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Forget Rate Hikes, It’s Really The ‘Neutral’ Interest Rate Now

By Jeffrey P. Snider 

In September 1979, the Federal Reserve Bank of St. Louis published a paper that attempted to clarify the monetary and economic characteristics of repurchase agreements. The name itself offers little but further confusion as prior to the 1990’s repos could be classified as either collateralized loans or actual sales and purchases depending on individual circumstances. In some cases, the two counterparties on a repo might simultaneously structure each of their end of the transaction as the opposite condition; consistency was a matter of idiosyncrasy. The Federal Reserve itself used such flexibility in originally conducting open market operations, as the Fed holds absolutely no statutory authority to engage in collateralized lending of this kind, but does hold legal standing with which to buy and sell government bonds.

In 1961, the Federal Reserve voted to reauthorize, or rather reaffirm what it believed existing authorization, of the FOMC to engage in repurchase agreements with non-bank securities dealers at less than the Discount Rate. In the Fed’s 48th Annual Report, it is noted that Governor J.L. Robertson dissented from that vote in further expressing, “the opinion that repurchase agreements were in fact not purchases of securities in the open market, such as the Reserve Banks were authorized by law to enter into, but instead were loans to dealers at fixed interest rates that were not related to the yield on the securities.” That made them, to Governor Robertson at least, dubious monetary instruments and Open Market policy.

Since repos were vastly expanding throughout the 1960’s and 1970’s, there came a time for at least recognizing what they were or might be given the larger context of inflationary-driven malaise in the Great Inflation. When the St. Louis branch of the Fed got around to its opinions in 1979, their “answer” was truly none at all:

To the extent that RPs [repurchase agreements] are used to accumulate liquid balances over a period for some anticipated future outlay, they may be more appropriately classified as time deposits rather than demand deposits; such balances would be more appropriately included in the M2 concept of money which includes liquid savings, rather than the M1 concept which does not. Even if it is concluded that BPs are not money (M1), however, the rapid growth of this highly-liquid asset has almost certainly affected the velocity of demand deposits by permitting corporations to obtain desired liquidity with fewer demand deposits than otherwise.

Repo 1979 Outstanding RPsIf repos were so confusing in legal and monetary standing, eurodollars were in parallel indecipherable. Writing in FRBNY’s June 1975 Monthly Review, First VP and Chief Adminstrative Officer of the New York Branch, Richard Debs, expressed what was pretty much the prevailing sentiment about eurodollars:

Finally, for the sake of logic, I should mention the legal framework of the Euro-dollar market, since I included the Euro-dollar market in my working definition of international banking from the point of view of the United States. However, I’m afraid that I can’t do much more than just mention it. The Euro-dollar market itself is not easily definable, and its legal framework, if any, is even less so. The market grew rapidly without the assistance, or burdens, of an integrated or even coordinated set of laws. It is an international—or multinational, or transnational—phenomenon, but it is regulated only to the extent that the Euro-dollar activities of the institutions operating in that market—the Euro-banks— are subject to regulation and supervision by the national jurisdictions in which they operate.

A month before that, speaking in April 1975, Fed Governor Robert C. Holland said of monetary policy and eurodollar potential:

A policy of monetary expansion might have less predictable effects on expanding credit in the United States and might be rendered less effective if U.S. banks utilized available resources to expand their overseas Eurodollar activities than for loans which might expand business activity in the United States.

The context in which all of this scholarship and inquisition was taking place is highly relevant to our current predicament. The 1970’s produced what was called then the search for “missing money.” They all knew, or at least enough of these economists, that “something” was wrong in how they viewed monetary behavior and the interplay with the economy. Undoubtedly, these new and misunderstood financial advances were key to the upheaval, economic and financial, and there was a determined effort to argue for it.

Even in official policy positions, the Fed had ended the 1960’s somewhat ambivalent about repos but quite against the eurodollar, only to suddenly shift course at least with the latter once they figured out there was significance even if they didn’t understand why. In the monetary policy “tightening” of 1968 and 1969, the Fed exposed very real fragmentation in its own post-war monetary setting. With the technological upheaval of that time, there were grave practical effects (as these later 1970’s papers were attempting to address).

In that specific case, as banks were prevented from raising interest rates they offered on deposit balances by Regulation Q, eurodollar banks held no such restrictions and so large commercial banks ended 1968 and began 1969 with a huge deposit outflows. If that were the end of the story, the Fed might have been quite happy with the result (tightening, after all) but instead those large banks simply borrowed those deposits back from London (mostly) in the form of eurodollar liabilities. By the end of 1969, large commercial banks saw their liability balances in large CD’s decline by half, to $11 billion, while eurodollar borrowing balances grew by $13 billion (these were very large numbers for that time).

The Fed responded in almost record fashion as New York bank after New York bank were given the go ahead to set up what were called “Nassau shells”; nothing more than brass plate names on a door in the Bahamas that would trade eurodollars in theory offshore but intimately connected to a terminal stationed inside the respective Wall Street banks. The Fed didn’t know what a eurodollar was, but they apparently knew enough to suddenly approve lest they become an agent of destabilization.

Through the whole of the “missing money” 70’s, the Fed by the middle of the 1980’s just gave up on the task of defining what was or was not “money” and currency-like reserves. Instead, they decided that it wasn’t important and that what would be was interest rate targeting itself, a shift that was intended to cast a wide monetary net around everything that had or might become “money-like” within the frame of domestic banking. By the 2000’s, of course, money markets were thought to be a singular mass or monolith of very little actual distinction, and so monetary policy treated these esoteric markets as if they were just some indefinable extension of domestic “money” because to that point they seemed (and I cannot overstate this word, “seemed”) to behave. Even as the Fed was forced to abandon M3 in March 2006 and at the very same moment Alan Greespan was in full throat of some mysterious “global savings glut” they were entirely comfortable in their own monetary ignorance.

That was a curious position given that a “global savings glut” might itself appear to be “missing money”, perhaps revised for the 21st century character of now explicitly dominating wholesale function. It seemed a relevant proposition given that the Fed in the 1970’s was entirely worried about what it could do (or what it might not be able to do) under such evolving banking circumstances and monetary terms; now those terms had taken over in ways still, to this day, unimaginable.

With that institutional dedication to ignorance remaining as the operative monetary policy position even now, it stretches belief the unearned confidence that is expressed in the ability of the FOMC and policy to get anything right. On Thursday, the federal funds rate fell below the 25 bps rate floor declared over and over by the IOER and RRP. There is no reason in the world, even on year-end window dressing, why someone, let alone a multiple someones, would lend unsecured below 25 bps when they could lend alternately, as theorized, via RRP secured to the Fed or, if a depository institution, let funds idle on account at the Fed to gain IOER – or just lend in GC repo secured at 70 bps (MBS)!

ABOOK Jan 2016 Fragments EFFABOOK Jan 2016 Fragments GC Repo

In reality, however, there is much about each of the individual money markets that makes them less than a complete whole; trading so far, but especially December 30, suggests very real distinctions. In other words, it required the intermediation of money dealers in the 1970’s to produce such orthodox confusion then and it still requires active intermediation today in order to display even the contours of competence. Toward that end, Vice Chair Stanley Fischer already wants to move on despite the appearance of money market difficulties in the FOMC’s first move.

“One possible concern about our unconventional policies has eased recently, as the Fed’s normalization tools proved effective in raising the federal funds rate following our meeting two-and-a-half weeks ago,” Stanley Fischer, the Fed’s second in command, told an American Economic Association conference.

“Of course these are early days yet,” and if issues do arise, the Fed is ready to address them, added Fischer, a close ally of Fed Chair Janet Yellen.

“Eased recently” is far different than “put to rest”, though I suspect that careful language is completely intentional in just that manner. If it were just a matter of federal funds, Thursday’s operations should have at least raised more concerns. But it isn’t just a matter of federal funds, as bill rates remain shallow and repo rates remain elevated. Fischer, however, says that monetary policy is now focused on something entirely different, guiding some “neutral” policy rate in order for the full economy to achieve its non-inflationary potential; pay no attention to money markets at all, the Fed is on to much bigger pieces.

A key topic at the conference was the so-called equilibrium real interest rate: the level of borrowing costs associated with stable inflation and full employment.
The debate over this rate appears set to be a defining focus for the Fed in 2016, as policymakers seek to raise rates quickly enough to head off the threat of inflation but slowly enough to keep the recovery from losing steam.

So don’t worry about the federal funds rate, the monetary corridor or actual rate increases across all the money markets, rather we should instead focus all attention on some mythical rate that doesn’t actually exist in anything outside orthodox DSGE models that haven’t assumed the correct monetary position since before the “missing money” of the 1970’s? My response to that is simply that there are times when it takes so very little actual effort on my part to write “they really don’t know what they are doing.” At least in the 1970’s the Fed and economists made great effort to try to bridge that theoretical gap and seriously study the wholesale banking revolution in the context of potential monetary conditions.

Now? “Trust us.”

As it is, we seem to be revisiting Governor Holland’s open suggestion from 1975, with slight revisions for our current circumstances. “A policy of monetary expansion”, such as ZIPR and QE, “might have less predictable effects on expanding credit in the United States and might be rendered less effective if” US and now global banks were stained with misunderstood, if not unknown (to economists), monetary decay by which money markets would be highly attuned. Vice Chair Fischer wants us to believe that his monetary policy views can even define, let alone measure, some “neutral” economy-wide interest rate when the same policy body has taken no interest in money for decades.

Further, given the integration of eurodollars into the mix, we are meant to think that the FOMC can make that “neutral” rate applicable, in effect beyond theory, to China, Nigeria, Argentina, Canada and everywhere else which might apply to “dollar” conditions. We know, of course, this last count false given that Fischer doesn’t even take it into consideration. For him, as orthodox economics, the US monetary system remains somehow a closed loop, shut off of and from foreign influence. It is a highly curious proposition given the events of 1969 alone, never mind all that has happened since then (including the ridiculous “global savings glut”).

Even though at one point the Fed tried to learn, it really never did. It was good of Vice Chairman Fischer to remind everyone of exactly that point by demonstrating, yet again, the institutional inertia of the post-Great Inflation Federal Reserve even upon close inspection of their most recent handiwork. The missing money remains, for the Fed, missing; for the global banking system in practice, it has become everything.

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