The Fed’s Management of Liquidity is All Wet
Over lunch several years ago, former Federal Reserve Board chairman Paul Volcker spoke of enjoying fishing in Maine in the area around Pocomoonshine Lake.
The area known as Downeast Maine lies north and east from Bangor to St. John, Canada, and the Bay of Fundy, and is comprised of numerous bodies of water. These stunning lakes and streams, many connected, some manmade, are all carefully managed by local communities, a vital part of the wild ecosystem of Maine.
Each season, the water flowing into and out of the various Downeast lakes must be monitored and regulated, both to enable human activity and also to protect the native species in this vast watershed. The various fish in the region have different spawning seasons and their activity is directly impacted by the water levels. Leave too little water in the lakes and the salmon may not spawn successfully. Release too much water too soon and boats—even aircraft—may encounter rocks and other hazards. Achieving balance in these hydraulic systems is a matter of mathematics, weather forecasting, and consistent attention to changing short-term factors.
It is no accident, then, that so many economists favor fishing as a recreational activity. The folks at the Federal Reserve Board have been engaged in their own exercise in managing liquidity over the past decade, so far with decidedly mixed results. Under chairmen Ben Bernanke and Janet Yellen, more than ample liquidity covered the proverbial rocks, thanks to massive Fed purchases of Treasury securities and mortgage bonds.
Over the last year, though, Chairman Jerome Powell and his colleagues on the Federal Open Market Committee (FOMC) have poorly anticipated how changes in what we call “monetary policy” will impact the credit and liquidity available to real markets and real people.
Last December, the FOMC just missed causing a train wreck of illiquidity. Market volumes in the world of bonds plummeted. Stocks lost 10 to 20 percent of their value in a matter of days. New debt securities issuance in the high yield market, perhaps the most important indicator of U.S. economic health, fell sharply. The ebb of cash out of the markets was exacerbated by rules imposed by Congress and federal bank regulators that encourage the largest depositories not to lend and to hoard liquidity like medieval fortresses.
“No bank wants to be short of sufficient reserves if a market suddenly seizes up, especially foreign banking organizations that borrowed from the Fed during the 2008 financial crisis and came under political pressure afterwards,” says Amherst Pierpont Securities in New York, one of the few non-bank primary dealers of Treasury debt. “The Fed for now looks focused on smoothing any immediate volatility in funding. But assuming the Fed can dampen concerns, it may need to revisit the ground rules for managing liquidity in a much more complex post-crisis market.”
Part of the “complexity” facing the FOMC is that, unlike during the era of Paul Volcker and his successors at the Federal Reserve Bank of New York, today the monetary policy discussion is largely detached from the real world of financial markets. By paying interest on excess reserves that banks deposited at the Fed after 2009—reserves created by the Fed’s purchases of trillions of dollars in Treasury debt—the Federal Reserve added $10 billion per quarter to the banking industry’s revenue. Yet the central bank under Ben Bernanke and Janet Yellen also created some big problems for the future.
In his 2018 book Floored: How a Misguided Fed Experiment Deepened and Prolonged the Great Recession, George Selgin of the Cato Institute describes why the Fed’s policy moves after 2008 made a mess of monetary policy by paying overmuch for excess bank reserves. And through rules meant to ensure the liquidity of large banks, prudential regulators provided even more incentives for banks to, according to Selgin, “accumulate excess reserves [deposited at the Fed] instead of taking part, as they otherwise would have, in additional wholesale lending.” The net effect was that the economy grew more slowly than might have otherwise been the case and with greater market volatility.
Not only is today’s combination of monetary and prudential regulatory policy serving as a drag on economic growth, but the FOMC now faces a grave imbalance in liquidity in the financial markets, as the Treasury racks up record fiscal deficits. The rocks are clearly showing, to borrow from the fishing metaphor, and contagion is now possible. Short-term money markets are dysfunctional and lack sufficient cash liquidity to operate, eroding the FOMC’s credibility on monetary policy.
It is useful to recall that the FOMC was talking about raising interest rates a year ago. Now it’s lowered target rates and even begun to add Treasury securities to its portfolio to the tune of $60 billion per month. We used to call these purchases “quantitative easing,” but under Chairman Powell the lexicon has changed. New speechwriters have been hired by the Board of Governors to manage new terminology, this as part of the Fed’s manic compulsion to “communicate” and provide “guidance” to the markets.
Beneath the public muddle is a far more profound state of confusion over just how to implement policy and why. The Fed lacks a clear understanding of the connections between the abstract, almost mystical world of monetary policy and the quantitative world of secured finance. With the monetary narrative composed of qualitative terms such as “confidence” and “expectations,” it is often difficult for investors and business leaders to parse just what the Fed is trying to say.
The difficulty faced by businesses and consumers is that the economists who dominate American monetary policy have little direct experience with the financial markets. When warning signs emerged in the market for fed funds this summer, the FOMC was unaware. The quarter-close in June in the U.S. money markets was quite messy, with financing rates for Treasury paper and agency mortgage securities spiking several points over the Fed’s so-called “target rate” for fed funds. The volatility after June 30 persisted for weeks, though it went largely unnoticed in Washington.
In July, when JPMorgan CEO Jamie Dimon told an audience at an investor conference sponsored by Barclays that, in so many words, his bank would no longer be the marginal provider of cash to the fed funds market, nobody at the Fed seemed to notice. Only in September, when the now daily spikes in short-term interest rates had reached 10 percent, did the harsh news headlines force the FOMC to act. The markets for fed funds, let us recall, are the foundation for all interest rates in the United States, including commercial lending, auto loans, home mortgages, and other credit types. In the past year, overnight repurchase agreements for Treasury and mortgage securities have traded as high as 6 percent and 6.6 percent respectively, levels at which these markets cannot operate for extended periods of time.
If the Fed cannot keep the markets inside of the target for fed funds, now 1.75 to 2 percent, then this volatility will be transmitted to the entire U.S. economy, both in terms of market prices and the erosion of Fed credibility. Today, Powell is confronted by the reality of bond market volatility and a Congress that is largely out of control when it comes to public spending. The polite narrative heard inside the Federal Reserve Board about “confidence” and “inflation expectations” is entirely inadequate when challenged by hard quantitative factors such as market interest rates and volatility.
A big part of the Fed’s present-day dysfunction comes from the fact that everyone there is engaged in a communications effort that diminishes the value of their own guidance. Instead of communicating the consensus view of the FOMC, the various voting members offer their opinions to anyone who will listen. The result is a confusing cacophony that diminishes the impact of Fed policy pronouncements and confuses the investors and business leaders who must ultimately drive growth and employment.
The well-intentioned but ultimately misguided experiment in “quantitative easing” has now been shown to have significant downsides. The Fed now faces the same problem as the people of Downeast Maine in managing the lakes upon which they depend for their livelihoods. But do they have the tools to handle the task?
Christopher Whalen is an investment banker and chairman of Whalen Global Advisors LLC. He is the author of three books, including Ford Men: From Inspiration to Enterprise (2017) and Inflated: How Money and Debt Built the American Dream (2010). He edits The Institutional Risk Analyst, and appears regularly on such media outlets as CNBC, Bloomberg, Fox News, and Business News Network. Follow him on Twitter @rcwhalen.