A "Significant Liquidity Event"

Today there was, as Brad DeLong notes in a series of posts on the topic, a "significant liquidity event." Because of this event, "today the monetary base in the North Atlantic economies is 7% higher than it was yesterday."

Let's back up. From the first post of Brad's linked above:

This morning, the ECB allocated about $130 billion in a one-day quick tender to calm jittery markets. The scramble for liquidity in Europe spilled over into the U.S.: The Fed, in an effort to get the federal funds rate back down to its target 5.25% and meet the spike in demand for cash, twice entered the market today to inject cash.

Just for fun, I thought I'd present a textbook version of this event. Here's the graph of the market for bank reserves:

The initial equilibrium, before the event, is at E₁ where the supply and demand for bank reserves intersect (this is a picture of the federal funds market, i.e. the market for overnight loans of bank reserves between banks). The demand curve slopes downward because the federal funds rate is the opportunity cost of holding bank reserves. Thus, when the cost of holding bank reserves falls (i.e. the ff falls), more reserves are held (as insurance against deposit outflows, and for other purposes).

Reserve supply, shown as vertical lines at R₁ and R₂ in the diagram is controlled by the Fed through open-market operations. At any point in time, the supply of reserves is fixed, so the line is vertical (or at least approximately so in more general models). 

Banks can borrow money in many different places using different financial instruments, but two places to obtain reserves are the federal funds market and the discount window. So long as the ff-rate is lower than the discount rate, banks will choose the ff market over the discount window. But if the ff-rate tries to rise above the discount rate, banks will switch to the discount window since that will be the cheaper source of funds. In the diagram, this is represented by a vertical supply of reserves up to the discount rate, then a horizontal line at that the discount rate (which is always the ff+1% under current bank operating procedures) since the Fed stands ready to lend as much as banks want through the discount window at the discount rate.

Now let's turn to today. As noted in the quote above (from the WSJ Economics blog), "The scramble for liquidity in Europe spilled over into the U.S." This is shown as an increase in the demand for reserves (i.e. for liquidity) indexed by (a) in the diagram.

If the Fed did not respond, the ff-rate would begin rising, potentially even reaching the discount rate. To avoid this, and maintain a federal funds rate of 5.25%, the "Federal Reserve subsequently poured a little more cash than usual into the U.S. banking system in order to deal with demand spilling over from Europe." The total amount of the injection was $24 billion, and this is represented by the shift in the supply of reserves indexed by (b) in the diagram. The result is a new equilibrium at E₂ where reserves have been increased to accommodate the increase in demand, and the ff-rate is at 5.25%. once again.

Update: I should have noted that this was an attempt to illustrate the statement from the WSJ: "The Fed, in an effort to get the federal funds rate back down to its target 5.25% and meet the spike in demand for cash." Demand for reserves would go up, for example, if banks anticipate bad mortgage loans in the future since they would want to have extra reserves on hand as insurance against that eventuality (to the extent they are exposed), or if alternative sources of funds dry up due to the evaporation of liquidity. The graph does not show the effects of the problems in mortgage markets on the supply of reserves, i.e. a fall in the supply of reserves from bad loans would also increase the ff-rate and require an injection of reserves to offset it.

Comments

[Chris]

Thanks!

I read all of DeLong's posts, but I don't understand where the sudden demand for short-term borrowing, or sudden shortage of lending has come from.

[William Polley]

Looks like the mental notes I was making for my intermediate macro course which starts in a couple weeks. What a way to start a macro course with this in the news.

[kthomas]

William, both interesting and dangerous.

How many more times will the ECB or the Fed do this before the fiscal year is out?

Too much funny money.

[heckler]

yup, it's a ponzi scheme unraveling all right!

[heckler]

What a way to start a macro course with this in the news.
--
What a way, indeed. Have you thought about investing in a kevlar vest?

[gordon]

I notice the money is being "injected" into borrowing and lending markets, not into the pockets of the people who stand to lose the most - homeowners. The fundamental aim is to prevent bankruptcies among financial intermediaries, not to alleviate the basic problem of creeping poverty.

[anne]

So far as I understand, the Federal Reserve liquidity injection was of no consequence. About $20 billion is injected on any given day, less at times, more at times. So $24 billion was of no concern to me, no matter the news. The issue that interests me is finding which institutions are holding difficult mortgage debt. I know for sure which do not, but finding the holders is tricky.

[mdm]

I see a hard landing on the horizon.

[Sarah]

William-- I can go you one better: I'm in the middle of taking macro right now-- and we're scheduled to visit the Fed tomorrow!

[kthomas]

anne, your comment is suprising. let's not lose touch with the short term.

the amount was small, but the questions it raises are fairly compelling. for example, what does this tell the street?

[anne]

Nothing; watch the bond market and there was no investment-grade difficulty at all today. Investment-grade debt has been fine, as has high quality below investment-grade. The liquidity issue appears to be a selected institutional problem, with banks appearing secure. I am prepared to be entirely wrong, and I want to understand who is holding difficult mortgage debt, but not worried.

[anne]

Paul Krugman will write on liquidity tomorrow, and I always take Krugman completely seriously and am prepared to worry some although after my run now I am too darn tired to worry. Good grief, that was hard.

[dd]

Glad there are no worries. My eyes are on illiquid derivatives; but then where does one go for a derivatives quote but to illiquid private markets. MarkIt is nice; but not regulated. The only issue is which Glass-Stegalless entity goes first. My bet Bank of NY Mellon; albeit one hopes Geithner, surveying the battlefield has ample troops.

[Julie]

Your explanation of the liquidity event is just what I need for my new AP macro students. Our Fed Challenge team was a national finalist and recently presented the current state of the economy at the Board of Governors in May. Earlier today after listening to many TV pundits get it all wrong about the ECB and Fed--never once mentioning reserves and increasing demand for reserves, I emailed my Fed Challenge team--most on their way to college soon. Their question was why has the demand for fed funds increased--what is/are the event(s) behind this increased demand, do we know them yet? These kids understand and know the Fed conducts open market operations on a daily basis--and they know the fed funds rate is a "target rate". These are high school students......As Brad Delong would say....why can't we have a better press corps?"

[chris]

Thanks for the update. I think I get it now.

I wish I had shorted subprime lenders. Every morning on NPR I hear of a different one going under!

[anne]

Well, there has been a significant international liquidity event and my dismissing of the significance was entirely wrong. The evidence is not in the middle or long term investment-grade bond markets, but in highly unusual volatility in short term bond markets. Now to try to understand, and fast.

[dd]

Anne, understanding comes from information and there is so little on opaque and lightly regulated markets that straddle the regulated markets. It is why I follow Geithner's speeches and await a calming word from him; but so far nothing. His speech of May 15 on "Liquidity Risk and the Global Economy" is worth a read.
http://www.newyorkfed.org/newsevents/speeches/2007/gei070515.html

[johnchx]

Mark wrote:Demand for reserves would go up, for example, if banks anticipate bad mortgage loans in the future since they would want to have extra reserves on hand as insurance against that eventuality...

This doesn't sound quite right to me. In particular, it seems to confuse reserves with capital. If a bank is forced to write down or write off a loan, that impacts its capital, but has no direct impact on its reserves at all.

I suspect this confusion has to do with the use of the term "reserve" in financial accounting ("creating a reserve for bad loans"), which has nothing to do with "reserves" kept on deposit with the Fed.