Starting in late March, something unexpected happened: as the Effective Fed Funds rate drifted higher, it broke above the implicit upper bound on the interest rate corridor defined by the Interest on Excess Reserves. It was not meant to do this.
This loss of control over the effective Fed Funds rate prompted many to speculate that reserves (i.e. liquidity) in the system was too low, and sure enough, it all culminated with the end of the Fed’s tightening cycle which was followed by 3 rate cuts in the past 4 months, but more importantly, resulted in the repo crisis in late September (which we had previewed in August) and which served as the catalyst for Powell to launch “NOT QE” in October, whereby the Fed is now injecting $60 billion per month in liquidity via monetization of T-Bills, a process that has promptly sent the Fed’s balance sheet back over $4 trillion, an increase of $280 billion in 7 weeks.
Yet while the Fed’s emergency response to the repo crisis helped restore a “normal” level of liquidity to the system, another unexpected consequence has emerged: the Fed is now losing control of rates again, only this time in the opposite direction!
As Bloomberg points out this morning, as a result of its recent interference with market liquidity levels, the Fed’s key effective fed funds rate – aka the “main interest rate” that the Fed controls – is getting close to the edge of the range the Fed is targeting.
As shown in the chart below, after the Effective Fed Funds rate kept drifting ever high during the period of reserve scarcity, we now find ourselves on the other side of the boat, and as a result of the Fed’s actions such as repo operations and T-bill purchases, the effective fed funds rates has been pushed to 1.55%, just shy of the Fed’s lower bound target of 1.50% (the upper is at 1.75%). And, as Bloomberg points out, “some are worried it could dip below.”
As Bloomberg’s Alexandra Harris politely puts it, “when that rate strays, it tends to signal that the Fed doesn’t have strong control over its main tool for implementing monetary policy, a worrisome prospect for central bankers. It happened in mid-September as fed funds briefly jumped 5 basis points above the upper bound, prompting hundreds of billions of dollars of Fed intervention to get things back under control.”
Said otherwise, the Fed’s actions have resulted in a dramatic lurch in the US financial system, from too little liquidity to too much. It also explains the dramatic surge in the S&P500, which has increased every week for the past five, the same period that saw the Fed’s balance sheet grow week!
And with stocks surging, for now nobody is asking questions, although it is only a matter of time before someone notices that we have shifted from one extreme to another: “It’s all just about Fed credibility and maintaining control over fed funds,” BMO rates strategist Jon Hill said. “That’s absolute.”
Well, if it is about credibility, the Fed has none: as noted above, starting in March, the Fed lost control over the Effective Fed Funds rate, only at the bound of the target range. As we discussed before, to keep the effective fed funds the range, the Fed was forced on four occasions to adjusted another key rate, the Fed’s interest on excess reserves rate, or how much the Fed pays banks for parking reserves with it.
Lowering IOER acted as an anchor that pulled fed funds back down, to an extent. The first three times IOER was tweaked, the central bank took action when fed funds got within 5 basis points of the top of the range. The fourth occasion was in the midst of September’s market turmoil, when it actually breached.
Fast forward just two months later when we have observed a dramatic U-turn as the fed funds is now just 5 basis points from the bottom of the central bank’s range. And while it’s dead in line with the current IOER rate of 1.55%, there are suggestions that it may be weighing too much. In fact, as Bloomberg notes, some strategists are wondering whether it is time for the Fed to adjust the IOER again, this time in the opposite direction closer to the midpoint – currently 1.625% – between the upper and lower limit.
“The symmetry is pretty compelling that they might do this,” said BMO’s Hill. “Five basis points seems to be when they decided.”
However, what is most likely is that the Fed will do nothing: while Powell was instantly spooked when there was too little liquidity, there is no indication the Fed will move if there is too much (as there is now courtesy of nearly $300 billion in liquidity injections in the past two months).
There is another reason why the Fed may prefer an excessive liquidity situation: we are approaching year end, when many worry that rates could soar higher, as they did at the end of 2018.
Knowing that, policy makers might find some extra room between fed funds and the upper boundary useful.
“A lot of the same frictions that happened in September are still there,” said NatWest strategist Blake Gwinn. “The Fed’s actions clip the tail end of a spike, but there’s still frictions in getting cash to where it needs to go.”
He sees 70% odds of a year-end jump in fed funds. “There’s no downward spikes” in that rate, “so I’m not really worried about it dropping below” the low end of the Fed’s target range, he added.
According to Jefferies money-market economist, Thomas Simons, a breach of the lower bound by fed funds will be ignored and the Fed “may never need to worry about the fed funds rate breaching the bottom of the range”. Two months of liquidity injections suggests there is little risk that the central bank is providing too much liquidity that will push fed funds below the lower bound.
Too much liquidity “is a problem the Fed would love to have,” Simons wrote. Of course, he is correct: in fact the only downside to “too much liquidity” is that the world’s biggest asset bubble is just getting bigger just as the president of the US demands (when it bursts it’s all over of course, but that will be some other Fed chair’s problem).
In other words, Powell has nothing to lose and little to gain by standing in the way of risk prices levitating ever higher on the latest massive liquidity injection by the Fed meant to stabilize money markets and restore the Fed’s “credibility”, but really meant to push the S&P500 to all time highs just before the 2020 election to make sure that Trump is elected.