The Demand for Currency

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I have been pondering a question and hopefully someone can point me in the right direction.
I'm trying to grasp a better understanding of international currency markets.

As interest rates increase, the demand for bonds increases and the demand for currency decreases- so they say.

However, if the demand for bonds increases than wont also the demand for the currency that the bond is denominated in also increase.
From a domestic standpoint, I can see how the demand for currency would decrease but on an international scale it seems that the demand for that currency would increase.

Does the demand for the currency from international investors outweigh the decrease in demand for the currency of domestic investors?

Any thoughts?

Thanks!

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Thank you very much for both posts. I'm intrigued about your strong foundational knowledge and very appreciative of the... (more)

matt213 (Apr. 19, 2013 @ 1:22a) |

Since I can tell you're the type that enjoy's learning(like I do) I figured you would appreciate 'the book' on this one.... (more)

dshibb (Apr. 19, 2013 @ 3:22a) |

Let me give you a visual for #6 because that is a bit confusing:

Today under Fed quantitative easing(money printing)

Fed c... (more)

dshibb (Apr. 19, 2013 @ 4:05a) |

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matt213 said:   I have been pondering a question and hopefully someone can point me in the right direction.
I'm trying to grasp a better understanding of international currency markets.

As interest rates increase, the demand for bonds increases and the demand for currency decreases- so they say.

However, if the demand for bonds increases than wont also the demand for the currency that the bond is denominated in also increase.
From a domestic standpoint, I can see how the demand for currency would decrease but on an international scale it seems that the demand for that currency would increase.

Does the demand for the currency from international investors outweigh the decrease in demand for the currency of domestic investors?

Any thoughts?

Thanks!


Do your own homework.

Turn this in:


C.R.E.A.M.


Like a boss.

matt213 said:   As interest rates increase, the demand for bonds increases and the demand for currency decreasesDid high rates cause demand to increase or did rates increase because of low demand?

Wow,

Didn't realize people in these forums were jerks. I graduated with a degree in finance and international business and I was becoming more interested in currency markets recently.

I posed this question seriously because it is something I was pondering while sitting on the train commuting back and forth to work.

My hope was that people in these forums, which admittedly I found through a quick Google search, would be people who are interested in the financial markets. Period.

Mapen - I was assuming that high interest rates would cause demand for bonds to increase. As the rates push higher, people will go after those high yielding bonds.
Thanks for being the only person without some sort of superiority complex.

matt213 said:   Wow,

Didn't realize people in these forums were jerks. I graduated with a degree in finance and international business and I was becoming more interested in currency markets recently.

I posed this question seriously because it is something I was pondering while sitting on the train commuting back and forth to work.

My hope was that people in these forums, which admittedly I found through a quick Google search, would be people who are interested in the financial markets. Period.

Mapen - I was assuming that high interest rates would cause demand for bonds to increase. As the rates push higher, people will go after those high yielding bonds.
Thanks for being the only person without some sort of superiority complex.



Oh, well in that case, I'll say...


Do you own homework.


(just so I don't get accused of being "a jerk" who "won't do your homework for you", When people buy bonds with currency, they are taking currency they had been holding and putting it back into circulation, thus reducing demand for the currency. If the interest rates rise, fewer people will want to hold currency since it may lose value. )

I might ask why forums such as this exist if not to ask these kind of questions. This is the first time I've ever posted in a finance related forum, however I have had experience posting in other forums - specifically forums related to C++ programming. Each time I struggled with one of my programs and was unable to determine what was wrong, experienced people in the forums helped me out. I'd like to further express that I never took any classes formally in programming, or I would have asked my paid instructor to help me instead of the online community. Perhaps it's a result of the community and not the topic/subject at hand... this is what I hope. Usually I would ignore this, but I feel like their is merit to say this. In reality, I know there is not since only a handful of people will read this and it will soon be forgotten.

Why would people be concerned with currency losing value if interest rates rise? (I'm actually curious about this reasoning and not trying to be cheeky) It stands to reason that fewer people will want to hold currency at times of high interest rates because they can receive high interest for lending their currency, such as in the case of a bond. Since one of the determining factors of the yield on any given bond is the risk-free rate than people will buy bonds for the higher yield.

.

The premise of your question seems to be wrong. Bond demand won't necessarily rise because interest rates rise. For a bond investor, the only thing that matters to them is the real return after inflation and taxes over the long run. An individual would only forgo consumption today and buy a bond to increase his purchasing power in the future. Thus you could have a situation where interest rates rise, but inflation and taxes rise more than interest rates and bond demand actually falls.

A bond is simply a promise to repay principal based currency in the future, plus interest. Thus if the demand for a currency falls then that also means the demand for bonds will fall accordingly.

Also, keep in mind that import/exporting will also purchase/short currencies as a hedge on their goods.

matt213 said:   Why would people be concerned with currency losing value if interest rates rise? (I'm actually curious about this reasoning and not trying to be cheeky) It stands to reason that fewer people will want to hold currency at times of high interest rates because they can receive high interest for lending their currency, such as in the case of a bond. Since one of the determining factors of the yield on any given bond is the risk-free rate than people will buy bonds for the higher yield.


Currency loses value through inflation. As interest rates rise, there might be a risk of inflation occurring or increasing. So, if you think there will be inflation, you don't want to hold cash, because your dollars will buy less tomorrow than they do today.

ETA: do your own homework

Thanks for your replies.

brettdoyle - I had the same concern that the issue was with my premise of bond demand rising with interest rates. Mostly, this is because I still remember an old college professor preaching that the only thing bond investors care about are the yields they get on their bonds. My premise actually stems from here source
In the last two sentences under the header 1. Interest Rates, it states "So a rise in the interest rate causes the demand for bonds to rise and the demand for money to fall since money is being exchanged for bonds. So a fall in interest rates cause the demand for money to rise."

I see the situation you presented as completely reasonable, so I suppose this statement is clearly meant to be viewed as a general rule of thumb.

GreyRabbit - I like that you brought this up, as I had overlooked it. If a company is purchasing/selling a large amount of goods or services abroad, they would certainly hedge their positions causing demand for the currency to fluctuate. I want to think of some good examples and give this some thought.

I trade equities and derivatives, mainly options, but I'm interested in FOREX and want to get a fundamental grasp on it! Thanks for the insight.

To begin to build the foundation of knowledge needed for a strong understanding, I'm trying to determine all of the factors that cause demand for different currencies to fluctuate.

Exchange rates. Interest rate parity.

matt213 said:   Wow,

Didn't realize people in these forums were jerks.


There exists a flame-free thread for the thin-skinned.

matt213, just ignore the people who apparently would prefer another "What should I do with this nickle I found under the sofa" type posts to something like this.

So to answer your question you have to ask why interest rates are rising. Is it inflation premium or base interest rate increases(higher R*). If inflation is rising a lot of time investors demand higher inflation premium in the interest rates and if that amount exceeds future inflation expectations than you'll see demand for bonds and by extension currency.

If interest rates are rising because R*(base interest rate) is increasing than that is something that causes *both currency and bond demand* to increase.

If interest rates are rising because inflation rate is rising and the inflation rate(or expected inflation rate) is higher than the interest rate then you would presume that demand wouldn't come into the bond market and especially not the long end of it.

So you're right in your premise that the 2 should be linked, and you were wrong in your premise that a certain environment causes them to lose that linkage(with maybe the exception of yield curve expansion vs. compression which is just a different matter).

If you want an interesting theory on this subject matter look up the Taylor rule where it's theorized that higher currency and bond demand is caused by the interest rate being higher than the inflation rate(or the expected inflation rate) vs. lower currency and bond demand is caused by the interest rate being lower than the inflation rate(or expected inflation rate). So under this theory again the bond and currency market would be linked, but demand would be based upon the spread between inflation rate and interest rate.

That theory can only exist in a vacuum of 'all else equal' because it discounts other factors that could play. For example if your inflation rate(or expected inflation rate) is higher than your interest rate, but your better than basically all the other markets in the world than you get investment just on the basis of 'no better alternative' and not as endorsement of your currency or bond market.

Make sense?

matt213 said:   1. Interest Rates, it states "So a rise in the interest rate causes the demand for bonds to rise and the demand for money to fall since money is being exchanged for bonds. So a fall in interest rates cause the demand for money to rise."

I would take that not as a rule for money vs. bonds, but instead a "all else equal" for yield curve expansion(i.e. the interest premium between the low end and the high end of the yield curve). Understand that for a lot of purposes cash in a deposit institution or money market is really just a bond with a 1 day maturity on one extreme end of the yield curve.

Apparently, people here don't do real FOREX trading. I don't see the point of discussing.

dshibb - Thanks for the well thought out reply. It was refreshing to read a post with a logical flow, as it indeed made a lot of sense.

Seeing as how interest rates right now are still historically low (Fed Funds Target .25), the only direction they can move at this point is up once the Fed Reserve decides to make a move. This would suggest that once the base rate is increased, demand for currency and debt will also increase.

Also, I just bookmarked the Taylor Rule and will give it an in-depth look after work. If I'm understanding properly from your explanation, than according to the theory, the larger the spread between the interest rate and inflation (interest rate on top), the higher demand will be for currency and the bond markets. I can see why this is in terms of bonds obviously, but in terms of currency a bit of understanding eludes me yet. Perhaps after some reading I'll make the connection.

I wanna read more about what market conditions cause the different levels of inflation to occur as well, as I'm a bit rusty on this.

Yeah, that would explain why one always gets better interest rates in a money market account vs. a traditional savings account (Well at least now a days).

Thanks again, back to work!

This forum has a problem with kids joining asking fir homework help- thats why the initial replies were to that effect . once you explained yourself a bit more , As you see , the serious respondents will often appear

Unlike other forums you may have visited , this forum doesnt take kindly to newbies who often ask one question and leave , so if you give us a chance and become a regular contributor you'll find the community far more engaging and learn the serious respondents from the others

the problem isn't just newbies --- we also have some long time members who pose as newbies and pose discussion questions for whatever reason

As to OP's question. I don't think there is a set rule. If you can find a foreign bond paying a high interest rate and the currency is appreciating, you have a good investment.

matt213 said:   dshibb - Thanks for the well thought out reply. It was refreshing to read a post with a logical flow, as it indeed made a lot of sense.

Seeing as how interest rates right now are still historically low (Fed Funds Target .25), the only direction they can move at this point is up once the Fed Reserve decides to make a move. This would suggest that once the base rate is increased, demand for currency and debt will also increase.

Also, I just bookmarked the Taylor Rule and will give it an in-depth look after work. If I'm understanding properly from your explanation, than according to the theory, the larger the spread between the interest rate and inflation (interest rate on top), the higher demand will be for currency and the bond markets. I can see why this is in terms of bonds obviously, but in terms of currency a bit of understanding eludes me yet. Perhaps after some reading I'll make the connection.

I wanna read more about what market conditions cause the different levels of inflation to occur as well, as I'm a bit rusty on this.

Yeah, that would explain why one always gets better interest rates in a money market account vs. a traditional savings account (Well at least now a days).

Thanks again, back to work!


No problem. You're welcome!

Again it helps to think of all currency as essentially credit in and of itself. When you deposit cash at a bank that is an asset to you and a liability to the bank. I.e. they are borrowing money from you to go and make loans. So often times when you talk about bonds people will ask you "what duration?". On one end you have 30 year bonds and on the other immediately callable. Your money in a deposit account is basically a bond with a 1 day maturity.

So to answer your question if you were an adherent to the Taylor rule you would apply that methodology to each interest rate along the curve. Current inflation rate vs. ultra low duration(deposit, money market, ultra short bond fund, etc.), Average expected inflation rate over lets say 5 years vs. a 5 year bond interest rate, same for 10 years, same for 20 years, etc. Make sense?

Inflation: Google "MV=PQ" and "fractional reserve banking"

Basically it works like this: If I kept the supply of money and the supply of goods the same than the price of goods should stay about the same. If the quantity of goods rises, but the supply of money stays the same than prices will fall because there is less money relative to the quantity of goods. On the other side if I increase the supply of money more than the supply of goods than prices should increase because it's more quantity of cash chasing less goods.

What many people fail to understand is that the private sector prints far more money than the Fed could dream of, but **it's the Fed that enables the private sector to do that**. For example the US economy printed a lot more money in the mid 2000s via the mortgage market than Fed has printed by the outright buying Treasuries or MBS today. But that is not an endorsement of what the Fed is doing allow me to explain...

During the mid 2000s bank capital ratios(google Basel II for a start) were falling, the American public had substantial debt capacity, and the price of money(interest rate) was cheap so you obviously a lending boom. When that money was lent out it would buy whatever(home, car, luxuries, etc.) and would then be redeposited in the banking sector allowing for the bank to have effectively printed money out of thin air(you have a deposit, you lend almost all of it out, it comes back and gets deposited, you now have 2 people with close to the same deposits and the bank has leveraged it's liquidity). Now this massive amount of new money 'printing' occurred because the Fed enabled it to with cheap interest rates(if interest rates are higher, than you need more productive and higher returning activity for both parties to want to be party to that debt which means less loans get made and less expansion of the money supply occurs). So in the mid 2000s banks pretty much fully levered out their cash reserves or "monetary base".

What has been happening today is that the Fed keeps a low effectively 0% base rate and with their printing most of that cash ends up back at the Fed as a deposit by a financial institution at the Fed. So they print money, most of it briefly passes through the economy for a minor change in economic activity and then goes to a financial institution that puts it in their cash reserves at the Federal Reserve. Seems a little weird doesn't it for the Fed to do so much for it to just wind up back with them, right? Well that is also the reason why they have to print so much in order for it to even have a marginal impact. So now going forward banks have huge cash reserves and what happens if these massive Fed created reserves start to get lent out? If that happens then you'll see high inflation. Some people believe that the Fed will stop that before it happens. Basically they think the Fed will sell a ton of assets, raise the reserve ratio, etc. and all of that excess monetary base will just disappear and no inflation will occur. I'll hold off on my opinion on whether I think that will happen. Also, it's tough to say how long it will be before financial institutions would even start really lending out those reserves in mass anyway(could be a year or 2 it could be the better part of a decade).


I honestly don't think the Fed will raise interest rates above the inflation rate any time in the near or medium term(that's just my guess). I also don't believe at this stand point that the Fed raising the FFR would have any structural impact on interest rates whatsoever(that one catches people be surprise) and that is because the FFR only sets deposit rates to the extent that if you're a bank you wouldn't have substantially higher deposit rate than what you could borrow at the Fed because you would only be raising your cost of capital. If instead your awash in more liquidity than you know what to do with(like our banking system is) and the FFR increases nothing changes for you because you can still get more than enough deposits and liquidity at near zero without relying upon the Fed window(because of actions the Fed took in the past). I will say that the RIR can raise interest rates, but that new tool is downright dangerous. The only really non dangerous tools for controlling inflation are asset sales, reserve ratio increase, or yet more capital ratio increases(which is probably the primary reason why you have little inflation today--banks have more than enough liquidity to lend, but have limited excess capital to lend).

Deposit rates vs. money market account rate differences are explained above. Basically, deposit institutions are awash in so much cash they would actually almost prefer to have less of it. Money market accounts or ultra short bond funds match incoming cash with fixed income(bond) asset purchases immediately so they don't have the problem of having massive quantities of excess cash laying around.

If you want a visual analogy to understand all of that picture a hill filled with snow once.

At the top of the hill is giant pile of snow representing the monetary base of the United States and if that pile of snow starts to fall down the hill it will gather size and speed. This represents the effect of banks lending out those reserves, expanding the money supply, and causing inflation.

Now picture 2 more things. 1) Basel III came around as a response to the financial crisis(and a desire to make more structurally sound banks) and started building a larger and larger wall between that pile of snow at the top and the rest of the hill preventing a lot of that snow from falling down the hill and causing an expansion of the money supply and inflation. Then picture the Fed coming in and dumping massive quantities of snow at the top of the hill and some of that seeps over the wall and down the hill causing more economic activity and higher asset prices(higher stock prices, higher bond prices--lower yields, etc.). Now at one point about ~6 years from now that wall that is being built up will stop being built any higher(note many banks will likely hit that capital ratio 'wall' and be able to lend out more freely well before 6 years from now).

So the question becomes when that time happens is that giant pile of snow(monetary base) going to tip over that wall and start gathering in size(inflation) or are central bankers who piled up that giant amount of snow going to pull a rabbit out of their hat and figure out a way to remove a lot of that piled up snow from that spot before it has a chance to start rolling down the hill? If you can answer that question than you have your answer as to whether or not inflation will occur in the future. There is also the question of *when* which is a question of when another lending boom will occur, whether it will happen fast or just continue to get increasingly larger(and kind of sneak up on you), and what group of people/entities will have the capacity to take on that debt.

Hopefully, if there was any confusion in the above post that this analogy sort of clarifies it for you.

Thank you very much for both posts. I'm intrigued about your strong foundational knowledge and very appreciative of the time and effort you put into your explanations.

The only place I got lost was your 8th paragraph that starts "What has been happening today..." I understand that one of the factors that enabled banks to effectively "print money" was having a near 0% interest rate coupled with very low liquidity requirements (banks could lend out a dangerously large portion of their deposits). The regulation that is preventing this from happening again is the higher liquidity requirements right? (The fact that they can only lend out lets say 50% of their deposits)

The huge cash reserves you are saying that banks have - are these the reserves that they have at the Fed? Why would banks pile money at the Fed in excess of the amount they are required to by law (the Fed's reserve ratio requirement)? It is my understanding that if an institution has excess reserves at the Fed, they can lend it overnight at the Fed Funds Rate to institutions who are in danger of over-drafting or dipping below the reserve requirement. Wouldn't it be more beneficial for them to invest these extra funds elsewhere?

If these institutions really do have massive reserves of cash at the Fed that are far in excess of whats required, I guess my question is why? You were mentioning that if they began lending this money (I'm assuming the amount is the spread between the amount deposited and the amount required to be deposited), it would essentially be pumping tons of extra cash into the money supply which would cause inflation. Why are they not lending it already? Also, what kind of assets can the Fed sell that would make these reserves disappear?

I'm sorry if I appear to have overlooked something obvious.

And thank you for the visual representation as well. It's nice to have analogies to solidify/check our understanding as Plato pointed out when he created the Allegory of the Cave to explain Socrates' Divine Line.

Since I can tell you're the type that enjoy's learning(like I do) I figured you would appreciate 'the book' on this one.

Sorry to anybody else that likes the shorter version. I do promise that there is a lot of good stuff in here otherwise I wouldn't have written it. It's basically an all you need to know about bankin post which is actually quite short given the subject.


1) You need to understand the difference between capital ratios and liquidity(cash reserve ratios). These 2 things are the absolute most important things in the system when it comes to the issue of the soundness of our banking system(i.e. resilience during a systemic event) they also just so happen to be 2 of the 3 things(the 3rd being interest rates) that very much limit the ability of the banking sector to over lend, effectively print too much money, and cause inflation.

A) Now reserve ratio(which is the issue of bank liquidity or cash reserves) has to with a banks ability to withstand a run on their institution's liquidity without seeking outside assistance(usually from the Fed). It also controls the expansion of the money supply by requiring banks to set aside a percentage of deposits before lending out the remainder. The reserve ratio in the United States is 10%. That means that when they get $100 in deposits they have to set aside, $10 and can lend out $90. When that comes back after being lent out and deposited they have to set aside $9 and they can lend out $81, etc. A 10% reserve ratio means that the banks have levered out their entire liquidity when their outstanding loans are 10 times their cash reserves(or monetary base). Needless to say today banks have substantial excess cash reserves at the moment; more than they've ever had which is if you look at a banks financial statements returns on assets are only around 1%(cash reserves is an asset that effectively earns 0%--.25% to be exact via the 'reserve interest rate' which I'll explain below). Why this is will be explained partially by the next piece and more so further down.
B) Capital ratio is a look at effectively a banks net worth or solvency(not liquidity). This is calculated by taking assets minus liabilities. Our government in it's implantation of Basel III requires that banks maintain a certain capital ratio(or net worth relative to total bank assets). A good way to understand this is if you understand how a margin brokerage account works. The typical margin brokerage account will probably let you leverage your equity by 100% or 2:1. If you fully leveraged out with $100k, you would have $100k account balance(net worth), $100k on margin(debt/borrowing), and $200k in assets. Your capital ratio would be 50%($100k in account balance(equity)/$200k in portfolio value(assets). Under Basel III(Google it) about 6 years from now US banks need to have a 'Tier 1 capital ratio'(just a slightly more complicated formula designed to siphon much less risky assets like US T-Bills) of about 7%. This amount effectively triples the capital ratio that was in place prior to the crash. It limits a banks capital leverage(not liquidity leverage) to about 14 times their capital. Also 7% isn't quite complete. They are also implementing 'conservation buffers', 'counter cyclical capital buffers', and a "systemically important financial institution buffer" that is essentially an additional safety measure against 'too big to fail' banks(and some would call this a performance tax on the largest institutions because they can't lever as much as their smaller peers--I know Jamie Dimon was pretty pissed at that one). These additional buffers can put a banks capital ratio over 10% and limit their leverage to less than 10 times. Now these new rules are being phased in over multiple years so each year banks have to set aside more capital than they did the year prior which brings me to one huge reason why banks haven't been lending out their cash reserves...

Basically, you as a bank can only lend out based on the ***lesser*** of your reserve(liquidity) ratio or your capital ratio. Right now they are awash in liquidity, but they have limited capital. So since that is the weaker link in the chain capital ratio dictates how much they can lend out. So under Basel III if they earn a profit for the year a decent chunk of that has to be set aside to boost their capital ratios over this phased in implementation. They can only really lend out based on the additional capital they earned *in excess* of the amount they have to set aside for that year. So it effectively keeps on ratcheting up the limits on their ability to lend and you only receive net additional lending if the amount of earnings for the year exceeds these additional limits on capital.

Also keep in mind that after the crisis banks already had a fall in their capital(net worth) and that was based on a lower capital ratio. They have to earn their way up from that low bar up to the new capital ratios in 10 years time. That means just to be regulatorily compliant they have a lot of capital they have to not only earn, but set aside with basically no corresponding lending associated with that money set aside each year.

2) Now you may wonder why banks allow themselves to be stockpiled with massive cash reserves if they can't even use them because of capital controls(with the exception of getting .25% from the Fed for cash reserves). Well it's because those cash reserves cost them zero. They pay 0% deposit rates on that money so it doesn't hurt them there(they can't lend it out so they don't really gain anything either besides a quarter point, but it also doesn't hurt them). They also don't want to develop a reputation as a bank that is trying to turn away customers(although some banks have moved ahead annual or monthly maintenance fees to try to at least make a little more money from these deposits). Also, they can make money from overdraft fees and NSF charges, etc. But really the main reason why they don't turn away this money is because they benefit from the relationship. People that deposit money at their institution take out car loans, credit cards, mortgages, etc. from that same bank. They also might get revenue from in house or contracted financial advisors, insurance agents, etc. So they definitely don't want to burn a bunch of relationships to get this excess cash off it's balance sheet. Also, they don't want to scare off depositors now just to realize in the future that they can really start lending a lot again and then realize at that time they don't have as much depositors as they would prefer(it takes a long time and effort to build up loyal depositors you may not need them now, but you may need them in the future).

3) The other main reason why there isn't that much lending going on today(outside of the mortgage market courtesy of the Fed buying up as mortgages as there are created every month--yes that much) is that the American public and American small businesses just don't have that much debt capacity at the moment. The balance sheets of the typical American or American business just aren't that pretty to look at. They already have a lot of debt so to hand over more at attractive interest rates is just seen as to risky when it's already difficult for many Americans to pay off their existing debt loads.

4) Now in a previous post I asked the question(rhetorically) where is this debt capacity going to come from for another boom. I actually think that it's just going to sneak up on people. See if in the future debt is slowly being increasingly more lent out and that is starting to barely show up in inflation numbers than the populations existing debt loads get slightly devalued as well. So in a way you get a bit of a 1-2 punch because you lend out create a bit of inflation, inflation devalues the populations debt a bit, and then that population has a little more debt capacity for you to lend more to(which causes the same affect and after that plays out you do it again and the affect is even bigger, etc.). So I personally tend to believe that once this gets started it's not about finding some new group of people that has little debt to lend cheaply to(where are you going to find that?), but instead it's about a slow build of a self reinforcing cycle of a little more debt, little more inflation, a little more debt, little more inflation, etc. as those reserves increasingly get lent out. But again this is just my guess here, I don't actually know if that is how it will play out(and again I have to mention that there are plenty of people who think that the Fed is just going to come in and 'shovel off' all of those excess cash reserves so that there isn't any excess to even lend out.

To answer you're remaining questions specifically
5) "Huge cash reserves are they at the Fed" yeah almost entirely. They do keep a little in their bank vaults to handle day to day transactions, but they find the Fed to be a safer place so they just deposit it there(like a bank account for banks). Also, at the moment the Fed pays banks .25% to keep excess cash there so that is where they keep it. That again is called the reserve interest rate and it was invented only about 4 years ago.

6) The Fed can sell what they've been buying a lot of the last few years. When they buy assets like treasuries and mortgages(mortgage backed securities) they create cash out of this air and that cash goes into the markets and they remove that asset(treasury or mortgages) from the markets. Once again that extra cash just quickly finds its way to a deposit institution(with a minor impact on the economy on route) where that financial institution already has to much cash and they deposit it at their bank, the Fed and it doesn't have any more effect on the economy really. Now when the Fed goes to put the assets they've been buying up for sale, they put that asset back in the market and they remove the currency from circulation. Basically that will follow this path: A person/institution walks into their bank pulls money out of their account; their financial institution will have to grab from their cash reserves at the Fed to make that depositors cash available and that money will be exchanged for the asset(treasury, mortgage backed security, etc.) the Fed is selling. So what actually once again happens is that the money that passed from the Fed printing press back to the Fed with a banks name on it during quantitative easing(Fed printing) passes back through the same channel from the Fed(with banks name on it) to the Fed(with no banks name on it) and the excess currency is destroyed once it arrives back at the Fed. Dizzying isn't it? Almost seems like a pointless left pocket, right pocket game doesn't it? It sort of is. One thing that get's discounted is that when the Fed starts selling, the value of those assets will start to fall relatively quickly which means they will get less Cash Back than they initially created which means that asset sales likely aren't going to 'shovel up' all of those excess reserves by itself. They'll be forced to use other methods like reserve ratio increases(so the cash reserves stay with the banks, but they just regulatorily prevent them from ever leaving).


This is a lot so feel free to ask any and as many questions as you like.

Let me give you a visual for #6 because that is a bit confusing:

Today under Fed quantitative easing(money printing)

Fed creates cash ---> Cash goes to seller of asset ---> Spends money once on something else---> Seller of 'something else' deposits money at a bank ---> Bank deposits money back at Fed as a cash reserve(pile of snow at the top of the hill).

Fed buys asset <---- Seller of asset hands over asset(Treasury, MBS, etc.)


Fed reverses course and starts selling those assets instead of buying them

Bank removes excess cash held at Fed ---> Provides cash to depositor who is removing the money from the bank ---> Depositor pays cash to the Fed for an asset that is being sold by the Fed ---> Fed takes cash from person/entity in exchange for asset ---> Cash is removed from the system and effectively destroyed and effectively contracting the monetary base(effectively shoveling snow off of the top of the hill)

Fed Sells Asset ---> Buyer of asset now owns it meaning the asset is now in circulation while the cash isn't

So in theory these things should completely cancel each other,(one inserts cash and removes asset and the next action removes cash and adds back in asset) wash, right?...


Problem: What if a lot of Fed selling causes the assets in question to be worth less than what they paid for it under Quantitative Easing and they fetch less cash when they sell them? Well that means they originally pumped in a lot more money into the system and now they're pulling out a less amount. That means that on this action they haven't succeeded in removing all of the extra reserves they helped to create. They would need to do even more actions to remove those excess cash reserves to prevent those cash reserves from being leveraged, lent out, expanding the money supply, and causing inflation.

Also, if those assets are falling in value than the yields on them are rising. That isn't pleasant for a couple markets in general. One is the treasury market. I.e. treasury yields go up, the US government has to pay more interest expense, the deficit grows, etc. which bags the question does the Fed even have the will power to effectively blow up their 'bosses' interest expense by engaging in a lot of asset sales? IMO, I doubt it so they probably wont sell much until inflation is already at hand. Also, a lot of sales of Mortgage Backed Securities wouldn't be very good for mortgage interest rates either. Again I wonder if they actually have the balls or willpower to hurt the housing sector that they have essentially thrown the kitchen sink at trying to spark a recovery in. Again, IMO I doubt they have that willpower, but that is just my opinion. So it shouldn't be any secret now that I'm predicting more inflation at some point in the future over higher interest rates, but again that is just my opinion it doesn't mean that I'll be right.



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