personal views of a former fed trader

Don’t Fight The Fed

The Fed has developed enough new tools that there are almost no limits to how far it can tighten. Prior tightening cycles often led to financial instability that prompted sudden easing, but that was before the revolution of March 2020. At that time the Fed acted as lender of last resort to not just the typical financial sector entities, but also to real economy entities including municipals, corporations, and even small businesses. The emergency facilities were intended to transmit low rates to the real economy even when the financial system malfunctioned, but those facilities can also be used to transmit higher rates. An aggressive tightening will likely lead to cracks in financial markets before inflation is tamed. In that case, the Fed now has the tools to support the real economy and keep tightening until the last ounce of inflation is squeezed out. This post reviews the Fed’s tool kit, notes still it lacks one important tool, and suggests Fed tightening can be more aggressive than expected.

Two Mode Transmission

The Fed has gradually bypassed the “middleman” and assumed a lender of last resort role to a wide swath of the financial and real economy. Historically, the Fed provided emergency loans to commercial banks who then lent to everyone else. But that model became less effective with the growing importance of capital markets. Today, borrowers obtain financing from a wide range of non-bank lenders including investment funds and securities dealers. During the GFC the Fed recognized this reality and acted as lender of last resort to some of these non-bank lenders through an alphabet soup of special lending facilities. The non-bank lenders were then able to continue providing loans to end borrowers.

Emergency facilities in 2020

The Fed went one step further during the March 2020 panic and acted as lender of last resort not just to financial intermediaries, but also directly to end borrowers. It provided loans to the real economy, including corporations, state and local governments, and even to small businesses. The real economy was thus able to access financing despite financial instability and concerns over the health of financial intermediaries. The Fed essentially insulated the real economy from the costs of financial instability. As first noted by Steve Kelly on his excellent blog, the policy response to something inevitably “breaking” no longer has to be blunt tools like rate cuts and QE.

Almost There

The one tool the Fed still lacks is greater control over the Treasury market, where cracks can impact entities outside the web of its facilities. Treasuries are stores of dollar liquidity and also benchmark global dollar rates, so Treasury market malfunctions deeply impact both the real and financial economy. Yet, Treasury yields are determined by many factors beyond the stance of monetary policy. The size of the fiscal deficit, market liquidity, regulatory constraints, foreign reserve strategies, market sentiment and many other factors shape these fulcrum rates. A crash in bond prices may lead to rates that are too high, and a massive flight to safety due to developments abroad may lead to rates that are too low.

Treasury market has grown much more rapidly than market liquidity.

A more refined tool beyond QE/QT would be needed for monetary policy to more effectively reach all corners of the dollar world. QE and QT are basically half measures intended to influence Treasury yields by buying or shedding set quantities of Treasuries. Policy implementation by targeting quantities was already experimented with in the 1980s with mixed success. Targeting rates proved to be more successful and is currently implemented in the front end through administered rates. A further extension of this in the footsteps of the BOJ may be needed at some point. Recall, malfunctions in the repo and FX swap markets led to Fed facilities that act as soft rate ceilings.

Pulling Out the Stops

The Fed’s has stated an unconditional commitment to price stability, and largely has the tools to back that up. Future Fed lending facilities may or may not take previous forms, but the precedent of directly engaging the real economy has been set. This greatly expands the transmission of monetary policy, despite weak control over longer dated Treasury yields. The Fed’s single focus now is inflation, which is a real economy phenomenon that is likely less sensitive to higher rates than the financial economy. By essentially disintermediating the financial system, the Fed can address these two economies differently. Policy can be far tighter and remain so even after “something breaks.”

21 Comments

  1. Paul Matthew Leddy

    what of the US gov’t debt? sure the Fed can spike rates but how to service USA debt?

    • Joe

      Fed could print money to make debt payments so US national debt has never been a problem again. That’s why no one really talks about it anymore. Only the US could do this though because of the US dollar’s status as the world’s reserve currency.

      • Jack

        To flippant to say the Fed could print money to make debt payments. As well as the obviously severe political and market implications of doing that, it would create reserves, and the Fed pays interest on reserves. The only solution ultimately is nominal growth faster than interest expenses, i.e likely negative real rates.

        • Donnie

          “… it would create reserves, and the Fed pays interest on reserves. ” to whom they pay those interest?Sorry I’m foreigner so maybe I’m missing sth.Pls expand what you mean.

        • Matt

          @Jack I agree 100%.

      • SH

        But won’t printing USDs weaken the status as the reserve currency?

    • Wayne

      Not an issue, they can simply issue more debt to pay the interest.

    • Wayne

      Not an issue, they can simply issue more debt to pay the interest.

  2. KK

    The big problem with QT, IMHO, is that while QE impacted long term rates as they took duration out of the market (UST and MBS) as well as sold a lot of vol (MBS), QT is happening through maturities (so run off in short duration instruments). If the Fed was serious about QT they would start to sell assets across the curve (reverse of QE) to be impactful. The tools that they have are great at easing policy but i don’t believe that they have the tools (or the political will) to help with the transition to a tighter policy regime (and the ensuing liquidity/credit crunch). If the Fed was serious they would
    1) open the SRF to the FHLBs (as the lender of next to last resort to the banking system especially regionals and against less liquid collateral and
    2) Exempt Treasuries from leverage ratio calculations. This option will also help with the anemic depth of liquidity in the secondary market for Treasuries

  3. Ravi Shanker

    so a dozen Econ PhDs are going to replace an ecosystem of millions doing transactions, and making decisions at a micro level. Iam sure that will work well.
    This is a cargo cult. They can simulate the macro outcomes of a vast ecosystem of micro decisions, but is that really the same thing? Like those Melanesian islanders building straw structures that look like a control tower and putting sticks in their hair to look like antennae – did’nt work to bring the airplanes back!
    Low inflation and economic growth are outcomes of a system that has millions of participants making financial decisions that results in allocation of resources to the right places. And weeding out unprofitable, inefficient entities.
    Fiddling with macro level indicators ( like rates ) is like forcing the needle of the thermostat to 70 degrees and hoping that fixes the broken furnace.

  4. ispanyolca

    Dear wang
    Problem is that there are more TSE than repo liquidity.

  5. Bill Tsui

    Hey Joseph!

    If there is mass foreclosures in the real estate market, would that help the Fed reduce their MBS holdings in addition to the monthly roll off? I have no clue what the numbers would be but rise in interest rates, cause prices to go down what percent, then defaults on mortgages against their Fed MBS holdings.

    Bill

  6. Jack

    In concrete terms, what programs do they have that could specifically tighten policy on Main Street? It seems easier to ease credit conditions in specific places than to tighten them…

  7. Count_of_Schlick

    So the point is what – have friends in the Banking Cartel so you can access some of the alphabet soup acronym named lending programs? The lack of sound money / lack of free markets has absolutely wrecked this country and created extreme ineqality, and allowed a bunch of Globalist Kleptocrats to become fabulously wealthy due to their connections to the Banking Cartel, AND allowed an inherently inefficient, wasteful, & coercive monopolist (aka Federal Government) to become a huge liberty destroying monstrosity due to the FED lending it money no matter how big it wants to get….
    When will Mr. Wang (& others that make their living from it ) stop being an apologist for the monstrosity known as the Federal Reserve? Probably NEVER, as there is too much to be gained for those connected….

  8. Rod MacIver

    I appreciate your insights Joseph.

    I’ve particularly enjoyed you appearances on Blockworks Macro.

    Thank you.

  9. George Dagnino

    The bottom line is most measures of liquidity show much slower growth.

  10. Anza

    Dear Joseph, your blog is an excellent read!
    This one left me with a question:

    Do you think the Fed will somehow manage to “covertly” prop up corporate bond markets while equities keep plunging to ever lower levels?

    If yes, how?

  11. Tim

    Are we sure the Fed is tightening as much as they can?

    “Drugs are hard to kick. Fed was supposed to sell $30B Treasuries and $17.5B Mortgage-Backed Securities per month starting June 1. QT, During June, MBS holdings rose almost $3 billion. Treasury holdings fell less than $10B.” – Burry

  12. Jack Kruse

    Nice post but there is a big hole in this theory. How do they solve the balance of payments issues that develop as they nuke equities and tax receipts go? They can drain the Treasury account, but it doesn’t have enough money. With QT they cant use bonds to make up the shortfall. So, what are the mechanics of how they fund the gov’t in this case?

  13. Spencer Bradley Hall

    Re: “Policy implementation by targeting quantities was already experimented with in the 1980s with mixed success. Targeting rates proved to be more successful and is currently implemented in the front end through administered rates.”

    The FED no longer has the “tools” to control N-gDp. The money supply can never be properly managed by any attempt to control the cost of credit. Interest is the price of credit. The price of money is the reciprocal of the price level.

    The effect of the FED’s operations on interest rates is indirect, varies widely over time, and in magnitude. What the net expansion of money will be, as a consequence of a given injection of additional reserves, nobody knows until long after the fact.

    The consequence is a delayed, remote, and approximate control over the lending and money-creating capacity of the payment’s system.

    Monetarism has never been tried. Monetarism involves controlling total reserves, not non-borrowed reserves as Paul Volcker found out. Volcker targeted non-borrowed reserves (@$18.174b 4/1/1980) when total reserves were (@$44.88b).

    Monetary policy should delimit all required reserves to balances in their District Reserve bank (IBDDs, like the ECB), and have uniform reserve ratios, for all deposits, in all banks, irrespective of size (something Nobel Laureate Dr. Milton Friedman advocated, December 16, 1959).

  14. Spencer Bradley Hall

    re: “The Fed went one step further during the March 2020 panic and acted as lender of last resort not just to financial intermediaries”

    Never are the banks intermediaries in the savings-investment process. From the standpoint of the entire payment’s system, commercial banks never loan out, and can’t loan out, existing funds in any deposit classification (saved or otherwise), or the owner’s equity, or any liability item. Every time a DFI makes a loan to, or buys securities from, the non-bank public, it creates new money – demand deposits, somewhere in the system. I.e., all deposits are the result of lending and not the other way around.

    All monetary savings originate within the payment’s system. The source of interest-bearing deposits is non-interest-bearing deposits, directly or indirectly via the currency route (never more than a short-term seasonal situation), or through the bank’s undivided profits accounts. This is the cause of secular stagnation, the impoundment of monetary savings, the deceleration in velocity.

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