as everyday Cubans.

Here she is pleading for help on YouTube—help from the very Chilean government she previously accused of terrorism. Be sure to use CC translation to English.

(Hat tip to JW, the Left Coast Correspondent’s associate currently locked down in Japan. He has plenty of food, soap, and toilet paper)