Two readers pointed us to very good post by John Hussman that goes through the Fed’s open market desk operations in detail, and then looks at similar work done on the European Central Bank’s activities (including its widely reported $500 billion liquidity injection). He concludes that in fact liquidity, meaning bank reserves plus money in circulation (the monetary base, which is what central banks control directly) has not increased.
This is remarkable, particularly since the powers that be have been giving the impression otherwise, that they have been responding to the seize up in the money markets and turning on the spigot. What gives?
First, let’s give the high points of Hussman’s conclusion and his supporting evidence:
Simply put, contrary to the impressions they attempt to create, neither the Fed nor the ECB have “injected” material amounts of “liquidity” into the international banking system in recent months. This is not a call for them to do so – to some extent their hands are tied by inflation pressures, currency risks, and profligate government spending (particularly in the U.S.). The problem is that by creating the illusion that they are doing something material – when the problem in the global financial system is not confidence, or liquidity, but solvency – the Fed and the ECB misdirect the attention of investors, provide false hope, and will ultimately do a great disservice to investors and to their own credibility…..
At present, the Fed has injected less than $20 billion in total “liquidity” since March – nearly all of which has been withdrawn from the banking system as currency in circulation. Normally, the Fed would have done a “permanent” open market operation by now, to finance this increase in currency demand (which predictably grows by $30-50 billion annually). But by constantly rolling over temporary repos every week or two instead, the Fed can act as if it is “doing more.”….In short, the Fed is doing nothing more than predictably rolling over its repos, but with great flourish as if something more is going on…..
Last week, the market shot higher on reports that the European Central Bank was injecting 348.6 billion euro (the equivalent of US$500 billion) of liquidity into the European banking system. The truth is that the ECB actually drained liquidity last week…..
Just as in the U.S., the bulk of the reserves in the European banking system are financed by the continuous rollover of repurchase agreements. In the Euro-zone, the total outstanding amount of these repos has been fairly steady around 450 billion euro. Also, as in the U.S., the ECB has moderately increased the amount of repos outstanding to cover the holiday period through January 4. Still, this increase has only had only minor effect on the 30-day average, and even measured daily, represents only about 38 billion in additional euro to cover the holiday currency demand for the entire Euro-area.
Despite the apparently enormous amount of last week’s 348.6 billion euro “main refinancing,” the fact is that it was a rollover of existing repos, not a “new injection” of funds.
What’s more interesting is what didn’t get reported. If you examine the ECB’s own data, you’ll find that as of Friday, December 14, the ECB had a total of 488.5 billion euro in outstanding “liquidity,” 268.5 billion euro of which was set to expire on Wednesday, December 19…..
At the beginning of the week, the ECB had 488.5 billion euro in net liquidity outstanding. By the end of the week, the ECB had 485.5 billion euro outstanding.
So here’s the blunt truth: the ECB drained 3 billion euro of liquidity last week! (boldface theirs)
The story reported and repeated ad nauseum on the financial channels was that the ECB “injected” the equivalent of US$500 billion of “liquidity” into the international financial system last week. The slightly more refined version was that Wednesday’s 348.6 billion EUR refinancing was dramatically higher than the 268.5 billion EUR refinancing that was expected.
The real story is that on Wednesday December 19, the same day the ECB did that 268.5 billion refinancing (isn’t it interesting that at prevailing exchange rates, it translated into a “headline number” of almost exactly US$500 billion?), the ECB also did a massive 133.6 billion EUR “liquidity absorbing” operation, which it then rolled over the next day and then into next week. (boldface theirs)
The final items to note are the transactions on 12/20/2007. First, the 48.5 billion “liquidity providing” transaction that day was a rollover of a long-dated 50.0 billion EUR repo from September. Next was the 10.0 billion EUR transaction on 12/20/2007, which I’ve marked with an asterisk. The ECB reference code on that transaction is “TAF07001.” This was the much publicized U.S. dollar “term auction facility” transaction coordinated with the Federal Reserve.
But look closer. That same day, the ECB entered a liquidity absorbing transaction of 150.0 billion euro. The net result was 48.5 + 10.0 provided, plus the 133.6 expired “absorbing” transaction, minus 50 billion expiring from September, minus the new 150.0 billion absorbing transaction = -7.9 billion euro.
So on the very day that the ECB engaged in a “coordinated injection of liquidity” through the new term auction facility, the end result that day was to drain 7.9 billion euro from the international financial system.
As a final observation, in the above chart, Bill Hester broke the ECBs repos into short-dated and longer-dated (greater than 16 day) categories. He observed that following the August turmoil in the financial markets, the ECB shifted the maturity of their repos from short-dated toward longer-dated transactions. Evidently, the ECB has been trying to provide somewhat more predictability to the banking system as to the availability of funds. This is an indication that they are at least trying.
What does this portend? The major central banks are making a show of adding liquidity, yet are not doing so. That says the real mechanism being used to make a substantive difference is policy rates, not infusions of liquidity.
Several possibilities, not mutually exclusive, may explain this course of action. The monetary authorities are no doubt concerned about inflation (the eurozone rate is above the ECB’s target; they held off from making a rate cut; the Fed, despite focusing on core inflation rates, no doubt has also noticed the increase in inflation expectations). Rate cuts and other actions tend to produce diminishing results, which might lead central bankers to want to hold some firepower in reserve. A hard-to-evaluate (in conventional frameworks) factor is the continued large scale operation of the carry trade, funded by near-free loans from Japan.
The regulators may feel the crisis is one of confidence, rather than liquidity (indeed, all signs are that banks have ample cash reserves; the problem is characterized as reluctance to lend). Thus, measures to increase liquidity would be inappropriate, while measures to signal support and willingness to depart from business as usual might be the right remedy. Or they could think the crisis has been exaggerated by banks and securities firms for self-serving reasons. These moves thus will keep legislators and the press from pressuring central bankers to do more.
But we also get to the interesting second layer: why do so few bother to look at the data? It takes some doing to net out the various transactions, but the information is there. Journalists have a weak excuse for not going there (too many stories, too little time) but it’s surprising and sobering that so few professional investors pay attention.
A final observation from Hussman:
As an additional remark, as I noted in mid-October, “we’re likely to observe a growing amount of what will wrongly be viewed as ‘cash on the sidelines’ and ‘money creation’ in the banking system. The problem is that the commercial paper market has dried up. If savers are not buying those securities as the proceeds come due, and a good portion of the borrowing is still somehow being rolled over, then it must be the case that the savers who used to own commercial paper are now saving in another form, and the borrowers who used to issue commercial paper are now borrowing in a different form. Most probably, banks will be the chosen intermediary, because savers view bank deposits as insured and somewhat safer than unsecured commercial debt.” This is a very predictable outcome, so be careful not to interpret, say, increases in M3 as being the result of “Fed liquidity.”