• Bull.




EDITOR'S NOTE: This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.

The Fed Is the Authority On "Financial Stability"? LOL - z Fed  Haven t a clue  cartoon 07.13.2016  4

The Fed just released its Financial Stability Report, here. I find it ironic that the institution that:

  1. Missed all of the warning signs leading up to the financial crisis
  2. Started a massive bond buying program, commonly known as quantitative easing (QE), just three months before the 2007-2009 recession ended
  3. For some completely mysterious reason kept its interest rate target at zero for more than 6.5 years into the economic expansion and
  4. Was slow to recognize that a serious inflation was underway, has become the nation’s authority on financial stability

Correct me if I’m wrong, but I don’t believe that the Fed has ever anticipated a financial crisis.

I believe the best things the Fed can do to promote financial stability are: a) stop trying to interfere with the market by buying large quantities of Treasuries, MBS, agency debt, and corporate and municipal debt, and b) stop setting a target for an interest rate that is determined in the nearly defunct and now essentially useless federal funds market that only banks and a few other institutions can participate in.

Because of these actions, market participants and the public at large hang onto every new pronouncement from the Fed about its bond buying and federal funds rate target. The media then makes ridiculous statements about how increases in the Fed’s target for the federal funds rate will cause mortgage rates, credit cards rates and long-term bond rate to increase in spite of overwhelming  evidence to the contrary (e.g., see Mortgage Rates, Long-Term Rates 1, Long-Term Rates 2, Long-Term Rates 3, and Event Study Evidence). Doing a) and b) would put an end to all of this nonsense.

Reducing the Fed’s balance sheet to the point where banks’ reserves are determined solely by banks’ need for reserves to carry out their daily operations (remember there are no reserve requirements now). This would enable the Fed to end its policy of paying banks interest for holding the massive quantity of reserves QE created. This policy was adopted in the belief that banks would hold these reserves rather than lend them and, thereby, increase the money supply. I have demonstrated that this policy has been completely ineffective here. Its only accomplishment is to give banks billions for doing nothing.

Furthermore, the Fed would no longer have to conduct operations in reverse repurchase agreements to keep the federal funds rate at or close to its target level.  As of November 2, the Fed held $2.5 trillion of reverse repos.   

Because market participants, the media and the public believe that the Fed’s actions have a huge effect on interest rates and the financial markets generally, the Fed’s actions have increased financial instability rather than reduced it. In any event, financial stability cannot be micro-managed by the Fed, the government or anyone else.

Anyone who thinks otherwise doesn’t understand financial markets.