The Amazing Kreskin For Fed Chair
On September 29, 2008, Morgan Stanley pledged $66.5 billion in collateral at the Federal Reserve's recently expanded Primary Dealer Credit Facility (PDCF). Aiming to take over in an intermediary role from the private tri-party repo market, the Fed expanded its list of eligible collateral to become a full substitute. For its pledged collateral, Morgan Stanley obtained $61.3 billion in "cash" from the Fed, for an effective haircut of about 8%.
That arrangement has subsequently been criticized as inadequate collateralization given what was actually pledged. Morgan Stanley posted, among other securities, $21.5 billion in stocks, $19.4 billion in securities without a rating, and $6.7 billion in junk or defaulted credits. As Lehman Brothers had failed only two weeks prior, the Federal Reserve found itself in a hornet's nest of panic in the repo markets and was therefore intentionally generous with its terms.
Liquidity is not a single concept, intertwining both money stock and flow. It takes both pieces to achieve effective or systemic liquidity. The panic in 2008 was not one where the system was short of money stock; in fact, there was a surplus of funding in certain markets. That included the Federal funds market, the primary means of monetary transmission in the current monetary regime.
On Monday, September 15, 2008, the day Lehman Brothers' death was announced, the effective Fed funds rate spiked to 2.64%, well above the 2% target set by the FOMC as being sufficient toward systemic liquidity. The next day, the effective rate was back down close to target, but spiked again the day after. However, by Friday, September 19, the effective rate dropped to 1.48%, 52 basis points below target. It would remain below target nearly every day until ZIRP was announced in December of that year.
That contrasted highly with LIBOR, the wholesale money rate for unsecured funds in eurodollars. That meant that there was a shortage of available funding in London eurodollars at the same time there was a huge surplus in New York Fed funds. There was money stock available, but no means to move it where it was most needed. Thus, the Federal Reserve appealed to the "junk" collateral list of the PDCF.
These were not the only means attempted to get money stock moving and flowing. I highlighted the TSLF a few weeks back; a program for swapping illiquid collateral held by dealers for US Treasury securities held by the Fed in its SOMA portfolio. In addition to that, at the height of the crisis in September 2008, the Fed engaged in $50 billion of reverse repo operations. Ostensibly, a reverse repo transaction is designed to drain reserves from the system as an "exit program".
In the context of September 2008's repo market panic coupled with the surplus of "reserves" in the Fed funds market, the draining of said reserves actually makes sense. It flies in the face of conventional understanding of what elastic currency should look like in a panic, but these were extraordinary times where the definition and recognition of the currency in need of elasticity had drastically changed. Again, it wasn't reserves in short supply; it was the means to flow them (collateral).
A reverse repo program, then, accomplishes two goals simultaneously. First, by removing reserves the central bank can help alleviate the surplus in the Fed funds market and attempt to push the rate back up toward the target. There is nothing so loathsome to a central banker as an interest rate that does not conform to its target, whether above or below. It is a highly visible signal to money markets and financial participants that something is very awry.
Second, the reverse repo, while draining reserves, actually injects the dealer system with desperately short collateral. Since the Fed is taking in cash and moving out government bonds, it places the Fed in the role of collateral distribution rather than the more traditional money supply expansion.
In addition to these measures, on September 17, 2008, the Federal Reserve formally requested assistance from the US Treasury in the form of the Supplementary Financing Program (SFP). Here the Treasury Department would issue SFP bills, increasing its borrowing from the market, that largely functioned like Cash Management Bills (a particular form of treasury bill, a short-dated government debt security). The major operational difference for SFP bills were their placement in Federal Reserve accounting. SFP proceeds were a liability of FRBNY in an account that was detached from accepting any tax receipts or paying government obligations.
The effect of issuing SFP bills was to further drain reserves from the banking system since their purchase by dealers transferred cash from bank reserves to this inert Treasury account at FRBNY. Again, like the reverse repos, the SFP was a collateral creation and dispersal procedure - less "cash" reserves, more high quality collateral. In both cases, the Fed acted as intermediary and transmitter of high quality collateral into the marketplace at the expense of reserves.
At its height in October 2008, the US Treasury had issued $560 billion in SFP bills, an amount nearly double the total Federal funds volume.
Despite all these attempts at draining reserves, the Federal funds rate continued stubbornly below target as unsecured lending to firms outside the primary dealers (including a great many in Europe) refused to return. Even with this enormous collateral support, there was not enough to go around for an effective flow of already existing stock. Illiquidity effectively persisted.
There was a catalogue of lending programs that accompanied these measures as well. In addition to the PDCF and TSLF, the Fed initiated the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Term Auction Facility (TAF) and US dollar swaps with other foreign banks. In short, the Federal Reserve became the primary repo intermediary since every single program was collateralized in one form or another. The Fed was playing both sides of the repo equation, both collateral lender and cash lender concurrently. In the panic of 2008, the primary goal of restoring functional liquidity to the system was conducted not through sheer balance sheet expansion and "money printing", but expanding collateral acceptance and availability. The Fed became the repo market.
That from September 15, 2008, through October 1, 2008, the Fed's balance sheet had increased from $939 billion to $1.5 trillion was an unwelcome event. Such circumstances drove this persistent emphasis on draining reserves (despite the nearly $600 billion increase in the Fed's balance sheet, bank reserves only rose $168 billion) as much as operationally possible. As the only repo market alternative, the Fed's primary responsibility was collateral management; reserves were a wasted byproduct of being unable via the necessarily ad hoc nature of these programs to run a matched book like private dealers.
The conventional wisdom that continues today is that balance sheet expansion ("money printing") saved the financial system and got Ben Bernanke the cover of Time magazine. That is simply not the case since it was never a problem of money stock like the early 1930's. Collateral and repo were the epicenter of panic, and thus every single emergency central bank measure, outside of the appeal to low interest rates, was a function of collateral transformation or creation in some form or another. The liquidity backstop the Fed promised when creating its interest rate targeting regime was not really about dollars as even it expected, it was about bonds and securities.
The subsequent episodes of "money printing" and balance sheet expansion, known colloquially now as QE, actually have absolutely nothing to do with bank liquidity. In fact, the opposite has been observed and documented during periods of QE. In early 2011, just as QE 2 was in full measure, collateral shortages began to appear in the US Treasury repo markets. Not only was the Fed buying up a supply of high quality collateral, there was also the winding down of the SFP bills as the federal government neared the debt ceiling (the SFP balance was actually driven down to zero by the end of 2009 as the US first approached the debt ceiling, but regrew to $200 billion once the debt ceiling was increased in mid-April 2010 until 2011's "debate").
Since these large scale asset purchases (LSAP) that form the basis of QE remove highly demanded collateral, and given that effective liquidity has been far more closely associated with effective flow than money stock, liquidity is not the real goal of QE. These programs are not designed for increasing the amount of "money" flowing into the real economy through banking credit expansion. They are designed in the wrong direction to accomplish such a goal, actually undertaking the opposite of what the Fed was doing in the last months of 2008.
In other words, QE's create nothing more than immovable and torpid bank reserves that only serve one indirect purpose: create inflation expectations beyond the zero lower bound (that it subsidized borrowing costs of the federal government is a "bonus"). If bank reserves were actually useful they would have been deployed in great quantity to this point, and the "mystery" of the missing inflation that was expected in the wake of all this LSAP/QE/money printing would no longer be a mystery. But the fact that so many people were driven to fear inflation as a result of naked and aggressive balance sheet expansion is actually the primary point of the entire affair.
Ever since the 1970's, economists and monetary practitioners have fallen in love with rational expectations theory. Even the first generation of rational expectations pioneers was somewhat cautious and disapproving of how its later proponents have evolved its uses and circumstances. At its core, rational expectations was one explanation for why monetary policy was so inept during the Great Inflation - that investors and economic agents responded not to direct monetary management, but their expectations of future monetary management. Therefore, even if the Fed "tightened" but investors expected that tight money period to be relatively short, they would condition their actions toward the future expectations rather than actual current conditions.
In the course of monetary policy during the late 1960's and early 1970's, what became known as "stop-go", this gyration between tight money and loose money, as the real economy heaved and restrained between inflation and recession, was a real monetary problem that policymakers seemed genuinely unable to solve. Rational expectations theory was one means through which economists developed a wider interpretation of inflationary mechanics and the interplay with policy (in other words, it was a plausible explanation used to avoid admitting failure, and thus to continue to deny markets a full place in setting the price of money).
Taken beyond that context, however, rational expectations is now the basis for the transformation of the Federal Reserve from a traditional central bank that is tasked with managing actual money and seasonal bank flows into the Amazing Kreskin. If rational expectations is an accurate and usable theory, then it can extend into managing not just investors' expectations for inflation but even consumer and business behavior.
One of the primary academic lessons from the Great Depression was that consumers and businesses were driven by undue fear into hoarding currency and avoiding any risk - the "bunker mentality". Rational expectations theory gives central bankers the basis to counter that mentality and potentially defeat such an economic decline. If the Fed can utilize certain monetary tools to emanate a veneer of functionality and a reduction of risk potential (i.e., eliminating "tail risk"), it believes it can effectively counter natural business cycle progression.
If the Fed can do that during a downturn, why not unleash its psychological manipulation to achieve "full employment" and a better boom? Monetary policy does not actually have to accomplish anything on its own, it merely has to be credible enough to get enough people and businesses to think that it will. Once a critical mass of psychosomatic trickery is reached, the economy moves and grows as designed by its central planners.
Circling back to QE after the Great Recession, the balance sheet expansion is the means to establish credibility for fooling the public into inflation fears. Once inflation expectations are registered and entrenched, conventional theory posits that they will induce consumers to spend rather than save, and businesses to invest and hire to take advantage of the expectations for rising prices. If it worked as designed, the movement or flow of those newly created reserves would actually be superfluous.
But we know that academic expectations and the real world seldom align. Instead of embedded inflationary expectations fostering growing levels of real economic activity, we have financial expectations for hedging leading only to commodity price pressures. Businesses have responded not by hiring and investing in productive capacity to capture rising revenue, but by maximizing financial investment to further manipulate stock prices through stock repurchases and dividend payments. And in the actual squeeze of mediocre to declining revenue prospects, American businesses have by and large jealously guarded profit margins and have taken absolute care to remain lean and highly productive (in dollar terms). Businesses, it appears, are responding to inflation expectations and commodity costs far differently than the academic models have predicted, by further retrenching rather than expanding.
This is not to say that no "money" has been moved into the financial system. Rather, the trickle of movement, or what small flow has been seen so far, is misguided by those inflation expectations, including investing in the stock market (see margin debt and net free credit balances for stock accounts, for example). Some credit has been created with the backstop of balance sheet expansion, but it was simply leakage and not the primary means of instituting monetary policy. Beyond that, however, the most damage is done through the repurposing of previously useful financial resources and real economic behavior corrupted by the intentional deceit toward inflation expectations.
To put it as bluntly as possible, true liquidity is abundant collateral and QE is the opposite. But that was never the full concern of policymakers. This is, and will continue to be, an immense experiment of monetary deceit and deception. I have little doubt that Chairman Bernanke and the FOMC view this as necessary and proper, like a doctor intentionally fooling a patient to move beyond unhealthy habits. But like any placebo there is a danger of discovery, particularly as its use is totally uncorrelated with the intended outcome.
Without the weight of actual and healthy economic flow (as opposed to merely financial flow), the removal of inflation expectations is equivalent to retrenchment. Add in the loss of credibility (why are "headwinds" continually confounding FOMC expectations?) and the rational expectations theory is turned on its ear. This is accomplished by the real means through which QE has an impact - the loss of collateral and diminished flow.
The Amazing Kreskin was simply an illusionist devoid of true magic and power; the Fed chair is similarly situated. But where the downside of falling under Kreskin's spell was to be entertained, the deceit of monetary policy contains very real costs, disrupting natural economic progression into drastically counterproductive tendencies and actions.