Everyone believes that the modern central bank is an omnipotent economic force. What if it isn’t? What if it can’t even do the most basic of things that it says it can – control interest rates?
Asking the question almost feels sacrilegious, given how everyone is taught that the central bank sits in the middle of modern finance, and that nothing happens in markets without their sanction.
On top of this, the vast majority of financial folk believe what they were taught, which makes questioning the central bank-centric model a lot more difficult.
But, do central banks actually control interest rates?
Let us first consider this question from an empirical perspective, comparing US Treasury yields with the Federal Funds Target Rate (FFR).
If central banks really are omnipotent, then the Fed, being the most important one of them all, should have control over short term US rates. “Control” in this case meaning the Fed’s policy decisions regarding the FFR defines turning points in short term US rates.
After all, if the Fed really controls interest rates, then rates must do what the Fed says.
The FFR is compared against yields on the US 2 year Note, as this is the longest maturity over which the Fed’s policy rate is thought to directly influence.
Also, the FFR data in the chart combines the single rate that it was before December ‘08 with the lower bound of the target range that the Fed switched to after.
Looking at the above chart, it is quite clear that the Fed follows, rather than leads markets. In interest rate cycles going back to 1984, the Fed has always cut rates after 2y yields peaked.
While this delay was not too egregious, the last two cycles saw the Fed wait for longer periods of time before cutting rates. During the months leading up to the Great Financial Crisis, the Fed only cut rates in September 2007, about 15 months after 2 year yields peaked in June 2006.
There was a similar delay going into 2020’s recession, with the Fed cutting rates in September 2019, almost a year after 2 year yields peaked in October 2018.
Both scenarios will forever be remembered for the financial maelstroms that followed, with Wall Street’s implosion in 2008 and Covid induced lockdowns in 2020, but rate cuts prior to these events point toward recessionary conditions already being in place.
More importantly, the rate cuts coming about a year after 2 year yields made their highs point towards the US Treasury market pricing in recessionary conditions before the Fed.
Now, looking at rate hikes, we observe the same patterns.
Firstly, going back to 1984, the Fed has only ever raised rates after 2 year yields made their lows.
Secondly, just as with rate cuts, the Fed is taking longer to raise rates. However, it is important to note that this only applies to one rate hike cycle, in December 2015, which came about 52 months after the 2 year yield made its lows in August 2011.
If the Fed is always lagging the UST market, doesn’t that, by definition, make the market the leader, and the Fed the follower?
In order to see if the Fed continues to take longer before raising rates, we will have to see how long they wait before raising rates in the current cycle.
This of course raises the very valid question, is it not reasonable for the Fed to take longer to make their decisions given very uncertain economic conditions?
In the minds of the Fed, or more specifically, the FOMC, this means that for rate hikes, they want to be sure (or as sure as anyone can be) that the economy is “ready” for higher interest rates. Simply because they are afraid higher rates will choke off economic growth by causing people to borrow less.
This hesitancy to raise rates must be balanced against the dangers of letting inflation take root, which is supposedly stoked by low rates which encourage people to borrow and spend.
Rate cuts, on the other hand, come at the same problem from the opposite direction.
If the economy is growing at a nice clip and prices are generally rising in a good way, central banks require strong and consistent evidence that conditions are deteriorating before cutting rates. Here, their main concern is to not supercharge existing inflation with their rate cuts.
The way the Fed and other central banks go about deciding if the time is right to raise or cut interest rates is by looking at economic data and conditions in the financial markets, specifically in the fixed income (bonds) segment.
At first blush, this seems reasonable and normal.
But, if one thinks about it a little more, doesn’t the market look at the same data in order to make its own projections, while also trying to predict what the Fed will do, and adjust asset prices accordingly?
As such, the Fed, by basing their decisions on the same data while also weighting market conditions, just creates a circular reference.
The crucial issue at hand is this: the Fed believes that market determined financial conditions are a good enough signaling mechanism to consider them when enacting monetary policy.
So what makes the Fed more capable of projecting future economic and financial conditions?
After all, if someone is projecting the future by basing their opinions on a source that already projects the future, what use is there for that someone?
On top of this, the reason the Fed takes into account market prices and conditions is because the market, especially in USTs, has proven prescient on multiple occasions. If the bond market reliably distills the “Wisdom Of The Crowd”, what use is there for the Fed’s current form of monetary policy?
Let’s not forget that the economy takes the interest rates set by the markets. The Fed, in its current policy framework, seeks to influence the rates set by the market, and from there the broader economy.
Hence, the Fed touches the economy only in an indirect way. Given that the Fed’s interest rate decisions consistently lag turning points in US 2 year yields, the Fed’s policy of targeting interest rates really is of little practical consequence.
Consequently, the Fed trying to influence interest rates indirectly, by using market prices and conditions as inputs into their decision making, is no different from traders and investors looking at markets to figure out what the future holds.
Which means that, at the end of the day, the Fed is just like these traders and investors – subject to the timing of their investment decisions, whether they actively try to time the market or not.
If so, why the pretense of analysis and delays in changing their policy stance? They are just going to lag the bond market anyway.
The Fed has announced that it will establish two new repo facilities, one domestic Standing Repo Facility (SRF), and the other international.
The purpose of which is to ensure that funding markets have ready access to cash during times of acute market stress. While this is a positive step, in the sense that the Fed is actively trying to pre-empt future market meltdowns, it is unfortunately one that will not work.
Firstly, the Fed has gotten the problem the other way round. In times of market stress, people need collateral more than they need another outlet with which to raise cash with their collateral.
Think about it for a minute; market stress is a product of mass liquidations which stem from collateral/margin calls forcing people to sell assets to raise cash.
The stress becomes acute when this initial wave of selling precipitates further waves of collateral/margin calls that lead to even more selling, at which point it becomes a negative feedback loop.
During such times, demand for collateral skyrockets because traders and investors need to post more of it to avoid liquidating their positions. This is a result of collateral requirements increasing as market volatility increases – lenders want more assurance against market uncertainty.
Unfortunately, the increase in volatility also decreases the availability of collateral in the open market as everyone looks to hoard it for their own purposes.
Which is exactly what happened in 2008 and 2020.
As such, during times of crisis, everyone is scrambling to get their hands on collateral. People want collateral, and those who have it are kings.
The UST market seized up in March last year because people were hoarding collateral. That is, they were not willing to sell Treasuries because they needed them either for use as collateral, or as buffers against even more volatility.
Lack of collateral is the problem here, not the ability to use collateral to raise cash.
The Fed’s new SRF clearly demonstrate that they view the latter as the problem, not the former, hence them getting the problem the other way round.
Furthermore, the financial system itself is shouting about their lack of collateral, at progressively louder volumes. All one has to do is look at the explosion in usage of the Fed’s Overnight Reverse Repo Facility (RRP), which is almost at $1 trillion now.
Which brings us to our second consideration, that the new repo facility might not be large enough.
While a daily cap of $500 billion sounds high, it is important to remember that trillion dollar markets seize up during financial crises, and Overnight RRP use is also almost at a trillion. $500 billion would be enough if markets worked in a predictable, linear, and smooth fashion.
Unfortunately, they do not.
As such, it’s not about the smooth provision of medium-sized amounts of credit, but rather the ability to provide massive amounts of credit to meet massive amounts of demand for it, arising at the same time.
From this perspective, $500 billion is like a sea wall trying to stop a tsunami.
Lastly, the Fed already conducts daily repo operations, and over the course of the crisis period last year, conducted more frequent repo operations at larger amounts. This is an important psychological factor, because the market is, at this point, conditioned to the Fed taking some kind of action during market meltdowns.
It might not even be an understatement to say that, since 2008 and all the QEs that were implemented between then and now, market participants all around the world expect the Fed to intervene when markets convulse.
But, despite this expectation, 2020’s crisis still happened, and the UST market still froze.
Why then, would another $500 billion facility work now?
To be continued…
While the Fed has misdiagnosed the collateral issues plaguing the repo market, it is important to understand that its new Standing Repo Facility (SRF) can alleviate some pressure in the financial system during times of crisis.
It is possible that during periods of collateral stress, or, more colloquially, market meltdowns, repo counterparties will refuse to transact in anything except the highest quality collateral – T Bills.
Should this occur, normally widely accepted forms of collateral such as Agency MBS and Agency debt may no longer be accepted for repo. The end result being holders of such securities will no longer be able to use them as collateral to borrow cash in the repo market.
This is where the SRF can help by providing an invaluable source of last-resort repo liquidity for Agency related securities. Unfortunately, as illustrated in the chart below, the share of Agency debt and MBS securities used in repo transactions just isn’t very high.
Consequently, any positive effects arising from the Fed’s new facility providing last resort repo liquidity for Agency related securities will not be very significant.
This last-resort repo liquidity could also extend to Treasuries.
Not all forms of collateral are created equal, even within the UST asset class. In general, tenor and liquidity are the main factors in determining the desirability of collateral types ,and the same applies to Treasuries.
Which means that, in times of severe stress, some types of USTs can fall out of the bucket of “acceptable” collateral, as demonstrated in 2020 when Off The Run Treasuries were shut out of the repo market.
This collateral “divergence”, for lack of a better term, within the UST asset class is where the SRF can really shine. Traders and investors who find themselves holding Treasury securities that were once widely accepted as collateral in the repo market, but are suddenly not, can turn to the Fed’s new facility.
This will alleviate the pressure on this subset of market participants during a financial crisis, and could prove to be valuable in helping some of them avoid falling into insolvency.
In a semi-related way, another possible scenario where the SRF can be effective is when holders of USTs (the shorter tenor ones that are still accepted) need to borrow cash in the repo market but deem repo counterparty risk to be too high. Posting their collateral to borrow from the Fed then becomes the best option.
However, this could lead to the opposite of what the Fed intends by exacerbating illiquidity in the repo market, as collateral holders refuse to transact with anyone but the Fed, leaving those scrambling to get hold of collateral with even less chance of doing so.
Should this happen, it could lead to more severe sell offs across global markets as traders and investors are forced to liquidate positions in whatever assets they hold in order to raise cash to meet collateral/margin calls.
Ultimately, while the scenarios mentioned above are instances where the SRF can make a difference, it won’t be enough.
Because for all that the Fed and market folks want to believe in it, the SRF simply does not solve the underlying problem of collateral scarcity!
Of course, if the Fed can prove that it has the ability to better predict the future than the bond markets it closely follows, then the central bank should take all the time it needs before changing its policy stance.
However, as the financial crises of 2008 and March 2020 so painfully show, the Fed does not know more about the future than everyone else.
Recall that the Fed did not foresee the housing crash and ensuing financial crisis of 2008, as well as how bad financial conditions would get in 2020.
Bear in mind that in both cases, the Fed had already cut rates prior to the crazy market sell offs that define those times. That is, 2 year yields had already peaked, and the Fed had taken their delay, then decided that they should err their policies on the side of markets.
Even so, the large selloffs still happened!
Another way to think of this is:
Had the Fed known beforehand how desperate markets would get for liquidity amidst endless cascades of margin calls and forced selloffs, wouldn’t they have cut rates by more earlier?
Yet, in both 2008 and 2020, the bulk of their rate cuts came after markets started to plummet. Again, the market leads, and the Fed follows.
Consequently, the Fed, by waiting and wanting to be sure before enacting changes to their policy stance, really is actively trying to time the market.
This is made evident by their delay in raising/cutting rates relative to turning points in the 2 year yield, and also by their statements justifying those delays.
In November 2006, Ben Bernanke, then Chairman of the Fed, publicly warned that the risk to the economy lay with further inflation, and not a slowdown in growth, adding that:
“Whether further policy action against inflation will be required depends on the incoming data.” (Emphasis ours)
Does this not sound strikingly similar to investors who say that they will not enter into a position until more data comes in?
Or traders who hold off buying or selling until the “market confirms the move”?
Bernanke made his comments all those years ago in defiance of calls for rate cuts, but what did 2 year yields have to say about it? They peaked in June of ‘06, five months before Bernanke’s comments, then went on to plunge to what were then record lows.
All while risk factors that were the exact opposite of what Bernanke identified coalesced and morphed into a financial crisis that engulfed the world.
Now, it would be perfectly reasonable to say that hindsight is 20/20, and what is written above is invalid because we know now how things panned out. And saying so would be an accurate criticism, because it is very nearly impossible to consistently predict the future with some degree of accuracy.
But, this virtual impossibility is the whole point, as it shows that when it comes to predicting the future, the Fed is just as clueless as the rest of us!
Regardless of their reputation, or what people believe that they can do, the Fed is a collection of human beings looking at the same economic trends and data ( although the Fed does have access to non-publicly available data) as everyone else.
They are susceptible to the same cognitive biases and lack of broader perspective as everyone else, and their current policy framework has them trying to time economic cycles, also like everyone else.
Is it any wonder that they cannot preempt financial crises?
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