Dispelling some of the myths and hysteria

"The Federal Reserve has to be one of the most talked about and least understood institutions on the face of the planet. It's attributed with powers it does not possess and functions that it does not do, and the majority of the misunderstanding stems from the profound and systemic conflation of money, credit and asset values, which is exacerbated by an apparent systemic inability to discern the difference between theory and factual reality."

Dwain Dibley

Here is the key to understanding the Federal Reserve Banking System:

There is no US law granting the Federal Reserve the authority to create

US legal tender money, or any money of any type.

It is against US law (12 USC 411) for the Federal Reserve

to use US legal tender money in any of its market operations.

Having established these facts, read on.

In order to understand the Fed's $4.5-Trillion 'denominated in dollars' balance sheet, you have to understand what comprises that balance sheet. So in that vein, let's cover just two of its primary components.

The first component is $2.4-Trillion of bank assets (not money) held on deposit at the Fed. The majority of these bank-owned assets (primarily Treasuries and Agency Mortgage Backed Securities) are referred to as "excess reserves". The Fed, being a depository for the banking system, has little control or say over the disposition of those assets.

The second component is $1.8-Trillion of assets (primarily Treasuries and Agency Mortgage Backed Securities) held as collateral backing the issue of legal tender from the Treasury, it cannot get rid of that.

Setting aside several billion in other Fed held assets they can’t unload, you’re looking at maybe about $520 Billion or so in Fed held assets that they can actually work with. Not so much, is it.

Let’s look at this from a different angle, 'reserves'. 'Reserves' is one of those ambiguous Fed doublespeak terms that can reference a range of different items and aspects of the bankster system serving different functions. So, let’s cover, what the Fed claims are ‘reserves’.

1) Reserves are: Cash held in bank vaults (actual money).
2) Reserves are: Bank assets held on deposit at the Fed (not money).
3) Reserves are: Assets purchased by the Fed in its open market operations (credit generation).
4) Reserves are: The liquidity provided by #2 and #3 in the interbank settlement system (credit).

When the Fed talks about 'adjusting bank reserves', it’s talking about using #3 to effect changes in #4 and because the interbank system is a closed system, under normal conditions, the Fed could affect the overnight interest rates (interest charged on loans within the interbank system) by buying and selling its reserve assets, which affected available liquidity (also referred to as 'money supply') in the interbank system, which also affects the banking system's ability to generate debt/credit as 'loans'.

That’s not the case anymore. With the banks holding excess reserves (assets) providing liquidity (credit) to the interbank system, the Fed’s ability to affect Interbank interest rates in the traditional manner has been effectively naturalized. This is because the Fed’s share of the liquidity is proportionally insignificant to the liquidity provided via the banks’ reserve assets parked at the Fed. The Fed has effectively lost control of the interbank system and its balance sheet. Think about it, if the Fed controls the interbank interest rate by adding or subtracting liquidity, then what do you think all that excess liquidity held by the banks is doing to that interest rate? It's pushing it down and holding it at zero. The only thing the Fed can do is arbitrarily set interbank interest rates, as it has always been doing, along with paying interest on excess reserves as a means to establish a floor under those rates and, hopefully, temper the pavlovian responsiveness of the markets and Wall Street by dazzling them with bullshit.

One of the primary reasons the Fed is reluctant to reduce its balance sheet by selling its comparatively meager assets is because, they know full well that the banks that buy those assets will turn right around and park them in their reserve accounts, effectively nullifying their efforts while highlighting what a farcical joke the entire Fed system is. And this is why the Fed has chosen to reduce its balance sheet in the manner it has, which is by allowing a set amount of securities come to term and simply zeroing that amount off their balance sheet. A side effect of the Fed reducing its balance sheet in this manner is that it also reduces USG debt by the same amount.

*Even if the Fed could convince the banks to relinquish their control over the interbank system and withdraw their reserve assets, those assets would just become 'assets held outside the Fed', not money.

And none of this has anything to do with the actual US money supply,
which currently stands @ $2.2-Trillion in U.S. Legal Tender.

Note: In case it wasn't made clear enough; the bank reserves provided by the banks and held at the Fed are the assets, not the liquidity (electronically transferable claims) the assets provide to the interbank system, which is managed by the Fed via it's Open Market Operations.

Also, the Fed does not create reserves. The only agencies that create reserves are the Bureau of Printing and Engraving (Federal Reserve notes), the Treasury (Treasury Bonds & Special Drawing Rights Certificates), Government National Mortgage Association, Federal National Mortgage Association, and the Federal Home Loan Mortgage Corporation (Agency MBSs). Federal Reserve notes, Treasuries, SDRs and Agency MBSs, along with Gold Certificates, are the only items that legally qualify as reserves, none of which are created by the Fed. Fed and bank generated deposit credit is not a reserve asset.

In over 85 years of the FRN being designated the official currency of the United States, not a single economist has ever identified a single instance where the Fed actually used that official currency in any of its market machinations, and that's because they can't and that's because to do so would be against the law (12 USC 411). The Fed uses deposit credit denominated in dollars, not a US currency. And yes, this also means that the Fed is not 'monetizing' US Treasuries via its Open Market Operations, generating a credited deposit in the amount of the Treasury is not 'monetization', 'monetization' only occurs when actual legal tender dollars are used, and the only time that occurs is when the Fed posts US Treasuries and other reserve assets as collateral in order to get FRNs, US legal tender, from the Treasury.

Who Is Holding All the Excess Reserves?

Standard & Poors: Banks cannot and do not lend out reserves

Covering a few points made in the S&P article: The first point is, assets equal reserves (A=R). This means that without the assets there can be no reserves. Second, the act of the Fed buying assets in its open market operations does not create reserves, it creates deposits, it is the asset purchased, that creates the reserves (again A=R). Those two points, as I have contended, were affirmed in the article.

OK, skipping over the kabuki theater that was QE, other than to note that the Fed was buying assets from outside the system during QE, which means it was creating new reserves in the system and new deposits outside the system, let's cover some other points the article made.

"The Fed can create reserves as needed". This assertion was unequivocally proven false during the 2008 financial crisis. Remember at the beginning of the crisis the Fed was crying about the banks being under-reserved? If the Fed can create reserves as needed, then how could the banks be under-reserved? The correct answer is, the Fed cannot create reserves as needed, it can only create reserves in the dollar amount of the assets it currently holds. How did the banks respond to the Fed's cry? They responded by depositing qualifying assets to their reserve accounts, which created the requisite reserves. Also of note is that those reserves are carried as a liability on the Fed's books because the Fed doesn't own them. If the Fed doesn't own the bank reserves created by the bank deposited assets, then it cannot own those assets either, which means that the Fed cannot sell those assets in any effort to reduce its balance sheet because if it did so, it would be stealing reserves from the banks (remember A=R, without the A, there's no R). This last part was proven in 2015/16 and it will be proven again as the Fed currently goes about reducing its balance sheet in the exact same manner as it did in 2015/16.

Moving on to the three ways individual banks can reduce their reserves, two of which just shuffles ownership of the reserves held at the Fed, and the third way was by people withdrawing their money from the bank (loans, as implied by the article, are not required for this to occur). This applies in so far as 'cash in vaults' are counted as reserves held, which is optional for the banks. The broader picture is that if the cash didn't come into the bank's possession via deposit then the bank had to buy the cash from their regional Fed bank using their reserves held at the Fed. Because the Fed is required to post collateral equal to the cash issued for circulation and that collateral being the assets used to create reserves, the Fed gets that collateral from the assets deposited by the bank receiving the cash, thus balancing the reserves paid by the bank for the cash with the assets held. There is a fourth way, not covered, that the banks can reduce their reserves at the Fed, they can simply take back their assets, but why would they when they're being paid to keep them there.

This comes back to the nature of the liquidity called reserves and why that liquidity is almost always equal to the assets held and that is this; the liquidity is electronically transferable claims to the assets held, which means A is R, which also means the Fed does not create reserves, it just manages the liquidity created by the reserve assets held. Think about it, if the Fed controlled the supply of reserves then there would've never been any shortage or excess reserves. Therefore, the claim that the Fed creates reserves or that the liquidity created by the assets are the reserves is as valid as the claim that bank-generated credit or bank deposit liabilities are the money.

Addendum: On the Fed's Open Market Operations (OMO). There are three primary assets that the Fed works with, they are Treasuries, Agency Mortgage Backed Securities (AMBS), and Special Drawing Rights Certificates (SDR). These assets are primary because they are guaranteed to pay at face value by the USG, regardless of market conditions. These assets provide the backing for the liquidity, referred to as reserves, it uses throughout its market operations.

When the Fed buys an asset via its OMO, it credits the seller's reserve account in the amount. This credited deposit does not add to the reserves at the Fed because it has no asset backing, which is required for it to be reserves, it's just a credit, like the credit in your deposit account, the Seller recoups its cost for the asset + profit.

This is key to understanding how the Fed functions, it is the assets purchased by the Fed that add liquidity reserves to the interbank system affecting the Fed Funds Rate, and driving it lower. When the Fed sells assets (which I don't think it has done since 2007, it has been letting them mature and zeroing them off the books), it drains reserve liquidity out of the interbank system causing the Fed Funds Rate to go up.

So you see, the Fed's Open Market Operations is not being used to affect the overall money supply in the economy to affect the Fed Funds Rate, it is using its OMO to adjust liquidity reserves in the interbank system to affect the Fed Funds Rate, which affects interest rates throughout the economy, which, in turn, affects the supply of credit, erroneously referred to as money in the economy.