"tackling inflation would be easier if the Fed could pull money out of people’s checking accounts"
The Fed can't do this, but the Feds certainly could, through the mechanism of a wealth tax or raising marginal rates. Your entire argument (which I certainly agree with) offers robust support for managing the economy more through direct fiscal transfers and taxation; much less through the Fed and rates; and not at all through QE. Replace modern monetary policy with old-school fiscal policy, in other words.
It is complex questions that I am after to explain the macro world we live in, and everyone seems to have dull answers to questions I didn't ask. Your writing is data driven, intelligent and with a different perspective. Makes me ask the questions that make me better prepared for economic events.
Is the fed/government more afraid of inflation or deflation/depression? - (it depends). I have never been more convinced of the trajectory of the economy when I realized that the difference between previous downturns and this one, is severe inflation. And you hit the nail on the head on this question in this article.
Or maybe I am just a perma-bear. Either case, these articles are one of my favourite economic sources, and recommend to anyone interested in understanding things a little better.
The Furnace was my first exposure to your writing. I would like to tell you that after reading many explanations of why QT is dangerous, including The Fed Guy, I found yours to be the most clear, concise and easy to understand.
The connection between deposits and liabilities at the banks and the Repo market is one that has been alluded to a great deal – but the simplicity of your explanation made it very apparent to me the corner that the fed could find themselves in.
I am concerned greatly that any backstopping of the Repo market will be considered a pivot by market participants who are very focused on the currency implications of higher rates, at the expense of tamping down inflation.
Is it possible that if the fed backstops the repo market to ensure liquidity that the result is a much higher stock market, resulting inflation and corresponding longterm severe financial issues or am I over simplifying the problem?
appreciate any insight you could provide...now i am off to read the rest of your substack.
Great write up as always Bear! I just had one question:
Bank cash went up by 10x between 2008 and 2014 from the previous QE, but demand deposit did not have a similar spike. As I understand from Down the Drain, QE provide cash to owners of financial assets who then deposit their cash into commercial banks. Would this deposit not increase the demand deposit? If so, then why do we not see demand deposit following the path of bank cash?
Hey Bear, great piece. Such a pleasure to always read the pieces AND the interaction between you and your readers! Keep up the great work :)
You wrote:
"On the short end, government money market funds meanwhile have reduced their holdings of USTs in favor the RRP."
Being a long time reader of yours, I remember you writing in your piece "Down the Drain" that the Fed essentially chose to pay interest to MMFs that park funds in the RRP. Specifically, what drew my attention back then was the phrase (in quotes): " This week’s rate hike increased the RRP rate from 80bps to 155bps. With the 1-month UST yielding just over 105bps, there is now 50bps of incentive to sell UST and allocate to the RRP."
The Fed rate is currently at 3-3.25% and the 1-month T-bill yields 2.67%, so essentially the arbitrage opportunity is around the same. as it was then. This implies that MMFs would still be incentivized to forgo buying USTs in favor of truly riskless RRPs.
What I do not get is, why would the Fed chose to do so? Wouldn't it be convenient for the Fed to stop raising the interest rate in the RRP with the same amount that they do during each rate hike? This way, the "truly riskless" RRP would yield less than T-bills at some point and this provide an incentive to some MMFs to gradually move funds from the RRP right into USTs. As I understand it, there is around 2-2.5 trillion USD worth of liquidity parked in RRP at the moment which could help absorb liquidity shocks.
And then, I would like to hear your thoughts on whether USTs could be used as a weapon from foreign holders of USTs against the US, as part of an economic war if things were to escalate. For example, China holds around 13% of USTs (according to this site ----> https://ticdata.treasury.gov/Publish/mfh.txt). In a scenario where China decides to respond back to US waging an economic war to them (tarrifs, ban of EUV machines, ban of export of high end chips, delisting of certain entities from US stock markets) and escalate by dumping their USTs in the market, wouldn't that further exacerbate the UST funding problem you mentioned in your piece? And what would be possible scenarios from there onward? I suppose funds parked in RRPs could act as a backstop against that, if I have understood the mechanics correctly.
Beautiful analogy. I will now recommend this to anyone who wants to understand this (arguably complex) topic. Humor me, though. Adding too much fuel creates a lot of smoke because of incomplete combustion (which is the goal, so that you can remove the fuel later if its too much). In your analogy, what would the smoke be?
Loved the real life analogy of your grandbears’ fire place Bear.
The reason you developed those skills is because either the wood was not infinite,and comes at a cost,and of course Bears like the temperature ‘just right’
Assume the wood heap (coal)is infinite in your application.
So is it that all the doors and windows are open,and despite burning at a high rate,no warmth is accumulating to allow the fire to be turned down?
2. Agree that the declining bank reserves set the stage for sept 2019, though in combination with intraday bank liquidity requirements established post GFC. Fabulous paper on the subject. https://www.nber.org/system/files/working_papers/w29090/w29090.pdf . One notable difference sept 2019 to now though is the Fed became a repo lender on an emergency basis in 9/2019, there was no standing facility/systematic liquidity relief valve to police the top end of the range like there is now with the SRF.
3. I generally think all the liquidity being "sterilized" in the RRP will eventually transfer to cover the liquidity hole caused by QT. I think the govt. MMFs are parking the money in RRP because its often a better play for yield (not to mention its effect on MMF liquidity requirements) than short term UST given it keeps increasing by 75 bp every 6-8 weeks. When we get to the terminal rate I think that dynamic shifts and WAMs of the MMF will get much closer to their 60 day max. Even before then though, If repo rates rose above RRP due to funding stress I dont know of any reason why those MMFs wouldnt shift deployment of their cash to grab the extra yield.
4. On treasury liquidity. As a technical matter I dont think there can be insufficient liquidity in the primary market. As I understand it the primary dealers have no choice but to provide it even if nobody else bid, though that doesnt mean the yield cant be super high. On the secondary market. I think the MMF/RRP liquidity would eventually deploy since if price of UST got low enough an attractive carry trade funding through repo from MMF (at rate higher than RRP) would develop for entities with the B/S space to do it. SRF probably an eventual backstop here too
That said, I am very new to the world of finance systems (i literally first learned how QT worked in relative detail from reading dispatch 8 of your blog in June) so its possible im saying ill informed things.
Loved it. I've listened to heaps of Jeff Snider so I'm extremely familiar with the bank reserves are not money argument. Thus it was interesting to read your piece and get a bit of perspective on how those reserves can seep into the economy. It your article is correct, this situation we are facing could be even worse than imagined.
"tackling inflation would be easier if the Fed could pull money out of people’s checking accounts"
The Fed can't do this, but the Feds certainly could, through the mechanism of a wealth tax or raising marginal rates. Your entire argument (which I certainly agree with) offers robust support for managing the economy more through direct fiscal transfers and taxation; much less through the Fed and rates; and not at all through QE. Replace modern monetary policy with old-school fiscal policy, in other words.
TLBS, you are a true gem in a sea of dull rocks.
It is complex questions that I am after to explain the macro world we live in, and everyone seems to have dull answers to questions I didn't ask. Your writing is data driven, intelligent and with a different perspective. Makes me ask the questions that make me better prepared for economic events.
Is the fed/government more afraid of inflation or deflation/depression? - (it depends). I have never been more convinced of the trajectory of the economy when I realized that the difference between previous downturns and this one, is severe inflation. And you hit the nail on the head on this question in this article.
Or maybe I am just a perma-bear. Either case, these articles are one of my favourite economic sources, and recommend to anyone interested in understanding things a little better.
Cheers! (Phil)
Dear Mr.Bear,
The Furnace was my first exposure to your writing. I would like to tell you that after reading many explanations of why QT is dangerous, including The Fed Guy, I found yours to be the most clear, concise and easy to understand.
The connection between deposits and liabilities at the banks and the Repo market is one that has been alluded to a great deal – but the simplicity of your explanation made it very apparent to me the corner that the fed could find themselves in.
I am concerned greatly that any backstopping of the Repo market will be considered a pivot by market participants who are very focused on the currency implications of higher rates, at the expense of tamping down inflation.
I imagine you are well versed in what lead to the great depression, I was not familiar with the nuance until I read this recent history of the fed on Bloomberg. Please note: II.The Great Depression https://www.bloomberg.com/news/features/2022-08-15/how-the-federal-reserve-responded-to-8-economic-crises?sref=PHnbDlDG
Is it possible that if the fed backstops the repo market to ensure liquidity that the result is a much higher stock market, resulting inflation and corresponding longterm severe financial issues or am I over simplifying the problem?
appreciate any insight you could provide...now i am off to read the rest of your substack.
thanks again for the thinking and the writing
simon
Great write up as always Bear! I just had one question:
Bank cash went up by 10x between 2008 and 2014 from the previous QE, but demand deposit did not have a similar spike. As I understand from Down the Drain, QE provide cash to owners of financial assets who then deposit their cash into commercial banks. Would this deposit not increase the demand deposit? If so, then why do we not see demand deposit following the path of bank cash?
Hey Bear, great piece. Such a pleasure to always read the pieces AND the interaction between you and your readers! Keep up the great work :)
You wrote:
"On the short end, government money market funds meanwhile have reduced their holdings of USTs in favor the RRP."
Being a long time reader of yours, I remember you writing in your piece "Down the Drain" that the Fed essentially chose to pay interest to MMFs that park funds in the RRP. Specifically, what drew my attention back then was the phrase (in quotes): " This week’s rate hike increased the RRP rate from 80bps to 155bps. With the 1-month UST yielding just over 105bps, there is now 50bps of incentive to sell UST and allocate to the RRP."
The Fed rate is currently at 3-3.25% and the 1-month T-bill yields 2.67%, so essentially the arbitrage opportunity is around the same. as it was then. This implies that MMFs would still be incentivized to forgo buying USTs in favor of truly riskless RRPs.
What I do not get is, why would the Fed chose to do so? Wouldn't it be convenient for the Fed to stop raising the interest rate in the RRP with the same amount that they do during each rate hike? This way, the "truly riskless" RRP would yield less than T-bills at some point and this provide an incentive to some MMFs to gradually move funds from the RRP right into USTs. As I understand it, there is around 2-2.5 trillion USD worth of liquidity parked in RRP at the moment which could help absorb liquidity shocks.
And then, I would like to hear your thoughts on whether USTs could be used as a weapon from foreign holders of USTs against the US, as part of an economic war if things were to escalate. For example, China holds around 13% of USTs (according to this site ----> https://ticdata.treasury.gov/Publish/mfh.txt). In a scenario where China decides to respond back to US waging an economic war to them (tarrifs, ban of EUV machines, ban of export of high end chips, delisting of certain entities from US stock markets) and escalate by dumping their USTs in the market, wouldn't that further exacerbate the UST funding problem you mentioned in your piece? And what would be possible scenarios from there onward? I suppose funds parked in RRPs could act as a backstop against that, if I have understood the mechanics correctly.
Happy to hear your thoughts on the above.
Beautiful analogy. I will now recommend this to anyone who wants to understand this (arguably complex) topic. Humor me, though. Adding too much fuel creates a lot of smoke because of incomplete combustion (which is the goal, so that you can remove the fuel later if its too much). In your analogy, what would the smoke be?
Loved the real life analogy of your grandbears’ fire place Bear.
The reason you developed those skills is because either the wood was not infinite,and comes at a cost,and of course Bears like the temperature ‘just right’
Assume the wood heap (coal)is infinite in your application.
So is it that all the doors and windows are open,and despite burning at a high rate,no warmth is accumulating to allow the fire to be turned down?
Thank you
Another fabulous post. I super enjoy reading your blog. A few comments:
1. At the risk of being that guy...(though in truth i kinda am that guy :) https://johncomiskey.substack.com/p/projecting-qt-balance-sheet-impact) QT pace will almost certainly never reach 95b. A more realistic go forward pace given MBS prepayment speeds is 80b.
2. Agree that the declining bank reserves set the stage for sept 2019, though in combination with intraday bank liquidity requirements established post GFC. Fabulous paper on the subject. https://www.nber.org/system/files/working_papers/w29090/w29090.pdf . One notable difference sept 2019 to now though is the Fed became a repo lender on an emergency basis in 9/2019, there was no standing facility/systematic liquidity relief valve to police the top end of the range like there is now with the SRF.
3. I generally think all the liquidity being "sterilized" in the RRP will eventually transfer to cover the liquidity hole caused by QT. I think the govt. MMFs are parking the money in RRP because its often a better play for yield (not to mention its effect on MMF liquidity requirements) than short term UST given it keeps increasing by 75 bp every 6-8 weeks. When we get to the terminal rate I think that dynamic shifts and WAMs of the MMF will get much closer to their 60 day max. Even before then though, If repo rates rose above RRP due to funding stress I dont know of any reason why those MMFs wouldnt shift deployment of their cash to grab the extra yield.
4. On treasury liquidity. As a technical matter I dont think there can be insufficient liquidity in the primary market. As I understand it the primary dealers have no choice but to provide it even if nobody else bid, though that doesnt mean the yield cant be super high. On the secondary market. I think the MMF/RRP liquidity would eventually deploy since if price of UST got low enough an attractive carry trade funding through repo from MMF (at rate higher than RRP) would develop for entities with the B/S space to do it. SRF probably an eventual backstop here too
That said, I am very new to the world of finance systems (i literally first learned how QT worked in relative detail from reading dispatch 8 of your blog in June) so its possible im saying ill informed things.
Thanks again for your posts.
Does the Fed's current limited capacity to rein in deposits demand further legitimize (in their eyes) the need to institute a CBDC conversion?
Loved it. I've listened to heaps of Jeff Snider so I'm extremely familiar with the bank reserves are not money argument. Thus it was interesting to read your piece and get a bit of perspective on how those reserves can seep into the economy. It your article is correct, this situation we are facing could be even worse than imagined.