# Central Banking 101  ## Metadata - Author: [[Joseph Wang]] - Full Title: Central Banking 101 - Category: #books ## Highlights - The third type of money is central bank reserves, a special type of money issued by the Federal Reserve that only commercial banks can hold.1 Much ([Location 90](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=90)) - Tags: [[blue]] - A commercial bank can convert its bank reserves to fiat currency by calling up the Federal Reserve and asking for a shipment of currency. A $1000 shipment of currency would be paid for by a $1000 decline in reserves from its account at the Fed. Commercial banks use bank reserves when they pay each other or anyone else who also has a Fed account, and they use currency or bank deposits to pay everyone else. ([Location 94](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=94)) - Tags: [[blue]] - The final type of money is Treasuries, which is basically a type of money that also pays interest. ([Location 97](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=97)) - Tags: [[blue]] - Central bank reserves are created when the central bank buys financial assets or makes loans. The central bank is the only entity that can create central bank reserves, so the total amount of reserves in the financial system is completely determined by central bank actions.2 For example, when the Federal Reserve purchases $1 billion in U.S. Treasury securities, it creates $1 billion in central bank reserves to pay for them. That happens whether the seller of the Treasuries is a commercial bank or a nonbank. ([Location 120](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=120)) - Tags: [[blue]] - Prior to the 2008 Financial Crisis, the Fed conducted monetary policy under a reserve scarcity regime where the Fed controlled short-term interest rates by making slight adjustments to the level of reserves in the banking system. There were only around $30 billion in reserves in the entire banking system, compared to a few trillion today. ([Location 161](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=161)) - Tags: [[blue]] - The Fed now controls short-term interest rates by adjusting the interest it pays banks on excess reserves and the offering rate of the Overnight Reverse Repo Facility,3 a program where participants can loan money to the Fed. ([Location 165](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=165)) - Tags: [[blue]] - A common misconception is that a bank takes in deposits and then lends those deposits out to other people. Rather than lend out deposits, a bank simply creates bank deposits out of thin air when it makes a loan.4 This is very similar to the way a central bank acts when it creates central bank reserves. The central bank acts as a bank to commercial banks, and commercial banks act as a bank to nonbanks like individuals and corporations. ([Location 183](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=183)) - Tags: [[blue]] - However, a meaningful difference is that there are many commercial banks while there is only one central bank. As there is only one central bank, all the reserves created stay on the central bank’s balance sheet and are shuffled among the different reserve accounts as commercial banks make payments to each other. In the case of commercial banks, each commercial bank has its own balance sheet and creates its own deposits. Therefore, it is possible for a depositor to withdraw a bank deposit and move it off one commercial bank’s balance sheet onto another commercial bank’s balance sheet. When this happens, one commercial bank must make a payment to another. This payment is made in the form of central bank reserves. ([Location 187](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=187)) - Tags: [[pink]] - Should the commercial bank have more outflows than anticipated, it can always borrow reserves from another commercial bank or from the Fed to make payments. ([Location 195](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=195)) - Tags: [[blue]] - Banking crises occur when a bank has made too many bad loans and becomes insolvent. When that happens, a bank’s deposits may no longer be convertible to currency at par, so a $100 deposit may not be convertible to $100 in currency as depositors share in the loan losses. Depositors will panic and try to withdraw their deposits at the same time, accelerating the bank’s demise. ([Location 198](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=198)) - Tags: [[blue]] - In practice, the $250,000 FDIC deposit guarantee fully covers the deposit balances of the vast majority of depositors. For these people, bank deposits are risk-free money. ([Location 205](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=205)) - Tags: [[blue]] - In practice, the purported benefits of CBDC are illusory. Government deposit insurance already makes bank deposits safe, and electronic payments today are already instant and very low cost. The true purpose of a CDBC is as a policy tool to conduct fiscal and monetary policy. ([Location 214](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=214)) - Tags: [[blue]] - While a retail investor would likely hold most of their money in the form of bank deposits, an institutional investor would use Treasury securities for this purpose. Treasury securities are essentially money for large investors. ([Location 227](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=227)) - Tags: [[blue]] - However, a purchase of $100 worth of Treasury securities can fluctuate with market pricing. Longer-dated Treasuries are more sensitive to expected changes in inflation and interest rates, so their market values fluctuate the most, while the market value of shorter-dated Treasuries fluctuates very little. When held to maturity, these fluctuations in value do not matter, but if sold before maturity they could result in gains or losses. ([Location 230](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=230)) - Tags: [[blue]] - In practice, investors are not using their Treasuries to buy real economy items but to make other investments. To do so, investors can pledge Treasury securities as collateral at their broker to purchase financial assets. Essentially, an investor can buy financial assets like stocks or bonds using Treasury securities. ([Location 236](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=236)) - Tags: [[blue]] - The Fed prefers to conduct monetary policy by purchasing Treasuries, but they also actively purchase Agency MBS in their quantitative easing purchases. ([Location 266](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=266)) - Tags: [[blue]] - In March 2020, people throughout the world were scared and they wanted to hold dollars. Investors were withdrawing from their investment funds, and foreigners were selling their home currency for U.S. dollars. To meet these withdrawals, investment funds and foreign central banks sold their Treasuries just as if they were withdrawing from an ATM. But in this case, they found that they could not sell their Treasuries except at sizable discounts. The ATM machine was broken. When an institutional investor sells their securities, they call a dealer and expect the dealer to offer a price. The dealer would normally buy the security, hold on to it, and then sell it to another investor, earning the difference between the prices. In March of 2020, a large number of investors called up their dealers and asked to sell securities. Mortgage REITs, who borrow money to invest in mortgage securities, were selling large amounts of Agency MBS to repay those loans. Corporate bond ETFs were trying to sell their bonds to meet investor withdrawals. Prime money market funds were trying to sell their commercial paper holdings for the same reason. Dealers were suddenly flooded with securities and reaching the regulatory limits of their security inventory holdings. ([Location 272](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=272)) - Tags: [[blue]] - the Fed gave bank holding companies a temporary reprieve of some of the regulations that limited their balance sheet size. Second, they opened up a new Foreign Repo Facility to allow foreign central banks to obtain dollars without selling their Treasury securities. Third, the Fed resumed massive quantitative easing. The last point was key in stabilizing the markets. In the brief span of a few weeks, the Fed purchased almost $2 trillion in Treasury securities and Agency MBS from the dealers. These purchases offered a way for dealers to off-load their large inventory of securities and have room again to purchase securities from their clients. This restored the “moneyness” of Treasury securities and significantly helped stabilize the broader market. ([Location 289](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=289)) - Tags: [[blue]] - Just as the level of central bank reserves is determined by the Fed, so the level of bank deposits in the banking system is largely determined by the collective actions of commercial banks.6 Bank deposits are created when a commercial bank purchases an asset or creates a loan, and they are destroyed when the loan or asset is repaid. The level of bank deposits is thus largely an indicator of the level of loans made by the banking system. ([Location 334](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=334)) - Tags: [[blue]] - When an investor purchases stocks or bonds with their bank deposits, then their bank deposit ends up in the bank account of whoever sold them the stock or the bond. The total level of the bank deposits in the banking system is unchanged. The bank deposits are essentially being shuffled around the commercial banking system, but they neither increase nor decrease. Large amounts of investment can occur at both low and high aggregate levels of bank deposits. ([Location 338](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=338)) - Tags: [[pink]] - The Fed thinks of the economy through the lens of interest rates, which is the primary tool through which the Fed achieves its mandate.7 In the eyes of the Fed, there is a thing called r* (pronounced “r star”), which is the neutral rate of interest at which the economy is neither expanding nor contracting. When interest rates are below r*, then the economy is expanding, inflation is rising, and unemployment is ticking lower. When interest rates are above r*, then the economy is slowing, inflation is declining, and unemployment is ticking higher. ([Location 349](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=349)) - Tags: [[blue]] - When the economy is in trouble and the Fed’s models show that r* is currently a very low or even negative number, then the Fed will do everything it can to get interest rates below r* to promote economic growth. They will first cut their target overnight interest rate to zero, then they will try to lower longer-term interest rates by buying lots of longer-dated Treasury securities, which will then increase the price of the Treasury securities and correspondingly lower their yields. Longer-dated Treasury securities are less sensitive to changes in the overnight interest rate, so the Fed tries to indirectly influence them through quantitative easing. ([Location 356](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=356)) - Tags: [[blue]] - The Desk collects market intelligence through a wide network of contacts. Their main contacts are the primary dealers, who are obligated to speak with the Desk as part of their primary dealer responsibilities. On a secondary basis, the Desk speaks with commercial banks, government-sponsored enterprises, hedge funds, pensions funds, corporate treasurers, and small dealers. Generally speaking, most significant players in the financial markets will have a relationship with the Desk. These secondary sources are not obligated to speak with the Desk like the primary dealers are, but they are generally happy to maintain a relationship with the Desk. They understand that the conversations are confidential and are happy to help the Fed carry out its work. ([Location 363](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=363)) - Tags: [[blue]] - When the Fed undertakes quantitative easing (QE) it will announce the quantity, pace, and type of assets it will purchase, but it does not know beforehand how the market will react. This is understandable, as market reactions are very difficult to predict because it is not clear what is already priced into the market. The Fed will size its program based on internal models and try to determine the market’s expectations using surveys of a wide range of market participants. The Fed will then adjust the program on an ongoing basis, mindful of potential side effects such as buying so much of a specific security that normal market functioning is impaired. ([Location 380](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=380)) - Tags: [[blue]] - When the Fed purchases a financial asset from a nonbank investor, the Fed sends the payment as reserves to the investor’s commercial bank. The commercial bank then credits the investor’s bank account. In this instance, the commercial bank is acting as an intermediary between the Fed and the investor since the investor is unable to hold reserves. The Fed’s action of purchasing assets increases the level of central bank reserves in the system as well as commercial bank deposits. ([Location 386](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=386)) - Tags: [[blue]] - The Fed’s goal with QE is to lower longer-term interest rates, with the increase in reserves and bank deposits being a necessary byproduct. Academic models suggest that QE is effective in lowering interest rates and does help boost inflation.8 However, the experience of the Fed, the BOJ, and the ECB all show that massive QE, at least by itself, is not enough to sustainably move inflation higher. ([Location 389](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=389)) - Tags: [[blue]] - QE appears to lift financial asset prices but not necessarily economic activity. QE essentially converts Treasuries into bank deposits and reserves, thus forcing commercial banks as a whole to hold more of their money in the form of central bank reserves, and it forces nonbanks as a whole to hold more of their money in the form of bank deposits. Inflation occurs when demand in the economy pushes against supply, and money that was held in Treasuries was money that likely wasn’t going to be spent in the real economy. Forced to trade in their Treasuries for bank deposits, nonbanks can trade their bank deposits for higher-yielding corporate debt or speculate on equity investments. ([Location 394](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=394)) - Tags: [[blue]] - A commercial bank is a special type of business that holds a license from the government to create money. Almost all the money the general public uses is created by commercial banks. The ability to create money makes these banks an indispensable part the economy; when they create more money, there is more economic growth. ([Location 417](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=417)) - Tags: [[blue]] - The basic business model of a commercial bank is earning the difference in interest rates between the assets it holds and the liabilities it owes. The assets a commercial bank holds are typically loans that it originated, including mortgage, commercial, and consumer loans. Commercial banks also typically hold high-quality securities like Treasuries or Agency MBS as investments. On the liability side, the bulk of commercial bank liabilities are retail deposits, which are bank deposits owed to individuals. Other liabilities include wholesale deposits, which are deposits owed to institutional investors like money market funds. Retail deposits earn little interest, while wholesale deposits tend to earn market-rate interest. ([Location 419](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=419)) - A commercial bank faces two fundamental problems: solvency and liquidity. Solvency is making sure the bank deposits it creates are backed by sound loans, and liquidity is making sure those deposits are freely convertible to bank deposits created by other commercial banks and to fiat currency. ([Location 430](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=430)) - Tags: [[blue]] - The second problem a commercial bank must solve is liquidity. Suppose that the bank makes a $100 loan to a creditworthy borrower, but then the borrower immediately withdraws the money to pay their supplier, who banks with another commercial bank. Commercial banks have to make sure they have enough central bank reserves to settle payments with other commercial banks and that they have enough currency on hand to meet any depositor withdrawals. ([Location 441](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=441)) - Tags: [[blue]] - To solve liquidity problems, commercial banks carefully study the daily payments needs of their customers and then seek to hold enough liquid assets to meet those needs. These assets are usually central bank reserves, but they can also be Treasury securities or Agency residential MBS (RMBS). ([Location 446](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=446)) - Tags: [[blue]] - there are limits to the amount of money they can create. These limits come through regulation and profitability. ([Location 480](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=480)) - Tags: [[blue]] - In a broader sense, commercial bank money creation is limited by the investment opportunities available. The equity investors in a bank want to earn a high return on their investment, so they want the bank to make investments that earn higher interest income. When the economy is booming, many borrowers are willing to pay high interest rates to fund profitable projects, but in a recession, there are far fewer worthwhile opportunities. Banks thus create more money during economic booms. During a recession, a bank may contract its lending, naturally reducing the supply of money as the economy has a lower demand for money. ([Location 487](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=487)) - Tags: [[blue]] - The Treasury does not decide how much debt to issue; that is determined by the federal government’s deficit, which is a result of decisions by Congress. Congress enacts legislation that determines the federal government’s spending and its tax revenues, the difference of which is the deficit. However, the Treasury does decide how it will go about funding the deficit. This gives Treasury influence over the shape of the interest-rate curve, where a decision to issue more longer-dated debt will lead to a steeper curve and a decision to issue more shorter-dated debt will lead to a flatter curve. The increase in the supply of debt in any segment will lower the price of debt in that segment, which leads to higher yields. The overarching principle of Treasury’s debt management strategy is to provide the lowest cost of financing to the taxpayer over time. To that end, Treasury will perform its own analysis, along with input from the private sector, to determine the cheapest way to fund the deficit. ([Location 521](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=521)) - Tags: [[blue]] - For example, when Congress passed the $2.2 trillion CARES stimulus package in March 2020, the Treasury met the bulk of the financing need through $1.5 trillion in Treasury bills, which are Treasury securities that mature in less than a year. The bills were easily digested by money market funds, who have over $4 trillion in assets that constantly need to be rolled over into short-term investments. On the other hand, the market for longer-term Treasury securities is populated by investors who have longer time horizons and are less able to react to short-term fluctuations. These investors, which include pension funds, insurance companies, and sovereign funds, will not suddenly have more money to invest if Treasury issuance surges. ([Location 537](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=537)) - Tags: [[blue]] - Like commercial banks, shadow banks take on liquidity and credit risk by creating loans or purchasing assets. However, they cannot create bank deposits the way commercial banks can, so instead, they borrow from investors to fund their assets. Rather than being creators of money, shadow banks are intermediaries. ([Location 553](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=553)) - Tags: [[blue]] - The basic business model of a shadow bank is to use shorter-term loans to invest in longer-dated assets. This mismatch creates an opportunity for profit as longer-term interest rates are usually higher than shorter-term interest rates. The shadow bank may also be earning a risk premium by investing in riskier assets. ([Location 562](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=562)) - Tags: [[blue]] - In recent decades, the shadow banking system has grown to be larger and more influential than the traditional commercial banking system. ([Location 569](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=569)) - Tags: [[blue]] - In addition to making markets for financial products, dealers also act as financial intermediaries, borrowing from one client to lend to another. For example, a hedge fund may want to take out a one-month loan from a dealer collateralized by some securities. A dealer would make the one-month repo loan, then source the money by borrowing from one of its investor clients using those same securities as collateral. However, the dealer will likely borrow on an overnight basis instead of matching the maturity of the two loans. Since the interest rate for overnight loans is lower than the rate for one-month loans, the dealer will be able to earn the difference between in interest it receives from the one-month loan to the hedge fund and what it pays its investor client for an overnight loan. This type of transaction is called a matched book repo trade, because the two repo transactions offset each other. ([Location 585](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=585)) - Tags: [[blue]] - That is exactly what happened in 2008. In March 2008, Bear Stearns, a major investment bank and primary dealer, failed when its investments in the subprime mortgage market soured. When investors heard about Bear Stearns’ troubles, they became afraid and refused to renew their repo loans to Bear Stearns. Bear Stearns was thus forced to sell its assets at fire sale prices to repay those loans. This hurt asset prices and led investors to be cautious in their lending to all dealers. It was only when the Fed stepped in as a lender of last resort that confidence was restored and market conditions normalized. The Fed is not usually able to lend to primary dealers, but in this case exercised its emergency lending powers, known as 13(c) after the section in the Federal Reserve Act authorizing them, and established the Primary Dealer Liquidity Facility (PDCF).13 The PDCF was basically a discount-window facility available only to primary dealers. ([Location 597](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=597)) - Tags: [[blue]] - The rise of securitization played an important role in the 2008 Financial Crisis by fundamentally changing the business model of many commercial banks. Traditionally, a commercial bank held on to the loans it originated, so it was careful who it lent to. A commercial bank could easily end up bankrupt if just 5% of its loan assets were written off. But the rise of securitization meant a commercial bank could earn fees by originating a loan and selling it to a securitization vehicle. Many commercial banks began to transition their business model from earning interest on loans to earning fees on originating loans. Since they did not hold the loans themselves, commercial banks were less interested if a loan soured. That was a risk borne by the securitization bond investors. ([Location 738](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=738)) - Tags: [[blue]] - Liquidity is a real concern for institutions or wealthy individuals who have a lot of money. A big part of the reason China owns trillions in Treasuries even though they are not very friendly with the U.S. is because they have no alternative; there is no other market deep enough to hold all that money. ([Location 832](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=832)) - Tags: [[blue]] - central bank reserve ratios together with the quantity of central bank reserves do not limit the size of the banking sector. The Eurodollar system can use bank deposits as if they were central bank reserves, and thus expand virtually without limit. Suppose there was $100 in reserves and a reserve ratio of 10, then that implies that total domestic deposits cannot exceed $1000. But if a foreign bank held $100 in those deposits, it could use them as reserves to also make dollar loans and create dollar deposits. The foreign bank wouldn’t be under Federal Reserve regulation, so they would be free to decide their own reserve ratio, which could be higher or lower depending on their risk tolerance. ([Location 926](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=926)) - Tags: [[blue]] - the growth of money is driven by bank profitability. If there are many quality borrowers willing to borrow at profitable rates, then a bank will make the loans. The profitability of a bank’s loan is largely dependent on its net interest margin, which is the difference between the interest it earns on the loan and its funding costs. Ideally, it will have many retail deposits at 0% interest, but if not, it will have to go to the money markets and borrow funds at market rates. One way to estimate the general profitability of the commercial banking is to look at the steepness of the yield curve, specifically the spread between 3-month bills and the 10-year Treasury. A wider spread suggests a more profitable banking sector, which in turn is positive for economic growth. ([Location 932](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=932)) - Tags: [[blue]] - foreign central banks hold around $7 trillion in dollars in their foreign reserves portfolio, which are largely invested in safe U.S. dollar assets such as Treasuries or Agency MBS. The foreign central banks obtained their dollars when their residents exchanged dollars for their home currency or as a byproduct of central bank operations like currency intervention. Institutional investors in Japan and the Eurozone, both regions which have lower interest rates than the U.S., have been increasing investments in U.S.-based assets such as Treasuries, Agency MBS, and corporate bonds. They usually obtained their dollars through FX-swap loans. ([Location 985](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=985)) - Tags: [[blue]] - Interest rates are the building blocks of all asset prices, financial or real. For example, a home buyer takes the mortgage rate into account when deciding how much they are willing to pay for a home, a corporate raider makes a hostile bid for another company based in part on how much their junk bond financing will cost, and an investor takes a stream of cash flows and discounts them with a risk-adjusted interest rate to price a stock. Assets cost money, and interest rates determine how much money costs. ([Location 1042](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1042)) - Tags: [[blue]] - The foundational interest rates for all U.S. dollar assets are Treasury yields, which are the return an investor earns when investing in Treasuries. These returns are considered risk-free, so they form a basis on which all risky investments can be judged. Investors will take a look at how much they can earn by buying Treasuries and then compare that return to what a potential investment is offering. Investors will expect to earn a bit more in a risky investment, with the additional premium increasing with the level of risk. The level of Treasury yields thus has a significant impact on the expected returns from all assets. ([Location 1045](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1045)) - The Fed controls short-term interest rates, but long-term interest rates are largely determined by market forces. The level of Treasury yields can have a powerful effect on asset prices, because lower yields imply higher asset price valuations. Analyzing the level of yields and shape of the yield curve can tell us what the market views as the Fed’s next action as well as the market’s expectation for economic growth and inflation. ([Location 1053](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1053)) - Tags: [[blue]] - The Fed controls short-term interest rates through its control over overnight interest rates. In theory, this is through its control of the federal funds rate, which is the rate commercial banks pay to take out an overnight loan for reserves on an unsecured basis. ([Location 1057](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1057)) - Tags: [[blue]] - In the current world with very high levels of reserves, the Fed controls the federal funds rate by adjusting the interest rate it offers on the Reverse Repo Facility (RRP) and the interest it pays on reserves that banks hold in their Fed account. The RRP offers a wide range of market participants the option of lending to the Fed at the RRP offering rate. These market participants include money market funds, primary dealers, commercial banks, and a few government-sponsored enterprises. The option to lend risk-free to the Fed at the RRP offering rate puts a floor on the returns they are willing to accept from the private sector. ([Location 1068](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1068)) - Tags: [[blue]] - The Fed makes sure the federal funds rate stays within its target range by adjusting the interest it pays on reserves. Prior to the crisis the Fed did not pay interest on reserves. The ability to earn interest risk-free from the Fed gives commercial banks a bargaining position when they think about lending or borrowing in the federal funds market. If interest on reserves were 1%, then a bank would only lend reserves if the rates they received were greater than 1%. ([Location 1075](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1075)) - Tags: [[blue]] - In practice, the RRP offering rate is probably a much more influential rate than the federal funds rate. The RRP rate is available to a wide range of market participants, while the federal funds rate is available only to commercial banks. This means that changes in the RRP rate affect the opportunity costs of a much larger group of market participants. ([Location 1091](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1091)) - Tags: [[blue]] - While the Fed determines short-term rates, the market determines longer-term interest rates. ([Location 1104](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1104)) - Tags: [[blue]] - The Eurodollar futures market is the deepest and most liquid derivatives market in the world. Eurodollar futures are essentially the market’s best guess of what future 3-month LIBOR rates will be. Since 3-month rates are firmly within the Fed’s control,38 this is largely a bet as to what the Fed will do in the future, which in turn is a bet based on how economic conditions will unfold. ([Location 1114](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1114)) - Tags: [[blue]] - Of all the financial instruments, Eurodollar futures are the most reflective of economic fundamentals. Eurodollar traders know the Fed will react according to how the economy performs, so they focus on hard economic data even as other asset classes are stuck in moments of euphoria or fear. Often times, they will even disagree with the Fed. ([Location 1118](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1118)) - Changes in trade policy or monetary policy of foreign countries have a meaningful impact on the international demand for Treasuries but are difficult to predict. ([Location 1158](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1158)) - Tags: [[blue]] - Domestically, the Federal Reserve is the largest purchaser of Treasuries. The Fed’s actions are very difficult to predict because they depend on financial conditions and the judgement of the policy makers at the time. In 2019, many market participants were expecting Treasury yields to rise due to the federal government’s growing deficit. When the 2020 COVID-19 panic struck, the Fed decided to purchase over $1 trillion in Treasuries over a span of weeks and committed to purchase large amounts going forward. This essentially solved the demand issue and kept Treasury yields at record lows. The COVID-19 panic, and the Fed’s strong reaction, could not have been predicted beforehand. As the Fed becomes increasingly aggressive in its willingness to purchase Treasuries, other factors that affect longer-term yields appear to become less important. ([Location 1159](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1159)) - The yield curve can be used to infer the market’s perception of the state of the economy. Market participants often focus on an inverted yield curve—one where longer-term yields (usually the 10-year Treasury) are lower than short-term yields (usually the 2-year Treasury or 3-month Bill)—as a sign that the economy will soon be in recession. ([Location 1172](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1172)) - Tags: [[blue]] - The shape of the yield curve is also in part determined by Fed action. The Fed purchases longer-dated securities through quantitative easing, which effectively lowers longer-term yields and thus flattens the yield curve by putting downward pressure on longer-dated yields. In the past, the Fed has also engaged in operations which flattened the yield curve by selling short-term Treasuries and buying longer-term ones.43 This flattens the yield curve by raising short-term interest rates in addition to putting downward pressure on longer-term rates. The size and composition Fed’s portfolio can thus impact the shape of the Treasury curve. ([Location 1180](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1180)) - Tags: [[blue]] - Even if affected by Fed action, interest rates are still regarded as the best market signal for the state of the underlying economy. ([Location 1188](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1188)) - Tags: [[blue]] - Money markets are markets for short-term loans with maturities that range from overnight to around a year. Money markets are the plumbing of the financial system; they keep the financial system working but are out of sight. The shadow banks and commercial banks are often structured to have longer-tenor illiquid assets funded by short-term liquid liabilities borrowed from the money markets. ([Location 1190](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1190)) - Tags: [[blue]] - While still sizable, unsecured money markets have correspondingly become less important. Secured money markets appear to increasingly be the money market of choice for borrowers and regulators, with the Fed now publishing secured overnight reference rates and controlling secured overnight rates through ongoing repo operations. ([Location 1200](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1200)) - Tags: [[blue]] - The two largest segments of secured money markets are the repo market and the FX-swap market. Repo loans are secured by securities such as Treasuries, corporate bonds, MBS, or equities. FX-swap loans are loans in one currency secured by another currency, such as a loan for 1000 euros secured by collateral of 1000 U.S. dollars. ([Location 1204](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1204)) - Tags: [[blue]] - Economically, this is equivalent to borrowing money using the security as collateral. The slightly higher price paid to repurchase the security is equivalent to the interest on the loan. This transaction structure is advantageous from a bankruptcy law standpoint; even if the borrower files for bankruptcy, the lender will be allowed to seize the collateral because it has technically been sold to them. If the transaction were structured as a secured loan, then the lender would have to go through bankruptcy court before seizing the collateral. ([Location 1209](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1209)) - Tags: [[blue]] - The repo market is the essential link that allows Treasury securities to be “money.” The Treasury market is already the world’s deepest and most liquid market, but a $1 trillion overnight repo market goes one step further and allows Treasuries owned outright to be converted to bank deposits any time for virtually no cost, and then returns the same Treasury security the next day. Of course, borrowers can easily roll over their overnight repo loans for as long as they want or choose a longer-tenor repo loan. This makes Treasuries fungible with bank deposits, thus turning Treasuries into money and giving the U.S. Treasury the power of the printing press. ([Location 1220](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1220)) - Tags: [[blue]] - The repo market is also a market for cheap leverage. Investors can speculate on securities by putting down a little of their money as equity and borrowing the rest in the repo market. This is because an investor can purchase a security, simultaneously enter into a repo agreement to borrow against that security, and then pay for the initial purchase of the security using proceeds from the repo loan. For example, a hedge fund who wants to invest $100 in Treasuries can put down $1 of its own money and end up borrowing the remaining $99 in a repo transaction. ([Location 1224](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1224)) - Tags: [[blue]] - The cash borrowers in the repo market are primarily dealers and the investment funds who borrow from the dealers. Usually a money market fund would lend to a dealer who in turn uses the money to finance their own inventory of securities or acts as an intermediary and re-lends the money to a hedge fund client. ([Location 1241](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1241)) - Tags: [[blue]] - In recent years, the Fed has become an active borrower and lender in the repo market through its Repo and Reverse Repo Facilities. The two facilities are used by the Fed to control repo rates. The Fed’s Reverse Repo Facility offers money market funds a place to park their money at a set interest rate. This helps the Fed maintain a floor for repo rates because it provides money funds with strong bargaining power against dealers. The Fed’s Repo Facility has a similar purpose: it acts to prevent repo rates from rising too much. The Repo Facility provides virtually unlimited repo loans to primary dealers at a set rate, which then acts as a soft ceiling for repo rates. If a money market fund demands rates higher than the Fed’s Repo Facility rate, the dealer can just borrow from the Fed instead. The spread between the Reverse Repo Facility rate and Repo Facility rate is usually only a small fraction of a percent. ([Location 1247](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1247)) - Tags: [[blue]] - During the 2008 Financial Crisis and the 2020 COVID-19 panic, the FX-swap basis for major dollar crosses exploded from a fraction of a percent to several times that in a matter of weeks.50 This implies significant stress in the U.S. dollar funding markets because borrowers are unable to borrow dollars unless they offer exceptional interest rates. This could happen as U.S. dollar holders pull back their FX-swap lending to conserve dollars and reduce risk amidst market turmoil. When the dollar lenders pull back, foreign investors who borrowed dollars in the FX-swap market on a short-term basis to purchase longer-term U.S. dollar assets may be forced to sell those assets at fire sale prices. Foreign banks with a U.S. dollar loan business and who manage their currency risk through the FX-swap market may be forced to rollover their FX-swap loans at very high rates, leading to significant capital losses that cause them to retrench from lending activity. All this causes significant stress in the financial markets. ([Location 1303](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1303)) - Tags: [[blue]] - Focusing solely on domestic interest rates can be misleading because money markets are global. Changes in interest rates in one country automatically affect those in other countries via arbitrage. Not all investors can participate in the arbitrage due to varying levels of sophistication and risk tolerance, so the opportunities persist. ([Location 1331](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1331)) - Tags: [[blue]] - Before the 2008 Financial Crisis, commercial banks were major participants in the unsecured money markets. The well-known benchmark rate, 3-month LIBOR, is in fact a benchmark rate for the interest rate a commercial bank would have to pay to borrow dollars on an unsecured basis for 3 months. Borrowing in unsecured money markets was an easy way for a commercial bank to expand its loan portfolio without worrying about deposit outflow. When a commercial bank aggressively expands its loan portfolio, it will often experience net deposit outflows as the newly created deposits are spent by borrowers and end up deposited at other commercial banks. In this case, a commercial bank could go to the market even when they don’t have collateral and borrow in the unsecured money markets to replace the lost deposits. ([Location 1339](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1339)) - Tags: [[blue]] - The largest segment of unsecured money markets are certificates of deposit (CDs), which are essentially deposits that cannot be withdrawn until they reach a preset maturity date. While data on CDs is not publicly available, Federal Reserve data show that commercial bank time deposits were around $1.6 trillion in 2020. Time deposits are a slightly broader category of bank liabilities that include CDs. These deposits offer banks a way to manage outflows, and depositors a way to earn competitive interest rates. The largest issuers of CDs tend to be foreign banks, as they lack the stable retail deposit base that domestic commercials banks have. Retail deposits can be withdrawn any time, but in practice tend to just sit in the bank. Domestic banks have an easier time managing their deposit outflows because most of their deposits are stable retail deposits. Foreign banks don’t have retail businesses, so they have to instead rely on CDs where the depositor is contractually obligated to keep the deposit at the issuing bank until the CD matures. ([Location 1344](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1344)) - Investors in CDs tend be very rate sensitive. These investors will quickly move money from one bank to another even for a fraction of a percent. The largest investors in CDs are prime money market funds, who usually invest in CDs issued by a number of commercial banks as a way to diversify credit risk. ([Location 1352](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1352)) - Tags: [[blue]] - Another common unsecured money market instrument is commercial paper (CP). Whereas CDs are legally deposits and can only be issued by commercial banks, CPs are short-term unsecured debt that are not deposits, so they can be issued by any entity. When a financial institution issues CP, it is called financial CP. Insurance companies, bank holding companies, dealers, and specialty finance companies are all common issuers of financial CP. ([Location 1355](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1355)) - Tags: [[blue]] - The most well-known unsecured money market is the federal funds market, which is where the Fed sets its policy rate. The federal funds market is an interbank market where commercial banks borrow reserves from each other on an overnight unsecured basis. Historically, commercial banks borrowed in the funds market to have enough reserves to meet reserve requirements at the end of the day or to meet daily payment needs. In a sense, it was the marginal cost of funding for a commercial bank. The Fed hoped to influence longer-term interest rates and bank lending activity by raising or lowering the federal funds rate. ([Location 1384](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1384)) - Tags: [[blue]] - The Fed was able to control the funds market because it had complete control over the supply of reserves in the banking system, and a very good sense of the demand for reserves. The demand for reserves came from the regulatory framework that commercial banks operated under, which forced them to hold certain levels of reserves depending on their size and the types of liabilities they had. The Fed knew exactly how much reserves the commercial banking system as a whole needed and adjusted the supply of reserves so that the funds rate stayed within the target range. As is discussed in Chapter 5, the Fed now controls the funds rate with a new framework. ([Location 1389](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1389)) - Tags: [[orange]] - While unsecured markets remain sizable, they are much smaller than they were prior to the financial crisis. The financial crisis was fundamentally a banking sector crisis, and that experience left many market participants, including banks, wary of unsecured exposure to banks. Regulators have also put forth rules that make it unattractive for a bank to borrow in the unsecured money markets. As a result, the interbank unsecured money markets have virtually disappeared. What remains of the unsecured money markets is primarily a nonbank to bank market, and that has also shrunk significantly due to Money Market Reform. ([Location 1393](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1393)) - Tags: [[blue]] - In the post-financial-crisis world, the federal funds rates is basically unchanged each day, like an EKG meter that has flatlined. This is due to two reasons: quantitative easing and Basel III. Quantitative easing significantly increased the level of central bank reserves in the banking system from about $20 billion to a few trillion. Commercial banks have much less of a reason to borrow in the funds market when they already have so many reserves. In addition, Basel III made interbank borrowing less attractive. When a crisis hits, those loans are usually the first to disappear and leave a bank scrambling for cash, so Basel III seeks to make commercial banks safer by encouraging them to reduce their overnight unsecured borrowing. ([Location 1404](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1404)) - As the funds market has largely lost its significance as a signal for funding conditions, the Fed is likely to move its target rate to other reference rates. This could be one of the Fed’s new references rates such as Secured Overnight Funding Rate (SOFR), which is a reference rate based on overnight repo transactions secured by Treasury collateral. SOFR captures a market that is around $1 trillion in size with a wide range of market participants, so it is much more representative of real funding market conditions. In addition, the Fed already has good control over the overnight repo market through its Reverse Repo and Repo facilities. ([Location 1413](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1413)) - Capital markets are where borrowers go to borrow from investors rather than from commercial banks. The borrowings are usually at tenors of several years, which put the borrowings outside of money markets. Capital markets financing is different from a commercial bank loan in that it does not increase the amount of bank deposits in the system, but allows holders of bank deposits to lend them to other nonbanks.51 In a sense, it allows a more efficient use of existing money by allocating it to the borrowers who value it the most. ([Location 1419](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1419)) - Tags: [[blue]] - Capital markets are broadly divided into equity and debt markets. Equity markets are where a company offers an ownership interest in itself in exchange for bank deposits. Debt markets are where a borrower offers an “IOU” in exchange for bank deposits to be repaid with interest at an agreed upon date. ([Location 1423](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1423)) - Equity markets are the most followed financial market by the public. Major equity indices like the Dow Jones are talked about on the news and often viewed as a barometer for the health of the overall economy. However, equity markets are actually the most emotional market and least reflective of economic conditions. ([Location 1426](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1426)) - Tags: [[blue]] - Over the past two decades flows from passive investors have grown to become the marginal investors in the equity market. This has a few extremely important implications: • The stock market trends higher. Every week there is a constant flow of new money entering the stock market, even if valuations are considered to be sky high. This creates an upward bias in the market as a whole. • Stocks with large market capitalizations continue to get even bigger at an accelerating rate. Retirement accounts are usually set to track a certain stock index, like the S&P 500. Companies with larger market capitalizations in an index are allocated a greater share of money by index tracking funds, which in turn pushes the price of the stock higher. This is because a stock’s order book depth, which represents the amount and size of the outstanding buy and sell orders, does not scale perfectly with the market cap of the stock, so the increased investment flows into large cap stocks push their prices upwards at an accelerating rate. As the price of a stock rises, it becomes a bigger part of an index and so more money needs to be allocated to it, reinforcing the upward momentum. In a market dominated by passive investment, companies with large market caps become even bigger. This is exactly what is seen in the incredible outperformance of large cap tech companies like Microsoft or Apple. Not coincidentally, the two companies happen to be members of all three major equity indexes: the Dow Jones, S&P 500, and Nasdaq. • Value investing no longer works. Value investing relies on the idea that “cheap” companies tend to appreciate over time and outperform the market. This was famously documented by the Fama-French study that used price to book value as a measure of value. However, that study was done in a world before passive investment flows dominated the market. Cheap companies, which tend to be smaller companies, are largely absent from the major stock indices that receive passive investor flows. These value companies thus continue to underperform. The active investors that look for value cannot compete with the constant torrent of retirement money that drives major stock indices higher. ([Location 1445](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1445)) - In November 2010, Chair Bernanke, in defense of a new round of quantitative easing, noted that higher stock prices created a wealth effect that could improve consumer sentiment and thus consumer spending.54 The Fed believed that higher stock prices could help them achieve their policy goals. The stock market had appeared to become a policy tool. ([Location 1465](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1465)) - Tags: [[blue]] - Debt capital markets are less glamorous than equity markets, but larger and arguably more important. These are where companies or governments borrow money by issuing bonds. A bond is just a promise to repay issued by a borrower in exchange for an investor’s bank deposits. ([Location 1529](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1529)) - Tags: [[blue]] - When a commercial bank originates a loan, it creates bank deposits that are credited to the borrower’s bank account, but when a nonbank borrower issues a bond to a nonbank investor, then the nonbank investor sends bank deposits to the nonbank borrower’s account. Rather than create more bank deposit money, the debt capital markets allow a more efficient use of existing bank deposit money.57 ([Location 1531](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1531)) - Market participants usually evaluate bonds in terms of their yields as a spread to Treasury yields of the same tenor. For example, a 5-year bond issued by Microsoft would be evaluated by how much additional yield it offers over 5-year Treasuries. Treasuries are assumed to be risk-free and highly liquid. The additional yield offered by the Microsoft bond is meant to compensate an investor for the credit and liquidity risk the investor is taking. ([Location 1544](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1544)) - Tags: [[blue]] - Borrowers in the investment-grade corporate bond market tend to be larger corporations with solid credit ratings. In recent years, the investment-grade corporate bond market has grown tremendously as interest rates and corporate bond spreads reached record lows. The highest rated corporate issuers can borrow billions at yields that are only slightly above inflation and much lower than what any commercial bank can offer. This is because a bank would price a loan not just on credit risk, but would also take into account the effect the loan has on its regulatory ratios and return on equity. Corporate bond investors do not have these concerns but focus on the relative returns of comparable products such as Treasuries or Agency MBS. As central bank policy has reduced the yields on comparable products, corporate bond investors have been forced to accept lower and lower yields on their bond investments. ([Location 1583](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1583)) - Tags: [[blue]] - The BOJ was the first major central bank to begin buying corporate bonds in 2013, followed by the ECB in 2016 and finally the Fed in 2020. These purchases were justified based on improving the transmission of monetary policy by lowering the borrowing costs of corporate borrowers, thus stimulating the economy. Instead of relying on low rates to be transmitted to borrowers through the banking system, the central bank can now directly lower the borrowing costs of corporations by buying corporate bonds and thus pushing yields lower. Corporate bond purchases by central banks do appear to lower corporate borrowing costs, but also appear to make corporate bonds less sensitive to economic fundamentals. Many market participants now are less concerned with their risk exposure to corporate debt as they believe the central banks will just keep bond prices high even when fundamentals deteriorate. ([Location 1599](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1599)) - Tags: [[blue]] - One of the ways in which a corporation can boost its equity prices is by issuing debt to buy back equity. Suppose that equity holders, because they are subject to more risk, demand a 10% return on their equity. At the same time, because interest rates are low, the same company can issue debt at 5%. Then, by issuing debt to buy back stock, the corporation reduces its cost of capital. The company is effectively borrowing at 5% to repay 10% obligations. At the same time, there will be fewer shares of stock outstanding so each shareholder would receive more of the earnings. This leads to higher stock prices purely through financial engineering. ([Location 1613](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1613)) - The Fed has been an active buyer in the Agency MBS market since the 2008 Financial Crisis with the stated objective of supporting the housing market and placing downwards pressure on interest rates. The Fed’s holdings as of September 2020 were a sizable $1.9 trillion, around 20% of all Agency MBS outstanding. By purchasing large quantities of Agency MBS, the Fed encourages mortgage lending by increasing the resale value of mortgage loans. Mortgage lenders usually sell the mortgage loans they originate to investors, who hold them through Agency MBS. When prices for Agency MBS are high, mortgage lenders are incentivized to increase lending, even at lower interest rates, because they can resell the loans at higher prices to Agency MBS investors. ([Location 1667](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1667)) - Tags: [[blue]] - The Fed has been the single largest buyer of Treasuries since the beginning of quantitative easing in 2008. The stated purpose of the purchases was to stimulate the economy by lowering medium- and longer-dated Treasury yields, which the Fed otherwise did not have much control over. Since all assets are in part priced off of Treasury yields, lowering these yields leads to lower mortgage rates, auto rates, commercial loan rates, etc. As of September 2020, the Fed has increased its share of the Treasury market to 20%. This clearly exerts downward pressure on Treasury yields, but likely still leaves room for price discovery. ([Location 1736](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1736)) - Tags: [[blue]] - The Fed was established in an era where commercial banks were the dominant players in the financial system, so its attention was naturally focused on the commercial banking sector. The Fed regulates domestic commercial banks to ensure they are prudently run and offers them emergency loans through the discount window to meet unexpected liquidity needs. However, the growth of shadow banks and offshore banking meant that a significant amount of financial activity now takes place outside of the Fed’s purview. ([Location 1750](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1750)) - Tags: [[blue]] - The Fed ultimately decided to lend to foreign banks by establishing central bank swap lines with a roster of friendly foreign central banks. The Fed would lend dollars to a foreign central bank, who in turn would lend to the banks within their jurisdiction. The swap lines solved the global dollar bank run, but they also essentially made the Fed the backer of the global dollar system, both within and outside of the U.S. ([Location 1773](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1773)) - Tags: [[blue]] - In March and April of 2020, the Fed announced new facilities that were targeted at lending to small businesses through commercial banks and larger businesses through the capital markets.68 The Primary and Secondary Corporate Facilities would buy corporate bonds in the primary and secondary market, while the Main Street Lending Facility offered to buy eligible loans that commercial banks had made to small businesses. The Fed had firmly stepped beyond its traditional role of offering liquidity to commercial banks, to offering liquidity to virtually all of America’s businesses. They had democratized access to their balance sheet to virtually everyone but individuals. ([Location 1792](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1792)) - Tags: [[blue]] - Negative interest rates appear to have a negative impact on bank profitability. Negative interest rates are implemented on central bank reserves, so in aggregate, it reduces the income of the banking sector. It also shifts the entire interest-rate curve lower, so loans earn less interest. Notably, European banks have been suffering declining stock prices for over ten years, while U.S. banks have been able to exceed their 2008 highs. The negative impact on the banking sector is one of the reasons U.S. policy makers are hesitant to implement negative rates. A healthy banking sector is needed to create loans that fund economic growth. ([Location 1869](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1869)) - Tags: [[blue]] - However, low or negative short-term interest rates can have tremendous impact on financial assets. This is because many speculators buy financial assets using very short-term loans. When the Fed lowers overnight rates by 1%, that fully flows through to overnight repo rates and stock market margin interest rates. ([Location 1874](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1874)) - Tags: [[blue]] - Judging from a decade of experience, lower interest rates appear to boost financial assets, but not necessarily real economic growth. ([Location 1879](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=1879)) - Tags: [[blue]] - A couple noteworthy Fed outlets are the New York Fed’s Liberty Street Economics blog and the Board of Governor’s FEDS Notes section. In addition, the Board of Governors’ semiannual Financial Stability Report is an excellent and accessible publication that provides a good overview of the state of the financial system based on the data the Fed has collected. ([Location 2065](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=2065)) - Tags: [[blue]] - On August 27, 2020, Chair Powell announced the Fed’s new monetary policy framework at the annual Jackson Hole Economic Policy Symposium.80 The framework made two significant changes to how the Fed conducts monetary policy: average inflation targeting and asymmetry in maximum employment. ([Location 2084](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=2084)) - Tags: [[blue]] - the Fed’s strategy statement previously noted that its policy is informed by “deviations from [employment’s] maximum level.” That meant that the policy rate could be raised when employment exceeded its maximum level and could be lowered when employment was below its maximum level. In its new strategy statement, the Fed now notes its policy would be informed by “assessments of the shortfalls of employment from its maximum level.” This means that employment higher than the Fed’s estimated maximum level would not encourage the Fed the raise its policy rate. ([Location 2088](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=2088)) - The Phillips curve is a concept in economics that links the unemployment rate with inflation, where a lower unemployment rate would generate higher inflation. Specifically, inflation would rise when the economy exceeded its maximum employment. However, in recent years, the link between unemployment and inflation seems to have significantly weakened. ([Location 2093](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=2093)) - the Fed is now saying that a low unemployment rate (high levels of employment) will no longer factor into its decision in tightening monetary policy. ([Location 2099](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=2099)) - The Fed has officially adopted an average inflation targeting framework where past undershoots of its inflation target would be met with future overshoots, such that the average inflation over a period of time would be around 2%. This opens the door to the Fed allowing persistent prints of inflation over 2%, which would not have been allowed under the prior framework. ([Location 2103](https://readwise.io/to_kindle?action=open&asin=B08TV1MP8C&location=2103))