Fed Exit Strategy? (An Update)

With regard to the manipulation of markets by elite players, government and private, if it's true in normal times the Fed and not the "free" market determines the short-term interest rate, does it follow that the key price in our economy is centrally planned and administered?
As I see it, not having studied one semester of any Economics class in College, as long as the FED can raise and lower the Overnight Interest rate they effectively indirectly control the direction of the commercial short term interest rates.
 
This is where you are going wrong. There is no headwind. There will be a headwind when the Fed actually begins removing net reserves from the banking system. This is not happening. To use an analogy, the Fed has been filling up the swimming pool. They have not begun to drain the pool. Once the asset purchases cease in March, they will not be draining the pool then either ... they simply will not be adding any more water (other than the interest paid on reserves).

A better analogy is that the fed has been playing musical chairs and supplying endless number of chairs. Now, the Fed has told you that at some time, they will start taking the chairs away and the music will stop, and has undertaken actions towards that end. Do you keep dancing and do you sit down? The mere fact that the Fed is telling you that they will start taking the chairs away will cause people to change their behavior.
I agree with you that the Fed "telling you that they will start taking the chairs away will cause people to change their behavior.". This is what I termed the psychological component in my article and why investors would react negatively ... because they will believe that the Fed monetary policy being employed is as impactful w/respect to the effect on the banking system now as it has been in the past.

But this is not a typical rate cycle. The Fed is really between a rock and a hard place. The system is overloaded with bank reserves, rendering traditional monetary policy ineffective ... until the balance sheet can be brought down to more normal levels. It could be years until they begin taking away any significant number of chairs (if any). Meanwhile, if investors anticipate they will do so too soon, I think money will be lost with such bets ... because certain markets would swing back to some degree once investors realize that the supposed "exit" is really not being executed. This is what I think is most likely to happen. That is, I do not think the Fed will get tough on draining reserves in any amount of significance. It will play the sterilization game, which is not an exit.

I agree that ending the asset purchases (if they in fact happen and do not get cranked up again) decreases the tailwind the markets are experiencing. But this is not the same as exiting (not a headwind) ... it is simply discontinuing the injection of more money into the system. It is the end of quantitative easing ... the end of increasing bank reserves. There is a big difference. And back to my original point, the upping of the discount rate has nothing to do with this. The upping of the discount rate has no impact on reserves. This (and the impotent federal funds rate as a tool of monetary policy) is my primary point.

The raising of the discount rate is a signal to the market. It is a signal to the market that the era of easy money is ending some time in the future. This is enough to provide a headwind to the market because asset markets have been driven by liquidity.
Not a headwind in the same way as you described the tailwind provided to the market (not a consistent definition). The headwind you describe here is psychological (and as I said earlier, my article agrees with this). However, the upping of the discount rate has no impact on reserves. Neither will upping the target rate for federal funds. But, the tailwind you described did impact reserves because the tailwind was the injection of reserves into the banking system. Consistently, I am defining headwind to be the converse of this ... the draining of reserves from the system. This is not happening and is not likely to happen for some time.

As far as signals are concerned, the Fed sends signals all the time. Everyone knows that the Fed would like to reduce its balance sheet. This is not news. But what is in serious question is when the Fed will actually commence its exit ... when it will begin draining reserves by selling assets. This is what matters. There is no new information here.

Brian
 
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With regard to the manipulation of markets by elite players, government and private, if it's true in normal times the Fed and not the "free" market determines the short-term interest rate, does it follow that the key price in our economy is centrally planned and administered?
As I see it, not having studied one semester of any Economics class in College, as long as the FED can raise and lower the Overnight Interest rate they effectively indirectly control the direction of the commercial short term interest rates.
Neubarth, just to be clear here ... The Fed does not set this interest rate (the market for federal funds set this interest rate ... that is, the supply and demand for reserves). It sets the target for this interest rate. Once you understand how the Fed actually implements this target, you will then come to understand why the Fed no longer has control of the federal funds rate through traditional monetary policy (how it normally implements its target).

Brian
 
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Not a headwind in the same way as you described the tailwind provided to the market (not a consistent definition). The headwind you describe here is psychological (and as I said earlier, my article agrees with this). However, the upping of the discount rate has no impact on reserves. Neither will upping the target rate for federal funds. But, the tailwind you described did impact reserves because the tailwind was the injection of reserves into the banking system. Consistently, I am defining headwind to be the converse of this ... the draining of reserves from the system. This is not happening and is not likely to happen for some time.

As far as signals are concerned, the Fed sends signals all the time. Everyone knows that the Fed would like to reduce its balance sheet. This is not news. But what is in serious question is when the Fed will actually commence its exit ... when it will begin draining reserves by selling assets. This is what matters. There is no new information here.

Brian

The reason why it is psychological is because the market knows that the Fed must drain reserves in the future. If that tightening does not happen for a long period of time, say, 3 to 5 years, then the market will forget about this raise on go on with life. But I don't think that is going to happen.

When the Fed cut the discount rate in 2007 in the article I linked above, it was a signal that the economy was going to get worse, not better, and that was bad for the markets, even though the cut did not effect the real economy and did not much effect the banking system. This was not the conventional wisdom at the time. Asset markets spiked up initially but then sold off. What I believe now is that because asset markets are so dependent upon the liquidity injected into the system, any indication that the Fed is beginning to withdraw it - whether that is the end of QE or a rise in the discount rate - is negative for the market, because without the liquidity in the system, markets would be a lot lower than they are today. That doesn't mean markets are going straight down, but it does signal that the Fed is beginning the process of normalization, and if the environment were "normal," asset prices would be lower.
 
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Not a headwind in the same way as you described the tailwind provided to the market (not a consistent definition). The headwind you describe here is psychological (and as I said earlier, my article agrees with this). However, the upping of the discount rate has no impact on reserves. Neither will upping the target rate for federal funds. But, the tailwind you described did impact reserves because the tailwind was the injection of reserves into the banking system. Consistently, I am defining headwind to be the converse of this ... the draining of reserves from the system. This is not happening and is not likely to happen for some time.

As far as signals are concerned, the Fed sends signals all the time. Everyone knows that the Fed would like to reduce its balance sheet. This is not news. But what is in serious question is when the Fed will actually commence its exit ... when it will begin draining reserves by selling assets. This is what matters. There is no new information here.

Brian

The reason why it is psychological is because the market knows that the Fed must drain reserves in the future. If that tightening does not happen for a long period of time, say, 3 to 5 years, then the market will forget about this raise on go on with life. But I don't think that is going to happen.
I think the market will come to question the Fed's resolve to exit much sooner than 3->5 years, if the Fed does not actually commence selling assets by that time. I believe by the end of 2011, if not mid 2011. In any event, I have yet to see a credible strategy, just proposals of delay tactics and sterilization (which is not an exit ... and the market will figure that out). The more than $1 trillion in MBSs on the balance sheet is a serious problem with no evident solution. Their supposed plan to have money market funds purchase treasuries from the Fed (because the primary dealers cannot handle the volume) does not help with selling the much larger stash of MBSs. Besides, it is not the treasuries that they need to sell. The amount of treasuries they have now is nearly exactly the level they had before the sterilization operations (selling treasuries to sterilize the reserves created by the lending facilities) that began in December 2007 and ended in September 2008.

Brian
 
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HEADLINES SAY UNEMPLOYMENT DROPPING YET THE REALITY IS EMPLOYMENT PER CAPITA IS DROPPING.
fredgraph.png

WE ARE BACK TO 1955 EMPLOYMENT LEVELS
 

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