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Red flags at the Fed

The US Federal Reserve has released an avalanche of fresh cash injections after the short-term money market unexpectedly went haywire. It's not quite  quantitative easing (yet) but it does signal the end of any potential return to pre-GFC balance sheet levels, says Patrick Carvalho.

Last Thursday, the U.S. Federal Reserve Bank pledged to offer on a daily basis at least $120 billion of cash injections in the short-term money market, up from the initial $75 billion supply agreed last month.

The central bank interventions raised red flags about a revival of the cash crunch in 2007 leading to the Global Financial Crisis.

In addition, the Fed announced an ongoing operation targeting $60 billion a month in bond purchases to boost bank reserves, unnervingly resembling the three rounds of large-scale asset purchase programmes – or Quantitative Easing (QE) – deployed after the last financial crisis.

Officials were quick to dispel any misunderstanding, with Fed Chairman Jerome Powell repeatedly insisting: “This is not QE. In no sense is this QE.”

But as the old saying goes, “Never believe anything until it is officially denied.”

The truth probably lies halfway. The Fed bond buying operations are not (just yet) quantitative easing as introduced, but they do signal the end of any potential return to pre-crisis balance sheet levels.

For America, and for the world, that means our ability to fight the next recession will not be duck soup.

The crunch is back
As the Fed prepared to discuss the policy interest rate at its September meeting, the short-term money market unexpectedly went haywire. The “repo” rate – i.e. the cost of how much private banks and other market players pay for overnight loans using repurchase (or repo) agreements – jumped to an annualised 5 percent on 16 September, and almost 10 percent in the early hours of the following day.

That was abnormally high as repo rates usually track the benchmark federal-funds rate, which was just above 2 percent throughout August and early September.

So for the first time in more than a decade, the Fed acted with full force on 17 September with an avalanche of fresh cash injections to normalise the overnight loan rates.

The repo market underpins much of the US financial system, boasting more than $1 trillion in short-term loan transactions every day. Basically, it is the go-to source of cash that American financial firms may access to run their daily operations.

That means a repo market malfunction can have deep repercussions throughout the economy. Of particular note is that spiking repo rates were a notorious early warning sign of the last financial crisis.

This year’s cash crunch is of a different nature from the seismic waves last felt in the wake of the Global Financial Crisis, though. For one, there is no doubt about the quality of collaterals offered in the current overnight repo loans. The bulk of repo loans in 2007 were backed by suspicious mortgage securities, while most collaterals now comprise of high-quality American Treasury bonds or bills.

But that still does not explain what is driving the ongoing repo market upset.

Market reservations
Initial explanations for the mid-September repo rate glitch blamed an unusual coincidence of two financial deadlines on 16 September, namely the cut-off for quarterly corporate tax payments and Treasury auction settlements.

An emerging consensus now points to a much larger structural deficiency in the financial system itself, including in the rules implemented after the last financial crisis to increase market resilience.

According to this narrative, these two originally unconnected events led to a large peak transfer of cash from the private sector to the government, and therefore temporarily drying out market liquidity.

That explanation made perfect sense. Except these two events were not unexpected at all, allowing plenty of time for financial firms and monetary authorities to plan in advance for any cash shortfall.

In addition, financial calm should have returned to the repo market after the original Fed interventions – but it did not happen. To the contrary, Fed authorities have consistently inundated the short-term money market with tens of billions of daily liquidity injections, reaching roughly $200 billion of cash loans for the final day of September.

An emerging consensus now points to a much larger structural deficiency in the financial system itself, including in the rules implemented after the last financial crisis to increase market resilience.

Under regulations following the 2009 Basel III international regulatory accord, the Fed enforced large American banks to progressively boost their liquidity coverage ratio (LCR), which requires banks to park a certain amount of cash reserves with the Fed at all times. The rationale is the higher the required bank reserves, the higher is the ability to absorb negative shocks in distressed financial times.

At first, as the Fed underwent through successive QE rounds, banks stockpiled cash in their reserve accounts, reaching a peak of $2.9 trillion in July 2014. However, once the Fed reversed course early last year to unwind its balance sheet, so did the banks’ reserves.

Bank reserves held at the Fed are now below US$1.4 trillion, the lowest level since 2011, making the LCR requirements a de facto constraint. The result is a cash drought that, without further actions, will increasingly rock financial markets, as with the repo rates last month.

For the Fed’s part, Powell already dismissed relaxing LCR rules. Instead, the monetary authority will provide a range of actions to increase market liquidity. That includes new rounds of large-scale bond purchases, leading many to wonder whether these constitute a resumption of quantitative easing.

The duck test
On top of repo market spot interventions, the Fed started a six-month operation to buy short-term Treasury bills at an initial monthly pace of US$60 billion. In addition, the central bank will continue to monthly purchase up to US$20 billion in other Treasury securities to cover for maturing bonds in its possession.

As a result, the Fed balance sheet has increased by more than $200 billion in the past two months. (For comparison, at the height of its largest and final round of quantitative easing, the Fed was buying US$85 billion a month of Treasury bonds and other securities between December 2012 and October 2014.)

Despite similarities with previous QE rounds, the Fed stated in a recent media release the current purchases of Treasury bills are “purely technical operations aimed at maintaining reserves in the banking system at an ample level.”

So according to the Fed storyline, despite quacking like a QE, the current bond purchase operations are nothing like it, as they are not targeted at putting downward pressure on longer-term interest rates “and thus should have little if any effect on household and business spending decisions and the overall level of economic activity”.

That is a valid point, but some market analysts are already questioning how long the Fed can sustain its money market interventions by short-term bond purchases only before moving to a wider range of Treasury maturities.

Looking ahead
Beyond these semantic disputes on large-scale bond purchases, recent events provide another takeaway.

Attempts to return monetary policy towards a pre-financial crisis environment have been thwarted by loud reality checks. Despite a record 10-year growth streak combined with 50-year low unemployment rates, the Fed has proven unable to withdraw its lifeline support of cheap credit.

So with further Fed fund rate cuts and ramp-up bond purchases in the horizon, one might only wonder how much room there will be to duck and cover when the next financial quake hits.
 

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