<b>'..What makes this nearly beyond belief is that encouraging this yield-seeking speculation was one of Ben Bernanke’s intentional
objectives. That’s not economics, it’s sociopathy.
..
..the proper order of policy normalization should have started by gradually running down the size of the Fed’s balance sheet. Inexplicably, the Fed seems to believe that raising market interest rates to 0.25% by directly paying interest to every Joe in sight is materially different from a world where investors instead simply hold Treasury bills yielding 0.25%..'</b>
<blockquote>'As the Fed drove the monetary base to the most extreme level in history, the “reach for yield” didn’t stop at Treasury bills. With over $4 trillion in hot potatoes steaming uncomfortably in the hands of investors, they reached for yield in riskier securities (just as similarly uncomfortable investors chased mortgage securities during the housing bubble). This drove up demand for junk debt, leveraged loans, and equities, all of which became the beneficiaries of reckless but ultimately temporary yield-seeking speculation. What makes this nearly beyond belief is that encouraging this yield-seeking speculation was one of Ben Bernanke’s
intentional objectives. That’s not economics, it’s sociopathy.
..
Last week, the Fed finally moved from the zero bound, pushing short-term interest rates, including the federal funds rate and the 3-month Treasury bill rate, to 0.25%. Now, traditionally, the way to accomplish this would be to shift the monetary base back to about 13-14% of nominal GDP. To get to short-term rates of 0.25%
through market supply and demand, the Fed needed to roll about $1.7 trillion in Treasury securities off of its balance sheet as the bonds matured. We know from nearly a century of history that market interest rates would hardly have budged until the balance sheet was about $1.4 trillion smaller, so doing so would not have been disruptive to the credit markets. Instead, the Fed has insisted on continually reinvesting the proceeds of maturing holdings into new Treasury debt, holding its balance sheet near its peak, above $4 trillion.
So how will the Fed move the Federal Funds rate up to 0.25% with $4 trillion dollars of monetary base still outstanding? First, it announced that it would increase the amount of interest it pays to banks on $2.6 trillion of reserves, raising the rate to 0.50%. I know - the 0.50% doesn’t seem to make sense if the target fed funds rate is 0.25%, but all will be clear shortly. See, the second thing the Fed did was to vastly expand something called a “reverse repurchase” or RRP facility that will pay 0.25% to other institutions that also hold cash, but aren’t eligible to receive interest on reserves. These include the GSEs, foreign banks, and money market funds - what the Fed calls an expanded list of “counterparties.”
“Reverse repurchase”? OK, here’s what’s going on. The Federal Reserve Act allows the Fed to buy and sell Treasury securities on the open market. It doesn’t, however, authorize the Fed to go out and pay interest directly to money market funds and foreign banks. But since the Fed refuses to shrink its balance sheet, the only way to hit the 0.25% Fed Funds target is for the Fed to pay interest outright to every Joe who might otherwise lend U.S. dollars at a lower rate. Since the Fed can’t just pay interest to financial institutions that aren’t U.S. banks, it has to make the payment look like it’s a transaction involving a Treasury security.
To pull this off, the Fed has announced that it will open “reverse repurchases” to a whole new list of counterparties, limited only by the amount of Treasury securities it owns. A reverse repurchase goes like this: the Fed agrees to “sell” a Treasury bond to some money market fund today, and to buy it back tomorrow at exactly the same price, plus one day of interest at 0.25%. So the money market fund essentially gets “paid” 0.25% interest on its overnight “investment.”
The effect of it all is this. Rather than reducing the size of its balance sheet, the Federal Reserve has raised its target federal funds rate to 0.25%, to be accomplished with two tools. First, the Fed has raised the interest rate it pays banks on their idle reserves to 0.50%. Second, in order to keep GSEs, foreign banks, and money market funds from lending at a rate lower than 0.25%, the Fed has essentially removed the cap on its “reverse repo facility,” and will pay 0.25% on those RRPs.
Once again, this begs the question: Since the marginal lenders will now be getting 0.25% through the RRP facility, wouldn’t we obtain a 0.25% federal funds rate even if the Fed only paid the banks 0.25% on their excess reserves as well? Wouldn’t over $6 billion annually be returned to the Treasury for the benefit of U.S. citizens, rather than paying banks that additional 0.25% on reserves for no purpose? Once again, the answer is yes, but as the Grinch urged Cindy Lou Who - just take your cup of cold water and go back to bed dear... You didn’t see anything.
..
Last week, without taking any care to reduce the size of its balance sheet, the Federal Reserve instantly changed the monetary environment to one that is observationally equivalent to the one that prevailed in 2009. By raising interest rates artificially (through interest payments on reserves and reverse repurchases) and applying those payments to everything but currency in circulation, the Fed has neutralized the misguided speculative prop it created through 6 years of policy distortion, and it did so in one fell swoop. That prop was the presence of $4 trillion in zero-interest money, plus zero yields on the entire outstanding stock of Treasury bills with maturities of 3 months or less. In the blink of an eye, short-term market rates and fed funds are back to 0.25% as they were in 2009, and the remaining stock of
zero-interest hot potatoes has suddenly contracted below the 2009 level of $2.3 trillion because total U.S. bank reserves are eligible to earn interest, and even base money outside the U.S. banking system is eligible for 0.25% interest via RRPs.
..
In my view, the proper order of policy normalization should have started by gradually running down the size of the Fed’s balance sheet. Inexplicably, the Fed seems to believe that raising market interest rates to 0.25% by directly paying interest to every Joe in sight is materially different from a world where investors instead simply hold Treasury bills yielding 0.25%. But consider a quick thought experiment. Suppose that the Fed was to immediately contract its balance sheet by $1.7 trillion, reducing the amount of Fed-created liquidity, and instead placed $1.7 trillion more Treasury bills into the hands of the public, yielding the same 0.25%. From the standpoint of the public and the financial markets, nothing would change, except that $1.7 trillion of 0.25% base money sitting idle in the financial system would now instead be held by the public in the form of T-bills with the same yield.'
- John P. Hussman, Ph.D.,
Reversing the Speculative Effect of QE Overnight, December 21, 2015</blockquote>
Context<blockquote>
'..The only way to stop the menace of boom-bust cycles is for the central bank to stop the tampering with financial markets..'Deja Vu: The Fed's Real "Policy Error" Was To Encourage Years of Speculation, December 14, 2015
Banking Reform</blockquote>