The Fed Funds Target Is Peter Pan, Easter Bunny & Santa Claus
In the middle of next week it is widely expected that the FOMC will vote to increase the federal funds target by one quarter of one percent, the first such increase in almost a decade. The terms contained within that sentence are no idle words or stranded letters; there is exactness within their meaning. The federal funds target refers specifically to a segment of the vast money markets that practically no one uses anymore, making the decision for emphasis remaining upon it as this "historic" inflection occurs a curious one. Second, the FOMC itself is an accident of history, a reflection from a time when rigidity was less of a permanent state.
The acronym of the policymaking body, at least as far as the federal funds target (and IOER, RRP, TDF and term RRP), is the Federal Open Market Committee. The name derives from the early 1920's when the Federal Reserve System was still trying to figure out what it was doing. For some reason, we are meant to expect such pliability to be entirely within the past despite the fact that nothing ever stands still; as if economics has itself reached a permanent plateau of total understanding and fortitude.
The early Fed was given a small(ish) mandate, little legal guidance and enough room to explore how to use any of it (which, some might argue, was and remains the entire problem). The Federal Reserve Act of 1913 is astonishingly vague, but any surprise upon that front owes more so to what the "central bank" has become lately than what at least the public expected of it originally. Becoming a mandate to facilitate, essentially, commerce, largely through some kind of unspecified "currency elasticity", the Federal Reserve set out immediately into the politics of World War I.
Among the great unknowns for the Fed was the fact that it had been confined to a one-way policy regime - the bank could effectively "expand" the money supply through several channels, but had no defined ability toward its opposite. While that may have been a simple lack of foresight on the part of the system's designers, though not likely, it as much suggests the role the bank, really 12 banks, was supposed to play. Limited to currency elasticity, contraction was not really on anyone's mind - especially throughout the later parts of the 1910's.
For whatever the Fed might have thought for itself, there was one hard mandate for which it was to follow closely. The regional reserve banks were not to be a drain upon society in any fashion, a more literal mandate than the esoteric concepts of economic management that define, loosely, current operations. In other words, in very strict terms, the Fed was to be internally viable as a direct matter of trying to sell this central bank to the public in the beginning (which goes a long way in defining the lack of urgency that existed in 1913; the public so ambivalent for the institution that the Act's sponsors knew full well that it would have become a defining political yoke had not this profitability clause been up front).
That made the Federal Reserve banks true banks in the sense that they had a monetary role different from banks but equally a survivorship struggle to make money; which meant a portfolio, or really twelve separate portfolios. The regional Fed banks could incur profit either through the monetary act of discounting or by holding actual securities, largely, but not limited to, government bonds. As straightforward as that sounds, in practice it was something altogether different. Further, that "different" came as a surprise to the Fed's early managers.
Part of that was due to the early mechanical nature of monetary accounting with this new Federal Reserve system, and how money was introduced and redistributed throughout the nation. First and foremost, as you can easily observe by the curious repetition of panic in the month of October (or at least September), the American economy of the 19th and early 20th centuries was beholden greatly to seasonal money flows; actual money flows. Agriculture and the seasonal harvest and planting efforts were that base, but so, too, was the spike in spending around Christmas (creating heavy monetary demand not just on the coasts but also the interior, with strains on all levels of the correspondent system).
Not only that, but there was seasonality to consider in terms of financing the government, a responsibility that fell within the New York branch as the agent of the Treasury Department. By virtue of the Federal Reserve Act's legal declaration, the various individual branches were not supposed to act on their own portfolio should any conflict with the monetary needs of "accommodation" arise; even though profitability was one of the only defined responsibilities. However, "accommodation" itself was far too bland of a concept to incur operative instruction; does one Fed branch relinquish its investment needs for the monetary condition of another? Is that true for when any possible connection isn't actually clear?
When a Fed branch bought securities for its portfolio, it did so by issue of check or the credit in the deposit account of the counterparty. The net effect was to increase the systemic level of reserves, as the transaction increased the balance (after the check cleared, in that option) of counterparty reserves without an offsetting reduction someplace else. But when that counterparty was located in a district other than the legislative boundary established for each Fed branch, portfolios and reserves became quite entangled in unpredictable fashion.
Further, it was discovered that counterparty banks that sold securities to regional Fed portfolios would often dollar-for-dollar reduce their borrowings from the Fed (in discounted bills at the Discount Window; another term still in use that used to have a defined meaning and specific purpose quite different than plainness that passes for current structure).
In the monetary reduction during the 1920 depression, the regional banks found themselves undercut via profitability. According to Allan Meltzer's A History of the Federal Reserve, Volume 1, the accumulated surplus (profit) of the twelve branch banks was $83 million, after franchise fees and dividends. That was a good number owing to the high discount rates (in trying to belatedly unwind the monetary mess of the late 1910's) and high volumes in bill transactions. During 1921, toward the bottom of the depression, the system's surplus was just $16 million as allowances (discounting) collapsed in volume. Worse, projections for 1922 indicated that the branches would be in some high level of deficiency in violation of its profit mandate (though this was arguable on technicalities including undistributed past surpluses).
Beginning October 1921, the branches acted and began accumulating a huge position in government securities; amounting, in total, to a $400 million buying spree by May 1922. In February and March alone that year, the Fed system added $200 million in bonds, doubling its then-total. This huge distortion in monetary and fiscal mechanics provoked a sharp response from the Treasury Department. Treasury Secretary Andrew Mellon practically demanded that the reserve branches sell all those treasuries (what a different world), writing, as Meltzer points out, "I should regard it as particularly unfortunate if incidental questions of expenses and dividends were to be permitted to control on questions of major policy."
It may seem otherworldly, but in that time the US government ran a surplus and would continue to do so for the rest of the 1920's. Thus, when the Treasury accumulated some substantial fiscal sum, it was directed to retire outstanding debt, mostly war debts from the Great War. In that circumstance, the Federal Reserve's purchases of UST's were sometimes in competition with the Treasury Department, most especially in late 1921 and early 1922. Treasury regarded that episode as particularly harmful and unnecessary.
Because of that, and because of internal politics trying to guide the decentralized system, the result was greater coordination on the part of these "open market" operations. Since the New York branch was essentially the Treasury Department's agent, it held greater interest in policy construction and the conduct in actual transactions (on both sides). In May 1922, at the behest of Governor Strong as head of the New York branch, the five Eastern reserve district heads formed a committee intent on coordinating purchases and sales in the government securities market. With New York present, it was felt that Treasury's interests could be reflected into that policy coordination.
A year later, the Open Market Investment Committee was formed with the same five regional chiefs serving or appointing the committee, but now with policy supervision by the Federal Reserve Board of Governors. By December 1923, the open market portfolios were combined operationally, and given pro-rata shares, underneath the Open Market Committee structure.
While that was ostensibly a means to solve the profit and portfolio problems of the individual Fed branches, there was a greater policy shift and concern occurring behind the scenes. Governor Strong, in particular, as Meltzer recounts, had become very aware and concerned about the Fed's mandate "weakness" in the form of being unable to constrict monetary activities. Part of what made the 1920 depression so intense was the massive inflation in the years before it, especially 1919, and Strong wanted to be able to exercise some constrictive procedure unlike the banks' experience in the great inflation of the late 1910's.
What was troubling even by 1923 was that the regional banks could not find enough volume in acceptances as an alternative to asset-earning potential of holding government bonds. The Chicago branch, in particular, was adamant that forcing Fed branches to rely on acceptances (discounted bills) alone, as Treasury demanded, would squeeze out all commercial bank activity in that portion of the money markets. Through that and other means, the Federal Reserve had come to appreciate a new potential lever of monetary control. Open market actions had been shown a potent catalyst across multiple internal channels, and thus what was left lacking was the ability to coordinate them and a philosophy with which to govern that coordination.
When the new Open Market Investment Committee was formed, much less emphasis had been placed upon the "I" in the committee's designation from the New York point of view. The statement for the committee's objective was written, again back to Meltzer, as, "to be governed with primary regard to the accommodation of commerce and business, and to the effect of such purchases or sales on the general credit situation." In many ways, this wasn't much of an update except insofar as it recognized an evolution past geographic fragmentations. Money, as credit and otherwise, could by the 1920's more easily flow (and not flow) between disparate locations - the banking system had surpassed into a national affair even though the Fed was created regionally.
More importantly, however, as Meltzer rightfully points out, open market operations had the practical effect of placing monetary policy on a different footing vis a vis gold. This point cannot be overstated, as gold held the primacy potential to "overrule" any policy action. Reserve member banks would be more induced by the immediate actions of open market transactions to repay Discount Window borrowing and thus expand national credit, or the vice versa, without having to await gold inflows, or outflows, to affect any transition. In this way, open market purchases would offer a way to "sterilize" actual money flows; central authority over market condition; taking in technological revolution to be harnessed in explicit programs and intentions.
Since then, the various ways and means of banking has likewise evolved, and policy with it only insofar as the "rules" and objectives carrying out the same open market authority. The change in open market policy to targeting a specific interest rate in the federal funds market, for example, didn't arise until sometime in the 1980's. The mechanical nature of the federal funds target, though, is roughly the same as had been "found" in the early 1920's. The change to targeting the interest rate in one money market was profound, especially given the unprecedented evolution of money itself in the 1960's and 1970's. In short, interest rate targeting arose solely because prior money targets could not well define "money."
That point continued throughout the 1990's, as the eurodollar market surpassed even the federal funds market in raw volume as well as more general liability management; again, the repetition in format as by then banking had grown past national boundaries just as it had once superseded regional fragmentation. And still the Fed targets the federal funds rate. Prior to August 2007, there was no obvious distinction between federal funds and eurodollars, as in both money markets there was enough flexibility in bank accounting to arbitrage any interest differential New York to London, or in reverse. Such apparent seamlessness obscured radical changes in the very core processes of banking and money.
In September 2004, the Bank for International Settlements published a paper outlining a startling shift in even eurodollar behavior. Eurodollar deposits (generic liabilities more generally) had until the 1990's been mostly redirected back inward into the eurodollar interbank money markets - and thus that close coordination with federal funds and the apparent reach of monetary policy through open market operations. From the BIS:
"Eurodollar deposits are increasingly concentrated in London. While the overall structure of the London interbank market remained stable for much of the period of eurodollar growth, the long-term relationships governing the flow of funds through banks in London appear to have changed recently. Whereas 75 cents of every dollar deposited in London was returned to the interbank market until the mid-1990s, this redeposit rate has dropped to just above 50 cents on the dollar in recent years."
The BIS was quick to blame the introduction of the euro, but the nature of this shift, especially in light of what was to come, belies such simplicity. Much of the changing structure in eurodollar "recycling" benefited "non-bank" entities as a direct funding mechanism - in "dollars." Those "non-bank" participants were, of course, the shadow firms that dominated the later housing bubble period and led the entire global financial system toward catastrophe only a few years later. It is important to note, once again, that a little more than a year after the BIS published this paper the Federal Reserve announced it would stop publishing M3; a broad "money" aggregate that included repos and, of course, eurodollars.
In global "dollar" practice, what the BIS was picking up, a decade later, was the monetary evolution that started in 1995 with RiskMetrics and VaR - the coming ascension of derivatives and dark leverage that marked the rise of "shadow banking" outside not just the banking system but, as we saw in 2007 and 2008, "offbalance sheet" behavior as well. The eurodollar portion here was important in establishing once more the indisputable fact that money itself had evolved, a proposition that the Fed rejected in 1979 (and again in deciding to target the federal funds rates whenever that decision was made in the 1980's; the exact timing and reasoning has never been given).
In examining the explosive growth in eurodollars throughout the 1970's, after literally fighting against it in the 1960's (capital controls and reserve requirements), the Fed had come to discard them as anything other than an "investment choice" for domestic banks. Thus, by not realizing the eurodollar's monetary status, the Fed would focus monetary policy instead on internal money markets and deposit balances. What the BIS was truly reporting in 2004 was that the 1970's rejection of eurodollars as money was not just wrong, it had been wrong for more than a decade by then to the point that global financial flows, "dollars", had already been altered significantly - what Alan Greenspan and Ben Bernanke called a "global savings glut" was instead the eurodollar backbone of asset bubbles they would take great pains, officially and not, to deny.
Shadow banks, in particular, had come to use the eurodollar market for actual monetary funding in dollar denominations, but that was just the tip of the iceberg for offshore "dollar" liabilities more broadly - derivatives and what I have called math-as-money. The fact that the Fed discontinued M3 not long thereafter validated the BIS warning about not just money shifts but specifically eurodollar changes.
Tragically, the flipside of the 1979 discussion was an explicit warning that actually came true - the authors at FRBNY then noted the distinct geographic weakness, whereby if the Fed did not count the eurodollar market as money there would be nobody, no central bank or any kind of potential elasticity, to step in should irregularity or panic attend eurodollars. Starting August 9, 2007, that is exactly what happened, as the FOMC maintained open market responsibility still in federal funds alone. The fact that dollar swaps with foreign central banks would reach almost $600 billion in October 2008 shows just a fraction of the size of that policy error.
Why didn't monetary policy evolve with circumstances and technology, as it had done in the Fed's early years? Even today, the FOMC prepares to, again, increase the federal funds rate without any appreciation for the broader array of interconnected global "dollar" markets. Unless you think economics has achieved a permanent state of bliss, this is far beyond irresponsible.
There are a few clues about all this. Last year, and for several years before it, the FOMC and the Federal Reserve's staff economists had at least started some work on finding an alternative to the federal funds target. In fact, as late as May 2014, Dallas Fed President Richard Fisher said, "It's my opinion that the fed funds rate is not the right tool going forward." In private discussions and what has been released via monetary policy "minutes" more than suggest that the FOMC is unsteady in actually how it might "raise rates" - especially since "rates" applies to a broad spectrum of money markets that cross the global banking regime. They apparently came up with nothing.
I wrote several weeks ago that:
"And so it leaves an extremely chilling dichotomy that says a great deal about where we are, and why that is. Just a year ago, the FOMC was quite unsure, and curiously open about it, exactly how it might truly go about raising rates. It seems an odd thing to be concerned with given the surety by which all monetarism projects, but that was, once more, a slight acknowledgement to the insufficiency of the generic monetary position, pre-crisis, that I described above. The federal funds rate, by any count that is meaningful, just doesn't matter - in relative and proportional terms, there is nobody there."
Here we are on the precipice of simply testing faith, and faith alone. The federal funds target is Peter Pan, the Easter Bunny and Santa Claus; if you believe in them, they are "real" because sure as not there is no money in any of it. The Fed will try to, once more, control money markets without the use of any money whatsoever. It is important to note that this occurred once already before, exactly during that period between the BIS's general warning about "something" wrong with global eurodollars, continuing through the end of M3 and right on into the Panic of 2008. Alan Greenspan had no more control over the money markets than Janet Yellen does now, even with all her "secondary" corridor attempts (IOER, RRP, TDF, etc.); you could even argue that Yellen has even less direct ability now due to the structural impositions imposed by the eventual weight of the huge and global monetary imbalances revealed by Greenspan's (and then Bernanke's) utter weakness.
It marks a particularly stunning contrast, whereby the Federal Reserve in its early years was quite attuned to how "things" actually worked, and leveraged them, especially FRBNY, to its advantage (though, it also needs to be pointed out, it wasn't exactly fruitful, "sterilization" and all, past 1929; suggesting, perhaps, the lesson in governing dynamics is that they might want to consider stopping altogether). Having established the precedent, monetary policy objectives remain largely the same even though the Fed has instead studiously avoided any monetary reckoning for forty years. They don't care a bit about "money" itself, just so long as they get to press upon an interest rate target, apparently any one will do, and claim supremacy in doing it.
Like all the QE's here and everywhere else, should we be surprised when nothing expected happens? I suspect that they will have difficulty in getting rates to align, but my contention is bigger than that. Namely, raising rates, real or imagined, are supposed to signal their shift in concerns to an economy that is potentially "overheating", and that is all they really think is necessary which is why money, to them, doesn't matter. It is, however, an economic condition that has already been made implausible by actual markets and actual money, including and especially all manner of eurodollar expressions; suggesting, really demanding instead, that money remains the problem not psychology.
The fact of their unwillingness to evolve policy with money and banking, clearly driven by ideology, is a nod to these results and those yet to come.