Tag: finance

Stable Coins

Digitizing our bank deposits (digital dollars—stable coins) would (will) represent another step forward in the ease and efficiency with which we can make payments and will enhance bank stability. Most of the US supply of money (US dollars) is in the form of our dollar deposits at our banks and most of our payments these days are already made by electronically transferring bank deposits from me to you via my bank to yours. I have discussed all of this in more detail earlier: “Econ 101-Money”

Developing the rails for paying with stable coins is a further improvement on our existing payment options. It is not revolutionary. The payment of cash (currency) requires no infrastructure (e.g. Merchant contract with credit card issuer and card reader, etc.). You just hand it over and anyone can accept it (hopefully the person you intended to receive it). The electronic transfer of a bank deposit balance (e.g., Zelle, Venmo, e-wire) requires the enrollment of the recipient in that particular payment vehicle.  It took decades for credit cards to be widely accepted. Hundreds of companies now issue Visa cards (mine is issued by United Airlines) and all are accepted wherever any of them are accepted. But it took a lot of work to build that system.

What do stable coins issued by banks add that might be useful? From the bank side issuing stable coins from deposit balances simplifies the bank’s management of the assets that back them. When its customers withdraw cash these days, the bank must purchase it from the Federal Reserve in order to pass it on to you. It pays the Fed for the cash from its reserve deposits at the Fed, which reduces its ability to extend credit to businesses and households. If its reserves at the Fed are not sufficient, it will need to borrow from another bank or sell another asset.

The withdrawal of cash from bank deposits tends to follow seasonal patters. Thus the squeeze on its reserves at the Fed would tend to create seasonal fluctuations in bank credit hence in the money supply.  Thus the Fed attempts to offset the impact of currency fluctuations on bank reserves and thus credit with offsetting purchases and sales of government securities (so called open market operations) or with temporary loans to banks in its “lender of last resort” function. If a bank can issue its own currency (as they did in the old days) when a customer withdraws cash from its deposits, its asset backing (and reserve deposits at the Fed) will not be affected. Banks will now be able to do this by issuing their own stable coins. While the customer’s deposit balance will fall when withdrawing cash (or stable coins), its total of stable coins “cash” plus deposit balance will not change thus the bank assets backing them do not need to change. Thus, such fluctuations in the currency/deposit ratio would not product a fluctuation in the money supply.

From the customers side the stable coins are as good as traditional cash only to the extent that the infrastructure to accept them (e.g. phone wallets) has been designed and widely acquired/accepted. Just as it took many years for credit cards (Visa, Mastercard and American Express) to be widely adopted, the same will be true with stable coins. Just as you might now swap addresses via your respective mobile phones, you will be able to make payments.

If everyone can issue their own money it degenerates to barter, i.e. it would not be money at all. The essence of a successful means of payment is the certainty of its ultimate claim on the central bank’s official monetary liability (the dollar). When central banks were limited to issuing currency redeemable for “something” such as gold or silver, the amount they issued was limited by their holding of gold or silver, etc.  Today the Fed’s supply of money is limited by Congress’s mandate for price stability and full employment. And ultimately the government must accept such dollars in payment for our tax obligations stated in the same currency.

Econ 101: Interest Rates –Another Go

A month ago I reviewed the role of the Federal Reserve’s policy interest rate: https://wcoats.blog/2025/07/17/the-feds-policy-interest-rate/   The subject is so important and seemingly misunderstand by many that I am reviewing it again here.

Interest rates balance the supply and demand for financial assets. Households and firms that save some of their incomes demand financial assets. Households and firms that borrow to invest in productive capital or for whatever reason supply those assets (mortgages, bonds, etc.). Rates on longer term assets reflect the expected value of the short-term rates over that period. Thus the interest rate on a ten year bond reflects the expected value of one year bills over the ten year period plus a small risk premium because the string of short term loans are an alternative to the single fixed rate ten year loan.

The policy interest rate of the Federal Reserve is set by the Fed to pursue its objective of stable money (defined by the Fed as 2% inflation) and high employment (the Fed’s dual mandate imposed by Congress).

This note reviews the Fed’s policy rate. Since 2008 the Fed’s policy rate has been the rate it pays banks for the money they keep on deposit with a Federal Reserve Bank (of which there are twelve but that is unimportant for understanding the role of the policy rate), which on Aug 6 amounted to $3,332 billion. This rate is known as the Interest on Reserve Balances (IORB).

If the IORB matches comparable market rates for equally liquid funds (the so-called neutral rate), banks will maintain their existing Fed deposits. If it is set above that level, banks will have a financial incentive to place more money with the Fed, i.e. lend less in the market, thus creating fewer deposits and reducing the money supply. If the IORB is set lower than the neutral rate, banks will draw down their Fed deposits to lend more in the market thus increasing deposits and the money supply.

The IORB is currently (Aug 6) 4.5%, where it has remained since Dec 2024. At this rate broad money (M2=bank demand, time and savings deposits) has grown between 4% and 5% (from a year earlier) over the last three months. Given that inflation remains above the Fed’s target of 2% it would not seem wise to lower the policy rate and increase the rate of monetary growth especially as higher tariffs go into effect.

To repeat from earlier blogs (because it is so important), if markets anticipate higher inflation in the future (next few years), market interest rates on longer term debt will increase to preserve their real (inflation adjusted) value. Lowering the Fed’s policy rate prematurely would increase the market’s anticipation of higher inflation rates in the future. In other word, lowering the IORB now is likely to increase interest rates on longer term debt. Leave the Fed alone to do its job as best it can.

The Fed’s policy interest rate

Among the things our protectionist, isolationist President fails to understand correctly is the role of the Federal Reserve’s policy rate. He wants interest rates to be lower and thinks that the Fed can cause that by lowering its policy rate. That rate used to be the overnight money market rate. If the Fed lowered that target it would supply more money (bank deposits at one of the twelve Federal Reserve Banks) to banks and thus the interbank money market for managing bank liquidity by buying government securities from banks. If banks’ liquidity (“reserves”) is increased, their demand to borrow in the interbank money market will be reduced and thus the interest rate prevailing in that market will be reduced. Thus, raising or lowering the Fed’s policy rate (and the consequent change in base –Fed reserve—money) was the instrument by which the Fed controlled the money supply (its own base money and the more relevant boarder bank money—M1, M2, etc.)

If you are into this subject, you will already understand what money is and where it comes from. If you would like a refresher read this: https://wcoats.blog/2024/11/08/econ-101-money/  

The above description of the policy rate was applicable until 2008 when banks held minimal reserves (or excess reserves when there was still a minimum reserve requirement) at the Fed. But in response to the financial crisis in 2008 when the Fed purchased huge quantities of government debt (and mortgage-backed securities), the Fed began to pay banks interest on their now very large deposits at the Fed to keep them from lending them in the market and thus expanding the money supply excessively. So, the relevant Fed policy rate now is the rate it pays on banks’ reserves at the Fed, the so-called Interest on Reserve Balances (IORB).

As with the policy rate in the old regime, the IORB is the instrument by which the Fed now controls the growth in the money supply. When the IORB is reduced below prevailing overnight market rates banks will draw down their Fed deposits to lend at the higher market rate thus increasing money growth.

Interest rates in the market are determined in and by the supply and demand for credit in the market. If the Fed lowers its IORB it will increase the growth rate of dollars. The Fed will do so when it judges that appropriate for achieving its inflation rate target of 2.0 percent. The twelve-month inflation rate in May was 2.4% and rose to 2.7% in June. The Fed decided not to lower the rate further at this time. Doing so could well lead market participants to expect higher inflation in the future, which would raise (not lower) market rates for say 10 year Treasury bills.

Current Fed policy seems appropriate to me. It adheres to an inflation forecast targeting regime that has become popular in recent years in major central banks. But it reacted by raising rates too slowly in response to the surge in inflation in 2021-2 during the Covid pandemic. Inflation reached 9% in mid 2022. A better system is to return control of the money supply to the public that can buy and redeem dollars at a fixed price for a hard anchor (such as a gold standard). I laid this out in the following blog: https://wcoats.blog/2022/06/06/econ-101-the-value-of-money/