Ideology Drives the Fed, And It Has Nothing To Do With Free Markets

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The Japanese bond market has seen a plethora of fireworks ever since the Bank of Japan stopped announcing intentions and started doing balance sheet expansion. The extreme volatility in Japanese government bond prices indicates both the unprecedented nature of "liquidity" being unleashed and a tremendous amount of uncertainty as to just how it will eventually affect, well, everything.

Those two adjectives, unprecedented and uncertain, are seemingly inseparable as they relate to finance and monetary economics, having been used consistently and constantly ever since August 2007. They seem quaint and tepid now, but the first "emergency" policy measures enacted in the months after the first warnings were unprecedented and caused a great deal of uncertainty.

On March 11, 2008, the Federal Reserve launched the Term Securities Lending Facility (TSLF) to facilitate actual liquidity in the collateral markets (better known as repo). It was a rather unnoticed and under-appreciated program that was crafted and enacted in response to the realization that so much of the collateral that the overall repo market depended on for operational liquidity was increasingly shunned. The size of the acceptable collateral pool shrank as mortgage bond and structured note products became unacceptable to cash owner counterparties throughout the global system. This was as true in European markets as it was within the United States.

The TSLF proposed an answer to that problem by allowing primary dealers (those 20 large banks directly connected to the Federal Reserve through its New York City branch, FRBNY) to swap unusable collateral for what repo counterparties were most in search of - US treasury securities. The terms of the swap were 28 days, with fees set by bids in a single price auction. FRBNY would utilize the idle treasury debt sitting in its SOMA portfolio as a means to increase the collateral pool depth. The primary dealers could then earn a spread on these swapped collateral positions, giving them good incentive to ensure some degree of proper collateral circulation.

By April 2008, just a few weeks after the tragic demise of Bear Stearns, the TSLF had seen about $150 billion in activity. At its height, toward the end of 2008, it was running about $200 billion in collateral swaps. It was more than acceptable to the FOMC since it was essentially just a security-for-security transaction, the overall balance sheet size of the Federal Reserve would not be impacted in the slightest.

From all accounts it was actually effective given its limited scope. In those early days of 2008 as policymakers struggled to handle growing illiquidity, spreads between GC repos and the effective Fed funds rate widened precipitously (and no doubt played a role in Bear Stearns' demise). The reason was simple - less collateral in the usable pool. The TSLF narrowed the spreads and kept a measure of liquidity in the very space where panic was beginning to spread outward.

By December 2008, however, the Fed had moved on to ZIRP, thus bringing the target (and effective) Fed funds rate down to essentially nothing. That narrowed the spread between GC and Fed funds, but not for the same reason as TSLF, and thus the results were different. Because spreads were, in fact, depressed by ZIRP, the TSLF usage fell off to nothing by mid-2009 since fees for using the swap made it relatively expensive.

Instead, around the same time, the Federal Reserve went in a new direction for monetary policy. It would conduct the first real American experiment with QE. While the TSLF was considered unprecedented and uncertain at the time of its launch, it was an order of magnitude or two below QE 1. That fact demonstrates one of the foundations of monetary policy in this current age and philosophical structure.

Ben Bernanke said it best in response to a question at his June 20, 2012, press conference. The Fed Chairman noted how relatively straight-forward central banking in crisis is to him and his global central bank counterparts:

"But our view of the effects of these programs on the economy is that the total stock of outstanding securities in our portfolio is what determines the level of accommodation that the economy is receiving."

For central banks, it is as simple as the "money" supply. While the TSLF was nice and had a functional role, it was just fine-tuning around the preferred central axis of monetary efficacy, the balance sheet expansion. This is particularly true in the age of ZIRP. Once that zero bound (of interest rates) has been reached, the prime directive of monetary policy (low interest rates equal economic stimulus and expansion) can only be carried through these unconventional measures. Something like the TSLF with its security-for-security design does nothing to accomplish the prime directive, so we have seen nothing like it since it officially expired in February 2010.

It is ironic, then, that in the age of giant QE across the globe that central bankers universally decry the "transmission mechanism." The less balance sheet expansions seem to be effective in the real economy (as opposed to stock and asset prices), the larger the impulse toward more balance sheet expansion - to the point that every central bank is doing the same thing at the same time. The level of unprecedented is unprecedented itself, and it leads to volatility and uncertainty.

But even before this current era of unlimited QE and such, there was caution being expressed in some unusual places. I say unusual because institutions like the Bank for International Settlements do not typically depart from orthodoxy. Partly because it has a close working relation with central banks around the globe, but also partly because it shares the same philosophical affinities with those same banks, the BIS is not a place to go for striking criticism of monetary conventions.

In its 82nd Annual Report delivered in March 2012, months before unlimited QE became reality, the BIS noted:

"With nominal interest rates staying as low as they can go and central bank balance sheets continuing to expand, risks are surely building up. To a large extent they are the risks of unintended consequences, and they must be anticipated and managed. These consequences could include the wasteful support of effectively insolvent borrowers and banks - a phenomenon that haunted Japan in the 1990s - and artificially inflated asset prices that generate risks to financial stability down the road."

Apart from the uncouth (in the eyes of conventional economics) assertion that asset prices can ever be "artificial", the idea of unintended consequences is nothing new in terms of either unprecedented central bank actions or even "normal" monetary operations. There is always a cost to every measure, a give and a take. There are no free lunches, even when printing "money".

Going back to that June 2012 press conference, Chairman Bernanke highlighted a specific mechanism for transmission of monetary policy objectives through QE:

"In particular, by acquiring securities in the market and bringing them onto the Fed's balance sheet, we essentially induce investors to move into substitute securities. So, for example, an investor who sells a Treasury security to the Fed may end up buying a corporate bond instead, and so the effect will be to lower corporate bond rates and corporate spreads. Or a bank may, having sold its Treasury securities, may decide to make a loan instead."

What is being described here is the substitution effect, where the Fed takes a "risk-free" asset out of circulation with the purpose of "forcing" investors or banks into more risky assets (how this can actually lead to anything other than artificial pricing is another fertile topic). In his specific example cited above, he makes the direct relationship of a bank that is relieved of treasury securities from its balance sheet to its further inducement into making a loan. The economy wins in that scenario.

But if we back up a few steps, going all the way back to the TSLF, we have to realize that the pool of collateral shrunk in 2007 and 2008, but never really rebounded. Sure, the federal government has borrowed an extra $6 trillion (give or take a few hundred billion) through additional debt and greatly expanding the quantity of treasury securities in existence, but that doesn't change the repo dynamic. Repos need a supply of on-the-run securities to function - debt that has just been auctioned. With that in mind, the only functional level applicable to the collateral pool is the size of the on-the-run marketplace, and that has not much changed; absolutely nowhere near the 60% spike in federal debt.

In a January 2011 Working Paper for the Federal Reserve Bank of New York titled Responses to the Financial Crisis, Treasury Debt, and the Impact on Short-term Money Markets, authors Warren Hrung and Jason Seligman argue that QE has been ineffective in terms of actual liquidity. Through empirical study, the authors argue essentially that QE removes far too much collateral from the repo markets to advance the course of general bank liquidity.

"We find that the TSLF, which was introduced specifically to address stresses in short-term funding markets, was effective in alleviating the dislocations due to the increased demand for Treasury collateral as the crisis progressed...

"However, we find that OMOs by the Federal Reserve (both temporary and permanent) which also impact the level of Treasury collateral, did not alleviate funding market stresses during our sample period. These results also highlight the need to carefully consider the impact of policies beyond their intended target."

Hrung and Seligman further note that the subsequent LSAP's (QE's) reduced interest rates effectively, but did not positively affect liquidity since so much collateral was removed (though I would note that QE 1 was less dramatic since it removed former mortgage bond collateral that was illiquid at the time). From the Fed's perspective, then, the LSAP's achieved their prime directive of reducing interest rates. But the Fed now has to wonder why those low interest rates have seemingly disconnected from the historical relation with a "stimulated" economy and failed to deliver the promised economic robustness. The reason is, as the authors show, unintended consequences, in this narrow case actual liquidity.

Going back to Chairman Bernanke's narrative, from this we can conclude that it is not a direct relationship through the substitution effect - a bank may well sell its bond to the Fed in a QE, but as that removes collateral from the pool there are a number of indirect and unintended effects (from rehypothecation chains to GC spreads to repo specialness) that necessarily obstruct that bank's, or, more precisely, the overall banking system's, reinvestment in a loan. There does not exist in the real markets, contrary to Bernanke's assertion, a direct link between QE and economic "stimulus" through bank credit. Given these very real obstructions, it might be more likely to expect large financial firms to actually avoid making loans in favor of less "rigid" assets like equity futures and corporate synthetic credit positions (perhaps even IG9?).

Instead, QE's reduce the supply of usable collateral in an unintended consequence to what the Fed is trying to accomplish, but repo markets are forced to act in the constraints of this distortion. That spills further into wholesale money markets and feeds back into monetary policy. Markets themselves must respond. The Fed just assumes it has the luxury of ignoring repo; the banking system cannot.

The unintended consequence is a relatively well-known fact of government intervention on the fiscal side, but because the central bank is reflexively believed to be a central part of the market economy it is suspended in this context. Yet, as example after example of distortion records, the Fed and its compatriots are far, far more government than market. The market is separable from the central bank and thus acts on its own and to its own. The central bank only distorts that.

Going back to the commonality through the BIS and all of orthodox economics (including monetarists and Keynesians), there is a curious uniformity in this manner. Despite nomenclature that signifies adherence to markets and capitalism, there are absolutely no appeals to market solutions. In every case, markets are to be upended in favor of government action - either fiscal or monetary.

At the June 2012 press conference, Chairman Bernanke opined that, "Monetary policy by itself is not going to solve our economic problems. We welcome help and support from any other part of the government, from other economic policymakers."

In that BIS Annual Report, it was also noted that, "The extraordinary persistence of loose monetary policy is largely the result of insufficient action by governments in addressing structural problems. Simply put: central banks are being cornered into prolonging monetary stimulus as governments drag their feet and adjustment is delayed."

The only two options available in addressing structural economic problems are fiscal government or monetary government. And where direct government is "dragging its feet", monetary government is there to step in and prolong...something. Everything is controlled and cajoled; markets are discounted and not to be trusted.

To emphasize this point, we need only go back one more time to that June 2012 press conference. In describing one expectation for the prime directive, low interest rates, Bernanke makes another assumed link between cheap credit and real economic fortunes:

"If a firm has a low cost of capital, and we've seen a lot of corporate borrowing in the last couple of years, then they're more likely to expand, to add capital, to add products, and, consequently, they are more likely to hire."

There is again a solid empirical foundation for this narrative expectation as that describes the recent history of rates and corporate actions. Further, he is correct to assert that we have seen a great deal of corporate borrowing (while leaving out the fact that this is largely contained in larger businesses), but these large corporate businesses haven't responded as they have in recent history or as Fed policy has expected. Instead, corporate business has been more likely to invest funds overseas or return them to shareholders through increasing dividends and stock repurchases. The former is tied closely to the dollar's debasement (a combined consequence of ZIRP and QE) while the latter is a response to a range of currently distortive incentives, including the lack of organic revenue growth (the failed prime directive) coupled with asset inflation (the unintended consequence of financial firms eschewing loans and speculating in IG9 and other risky assets).

Monetary government is no different than fiscal or regulatory government. Even when deficiencies are well-known and addressed, like the TSLF and repo collateral, governments enact policy based not on results or operational reality, but on unrelated factors including recency bias, managerial ignorance and, above all, ideological rigidity. The Fed knows and has even acted favorably in the collateral pool, yet when conditions really warrant favorable action they continually appeal to counterproductive QE because of simple ideology. This is the complete opposite of markets.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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