June 29, 2021 | First we give kudos to Dr. Lawrence Summers in this edition of The Institutional Risk Analyst. He correctly called out Federal Reserve Chairman Jerome Powell for the growing contradictions in US monetary policy. But even Summers, who famously commented on the difference between insiders and outsiders in the world of public policy, is still behind the curve when it comes to monetary policy.
Simply, even smart guys like Larry Summers reflect the outsider narrative, a description that holds that the Federal Open Market Committee is just thinking about changing policy in the future. In fact, the FOMC has been shifting policy for months, but this reality is not yet palatable to the public narrative on monetary policy that one finds in the media mainstream.
Powell himself called the change a "tweak" when, in fact, it constituted an explicit bailout for money market funds. "Investors stashed a record amount of cash in an overnight facility at the Federal Reserve on Thursday," reported Colby Smith in the FT last week, "after the central bank started paying interest on the money to prevent negative rates taking hold in parts of the US financial markets."
Dr. George Selgin of Cato Institute put it succinctly last week:
“Despite having switched to a ‘floor’ operating regime in October 2008 (and permanently in January 2019), and thereby all but ending interbank lending on the fed funds market, the Fed continued to maintain the pretense of ‘targeting’ the fed funds rate. But in reality, it no longer used open-market operations to keep a freely-fluctuating interbank funds rate close to its targeted value.”
“Instead, [the FOMC] adjusted its policy stance by altering the interest rate it paid on bank reserves (IOR rate),” continues Dr. Selgin. “Lending on the fed funds market didn't cease altogether only because some GSEs w/ Fed balances aren't eligible for IOR. So, they lent their balances to banks for a share of the banks' IOR earnings. The fed funds market became nothing more than a locus for such arbitrage.”
Our version of George’s outstanding graphic from FRED is below. As the chart illustrates, the Federal Reserve Board hiked interest rates on IOR and RRPs last week.
Years ago, we coined the term “managed stability” to describe the Fed’s control over the largest money center banks operating in Latin America, a less than distinguished group led by the predecessor of Citigroup (NYSE:C). For many years, the Fed and other regulators kept these banks on de facto life support, all the while pretending all was well.
In the intervening years, the FOMC has rejected the guidance of Congress in the 1978 Humphrey Hawkins law, guidance that explicitly commands the central bank to focus on private sector solutions to the problems of growth and full employment. Instead, the central bank has followed the political fashion, skewing ever more interventionist and socialist in its policies. Today, for example, a target of 2% inflation is equated with price stability.
In the search for a perfectly managed market, the chairs and members of the FOMC have borrowed the bad example of Europe and approved a creeping nationalization of the short-term money markets. The level of federal funds has become a polite irrelevancy in 2021, yet the keepers of the conventional narrative pretend that there is still a private market for overnight unsecured lending between banks.
In fact, like the money center banks of old, today money market funds are now wards of the state. Killing LIBOR, seen in this light, was a necessary condition for achieving “managed stability” in the US capital markets. Why bother investigating the role of money market funds in the market volatility of March 2020? The Fed has already made its decision to bail them out without consulting President Biden or the Financial Stability Oversight Council.
More than merely taking over the private market, the Federal Reserve Board has also supplanted the FOMC in terms of making US monetary policy. While the FOMC sets the level of asset purchases for the system open market account (SOMA), the Fed’s seven seat Board of Governors sets the level of IOR and RRPs. Again, Dr. Selgin explicates:
“[The set-up allows the Fed to maintain the fiction that the FOMC, which sets the target range limits, is regulating the stance of monetary policy, as the Federal Reserve Act requires it to do, when in fact... [I]t is the Federal Reserve Board, which sets the IOR and ON-RRP rates, that's really calling the shots, albeit with the FOMC supplying its rubber stamp and (supposedly) making the actual decisions.”
Having now changed the emphasis of monetary policy from excessive ease to a more muddled form of schizophrenia, investors are left to ponder the next thing. The Fed is still buying Treasury debt, mortgage-backed securities and forward positions in agency securities known as “TBAs,” on the one hand, but taking hundreds of billions in cash out of the markets via RRPs.
What is the net, net market position of the Fed? Nobody inside or outside the pretty building on Constitution Avenue has the faintest idea. As funds flow out of the Treasury General Account into banks, the Fed is desperately trying to reduce the amount of cash in the US banking system with RRPs. Meanwhile, money market funds are now lending hundreds of billions daily to the Fed, which the central bank uses to fund ever more QE.
With each purchase of T-bills and MBS via QE, the Fed is adding to the surfeit of liquidity but not actually encouraging banks to lend. This is one of the most interesting and least noticed aspects of US monetary policy. The Fed is paying lip service to fostering growth and full employment, but its actual policy seems to be retarding credit creation within the US banking system even as it acts to prop-up money market funds.
Meanwhile, outside of the largest US banks, the markets have run riot, with the Fed’s liquidity fueling an asset bubble of historic proportions. The year 2021 is already looking to set another record in initial public offerings. Add the fact of higher rates and perhaps even wider spreads, and financials take on a far more positive outlook. The basis trade has moved a lot in recent weeks on precisely this promise, suggesting banks, REITs and funds may get further relief from QE.
The only issue is the fragility of the narrative around Fed policy, a significant issue that relates directly to confidence. The Fed somehow pretends they can manage an increasingly unsteady policy construct of asset purchases and short-term sales via RRPs. The hope is that taper of MBS can be accomplished without further bad PR about the Fed boosting home prices and killing affordability.
But the bigger issue is that shifting QE to Treasury notes and bonds means that the current Fed balance sheet is now the new normal, more or less $7-8 trillion. That suggests that the level of inflation seen in housing and other assets over the past several years is unlikely to be transient and may represent the new floor for the eventual maxi correction several years out. So when you hear people talking about the Fed tapering QE next year, you know they are behind the proverbial yield curve.