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Friday, November 07, 2008


liquidity trap: fed gives up on interbank lending -- quantitative easing is on the way

despite the downward flow of LIBOR, there's been precious little real business being done at the rate. whatever was being done is now to stop, it seems, as the fed moves to replace the interbank fed funds market entirely. per the ft:

Michael Cloherty at Bank of America...:

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.

in other words, we are beyond monetary policy. but bernanke does not agree, or at least is convinced that the trap can be broken.

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.

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. ...

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.

short version: the fed won't sterilize its balance sheet expansion going forward will sterilize not via SFP draws on the market but on accruing reserves. more via ft -- and see the comments below.

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.

success will mean the annihilation of the recent dollar rally. failure may mean the failure of the federal reserve system.

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.

UPDATE: more from jim hamilton.

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Great FT link, however I think I am drawing different conclusions than you when you say "success will mean the annihilation of the recent dollar rally". The changes described do nothing to put the expanded monetary base to "work" in an inflationary way... it seems they simply sterilize it through paying interest to keep it at the fed versus using open market operations selling SFP bills. The endgame implied being less supply of treasury bills -> higher prices -> lower yields. A smaller dollar impact perhaps based on relative yields between countries but I wouldn't expect anything large. Do you interpret it differently?

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While I'm not certain I agree, London Banker actually suggests that the raised interest on reserves could be intended to defend the dollar!

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what i gather, hbl, is that the purported intention is to keep expanding monetary base until it does work. pardon me while i work through this in baby steps while leaning on jim hamilton. please critique as you see fit.

in normal times, the fed puts cash in by buying treasuries out of the market.

now, zero-yielding t-bills and cash have become interchangeable, and so fed purchases of treasuries do nothing. this is why the fed is out there buying risk assets (ie, krugman's third way).

but it thinks it isn't doing enough to properly offset the unwind.

banks are keeping the massive sums of liquidity the fed is giving them on reserve (against future losses?) rather than lending. but because they pay a discount to the interbank rate, those sums could be larger.

now they are going to eliminate the discount and pay full rate -- replacing the interbank market and drawing more funds to itself.

the fed was expanding balance sheet by treasury depositing SFP bills -- treasury sell bills, funds despoited with fed, fed buys risk assets.

now, the fed will instead entice larger reserve balances to grow rather than treasury increasing its SFP account. no one will sell anything; and yet more risk assets will be brought on balance sheet. that is quantitative easing.

london banker is obviously right that the move is attracting reserve deposits into the dollar for the moment.

but success -- meaning a return to credit creation -- would result in drawdowns of reserve deposits. the fed would normally compensate for that by selling securities, but the fed has already sold most of theirs; it won't be able to quickly collect on loans to troubled banks or unwind special facilities; and its "other assets" are unmarketable (which is why it owns them).

they would then be -- if i reason properly -- in a position of having to expand the liability side of their balance sheet to compensate for reserve flight. barring more SFP bills, that means printing.

again, my chain of conclusions is open to criticism. this is weird territory for me, and i am not sure.

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another interesting tidbit -- bloomberg is suing under FOIA to get at what the fed has taken as collateral against $1.5tn in loans -- and the fed is fighting it. secrecy is always and everywhere the mode of imperial operation.

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Thanks for explaining -- I think I understand your rationale... Basically the concern is that the Fed, by phasing out SFP in favor of only higher interest on reserves held at the fed, is handicapping its ability to limit the inflationary effects of an expanded monetary base in the future.

With SFP active, the Fed could simply expand SFP issuance to mop up excess liquidity... With interest on reserves instead couldn't it raise the rate of interest paid on reserves to bring more of that money back or slow down expansion of lending, if it was truly worried about veering into hyperinflation as opposed to just offsetting some of the broad money supply deflation? It seems the fed could still control the outcome via this different mechanism and that the main change discussed in the FT article is again that it results in less treasuries in circulation and theoretically supports asset prices. However, I'm suspect that this will work in practice to the extent desired, as in effect the interest on reserves is like an exclusive treasury bill that only banks have access to, reducing their demand for treasuries in circulation.

I'm way out of my depth though so I'm also happy to be corrected :)

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