Let's Choose Capitalism This Time Over a 'Yellen Put'

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One significant factor where I find myself in total agreement with the monetarists over at the FOMC is that "reserves" are meaningless in every context but the setting of monetary policy. This is not uncontroversial terrain, but it should be. Banking is not what most people think of it and in the modern "shadow" (wholesale is a better word, as is "eurodollar standard" for the global end of it) system there are far more important settings. The liability created by the Federal Reserve, titled "reserves", is only a byproduct of whatever it is the Fed is trying to influence through the Open Market Desk.

That has not stopped nearly everyone from commenting on the status of reserves, especially as four successive episodes of QE followed ZIRP. At the outset, there was no end to hyperbole about how the rapid accumulation of reserves would unleash a torrent of "inflation." Now on the other side, the conjecture has fallen to the opposite position.

This has been increasingly muddied by what the FOMC has been doing in the past year and a half. Contrary to conventional commentary, the preparation for the potential end of ZIRP and QE has been ongoing pretty much since 2010. It was that year in which the Fed introduced its Term Deposit Facility (TDF), and has been performing small-scale tests with it ever since.

In terms of exiting "emergency" monetary policy measures, it was believed that the Reverse Repo Program (RRP) would bear the brunt of the monetary lifting upon interest rates. Thus the RRP was drawn into operation on a more realistic scale almost a year before the TDF. As I have described to no end, the RRP has failed to live up to every expectation, a reality in which the FOMC itself seems to have accepted via October's meeting minutes. Enter the TDF.

Larger tests in the TDF began in earnest in mid-June. You have to understand that there is an infatuation with European monetary operations in all of these measures that seem to have come from nowhere. Prior to 2007, the Fed had its Discount Window, a relic to its founding purpose, and the federal funds rate. Those have both been rendered almost totally immaterial by "events", most of which occurred while the FOMC stood by stupefied by a banking system they did not, actually could not, recognize.

One of the primary problems in the acute stages of panic (there were actually two phases to the panic; one began on August 9, 2007, and then flared again in September 2008 when the FOMC had already declared, as Ben Bernanke did publicly in June 2008, that the worst was behind) was the sudden and unintelligible (for orthodox economists) decline in the federal funds rate below, often significantly and durably, the Fed's target. During the worst parts of the panic in autumn 2008, the federal funds effective rate not only fell far below target but remained there.

To answer that, the Fed began searching for ways to "drain" or "soak up" reserves. Such a task becomes even more paramount as the desperation "forces" the monetary agency down to the infamous monster of the zero lower bound (ZLB). There is not an orthodox central banker alive that does not, still, fret the ZLB. The ECB has crossed that rate Rubicon in June, and is now living with the whirlwind of having done so (it's getting ugly).

The IOER was scheduled for launch in 2010, but was moved up to October 2008 in an attempt for the Fed to gain control of short-term interbank rates that were defying its target to the downside. By removing "excess liquidity" and locking it up at the Fed (by paying a small interest rate) the idea was that the private market for federal funds would see rates rise to where they "should" reside. They did not. This has remained a problem, spiking intermittently in the years since, throughout.

In the European version of monetary "plumbing", the ECB offers a rate "corridor" of three primary levers. Without getting too far into the details, they essentially establish a ceiling, a midpoint and a floor by tailoring incentives and structures so that the private market "behaves." Except that in Europe, too, the private market has not. The European interbank rate, Eonia, has also "defied" monetary command, resting close to zero all throughout the LTRO period instead of at a positive spread to the MRO (midpoint).

However, that is a totally different problem than the Fed's flailing at establishing a rate floor. The ECB's deposit account has indeed done its job as private market rates do not penetrate the rate floor as seen in the US. Instead, the ECB has "had" to move the floor to negative in order to allow the MRO to "chase" Eonia. That's simply an esoteric and technical way of saying that the ECB, like the Fed, doesn't have as much influence as it thought prior or, more importantly, proclaims of itself. The establishment of the European rate floor into nominally negative territory seems to have, again, opened a major problem in eurodollar funding conditions.

The primary outbreak of funding inadequacy is something like the "rising" dollar. The eurodollar standard which connects the entire financial world, across all boundaries and apparent systemic divides, and global trade is run on a massive short "dollar" position. Banks borrow them wholesale and then lend them in a maturity transformation. However, these are not "dollars" as you were taught of "dollars" in school. They have no legitimacy other than one accounting and legal convention whereby US domiciled banks and foreign bank subsidiaries operating in the US (mostly NYC) can use "eurodollars" as their own liabilities upon transfers inside and outside the United States (this works both ways, as foreign subs can borrow federal funds and transfer those liabilities to the eurodollar market).

That fact had, until August 2007, led to the development of an apparently seamless financial system of wholesale "dollars" forming the basis of nothing short of massive asset bubbles. The transmission of monetary policy worldwide was based on this arbitrage "opportunity" of accounting convention, meaning that "dollars" would flow where rates were disparate - federal funds in the US and LIBOR in eurodollar London. The developing panic beginning in 2007 fractured this system, as you can plainly see on any LIBOR chart suddenly gaining a positive spread to federal funds - a spread that never dissolved throughout 2008 in sharp defiance of the FOMC's growing confidence.

How, then, is the monetary policy apparatus operating in NYC through FRBNY's Open Market Desk supposed to affect eurodollars? The QE-style answer is to increase the level of "reserves" but the Open Market Desk does so only through transactions directly with Primary Dealer banks, who are then supposed to transmit not those "reserves" but their own liabilities (true "dollar" supply) far and wide. That was precisely the problem at that moment in time, as the Primary Dealers, among all other financial institutions, were more than content to simply sit it out, especially eurodollar irregularities. London and the eurodollar market ran dry of "dollars." That means, unequivocally, that "reserves" are not very important to actual liquidity and function, instead bank balance sheet considerations are the primary expression of monetary function, as well as its primary limitation.

On the US side, "dollars" were suddenly and plainly plentiful, which is why the Fed went into overdrive trying to "soak them up." That systemic deficiency illustrates the utility, in their minds, of a hard rate floor like Europe.

Of course, the eventualities of the panic in 2008 rendered the Fed's "aid" almost fully moot on all counts. The interest rate "stimulus" of rate targeting was wholly useless to this framework and it wasn't until after the panic was over that the Fed finally removed all restrictions on its dollar swaps with other central banks, thus finally calming most of the distress in eurodollars by opening up a separate channel for "flow." In other words, after all the carnage had been taken, the Fed stepped in and essentially replaced the wholesale interbank market. Private liquidity became public liquidity, and so "too big to fail" had to be enforced (there was no way to separate the Fed's takeover of wholesale finance from potential bank failures).

For all that happened, Ben Bernanke was, almost exactly five years ago, made Time Magazine's Person of the Year. The goalposts were moved in that he was lauded not for preventing panic and economic destruction, those happened to a great degree, but for not "allowing" it to be worse. That has become conventional wisdom in most places, though dissatisfaction is never stripped from it, that the FOMC's actions then saved the financial system from annihilation.

In the years since very few have bothered to ask whether it was worth saving in the first place. The current predicament over QE's end offers a compelling (certainly to me) narrative of exactly that question.

Just as so many were confused about "reserves" in the build-up phase of QE, there is enormous confusion now about its end. A simple glance upon the Fed's balance sheet today, the H.4.1 release, has unleashed a torrent of crazy. Some have dissembled that bank "reserves" have indeed declined by about $330 billion since the end of August as an undisclosed and pre-emptive tightening. Is the Fed actively selling its bond portfolio? Are banks using that "liquidity" to finally unleash the torrent of "inflation"?

Neither of those suggestions is anywhere close to what has taken place (and the latter is mathematically impossible since only the Fed can change the quantity of reserves). The Fed is not selling bonds at all, instead still increasing its asset base and thus "supplying" reserves. However, as I noted back at the beginning, the TDF is being fully tested now, with the latest weekly take-up just over $400 billion. In the mechanics of central bank accounting, that is a factor "absorbing" reserves, meaning a subtraction from the largely irrelevant (as explained above) bank reserve category. The Fed is not tightening but rather testing its ability to project "tightening."

In fact, the test ends next week which means that total bank reserves will rise by about $400 billion (and I can only imagine what that will do to commentary) unless, like the RRP, testing is "allowed" to continue. This exercise, like that of the IOER and RRP, may change the quantity of bank reserves, but in doing so fully confirms their irrelevance except to only one facet - what the Fed is doing with monetary policy. Broader liquidity has not been affected by the quantity of reserves, instead the dramatic, global liquidity event of October 15 was already burrowing its way through the system's rot while the first test was underway in June. That liquidity decay defied the first test's ramp up and then its conclusion, as repo rates persisted "special" and fails began to spasmodically spike on and off, meaning there was no discernable aid and impact from the TDF at all - just like the RRP which was supposed to be fully functional but was also curiously fruitless.

The primary purpose of these "reserves" at the business end of QE is as a means of influence. Monetary policy is all about psychology, and in the business of liquidity "reserves" are nothing more than soft reassurance to Primary Dealers in the indirect hope that they will transmit such influence further on.

"Our results provide some grounds for optimism about the likely efficacy of nonstandard policies. In particular, we confirm a potentially important role for central bank communications to try to shape public expectations of future policy actions."

That passage was quoted from a 2004 paper written by Vince Reinhart, Brian Sack and Ben Bernanke. The intent of the paper was as it says above. While "nonstandard" policies like QE can directly affect the prices of the assets they are purchasing, Bernanke et al. are directing attention toward broader monetary impacts on the economy. To that end, the quantity of reserves only stands as confirmation of central bank intent, and thus should conform to "communications."

"If central bank "talk" affects policy expectations, then policymakers retain some leverage over long-term yields, even if the current policy rate is at or near zero."

That quoted portion is highly relevant to the FOMC as it meets next week. They are discussing changing wording in their policy statement about keeping interest rates at ZIRP for a "considerable period." By potentially removing that phrase they want to begin to signal that ZIRP is being removed, if only slowly and at, they say, a data-dependent pace. The quantity of reserves is an afterthought that will only confirm the language change if it actually does occur.

However, the theory is already in deep trouble. Bernanke's idea of "retain some leverage over long-term yields" has already been obliterated. The FOMC may talk like the US economy is in good shape to withstand (in their minds) an end to ZIRP, but bond investors have grown solidly and increasingly bearish about that ever since November 20, 2013. If there was any influence on long-term rates from the setting of short-term rates, with whatever indirect visuals of the quantity of "reserves", it is completely unapparent at this moment. Instead of the treasury curve rising in nominal terms while steepening, it is doing the exact opposite and to a degree not seen since the worst days of 2009!

To which, given all this discussion, the natural question to ask is what good is a rate floor if short-term rates have no bearing on policy transmission? It seems to be a perfunctory fixation over the last crisis rather than a forward-mechanism to potentially the next. And the next crisis may well be already at hand, as not only have credit markets in the US grown 2009-style bearish, credit markets all over the world (both developed and emerging) have now joined and, as you may have heard, oil prices are down almost 50% from June (despite all the assurances of lower gasoline as a "tax cut" benefiting consumers, an oil price decline of this magnitude is exclusively the purview of global recession, including the US).

But these credit market visibilities and oil prices are related to the eurodollar standard. Again, starting the first week of July, the US "dollar" began to rise in price denoting a tightening of balance sheet constraints. That has meant the global dollar short growing more and more tenuous, or, in more blunt terms, "dollar" contraction as bank balance sheets adjust inward. The result has been this flashing liquidity crisis that finally broke out into the wide open (at least for mainstream commentary that could no longer look away from what was already apparent globally) by October 15. To which the quantity of reserves played absolutely no role, nor did the intent of the FOMC to test its irrelevant dedication to this still-dubious (after six years of obsessing) rate floor.

This is another way of saying that the financial system that QE supposedly healed, embarking from the "heroics" of Ben Bernanke and his comrades, is in some very important respects worse than it was. Further, if trillions upon trillions of "stimulus" provided globally cannot stem the next leg of recession after having obtained exactly zero real recovery, then I ask again what was worth saving the first time?

To ask that question is to find the answer, as you realize that "saving" the banking system was a second order priority, instead that the primary directive was and is to maintain the status quo of the top-down command economy. The banking system is a monetary tool to "smooth out the business cycle" or, as was referred at the outset of interest rate targeting, to "fill in the troughs without shaving off the peaks." So the system was set up whereby wholesale banking would bypass all orthodox understanding because it was deemed "necessary" to achieving those economic ends. In short, it didn't really matter where or how banking evolved as long as next quarter's GDP was "sufficient."

Of course, after years and years now of insufficient GDP, facing the looming prospects of even worse results, it has become clear even to central bankers that "someone" shaved off the peaks. You see this admission in central bank policy itself "evolving" all over the world. This week the PBOC has totally confused almost everyone, other than anyone who has actually been paying attention outside the purview of ideology. The Chinese central bank has essentially admitted that QE-type policy doesn't work at anything other than massive debt expansion, and thus total economic waste, and so is attempting to undo or at least mitigate the damage (this is contained under the euphemism of "reform").

Even the FOMC itself has very quietly set aside almost all remnants of Bernanke-isms. With QE now ended (and for reasons not being proclaimed publicly) the very much related idea of "forward guidance" was quietly scrapped in September, though the Fed's own website tries some misdirection on the subject - the current reference to "forward guidance" under this new framework is actually the opposite of what "forward guidance" was supposed to be.

Monetarism is never what it seems, which is highly germane to whatever is coming next. Most commentary dismisses it as pensive fancy, but there are dark clouds gathering drawing the seeds of accountability closer. If we end up in a terrible economic position yet again, was this system worth saving the first time? It doesn't even work how it is supposed to, but as long as the status quo is maintained, and asset bubbles tantalizing those with the shortest attention, the standards and benchmarks for success can be reduced, lowered and altered wholesale. This all raises the intriguing possibility that perhaps the status quo simply cannot be maintained at all, as soft central planning may have reached the inevitable wall. If that is true, do we "let" Bernanke's successor, Janet Yellen, "save it" yet again? At some point it may yet dawn that capitalism is an actual, viable alternative.


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

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