Last week's volatility in the market for fed funds gave a lot of equity managers an opportunity to brush up on their understanding of the workings of the short-term money markets. The Fed of New York was forced to offer cash to the Street in the form of forward repurchase agreements all week. These activities are likely to continue.
Nathan Tankus posted a good discussion of the mechanics of adjusting bank reserves on Twitter last week. He particularly highlights not only the Liquidity Coverage Ratio or LCR, but also the additional liquidity stash meant to fund a resolution of an insolvent money center bank.
Given that we would never actually resolve a bank over $100 billion assets, we wonder why this rule exists: What is the point of the “resolution liquidity” for a G-SIB if we’re likely to just put the bank into an FDIC conservatorship a la Indy Mac and then sell it after a bad asset cleanup?
We appreciate the kudos on our call this past July on CNBC regarding liquidity problems in the markets, but we erred in thinking that merely ending the runoff of the Fed’s portfolio was sufficient. When our colleagues who trade TBA, and agency and whole loan repo, saw cash tightening up in the middle of August, that was a sign that problems lay ahead. Even with the Fed’s operations, the repo market is still displaying a lack of liquidity.
A lot of people asked: what is going on? The best primer we can suggest is the 2018 book “Floored” by Dr. George Selgin of Cato Institute, who has been producing excellent research focused on the mechanics of monetary policy for years. Selgin describes “How a Misguided Fed Experiment Deepened and Prolonged the Great Recession.”
By deciding to target the Fed Funds rate after Congress amended the central bank’s mandate in 1977, the Federal Open Market Committee essentially nationalized what had been a free market rate. Since then, whenever the FOMC wanted to adopt a looser stance to achieve the inflation and/or employment mandates set by Congress, it would lower the target for Fed funds.
Here’s the problem. Who gave the FOMC the authority to essentially intervene in or “target” the private market for fed funds on a permanent basis? As Selgin notes:
“It is important to note that the federal funds rate, whose value the FOMC endeavors to control, is a private-market rate. Its level, like those of other market-determined, interest rates, depends on the interaction of supply and demand – specifically the supply and demand for the reserve balances at the Fed, a.k.a. ‘federal funds.’”
Tankus notes in his 20-part discussion of reserve mechanics that “Basel 3 has imposed liquidity requirements that encourage hoarding and discourage buying treasuries. The Federal Reserve is still behind the curve at becoming Dealer of Last Resort.” Ditto. And Selgin argues that paying interest on excess reserves held at the Fed has created some decidedly unanticipated consequences.
To understand why the Fed's cash adding operations seen last week are likely to continue, read David Andolfatto of the Federal Reserve Bank of St. Louis and Jane Ihrig of the Federal Reserve Board of Governors: “Why the Fed Should Create a Standing Repo Facility.” They focus on how the FOMC’s use of increased or “excess” reserves that banks deposit at the Fed have distorted the money markets. They write:
“Even though balance sheet normalization is well underway, we think it is never too late to introduce a repo facility. The FOMC would learn over time whether the facility is working to reduce the demand for reserves. The FOMC could do so, for example, by permitting reserves to run off organically with the growth of currency in circulation while remaining confident that interest rate control would be maintained through the repo facility.”
The authors essentially argue that by making a market in Treasury and agency securities (at least GNMA and Federal Home Loan Bank issues) via a standing repo facility, the FOMC can encourage banks to meet their reserve requirements by holding securities instead of reserves.
They also suggest that a permanent repo facility would allow the FOMC to continue to shrink the system open market account portfolio. And they suggest another not insignificant benefit of encouraging banks to treat Treasury securities as equivalent to reserves:
“Finally, apart from being consistent with the 2014 Policy Normalization Principles and Plans, a repo facility would minimize the politically bad optics of the Fed paying interest on reserves (of which a large share goes to foreign banks). It seems both wise and proper to let the Treasury directly bear the interest expense associated with the regulatory demand for [high quality liquid assets] HQLA.”
The question of how much monetary policy intrudes into private markets, including the fiscal operations of the Treasury, was raised in an exchange on Twitter last week. Nathan Tankus retorted to a question about the lack of discussion of fiscal operations in monetary policy:
As we learned long ago from Robert Eisenbeis, former head of research at The Federal Reserve Bank of Atlanta, the Treasury and Fed are alter-egos. The Fed is a creature of the Treasury and as such is merely a new layer of leverage added to the US political economy a century ago on the eve of WWI. Since then we’ve added the GSEs and various other government sponsored schemes to lever up the US economy even more. But the key point to us is that when the actions of the Treasury affect the federal funds rate or inflation or employment, how can the FOMC possibly know how to respond? Well, they don’t.
Former Fed Chairman Alan Greenspan told CNBC in 2015 that if all countries don’t tackle fiscal problems, monetary policy will be “become utterly irrelevant.” “The real problem has got nothing to do with monetary policy—although I grant you it’s a crucial issue short term—it’s fiscal policy,” he said. “If we [had] matched up to Simpson-Bowles basic recommendations of a few years ago, we’d be in a much better place now. And we could have a legitimate discussion about monetary policy ... which is a minor consideration relatively speaking.”
Here are some other responses we got on the question we posed: Is fiscal policy “irrelevant” to monetary policy?
- David Kotok, Chairman of Cumberland Advisors:
“Yes. Yes. And yes it is.
"Old days. Central bank supplied required bank reserves and currency. That was liability side of central bank balance sheet. Asset side of US treasury holdings were determined by the liability side.
"New days. Fed is an arm of fiscal finance, remits spread to the Treasury. Asset side permanently larger and liability side multidimensional use."
- Michael Pento, President of Pento Portfolio Strategies:
“This is an easy question to answer; profligate fiscal policies tend towards promoting loose monetary policies in order to augment demand for government bonds and ensure state borrowing costs remain tractable.”
- Mike Fratantoni, Chief Economist at the Mortgage Bankers Association:
“It is certainly not irrelevant. The Fed is charged with keeping the economy at full employment while maintaining price stability and financial stability. They need to be aware of how different fiscal actions could impact the economy and their ability to reach these goals. The difficult balance is knowing when to speak out about their views on the consequences of fiscal policy actions with respect to their goals, without getting entangled in the necessarily political choices that many fiscal policy actions entail.”
- Robert Brusca, Chief Economist FAO Economics NYC:
"No fiscal policy is never irrelevant. But no one is trying to make them work together either. So it is easy to see how some might think fiscal policy is irrelevant. In the 1980s Volcker held up a rate cut telling Congress it had to pass a bill to contain the deficit before he would cut rates.
"Janet Yellen and her Fed went ahead with a program of rate hikes in part because it saw the Trump tax cuts and fiscal policy as too expansive at a time the economy had 'few idle resources' that did not turn out well as the Fed over tightened and is currently in the process of rescinding its excessive rate hikes.
"The main 'problems' with fiscal policy is that it is too tempting. Keynes' Idea was to use it as a counter-cyclical tool- on then off. But once governments start using fiscal policy for economic expansion they just can't control themselves - fiscal policy is the opiate of.the elected."
We think the key point is that the changes in the mechanisms used by the Fed that Selgin describes so nicely in “Floored” have, in turn, had a profound impact on the dealer community and their willingness to take risk. The volatility introduced into the market for reserve assets is not helpful either.
More, the HQLA and “resolution liquidity” that the largest banks are required to hold has also had the effect of tightening liquidity in the short-term markets. Banks, after all, are the largest cash providers to the repo market, that is typically populated by smaller dealers. These same dealers make markets in Treasury and agency securities, and provide financing to the non-bank sector.
So now we fix the problem largely caused by the Bernanke and Yellen FOMCs, Dodd-Frank and Basel III, by increasing the government’s control over the once private market for federal funds. The report by Andolfatto and Ihrig provides a road map for how the FOMC is likely to deal with the liquidity crisis in the short-term money markets, both immediately and in terms of addressing some of the structural flaws in Fed policy illustrated by Selgin in his book. The once private market for fed funds will now be truly "federal" going forward.
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.