From the influx of emails I received it appears many readers are reacting negatively to statements made by Richmond Fed Pres. Jeffrey Lacker this morning. It's important to put his statement in context. So let's discuss the banking system...
The goal of a bank is to maximize net worth for its shareholders. This objective is achieved by lending out money at a rate which exceeds the cost of borrowing. Because lending is a risky business (haha do I need to explain that?), shareholders require that banks keep excess reserves to protect the security of their deposits. These reserves are stored in their vaults and are used to meet the demands of depositors.
Banks have three types of assets..
1.Liquid Assets like US Treasury bills .
2.Investment Securities like US Treasury bonds and Agency MBS
3. Loans made to corporations and consumers.
The Federal Reserve's role in this whole process is to provide banking services to commercial banks like JP Morgan Chase, Citi, and Bank of America. The Federal Reserve controls the amount of money banks can lend and therefore controls the amount of money in circulation.
There are three ways the Fed does so... they can do this via adjustments to the required reserve ratios, raising or lowering the discount rate, and by purchasing or selling assets to/from banks via open market operations (purchasing TSYs and MBS from banks).
Required reserve ratio is the minimum percentage of deposits that banks must hold as reserves. When banks have extra reserves, they are able to lend out those funds, which creates money.
The discount rate is the rate at which the Fed will lend reserves to banks in need. Currently the discount rate is at historic lows which implies banks can borrow cheap excess reserves to make new loans (thus creating money and earning more profit).
Open market operations are the purchase or sale of government securities. The Fed has taken additional actions to provide liquidity in the marketplace by purchasing agency MBS in the open market. When the Fed buys from banks, they are taking assets of their balance sheet in exchange for money (reserves). The more the Fed buys in the open market, the more excess reserves banks will accumulate and therefore create money by lending to businesses and households.
Whenever the banking system has excess reserves, banks can create new money through lending. Whenever the banking system lacks reserves, they decrease their loans and rebuild reserves...this slows the growth rate of money.
Plain and Simple: The money creation process is one big cycle that is controlled by the Federal Reserve. The Fed sets reserve requirements and the discount rate, banks then borrow excess reserves (cheap right now) and lend them to consumers and businesses. Those same consumers and businesses then deposit money in another bank thus raising the quantity of money in circulation, that money is used to make interest payments to the bank the consumer or business borrowed it from....this process keeps occurring until all excess reserves are removed from the banking system. Each time the process restarts there is less money to lend...that is unless the Federal Reserve is conducting open market asset purchases on a regular basis.
Let's look at how this relates to Jeffrey Lacker's statement regarding the MBS purchase program....
Here is the pertinent paragraph....
"Purchases of agency debt and agency mortgage-backed securities continue, however, and those purchases supply reserves which reduce the amount that banks need to borrow from the Fed to satisfy their elevated demand for reserve account balances.
Plain and Simple: the Fed's open market operations are adding excess reserves to the banking system. These reserves cost the banks nothing.
"Should those purchases continue at their current pace, there will come a point at which the banking system will no longer need to borrow to obtain the desired level of reserve balances."
Plain and Simple: if the Fed keeps purchasing massive amounts of MBS in the open market, banks wont have to borrow money from the Federal Reserve to build excess reserves (which costs them money...remember the discount rate).
"At that point further asset purchases would then push the supply of reserve balances beyond demand, and would necessitate a downward adjustment in other yields to induce banks to voluntarily hold large balances."
Plain and Simple: Money will be too cheap. Because of the shape of the yield curve, banks will continue to lend until all excess returns are eaten up.
"This would provide discretely more monetary stimulus than past asset purchases have provided thus far, since arguably such purchases have until now simply displaced bank borrowing from the Fed."
Plain and Simple: Up until now the Fed's OMOs (open market operations) have served as an inexpensive way for banks to satisfy the Fed's required reserve ratios. If OMOs continue, the money creation process will slowly increase its pace and eventually lead to money being created too fast in the banking system.
"With the economy leveling out and beginning to grow again later this year, and with bank reserve demand ebbing as financial conditions improve, I will be evaluating carefully whether we need or want the additional stimulus that purchasing the full amount authorized under our agency mortgage-backed securities purchase program would provide."
PLAIN AND SIMPLE: LACKER IS WORRIED ABOUT INFLATION. If the Fed does not manage the money creation process effciently they would have to resort to drastic measures which could force the economy into an inescapable monetary policy trap that can only be broken by biting the bullet and letting inflation run its course.
This statement wasnt really about the mortgage market...we were more of an innocent bystander to the big picture. So...the MBS market was apathetic to Lacker's statements....we already knew the MBS purchase program was eventually going to come to an end....what he said today was no surprise!
LOOKING AHEAD...
The Fed will likely formulate a plan that allows for a gradual exodus from the mortgage market, just as they are currently doing in the TSY market. That said...we wouldnt be surprised if the Fed extended the MBS program into 2010.
NOW...the comments that will resonate in the minds of market participants.
"I won't be encyclopedic, but the labor market is a prime concern. We lost 247,000 jobs last month, and until employment is back on a solid growth path, income prospects will be suspect. In addition, average wage growth has slowed significantly; last year, average hourly earnings grew 3.9 percent, but so far this year they have only increased at a 1.5 percent annual rate. Thus household incomes are facing a double whammy from falling employment and sluggish wage growth, and weak incomes will likely put a damper on consumer spending growth. As overall activity regains momentum, the labor market should gradually improve and lead to a better outlook for incomes and spending. But right now that's just a forecast, and we will clearly need to monitor the situation carefully."
Plain and Simple: there is huge risk for a double dip. Fundamentals remain weak...the market's attention will be intently focused on the health of the labor market and its effect on consumer spending.
Rate sheet influential MBS coupons have created another perfect trend channel heading into "going out" marks....
MBS Market Alerts
