The Fed’s Ever-Burgeoning Market Manipulation Support

A set of articles in the Financial Times puts a nasty spotlight on what mission creep, or more accurately, mission leap, at the Fed. The central bank is moving unabashedly into price-setting, and stealth or formally backstopping, of more and more markets.

It’s one thing for the central bank to step in to shore up financial firms during a crisis via the means of providing liquidity. That principle goes back to the Bagehot Rule: “lend freely, against good collateral, at a penalty rate.” The idea was to make otherwise solvent firms pay a price for managing liquidity badly. It was also explicitly not intended to bail out bust banks.

But as we pointed out repeatedly during and after the crisis, the officialdom pretended that the meltdown was a liquidity crisis, simply a massive loss of confidence, rather than a solvency crisis. That belief served as the justification for failing to force writedowns of bad debt, require much higher level of capital, and at a minimum imposeg management changes on firms that needed bailouts (better yet resolving the worst of the pour decourager les autres).

We’ve refrained from saying much about the central bank’s forays into the repo market. Here are the key sections of tonight’s article from the Financial Times:

The Federal Reserve Bank of New York has emerged as the single largest player in an important segment of the short-term lending market that was at the epicentre of the financial crisis…

Armed with a balance sheet of $4.3tn of bonds purchased during quantitative easing, the Fed is using what it calls its reverse repo programme, or RRP, to trade with money funds at a time when tough new regulatory standards have made such borrowing less attractive for the banks…

When official short-term rates are eventually pushed higher, the Fed plans to use the RRP to drain cash from the financial system via short-term loans of Treasuries from its huge balance sheet.

Robert Grossman, managing director at Fitch, said the change in the Fed’s presence in the repo market had been dramatic and that the central bank could use RRP to significantly escalate its role…

Bill Dudley, New York Fed president, warned last month that if use of the repo facility were to grow too quickly it might “result in a large amount of disintermediation out of banks through money market funds and other financial intermediaries into the facility. This could encourage further enlargement of the shadow banking system.”

Without a cap on use of repo with the Fed, investors who ordinarily lend to banks could instead flock to the central bank in times of market stress, exacerbating a flight from funding of banks, he warned.

Yves here. Notice how perverse this all is. First, Paul Volcker violently disapproved of money market funds precisely because they competed with government guaranteed deposits. He was a big fan of having a floating net asset value to make the risk of money market funds more explicit. But during the crisis, they were backstopped. The big reason for the panic was that repo originally was done only with pristine collateral, meaning Treasuries. But demand for repo grew as more and more dealers needed to provide collateral for derivatives positions. That led to a need for more collateral, and increased acceptance of riskier collateral. The crisis in money market funds took place because the Reserve Fund, a large player, held Lehman commercial paper and “broke the buck,” leading to panicked withdrawals from other money market funds.

One remedy would be to discourage the use of derivatives, particularly since those markets have shown growth well in excess of GDP and the proliferation of derivatives is of questionable social value. That would reduce the need for collateral and would lead to a higher general quality of repo collateral. But the central bank is instead venturing into a new role, of controlling repo more directly and even at the early stage of this experiment, making itself a dominant player in the market.

A second disconcerting article was an opinion piece by Harvard economics professor Benjamin Friedman (hat tip Scott), The perils of returning a central bank balance sheet to ‘normal’: Asset holdings enable policy makers to regulate the economy. Now there are arguments to be made in favor of the Fed keeping its super-sized balance sheet and letting it run off as bonds mature. But Financial Times readers on the whole were quite negative about Friedman’s argument. His main points:

The evidence shows that these bond purchases indeed lowered long-term rates relative to short-term rates, and lowered rates on more-risky compared with less-risky obligations. A conservative estimate is that a $600bn bond purchase (the size of the Fed’s second round of bond buying) lowered long-term interest rates by about 25 basis points: not enormous, but a worthwhile contribution to the US economic recovery. And the effect of lower long-term rates was probably reinforced by higher equity prices and a cheaper dollar…

Before the crisis, many people urged the Fed to tighten policy to arrest the developing bubble in the mortgage and housing markets. An increase in short-term interest rates would have helped cool asset markets, but it also risked impeding growth in other sectors. If the Fed’s balance sheet had included mortgage-backed securities, it could have sold them, scooping froth out of those particular markets without depressing the rest of the economy.

What are the potential drawbacks of maintaining a balance sheet significantly larger than the pre-crisis “normal”? First, the central bank may suffer losses if it buys securities that fall in value. So far, this has not happened; central banks’ bond buying programmes have made them – and, therefore, taxpayers – record profits. Moreover, while such losses might ultimately impose costs on taxpayers, there is no risk from insolvency of the central bank itself. Unlike at private banks, which must keep cash on hand to meet withdrawals, central bank liabilities are not redeemable for anything else.

Unlike at private banks, which must keep cash on hand to meet withdrawals, central bank liabilities are not redeemable for anything else.

Second, because asset purchases have to be paid for, the huge increase in central banks’ holdings has required a corresponding increase in their outstanding liabilities. Those economists who think of prices and wages as determined by the liabilities of the central bank expected hyperinflation to follow. Yet no increase in inflation – not even a few percentage points – has yet appeared in any economy that has pursued this course. That is because the central banks in question have made it advantageous for banks to redeposit the additional reserves instead of lending against them. This has prevented these asset purchases from triggering what might otherwise be an inflationary flood of credit.

There is so much wrong here that it is hard to know where to begin. To the extent that the not-all-that-significant impact of QE on interest rates has affected the real economy, it has been through the wealth effect, not on real economy lending. As we’ve discussed at length, putting money on sale induces more borrowing only from parties where the cost of money is a major part of the cost of their product. Even then, they also have to be confident of end-market demand. Only players in the financial services game have fit that picture. The weak housing recovery, which depended mainly on private equity firms bidding up the most distressed properties, is already floundering. Similarly, banks don’t lend against reserves.

Friedman also fails to acknowledge that central banks can run up against an inflation constraint and thus require taxpayer recapitalization (as in they can’t monetize their losses without making inflation unacceptably high). And as for the Fed making money now, at ZIRP, that’s a given. If the Fed were ever to raise the Fed funds rate over 3%, the duration of its mortgages would lengthen and the economics of holding them would change radically, to put it politely. Finally, selling the sort of mortgages that the Fed holds now (government guaranteed) would not have done anything to stem demand for subprime pre-crisis. We discussed at length in ECONNED how CDOs based heavily on credit default swaps subverted normal market mechanisms and drove demand to the very worst mortgages. In fact, the Fed’s interest rate increases had greatly reduced demand for prime mortgages but didn’t dent subprime demand, the opposite of what you’d expect in a normal tightening cycle.

The third worrisome piece was by Pimco’s Paul McCulley, Make shadow banks safe and private money sound, which called for the Fed to backstop shadow banks. The fact that it did that during the last crisis (and the market expects that to happen again) does not make it sound policy. Financial claims are already a huge multiple of the real economy. Throwing more guarantees underneath them will only lead to the creation of even more speculative product. While it makes sense to prevent the collapse of the financial system, that needs to include serious penalties with no discretion, including the ouster of the management and repayment of the assistance out of firm capital over time. The price of a rescue has to be huge penalties for the firm and its key decision-makers or they will just pile on risk.

But this is where we are. Our central bank seems happy to be the counterparty of the last resort and absorb all sorts of risks so as to provide smooth sailing for financiers. Where this ends I cannot fathom, but I do not expect it to be pretty.

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  1. MikeNY

    I’m beginning to see the Fed as the analogue of the Church in pre-revolutionary France: defender and ennabler of the corrupt and oppressive Ancien Regime.

    Écrasez l’Infâme!

    1. fresno dan

      I know I sound like a broken record (for young people, record were vinyl disc with very shallow groves that allowed music to be played off of them. A broken record is when a groove could be damaged causing a portion of a record to continuously repeat) but I can’t get over the fact that the FED supports, covers, and enables criminal activity in the US and world financial sectors. Whether robo signing or LIBOR, AIG bonuses et al, the FED knows about all this criminal conduct and REFUSES to do anything to even mildly discourage it.

      Pretty much single handedly, the FED has destroyed representative government in America.

      1. OpenThePodBayDoorsHAL

        It’s a grotesque repudiation and invalidation of every founding principle of both capitalism and democracy.
        State activity in France is 75% of the economy. In the US it’s 42%, up from 18% in 1935. When we hit 100% we will be in the most grotesque form of meta-communism, where instead of the resources flowing with any proportion of equity to the masses, they concentrate ever upwards to the tiny neo-Politboro: the global billionaire class. How ironic that China seems to be moving the other way down the same continuum, from 100% state down to a lesser percentage.
        David Stockman perfectly captures this of course in his latest rant about Yellen:

        1. Nathanael

          State vs. private is a distraction, a confusion, a veil thrown to mislead your mind.

          The real thing you should look at is whether wealth and power are flowing to the 1%, or to the 99%. Whether “state” or “private” makes no difference.

          1. OpenThePodBayDoorsHAL

            There’s an important distinction: the state can do what it likes simply by decree, the private sector still has veneers of accountability to things like “shareholder value” and “market share” and even “public opinion”.

            1. OldFatGuy

              Oh really? Where was all that private sector “accountability” leading up to the crash? You’ve got it backwards, with a functioning democracy, it’s the state that has accountability and can’t simply do what it likes by decree. But we don’t have a functioning democracy. Without that, neither the state nor private interests face real accountability (which is where we’re at today).

            2. GlassHammer

              Let’s not kid ourselves; “Shareholder value” is just as vulnerable to the Principal-Agent Problem as “Taxpayer value”. And “market share” easily turns into absolute monopoly in our winner take all economy.

              Given the times we live in, I don’t think we even need to discuss how little “public opinion” matters.

              Like Nathanael said, “State vs. private is a distraction”.

  2. Swedish Lex

    The perils of trying to unscramble a omelette.
    There were alternatives to this mess/solvency crisis – in the U.S. and in Europe – that would have been difficult to execute, but the net result would have been less bad. But that would have meant stripping the bankers naked. So it never happened.
    I guess their best bet is to try to win more time.
    If they go back to normal “quickly”, I would really like to know in advance so that I can take shelter.

  3. NotSoSure

    I still remember the old days when people using the term PPT were called conspiracy theorists.

    1. Doug Terpstra

      Coincidence theories are falling fast. The idea that central banks were directly buying the stock market was ridiculed not long ago, now it’s confirmed. It’s become increasingly hard to distinguish between today’s tightly rigged market and the old soviet model of central planning, especially out-of-control military spending. It’s certain to end in a much bigger collapse (war) than the peaceful liquidation of the USSR.

      Central bank rigging seems to follow the obsessive-compulsive fire supression strategy of the USFS on behalf of the timber industry. The deadwood and understory kindling continually build up over decades until finally a conflagration erupts that defies containment and wipes out even the old-growth giants and consumes the entire forest.

    2. flora

      I read this post, the TISA post, the PE posts; I see Federal and Supreme Court decisions that too often favor finance over individuals in a way that overturns decades of precedence with little explanation; I read Matt Stoller’s Salon piece and normally I’d pass it all off as simply govt tunnel-vision incompetence. Except, now an idea (not an argument) occurs: maybe the highest levels are still focused on achieving some grand illusion of financial one-world utopia. (Oh, man, I hate it when I sound like tin-foil even to myself!) So they keep propping up failed policies and entities. Because someday, *someday*, it’ll all work, if it’s just big enough.

      About the Feds actions in this specific post: If the Financialization ship is sinking and the stern is already under water building out the bow won’t stop it from sinking. Somebody, please, bring back Paul Volker.

      1. Nathanael

        Again, don’t get distracted. It doesn’t matter whether we have one world government or lots of little governments, what matters is *whether those governments are democratic*.

        The “democracy gap” in the EU has been discussed a lot, and the European Parliament was actually intended to address this gap, but Europarl has been crippled deliberately by the elites.

  4. Jim Haygood

    Today former Fed governor Kevin Warsh joins Stanley Druckenmiller in asserting, in a WSJ editorial, that:

    The aggregate wealth of U.S. households, including stocks and real-estate holdings, just hit a new high of $81.8 trillion. No wonder most on Wall Street applaud the Fed’s unrelenting balance-sheet recovery strategy. Yet it provides little solace for families and small businesses that must rely on their income statements to pay the bills. About half of American households do not own any stocks and more than one-third don’t own a residence.

    Balance-sheet wealth is sustainable only when it comes from earned success, not government fiat. Wealth creation comes from strong, sustainable growth that turns a proper mix of labor, capital and know-how into productivity, productivity into labor income, income into savings, savings into capital, capital into investment, and investment into asset appreciation.

    The country needs an exit from the 2% growth trap. There are no short-cuts through Fed-engineered balance-sheet wealth creation. The sooner and more predictably the Fed exits its extraordinary monetary accommodation, the sooner businesses can get back to business and labor can get back to work.


    Meanwhile, back on the asset inflation front, the S&P is at a record high of 1,963 this morning. If you take the S&P’s Internet Bubble high of 1,527 in March 2000 and adjust it by the 39% CPI increase from then till now, we’d need to reach 2,123 to equal stocks’ record-high real price (and most extreme valuation ever) in March 2000.

    Happily, the cloud-cuckoo land of a new record real high in stocks is only 8% away from here. That’s potentially doable this summer. Go-go, Janet B. Goode!

  5. lakewoebegoner

    so I presume that the US is/will be more like Japan—a weird state where there is both structural deflation (from debt overhang, declining demand) and structural inflation (from the decline in wages moving faster than the decline in prices)?

  6. Dino Reno

    We are Chinese if you please with a command and control economy that can’t fail because those in power would be hung. This likely outcome for the elites tends to concentrate the mind. Failure and uncertainty are not options. Even small cracks in the facade are papered over immediately. Stay calm and resume your normal activities. This is a thousand year plan.

    1. Jim Haygood

      A journey of a thousand years begins with a single rate hike.

      Didn’t Lao-tzu say dat?

      1. fresno dan

        Close, but the complete quote was:
        A journey of a thousand years begins with a single rate hike, OF ONE BASIS POINT

        can’t raise rates too precipitously….

  7. John

    Why is it so many so called economists were jumping out their stuffy seats to support Yellin over Summers to lead the Fed??! I know. Not much of a choice. Either way we were going to end up with a very bank friendly Fed.

    1. Dino Reno

      The one thing the Fed can’t abide by and what appears to be the ultimate enemy of the Fed’s elaborate monetary charade is PRICE DISCOVERY. As long as it costs less to borrow than it does to buy, assets prices can remain an inflated mystery forever.
      Forever is the real Fed target. Data dependent is the funny little joke it tells itself.

  8. financial matters

    I see this reverse repo in a different light. To me it seems that it gives money market funds an alternative to investing money in the overnight tri-party repo market which to my mind feeds speculative derivative trading, etc.

    Instead it gives them access to the Fed for this money which most people consider ‘parked’ anyway and have no clue how it is really being used.

    The Fed therefore can effectively guarantee this money which isn’t really meant to be aggressively invested. It can also set the interest rate.

    1. Yves Smith Post author

      You are assuming that the result was that the Fed is displacing other repo activity, as opposed to increasing it by virtue of inserting itself.

      By the Fed using reverse repo, it is putting its Treasuries back into the market. Those Treasuries can be rehypothecated by the parties that want them

      The fact that the Fed has become dominant so quickly says that it is lending out its Treasuries a bit on the cheap. This in fact may be a response to the charge that “the Fed has taken so many Treasuries that we have a shortage of good collateral”. There have been tons of articles of this sort over the last two years (curiously you never saw much of this pre-crisis when collateral was worse). Again, the Fed appears unwilling to consider the question of why there is so much demand for collateral in the first place. After all, financial “innovation” is every and always good.

      1. Jim

        The discussion on RRPs is odd and its is borderline troubling that the article in FT actually stated-
        “The Federal Reserve Bank of New York has emerged as the single largest player in an important segment of the short-term lending market that was at the epicentre of the financial crisis…”

        Emerged???!!! Are you serious? The Fed sets short term interest rates via the operations conducted by the desk in NY. Repeat- THEY SET short term rates. No matter what the operating instrument or policy objective. Unless you are over 101 years old, you have not lived a single day where this was not the case. They are not emerging as anything, nor should we view the central bank a “player” when this market is the byproduct of securities finance.

        You also mention a shortage of good collateral but do not recall that from late 2011 through the end of 2012 the Fed sold about $650b(par value) in treasuries maturing within 3 years while removing the same amount(in par value) of longer duration, less liquid securities with long duration. Not sure how increased $$ volume in TRI-Party, O/N repos on treasury collateral increases anything but the size of the GCF repo pool.

        1. Ilya

          Government is selling bonds government bonds is directed to support markets primarily stock market. Government receives cash for bonds. Bonds can be used directly to secure purchases or indirectly through repos. Borrowers in repo market sell bonds obtained from government and get cash with simultaneous agreement to buy bonds back in a future moment. When Fed participates in reverse RP it simply brings back bond and returns cash. In other words government picks up excessive volume of bonds. Government put in the pocket difference in value between two dates representing sell and buy and two times bid-ask spread. This is a form of getting money on liquidity cycle. It does not look something wrong here. Nevertheless in QE the central bank buys 80-30 bn assets from commercial banks and private institutions. It is distinguished by buying or selling short term government bonds in order to keep interbank interest rates low. Hence now the repo market should cover QE program too. The problem is how QE effects on real economy and FX market is rather practical issue and we should be cautious.

  9. Chauncey Gardiner

    Thank you for this post. I would like to understand more about the specific real objectives of the Fed’s market manipulation policies, as well as the specific mechanics of how it is being done. It would be enlightening to also know the extent of involvement of other central banks, supranational entities, governments, and government agencies in coordinating policy actions globally and why.

    It is clear that some narrow constituencies have benefitted hugely disproportionately from these policies, which I believe have been to the long term detriment of the majority of Americans.

  10. impermanence

    “While it makes sense to prevent the collapse of the financial system,…”

    Actually, this is EXACTLY what needs to take place.

  11. financial matters

    Is this policy meant to bail out dealer banks or is it meant to redefine money market funds by getting them out of the dealer bank business? The massive daily churning going on in the tri-party repo market (dealer banks) seems wasteful as well as speculative.

    If money market funds could earn a no risk say 2% at the Fed this would essentially be like letting them invest in Treasuries. This would seem to be stabilizing and treating money market funds as most people think they are.

    This would seem like a good point to let investors know if they want to enter the tri-party repo market they are playing a different game with a different degree of risk.

    1. MikeNY

      The FT link didn’t work for me, and I’m not an expert in repos, but… there can always be an element of speculation in a repo transaction, no? The buyer of the security may be wagering that that the spot px at delivery date is lower (i.e., rates are higher), allowing him to cover for less than the contract px. In this case, the loser would be the Fed. In a rising rate environment, it would be a way for the Fed to absorb market losses on Treasuries, and to insulate money market funds and other participants from the loss.

      I’m not sure that’s what will happen, and the Fed’s holdings are so huge that perhaps they think they ARE the market. But it does seem to me a way to allow losses from rising rates to bleed gradually through the Fed’s income statement, which has been, as we all know, extremely robust as of late. I mean, if they really wanted to shrink the balance sheet, why not just either sell outright, or let the securities run off at maturity? Why enter into the reverse repo market at all? Who can be so desperate to show a Treasury on the balance sheet as opposed to cash??

      1. financial matters

        The money market funds are just looking for yield. They lend their cash into the tri -party repo system to provide overnight liquidity for various financial transactions and usually get a small positive return. But if these financial transactions go bad the dealer banks intermediating these transactions such as JP Morgan (part of the tri) can keep the cash. Ala Reserve Bank with Lehman. (The 2 losing parties of the tri).

        Most money market investors would probably be happy just to have a decent Treasury yield especially if they knew the details of how these funds are invested.

        1. MikeNY

          I think I understand, thanks. So these repos are typically short-term contracts for MM funds to invest surplus cash. But how can they get 2% unless they’re going way out on the yield curve, like into the 7s? Short term bills have no yield. Someone is taking that duration risk, and in this case it seems to be the Fed. The quandary of the money market funds is due to the Fed’s financial repression in any event. Someone, someday is going to get killed by rate normalization. Has the Fed decided it may as well be themselves?

          1. financial matters

            Congress and other regulatory agencies are unwilling to deal with the fragility of the money market system so that pretty much leaves the Fed. They set the interest rates so they could decide to give money market funds basically a risk free 2% yield.

            Money market stability is a big issue by itself. It would probably be better for dealer bank financial transactions to find sources of liquidity that were separate from this system.

  12. McWatt

    Hey has anybody seen a customer this week? Since all the talk of Iraq
    customers seem to be sitting on their wallets and knitting up their purses.

    “Catch-22 says they can do anything we can’t stop them from doing.” Heller

  13. Fiver

    The Fed has demonstrated itself to be a wholly corrupt entity which long since stopped acting in the public interest. Their ‘dual mandate’ is a laughable relic from a bygone era when quaint notions like ‘accountability’ or ‘legal’ or ‘credibility’ had meanings. They have only 1 function now, and that is to further enrich already fabulously wealthy people by whatever means at their disposal.

    Once free from the notion that the Fed has any benign purpose, some of its ways of doing business become more clear. For instance, the tidal waves of money unleashed by QE are just that – waves. They are turned on for a period of months, then off again. When the faucet is ‘on’ hot money flows into all manner of risky places in search of quick profits. This causes all sorts of trouble abroad, but we are told that is ‘too bad’, that the Fed is responsible only for US domestic policy, even though that is patently absurd. We can now say with certainty that those who know when the Fed intends to act, and in which direction, then have opportunities presented for looting and mayhem serving the purposes of other US policymakers.

    There is no doubt whatever that the so-called ‘Arab Spring’ was neither ‘Arab’ in origin nor in any way dependent on the time of year. What it was tied to were wildly spiking energy, food, and commodity prices resulted from gushers of cheap Fed money plowed into speculative markets. Food and gas riots were predicted in response, and they indeed appeared. Similarly, turning off the spigot has its own set of major impacts. Note how it was a big factor in up-ending Ukraine. My point is that if you go back and look at the waves of money in, and receeding flows of money-out, then a pattern appears, a pattern of instability, and once that pattern is known (i.e., ‘risk on vs ‘risk off’) various players, including sovereign States can position themselves to take full advantage. This is not trivial, and indeed can be seen as a major impetus for other nations to act to protect themselves from these ‘unintentional’ side-swipes.

    Here’s an example:

    1. Nathanael

      I agree with all of this except one bit. I do not believe it is possible for players to position themselves to take full advantage any more. The unpredictability and instability are reaching levels where nobody can control them, and if you think you’re positioned to take advantage of it, you’re riding a tiger and are probably going to get killed.

  14. trinity river

    Yves, thanks for this post. I wish I had been able to read this earlier in the day. I only wish I understood it well enough to explain it. I think I need to understand the implications. My econ/finance is not sufficient. I need Stephanie Kelton now. I will keep rereading.

  15. Francesco

    Conventional peak oil WAS in 2007. Global oil production is up slighty due to the very expensive low EROEI unconventional oil. Oil available for export is DECLINING NOW and steady. Central banks CANNOT print oil. In 2008 we had two choices: 1) the hard one 2) the harder one. Now we have no choices left, only the very very hard one. Go out, spend you money now as fast as you can. In 2035 there will be NO OIL AVAILABLE FOR EXPORT. Credit money is NOT capital and NOT wealth, it’s a claim on future energy production and consumption. Capital is techne and natural resources to trasform. Imagine the world that’s coming… no don’t do it !

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