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.