Federal Reserve

Debt Has Not Been Caused by Low Interest Rates, but Higher Rates Would Topple the Whole World Economy

Published by Anonymous (not verified) on Thu, 09/01/2020 - 8:00pm in

Yet more official hand-wringing about interest rates...when they aren't the core economic problem.

Sweden Retreats from Negative Interest Rate Experiment

Published by Anonymous (not verified) on Thu, 19/12/2019 - 10:04pm in

Sweden throws in the towel on its negative interest rate policy as inflation stays stubbornly low.

The blind Federal Reserve

Published by Anonymous (not verified) on Wed, 11/12/2019 - 5:35am in

Ever since the secured overnight repo rate (SOFR) spiked to 10% in September, there have been dire warnings that these exceptional movements show the financial system is fundamentally broken. The story goes that the post-crisis financial system is so dysfunctional that it is unable to operate without continual injections of money from central banks. The Fed's attempt to reduce the $4.2tn of reserves it added to the financial system in three rounds of QE has dangerously destabilised the financial system, so it has now had to re-start asset purchases to restore the lost reserves and refloat tottering banks.

It's fair to say that much has changed since the financial crisis. Prior to 2008, banks maintained far lower levels of reserves than they do now, typically at or just above their reserve requirement. They borrowed reserves from each other in the unsecured interbank market to settle customer deposit withdrawals and securities transactions. The Federal Reserve intervened in the interbank market to maintain the average rate banks would charge for lending reserves (the Fed Funds rate) at the target level set by the FOMC. (This is of course a much summarised version of the pre-crisis architecture.)

But after the crisis, all that changed. QE disconnected Fed reserve creation from banks' need for reserves for settlement. Since banks collectively are obliged to hold all the reserves created by the Fed, they became (collectively) awash with reserves. However, reserve distribution is uneven: some banks still needed to borrow reserves, while other banks were parking excess reserves at the Fed. To create a "floor" for the Fed Funds rate, the Fed started paying interest on those excess reserves. Had it not done so, the Fed Funds rate would have fallen to zero, regardless of the FOMC's decision. But even with the Fed paying interest on excess reserves, the interbank market has become a shadow of its former self. Banks, their trust in each other permanently damaged by the crisis, now want other banks to post collateral against borrowed reserves. Most of the action has therefore moved to the repo market.

The repo market isn't solely, or even mainly, an interbank market. It intermediates funds across the entire panoply of financial institutions, including broker-dealers, insurance companies, pension funds, hedge funds, mutual funds (MMFs) and real-estate investment trusts (REITs), and some non-financial institutions such as large corporations and municipalities. Most of the funds that move around the repo market aren't lent directly by banks. But all cash transactions in the repo market are intermediated by banks, without exception. Although the majority of players in the repo market aren't banks, the cash that they lend each other simply moves from one bank to another. Mainly, it moves between four large banks - JP Morgan, Bank of America, Citigroup and Wells Fargo.

Thus, when an MMF lends cash to, say, an insurance company, the money simply moves from a demand deposit account at say Citigroup to a demand deposit at another bank, perhaps JPM. If Citigroup is short of reserves to settle this movement, it must borrow them from another bank or, as a last resort, from the Fed's discount window. In the post-crisis world when big banks had more reserves than they knew what to do with, Citigroup wouldn't have had to borrow anything. But now that reserves are scarcer, and liquidity requirements for big banks are much tougher (including intraday liquidity, which is a whole new subject in itself), it's quite possible that Citigroup might have to borrow cash in the repo market to replenish reserves lost due to its MMF customers lending cash in the repo market. Meanwhile, JPM ends up with more reserves than it wants, so it lends cash in the repo market, thus transferring reserves to another bank, perhaps Citigroup. I totally understand that this is confusing, but this is what happens when the interbank market becomes absorbed into a general collateralised market made up largely of non-banks. It helps to remember that regardless of who owns them, electronic dollars never leave the banking system. Follow the money, not its owners.

And so to our SOFR spike. If a market interest rate spikes, it means market participants don't want to lend. That can be because they have stopped trusting each other, as when Reserve Primary MMF broke the buck in 2008. But it doesn't have to mean that. It might signify that they have other uses for the money or the associated collateral, for example if they need to hold more of them because of tighter regulatory requirements. Or it might simply mean there is a market shortage of cash or collateral, so they prefer to hang on to what they have rather than lend it to others and risk paying much higher funding costs themselves.

Much ink has now been spilled trying to discern which of these caused the SOFR spike. Most people blame banks. For example, according to the FOMC's Randal Quarles, the SOFR spike was because banks suddenly stopped lending to protect their reserve levels:

Randal Quarles, the vice-chair of the Fed, said on Wednesday that banks’ own internal stress testing may have led them to hoard cash rather than lending it in the overnight repurchase — or repo — market. 

Banks' own internal stress tests made them suddenly pull back lending enough for the Fed Funds and SOFR rates to spike into double digits? Really?

Unlikely though this sounds, Quarles could be on to something. This chart in a recent paper from the BIS shows a remarkable structural change in the composition of the interbank market:

Since mid-18, the entire market has become dependent on funding from just four big banks. If those banks reduce lending to the market even slightly, the market suffers a heart attack. As the BIS explains:

The big four banks appear to have turned into the marginal lender, possibly as other banks do not have the scale and non-bank cash suppliers such as money market funds (MMFs) hit exposure limits (see below).

This, I think, is what Quarles is getting at. The four banks collectively are acting as lender-of-last-resort to the market. They are effectively doing the job of a central bank. But they are not a central bank, they are commercial banks driven by their own profit motives - and those motives can be in conflict with the needs of the market. Furthermore, they are ultimately dependent on the Fed for cash liquidity. And the Fed has been blindly pursuing a monetary policy that diminishes the cash available to banks.

The total quantity of reserves in the system has been falling since 2015 due to the Fed running off its balance sheet: from mid-2018 onwards, reserves have been draining even faster due to higher debt issuance by the US Treasury, which the Fed has done nothing to offset. The BIS says that as reserves have become scarcer, and Treasuries more abundant, the big banks have reduced their reserve holdings in favour of Treasuries. But this means that they have less cash to lend. The repo market depends on them for cash, but they are becoming increasingly reluctant to lend it.

The final straw appears to have been a sudden increase in the US Treasury's General Account balance when the debt ceiling was lifted and quarterly tax payments arrived. This rapidly drained a very large quantity of reserves:

It is hardly surprising that, faced with a sudden liquidity shortfall of $120bn, banks stopped lending, causing the SOFR and Fed Funds rates to spike.

The BIS's analysis raises many questions. Firstly, should such a crucial market really be entirely dependent for liquidity on four big banks? The answer is surely "no". But what other market participants could now provide such liquidity?

Secondly, why does the market have such a need for cash? BIS suggests that part of the reason might be leveraged money market arbitrage trades by hedge funds, indirectly funded by MMFs, who are able to lend to these high-risk counterparties because the trades are executed through a central counterparty with banks taking the credit risk: 

Market commentary suggests that, in preceding quarters, leveraged players (eg hedge funds) were increasing their demand for Treasury repos to fund arbitrage trades between cash bonds and derivatives. Since 2017, MMFs have been lending to a broader range of repo counterparties, including hedge funds, potentially obtaining higher returns.These transactions are cleared by the Fixed Income Clearing Corporation (FICC), with a dealer sponsor (usually a bank or broker-dealer) taking on the credit risk. The resulting remarkable rise in FICC-cleared repos indirectly connected these players.

BIS says that during September, MMFs became reluctant to participate in these "sponsored repos" (my emphasis):

During September, however, quantities dropped and rates rose, suggesting a reluctance, also on the part of MMFs, to lend into these markets (Graph A.2, right-hand panel). Market intelligence suggests MMFs were concerned by potential large redemptions given strong prior inflows. Counterparty exposure limits may have contributed to the drop in quantities, as these repos now account for almost 20% of the total provided by MMFs.

It seems that MMFs fear runs on their scarce cash. The whole picture is one of taps running dry as the Fed and the US Treasury between them drain the reservoir.

Now, the Fed has started replenishing the reservoir, though it is decidedly stingy about it, which is remarkable considering that it seems to have had little idea of the consequences of its previous actions. It is painfully evident that the Fed no longer knows how the plumbing works, if indeed it ever did. At least Randal Quarles is trying to find out.

But to my mind simply replenishing the lost reserves is not good enough. We need to start asking hard questions about what the role of the repo market, and the big banks upon which it has become dependent, should really be. As the interbank market slowly dies, and reserves return to being scarce rather than abundant, the repo market is becoming the principal market through which monetary policy is transmitted. But it is poorly understood and extremely concentrated. Do we really want the transmission of monetary policy to depend entirely upon four large banks?

The Fed has also mooted SOFR to replace Libor as the principal benchmark rate for variable rate loans and derivatives. But SOFR is prone to wild swings, which is not good in a benchmark rate. The Fed seems to want the four banks that provide repo market liquidity to lend countercyclically, thus smoothing out spikes in SOFR. Should the stability of the principal market benchmark rate really depend entirely on the liquidity preference of four banks?

Finally, the Fed is replenishing reserves in order to support a market that is populated by non-banks as well as banks. The BIS says that the rate rise was partly because MMFs pulled back from lending cash for sponsored repos. Rate rises caused by lenders becoming nervous help to limit leverage and prevent markets becoming overheated. Yet the Fed is intervening in the repo market to dampen rate rises. Why are we once again allowing the Fed to provide an implicit backstop for risky non-banks, thus enabling them to misprice risk and gorge on leveraged trades without fear of market penalty? Have we learned nothing from the past?

The Fed's actions critically affect the way banks and financial markets behave, and this in turn impacts on the real economy. Yet it does not appear to understand the financial system that is emerging as a result of regulatory and market changes since the crisis. It is flying blind.

Image: "Blind Man's Buff", by Charles Baugniet, courtesy of Wikipedia. 

Related reading:

How the financial markets' plumbing got blocked - FT
The BIS Misses an Opportunity to Get Consistent with the Facts - Alhambra Capital
White Paper on the Repo Market Affecting U.S. Treasury and Agency MBS - IDTA (pdf)

Misunderstanding Volcker

A reappraisal of Volcker, who was more hostile to workers and less hard on financiers than the press would have you believe.

RIP, Paul Adolph Volcker

Published by Anonymous (not verified) on Tue, 10/12/2019 - 5:45am in

Paul Adolph Volcker is dead at the age of 92. (Most accounts of the man suppress the middle name, though it was often pointed out with bitter glee by builders and others who were undone by his high interest rate policies in the early 1980s.) As I wrote in LBO when he left office in 1987, if capitalism gave out a Hero of Accumulation award, he would have been first on the honors list.

Let’s recall what he did, because all the worshipful obits will almost certainly sanitize the history. Volcker was appointed chair of the Federal Reserve by Jimmy Carter—on the recommendation of David Rockefeller—to get inflation under control. Carter’s old Georgia friend and advisor Bert Lance tried to tell him it was a mistake, and that it would almost certainly cost him re-election. Lance, now remembered as little more than a Good Old Boy, if he’s remembered at all, was right. But Carter ignored him. The charms of a Rockefeller are irresistible.

Inflation is a complicated thing, and this is no place to delve into those complexities. For the purposes of this post I’ll just say a couple of things. Part of the reason for rising inflation in the 1970s was that oil exporters had been jacking up prices—from under $4 a barrel to over $10 in the first oil shock of 1973–1974, and then from under $15 to over $30 in the second shock, 1979–1980. Other commodity-exporting countries were trying to emulate their oil-exporting colleagues. And with those commodity price moves came calls for a new world economic order—one in which the North no longer lorded it over the South, and one in which the South claimed a larger portion of global wealth.

Domestically, labor was restive. There were an average of almost 300 major strikes a year during the 1970s—more in the earlier years of the decade, but they persisted throughout. There was a lot of worry that the working class had developed a serious attitude problem. There’s an appealing theory that reads inflation as a sign of stalemate in the class conflict: workers push wages higher and employers respond by raising prices to protect profits. If the workers were winning, profits would suffer; if employers were, wages would suffer. Neither happened in the 1970s.

The month Volcker took office, August 1979, the consumer price index was up almost 12% from the year before. (See graph below.) But the unemployment rate was 5.8%—not low, but below average for the 1970s. In Congressional testimony a couple of months later, Volcker declared that “The standard of living of the average American has to decline” if inflation was going to be subdued. He worked hard to make that happen.

Volcker years

He made that happen by driving interest rates up to levels previously unknown in US history (and the history at my fingertips goes back to 1857). The federal funds rate—the rate at which banks lend each other money overnight, the most sensitive indicator of Fed policy—went from 10.9% when he took office to 17.6% in April 1980. That drastic tightening of monetary policy sent the economy into a sharp recession. Unemployment rose by almost two points in a matter of months. The downturn was so brutal that Volcker retreated. He—and while Fed policy is set by a committee, the institution is dominated by its chair, and Volcker was a particularly forceful chair—drove fed funds briefly below 10% in the summer of 1980.

But inflation persisted as the economy recovered, so Volcker went back to war. He pushed the fed funds rate to a peak of 19% in January 1981, let it fall a few points into the spring, then pushed it back to 19% in June and July. The economy went into a deep recession, the worst since the 1930s (though we outdid it in 2008–2009). Bankruptcies zoomed, and the unemployment rate broke 8% in November 1981, 9% in March 1982, and 10% in September. Inflation, which had been falling in 1980 but not seriously enough for Volcker, began falling for real in late 1981.

With inflation breaking below 6%, Volcker relented in August 1982—not so much because the US working class was suffering and interest-sensitive industries like housing and manufacturing were in depression, because Mexico was about to “blow,” as he put it. Like many Latin American countries, Mexico had borrowed heavily in the 1970s, the the interest rate spike was ruining them. Fearing that a Mexican default would bring down the banking system, Volcker began pushing down the fed funds rate, and in August 1982 made it clear that the regime of extreme monetary tightness was over. Inflation continued to fall, however, breaking below 3% in 1983.

From the POV of the ruling class, a couple of very good things happened as a result of that regime of extreme tightness. The recession scared the hell out of the working class, leaving millions in terror of job loss. That consciousness was reinforced by Reagan’s firing of the striking air traffic controllers in August 1981; the leader of the striking local was hauled away in chains, a picture that spoke many more than a thousand words. Strikes fell from an average of 300 in the 1970s to 80 in the 1990s—and 23 since.  The stock market took off the minute Volcker made it clear that interest rates would fall; investors celebrated the decisive victory of the owners’ contingent in the class war, a party that has continued to this day. That fearful consciousness instilled by Volcker and Reagan persists in the US working class almost forty years later: make no demands or you might find yourself sleeping on the sidewalk.

PATCO in chains.png

There was an international dimension to that class war victory as well. Capital successfully turned Mexico’s threatened default into a great opportunity to restructure the global economy to its liking. As a condition for getting fresh loans, and indulgence on the old ones, Latin American and other debtors had to agree to open up their economies to foreign capital and trade and lift domestic regulations and subsidies—the entire package of hypercapitalism that would come to be known as neoliberalism. In less than a decade, calls for a new world economic order, one favoring the South, were replaced by a intensified arrangement of rich countries telling poorer ones what to do, down to the level of what basics like food should cost. As with the domestic reconstruction, Volcker was at the center of it.

RIP Paul Volcker, Hero of Accumulation.


Repo Madness: Fed Plumbing Gone Awry

Published by Anonymous (not verified) on Wed, 27/11/2019 - 1:55am in

How the Fed's fingerprints are all over the repo mess.

Wolf Richter: The Fed Slaps Down Negative Interest Rates

Published by Anonymous (not verified) on Thu, 21/11/2019 - 9:06pm in

The first major discussion of negative interest rates recounted in the FOMC minutes show serious disapproval.

Monetary Policy Transmission and the Size of the Money Market Fund Industry

Published by Anonymous (not verified) on Wed, 20/11/2019 - 11:00pm in

Marco Cipriani, Jeff Gortmaker, and Gabriele La Spada

Monetary Policy Transmission and the Size of the Money Market Fund Industry

In a recent post, we documented the transmission of monetary policy through money market funds (MMFs). In this post, we complement that analysis by comparing the transmission of monetary policy via MMFs to the transmission via bank deposits and studying the impact of the differential pass-through on the size of the MMF industry. To this purpose, we focus on rates on certificates of deposit (CDs) offered to banks’ retail customers and compare their response to monetary policy with that of retail MMF yields.

Differential Pass-through across Bank CDs and MMFs

The chart below shows the time series of three-month CD rates, MMF net yields, and the effective federal funds rate. Although both CD rates and MMF yields track the federal funds rate, their response to monetary policy changes is starkly different and has become even more so during the last tightening cycle.

Monetary Policy Transmission and the Size of the Money Market Fund Industry

Between May 2004 and July 2006, the effective fed funds rate increased from 100 to 525 basis points (bps). During the same period, the net yield of retail MMFs increased by roughly the same amount, from 0.5 percent in May 2004 to 5 percent in July 2006. As the table below shows, this corresponds to a pass-through of 99 percent. In contrast, over the same period, rates on three-month retail CDs increased only by half as much, reaching 3 percent in July 2006—a pass-through of only 50 percent. The pass-through on one-month CD rates was even lower, just 30 percent; indeed, the one-month CD rate was short of 200 bps by the end of the tightening cycle.

Monetary Policy Transmission and the Size of the Money Market Fund Industry

After a long period with policy rates at the zero lower bound, the Federal Reserve started a new tightening cycle in December 2015, which continued until December 2018. Over this period, the effective federal funds rate increased by more than 200 bps. Over the same period, the net yield of retail MMFs increased by roughly the same amount, with a pass-through of 91 percent, confirming the very high elasticity (or beta) to rate hikes observed in the early 2000s. In contrast, rates on retail CDs barely moved. The rate on three-month CDs remained below 10 bps until July 2017, and only increased to 20 bps by the end of the tightening cycle, a pass-through of only 5 percent; the pass-through to the one-month CD rate was similarly low, at only 2 percent.

The Expansion of the MMF Industry during Monetary Policy Tightening

Given the lower responsiveness of bank CDs to monetary policy tightening, one could expect that, during a tightening cycle, money flows from CDs to MMFs.

Indeed, as the chart below shows, the size of the MMF industry increased during both tightening episodes, lagging the increase in the spread between retail MMF yields and CD rates by roughly a year. From May 2004 until July 2006, the assets under management (AUM) of retail MMFs increased by 5 percent, followed by a further increase of 16 percent over the next year.

Consistent with the fact that rates on bank deposits have become stickier, during the last tightening cycle, the MMF industry increased even more dramatically. AUM of retail MMFs increased from $700 billion in December 2015 to almost $1 trillion in December 2018, a 37 percent hike, and kept increasing during the first half of 2019.

Monetary Policy Transmission and the Size of the Money Market Fund Industry

Is the Lower Beta on Deposits due to the 2014 MMF Reform?

A possible explanation for the lower elasticity of bank CD rates during the last tightening cycle is the effect of the 2014 MMF reform by the Securities and Exchange Commission, which went into effect in October 2016. By stripping prime MMFs of some of their liquidity features, the reform has made such investment vehicles a less attractive option for cash investors.

The sharp increase in the size of the MMF industry over the last three years belies such an explanation. If anything, as described above, the AUM of retail MMFs have increased even more sharply than in the early 2000s. Indeed, as documented by Cipriani and La Spada (2018), although prime MMFs have become a less attractive liquidity vehicle and have shrunk as a result of the reform, investors have shifted to government MMFs, which were not affected by the amended rules. Moreover, as shown in a previous post on Liberty Street Economics, within the MMF industry, government and prime MMF exhibit a similar monetary policy pass-through. Therefore, the intra-industry shift from prime to government MMFs should not have made easier for banks to leave their CD rates low.

Summing Up

The elasticity of bank CD rates to monetary policy tightening is much lower than that of MMF shares and has become ever lower after the financial crisis. The weaker elasticity of CD rates relative to MMF shares is accompanied by an expansion of the size of the MMF industry during tightening cycles. Such expansion was more pronounced for the last tightening cycle than during the previous one. This evidence casts doubt on the view that the MMF reform is a reason why the beta on CD rates has become so negligible.

Marco CiprianiMarco Cipriani is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Jeff Gortmaker is a former senior research analyst in the Bank’s Research and Statistics Group.

Gabriele La SpadaGabriele La Spada is an economist in the Bank’s Research and Statistics Group.

How to cite this post:

Marco Cipriani, Jeff Gortmaker, and Gabriele La Spada, “Monetary Policy Transmission and the Size of the Money Market Fund Industry,” Federal Reserve Bank of New York Liberty Street Economics, November 20, 2019, https://libertystreeteconomics.newyorkfed.org/2019/11/monetary-policy-tr....


The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

How the Fed Boosts the 1%: Even the Upper Middle Class Loses Share of Household Wealth to the 1%. Bottom Half Gets Screwed

It is bizarre to see the Fed present data showing the Gilded Age level of wealth accumulation by the 1% as if that were a badge of honor.

The People’s Money (Part 1)

Published by Anonymous (not verified) on Thu, 17/10/2019 - 12:55am in

An explanation of the Federal Reserve money system.