August 12, 2024 | The reaction to last week's brief market kerfuffle tells you a lot about markets and those who work in and around them. There are many thousands of analysts and media focused on the capital markets, yet some very large events go entirely unnoticed. Meanwhile, eager financial media were ready to describe the end-of-the-world market collapse early last week -- yet the promised apocalypse did not occur. This is fortunate since the BLS jobs data turned out to be wrong.
Economist Bob Brusca notes that there were "significant distortions in the July employment report that the BLS did not feature and, in fact, seemed to go out of its way to hide." He argues that the market disruption that followed the July report "would have been avoided had BLS pointed out that the July report was affected by weather disruptions."
More important, as more overheated sectors of the equity markets swooned, few observers picked up the obvious reference to the December 2018 market rout. This was the last time that the markets sold off in response to Fed action or lack thereof. Given the amount of discussion in the media about "carry trades," there seems little discussion of the near-disaster five years ago. The 10-year chart below from Bloomberg shows the spike in short-term interest rates for repurchase agreements in that year and the rapid capitulation by the FOMC which followed.
DTCC Repo Index
Source: Bloomberg (08/09/24)
The cause of the market tantrum on Monday and Tuesday of last week was a reprise of a familiar story, where the equity and credit markets suddenly retreat together, and the Federal Open Market Committee panics and then capitulates. By providing the needed liquidity, the Fed rebalances the scales, but this time around the selloff quickly lost steam. No response was needed.
Last week may have been a faux crisis, but a sudden loss in value awaits the inflated markets. Fear of contagion like that seen in December 2018, when the S&P 500 lost 15% of its value in a matter of weeks, still haunts Fed Chairman Jerome Powell and the FOMC. The Fed provokes contempt from private markets because of the way the central bank messed things up in 2018. Powell shattered that precious illusion of 1) a God's Eye view of markets globally and 2) firm control of said markets that allows investors to trust the judgement of Fed officials despite their lack of actual market experience.
Jerome Powell After Breakfast
Economist Komal Sr-Kumar describes the scene in December 2018 to his readers on Substack:
“Jerome Powell started 2018, his first year in office as Chairman of the Federal Reserve, on a high note. Inflation in the consumer price index had accelerated from 2.2% in February when he became the Chairman, to 2.9% by mid-year despite repeated increases in the Federal Funds rate. By November, inflation was back to 1.9%. Proud of his success, Powell told investors at his press conference on December 19 to be prepared for further monetary tightening during the following year. In response, equities cratered during the final days of 2018, and the Chairman’s message abruptly changed on January 4, 2019. The Fed would be patient with monetary tightening, he assured his listeners, and the central bank actually reduced the policy rate several times during the year.”
As in 2008, in 2018 the Fed lost credibility because the Board's GDP model did not capture the actual, effective level of liquidity in the markets. And the Fed's model of liquidity as a function of GDP still does not work. We discussed this situation in 2019 ("George Selgin on Frozen Money Markets & Competing With the Fed in Payments").
To compensate for their lack of clarity in 2018, the central bank made a dramatic and little noted change in monetary policy. Powell and the FOMC went "big" with reserves in a speculative and many would argue counterproductive fashion. The new monetary operating system at the Fed is a key topic of a new chapter in the revised version of our 2010 book “Inflated.” Some excerpts for the new book follow below.
Not only did Powell capitulate in January 2019 with rate cuts, but he and the other Committee members then authorized the de facto nationalization of the US money markets. By greatly expanding the Fed's open market operations, and making other legal and regulatory changes, the Fed essentially subsumed the private markets. This process began in the 1970s, when the FOMC under Chairman Arthur Burns began to target the yield on federal funds traded between banks as a policy indicator. But after 2019, the Fed's control of the markets was complete -- at least until investors decided to revolt.
Early in 2019, the chastened FOMC started to intervene aggressively in cash and forward markets, this a year before COVID. The Fed flooded the markets with liquidity and essentially made itself the counterparty in the credit markets. Combined with the centralized clearing of Treasury debt, the Fed now operates the US credit markets like a market simulation in the 1999 film “The Matrix.” As we’ve told readers of The IRA before, you still think that’s air you’re breathing?
The new policy regime abruptly put in place in January 2019 required the Fed to grow its balance sheet enormously, by purchasing securities using Treasury funds and paying interest on bank reserves to fund it. Remember, the Fed is the alter ego of the Treasury, its opposite. And the central bank is always an expense to the Treasury. When the Fed loses money, the Treasury takes a loss -- but Powell and the other governors don't talk about that very much. And the servile media rarely asks about the hundreds of billion in losses to date on Jay Powell's hedge fund.
By allowing the Fed to pay interest on bank reserves, Congress enabled the central bank to fund its own fiscal agenda and compete with the Treasury for funds. Quantitative easing is essentially the Fed's own fiscal policy project, separate from the Executive Branch. This illegal effort is enhanced by rules requiring banks to hold reserves at the Fed instead of Treasury securities. The SEC rule on central clearing of Treasury securities and Basel III favor holding bank reserves at the Fed over Treasury securities. Why?
Powell sought no authority from Congress for these changes nor made public notice about expanding bank reserves dramatically. The Fed merely put this momentous change into effect, funded with reserves paid for out of the Treasury's cash with no congressional appropriation. And because the Fed still does not understand the dynamics of bank liquidity, it appears that markets are even less stable now than before the Powell FOMC made these changes.
“The record indicates that the FOMC did not appreciate the consequences of its decision at the time,” wrote Bill Nelson of Bank Policy Institute in 2022, “and the question now is whether the decision will be revisited given how manifest and serious those consequences are.” Nelson continued:
“Specifically, the Fed announced that it would conduct monetary policy by over-supplying liquidity to the financial system, driving short-term interest rates down to the rate that the Fed pays to sop the liquidity back up. Previously, the Fed had kept reserve balances (bank deposits at the Fed) just scarce enough that the overnight interest rate was determined by transactions between financial institutions; those transactions consisted of banks with extra liquidity lending to those that needed it. Now the rate is determined by transactions between banks and the Fed. Moreover, the Fed has committed to providing so much extra liquidity that it would not need to adjust the quantity of reserve balances it is supplying in response to transitory shocks to liquidity supply and demand.”
On January 4, 2019, Powell completed the Fed’s capitulation to the markets and also signaled that the Board staff in Washington had badly misjudged the situation on reserves and liquidity. Few in Washington outside of the professional staff of the Fed and Treasury took note of Powell’s debacle. His failure required his two previous successors to close ranks around the Fed Chairman in a public media event on January 4, 2019.
Again, the Fed staff was too busy looking at their models and focused too little on the financial markets which they routinely take for granted. In 2019, the FOMC essentially nationalized the US money markets, eliminating private price discovery for a synthetic representation of a market with the Fed at the center of the known universe. The Fed and the clearing house are now the counterparties for all large trades in US Treasury securities.
More, the 2019 policy change featured a dramatic increase in banks reserves. Going big assumes that the Fed would need to get much bigger in the future to avoid market disruptions like December 2018. The Powell Panic in 2018 led to the explosion of the central bank's balance sheet in 2020. Yet as events showed, a larger Fed balance sheet seems to coincide with greater market volatility.
Look for the new edition of Inflated in 2025!
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