The Fed’s Focus On The Wrong Thing: RRP
From the lack of recovery in the labor force participation rate, money velocity, and loan growth, we can see that the Fed’s enthusiastic printing of bank reserves has not addressed serious problems in the economy.
This in turn suggests that the Fed’s current policy framework is ineffective at best, and invalidated at worst.
Considering that bank reserves sit at the core of the Fed’s (and other modern central banks) paradigm, this is where a shift in perspective can result in the most change.
Unfortunately, paradigms are also the most difficult to change, as they form the deepest foundations of our thinking.
In terms of modern economics, and by extension modern central banking, the single minded focus on bank reserves as a macroeconomic policy tool to the exclusion of almost everything else is the obstacle that must be overcome.
We know that bank reserves do nothing in the broader economy, and hence contribute little to economic growth or the general direction of interest rates. This is made abundantly clear by how banks make new loans ex nihilo, and thus increase the real money supply.
Since bank reserves are not lent out and simply sit on bank balance sheets, they are pretty much economically inert.
However, because reserves are the backbone of central bankers’ ideological approach and are thought of as the main lever through which they exert “control” on the economy, manipulating levels of bank reserves is all they know how to do.
The result of which is central bankers think that increasing bank reserves increases the money supply, even though they do not.
Changes in loan volumes are what increase (or decrease) money supply, and focusing on reserves means that they are focusing on the wrong money supply.
Which, by extension, necessarily means that they have been printing trillions in the wrong thing!
It also means that, more often than not, they focus on trying to control interest rates, which can lead to suboptimal results, and quite possibly catastrophic unintended consequences.
Take for example, the Fed’s recent decision to raise the rate it pays on its overnight reverse repo facility by 5 basis points, in line with their increase of IOER (the rate they pay on excess reserves) by 15 bps.
In the Fed’s mind, all of this was done to ensure the smooth functioning of short term funding markets, especially the Fed funds market. That is, the market for borrowing and lending bank reserves.
Per the Fed:
“Setting the interest rate paid on required and excess reserve balances 15 basis points above the bottom of the target range for the federal funds rate is intended to foster trading in the federal funds market at rates well within the Federal Open Market Committee’s target range and to support the smooth functioning of short-term funding markets.”
And the role of their reverse repo facility:
“ON RRP operations support interest rate control by setting a floor on wholesale short-term interest rates, beneath which financial institutions with access to these facilities should be unwilling to lend funds.” (emphasis ours)
But bill yields are still falling below the Fed’s reverse repo rate during the trading day, even as long term yields surge higher.
Clearly the Fed’s reverse repo rate doesn’t really serve as a floor, or if it does, then it’s a leaky one.
Although, this does beg the question – why would anyone want to earn less than what the Fed pays?
Simple, because they have some use for the asset, in this case 1 and 3 month UST Bills, outside of simply earning interest.
It is this other use of T Bills that the Fed, in its bank reserves induced blindness, cannot, or perhaps chooses not to, see.
Unfortunately for everyone else, that is, the world, the unintended consequence of their blindness is an even larger unintended consequence – a potential repo market meltdown.
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