Federal Funds Don't Matter As a Market, Or a Rate

Federal Funds Don't Matter As a Market, Or a Rate
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Here we go again. If you understand the basic physics of flight, the importance of airspeed, how the wing provides lift, etc., it still doesn’t in any way qualify you to fly an airplane. To actually do so requires intricate knowledge of the dizzying details of the vehicle you wish to get off the ground and keep that way in a controlled fashion.

If we are to be specific, the Federal Reserve’s sole purpose is federal funds. It has, of course, a double legal mandate to maximize employment with as low consumer price inflation as possible. But to accomplish these goals the central bank has exercised little other than moving around the federal funds rate. It’s their one job.

Of course, over the last ten years the Fed has gone way beyond the mere targeting of that rate (QE’s and such), but that’s exactly the problem. Largely because they had no idea what was really going on, starting with federal funds, for the last almost eleven years it’s been a disaster. It’s difficult if not impossible to avoid the worst circumstances when you are literally flying blind.

US policymakers are once again thinking about IOER and federal funds. It is important to review yet again why. As I write often, we still talk about 2008 because we aren’t yet done with 2008.

Just as the major part of the panic was beginning, on September 29, 2008, the FOMC held another emergency conference call to address multiple severe liquidity strains. You would have thought by then just the necessity of having had so many emergency calls would have woken somebody up sufficiently to have asked the others, do we really know what we are doing here?

There were several reasons for that particular call, starting with the one thing central banks were supposed to have rendered impossible. The whole point of interest rate targeting in the first place was to once and for all abolish such dangerous monetary chaos.  Instead, as they keyed their telephones to DC, the very visible precipice of full-scale global panic loomed directly ahead. To try and address this the FOMC discussed two alterations to their mode of operation.

The first was an increase in dollar swap lines with foreign counterparty central banks. As Open Market chief Bill Dudley described, “…European banking strains have been increasingly evident in recent days, especially this weekend following the announcement of the Fortis rescue and the nationalization of B&B in the United Kingdom.”

It should become clear as to why these technocrats never competently connected all the dots. Dollar swaps sent dollars into Europe, Japan, and elsewhere. Why? Because that’s what was causing all the trouble including the Fortis rescue and the nationalization of B&B in the United Kingdom. An alarm bell should have sounded long before the end of September 2008 that the issue was not federal funds nor even dollar but eurodollar.

Because the FOMC was voting that day to greatly expand the available swap lines out into the offshore currency world (even if indirectly and bureaucratically via local central banks rather than directly into the eurodollar market), the Committee was concerned about what to do with all the bank reserves that would be created as a byproduct.

It was simple central bank double accounting: swap lines were an asset where the larger the balance the greater the Fed’s total on its asset side; if nothing were done to offset them on the liability side (factors absorbing), bank reserves would necessarily rise by the same amount. Reserves mean something to central bankers that they don’t in the market.

Viewing reserves as they did, you would think an excess of them would have been welcomed at that particular moment in time. What mattered to them first and foremost was the federal funds target.

It had become a matter of reputation, even legend. Throughout Alan Greenspan’s long tenure, the world had come to believe that through nothing other than small incremental movements of the federal funds target the “maestro” would heavily influence banking, credit, and therefore unemployment and inflation. The federal funds target mattered more symbolically than anything, almost a self-fulfilling prophecy of expectations.

Thus, in the middle of crisis emergency action would require emergency measures to offset some of that action in order to maintain the target above all other considerations. To lose control of targeting would mean to broadcast to the world the central bank in fact had no monetary control (which some market participants far better understood than the empty suits at the FOMC). The Fed had some tools at its disposal to deal with reserves, but these were being used up and encountering limits. Should the level of bank reserves rise precipitously, as was about to happen, the FOMC wanted to make sure that the federal funds effective rate would remain close enough to where they wanted it.

When we typically think about such a paradigm, it’s usually in reference to rising short rates. It is the upward direction, after all, which indicates illiquidity and insufficient money. That was, however, LIBOR not federal funds. The latter had displayed a tendency toward the opposite direction going all the way back to August 10, 2007. In the conventional thinking of a Fed official, they just can’t have the federal funds effective rate deviate too far in either direction as it had.

To deal with the possibility of further shallowing, the FOMC on their call very briefly discussed IOER. The Committee’s secretary Brian Madigan stated simply, “We may need to use the excess reserves rate as the way to effectively set the federal funds rate.”

Members didn’t offer much debate about it because they didn’t think it required any. It was, to them, a very simple, straightforward matter. If you pay X interest on reserves, then there doesn’t appear any reason why banks would lend out at less than X. From the point of view of a bank, if you can obtain X from the central bank effectively lending it cash, why then would you lend in federal funds, repo, or whatever else at less than X?

On still another emergency FOMC conference call, this one held on October 7, 2008, amidst growing financial, monetary, and ultimately economic carnage, Bill Dudley expressed confidence about finally receiving statutory approval to start paying interest on reserves (which they would begin to do two days later). They viewed the situation with “soft” federal funds as critical.

“MR. DUDLEY.  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.”

Nope. Not even close. IOER never once created a floor under any money market rate, certainly not federal funds. As I have described many times before, not only did the federal funds effective rate refuse to behave, the problem actually grew worse (still lower effective rate) as the panic rolled on.

Originally, the rate was intended to be set at 75 bps below the federal funds target. On October 9, 2008, the policy target for federal funds had been cut to 1.50%, meaning the Committee was thinking 0.75% for IOER. Policymakers were stunned at just how low the federal funds effective rate had tended to be despite the first few weeks of payments, and so decided to narrow the spread expecting that would be even more assurance of success.

Nope. Not even close. When the FOMC next gathered at the end of October 2008, this time for their regularly scheduled policy meeting, Bill Dudley was forced to (try and) explain why it wasn’t working. They had just the week before reduced the spread to target federal funds minus 35 bps to try and coax the effective rate back up where it “should” have been. They were even debating about going so far as to just equalize IOER with the target.

"MR. DUDLEY.  …some banks have also been selling federal funds below the interest-on-reserves rate. We expect this to diminish over time as they gain more experience with the new regime. However, other factors, such as concern with their overall leverage ratios, could cause this phenomenon to persist. As a result, there has been a significant amount of federal funds rate trading below the interest-on-reserves rate.”

Ultimately, that is what happened and would continue. On November 6, IOER was brought up to 1% which was at that time equal to the federal funds target. Still the effective rate failed to respond. We don’t know if Mr. Dudley was being purposefully imprecise, regardless “concern with their overall leverage ratios” was in practice a euphemism for total monetary fragmentation.  

Not too much longer after that, the FOMC scrapped the rate as any kind of a floor for federal funds or anything else. Again, it never once worked as intended. The real issue was and is why, or, more appropriately, why were policymakers so adamant it would.

The last question is really quite easy; they really didn’t know what they were doing. The bigger problem is almost ten years later they still don’t. To realize this would be to move the discussion beyond bank reserves and federal funds altogether, which is what was required in 2007 and 2008, and, unfortunately, is still required in 2018.

Just recently, the staff at the Fed has been modeling and discussing a “technical realignment” of IOER. Under the current framework, the rate paid on excess reserves serves as something of a double floor, or at least that is how policymakers attempt to describe it. In truth, it’s more symbolic than effective. They want to still believe in it because they want to still believe they didn’t screw up everything down to the most basic stuff.

This technical realignment has to do with federal funds now being too high. It hasn’t yet broke above IOER, but it has been getting closer to the upper bound of the current target range. Since December 2008, the FOMC has conveyed its interest/money rate policy by describing a range for the effective rate inside which it will supposedly tolerate. The lower end is the reverse repo rate (RRP) while at the top sits this dubious double floor of IOER.

What has been proposed is to reduce IOER (here we go again) so that it might compel federal funds a little lower back away from getting too close to the upper bound. From what has been made public so far, the adjustment would be carried out at the next (or whenever) “rate hike” where the FOMC might vote for another 25 bps for the RRP but then only an additional 20 bps for IOER. It would narrow the range by 5 bps at the top, which the staff apparently believes will help keep federal funds more in line; reducing, they presume, the danger of it breaking their policy regime as other rates already have.

It’s as if 2008 never happened for these people, and that there isn’t a mountain of empirical history on the topic. The issue isn’t IOER right now any more than it was back then. Federal funds might be a potential problem in 2018 because LIBOR already has been, meaning once more eurodollars.

What the Fed should have (easily) realized very early on in the crisis was that when federal funds traded significantly below target it wasn’t the result of their creation of bank reserves (certainly not in 2007), rather it was the dumping of funding into domestic markets at the direct expense of those offshore. LIBOR rose precipitously as the other side of that process, where the growing spread between federal funds (or OIS) and LIBOR indicated the nature of the imbalance (offshore dollars) as well as the seriousness of it. Pure liquidity risk, or insufficient money in the system – the whole system.

They never once grasped what was really going on, which is why they so distracted themselves with attempting IOER. The focus on the federal funds rate and its relation to target should have been enough to correct the intellectual deficiency, but their frame of reference never moved. They only considered the matter in terms of making effective federal funds obey their target (in other words, only the target mattered), not why it wouldn’t and furthermore why it never did.

Each time they met to discuss how it could be that whatever the latest adjustment failed to make a dent in the problem they concocted all sorts of technical sounding rubbish to rationalize why it wasn’t a total conceptual breakdown. Before Bill Dudley’s comment I quoted above noting “overall leverage ratios”, he had before tried to lay blame in good part on the GSE’s who were prevented from receiving interest on reserves (it’s a technical argument that really, really didn’t matter, but it sounded good).

These habits never die at the Fed, an institution now wholly covered in complete denial. The FOMC has come up with another for why IOER may have to be changed. It goes like this: the recent large increase in the federal government’s budget deficit has required primary dealers to carry more treasury bills in inventory (bills are where changes in government borrowing register first); holding more bills means financing more bills, therefore a higher demand for repo funding; the repo rate rises as a consequence; therefore, the federal funds effective rate moves up in concert (secured vs. unsecured).

This is painfully obtuse. I’ve covered this issue before recently, only a little over a month ago, so I’ll merely quote what I’ve already written in these pages:

“If you instead learned from 2008 that these spreads are all about liquidity and liquidity risk (and therefore, you know, liquidations) LIBOR-OIS seems perfectly consistent with what actually happened – and might still happen (downside risk)…People are talking about LIBOR-OIS and so they [the FOMC] had to say something. Anything. But they couldn’t declare it was exactly what it appears to be because that would run contrary to everything they are doing, saying, and quite often take on nothing more than faith.”

Federal funds are being pressured because like LIBOR there is evident liquidity risk in a number of crucial spaces (just ask Indonesia, Brazil, or even India whose economy is the most fundamentally sound of any of them). This is a key difference from 2008 in that there is no dumping of excess funding on domestic markets. That may be because there is no excess funding to dump anywhere (some will attempt to blame the Fed’s balance sheet actions, so-called quantitative tightening, but so far the reduction has been trivial, and, as I always argue, bank reserves just don’t matter in light of balance sheet capacity issues – the very problem in 2008 and why the focus on reserves was an unnecessary and ongoing distraction).

To start with, this all came to a head in late January – when global stock markets, as well as Treasury bills (4-week), experienced a coordinated liquidation event (actually two, and probably three separate ones). They still haven’t recovered from them, which might propose to anyone whose job it is to extend liquidity that maybe there is something going on out there you might want to concern yourself with. Perhaps even cut back a little just to be prudently careful and do so first subtracting from the weakest, most risky players (such as EM counterparties still desperate for “dollars”).

The larger issue is more basic. Federal funds don’t actually matter, either as a market or as a meaningful rate. I don’t mean that it isn’t an important piece of global monetary operation (eurodollar system as a whole), rather this ridiculous idea that the Federal Reserve can control the economy by little more than moving around a single rate. They can’t even control that one rate under stress, which suggests they never really could before – they were just never tested to such an extreme until August 2007.

That would further propose they have no actual idea how the economy goes and what the real role of money is inside of it. Under econometrics and Positive Economics, long ago Economists decided they didn’t need to, they could substitute a single federal funds target foregoing detailed knowledge (believing past correlations to that rate would be permanent through all time). That’s an arguable proposition to begin with, but does it even matter if they can’t even get that one thing right?

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

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