At TSI over the past year and at the TSI Blog two months ago I’ve made the point that the Fed gave itself the ability to pay interest on bank reserves so that the Fed Funds Rate (FFR) could be raised without the need to shrink bank reserves and the economy-wide money supply. I explained that the driver of this change in the Fed’s toolbox was the fact that the massive quantity of reserves injected into the banking system by QE (Quantitative Easing) meant that it would no longer be possible for the Fed to hike the FFR in the traditional way, that is, via the sort of small-scale shrinkage of bank reserves that was used in the past. Instead, the quantity of reserves has become so much larger than would be required to maintain a Funds Rate of only 0.25% that even a tiny increase to 0.50% would necessitate a $1 trillion+ reduction in reserves and money supply, which would crash the stock and bond markets. The purpose of this post is to point out that while the payment of interest on bank reserves is now the Fed’s primary tool for implementing rate hikes, there are two other tools that the Fed will use over the years ahead in its efforts to manipulate short-term US interest rates and distort the economy.

Before going any further I’ll note that it isn’t just logical deduction that led to my conclusion regarding the purpose of interest-rate payments on bank reserves. It happens to be the only conclusion that makes sense, but it’s also the case that the Fed, itself, has never made a secret of why it started paying interest on reserves. The Fed’s reasoning was reiterated in a 27th February speech by Vice Chairman Stanley Fischer. A hat-tip to John Mauldin and Woody Brock for bringing this speech to my attention.

The two other tools that will be used by the Fed to raise the official overnight interest rate are Reverse Repurchase agreements (RRPs) and the Term Deposit Facility (TDF). The RRP isn’t a new tool, but its importance has increased and will continue to do so. The TDF is a relatively new tool, having been introduced on a small scale in 2010 and having been expanded in 2014.

The RRP is used by the Fed to borrow reserves and money for short periods, with securities (bonds, notes or bills) from the Fed’s stash being used as collateral for these borrowings. Now, an institution that has the unlimited ability to create new money can never run short of money and will therefore never need to borrow money to fund its operations, but the Fed sometimes borrows money via RRPs as part of its efforts to manipulate interest rates. Specifically, by offering to pay financial institutions a certain interest rate to borrow reserves and money, the Fed pressures the effective interest rate towards its target.

The TDF is similar to a normal money-market account, except that it is provided by the Fed and can only be used by depository institutions. The term of the deposit is currently up to 21 days and the interest rate paid is slightly above the rate paid on bank reserves.

Further to the above, when the Fed eventually decides to hike the Fed Funds Rate it will not do so by reducing the quantity of bank reserves. The quantity of bank reserves will probably decline as part of the rate-hiking process, but the quantity of reserves in the banking system is now so far above what it needs to be that it is no longer practical for reserve reduction to be the driver of a higher Fed Funds Rate. Instead, when the Fed makes its first rate hike — something that probably won’t happen until at least September-2015 — it will do so by 1) raising the interest rate paid on bank reserves, 2) increasing the amount that it pays to borrow money via Reverse Repurchase agreements, and 3) boosting the rate that it offers to financial institutions for term deposits.

A recent Mineweb article warrants a brief discussion. The article contains several illogical statements, which is not surprising considering the author. For example, this is from the second paragraph: “…the fact remains that any entity with sufficient capital behind it can usually move any market in the direction that suits it…” Large financial institutions and hedge funds undoubtedly wish that this were true, but in the real world these entities ‘come a cropper’ when they take big positions that aren’t fundamentally justified. However, I’ll ignore the other flaws and zoom in on the Ted Butler assertion that constitutes the core of the article. I’m referring to the assertion that banking behemoth JP Morgan (JPM) has managed to accumulate a 350M-oz hoard of physical silver while simultaneously causing the silver price to trend downward via the selling of futures contracts. It’s analysis like this that gives gold and silver bulls a bad name, because anyone with knowledge of how markets work will immediately see that it is complete nonsense.

Selling commodity futures and simultaneously buying the physical commodity cannot cause a downward trend in the commodity price, assuming that the amount sold via the futures market is equivalent to the amount bought in the spot market. Price-wise, the only effect would be to boost the spot price of the commodity relative to the price for delivery at some future time. Selling more via the futures market than is bought in the spot market could temporarily push the price downward, but the operative word here is “temporarily” since every short-sale must subsequently be closed out with a purchase. In any case, I get the impression from the above-linked article that JPM has supposedly managed to bring about a downward trend in the silver price while remaining net ‘flat’. This is not possible.

I don’t know how much physical silver is owned by JPM or what JPM’s net exposure to silver is*, and I couldn’t care less. I certainly see no good reason to comb through documents trying to find the answer because the answer is totally irrelevant to the investment case for silver. The investment case for silver is determined partly by silver’s market value relative to the market values of gold and the industrial metals, and partly by the same macro-economic fundamentals that are important for gold. Right now, silver has reasonable relative value and neutral fundamentals, with the fundamentals looking set to improve during the second half of this year.

I’m ‘long’ physical silver, despite, not because of, the ‘analyses’ of some of the most outspoken silver bulls.

*Neither does Ted Butler nor anyone else who isn’t a senior manager at JPM

At the beginning of last week I wrote that gold and the HUI were coiling, the implication being that a sharp 1-3 week move in one direction or the other would soon begin. There was no way of knowing the direction of the move, although the performance of the HUI/gold ratio relative to its 40-day moving average (MA) suggested that the direction would be up.

There were multiple head fakes last week, with a) gold bullion almost breaking out to the downside last Friday, b) the HUI chopping around near its 50-day MA, and c) the HUI/gold ratio being the only consistent indicator by sustaining its upside breakout. At this stage it looks like the HUI/gold ratio was sending the correct message, because both gold bullion and the HUI closed above the tops of their recent trading ranges on Tuesday 28th April.

The minor upside breakouts in gold-related stuff happened on the day before the Fed is scheduled to issue its next policy statement, which is out of character considering how gold has traded over the past 9 months. As noted in a commentary posted at TSI a few days ago, gold had closed lower over the course of the 5 trading days leading up to each of the past 6 FOMC meetings and would have stretched the negative pre-FOMC sequence to 7 if it had closed below $1201.80 on 28th April. Instead, it rebounded strongly and closed at $1211.50.

My thinking was that if the gold price had fallen over the first 2 trading days of this week it would have set the stage for a significant post-FOMC rebound, because the most likely outcome of this week’s FOMC meeting is a statement with almost no wording changes. No meaningful change to the wording of the Fed’s statement would mean that a June rate hike had effectively been taken off the table, which short-term speculators would undoubtedly view as gold-bullish (it’s actually irrelevant, but short-term moves are being driven by sentiment).

However, it seems that speculators have jumped the gun. As a result, buying in advance of Wednesday’s FOMC statement is now riskier. My guess is that gold and the gold-mining stocks will extend their gains if the Fed signals “no rate hike in June”, but there is now more downside risk associated with an unexpectedly ‘hawkish’ Fed statement.

One of the criticisms of the current monetary system is that the money isn’t backed by anything. However, while there are some big problems with the current system, this criticism isn’t valid. The reason is that money is never backed by anything.

Taking the specific case of the US dollar, the view that the US$ should be backed by something and the related view that the absence of backing implies a major flaw is a hangover from the Gold Standard. Under the Gold Standard that existed in the US prior to the early-1930s, a US dollar represented and was exchangeable into a fixed amount of gold.

The critical point is that under the Gold Standard the US$ wasn’t money; gold was money. The US dollars in circulation were receipts or IOUs that entitled the bearer to a certain amount of gold (money). The dollar itself wasn’t money. At most, it was a “money substitute”.

Today’s paper dollars are not IOUs or receipts. They are not “money substitutes”, they are money proper. Consequently, they do not need to be backed by anything. In fact, if they were backed by something then whatever was doing the backing would be money and the dollar itself would be a money substitute rather than actual money.

The situation isn’t as clear with regard to dollars in bank deposits as it is with regard to paper dollars, as the dollars in bank deposits are backed by the promise of the banking system to convert from electronic to paper on demand. It could therefore be argued that electronic dollars in bank deposits are money substitutes rather than money, although it is reasonable to count them in the money supply because the central bank has the ability to meet any demand for the conversion of electronic dollars into paper dollars.

The fact that today’s money isn’t backed by anything is therefore not the problem. If gold were money then the money also wouldn’t be backed by anything. That’s the nature of money. The problem, instead, is that for something to be GOOD money its supply should be fairly stable and it should be widely perceived to have value outside its role as a medium of exchange. The US dollar and all of today’s official monies fail to meet either of these requirements, whereas cryptocurrencies such as Bitcoin fail to meet the second requirement.