Wow! Just heard a so-called “banking expert” say that the Fed was reducing reserves on their balance sheet during quantitative tightening (QT), which has led to the current chaos in the overnight repo market. Not entirely true.
Asymmetric Libalibity Balance Sheet Accounting
During QE the Fed purchased assets in the secondary markets, primarily Treasury notes and bonds, and mortgage-backed securities (MBS), by increasing their liabilities in the form of bank reserves. During QT, on a monthly basis, the Fed did not reinvest some or all of the maturing securities purchased during QE up to a certain monthly cap. The U.S. Treasury, for example, would have to pay down the debt by reducing their cash balance at the Fed.
Rather than reducing reserves on the liability side, the Fed would reduce their liabilities by the reduction of the Treasury cash balance equivalent to the maturing securities. We are not certain, but suspect, when MBS rolled off, reserves were reduced. The Fed is a bit less transparent when it comes to their MBS portfolio, at least that is our perspective and could be due to the complications of prepayment risk.
Nevertheless, we believe QT worked more through a high powered fiscal channel as the maturing Treasuries sucked liquidity out of the market through maturing debt and not a direct reduction in bank reserves on the Fed balance sheet. As a consequence, the Treasury had to issue more securities in the market to replenish their cash balances, an effective checking account, at the Fed. Crowding out on steroids.
Still, at the end of the day, excess reserves in the monetary system have tracked the reduction in Federal Reserve assets fairly closely but certainly not a rho =1, perfect correlation. There is the rub.
Monetary Policy Is Complex And Complicated
As an undergraduate political science student (double major in econ), I read somewhere that President Kennedy had much trouble understanding the difference between monetary and fiscal policy. In fact, to prevent from conflating the two in public, he wrote cheat notes with a pen on each fist before his press conferences. I am still searching for the source of that factoid.
Even former Chairman Alan Greenspan admitted monetary policy is a black box,
There is, regrettably, no simple model of the American economy that can effectively explain the levels of output, employment, and inflation. In principle, there may be some unbelievably complex set of equations that does that. But we have not been able to find them, and do not believe anyone else has either.
Consequently, we are led, of necessity, to employ ad hoc partial models and intensive informative analysis to aid in evaluating economic developments and implementing policy. There is no alternative to this, though we continuously seek to enhance our knowledge to match the ever-growing complexity of the world economy. – Alan Greenspan, Decemeber 1996
The Pragmatic Capitalism blog has the best perspective on the complexity of today’s monetary system, in our opinion,
The monetary system is too complex and too dynamic for you to understand it all. So it’s better to understand enough that you can be competent, but not so much that you become a danger to yourself. – Cullen Roche
So, nobody knows with absolute certainty what the hell is going on in the repo and money markets.
Are bank reserves too low? Are markets starting too convulse because debt is too high? Is there a temporary mismatch in cash flows of different financial entities? Is the problem a temporary blip or more systemic? All of the above? None of the above?
Wish we could say, but we don’t know.
Nevertheless, as Goethe once stated,
By seeking and blundering, we learn.
Look At Deficit Financing
We do have our suspicions that the money market turmoil has something to do with what is happening with the huge increase in the budget deficit, which in the first 11 months of fiscal (Oct-Sep) 2019 is close to $1.1 trillion dollars. That’s larger than the combined GDPs of Austria, Ireland, and the Czech Republic. In addition, how the deficit has been financed during the budget ceiling negotiations we believe is also impacting market liquidity.
It’s tantamount to holding a beach ball underwater and then released when the President signed the debt ceiling deal at the beginning of August.
Add to that our distorted monetary system where interest rates are repressed and prices can’t clear the market but quantities will. Think, rent control.
A decade of extraordinary monetary policy experiments has left the system badly distorted. Thus the Fed is now like a pilot flying a plane with an engine that has been stealthily remodelled. Neither the passengers nor the pilot knows how the engine’s shifting cogs might affect the controls during a wave of turbulence, because there is little historical precedent. — FT, Sep 19th
Le Chatelier’s Principle (LCP)
It’s a classic case of Le Chatelier’s principle (LCP) in action. If one economic variable is repressed in a dynamic equilibrium system, such as prices or interest rates and not allowed to adjust to clear the market, another variable in the system will have to move to offset. The great economist, Paul Samuelson, did his Ph.D. dissertation on LCP.
Maybe that variable is cash liquidity?
It is clear to us, there is too much debt in the system to allow interest rates to move to their equilibrium levels in a steady-state normal world. We saw what happened in Q4 2018 to the stock market when the 10-year Treasury yield broke out higher, one year ago to almost this very day.
Because rates can’t move higher to a technical equilibrium level as the supply of debt increases, the larger budget deficits will have to be financed by either haven flows as other markets (stocks, e.g.) sell off, foreign inflows (stronger dollar), more indirect monetization in the form of some kind of QE or a derivative of POMO, OMO, a combination of all of the above, or whatever you want to call it.
It doesn’t seem there is much appetite to allow markets to fall to generate the haven flows nor for a stronger dollar. Ergo, the Fed will be forced to do the heavy lifting. If you been reading GMM over the years, you know which variable will offset the Fed activity. That is the end game.
Coming Soon
We are still working on the analysis but here is a sneak peek at some of the data.
Again, looking at the data in the table, we believe the Treasury is going to be issuing a lot more debt in the next few months to make up the months of nonborrowing from the public due to this year’s debt ceiling constraints, Similar to the first 8 months of last year (see table), which was a catch-up from the 2017 debt ceiling debacle.
As usual, we reserve the right to be wrong. Stay tuned.
Global Macro Monitor 