NIRP Is Its Own Big Problem, and Confirms QE's Disaster

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There is utter madness in the air, and it spans the globe. Japan, after spending the last nearly three years exploding its "money supply" only seems to have realized recently that the ungodly ¥184 trillion in new bank reserves have acted nothing like money. QQE, the added "Q" adding nothing, is now to be supplemented by negative nominal rates on those "reserves" to try to make them something more than an assault on accounting. The ECB, having led the charge below zero, expanded the negativity and then expanded it again - only to add a QE and now threaten more expanding on the wild side of zero. Between the PSPP (QE) and the CBPP, the third in that line no less, the ECB has added more than €650 billion in also bank reserves to find that, like Japan, they aren't anything but dead line items.

It is the perfect contrast in comparison that the Bank of Japan would add NIRP to its QE while the ECB would add QE to its NIRP, and then both talk about still more of either or both. In the US, the Federal Reserve raised the federal funds rate, which applies to a market that nobody uses to declare a recovery that increasingly nobody believes. Outside of federal funds, interest rates in markets that almost everyone around the globe does use have contrarily collapsed - and by more than a little. From the eurodollar curve to the US Treasury yield curve to even forward inflation rates, the only direction is the opposite of what Janet Yellen says and now tries.

To that discrepancy there has only been whispers of, why not, negative interest rates in the US now. While Chairman Yellen was careful not to put too much into the panic, on her side, though some markets are reacting already with that tinge, the fallback upon a gray area of legal authority really hasn't fooled anyone. If necessity is the mother of invention, surely desperation is the father of such insanity.

The madness here is not what central banks are doing, as that is what they are going to do no matter what. Economists are no scientists searching for truth and answers; they are ideologues calculating (secular stagnation) how little damage they might cause to retain their collective political station and cultural situation. The madness is that central bankers are allowed to continue at all.

They survive through credentials alone; any reasonable catalog, one that needn't be comprehensive either, obliterates any thoughts of effectiveness or even earned authority. There is only failure in their efforts and not the run-of-the-mill kind; spectacular botches that have enlarged and multiplied. Orthodox economics survived the Great Recession as purely a matter of the stunning nature of it. But it was only stunning in, again, how much orthodox theory got it all wrong.

It is still useful to regularly revisit that past because we are still living in it. The eurodollar system received its fatal blow on August 9, 2007, and the world has yet to recover because central banks will not allow it. And so everything they have done, everywhere these measures are tried, have only led to further and deeper failure. That started straight away with the first "emergency" measure the Fed took. While convention believes that the FOMC's initial pushback was the 50 bps rate cut on September 18, 2007, it was actually their actions on August 17 that year.

Only eight days after the eurodollar broke, the FOMC decided that they would "aid" money markets by reducing the Primary Credit "ceiling." Primary credit does not get any mention in the events of 2007 and 2008 because it was just that ineffective, but in reality this program was the second incarnation of the Discount Window. Prior, on January 9, 2003, the FOMC had decided that the former Discount Window and the set Discount Rate would be more useful and effective were it set not at a discount but at a premium 100 bps above the federal funds target. By removing administrative restrictions and pushing the rate upward money markets would enjoy the protection of a rate ceiling.

It was simply assumed, in that academic, bureaucratic fashion, that if any number of financial institutions got into some bothered condition, being forced to borrow at higher and higher rates, institutions in otherwise very good standing would hit the Primary Credit window and perform the expected arbitrage - borrowing at federal funds + 100 bps and then relending to other institutions at a small premium further thereafter (because the Fed also assumed that when it switched out of the true Discount Window format that removing the restriction on "reselling" federal funds would enable this kind of arbitrage chain).

The Fed on August 9, 2007, however, was already in trouble that wasn't limited to the ceiling of Primary Credit. The monetary policy target of that particular maintenance period was set at 5.25%, meaning that the Fed had implied it would undertake any amount of balance sheet activities (through the Open Market Desk) to supply (or withdraw, which turned out more of the factor) "reserves" to enforce that target. On August 10, the effective federal funds rate, which is a blended average of actual, individual trades, dropped below the target "floor" to just 4.68%. But that wasn't the true scale of the disorder, as some trades were booked at 0.0% that day, zero; and some as high as 6.05%.

In pure eurodollar trading, LIBOR rates jumped in the aggregate which apparently frightened the FOMC enough to their first monetary policy action of the AE period (after eurodollar). The committee voted on August 17 to reduce the Primary Credit ceiling to federal funds + 50 bps rather than the existing 100 bps. The FOMC believed, wrongly, that it would indirectly assist eurodollar markets by allowing a cheaper "ceiling" to be forwarded there through resold federal funds and then various bank subsidiary transfers.

However, on September 3, 2007, one-month LIBOR was fixed (again, an average of offered rates) at 5.765% and remained above 5.8% for another week - compared to the 5.75% "ceiling" of Primary Credit. At the same time, the effective federal funds rate kept shallow below the target "floor." A few weeks later, the FOMC then voted for the first "stimulus" of a 50 bps rate cut in the federal funds target, which was enough only to convince stock markets to register new record highs (some discounting mechanism). The internals of liquidity and eurodollars, as growing distinctly more disastrous from domestic "money", were unenthused by any of it. In fact, LIBOR pierced the now-further diminished ceiling yet again, this time in late November.

Every time the Fed intervened, they modeled only success. Even as late as the middle of 2008, ferbus and the other statistically elegant but economically irrelevant models were suggesting only a minor slowdown in the economy - monetary policy is always assumed effective even though it had already been by the autumn of 2007 shown not just ineffective but exactly how and why that was so.

What followed was one failure after another as policymakers continued stubbornly in their cocoon of 1950's literature, leaving a long and drawn out string of them throughout the whole period. On December 12, 2007, the Fed announced TAF auctions (Term Auction Facility) along with swap lines against the ECB, Bank of Canada, Bank of England and Swiss National Bank. The very existence of TAF itself indicated only total letdown of Primary Credit; it was an almost exact replica of the Discount Window, using the exact same collateral eligibility criteria and even the administrative restrictions once imposed (institutions to have been judged by their local Federal Reserve Branch bank to be "generally sound"). The first TAF auctioned $20 billion on December 17, 2007.

Less than three months later, Bear Stearns failed not from losses, directly, but illiquidity. To that period, the FOMC added more TAF, introduced the TSLF (allowing institutions to switch "toxic waste" MBS collateral for SOMA-held UST's) and then the PDCF which the Fed described(s) as, "The PDCF functioned as an overnight loan facility for primary dealers, similar to the way the Federal Reserve's discount window provides a backup source of funding to depository institutions." The federal funds target rate had been brought down to 2% by the end of April while LIBOR continued to an "unnatural" premium and spread.

The Fed by late spring and summer still declared cautious optimism about success, though really believing they had seen the worst. They should have known better as the strains in eurodollar vs. federal funds remained and then worsened, the GSE's found themselves in increasing insolvency due entirely to collateral issues and their mandates (the FHLB end of that saga is particularly instructive) and then the full events of September 2008 which none of those prior policy actions bore any effect upon whatsoever.

To which the Federal Reserve responded with simply more failure and then still more, etc.: in addition to several "cold fusions" apart from Lehman, the Fed undertook AIG's illiquidness to its (illegal) Maiden Lane SIV's, added some $50 billion in reverse repos and worked out with the Treasury Dept. the logistics of the Supplementary Financing Account (which turned, essentially, short-term treasury borrowings into an increase in US government securities in addition to SOMA holdings that could be "loaned" out as repo collateral). On September 18, the dollar swaps with the same central banks plus now the Bank of Japan were increased by $180 billion, and then six days later $30 billion more to another four central banks (the Reserve Bank of Australia, the Danmarks Nationalbank, the Norges Bank, and the Sveriges Riksbank). Then came the AMLF to bring the Discount Window (prior version) to commercial paper and money market funds (which is why it was also known as the ABCP MMMFLF) and ultimately the political argument about TARP, which the Fed supported in any incarnation.

Early October 2008 saw instead desperate, widespread liquidations and panic despite all the letters and acronyms; failure, failure, more failure.

The FOMC went back to work with the CPFF on October 27, the TALF on November 25, 2008, and in between still more dollar swaps (almost $600 billion at the worst) with more central banks (Brazil, Mexico, Korea, Singapore - as if the "dollar" problems were spreading rather than finding resolution via the Fed's "printing press"). These continued escalations in monetary countermeasures occurred now with only worsening indications even though there had already been panic. On October 23, 2008, swaps spreads in the 30-year maturity went negative for the first time and caused no end in confusion and fear, both signaling and becoming still further illiquidity.

Also on November 25, 2008, the first of the QE's was announced with $100 billion in direct purchase of agency paper and another $500 billion scheduled for MBS; then ZIRP on December 16, 2008.

The markets responded to all this massive "money printing" with still another wave of liquidations in early 2009, lasting into March, along with more acute fear of further bank nationalizations in Europe, especially the UK, predicated on "dollar" funding failure, failure and more failure. Plus, there was the small matter of the Great Recession itself, an event comparable only to the 1930's, which was never believed even possible given so much monetary power and expertise, then spreading its destructive capacity full way around the entire global economy. To all that Ben Bernanke ascribes to himself courage and heroism, as if revealed impotence and ignorance, self-imposed, is now the basis for monetary and economic gallantry.

From that depression, the global economy has not yet recovered despite still more monetary influence that was promised to deliver an end to what economists believed (and many still do) a temporary deviation from prior trend capacity and potential. This was the age of QE's, where the zero lower bound was no match for the scientific, mathematical precision of central banks now unleashed. Using inflation expectations about "money printing", intricately measured balance sheet expansion would foster rising prices against any "deflation" that might linger after the devastation nobody at the Fed wanted to claim responsibility for (or even openly acknowledge that they performed so miserably) and use that as the calculated and calculating forward impulse on the way to putting it all behind.

The Fed in December 2015 proclaimed the economy recovered but nobody seriously believes it, at least not in the manner in which QE's were promised and delivered. The only way to reconcile the economy as it is with the faintest hint of full recovery is to so heavily mark down and remove economic potential as to statistically admit that the Great Recession acted out a permanent reduction upon US economic capacity. That might pass for an academic standard of success, but the politics of today argue persuasively in favor of revolutionary dissatisfaction even if the vast populace, on "both" sides, has yet to fully examine this summary list; both before the event and then after, leaving no doubt as to the epicenter of the lunacy.

Since August 17, 2007, a span of 3,100 days, nearly eight and a half years, nothing the Fed (or any other central bank) has done has worked. It's not that the monetary policies have not worked well; it is that they haven't worked at all and are actually quite harmful. It may be harder to distinguish that latter charge in the US as compared to the easy visibility of QE's destruction upon, say, Japan (bank reserves under QQE +338.5%; real household income -7.1%), but that point has been rounding into visible shape throughout the latter half of 2015 and still more in early 2016. It's exactly why suddenly everyone, including Janet Yellen and all her cohort, is very, very nervous to say the least.

With the gathering storm threatening yet again, we are supposed to believe that central bankers have the answers now in a way that they haven't through all of those prior 3,100 days? Negative nominal interest rates are different than QE in only one word; "nominal." The central point of QE was to reduce "real" interest rates via again inflation expectations so that they would be negative; instead, inflation expectations in the US, as everywhere else, are now as low as they had been in the worst days of the Great Recession.

Any reasonable human, requiring at most less than reasonable intelligence, would examine this litany of only failure and conclude that they really don't know what they are doing. It is utterly and painfully obvious. The whole theory is rotten, top to bottom, yet they persist at it worse and worse no matter the outcome. Monetary officials have no idea how the monetary system actually works, a proven indictment by their own hand, so how are they supposed to use "monetary" policy to control the economy in just such a way that would be successfully different than all prior efforts at controlling the economy?

The resolve now is that negative nominal interest rates are not the "next" step in experimentation within the asylum, but it's much more than that; they are dangerous in a manner we still have yet to witness (as hard as that may be to fathom given the depths of incongruity and affront so far).

The problem with NIRP is that it erodes even more the factors holding the ledger system of eurodollars in place. Not only is there the problem on the cash borrower side of the interbank, wholesale system (as noted in the paragraph above) but a similar quandary for the cash "owner": why bother lending in repo at a sufficiently negative rate when it might be easier and less costly to just convert those positive but virtual interbank balances to physical cash and sit out the storm. In other words, if your only choices for otherwise idle cash (in virtual ledger form) are seriously negative central bank accounts (deposit account at ECB or perhaps a negative IOER?), seriously negative unsecured (Eonia, Euribor now, federal funds, LIBOR in the future?) or seriously negative secured (repo), then why bother with any when cash might be the least worst option. In a world losing faith in the central bank-inspired future, it might not even be least "worst."

To this point, even during the worst of the panic through the end of 2008 and into 2009, the "monetary" erosion has been contained (I use that word with purpose) entirely within banking and wholesale "money." Forcing NIRP on a global scale onto this fragile system, in a further weakened economic state, might trigger a crossover from wholesale money into actual money and currency. In Europe, where we can observe a sufficiently comparative system already further into the nominally negative, money market rates have only followed with nothing of the expected boost or response (which is why the ECB only talks about still more negative). The Deposit Account rate (equivalent in the US to IOER) is -30 bps, which has only led to -24 bps Eonia (overnight unsecured equivalent to federal funds) and negative Euribor all the way out to 12-months (with some alarming inversion past 2-month maturities).

At some unknown point, banks are going to decide that the combined weakening economic condition with more and more lost credibility on the part of central banks equals a fundamental alteration in their "reserve" structure. There are only two reasons to "lend" "cash" for one year at -6 bps; because you believe by the end of that year there might be more opportunities to do something other than being taxed on idleness, or because the administrative and physical costs of converting billions of euros into actual euros, physical notes, is that much more costly. The negativity already in Euribor rates in Europe suggests, strongly, especially the inversion however slight, lessening of the former reason and increasingly moving the probability spectrum to the latter.

In the wholesale money world, physical cash is illiquid. You have to change it to virtual, ledger balances in order to connect to these "money" markets - that is another element that the Fed and all these central bankers simply haven't figured out, or are prevented from doing so by the stiff and rigid terms of their anachronistic ideology. Converting wholesale balances to physical cash, then, is not a primary interest but it can be a defensive mechanism against further insane repression; it might end up being the only one.

If that tipping point ever occurred, the full weight of craziness would truly be revealed - there would be a literal cash shortage, the very convertibility run that once was common but has been believed extinguished by giving the central banks the "printing press" and authority (sometimes) to use it. By trying to force at first banks (they are already discussing ways to work around physical cash and the zero lower bound, in order that their penalties are equally real as bank) out of idle virtual, wholesale "money" balances, they may end up being forced into the literal printing press.

It might sound utterly crazy, but it is perfectly and astoundingly consistent with the past 3,100 days and is thus the trajectory put in place by everything described above. Central banks have only resorted to greater lengths of lunacy and nobody has yet looked at their record and demanded a merciful end. If the politics of our current time don't stop it first, then the actual laws of finance will one way or another. The fact that central bankers not only have failed but can only fail makes this a plausible concern. They have shown no tendency toward self-restraint no matter how disastrous their incursions, so anything is possible as a legitimate concern this far along.

In the case of this kind of convertibility strike, we have no idea where the line to cross lies but we do know the madness of economists in trying to find it. Desperation is everywhere and with good reason. Global NIRP not only reflects and proves QE's disasters, it would be a danger all its own beyond that employed by all prior failures - and they have all been failures.

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

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