Unintended Consequences of New Fed Policy Tools
Given recent focus on stress in the banking sector, I wanted to share some thoughts on the topic. Please note these are my personal views.
My main focus is on the Fed. Let me begin by stating I am neither a trained economist nor sadomasochist, which puts me in a rather good position to evaluate their policies from a practitioner’s perspective. It is not my aim to praise, disparage or otherwise critique policies enacted by today’s Fed. I am only interested in how their policies, tools and actions influence the macroeconomy and related effect on capital markets. Below, I outline a brief history of the modern Fed and how recent changes may have unintended yet foreseeable consequences going forward.
The Fed’s Role in Keeping Inflation In-Check: Pre-GFC
As Milton Friedman once said, “Inflation is always and everywhere a monetary phenomenon.” Simply put, more money in the system is inflationary, and vice-versa. In a factional reserve banking system (like the United States), banks are required to keep a fraction of their deposits as reserves and the remainder is circulated in the economy via stuff like loans. A good portion of those loans end up as bank deposits, which begets more loans, and so on. Simply put (and not accounting for things like velocity of money), more loan growth equals more money supply, which equals more inflation.
Because the Fed acts as inflation's lion-tamer, it is critical to understand how they influence bank lending, and in-turn, supply of money in the economy. The Fed sets reserve requirements for banks, which is the minimum percentage of deposits that must be held back at the Fed. These minimum reserves could not be loaned out. Prior to the Global Financial Crisis of 2008, any capital in excess of minimum reserves could be: a) lent to households and business in the form of traditional loans, b) lent to other banks on a short-term basis, or c) kept at the Fed earning no interest. Anyone who completed 3rd grade math knows that option ‘C’ is sub-optimal.
Accordingly, banks with lots of existing loans and continued strong appetite to lend would borrow from more-conservative banks with excess capital on hand. They would borrow-and-lend to each other overnight, paying-or-receiving interest determined by the Fed Funds Rate. The Fed would conduct open market operations to control the Fed Funds Rate by making slight adjustments to the supply of bank reserves. A higher Fed Funds Rate would make it more costly for banks to borrow, which would (in theory) reduce overall capital for loan growth and money supply growth, and… voila, inflation comes down.
Interbank Lending and the Fed During the Global Financial Crisis
During the GFC, interbank loan demand collapsed. No one wanted to aggressively underwrite new loans, let alone lend money to the next Countrywide. At the same time, supply of short-term funding disappeared. The Fed Funds Rate collapsed from 5.25% in mid-2007 to near zero in late-2008, removing any incentive to lend. Reserve balances shot up, with excess reserves going from roughly $2 Billion in early 2007 to nearly $800 Billion by the end of 2008. I would think a 40,000% increase of anything in two years should be considered statistically-significant. And in case you’re wondering… no, this wasn’t due to Quantitative Easing. QE1 did not commence until November 2008.
Once QE did get underway, the Fed threw fuel on the fire. Reserve balances continued to climb higher and higher. This posed an interesting challenge for the Fed. Once reserves became plentiful, modest adjustments to the supply of reserves via open market operations did little to control the Fed Funds Rate. At that point, the Fed needed a way to influence demand for reserves.
Interesting Developments (pun intended)
For most of its history, the Fed did not pay interest on reserve balances. Legislation in 2006 and 2008 changed that. It enabled the Fed to pay interest, first on required reserves (‘IORR’), then on excess reserves (‘IOER’) as well. Suddenly the Fed could control demand for reserve balances. If it wanted to stimulate the economy, lower the IORR/IOER (which is what the Fed did back then). Banks then have little incentive to keep money locked up and those funds should work their way into the real economy. If you want to temper inflation and remove money from the system, increase interest rates and banks will keep money at the Fed. In July 2021, the IOER and the IORR were replaced with a single interest rate on reserve balances (‘IORB’), which is how it stands today.
The other major post-GFC Fed change was the creation of the Overnight Reverse Repurchase Facility (‘reverse repo’), originally announced in 2014. This affects non-bank financial institutions that are also significant providers to short-term funding (such as broker-dealers and money market funds). Historically, these institutions would lend to corporations (commercial paper) and banks, and offer their investors a higher interest rate than they might receive from bank accounts. In a nutshell, reverse repos allowed non-bank financial institutions to deposit their funds at the Fed and earn de-facto interest. Previously, they were ineligible from receiving interest from the Fed. The concept of reverse repos is the same as interest on reserve balances. Raising the reverse repo rate should increase demand for non-bank financial institutions to deposit money with the Fed, as opposed to lending it to banks. That should reign-in bank capital, limiting bank loan growth, depressing money supply, and bringing inflation down.
The Post GFC Fed
What works in theory doesn’t always work in-practice. While the Fed kept interest rates near zero for over six years post-GFC, reserve balances continued to climb steadily higher. A lot of that was due to Quantitative Easing. But as Helicopter Ben dumped money into the system, it didn’t make its way into the real economy. Banks simply kept that money as reserve balances, which explains why QE never killed the dollar or created hyperinflation, as some had feared. New regulations like Dodd-Frank and Basel III, along with lingering concerns post-GFC and the PIIGS crisis, kept banks in ultra-conservative-mode. Regulators weren’t fussed – they wanted a well-capitalized banking system to avoid another ‘Lehman moment’. Excess reserves peaked in 2014.
Starting in 2014, the economy normalized and growth was back on track. Banks re-discovered their propensity to lend and the Fed began reducing QE (so-called ‘tapering’). Reserve balances started to decline. Finally, the Fed began raising rates in 2016 (so-called ‘lift-off’).
Despite steadily increasing rates from 2016-2019, excess reserves trended downwards over that period. Why’s that? Tapering alone does not account for the decline. Confounding theory again, banks were pushing money into the economy, despite ever-increasing interest on reserve balances. One explanation is that the opportunity cost of keeping money parked at the fed wasn’t enough to offset the opportunity cost of lending in the real economy. Another explanation is that the end of Quantitative Easing removed highly-manipulated long rates, enabling banks to accurately price long-term risk and inflation expectations. Either way, growth was picking up and inflation was still in-check. And so, Fed officials could pat themselves on the back. That is… until Covid.
Covid & Recovery
Mike Tyson once said, “Everyone has a plan until they get punched in the mouth”. While the Fed was busy backslapping, Covid punched global markets squarely in the jaw. Against the backdrop of extraordinary flight-to-quality, reserve balances spiked. In response, the Fed dropped interest rates back to near zero. Nevertheless, reserve balances continued to climb. Reserve balances peaked in mid-2021 at over $4.2 Trillion! Mind you, that’s $4.3 Trillion of bank capital at the Fed, that was not lent out to the broader economy.
I live in Queensland Australia. We have sudden severe storms that come out of nowhere, then leave as quickly as they came. When Covid suddenly dissipated in mid-2021, banks put away their umbrellas and started lending again. Combined with strong government backstops and fiscal support, lend they did. Between August 2021 and January 2023, Reserve Balances fell by a whopping $1 Trillion!
Remember the opening quote by Milton Friedman? In March 2021, US CPI registered a modest 2.4% annual change. By the end of 2022, it was clocking over 8%. More money equals more inflation, remember?
Here’s the disturbing thing. Despite the most-aggressive interest rate tightening in history, money supply (as measured by M2) has only gradually drifted downwards. While peaking in April 2022, overall money supply is still sitting at levels similar to late 2021… back when inflation really started to take off. Unless this changes very soon, it points to elevated inflation for longer (or a more-hawkish Fed) than most participants might expect.
Unintended Consequences of New Fed Policy Tools
This brings us to a critical point. The Fed has likely painted itself into a corner (I know it has an affinity for beige). If it fails to continue raising rates, the FOMC may need to consider a séance to raise Paul Volker back from the dead. No one really wants that. On the other hand, if it continues down a hawkish path, there could be other unintended and equally undesirable consequences.
As a result of introducing IORB and ON RRP as policy tools, the Fed has become the primary actor in short-term funding markets. According to notes from a 2014 FOMC meeting: “A permanently expanded role for the Federal Reserve in short-term funding markets could reshape the financial industry in ways that may be difficult to anticipate and that may prove to be undesirable.” (FOMC 2014)
By introducing interest on reserve balances, the Fed offers a huge disincentive for banks to lend to each other. In the old days, a weaker bank that needed quick capital and didn’t want to fire-sale illiquid assets could borrow from a stronger bank in the Fed funds market. After all, the stronger bank had no incentive to keep money parked at the Fed. No longer. Now, well-capitalized banks can keep that money in their interest-bearing piggy bank at the Fed. During times of financial stress, this saps liquidity for some banks that may need short-term capital quickly. For the same reasons, reverse repos give non-bank financial institutions a disincentive to lend to banks. According to notes from a June 2014 FOMC meeting: “Most participants expressed concerns that in times of financial stress, the facility’s counterparties could shift investments towards the facility and away from financial and nonfinancial corporations, possibly causing disruptions in funding that could magnify the stress.”
Historically, during periods of financial stress, money market participants would rush to buy very safe securities, like short-term Treasuries. There is a relatively fixed supply of these safe assets. Greater demand for those assets pushes prices up, making flight to safety increasingly costly. That self-reinforcing mechanism would stem the run. By contrast, reverse repos provides a safe haven with guaranteed stable rates. That induces investors to abandon most alternatives in a panic, further sapping liquidity for banks when they might need them most. Currently, reverse repo balances have surged and are sitting at over $2 Trillion. According to a December 2022 report from the Kansas City Fed, reverse repos account for nearly two-thirds of money market fund portfolios.
All of this points to a financial system with big winners and small losers. The winners are big banks that have built tremendous capital buffers, whereas weaker banks face greater funding liquidity risk in a crisis. In that context, it’s unsurprising Silicon Valley Bank met its demise, and there are likely others in a similar situation. When that happens, the winners have an opportunity to pick the bones of the dead for some real bargains. But along the way, it also creates uncertainty, volatility, and downright strange stuff.
Let’s look at the recent ‘rescue’ of First Republic Bank. On March 17, 2023, it was announced that the troubled bank would receive an injection of $30 Billion from a consortium of eleven (well-capitalized) banks including JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley. Very strangely, this was not in the form of a structured loan or equity. These banks deposited cash with First Republic for 120-days in savings accounts “at market rates”. As of March 24, the prevailing cash deposit rate in the US was roughly 10bps below the lower bound of interest on reserve balances. Why, then, would Jamie Dimon and friends do this?
I have no idea what discussions were had behind closed doors, nor what implicit government guarantee may be behind the rescue. But I do know it looks like complete buffoonery. And it also strongly hints that something is rotten in the state of Denmark. Perhaps we are beginning to see the unintended consequences of a new Fed model coming home to roost.
