The Only Thing That's Normal Is How Nothing Is

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As the Federal Reserve struggles desperately trying to sort out its rate policy situation, the debate still rages as to whether or not the recent small-scale asset purchase program qualifies as QE. Only recently has it dawned that maybe the two are related, acknowledgement of the wider debate. It’s not just rate cuts that are the issue for Jay Powell, he also would very much like to know the “right” level of bank reserves.

For one thing, an immediate problem, banks are filling up their orders for the FOMC’s not-repo repo operations again. They are oversubscribed by large amounts, the system’s primary dealers acting lustily in a way they hadn’t even last fall. This despite the fact that not-QE’s T-bill purchases have steadily and substantially raised the systemic balance of bank reserves (+$210 billion).

Before getting lost in the minutiae, it is instructive to recall how at one time there weren’t supposed to be any. Not by this point. It was fully believed, among policymakers and all, that when the time came for normal the Fed’s balance sheet would go right back to the way it had been before the somehow Global Financial Crisis.

Very early in 2011, only a week into what would turn out to be a crucial year, Federal Reserve Vice Chairman Janet Yellen sojourned to the very edge of the snowy, picturesque Rocky Mountains for The Brimmer Policy Forum at the Allied Social Science Associations Annual Meeting in Denver. Forget scenery, pretty much all anyone wanted to hear her talk about was QE2.

The world, certainly US central bankers, had been shocked by the developments in 2010. Trends were supposed to have been consistent with recovery but instead had smelled too much like 2008 and 2009.

In response to the growing malodor Ben Bernanke’s group launched a second round of asset purchasing, whose goals were threefold: to stoke inflation expectations because of, you know, that whole money printing thing; to force investors mainly cautious banks into risky assets by buying from them the safe ones; and, to raise the level of bank reserves, the presumed printing, so as to further lubricate very necessary financial functions devastatingly strained under illiquid circumstances.

By the time Yellen would arrive in Colorado, she was enthused as many people were. For a time, it had looked like they, and we, had dodged a second bullet. In what may be one of my favorite Janet Yellen moments, a brief one of clarity, she even acknowledged how the bond market actually works:

“…longer-term Treasury yields have risen substantially over the past couple of months since the FOMC initiated this round of asset purchases. I believe that this increase in Treasury yields likely reflects a number of significant factors, including incoming information suggesting a somewhat stronger economic outlook and the fiscal package that was announced by President Obama in early December and approved by the Congress about two weeks later.”

When the Fed or just the economy all on its own (I know, a distant pipedream) succeeds that will be what happens. Bond yields go higher, the interest on safe instruments adjusted upward to a much better world. We cheer for the recovery by the heavy selling of every UST.

She didn’t come right out and say it, but you could tell just by reading the text of her speech how the Vice Chairman really wanted to say it, how powerful this QE thing really was and proud policymakers were of their fantastic creation. Sure, they had to repeat it a second time, but that wasn’t their fault, you see. Let loose on a blank monetary canvass, this money printing, bank reserve thing was just awesome.

What she did say was that, according to the Fed’s stochastic modeling, for every ¼ point decline in Treasury yields due to the central bank bond buying it would equate to an additional 700,000 new jobs. Quarter point! And that didn’t even take full account of all QE’s magical properties, as Janet then spilled what was the central banker equivalent of a full-on display of chest thumping.

“It should also be noted that this exercise is performed as a deterministic simulation and hence does not capture the potential benefits of the asset purchase program in mitigating downside risks to economic activity and inflation.”

But Yellen’s “somewhat stronger economic outlook” wouldn’t even last the quarter. By April 2011, commodity prices were plunging again and then bond yields. On June 7, 2011, despite all the earlier satisfaction about QE2 Ben Bernanke told Congress that “monetary policy cannot be a panacea.” Funny, where would anyone have gotten that idea?

In August 2010, Bernanke had leaked his plans for QE2 at the Kansas City Fed’s annual Jackson Hole symposium. The following year, in August 2011, with QE2 having been completed, Bernanke promised his audience, much the same audience, that, “The Federal Reserve will certainly do all that it can to help restore high rates of growth and employment.”

Calling growth “disappointing”, the Fed’s then-Chairman rather than announcing QE3 (that would have to wait a year) he instead told the media that the Fed’s scheduled one-day September 2011 meeting would be extended an additional day. Policymakers needed more time, apparently, to discuss further ways to “support economic growth.”

All they would come up with was Operation Twist.

But even Twist was a major deviation in plans. Back when everyone thought QE2 was working well, in January 2011 Janet Yellen had told her audience in Denver that the Fed had already mapped out its exit. Because QE couldn’t possibly fail (twice), she purposefully brought with her (“for illustrative purposes”) materials outlining ferbus (the Fed’s main DSGE model) simulations for how the unwinding process would likely unfold.

It was originally believed, at its outset, that QE2 wouldn’t last more than a year and then once completed the higher level of assets would be maintained for two years afterward. They would then be unwound, securities allowed to mature, maybe even some sold, for an additional five years thereafter. By the middle of 2018, the Fed’s balance sheet was back, or back close to, the pre-crisis baseline.

No lingering trillions in bank reserves. As it was intended: the financial system goes back to normal, the economy then gets back to normal, and finally the Fed can safely return also to normal.

This raises immediate questions about…bank reserves. If the US central bank only ever intended them to be a temporary addition or backdrop to a system that had gone for decades without them, what must we conclude today in light of the inability of the Fed to figure the “right” amount of bank reserves that they now believe must total into the trillions forever?

As I’ve written many times especially during the course of QT, QE’s relaxing opposite, it had always been the plan to turn everything back over to the private money dealing system. The Fed hadn’t been a major part of it in the pre-crisis era; all those asset bubbles torching the global economy had been financed and monetarily sourced exclusively by the private system.

That system then failed, beginning August 9, 2007, to which the central bank initially responded with Temporary Open Market Operations (TOMO) before eventually panicking into Permanent Open Market Operations (POMO), the large-scale asset purchase programs called QE. All designed to raise the level of bank reserves, either temporarily, in the case of TOMO’s, or, as in POMO’s, for longer periods.

Despite the word “permanent” attached to the one set of OMO’s, they were never intended to be. Every single exit plan the Fed has had to come up with since QE was first announced in November 2008 ended with its balance sheet at, near, or within sight of its original setting.

Set aside the obvious problems with QE’s design and execution for a minute, how it never seems to actually work in the economy nor monetary system. What that would’ve meant is perfectly, absolutely clear: by the central bank’s own doctrine, the financial crisis was a breakdown in the private system which was met, for a time, with the public central bank system stepping in. Once the financial system had fully recovered, then the economy, officials had always intended to step back and turn things back over to the private side.

To drain the reserves near completely.

That was supposed to have been QT, it’s entire point and purpose.  Hey, you banks screwed up big time, we stepped in at the last minute and fixed it, you’re welcome, but now it’s your job once again.  

If you can’t ever go to that last step, what does that tell you?

For the US central bank, it can never be that obvious. The fallacy of sunk costs in monetary policy is personified in the absolute dedication to bank reserves. Even as the repo market last September reminded everyone of this very thing, officials have been busy during the half-year since trying to come up with any other explanation except the one staring them in the face.

It cannot be that the private monetary system remains broken. Why? Because it just can’t end up that it was all a lie; how all those policymakers who have traipsed through the FOMC’s boardrooms and staked their entire careers on what they did during the world’s biggest moment of need in four generations on the slightest, skinniest hill of beans. By admitting the private system remains unfixed and in serious need, no matter any level of public bank reserves, the last dozen years are tossed right down the drain.

And that’s just the beginning; not long after the flush finishes up just wait until the public takes a second look at what little those bank reserves accomplished during the crisis (again, I urge, read the 2008 and 2011 FOMC transcripts!)

Ever since the repo mess took place last September there has been an explosion of scholarship on the matter, which already tells you something important (to be Shakespearean, the Powell doth protest too much). And all of it, I mean all of it, comes away with only two conclusions: that it must’ve been some combination of technical factors, but also that no one can really say for sure that’s actually what it was.

Excluded right from the start is any examination of the most apparent case; a monetary system that never healed, hadn’t recovered, and remains in a fragile state of often obvious disarray.

What makes it obvious?

Go back to Janet Yellen. If at any time during the last decade or so because of QE or just via blind dumb luck had the financial system recovered leading the economy to actually boom, bond yields wouldn’t have just temporarily jumped, as they had for a few QE2-inspired months, they would’ve skyrocketed and stayed up there. Instead, especially after 2014, they like inflation expectations sank and have remained down here.

Through it all, the corruption. I don’t mean as in officials systemically looting the Treasury, rather the intellectual bankruptcy; a self-imposed blindness. The system must’ve been fixed because the central bankers all say the system must’ve been fixed.

What’s their evidence? Don’t laugh – low bond yields. In so desperately attempting to find something, anything consistent with these claims the very straightforward decline in safety yields due especially to the very same private banking system in question buying and hoarding only the most liquid and safe assets, somehow policymakers have felt compulsion to twist and spin collapsing bond rates (along with inflation expectations and the anticipated future path of short-term interest rates) into something else entirely.

Term premiums.

It was a difficult claim to make with a straight face in 2018 when curves were merely flattening. Now? Record low UST’s with people (finally) beginning to understand the very real possibility of negative yields in this very market.  

That’s the thing; negative yields were always a possibility. You might even say, as I have, that they were inevitable.

In the sense of this sort of overview, it really is just that simple. They say it’s been fixed and the bond market shows that it hasn’t.

Japanification wasn’t really zombie banks and an overextended economy plagued by a burst bubble. It was, as I wrote all the way back in 2016:

“The end result is an economy that goes nowhere, languishing in prolonged malaise seemingly caught in monetary limbo between perpetual recession and a recovery that intermittently appears to be just around the corner. It feels just good enough not be the worst case but also never completely breaking free of what feels like an unknown anchor. In the end, it is actually the worst of the worst cases, where the economy has been removed completely from the normal business cycle and left in indescribable, frustrating agony. This condition even has a name if but colloquial by design - Japanification.”

Only now, with Treasury yields poised as they are, does it begin to sink in. Another significant downturn after yet having recovered from the first one. After only false dawns in between, one after another, Janet Yellen in January 2011 describing the sensation almost perfectly right down to the yield trajectory, it’s been a tragedy and one of official making. That’s the corruption.

The ultimate costs the global economy will ultimately have to bear for this ongoing exploitation are still unknown, but they are about to be significantly upsized - again. That’s what record low yields say about the matter, the accumulation of these supposedly far off, long run consequences of, from the start, having equating bank reserves with anything of importance.

Kon'nichiwa. Welcome to the long run where the only thing that’s normal is how nothing is.


Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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