Thursday, November 6, 2008

Fed Losing Credibility?

(Felix Salmon) That's what David Rosenberg of Merrill Lynch charged in a note to clients today.

The issue at hand is the continued gap between the market fed funds rate and the target rate. The market rate has traded below the target for 16 straight days, Rosenberg points out, even after fed funds was lowered to 1 percent last week.

While most analysts think this is a sign of the Fed's quantitative easing strategy (to inject funds into the economy without using interest rate policy) Rosenberg thinks the FOMC needs to just come out and say it:

If the Fed has decided that they will no longer concern themselves with a Fed funds target they should admit as much in order to retain their credibility, in our view. Alternatively, if they still wish to target a Fed funds rate we think they should either lower it to market rates or act more aggressively to push the effective rate up to the announced 1% target rate. Having a target which they are unable to meet hurts the Fed's credibility at a time when markets are expecting another 50% increase in their balance sheet by year-end.

And it looks like the Fed was thinking along similar lines. This morning it announced that it would increase the interest paid on reserves to match the target federal funds rate. Wrightson-ICAP thinks this will "boost the effective funds rate by an extra couple of basis points."

My question: Paying interest on reserves is supposed to put a floor on the market fund rate and before today, the rate paid on reserves was basically 10 basis points less than the target. So why did the market rate trade even below that level?

Fed capitulates: the central bank is broken

(FT Alphaville) Or perhaps better, the entire banking system is broken.

For it appears that the US Federal Reserve has given up on the idea of easing stress on interbank and wholesale lending and is resigned to being the central bank-come-market-maker of last, first and every resort.

For some time now there’s been a debate about the direction of the Fed’s policy. Would we see target rates come down further? Quantitative easing? Massive T-Bill issuance in the open market?

From the Fed yesterday:

The Federal Reserve Board on Wednesday announced that it will alter the formulas used to determine the interest rates paid to depository institutions on required reserve balances and excess reserve balances.

Previously, the rate on required reserve balances had been set at the average target federal funds rate established by the Federal Open Market Committee (FOMC) over a reserves maintenance period minus 10 basis points. The rate on excess balances had been set as the lowest federal funds rate target in effect during a reserve maintenance period minus 35 basis points. Under the new formulas, the rate on required reserve balances will be set equal to the average target federal funds rate over the reserve maintenance period. The rate on excess balances will be set equal to the lowest FOMC target rate in effect during the reserve maintenance period. These changes will become effective for the maintenance periods beginning Thursday, November 6.

The Board judged that these changes would help foster trading in the funds market at rates closer to the FOMC’s target federal funds rate.

Why do such a thing? Michael Cloherty at Bank of America points out in a research note this morning that the move will cripple the Fed Funds market - that is, interbank lending:

The Fed is going to pay target flat for excess reserves rather than target less 35bps. This is likely to sharply reduce flows in the funds market. There is a staggering amount of excess reserves in the banking system– a normal level of reserves held at the Fed is $7.5bn, where last Wed there was $420bn. With that many excess reserves, funds should trade soft. Now, rather than lend to another bank at a sub-target rate, we should just see banks leave the $ in their account at the Fed. Volumes in the Fed funds market are likely to drop dramatically.

What that means is that the effective is likely to remain below target, and with volumes down, the effective will be even more volatle (unusual trades will have a larger impact on the average). This will make Fed funds futures contract even harder to trade.

The Fed isn’t supposed to work this way. The Fed is supposed to have a control over the monetary system; by which it can manipulate the rates at which banks lend to each other, and the rate at which banks lend to the economy.

And yet the Fed has cut rates - slashed them. Its target now stands at 1 per cent. It, and other central banks, have flooded the system with liquidity through a smorgasbord of different open market operations. Banks though, still aren’t lending to the economy. And they are still keeping huge sums in reserve. (They don’t have anywhere else safe to put their cash.)

Ben Bernanke knows this scenario. It’s not been admitted yet, but it’s looking very much like a liquidity trap. Rates on T-bills are already precipitously close to zero. Paul Krugman wrote in September (emphasis ours):

You still see people saying, in effect, “never mind the zero interest rate, why not just print more money?” Actually, the Bank of Japan tried that, under the name “quantitative easing;” basically, the money just piled up in bank vaults. To see why, think of it this way: once T-bills have a near-zero interest rate, cash becomes a competitive store of value, even if it doesn’t have any other advantages. As a result, monetary base and T-bills - the two sides of the Fed’s balance sheet - become perfect substitutes. In that case, if the Fed expands its balance sheet, it’s basically taking away with one hand what it’s giving with the other: more monetary base is out there, but less short-term debt, and since these things are perfect substitutes, there’s no market impact. That’s why the liquidity trap makes conventional monetary policy impotent.

How impotent? Consider the numbers: the Fed has an $800bn balance sheet to operate in a $50 trillion credit market. The only thing that gives it power is its ability to create monetary base, and in a liquidity trap, that power is useless.

Krugman’s point then was that Bernanke had come up with a third-way alternative to escape a liquidity trap, but that the alternative was, in practice, failing.

That alternative being a quantitative-easing type expansion of the balance sheet, but not to buy T-bills, but other assets - mortgage securities, for example. A Bernanke Twist.

In 1961, the Fed launched the first - formally, only - “Operation Twist”. The idea was that the Fed would use its powers in open market operations to target asset prices: specifically, to flatten the yield curve. The Fed operated directly in the long term Treasuries market in an effort to depress long-term borrowing costs (and thus stimulate economic growth) while simultaneously seeking to prop the dollar by supporting shorter term rates. Krugman again:

I guess the Fed had to try the “Bernanke twist.” And it did - the old Fed balance sheet, in which T-bills were the vast bulk of assets, is no more. But the effects have been disappointing, especially weighed against the risk, which I know is making Fed officials very nervous.

Bernanke though, now doesn’t look like he is giving up on the twist, as Krugman thought the advent of the TARP signalled. Indeed, the realisation seems to be, that as now a mere $800bn player in a $50 trillion market, the Fed needs more ammunition. Brad DeLong writes:

…the natural answer appears to be open-market operations working not on the liquidity premium but on the risk premium–Operation Twist on a Pan-Galactic scale.

How to fund that? You could issue T-bills. But as Brad Setser points out fundamental changes in the T-bill buyer market make that a risky proposition.

So you could just admit you were in a liquidity trap and use all those excess bank reserves to your advantage instead. As Cloherty writes at BoA:

If the Fed is going to pay target, it suggests that they may scrap the SFP bill program (there is less need to drain reserves to try to keep funds above the target). If that happens, that is $630bn of outstanding SFP bills that are no longer needed. Any reduction in SFP bills would likely be replaced by regular Tbills. But this means much less need for larger auction sizes out the curve-fewer SFP bills means fewer 2yr and 5yr notes.

The Fed’s move last night is the first big signal, then, that it will pursue a policy of quantitative easing.


At its core, the Bernanke Twist is a direct effort to try and support prices; to stop destructive debt deflation. We are in uncharted territory though. The Fed is not just trying to game the market in US government debt. It’s trying to support the entire asset-backed debt market.

Which is particularly risky when the the Fed is effectively supporting those prices by positioning itself as a risk sump.

No wonder, as Krugman says, Fed officials are “nervous”. This is an all-out gamble.

It isn’t clear just how much the Fed will need to throw into that system to actually prop it: so far, the Fed’s balance sheet alone has not been enough. The TARP doesn’t look like it has enough either. Consider the fact that total capital raised by the banking system is actually less than total writedowns taken to date.

There’s a big danger here for the Fed: that it is trying to catch a falling knife. The Fed is risking things it’s never risked before. That’s not to say we’re in apocalyptic territory at all; consider the firepower the Fed has behind it. It is though, to use a hackneyed, but apt phrase, paradigm shifting.

In Japan, where quantitative easing failed, the central bank’s balance sheet swelled to a size equivalent to 30 per cent of GDP. The Fed’s balance sheet is currently equivalent to 12 per cent of GDP.

Where we go from here then very much depends on how severe you see this crisis relative to Japan.

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