The Fed Has Become a Frankenstein of Epic Proportions

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In what increasingly seems like both a recurring nightmare and an unfortunate case of deliberate short-term memory, the Chinese banking system is exhibiting dysfunction that is far too reminiscent of global dollar markets in late 2007. Various "money" market spreads have decompressed to levels that are close to, or have already surpassed, records. Chinese swap spreads are wider almost across the curve, and the Chinese equivalent to the LIBOR-OIS (SHIBOR-China Gov't Repo) has widened to levels last seen in the middle of 2013 that caused no shortage of desperate worries. Given the astonishing increase in size of the Chinese system condensed into only a few years, it makes for a toxic brew that dollar observers once had too much familiarity.

It is exceedingly distressing just how short investors' memories appear to be, and a full part of that has been intent on the part of authorities. The operative theory, that resides not just in the developed world, having spread across every global corner and crevice, is to convince investors that central banks not only possess near-omniscience, but also exhibit the iron will to use it. With such promises and fantasies, investors easily forget the very recent past.

The starkest and clearest example of that, and one that will be studied for decades and generations to come, is the 2008 panic. To my increasing consternation toward more cynical tendencies, last week presented a near-unparalleled opportunity to get very close and personal to the central axis of the entire global system. The transcripts for the 2008 FOMC meetings were released, meaning that the entire affair is now public for the very first time.

Instead of a steady procession of pitchforks and torches to the Marriner Eccles building in Washington, DC., there has been an almost complete blackout on the subject. Nothing. It's as if 2008 was an ordinary year for the folks running the global monetary system, completely devoid of any newsworthy investigation or sensation. In many ways, that embargo is extremely telling.

The apathy over the whole affair in the public realm is, at least, somewhat understandable. This is very dry and dense stuff, for the most part, at least where it is most important. As far as the public is concerned, it seems that any passing attention, assuming it garners any, tends toward simply the real economy and its current trajectory. I referenced a Rasmussen poll earlier this year where a large majority of adults were believed to be in favor of an audit of the Fed, but that speaks more about the current dissatisfaction with recovery than anything of 2008. That the two are heavily linked is where this becomes paramount.

The public's disinterest is derived from the idea that the Fed can take care of the economy, and therefore needs little direct oversight. That has been qualified to some degree as most people are very much aware the "recovery" is lacking and flagging, but that is again counterbalanced by the internalization that Bernanke is a hero for saving the system. The public seems to believe this because they were told so by the Fed. It has been conditioned into the unconscious economic consensus that the Fed could, can and would take care of the economy.

Reading through the 2008 transcripts disabuses that notion entirely, which is why it should be at the head of every major and minor news website and program in the Western world and beyond. The solemn trust intentionally confiscated via monetary control has been molested by ignorance and shallowness, much of it intentional. The central banks of the world, to which the Fed is a "shining" example, are utterly incapable of the tasks they have expropriated from the people (via true markets).

At the December 15-16, 2008, joint FOMC and Federal Reserve Board meeting (they are two distinct units), Richmond Fed President Jeffrey Lacker stated this "settled" condition quite clearly in the context of what amounts to basic and total failure. Standing in the ashes of economic and financial ruin, the FOMC was debating what lay ahead and how they themselves were to fix it.

"It provides, for a lot of people, an intuitive link between money and inflation, and I think we-for all the warts of our policy in the early 1980s under Chairman Volcker-exploited that well, to convey to the public that we were committed to bringing inflation down in a simple, intuitive way. I think that can help us now, analogously, in convincing the public that we are going to be able to prevent deflation because we control money."

Controlling "money" is the base function of the central bank pyramid, as it was once of the true free market. The power of all central bank psychology is predicated on the idea that central banks have the "printing press" and can use it in a measured manner to produce the desired results. That assumes first that the user of the printing press can actually divine what those desired results just may be, and also that actual use of it is as clean and measured as they make it sound.

Again, that is the central axis upon which the entire system turns, the basis for the whole approach of centralized monetary monopoly. This idea that the power over money must reside in the hands of these "best and brightest" rather than markets is itself based on the idea that markets are not to be trusted. This is the timeless sentiment expressed in the very foundation of the Federal Reserve, as Robert Owen, one of the Fed's primary founders, asserted in a phrase that sums up such contempt for free market principles,

"It is the duty of the United States to protect the commercial life of its citizens against this senseless, unreasoning, destructive fear that seizes the depositor when he has been sufficiently hypnotized by the metropolitan press with its indiscreet suggestions."

There can be no doubt that such fear had seized the financial system in 2008, though it was not primarily depository rubes under the strain. The financial panic gripping "markets" then amounted to interbank fragmentation of both geography and institutional size. As Bill Dudley remarked at the March 18, 2008, FOMC meeting, "In my view, an old-fashioned bank run is what really led to Bear Stearns's demise. But in this case it wasn't depositors lining up to make withdrawals; it was customers moving their business elsewhere and investors' unwillingness to roll over their collateralized loans to Bear."

The FOMC called in favors to manage a "merger" for Bear, and then opened the Primary Dealer Credit Facility. That presented a bit of a problem for the Fed, particularly the Open Market Desk, because, "over the short run the New York Desk might not be able to drain reserves sufficiently quickly to keep the federal funds rate from trading extremely soft to the target." And the intended effect, despite the danger to undershooting the fed funds target, was, as Dudley explained that March,

"We hope, over time, none-because if we reassure the repo investors that they can roll their repo, we think that will dominate coming to the Primary Dealer Credit Facility. So if this works out the way we imagine it could work, the Primary Dealer Credit Facility use will be very nominal, so we won't have this issue."

And yet the panic progressed. Assurances were given both internally and to the public, and the financial system continued a slow-burn toward ultimate crisis. At the same time, the real economy was in desperate trouble, but the FOMC held firm to their models which told them their primary concern was inflation. On the eve of the worst "disinflationary" event since the Great Depression, the FOMC was primarily focused on price pressures (and the Phillip's Curve methodology).

At the meeting on September 16, 2008, the day after Lehman Brothers filed for bankruptcy, the FOMC was still not quite sure the insolvency proceedings would have much impact on the real economy. Philadelphia President Charles Plosser noted that,

"Given that my model is somewhat different from the staff's model, I continue to
believe that monetary policy at its current level is accommodative and that, if this current stance is sustained, the economy will experience faster inflation in the medium term. Indeed, the Greenbook forecast has changed only modestly since the last Greenbook. The economy remains weak but not appreciably different from what I anticipated or even what the Greenbook anticipated at the last meeting."

Again, this was the accepted sentiment at this meeting, the day after Lehman Brothers failed. Less than a month later at the October 7, 2008, meeting, after full-blown panic in almost every global market, including massive and widespread distress in dollar funding markets that would eventually erode almost every facet of primary credit creation in the US and beyond, the Fed had only slightly changed its economic outlook. Larry Slifman, staff economist reported,

"Using our usual method, which we described in the box in Part 1 of the Greenbook, we now think that the intensification of financial stress since the September Greenbook would subtract nearly 1 percentage point from real GDP growth in 2009."

That outlook was further bolstered, somehow without much common sense, by Robert Rasche of the St Louis branch,

"The Macro Advisers forecast from last weekend has flat GDP for the third quarter and a 2 percent annual rate of decline in the fourth quarter followed by weak but positive real growth in the first half of 2009. We have acted preemptively, aggressively, and unilaterally since the beginning of the year against the risk of an economic slowdown. We can afford to be patient until we have more information and can better assess the impact of recent financial market events on the real economy."

That was the basis of presentation which governed nearly all of the actions of these "best and brightest." The worst financial panic since the Great Depression, in which four major financial firms had just failed in recent weeks, not to mention the GSE mortgage behemoths, and the economic models upon which monetary policy was based expected it all to subtract just 1% from GDP in 2009! This matters not just because they were so very far off in their predictions, but rather because the Fed as an institution dedicated to the financial/real economy nexus failed to grasp even remotely how much of a financial/real economy nexus actually existed (and where that takes place).

The reason for such illogical sanguinity rests, again, in the political comfort of "control of money." It was both a feedback loop of self and recency bias, but also an impenetrable bubble in which reality could not intrude. This is not to say that there was no talk of the true downside; not at all. In both the September and October meetings many participants expressed extreme worries about how bad it might get, including a comment by Eric Rosengren (Boston Fed) in the September conference that was pretty much right on about what was coming in the next week. But that never really penetrated the bubble, and time and again the FOMC dismissed those fears as just nightmares of hard-to-believe scenarios.

Perhaps nothing characterizes that overconfidence as much as in Bill Dudley's (FRBNY Open Market Desk) opening remarks on October 7 - again, after the stock market had crashed and credit markets had been decimated.

"Although there is considerable uncertainty about the appropriate metrics and weights to use in examining the evolution of financial conditions over time, most data are consistent with the judgment that conditions have tightened significantly since the onset of the crisis, despite the 325 basis point reduction in the federal funds rate target... I am struck by the feeble market response to the substantial escalations implemented over the past ten days. These include expanding standing foreign exchange swap facilities' capacity to $620 billion from $290 billion; expanding the TAF auction cycles to $900 billion from $150 billion; and proposing a major backstop for the commercial paper market."

Chicago Fed President Charles Evans did the math, "You know, from the TAF October 7, 2008 10 of 30 to the TSLF, the primary dealer credit facility, and on down to today's facility on commercial paper, and then if you throw in the Treasury program, which is not exactly ours, and the swaps as well, I get to something like over $3 trillion that is being put out against collateral and to be lent. Is that the right order of magnitude?" The Fed had "put out" $3 trillion and, in the words of Bill Dudley, the market response was "feeble." Liquidity was everywhere and it was nowhere; a meltdown occurred as if the Fed was not even operating at such high capacity, or much at all.

The printing press is only powerful if you know how to use it and which outcomes are actually desirable. To drive that point home, the Fed had been looking to the new authority (originally scheduled via statute to become accessible in October 2010) to pay interest on excess reserves (IOER) as a crisis tool. Mentioned above, there was more than a little attention given to the "softness" of the federal funds rate as it persisted against other crisis measures. A chronic undershoot of the rate target is, perhaps, the most visible signal of crisis itself, putting a priority to the desire to enforce some floor on short-term money rates. That only grew in intensity during the last part of September and into early October 2008.

The IOER has been highly contentious from the moment that the FOMC first discussed moving forward that statutory authority as part of TARP. Again, at the October 7 meeting, Dudley laid out the theoretical expectations, backed up by numerous simulations run through the models.

"That's why getting interest-on-reserves authority was very, very important. As Brian has said in earlier briefings, interest on reserves is going to start on Thursday, and that's going to place a floor on the federal funds rate. So we think we're in a situation where we have a very important tool that will allow us to expand the balance sheet but maintain control of the federal funds rate. So we're not going to be compromising monetary policy."

Balance sheet expansion would come in relatively short order, through not only the programs Evans referenced but primarily in dollar swaps lines with other major central banks (but only a select group, unfortunately By December 15, however, theory had met reality once again, and, once again, the Fed was forced to re-assess. Bill Dudley once more,

"The interest rate paid on excess reserves (IOER rate) has not been a perfect substitute for the Treasury SFP program. Because the IOER rate for the two-week reserve maintenance period is set at the lowest level that occurred anytime during that period, the sharp drop last Thursday evident in the exhibit occurred because banks anticipate a substantial cut in the federal funds rate target and the IOER rate at this FOMC meeting. The drop in the effective rate has occurred even though we have increased the rate paid on excess reserves to equal the federal funds rate target."

That is quite a contrast between those two statements, only two months apart. Even Chairman Bernanke acknowledged the wide gulf between what he himself had hoped and what actually was taking place in the money markets and the efficacy of his committee's use of the "printing press":

"The interest rate paid on reserves is not currently sufficient to keep the rate at the target. That's for a lot of reasons with which you are all familiar. I would just note that the staff is still working. We should not give up on that."

The IOER and the expected floor on money rates is not some trivial issue, though it is perhaps one of the most esoteric. The undershoot of the federal funds rate to target was fundamental to the system as it devolved. Governor Kevin Warsh suggested as much the day after Lehman failed,

"Look at the CDS spreads for the two remaining independent broker-dealers, Goldman Sachs and Morgan Stanley, which Bill referenced. Goldman Sachs's CDS moved up another 190 or so morning. They are up 340 in the last two days. Morgan Stanley's are up 690. I wouldn't want to say whether those numbers are right or wrong. It may be that the business model is a failing one-that is, wholesale funding is no longer practicable in the world that we're now in."

That thought had to be banished from the conversation as it pointed out what amounted to failure in the larger picture of the governing dynamics. The wholesale funding model was expressly desired and cultivated by the banking system with both implicit and explicit approval of the Federal Reserve and its "printing press" abilities. That was the idea behind the LTCM bailout and the true nature of the "Greenspan put." The most basic premise behind all of it was that the Fed could convert and manage the wholesale system into a healthy real economy, fulfilling its promise to the public.

It never really could do any such thing, though Fed officials had been patting themselves on the backs for years prior to the crisis. There was a minor affair in the dot-coms, but Greenspan retained his genius with only slight blemishes. And that bred the bubble in which they would operate during 2007 and 2008 as they fell in love with their own theoretical notions of themselves instead of what they could realistically accomplish. Such complacency extended to conspicuous lack of curiosity as to what and how the banking system had grown to that point.

As we actually see from the 2008 meetings, they did not create a pathway to central planning utopia, the wholesale system was instead a Frankenstein of epic proportions. Time and again, as these transcripts show conclusively, they were surprised at the scale of credit structures and how the system had evolved. That was why they were consistently behind the curve during the pre-crisis period and the panic itself, as over and over the "best laid plans" that were thought as durable solutions were greeted "feebly" by markets. In summation, the "market", as Warsh suggested, was rejecting the entire wholesale model.

Such dramatic failure is a direct rebuke of the modern concept of the "control of money." If that wasn't evidence enough, we have the words and deeds of the control apparatus itself, so obviously wanting in the most basic competencies that are still assumed in plentiful supply. It's a powerful story that should be told, particularly as the FOMC has not self-regulated its own actions, but simply acquired more direct control over "markets" and "money" in the years since.


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

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