What the Sunday 3/15/20 Fed Announcements Do and Don’t Mean
I originally posted this to Facebook in the early morning on Monday 3/16 after reviewing emergency, and unprecedented, Federal Reserve announcements. I’m re-posting here so more can see through the lame mainstream commentary.
Warning: Don’t read if you want to persist in the delusion that everything bad in 2020 is caused by a virus.
At first glance, the two things that stand out to me are the unprecedented reduction in interest rate paid on reserves, and the *elimination* of minimum reserve requirements.
I want to explain why I don’t think these two measures will solve the problems that the Fed says they will. Then I’ll explain why the moves that attracted the most media attention probably won’t do the job either.
Then I’ll explain why I suspect this is all happening.
In 2008 the Federal Reserve introduced a new monetary tool. The Fed started to pay banks to not lend to their customers. The monetary tool is called interest on reserves. Because there are two types of reserves, one to meet legal requirements (“required” reserves) and the rest over and above the legal requirements (“excess” reserves), there are two interest payments, the rates determining which, are set by the Fed.
The two rates paid on excess and required reserves have virtually been the same since their origination. From 2009 to 2016, both the IORR and the IOER (the two rates), were set at .25%.
On Sunday 3/15/2020, the Fed adjusted them from their prior level of 1.1% to 0.10%.
That means the rate paid on reserves has been set to its lowest point ever.
This will crush what little incentive remained for banks to keep the new money they’ve received in exchange for junk debt previously offloaded to the Fed.
The second move is the elimination of reserve requirements. Adjusting reserve requirements is one of the tools that the Fed has had for much longer than it’s had the ability to pay interest on reserves. However, unlike interest payable on reserves, the Fed does not typically adjust the its reserve requirement.
This means that whereas prior to 3/15, the Fed required banks to hold a certain percentage of their deposits in the form of cash. If a bank had $100 million in deposits and the reserve requirement was 10%, then the bank would be required to hold $10 million in cash.
The Fed made this second move for the same reason it made the first, to attempt to get banks to lend.
The problem is that since 2008, banks have held massive levels of excess reserves. In other words, even the low 0.25% rate paid on excess reserves wasn’t enough to encourage banks to lend.
At this point, I don’t see why an additional 15 basis point reduction to 0.10% in interest paid on reserves nor why the elimination of the reserve requirement would fundamentally change bank lending behavior.
What caught the attention of the media was the Fed’s announcement that it would purchase *at least* $700 billion worth of assets, $500 billion of which would be used to purchase Treasury bonds and $200 billion of which would be used to purchase mortgage-backed securities (packages of loans compiled by the government-owned Fannie Mae and Freddie Mac). This *minimum level of purchases is to be made over the super precise period of “the coming months.”
The important thing to know is that this is nothing new. This is the standard way that the Fed increases the money supply since 2008.
What’s salient this time is that once these purchases are made, the Fed balance sheet will grow to its highest ever, from about $4.3 trillion to well above the previous high of $4.5 trillion.
This means that historically unprecedented Fed balance sheet and subsequent money supply expansion is set to resume from when that growth trajectory paused in early 2015.
But I don’t see anything in the transcript of the speech, the Fed press release, nor the Implementation Memo to suggest that there’s been any structural change that would address the lack of liquidity in various short-term credit markets (like the “repo” markets you’ve heard about recently).
So what *is* the problem?
Let’s think about this. If the price for debt is controlled and has been manipulated down to near nothing, but banks still aren’t lending, particularly to one another, why would that be?
Put it this way. Suppose the price of a brand of wine you like has been set to $5, when it used to be $20. You’d jump all over it, right? I mean, I would.
But wait. What if you knew that the wine you’ve always loved, that’s been offered to you for $5, that bears the same label you’re used to, is not the good stuff you’ve always drank? What if the quality of what’s on offer isn’t worth trading for, even with the price reduction and despite the label?
I think some privileged, highly capitalized bankers are in the same position you would be in my example. You have the money to buy the wine from the salesman, just like the capitalized bankers have the funds to buy short-term debt from other bankers. But you know the wine is trash, just like the bankers know that the debt they would have to buy is junk.
In short, I suspect that the quality of the debt on offer in exchange for short-term funding (the money banks need simply to run their day-to-day operations) is of exceptionally poor quality. What “poor quality” debt means is a subject for another time, but we’ve reviewed enough to settle on the point.
What the Fed did on Sunday did not address the underlying financial disease of poor quality debt (shit wine). It simply upped the credit limit available to perspective purchasers. It made perfectly capable bankers more capable of doing the things that they’ve already demonstrated they’re unwilling to do (lend to their competitor banks).
I suspect that what the Fed wishes would happen is that banks holding bad debt would just sell it straight to Fed. And I’m sure some of that has already happened. Consider the signal that selling bank assets to the Fed would send to the rest of the market about the quality of management decision making. Not good.
So despite all of these unprecedented moves, I don’t see how the Fed’s Sunday responses will accomplish what the Fed hopes it will accomplish (but won’t say it wants to accomplish). Nor will they do anything to resolve the underlying debt quality problem that’s caused the trading turmoil in the first place.
Please find supporting links below:
Powell’s statement: https://www.federalreserve.gov/.../FOMCpresconf20200315.pdf
The press release:
https://www.federalreserve.gov/.../monetary20200315a.htm
The implementation note: https://www.federalreserve.gov/.../monetary20200315a1.htm
Fed 2008 announcement on payment of interest on reserves:
https://www.federalreserve.gov/monetarypolicy/20081006a.htm
Fed FRED IOER and IORR:
https://fred.stlouisfed.org/graph/?g=lFwt
Fed FRED Excess Reserves:
https://fred.stlouisfed.org/series/EXCSRESNW
