Central Bak Operations

Today I want to dig a little into the NZ versus the USA systems for central bank monetary operations. (RBNZ in New Zealand, the FED system in the USA.)

We use an MMT framework from the start, so we recognize from the beginning that post 1972 we no longer have a fixed exchange rate system for international settlements (that was Bretton-Woods). So the domestic policy interest rate could be set at permanent zero without currency risk. Same in NZ since 1985 when we moved to a floating exchange rate.

With this basis in mind, we can begin to talk sensibly about central bank operations without the monetarist false framing.

We also take the central banks to be branches of government, they are not “independent”. The parliament/Congress grants the central bank committee discretion over monetary policy. But the central bank still take their marching order from Congress/Parliament, regardless of what any mainstream economics professors say (they tell a lot of fibs, perhaps not outright less since they do not know any better)

The US System

On bank reserves and liquidity.

Account Entries at the Fed

Bank reserves are just account entries at the Federal Reserve. In New Zealand these are called ESAS accounts (Exchange and Settlement Balance accounts). These are not physical cash holdings but digital balances “maintained by commercial banks at their regional Federal Reserve Bank.”

We need those quotes because who actually maintains these accounts? It is the central bank. The private chartered banks may send electronic instructions to the central bank when conducting payment clearing operations. But it is the central bank software that credits and debits those accounts. If a mistake is made either end then the accountants will damn well let the other end know, since one end’s credit is the other’s debit.

Payments Clearing Operations

The primary purpose of these reserves is for payments clearing operations, not for maintaining liquidity in the traditional sense. Banks use these reserve accounts to settle transactions between each other and with the government.

No Inherent Liquidity Risk

There is no inherent liquidity risk in this system. Banks can always make payment clearings as long as the Fed’s systems are operational. The notion of banks “running out of reserves” for clearing purposes is an outdated anachronism in the modern monetary system. In fact liquidity risk for bank reserves was never an applicable concept unless a central bank was (insanely) using a foreign currency.

Interest Rate Management

The regulatory and statutory requirements around reserves primarily affect interest rates rather than liquidity. The Fed uses tools like Interest on Reserve Balances (IORB) to influence the federal funds rate and, by extension, broader market interest rates.

Implications for Monetary Policy

This understanding has significant implications for how we view monetary policy:

1. Liquidity Provision: The Fed’s role in “providing liquidity” is more about managing interest rates and financial stability than about ensuring banks have enough reserves for clearing.

2. Reserve Requirements: The elimination of reserve requirements in March 2020 was less about freeing up liquidity and more about simplifying monetary policy implementation.

3. Quantitative Easing: Large-scale asset purchases (QE) primarily affect long-term interest rates and financial conditions rather than directly addressing bank liquidity needs.

We should add that in the USA all bank deposits are 100% FDIC guaranteed up to $250K. But MMT experts will point out there is no good reason why 100% full deposit insurance cannot be guaranteed. The ostensible mainstream concept is that customers can discipline their bank by going to another bank posing less deposit risk. But no one, not even expert economists, know the actual risks, even the bank managers cannot say what their risks of default are. The MMT framing is that,

The liabilities side is not the place for bank discipline. Banks can only be effectively disciplined on their asset side.

This means the loans and credit promissory notes the banks hold (their assets) are where regulatory and market discipline is effectively imposed. The hard lesson from banking history is that the liabilities side is not the place for market discipline on banks. Customers have absolutely no capacity to discipline their bank, except by pure guess work and a nose for the smell of fraud.

Do any bank customers make it an assiduous habit of sniffing for the stench of fraud being emitted from their bank?

Government’s Role

An important point about the government’s role:

• The only real risk to the payments system would come from government action that obstructs clearing operations, either through policy decisions or technical issues with the software systems.

This revised understanding (compared to mainstream knowledge and discourse) emphasizes the importance of the Central Bank’s role in maintaining the payments infrastructure and managing interest rates, rather than providing liquidity in the traditional sense. It also highlights the fact that in a modern monetary system, the constraints on bank lending are capital requirements, profitability considerations, and the availability of creditworthy borrowers, not reserve availability for clearing purposes.

It’s crucial for well informed policy decisions, and ultimately social equity, to have an accurate understanding of these fundamental aspects of the monetary system.

References:
[1] https://en.wikipedia.org/wiki/The_Federal_Reserve
[2] https://www.investopedia.com/articles/investing/081415/understanding-how-federal-reserve-creates-money.asp
[3] https://www.investopedia.com/articles/economics/10/understanding-the-fed-balance-sheet.asp
[4] https://www.investopedia.com/terms/f/federalreservebank.asp
[5] https://www.investopedia.com/terms/f/federalreservesystem.asp
[6] https://www.cfr.org/backgrounder/what-us-federal-reserve
[7] https://www.federalreserve.gov/aboutthefed/fedexplained/who-we-are.htm
[8] https://www.ecb.europa.eu/press/conferences/shared/pdf/20231109_money_markets/Vandeweyer_paper.en.pdf