Treadmill Effect and MZM
Jude Wanniski
April 11, 2005


From: Jude Wanniski  <        
To:      Ben.S.Bernanke@ * * * * *.GOV                                               
Subject: Treadmill Effect & MZM
9:19 am, 4/11/2005

Dear Ben:

This is an added note to our exchange from my colleague Paul Hoffmeister, after I sent him our exchange last night. He covers two points, elaborating on the "treadmill" effect and explaining why MZM is a better proxy for money demand than money supply.  



From: "Paul Hoffmeister" <>
To: "Jude Wanniski" <>
Subject: Treadmill Effect & MZM
Date: Mon, 11 Apr 2005 09:42:29 -0400

If I could just add two thoughts to the Bernanke exchange.

Bernanke did not refute our "treadmill effect" concept.  I think this is important.  It seems like FOMC members are well aware of this phenomenon. First, the November 2004 FOMC minutes show that the Manager of the Open Market Desk explained to the Board pressures on the funds rate around the  time of interest rate increases caused by increased demands for reserves.
This is what the minutes reported:

"The Manager also discussed the pressures on the federal funds rate prior to, and volatility in the rate that has ensued at times after, recent FOMC meetings as depository institutions sought to satisfy a larger portion of their reserve requirements before anticipated increases in the FOMC’s target funds rate. The Committee agreed that the Desk would continue to conduct
open market operations as it has in such situations--leaning against anticipatory pressures in the funds market while taking account of the reserve management implications of such operations for the remainder of the reserve maintenance period."

Moreover, the 2004 annual report of the NY Fed's Open Market Desk plainly describes the treadmill effect:

"Higher levels of excess balances held early in the period were also likely attributable to the series of widely anticipated increases in the federal funds target rate in the middle of the maintenance period.  Overnight rates firmed and banks held higher-than-typical levels of balances in the days ahead of each expected target rate increase, evidencing banks' increased demand for balances ahead of the target rate changes...."

Take a look at this interesting note a NY Fed offical sent me in response to my question about the rush for reserves during the time of an anticipated rate hike:

"By buying funds early in the maintenance period, prior to a highly anticipated rate hike, [banks] will be purchasing funds at a rate cheaper than the cost after the rate increase. For example, if the current target is 2.25% and rates are expected to move up 25 basis points to 2.50% next week, it will be cheaper to buy my reserves (and maybe some extra) this week at 2.25%.   Then next week when rates have moved to 2.50% I will either not have to pay the higher rate to fund myself (because I already funded my position for the maintenance period) or I can sell my excess reserves to other banks at the new higher rate (2.50%) and make a profit of 25 basis points."

(It seems as though banks can make a handsome 25-basis point profit by accumulating excess reserves and loaning them out to other banks.  This is more food for thought on the treadmill phenomenon.)

Additionally, using MZM to describe money demand will probably be difficult for Bernanke to accept.  In fact, most people use MZM as an indicator of money supply.  MZM comprises all monetary instruments that have zero maturity and are therefore redeemable at par on demand.  Included in MZM are currency, demand deposits, traveler's checks, savings deposits, and other money market accounts.  MZM includes all types of financial instruments that can be easily converted into dollar liquidity without penalty or risk of capital loss, ie it is a very close proxy of illiquid money (except for its currency component because it is already liquid).  Importantly, this financial statistic measuring illiquid money is inversely related to gold. When inflation increases, MZM declines, and vice-versa.  This relationship represents the preference for liquidity; that is why MZM is a better signal of money demand, than money supply.