The Fed Talks Money, But They Really Want Debt
Only a few months after the NASDAQ spiked to its all-time high in March 2000, the 3-month T-bill was trading just above 6%. It would only remain there for a short time as the impending dot-com bust was beginning to filter into the real economy through business investment. While consumers barely noticed the recession in 2001, the Federal Reserve did. Just seventeen months later the 3-month T-bill was yielding below 1.7%.
It was a breathtaking move in a very confined chronology. Sure, there was a very mild recession with the September 11 atrocity coming at the end of it, but such a low rate was cause for some concern within and without policy circles. The Fed itself was forced to defend its actions through communication and whispers of deflation. The dot-com bust threatened, so this thinking went, the assumed fragility of the consumer sector that had become rather indebted during the height of the go-go 90's. Debt and sharply declining asset prices exhumed the remnants of Fisher's paradox.
The means through which this change in rate regime was accomplished was the Federal funds target. In the relatively new experience of targeting the Federal funds rate, the 3-month T-bill usually traded just inside of that target. So where the Federal funds target was boosted by 50 basis points to 6.5% at the May 2000 FOMC meeting, the 3-month T-bill naturally followed.
The reason for this small spread under the fed funds rate is the simple trade-off banks make in allocating their short-term "money" resources, i.e., excess "reserves". They can lend them out to other banks in either New York (federal funds) or London (eurodollars), through their foreign subsidiaries, or they can lend to the US federal government. Since the federal funds and eurodollar markets are unsecured forms of lending, it makes sense that there would be a discount in T-bill rates to the target, considering US government obligations are considered "risk-free".
In that respect, then, the close connection between T-bills, fed funds and LIBOR is all about marginal trade-offs between largely "risk-free" markets for "reserves". This movement of "money" and the potential for arbitrage among them kept the rates in very close proximity. That indicated a closely connected, almost seamless transit conduit for US dollars globally - particularly as excess became excessive.
The seamless operation changed, all of a sudden, in March 2008. There had always been very short-term spikes or drops in say LIBOR compared to the Fed funds target, but the Monday after Bear Stearns failed there opened a "London premium" in eurodollars where none had durably existed before. The spread indicated a fragmentation effect, where US dollars were suddenly slightly more expensive in London than New York.
The premium for eurodollars was largely stable but noticeable until Lehman Brothers. In the days immediately following Lehman's demise, LIBOR and the effective Fed funds rate (the rate banks actually trade at, which is supposed to conform to the target set by the FOMC) spiked well above target, with the London premium remaining. But after a few days, where LIBOR continued to skyrocket, the effective Fed funds rate settled well-below target. That meant massive fragmentation - over-abundance of US dollars in New York; a dearth in London.
Both were huge problems for the markets to digest, the London dollar desert moreso for global banks. The surplus of Fed funds was much more of a problem for the Fed as it grappled with a much more convincing (at least compared to 2000-01) probability for the dreaded deflation. I have mentioned before the various emergency operations that were undertaken ostensibly to drain the system of reserves during the market panic.
What the Fed was actually trying to do, if one were to think about the global dollar pipeline, was to create a bypass through its own balance sheet to draw dollars out of New York and back into London. Interest rates alone were not enough; the huge run up in LIBOR did not entice more reserves to be placed in eurodollars, or at least not nearly enough to end the fire sales global banks were using to raise US dollar liquidity.
In the Eurosystem of monetary mechanics, where the European Central Bank (ECB) sits in the middle of National Central Bank (NCB) exchanges, the arrangement is quite a bit different. The ECB sets the target for monetary policy and lets the NCB's actually carry out the operations (for the most part). But unlike the Fed, the ECB is not targeting just one rate - it actually has three.
The three rates together form a rate corridor through which banks can form these wholesale or excess reserve trade-offs. Without getting too far into the details, the ECB effectively establishes a ceiling and floor for short-term interbank "money". At the floor is the "deposit facility"; an account for banks at their NCB's that pays interest set by the ECB where it wants this policy floor.
The relevant unsecured interbank lending rate is Eonia, the equivalent to the effective Fed funds rate; it is the rate at which global banks will lend euros overnight to each other. If there is a surplus of funds available, depressing Eonia out of its normal position around the midpoint of the corridor (hugging the MRO, the third of the ECB rate targets), it will only trade as low as the deposit floor. If Eonia falls to an equivalence or near-equivalence to the deposit rate, banks then have the arbitrage option to park excess reserves with the central bank rather than place them in the wholesale euro market. Since wholesale money contains some risk, particularly unsecured, the excess of reserves is "absorbed" by the deposit accounts as banks opt for "lending" to their central bank rather than other banks, and Eonia stays within its defined corridor.
At several points during the 2008 panic, and for nearly the entire time since, Eonia has traded at the deposit rate floor rather than its typical place at a slight premium to the MRO at the corridor midpoint. Like the Fed funds rate that traded well-below target, it indicates drastic fragmentation in euros - fragmentation that remains to this day.
Setting that euro-denominated complication aside for a moment, the Fed on October 6, 2008, right at the height of fire-sale, US dollar-London panic, moved forward statutory authority to pay interest on excess and required bank reserves. The Financial Services Regulatory Relief Act of 2006 authorized the Fed to pay interest on reserves beginning on October 1, 2011, but the Fed was eager and desperate to get the federal funds rate to its target. Since sometime in the 1980's, monetary policy changed from "money" to psychology, and thus the only important measure of policy was maintaining that Fed funds target - too low was just as bad for this policy as too high.
The Interest On Reserves (IOR, sometimes denoted IOER for Interest on Excess Reserves) was essentially an effort to recreate the Eurosystem rate corridor in the domestic dollar wholesale system (it would not translate directly to eurodollars); at least the lower portion of the corridor. The IOR would function largely as the deposit facility does in Europe, establishing a floor for the Fed funds rate as "excess" excess reserves would be parked at the Fed instead of inside the Fed funds market.
That was explicitly stated in the press release accompanying the initial IOR announcement,
"Paying interest on excess balances should help to establish a lower bound on the federal funds rate. The formula for the interest rate on excess balances may be adjusted subsequently in light of experience and evolving market conditions. The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System's macroeconomic objectives of maximum employment and price stability."
It has never worked as intended, though it remains to this day. The effective federal funds rate has never traded above the IOR rate once it was set to 25 basis points. What was supposed to be a rate floor akin to European operations has instead been a very durable rate ceiling.
The US complications reside in non-banks, such as GSE's and money market funds. Because of this functional difference and how they are treated by official favor, banks connected to the Fed and its IOR borrowed from non-banks at the federal funds rate and then deposited those funds at the Fed to obtain the IOR interest. As long as the fed funds effective rate remains below the IOR this risk-free rent remains in place. In other words, the banking system through the IOR process is removing liquidity from non-banks in order to make excess reserves further inoperable to the wider system - these larger banks get paid to make liquidity less effective.
If the federal funds rate pushed up toward IOR (and it has on a few occasions, but never above), the banks stop scalping these excess reserves from non-banks since the spread gets too small, in turn pushing the effective Fed funds rate back lower. However, these larger banks never lend into federal funds since it makes no sense to take on unsecured risk when the Fed's IOR account is readily available. The IOR ceiling proves irresistible.
QE, then, offers a complication to that process that does no further good toward effective liquidity. In "buying" government bonds or MBS from the "market", the Fed is injecting excess "cash" while segregating usable collateral onto its balance sheet. From the non-bank perspective, that cash is simply lent back into the fed funds market below the IOR to be scalped by the larger banks. Or, they can purchase short-term government debt at inflated prices, and "cash" ends up in largely the same place. Those larger banks that participate in "selling" bonds in QE, end up simply placing funds in the IOR account anyway.
Regardless of the pathway, excess "money" ends up idle. That is why the IOR has provided a durable ceiling to the Fed funds market instead of imposing the floor part of the expected corridor. But that's not the end to the complications.
The US government, for various and sundry ideological reasons, has been running a massive deficit since the last year of the Bush administration (TARP was expensive). That works in this IOR system as a removal of excess reserves since, from the non-bank perspective, a purchase at auction would debit the non-bank account of reserves at a commercial bank and credit the US Treasury account at the Fed. That US Treasury account is a "factor absorbing reserves", meaning it depletes the system's reserve balance.
On balance, that would mean less idle reserves and more usable collateral to repo into effective liquidity (and perhaps even risk taking). So where the US Treasury's deficit may actually be net-positive for systemic liquidity (without making any value judgment as to whether that is a desired result), QE does the exact opposite - more dependence on below-market fed funds and handicaps for non-banks, more "free scalp money" for banks, and all tied to less collateral in the system.
So the natural question to raise is whether eliminating the IOR will reduce this idleness/liquidity drain. It would be certainly a step too far to suggest an end to QE, given the preference of FOMC policymakers toward psychology over liquidity. But eliminating the IOR would, potentially, create massively negative short-term rates. Without the risk-free option of interest at an account at the Fed, the reserves become an asset in need of an "investment" by banks. The cumulative flood of such needs would push down everything from repo rates to T-bills to the effective fed funds and probably short LIBOR and swaps as banks would search in every wholesale corner for a low-risk substitute.
Negative interest rates are, in the view of the monetary mainstream, deflationary to the highest degree - voluntary capital destruction. So in this unbelievably convoluted mechanism, the IOR is actually instituting a floor of sorts on US interest rates, just not where the Fed expected. By maintaining this fragmentation between banks and non-banks, it opens that scalp/rent/arbitrage opportunity that at least keeps the Fed funds rate on this side of zero.
Back on the other side of the Atlantic, the European deposit floor's attraction to Eonia is simply an indication that the big "core" banks refuse to lend wholesale to anyone other than themselves. The "peripheral" banks find themselves unable to finance their books outside the Eurosystem and its various NCB and ECB financing windows (such as the LTRO's). So very much like the non-bank/bank divide in the US, there is a durable fragmentation of liquidity in Europe. In both systems, this extends into collateral and repo since central bank activities have played havoc with collateral supply and rehypothecation potential in both jurisdictions.
There is no money in any of this, at least nothing that can be plausibly or effectively used by real economy participants. As much as QE is sold and believed to be an increase in the usable money stock, and thus play up the public's expectations for inflation, there is no such practical outcome in any of these systems as I have outlined here. Excess reserves and the Fed's own balance sheet increase in an accounting sense, but so what?
It is all designed to fool the American public, and the dollar system globally, into believing in the inflation fairy that will supposedly fix all our economic ills. At its very basic level, modern monetary policy still holds the equation of exchange near to its heart. Increase M and either P or Q follows (they hope more Q than P, but at this point policymakers will take as much P). It just doesn't work that way as everything important (including everything I just described) takes place mysteriously inside V.
Milton Friedman's helicopter allegory is out of date in this monetary system. If the Fed were to get past all of this interbank, wholesale scalping nonsense and fragmentation, it would still be too dissimilar to Friedman's hypothesis for one all-important reason - credit money is not the same as money.
What the modern Fed does is cajole credit into creation, not currency or usable dollars. Money supply has nothing to do with money anymore, and everything to do with bank supply. Policymakers even talk as if debt were equivalent to the economy; raising credit levels is the same as raising "aggregate demand". If the Fed can "persuade" enough businesses and individuals to further indebt themselves it will have been successful by its own standards, and that is certainly different than what Milton Friedman suggested (not that I particularly agree with the helicopter, but it illustrates this functional difference well).
If I give you ten thousand dollars in currency right now you will behave far differently than if I gave you that currency attached to a durable debt instrument calling for its future repayment. In truth, given certain sets of conditions, people may even reject such "free money", even if the interest rate is set close to zero. In fact, banks and non-banks may even reject such "free money" as it becomes an obligation that is not easily remedied in an artificially depressed environment. Even some governments become sensible to such boundaries, though they surely vary in those degrees of sensibility relating to their ability to monetize or be subsidized.
This appeal to debt has not only made a mockery of money, it has made money itself largely irrelevant to the functioning of the system. The domestic banking system rejects currency in favor of collateral, but the Fed insists on the opposite to foster its silly game of expectations management. The more the Fed tries to control the economic contours of the financial relationship to the "market" system, the less relevant "money" becomes.
If current expectations are correct, Q2 2013 will mark the third consecutive quarter of sub-2% GDP growth. Given the dependence on trend-cycle analysis to estimate GDP and other economic accounts, it is very likely, in my opinion, that such "unexpected" weak growth will actually get revised lower whenever the NBER eventually decides to declare its intentions. So all this QE and repulsive financialisms amount to what? Record and divergent stock prices attached to bond and housing bubbles in nearly full revulsion. In short, instability abounds, again.
The Fed talks about money, but money is nowhere to be found in the messes of these centralized tendencies. It's debt they want, and they will confound even their own financialism to get it.
