Fed Exit Strategy? (An Update)

[gonegolfin]

My latest editorial can be found here, among other places ...

"Fed Exit Strategy? (An Update)"
http://www.financialsense.com/fsu/editorials/2010/0212.html

If you have not read the original, it is advised that you read it first ...

"Fed Exit Strategy?"
http://www.financialsense.com/fsu/editorials/2009/0729a.html

"Fed Exit Strategy?" forum thread is here ...
http://www.usmessageboard.com/economy/83001-fed-exit-strategy.html

Brian

 

[FireFly]

There is no exit. The government will continue to buy up stocks, bonds, & property until it has a controlling interest in our lives.

 

[Neubarth]

There is no exit while the economy continues to crash. Maybe in 4 or 5 years?

 

[FireFly]

There is no exit while the economy continues to crash. Maybe in 4 or 5 years?

Japan has been in the same boat for 20 years now. It seems to me the downturn really started here in the USA the second half of 1998 & we have been trying to inflate our way out of it every since. Now we are getting hit with baby boomer retirement on top of this cycle. I bet we are stuck for at least 10 more years.

 

[mayya555]

There is no exit. The government will continue to buy up stocks, bonds, & property until it has a controlling interest in our lives.

This will lead to general economy collapse. I doubt they would be that stupid.

 

[ReAmericaNow]

End the fed?

 

[georgephillip]

There is no exit. The government will continue to buy up stocks, bonds, & property until it has a controlling interest in our lives.

FireFly"

Will Government OR Wall Street continue buying stocks, bonds, and property until full control is achieved?
Does the answer to my question qualify as a distinction without a difference?
Big Government and Big Business are fusing in ways Mussolini would celebrate

 

[Paulie]

There is no exit. The government will continue to buy up stocks, bonds, & property until it has a controlling interest in our lives.

FireFly"

Will Government OR Wall Street continue buying stocks, bonds, and property until full control is achieved?
Does the answer to my question qualify as a distinction without a difference?
Big Government and Big Business are fusing in ways Mussolini would celebrate

Government and big business have been fused for decades.

 

[gonegolfin]

My latest editorial can be found here, among other places ...
"Fed Exit Strategy? (An Update)"

If you have not read the original, it is advised that you read it first ...
"Fed Exit Strategy?"

"Fed Exit Strategy?" forum thread is here ...
http://www.usmessageboard.com/economy/83001-fed-exit-strategy.html

Brian

As expected, the market overreacted to the Fed's decision to increase the discount rate Thursday. And this is just the irrelevant discount rate ... relevant only to the small banking institutions receiving a small amount of funding at the discount window. Simply noise. Imagine the market reaction when they go to move the federal funds rate (which, again, is now an impotent tool w/respect to monetary policy) ... but as I said, the only way they get the federal funds market to trade at a higher rate is to 1) raise the interest rate paid on reserves or 2) significantly drain reserves by selling assets. Option #2 is not going to happen anytime soon (there is a strong argument that it will never happen ... that we are at a new normal with respect to reserve levels). In our present situation, neither raising the federal funds rate nor raising the interest rate paid on reserves drains reserves from the banking system. These moves do not shrink the Fed balance sheet. The exit has not begun.

The below taken from my recent article ... "Fed Exit Strategy? (An Update)"

"The financial press has been fixated on interest rates influenced and/or set by the Fed, particularly when the Fed might begin increasing its target rate for federal funds (currently managed between 0% and 0.25%) as well as the discount rate (currently 0.50%). But focusing on these interest rates is not keeping the proverbial eye on the ball. Monetary policy targeting the federal funds rate (and discount rate) is impotent now (as discussed in the July '09 article). Massive bank reserve expansion by the Fed made sure of that."

"Such Fed actions will, however, have a psychological impact on investors accustomed to monetary policy before September of 2008 and believe that such policy is as impactful now as it was then."
--

Yes, investors were fooled as they still believe such policy by the Fed will impact the markets in the same way they did before September 2008 (when monetary policy took an unprecedented path).

Market overreaction is covered here ...

"Markets Misread Fed's Rate Move as Central Bank Stumbles"
http://finance.yahoo.com/news/Market...&asset=&ccode=

"Fed Seeks to Calm Investors After Surprise Discount Rate Rise"
http://moneynews.com/Headline/Fed-Ca...2/19/id/350287

Brian

 

[Paulie]

Brian, I thought that the fed funds rate increases BECAUSE the Fed sells assets?

Institutions purchase the assets from the Fed with their reserves, which causes the rate to rise because there is now less available money to lend, which causes the cost of borrowing to go up due to the now decreased supply of money?

Am I wrong?

And if this is the case, then why would raising the federal funds rate not drain reserves, like you are saying?

 

[gonegolfin]

Brian, I thought that the fed funds rate increases BECAUSE the Fed sells assets?

Please read the article again. Specifically concentrate on the following ...

"But focusing on these interest rates is not keeping the proverbial eye on the ball. Monetary policy targeting the federal funds rate (and discount rate) is impotent now (as discussed in the July '09 article). Massive bank reserve expansion by the Fed made sure of that. Banks are presently flush with reserves. $1.16 trillion in reserves are held on deposit with the Fed alone, significantly more than the roughly $10 billion held on deposit in early September of 2008. The Fed would need to drain a significant amount of reserves from the banking system simply to get the federal funds rate to drift meaningfully north from where it is today (near zero)."

Institutions purchase the assets from the Fed with their reserves, which causes the rate to rise because there is now less available money to lend, which causes the cost of borrowing to go up due to the now decreased supply of money?

Am I wrong?

Actually, it is the primary dealers that conduct transactions with the Fed. The depository institution with which the purchasing primary dealer has its "banking account" has its reserves debited (reserves are extinguished) and the primary dealer has its banking account debited when the Fed sells assets. When the Fed purchases assets (the reverse case), reserves are created.

And if this is the case, then why would raising the federal funds rate not drain reserves, like you are saying?

Simply raising the target for the federal funds rate does not drain reserves. This is simply a policy decision. An increase in the policy rate is implemented by executing operations that drain reserves (Ex. reverse repos, which are temporary ... or asset sales, which are permanent). But if the banks are drowning in bank reserves (as they are now), it would take a substantial amount of asset sales to have any effect on the actual market rate for federal funds.

It is all about supply and demand. There is a tremendous supply of reserves and very little demand.

As I stated in the article, the only way the Fed can move the market federal funds rate north is by raising the interest rate it pays on reserves. The federal funds rate is meaningless at this point in time. And raising the interest rate paid on reserves is not an exit strategy ... no reserves are drained. When the Fed does this, they will also raise the target rate for federal funds ... but the market rate for federal funds will simply get pulled along by the interest rate paid on reserves. Draining reserves will require asset sales. But in the absence of manipulating the interest rate paid on reserves (raising the rate), these asset sales would not move the market federal funds rate north until the amount of reserves in the system came down to considerably lower levels (probably near September '08 levels).

Brian

 

[Terral]

Hi Gone:

My latest editorial can be found here, among other places ...

"Fed Exit Strategy? (An Update)" ...

Any News about a FED Exit Strategy is 'propaganda' based upon a "Fools Story" ...

[ame=http://www.youtube.com/watch?v=ZQH7xiiaH2k]ALERT! U.S. Depression Breadline Hits New RECORD! FED Discount Rate Almost A Fool Percent[/ame]

Nobody even uses the Discount Window (Emergency Loan Window), because everyone uses the "Overnight Window" that remains unchanged. The U.S. Dollar appears to be stronger, because other currencies (like the Euro) are collapsing even faster ...

The U.S. Economy Is IMPLODING

GL,

Terral

 

[Paulie]

Brian I guess I was confusing the target rate with the actual rate. When you said raising the fed funds rate would not drain reserves, that's where you lost me, because I assume that if the Fed raises the target rate, they subsequently perform the necessary open market operations to achieve a real rate as close to the target as possible. This would obviously have to be achieved by selling enough assets to drain the requisite amount of reserves.

I suppose that your opinion that the Fed won't be shrinking its balance sheet back down to more "normal" levels, is shared by many others as well, considering the price of gold?

 

[Toro]

My latest editorial can be found here, among other places ...
"Fed Exit Strategy? (An Update)"

If you have not read the original, it is advised that you read it first ...
"Fed Exit Strategy?"

"Fed Exit Strategy?" forum thread is here ...
http://www.usmessageboard.com/economy/83001-fed-exit-strategy.html

Brian

As expected, the market overreacted to the Fed's decision to increase the discount rate Thursday. And this is just the irrelevant discount rate ... relevant only to the small banking institutions receiving a small amount of funding at the discount window. Simply noise. Imagine the market reaction when they go to move the federal funds rate (which, again, is now an impotent tool w/respect to monetary policy) ... but as I said, the only way they get the federal funds market to trade at a higher rate is to 1) raise the interest rate paid on reserves or 2) significantly drain reserves by selling assets. Option #2 is not going to happen anytime soon (there is a strong argument that it will never happen ... that we are at a new normal with respect to reserve levels). In our present situation, neither raising the federal funds rate nor raising the interest rate paid on reserves drains reserves from the banking system. These moves do not shrink the Fed balance sheet. The exit has not begun.

The below taken from my recent article ... "Fed Exit Strategy? (An Update)"

"The financial press has been fixated on interest rates influenced and/or set by the Fed, particularly when the Fed might begin increasing its target rate for federal funds (currently managed between 0% and 0.25%) as well as the discount rate (currently 0.50%). But focusing on these interest rates is not keeping the proverbial eye on the ball. Monetary policy targeting the federal funds rate (and discount rate) is impotent now (as discussed in the July '09 article). Massive bank reserve expansion by the Fed made sure of that."

"Such Fed actions will, however, have a psychological impact on investors accustomed to monetary policy before September of 2008 and believe that such policy is as impactful now as it was then."
--

Yes, investors were fooled as they still believe such policy by the Fed will impact the markets in the same way they did before September 2008 (when monetary policy took an unprecedented path).

Market overreaction is covered here ...

"Markets Misread Fed's Rate Move as Central Bank Stumbles"
http://finance.yahoo.com/news/Market...&asset=&ccode=

"Fed Seeks to Calm Investors After Surprise Discount Rate Rise"
http://moneynews.com/Headline/Fed-Ca...2/19/id/350287

Brian

I disagree.

The Fed Raises. Now What? - Toro's Running of the Bulls Market Blog

 

[gonegolfin]

My latest editorial can be found here, among other places ...
"Fed Exit Strategy? (An Update)"

If you have not read the original, it is advised that you read it first ...
"Fed Exit Strategy?"

"Fed Exit Strategy?" forum thread is here ...
http://www.usmessageboard.com/economy/83001-fed-exit-strategy.html

Brian

As expected, the market overreacted to the Fed's decision to increase the discount rate Thursday. And this is just the irrelevant discount rate ... relevant only to the small banking institutions receiving a small amount of funding at the discount window. Simply noise. Imagine the market reaction when they go to move the federal funds rate (which, again, is now an impotent tool w/respect to monetary policy) ... but as I said, the only way they get the federal funds market to trade at a higher rate is to 1) raise the interest rate paid on reserves or 2) significantly drain reserves by selling assets. Option #2 is not going to happen anytime soon (there is a strong argument that it will never happen ... that we are at a new normal with respect to reserve levels). In our present situation, neither raising the federal funds rate nor raising the interest rate paid on reserves drains reserves from the banking system. These moves do not shrink the Fed balance sheet. The exit has not begun.

The below taken from my recent article ... "Fed Exit Strategy? (An Update)"

"The financial press has been fixated on interest rates influenced and/or set by the Fed, particularly when the Fed might begin increasing its target rate for federal funds (currently managed between 0% and 0.25%) as well as the discount rate (currently 0.50%). But focusing on these interest rates is not keeping the proverbial eye on the ball. Monetary policy targeting the federal funds rate (and discount rate) is impotent now (as discussed in the July '09 article). Massive bank reserve expansion by the Fed made sure of that."

"Such Fed actions will, however, have a psychological impact on investors accustomed to monetary policy before September of 2008 and believe that such policy is as impactful now as it was then."
--

Yes, investors were fooled as they still believe such policy by the Fed will impact the markets in the same way they did before September 2008 (when monetary policy took an unprecedented path).

Market overreaction is covered here ...

"Markets Misread Fed's Rate Move as Central Bank Stumbles"
http://finance.yahoo.com/news/Market...&asset=&ccode=

"Fed Seeks to Calm Investors After Surprise Discount Rate Rise"
http://moneynews.com/Headline/Fed-Ca...2/19/id/350287

Brian

I disagree.

The Fed Raises. Now What? - Toro's Running of the Bulls Market Blog

Toro, your blog entry is incorrect. The Fed's move to up the discount rate is not a negative for asset prices ... not in this unique and unprecedented environment. Reserves are not being drained. The increase in the discount rate is purely psychological as reserves are unaffected. Additionally, Primary Credit usage has declined steadily since October '08, to the point where it barely registers on the Fed balance sheet ... pure noise.

Also, if you define liquidity to mean cash injected into the banking system (which is just such a definition when you say " ... unprecedented amount of liquidity unleashed by the government which subsequently flowed into asset markets."), then it is incorrect to say that "The government is now beginning to withdraw that liquidity.". They are not withdrawing liquidity. Again, the Fed is not draining reserves.

As I detailed in my article, the discount rate and federal funds rate are impotent and Bernanke knows this. The Fed has no control over the federal funds rate via traditional monetary policy, which is why the only way it can force federal funds to trade north of where it is will be by raising the interest rate paid on reserves. But again, even this will not drain reserves.

Brian

 

[Neubarth]

The Fed raising of the Emergency rate is quite frankly a political ploy. Most everybody noted last week that our bond sale was way under sold. People, banks and countries were simply not interested in buying our debt. What that tells me is that THEY do not trust our financial stability.

The Fed had to do something about it, so decided to use the ploy of starting to ease out of the easy money environment they had created to try to kick start the economy. They couldn't raise interest rates, because the economy is still collapsing, so they raised a figure head interest rate that is now only being used by banks that are in dire straights, thus assuring that more small banks will falter so the Big Ones can acquire them for pennies on the dollar.

It is all corrupt as hell, but what the heck it makes for good belly laughs that they can get away with all of this crap and keep a straight face.

 

[georgephillip]

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?

 

[Toro]

Toro, your blog entry is incorrect. There is nothing mechanical about the Fed's move to up the discount rate that is a negative for asset prices ... not in this unique and unprecedented environment. Reserves are not being drained. The increase in the discount rate is purely psychological as reserves are unaffected. Additionally, Primary Credit usage has declined steadily since October '08, to the point where it barely registers on the Fed balance sheet ... pure noise.

Also, if you define liquidity to mean cash injected into the banking system (which is just such a definition when you say " ... unprecedented amount of liquidity unleashed by the government which subsequently flowed into asset markets."), then it is incorrect to say that "The government is now beginning to withdraw that liquidity.". They are not withdrawing liquidity. Again, the Fed is not draining reserves.

As I detailed in my article, the discount rate and federal funds rate are impotent and Bernanke knows this. The Fed has no control over the federal funds rate, which is why the only way it can force federal funds to trade north of where it is will be by raising the interest rate paid on reserves. But again, even this will not drain reserves.

Brian

A few things.

First, liquidity is partly psychological. It is greatly affected by investors' willingness to take on risk and supply liquidity into the market. The fact that there is "nothing mechanical" in the discount rate - which I agree - misses the point. The Fed has provided an enormous tailwind to the market. That tailwind is now turning into a headwind.

Second, this, as the Fed stated, is the beginning of normalization. The Fed has stated that it will be ending quantitative easing next month. When the Federal Reserve starts moving, it usually does so in a time period measured in years. These are the first steps of a long process. Even if the Fed does not increase the funds target this year - and I believe they will not - investors now know that the tightening has begun.

That does not mean that asset prices are definitely going down. But what it means is that the central bank is now working against the market.

I'll post something that I wrote in 2007.

The Federal Reserve cut interest rates yesterday. We believe this represents a buying opportunity for investors. A year after cutting interest rates, the average return on stocks has been greater than 10%. We are upping our allocation in equities and recommend investors buy stocks now.​

- Wall Street strategists, January 4, 2001.

It was quite the cacophony on Friday, from Boo-Yah man proclaiming that the Dow would see the biggest point gain in its entire history to strategists telling investors to buy stocks to cheerleaders on Bubblevision proclaiming the end of this horrific bear market that went down a whopping 12% and lasted almost two whole months.

We here at Running of the Bulls are a naturally skeptical bunch (unnaturally skeptical? - ed.) ...

the problems we face have not gone away. Over-capacity in real estate has not dissipated. It takes time to work through over-capacity in any market, and over-capacity is a drag on economic and profit growth. ARM resets peak next year. Has the market completely discounted those peaks, as well as the unknowable after-shocks to the financial system that will follow? I doubt it. There will be capital calls by investors from hedge funds - Cramer says many hedge funds are down 50%-60% - which will probably trigger another round of selling. Finally, the liquidity argument is no more. With the Fed signaling its intent to intervene if need be, liquidity is not the scarce commodity it has been the past month. However, it is probably safe to assume that the copious amounts of liquidity that were used as a justification for almost any company being taken private is probably a thing of the past.

The discount rate cut was a positive, but is it a bullish sign or merely a less bearish one? There are still many problems in the market. I am wary of market cheerleaders and am approaching the market with caution.

Fight the Fed? - Toro's Running of the Bulls Market Blog

This is not the same economy nor the same market that marked the half century after WWII. Looking at it through that prism is a mistake. Given the valuations at which markets are trading and the problems still faced in the economy, the Fed tightening is not positive IMHO.

And if the market acts like it did in 2003-06, God forbid.

 

[gonegolfin]

A few things.

First, liquidity is partly psychological. It is greatly affected by investors' willingness to take on risk and supply liquidity into the market. The fact that there is "nothing mechanical" in the discount rate - which I agree - misses the point. The Fed has provided an enormous tailwind to the market. That tailwind is now turning into a headwind.

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).

[\quote]

Second, this, as the Fed stated, is the beginning of normalization. The Fed has stated that it will be ending quantitative easing next month. When the Federal Reserve starts moving, it usually does so in a time period measured in years. These are the first steps of a long process.

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.

[\quote]

Even if the Fed does not increase the funds target this year - and I believe they will not - investors now know that the tightening has begun.

Let's say the Fed increases the target rate for federal funds next month to 50 bps. This move will be meaningless and will not affect the market rate for federal funds (it will continue to trade where it is). They cannot achieve this new target rate without dumping about $1 trillion in assets from their balance sheet.

Thus, announcing an increase in the target rate for federal funds would not be making progress towards an exit because reserves would not be drained.

What they will do is this ... Bernanke knows the federal funds rate as their tool for conducting monetary policy will not work in this environment ... and the Fed is not ready to begin selling assets (draining reserves). Thus, they will announce an increase in the interest rate they pay on reserves. That will then force the federal funds rate to near the interest rate paid on reserves. That is, the interest rate paid on reserves will drag along the federal funds rate ... because the Fed is incapable of implementing the intended federal funds rate in the marketplace for fed funds without raising the interest rate paid on reserves.

Interestingly, raising the interest rate paid on reserves may in fact move away from an exit. This is because the Fed will be adding more reserves to the system in the form of interest (more than they are at present). If they move this rate to a level that exceeds the natural draining of reserves due to maturation of securities in its portfolio (and the Fed does not replenish these at auction ... the Fed is likely to replenish the treasuries), bank reserves will increase ... which is the same as quantitative easing.

So, until the Fed begins a real program of reducing its balance sheet (selling assets), the exit has not begun.

I'll post something that I wrote in 2007.

This is absolutely nothing like 2007 because the system is overflowing with reserves. As I said, conventional monetary policy no longer applies. Monetary policy implemented via the discount rate and target rate for federal funds is impotent. There is only the psychological component that I mentioned.

Brian

 

[Toro]

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.

Treasury bond rates are bumping up along 52-week highs. I do not believe that is a coincidence.

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.

If you remove demand from the market, the price should fall (and interest rates rise). The Fed will no longer be creating demand in the market. It doesn't have to sell. It just has to stop buying. In fact, it just has to change the perception it will stop buying. People thinking that the Fed is going to do something in the future is as, if not more important than what the Fed is actually doing right now. Markets are forward looking institutions.

What you are betting on is that there is enough private demand to replace the demand created and, perhaps more importantly, believed to be created, by the Fed. That's your bet. I don't know, but I am highly skeptical. Demand from the Fed has been enormous. Rates rising for reasons other than increasing demand for credit from the private sector is the same thing as a tightening.

This is absolutely nothing like 2007 because the system is overflowing with reserves. As I said, conventional monetary policy no longer applies. Monetary policy implemented via the discount rate and target rate for federal funds is impotent. There is only the psychological component that I mentioned.

Brian

I pointed out the 2007 quote because conventional wisdom was wrong about rate cutting. I believe that conventional wisdom - that the beginning of Fed tightening is positive for the market at the beginning of the cycle - will be wrong again.

I agree that conventional monetary policy no longer applies. I also believe that the conventional signals from monetary also do not apply. That is why rising rates is not the same signal as it was in the past. This is an asset-driven economy where asset prices matter more than at any point in time than in at least three generations.

Currently, both the stock and the bond market are pricing in a traditional, robust recovery. Stocks are pricing in either 20% sales growth over the next two years and high margins, or 10% growth and record margins. If we do not get this level of economic growth and profitability, then stocks and bonds are expensive, which is unsurprising given the oceans of liquidity the market has been floating on. Valuation in and of itself is enough to provide a headwind to asset markets.

Asset markets have floated upwards by the massive amounts of liquidity injected into the system, unlike anything we have ever witnessed before. Never in the history of our nation have asset markets been so dependent upon liquidity in the system. Any hint of removal is a headwind for those markets, and asset prices will struggle from here, unless there is a significant rebound in the economy, which I believe is unlikely, given the nature of the damage in the economy.

That is just my opinion. I believe few understand the current market environment because few in this country have lived through the current monetary, fiscal and economic environment.