In my January Premium Post, “An Interesting Interest Conundrum,” I laid out how the Federal Reserve was losing control over the Fed funds rate — a loss of control over its bedrock interest rate that indicates financial stresses are building in the banking system that increase the risks from runs on the banks:
After the financial crisis, when there was a risk of runs on banks, the Fed … require[d] the banks to hold more money in reserves … as a regulation safeguard when the Fed was trying to avoid total economic collapse. Deposits, after all, are liabilities because depositors are guaranteed they can demand instant cash at will. Depositors get extremely unhappy if this guarantee is not fulfilled. That looks something like this:
And you don’t want that.
The Fed funds rate is the Fed’s target rate for the amount of interest banks charge each other to make overnight loans to each other from their reserves. In a crisis, when banks need their reserves, the interest they charge each other will naturally skyrocket. To keep the monetary system from freezing up because banks won’t loan to each other, the Fed tries to push that rate down.
During the Fed’s Great-Recovery bond-buying program (quantitative easing), aimed at pushing that rate down, the Fed deposited huge amounts of money created out of thin air into bank reserve accounts to make sure they remained flush so there would be no panic runs on banks, but banks don’t like just sitting on huge piles of money, instead of making even more loans with those piles, especially after the crisis abates. The Fed, however, wanted them to continue to maintain those reserves in case crisis returned.
Because the Fed doesn’t typically operate by just mandating that its member banks do something, it had to find a way within the so called “free market” to entice banks to sit on those piles of new reserve money so the money would remain “in reserve.” My Premium Post went on to explain,
…This became too difficult to manage during the huge bond buying the Fed was doing during the Great Recovery. So, the Fed invented another tool to avoid having to manipulate the Fed funds rate that banks charge each other so that the rate stays within the Fed’s chosen range. In 2008 the US government approved this new power for the Fed, which allowed it to start paying banks interest on excess reserves (IOER) to entice them to keep more money in reserves….
The Fed can use the IOER to give banks incentive notto loan their excess reserves to other banks, even as they keep those reserves up, because they can earn the IOER rate the Fed has set with absolutely no risk just by holding on to their reserves and collecting the Fed’s interest payments.
Since its creation, the IOER rate has been set at the top of the Fed funds target rate to keep the Fed funds rate from exceeding the [Fed’s] stated target.
Now, however, the Fed funds rate is constantly pressing up to the top of that range, probably because banks are drawing down their reserves to buy and hold government treasuries, leaving them with less in excess reserves to lend to other banks.
Banks, I noted were now soaking up government treasures at the Fed’s request because the Fed was no longer refinancing many of the government bonds as they matured due to its bond roll-off (as a way of tightening money supply). Banks buy those treasuries by transferring money from their reserve accounts to the government’s reserve account at the Fed. I believed the Fed’s loss of control over its most basic interest rate would intensify later this year:
The system is building up internal strains that are becoming harder for the Fed to manage, so it is always expanding its tools (a.k.a. powers). Now it is talking of [revising the IOER] because even that new tool is not doing the job. It needs to do this so banks will not raise their interbank lending rates above the Fed’s stated target range…. They’ll have less incentive to loan if they can get an even higher risk-free IOER rate from the Fed for notloaning that money.
The Fed was pressed to do that, not so much out of concern for maintaining high reserves but to keep all interest rates that are pegged to the Fed funds rate (as most are directly or indirectly) from rising because that would cause more tightening throughout the economy, damaging the Fed’s “recovery.”
In another article early this year, “How the Federal Reserve’s Balance-Sheet Unwind is Unwinding Recovery,” I noted that the Fed’s stated target interest rate was really just playing catch-up with where the real market was forcing interest anyway due to the Fed’s quantitative tightening program, in which it is reversing QE by not refinancing federal bonds so that the government has to get the Fed’s member banks to soak up new bond issues in order to refinance its existing debt in the Fed’s absence:
I am calling this time in which we are now unwinding this monetary expansion the Great Recovery Rewind because I believe this attempt by the Federal Reserve and other central banks of the world to move us away from crisis banking is taking us right back into economic crisis. That is why this was the top peril listed in my Premier Post, “2019 Economic Headwinds Look Like Storm of the Century.” It is more potent in possible perils than all the trade tariffs in the world….
Ray Dalio, founder of hedge fund Bridgewater Associates, observes that quantitative tightening is bound to produce effects entirely opposite to those from quantitative easing, namely, “higher interest rates, wider credit spreads and very volatile market conditions.”
Sounds like now.
One of those unwanted effects for the Fed is that it is losing control over its primary lending rate. Another inevitable effect is that those bank reserves that the Fed said were making the US banking system more robust are fading fast:
Rising reserve risks. You may recall the Fed pumped up its member bank reserves to make us all more secure in case of runs on banks as we almost saw during the financial crisis of 2007-2009. Now, as you’ll see below, the reserves in the accounts of member banks have been bleeding out faster than red ink in the last days of a failing Ponzi scheme.
I posted the following chart to show exactly what was happening to member bank reserves as the Federal Reserve reduced its own balance sheet: (Top chart shows the reduction in the Fed’s balance sheet; red line in the bottom chart shows what happened to member bank reserves as the Fed stopped QE and how that runoff steepened when the Fed started tightening.)
Now, here is the conundrum I said would develop from this:
If the Fed continues to tell banks they must hold a certain ratio in reserves-to-loans as the most liquid form of protection against runs, then liquidity is going to tighten up if reserves fall and interest rates are going to rise due to shorter supply of loans. That could also explain why banks are not approving as many loans because reserves are falling.
The drying up of liquidity as bank reserves shrink due to buying government bonds means banks start charging each other more interest on overnight loans from their reserves, making it tougher for other banks to resolve their overnight stresses because fewer and fewer banks have any excess reserves (reserve that exceed the Fed’s requirements) to loan out. That means the Fed funds rate goes above the Fed’s target as real-market forces cause banks to cling tighter.
I contacted the Federal Reserve to get an explanation for what is happening as the Federal Reserve takes money out of the financial system with its balances-sheet unwind. I quoted the Fed’s full explanation in another premium post, but the essence is that, yes, in the words of a high-up Fed economist, there is a direct correlation between the draw-down in every member bank’s reserve accounts and the Fed’s unwind.
At the same time, I noted that the Fed is telling banks they have to maintain their liquidity coverage ratios (reserve requirements), which limit how much they can issue in loans in proportion to their (now diminishing) reserves:
One reason why people may have underestimated bank demand for cash to meet the new rules is that Fed supervisors have been quietly telling banks they need more of it, according to William Nelson, chief economist at The Clearing House Association, a banking industry group.
The Fed’s Great Recovery Rewind is reducing bank reserves as follows:
By shrinking its balance sheet, the Fed reduces the amount of reserves in the financial system, therefore lowering the amount of money banks have to lend to consumers and businesses.
The Fed loses control as financial stress builds
Without getting into more detail on the mechanics, let me show how the Fed is losing control over its bedrock interest. (Something that was, as noted above, not unexpected here by readers of my Premium Posts.) For the first time since 2008, the Fed funds rate recently exceeded its IOER and has been regularly doing that since:
Something unexpected has been going on in overnight funding markets: ever since March 20, the Effective Fed Funds rate has been trading above the IOER. This is not supposed to happen. Starting on March 20, the effective Fed Funds rate rose above the IOER first by just 1 basis point, and then, last Friday spiked as much as 4 bps above IOER.
Zooming up the point where the Fed starts losing control, which it barely was managing to maintain all of this year anyway …
Again: this should not be happening and has prompted numerous concerns among the analyst community [about] what is going on and why has the Fed – which previously adjusted the IOER specifically to avoid having the EFF trade outside the corridor – lost control of rates so badly.
I can tell you what is going on because I told readers months ago it was coming. As I just noted above, the determination of this primary interest rate to rise on its own when the Fed has promised it will not raise that rate indicates building liquidity pressures in member banks. Interest has a mind of its own when the demand for money starts to exceed the available supply.
In it’s May FOMC meeting, the Fed took the unusual action of lowering the IOER, which was already below the Fed funds rate in order, to suppress the Fed funds rate from exceeding the Fed’s stated upper bound.
Indicating the unusual nature of the Fed’s move this month, BMO Financial Group’s Ian Lyngen and Jon Hill responded to the Fed’s announcement by writing,
We’ll be the first to acknowledge surprise (though not total shock) at the FOMC’s cut of IOER…. The groundwork for an ease is rapidly developing.
The Fed has reached the limit at which it can withdraw money from the system while requiring banks to maintain safely high liquidity ratios in reserves, making money more precious when banks have to go to each other for loans. In fact, pressure is building for it to actually reverse course on its reversal of QE and go back to QE as one solution.
According to ZH, Barclays Bank’s rate expert Joseph Abate suggested …
…The 3bp rise in fed funds since April 16 “suggests that moments of upward pressure on the rate will become more frequent as bank reserves drop, and changes in the level of reserves now have larger effects on the Fed’s policy target.”
Uh huh. Interest has a mind of its own, and I said several times in late 2018 that the Fed’s target rate was really just rising to keep up with where interest was naturally going on its own due to the Fed’s unwind. Now that the Fed is pressured by the stock market to stop raising its target rate, it’s harder to maintain the illusion that is is actually controlling that rate.
The problem first showed up when tax payers started drawing down bank reserves to make their tax payments in April, but that is not a problem that typically happens in April. Such problems only start happening when reserves are getting too tight to handle regular annual loads like that.
More concerning is Abate’s conclusion that the large move also suggests that the banking sector is “nearing the steeply sloping part of the reserve demand curve” which means that “bank reserves are now significantly closer to what individual banks consider their ‘least comfortable level of reserves’ and thus banks are more willing to pay higher rates to retain these balances.” In other words, some $1.5 trillion in excess liquidity created by the Fed is no longer enough for banks which are starting to scramble to obtain additional liquidity, which needless to say, is very troubling for a banking system which is supposedly [a] “fortress” and “much more stable” than it was before the financial crisis. If anything, this means that even a modest liquidity draining crisis at any point in the future could have vastly more dire consequences than even the pessimists believe.
The financial structure is starting to show hairline fractures under normal annual stresses, indicating it wouldn’t have much robustness if it had to handle a real crisis. Interest rates are, in other words, raising themselves, regardless of the Fed’s decision to calm the markets by stating it will not raise interest.
The Fed’s options are to stop the balance-sheet runoff, which is causing this liquidity stress, sooner than planned (maybe even going back to QE) or start raising its target interest rates again so it, at least, looks like interest is going exactly where the Fed wants it to go. And we all know from December how the stock market would react to the second option.
Could it be the Fed slammed the brakes on its tightening that was supposed to continue well past this year on autopilot, not just to save the crashing stock market in December, but because it could feel that it was losing control of its key interest rate, which had a mind of its own?
For the moment, the April tax crush that revealed how close we are to liquidity stress is over; but if QT continues much longer, the stress in reserves is bound to show up more often.