When Alan Greenspan raised rates more than a decade ago, he just commanded that they be raised and the markets dutifully obeyed. The myth was unchallenged that the Fed could, if it wished, flood the market with bank reserves to reduce rates or contrarily starve it of reserves to raise them. The events of 2007-09 were essentially direct defiance to this legend of liquidity management capabilities, exposing the Fed as nothing more than the naked emperor.

We can observe this established fact in any number of ways starting with inflation and recovery, working back to the most direct aspects of global money. Even monetary policy itself has been reformed, though it is clear that many are not aware. As it stands with further debate about more “rate hikes”, the vast majority of commentary continues on with the already-disproved myth that Janet Yellen commands like Alan Greenspan once did.

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The fact of the matter is that the federal funds target rate is a phantom rate because it is consigned to a phantom market. The federal funds market, once a vibrant place of central and marginal systemic liquidity, is but a shell of its former self, populated with the leftovers of various non-economic GSE dollars. The FOMC is not unaware of this dramatic change; in 2014 in preparation for what policymakers thought would be a possibly condensed monetary policy “exit”, they debated reforming to some other control mechanism.

At the July 2014 FOMC meeting, for example, the minutes describe the committee members grappling with the fact that the federal funds rate though it might remain the “key policy rate” as a “communication tool” the current monetary mechanics were importantly nothing like a decade ago.

Participants agreed that adjustments in the IOER rate would be the primary tool used to move the federal funds rate into its target range and influence other money market rates. In addition, most thought that temporary use of a limited-scale ON RRP facility would help set a firmer floor under money market interest rates during normalization.

The Committee wasn’t even sure how the RRP would actually be used; some argued to use it to help set a floor for the coming rate corridor, pegging the RRP rate at the lower federal funds boundary. Others suggested that it be set somewhat below the target federal funds range and be given little or no role in the “exit” unless actually needed. Given behavior of money markets in 2016 (LIBOR and repo), it is fair to write that the FOMC still doesn’t know what it is doing.

In 2011, Elizabeth Klee and Viktors Stubenovs of the Federal Reserve Board, participating in an ECB workshop (later turned into a scholarly paper in December 2012), argued that US monetary policy changes were necessary to better reflect the actual operative money environment rather than remain wedded to federal funds as strictly for public communication of policy intentions. As with the rest of the world, repo rates dominate, including the ECB’s main policy lever the MRO which is collateralized and thus (theoretically) provides a floor for unsecured markets (it doesn’t anymore and hasn’t since 2007).

Traditionally, the Federal Reserve targeted the federal funds rate, expecting this rate to transmit its monetary policy stance to other short-term and longer-term rates. However, at the height of the recent financial crisis, the pass-through from the federal funds rate to other short-term rates deteriorated as the zero lower bound set in and money markets underwent structural changes. Furthermore, market participants anticipate that the inception of regulatory liquidity requirements will undermine selected unsecured money markets and their linkages by discouraging short-term financing among banks. Going forward, with the federal funds market potentially experiencing encumbrances, if the Federal Reserve wishes to implement monetary policy by targeting a money market rate, is there a viable alternative to the target federal funds rate?

Klee and Stubenovs submit that the UST GC repo rate would be a more reflective and appropriate monetary policy control lever. While I don’t necessarily agree with their conclusion as it relates to what the FOMC could do, I can’t argue against their reasoning that this is what they should have considered. After all, as I have written before, the “rising dollar” has itself been most characterized by the repo market and all its nonconformity. I don’t think that would have changed had the FOMC actually shifted to a repo target, but in hindsight there is at least a debate about whether or not it might have gone so much better (“global turmoil”) had they at least tried.

Instead, the Fed continues to this day to rely on what are really misconceptions. I wrote in March 2015 that these distinctions aren’t just academic issues, they were going to be (and have been proven to be) crucial to how burgeoning disorder would play out economically as well as financially.

To most people this is all arcane mechanics of an esoteric system that doesn’t easily lend itself to casual observation and interpretation. Regardless, this is vitally important and it is exactly that ignorance that the FOMC’s continued emphasis on the federal funds rate depends. As long as the public feels the Fed retains “enough” control with an irrelevant liquidity measure, policymakers don’t think it much matters about real liquidity. That ridiculous theory may change with time, though not likely in the manner in which they are planning.

The reason for these fallacies trace back to the history of money markets themselves, including eurodollars. It was taken for granted that what are really separate markets would continue to operate as a unified system of hierarchical “rules” even under tremendous strain because there was the US central bank supposedly behind it all. Again, starting in 2007, it was proved that there was nothing behind any of it – especially repo. The relative closeness of repo to something like federal funds was somewhat dubious and perhaps nothing more than accidental (forgive the lengthy reproduction):

With the rise of federal funds volume (still mostly connected to NYC) in the 1950’s, larger banks began to address the fragmentation and the opportunity given by a more fluid and liquid market for bank “reserves.” Because non-banks (a technical and legal distinction) were prohibited from directly participating and because banks were restricted as to the interest rates they could offer non-bank deposit accounts, repos became a popular tool to increasingly tap non-bank and non-NYC funding sources while giving non-banks an alternative to generating interest exclusively in other formats. In other words, banks engaged non-banks (corporations, municipal governments, securities pools) in repos at an interest rate slightly below federal funds so that non-banks could earn short-term something like money market participation (instead of strictly t-bills).

From the bank’s perspective, the repo was free of reserve requirements and interest controls so it was mutually beneficial as a source of bank funding. Over time, the repo rate (under most circumstances) began to trade in close proximity to the federal funds rate for these reasons. Because of that, the idea of these fragmented pieces of money markets becoming a singular whole was likewise turned to conventional wisdom and treated as such (particularly by monetary policy shifting to interest rate targeting, of the federal funds rate, in the 1980’s).

However, as the history of these markets amply demonstrates, they require action, activity and resources of intermediation to become apparently so. The very word that should most be applied to banking, but no longer is, is “intermediation” – literally meaning standing between two or more factors and bridging the gap. Money markets are not something themselves, they are the outcome of action and financial production.

This is all very relevant to the distinction of “bank reserves” as not strictly money in the 21st century, post-crisis eurodollar format. What was taken for granted as a unified whole never should have been believed as such because of the wholesale truth contained in that last sentence, “they are the outcome of action and financial production.” Liquidity isn’t just is, it is a process requiring resources and capacity of banks and their balance sheets. This is perhaps indirectly what Klee and Stubenovs were driving at in urging a change in monetary policy mechanics, to get the FOMC to realize that communication of the federal funds rate is nice but it doesn’t really do anything apart from signal to banks what monetary policy wants banks to carry out – leaving the response of banks as the true monetary constraint, including these times where banks act opposite the communicated policy intent.

By pushing for a repo rate target, the paper argues that it would theoretically start to stitch back together these variously fragmented money markets to begin operating again more as a whole. Some prominent observers even this year have argued that this is no longer important (due to regulations mostly), but according to “global turmoil” and this summer’s “something” I believe demonstrate that like the Fed these observers are engaging in nothing more than post hoc excuses to explain what is rather than why it is.

Once again today we see repo rates that are far out of line with what would be more reasonably determined as normal. The GC UST rate was 66.2 bps today, following 75 bps each of the past two days and 126.6 bps at quarter end. More importantly, I believe, reported repo volume in UST is once more declining in noticeable even dramatic fashion. While DTCC shows UST volume had been on average up to about $60 billion toward the end of September, over the past week and a half surrounding the end of Q3 as repo rates have been unusually high, average volume has fallen back to just $39.9 billion. Where is the balance sheet capacity?

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I think this has led to a number of further misinterpretations about the current state of money markets and beyond. On days like today and yesterday where various dollar indices rise (and gold falls), there is in my view an inappropriate tendency to filter those results through what is only communications policy. In other words, the media sees the dollar index as well as gold or UST’s and assigns perceptions of “hawkishness” in December as the cause of what really look like liquidations. Instead, realizing what monetary policy actually is (and what it is not by the basis of the repo market) recalibrates explanations of what look like liquidations to an environment increasingly bereft of liquidity capacity. “Tightening” monetary policy is not at all the same as “dollars” tightening.

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There is a world of difference between a “rising dollar” due to proper “hawkishness” anticipating economic recovery with a full liquidity backstop as rates rise and a “rising dollar” that might instead be traced to seriously withdrawn liquidity capacity that in the recent past has meant the opposite economic and financial condition. Seeing the difference between these two diametrically opposing scenarios requires understanding what monetary policy and bank reserves actually are (and what they are not) in this exposed global money framework.

The media talks about rate hikes as if it was still 2006 and implicit monetary policy is all that is required. Even then it still didn’t work but at least money markets were well-structured to give off the appearance of competence. They don’t even do that anymore and it isn’t a trivial distinction.

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