Note: This post first appeared on Patreon on 31 May 2018
This post is a direct response to the politics masquerading as economics embedded in a Bloomberg post about the Fed’s interest on excess reserves (IOER). The Bloomberg post is based on the analysis of Credit Suisse analyst Zoltan Pozsar, a former U.S. Treasury adviser.
And the gist of his analysis is encapsulated in the Bloomberg headline, “As Fed Loses Control of Overnight Rates, Blame Shifts to T-Bills“. The analysis is all wrong. And it highlights why people lose money trading government bonds using the “Bond Vigilante” paradigm, which the analysis relies upon. If you are in the fixed income markets, you need to get this right.
In normal times, the market is forced to follow the Fed Funds rate because there are no excess reserves in the system. The Fed Funds rate is the rate at which the Fed is willing to lend reserves to depository institutions. And because the Fed is the monopoly supplier of reserves, that rate also dictates the rate at which banks lend reserves to one another in the interbank market.
But when the Fed decided to purchase a bunch of financial assets – US government bonds and mortgage-backed securities – in an operation known as quantitative easing, it created reserves to make the purchase. These weren’t reserves that banks needed. Instead they were excess reserves, well in excess of what banks needed to back the credit they had extended.
So the economy was awash in reserves. And the Fed funds rate fell to the natural rate of interest for risk free overnight money, zero. That’s where dollar bills trade after all. The only reason reserves trade at a positive interest rate is because they are used by the Fed to hit a target that helps it try and steer the economy. Otherwise, that rate would naturally fall to zero, since it is risk-free.
When the Fed wanted to raise rates again to steer the economy because it believed we were close to full employment, it had a problem. The excess reserves meant that it could no longer use the Fed Funds rate as the sole controlling mechanism since banks were awash in reserves. So it has been forced to use IOER or interest on excess reserves as the controlling mechanism. The Fed sets the IOER it pays to depository institutions and then sets the Fed Funds rate accordingly. Here’s how the Fed describes this process. But do read this 2013 write-up by econ professor Scott Fullwiler for a more detailed description of how this process works.
That’s where we are today. Now, a week ago the Fed minutes were released. And they included a note that the Fed was going to make an adjustment to the IOER level given where the Fed Funds rate had been trading.
“The deputy manager then discussed the possibility of a small technical realignment of the IOER rate relative to the top of the target range for the federal funds rate. Since the target range was established in December 2008, the IOER rate has been set at the top of the target range to help keep the effective federal funds rate within the range. Lately the spread of the IOER rate over the effective federal funds rate had narrowed to only 5 basis points. A technical adjustment of the IOER rate to a level 5 basis points below the top of the target range could keep the effective federal funds rate well within the target range. This could be accomplished by implementing a 20 basis point increase in the IOER rate at a time when the Committee raised the target range for the federal funds rate by 25 basis points. Alternatively, the IOER rate could be lowered 5 basis points at a meeting in which the Committee left the target range for the federal funds rate unchanged. “
The long and short here is that the Fed Funds rate has been trading up at the top range of the band. The Fed, which has never had to deal with a hiking regime when banks are awash in excess reserves, now understands it needs to set the IOER rate below the top end of its desired Fed Funds rate band. That’s it. That’s all this says. It’s not about the Fed losing control. It’s about a technical adjustment due to the size of the Fed’s balance sheet.
The key takeaway by rational analysts then is that the Fed should be keen to decrease the size of its balance sheet. The increasing rate of IOER has created a lot of anti-Fed sentiment. Many people believe the Fed is giving banks free money as some form of crony capitalism. Moreover, I can also imagine that the Fed wants to dispense with the headache of dealing with IOER at all. It’s simpler to just set a Fed Funds target rate and be done. So my view is that this note in the minutes supports the notion that the Fed will continue to reduce the size of its balance sheet as it can.
The corollary of this is that the Fed is keen to increase rates just to have the firepower necessary to cut them. Doing so makes no sense whatsoever if the Fed causes the next recession by raising rates. However, if the Fed is able to successfully raise rates a considerable amount before the next recession hits, it will then need to rely on unconventional policy like quantitative easing much less. And I believe the technical challenges associated with raising rates when banks have a tremendous balance of excess reserves has put the Fed off wanting to use QE except in extremis.
Now Zoltan Pozsar makes a totally different argument. He says the Fed is losing control of overnight rates because of high T-bill financed deficit spending. If the Trump Administration weren’t creating so much red ink and financing it through T-bills, the Fed wouldn’t have this problem. That’s the Pozsar view. He is saying the deficit spending is too much and bond vigilantes want the interest rate to be much higher. So the Fed is losing control because of the excessive deficits. That’s his argument.
That’s just politics masquerading as economics though. It has no factual basis. Reserve balances and t-bills are near perfect substitutes. Why would we expect t-bills to transact at a vastly different rate than reserve balances? They won’t and they haven’t. Pozsar is just trying to embed his political view into his market analysis. And anyone listening to this is going to lose a lot of money, just as they did in Japan during the days of the widowmaker trade.
We may not like it, but the Fed has control. It dictates overnight rates. Full stop. The Fed controls overnight rates and is raising them right now for a host of institutional reasons. But the Fed can suppress them if necessary, despite the excess reserves in the system.
I continue to believe that the bond bear market thesis is flawed. Money managers following it will lose a lot of money. Bond bears cite inflation as one reason for their view. But we will soon see that the Trump deficits will not prove inflationary beyond the end of this cycle. More importantly, the bond vigilantes have no control over overnight rates, despite what Poszar is alleging. When bad economic and financial news hits, there will always be a flight to quality. And long-term yields will sink. We saw that with Italy. And we will see that much more virulently when the next recession comes. That’s when the bond bears will lose a lot of money.