21st Century Monetary Policy Is Increasingly Upside Down

21st Century Monetary Policy Is Increasingly Upside Down
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There have been just about 640 trading sessions since the FOMC began its rate hike trajectory. The first became effective on December 17, 2015, or Day 1. This shifting monetary policy stance has become notable only of late, however. That’s the weird part nobody wants to address.

December 2015 was a huge mess. Economically, financially, and especially monetarily, there was nothing about that month or the one following it that was good anywhere around the world. On January 15, 2016, the Dow Jones Industrial Average plummeted almost 400 points. As one CNN article put it, “The market freakout of 2016 keeps getting scarier.”

But what was this “freakout?” CNN pinned the blame on two very conspicuous symptoms. “Cheap oil and China remain the major culprits,” the article said. Yes, but what did those two have in common?

The prospect of a dangerous “dollar” shortage had become apparent long before the first month of 2016. The warning signs had been steadily recurring and intensifying since May 2014, and even before then. None of them were heeded because in the mainstream of monetary convention this was impossible.

The Federal Reserve through four quantitative easing programs had supposedly “printed money.” And not just a little, either. Engaging in multiple trillions of asset purchases, the net effect was an increase in the level of bank reserves to just about $2.8 trillion at its peak – in 2014. There was no way dollar liquidity could be the problem, or so we are supposed to think.

While putting on a brave face, one that is often couched as a monolithic block of certitude, not even Federal Reserve officials were so sure. For one, they had that unnerving experience in 2011 when the orthodox view of bank reserves was challenged directly by a renewed global “dollar” crisis. At that time, not all that distant from a full-blown monetary panic, the balance of bank reserves had peaked at around $1.6 trillion.

Below is the money comment from the FOMC meeting held on August 9, 2011, exactly four years after the eurodollar system broke:

“MR. SACK. Can I add a comment? In terms of your question about reserves, as I noted in the briefing, we are seeing funding pressures emerge. We are seeing a lot more discussion about the potential need for liquidity facilities. I mentioned in my briefing that the FX swap lines could be used, but we’ve seen discussions of TAF-type facilities in market write-ups. So the liquidity pressures are pretty substantial. And I think it’s worth pointing out that this is all happening with $1.6 trillion of reserves in the system.”

Therefore, what was decided by September 2012 and the advent of QE3 (and then QE4 later in December) was to increase the level as if that was the specific insufficient variable; $1.6 trillion was a lot, but was it enough?  Guess not.

That was always the problem with quantitative easing. If you have to do it more than once, it didn’t work. It cannot have been “quantitative.” You may suggest that people, even the central bankers, make mistakes sometimes. But four of them? It’s likely not “easing”, either.

This is the thing about 21st century monetary policy, it almost always appears upside down except for the rare occasion like this year. For example, Day 1 for Alan Greenspan’s curtain call was June 30, 2004. The “maestro’s” final act was going to be a determined series of rate hikes that signaled his Fed’s successful guiding through the economic rough patch of the dot-com era and aftermath.

Unlike the current regime, the mid-2000’s “tightening” was steady and consistent. By Day 640, the prior FOMC was already 140 days at its peak. In the time it has taken the current FOMC to go from 0% to 1.75% (RRP), the former had accomplished 17 hikes to take the federal funds target from 1% to 5.25% - with a third of a year to spare.

Yet, during that period nothing seemed ever to respond as “tight.” Take the dollar. Unlike now, there was practically no stopping its descent. The so-called weak dollar showed up around 2002 and didn’t terminate until March 2008 when Bear Stearns almost did. Nothing the FOMC did during that period upset the trend.

As such, there wasn’t any notice of “tightening” in any other important monetary spaces, particularly those off in the shadows. Derivative use, especially credit default swaps being deployed for regulatory capital relief, a technique of balance sheet construction that acted as an enormous balance sheet multiplier, absolutely exploded at the same time Greenspan intended the opposite.

Quite simply, the dollar fell because eurodollar supply still rose. Monetary policy was a minor speed bump that was easily overcome.  The central bank simply didn’t matter.

Beginning August 9, 2007, everything reversed. Monetary policy became more and more extreme in its “accommodations” yet nothing seemed to be accommodated by it. There was that whole global dollar panic, after all.

But no matter what has taken place since, the belief in it has been unshakable in certain quarters. The mainstream media, for one, has uniformly described every single central bank action as “easing” despite the mountain of empirical evidence it isn’t. Good standing editorial standards demand strict adherence to the pedigree of Economists rather than the contradictory outcomes of following their instructions.

So, the “rising dollar” of 2014-16 was put down simply as “overseas turmoil” of some unspecified nature. Though it was in every way an obvious dollar shortage focusing its destructive influences more so in foreign places, the textbook deflation that accompanies such monetary episodes did, in fact, register all across the US economy, too.

Even the CNN article cited above was forced to note:

“Also, it's not clear consumers are really spending their gas savings at the stores. The government said on Friday that U.S. retail sales dipped in the critical month of December. That's never good.”

It wasn’t. Ostensibly, the Federal Reserve sought its first rate hike in December 2015 because it believed its “accommodations” had worked. In the final push to $2.8 trillion above $1.6 trillion they thought they had achieved the long-sought recovery “lift off.” They hadn’t.

Instead, as has been revealed more and more by downward benchmark revisions to the major economic accounts, the US nearly fell into recession right at that moment. This near recession in Q4 2015 and Q1 2016 doesn’t appear anywhere in the official record. How could it?

At that time, US monetary policy even after the one rate hike was considered “highly accommodative.” Central bank officials from Janet Yellen on down made it a point to reinforce that point over and over and over again. If monetary policy was extremely loose, then to admit a severe dollar shortage would blast apart the whole rotten enterprise – starting with bank reserves.

The economy tailed off anyway, a fact acknowledged unofficially by the slow pace of subsequent rate hikes. The second wouldn’t follow until a full year after the first.

That leaves us with this year’s oddity. For the first time in a very, very long time US monetary policy is consistent with what increasingly looks like another dollar shortage developing. This correlation is causing conventional wisdom to commit the cardinal sin of statistical relationships: correlation is not causation.

Right now, obviously, isn’t the first time we’ve seen all the same contractionary symptoms; primary among them the breakdown of covered interest parity signaling issues with balance sheet capacity restraint. The dollar is rising again, of late to the point it’s causing major “overseas turmoil.”

But it’s the first time the media has been able to admit there just may be such a thing. For the sole reason of “rate hikes”, we can now talk about the world’s dollar problem. And that’s a problem.

If after everything that has happened over the last two decades everyone still believes the central bank is at the center of the monetary system, nothing will change. Quite simply, if you think the Fed is the reason for dollar tightening in 2018, then it follows the Fed can fix it by not tightening. And you will be surprised if they do reverse course when nothing happens. The world, though, would lose several more years we really can’t afford in the wasted belief.

The dollar fell (and bank stocks went up) when Greenspan and Bernanke did their 17 hikes; the dollar rises even though Yellen/Powell have done only 7. Did the Fed somehow get better at monetary policy over the twelve years in between?

You see this problem come up even where honest investigation of the eurodollar system is taking place (there are a few, a very few). It’s gone on long enough now that among the more open-minded scholars they can’t help but wonder about all this regular “overseas turmoil” and whether these things called eurodollars might be playing a central role in them.

The idea of a eurodollar started simply enough; straightforward deposits of US dollars in offshore accounts. Almost immediately, however, they started evolving toward something else entirely. For one, global dollar liquidity is defined not by deposits of anything, or even money. It is entirely an interbank space where banks trade different liabilities with and among each other.

The flexibility to be able to create a transaction on demand in this way had made the offshore system tremendously desirable from the perspective of any global bank. It was hugely efficient and more so represented almost limitless opportunity.

As such, and this is the key point, it developed entirely outside of the central bank framework. Sure, it was nominally attached to the domestic dollar system like federal funds, but it became so much more than even basic wholesale liquidity. There just weren’t any avenues for any central bank to obtain emergency entrance. Not with a 1950’s understanding of money and 1930’s capabilities (even QE is a very old concept).

Bank reserves mean something in the Economics 101 textbook, but before 2008 they didn’t exist in the dollar system. The eurodollar banks created their own system of “reserves” whereby there really weren’t any workable traditional equivalents. Liquidity was, briefly, a future concept not a present one.

Liabilities depend upon a collective belief that “the market” can supply liquidity at every point in the future.  It reminds one of insurance, at least in how Charles Dickens once described it.  He observed:

 "A person who can't pay, gets another person who can't pay, to guarantee that he can pay."

The eurodollar market is similar; a bank that has no dollars, gets another bank that has no dollars, to guarantee that everyone has dollars. In such a system, what would it matter if the central bank claims to hold, and offer, dollars? What really matters is the level of promises, or chained liabilities, that pertain to the collective sense of “the market.”

I know you don’t have any dollars, and I know I don’t, either, but we conduct our dollar business anyway on the basis that you or I could obtain them if we ever needed to. I give you a future liability to pay you dollars and you take it because you thoroughly believe that I can enter the market and find them on demand. Those future derivatives form the basis of what looks like a currency system, though in practice it is more akin to a computer network.

The Federal Reserve claims to have dollars, and in a very narrow sense it might. It may offer current liabilities through limited and constrained channels, but it doesn’t offer any of the same future capabilities that the market runs on. I may be able to obtain dollars as bank reserves (only if you are a primary dealer) to satisfy my current obligation to you when it runs out, but then what?

Our business is concluded, and that part of the system shrinks as there is no future capacity to do it again and again like we once did.

For those who aren’t primary dealers, funding reliance on these future concepts has become testy and temperamental, to put it mildly (just ask banks in Tokyo). The post-crisis whims of global banking are not a reliable basis for solid systemic potential and everyone now knows it in practice (especially after 2011) even if orthodox convention still dominates all contemporary discussion. Banks matter, not central banks.

This is why the Greenspan Fed can do 17 consecutive rate hikes and not make a dent in anything. To suddenly believe that 7 can upset the whole system (doesn’t matter the balance sheet level or the policy contraction in bank reserves) is nothing more than selective interpretation desperately clinging to the pre-eurodollar view of things.

After all, we are just repeating the recent past. To thus far in July 2018, we’ve seen all these things thrice before. They were just never reported honestly.

When oil prices crashed in late 2014 and early 2015, Economists ideologically committed to the technocratic success of the Federal Reserve stumbled about for any explanation that might be consistent with what was then a belief in full recovery and the still looming rate hikes that would be attached to the boom. It was a supply glut, they said, and lower oil prices would be a huge benefit and boost to consumers. Sharply lower crude would make the coming economic acceleration even more robust than everyone was expecting it to be.

Nope. It was instead textbook global deflation and the warning signs were everywhere. In March 2015, I wrote of a broad cross-section of eurodollar related conditions including oil, oil futures contango, copper, Danish krone, Swiss francs, Eonia, gold, euros, reals, etc.:

“While these are disparate indications spread across all sorts of markets and geographies, the one commonality between them is the ‘dollar.’ If we are to attempt any kind of more realtime indication of what eurodollar function looks like, it probably doesn’t get much [clearer] than this as all these market rates and prices are suggesting the same thing at the same time – look out for another ‘dollar’ episode potentially just getting underway.”

Some of the specific signals are different in 2017 and 2018, history rhymes rather than repeats, but the underlying basis and connection is so nauseatingly familiar. The only thing that has changed is because of the Fed’s actions the mainstream now feels safe to actually admit there may be something going on rather than just hiding it.

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

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