In order to understand the systemic
risk implications of the astronomical growth of
the repo (repurchase agreement) market, it is
necessary to have some basic knowledge of the
dollar money market, of which the repo market has
become a major component.
The telling
information is that repos now chalk up an average
daily trading volume of about US$5 trillion in the
United States, accounting for half of the money
supply ($9.97 trillion as of September).
Conventional perception notwithstanding, the repo
market is no longer as risk-free as presumed
because the money-creating proceeds from repos are
mostly channeled toward speculation that
contributes to systemic risks. The risk of
contagion, a term given to the process of
distressed contracts dragging down healthy
contracts in the same market as
speculators throw
good money after bad to try to stem the sudden
tide of temporary losses, can be magnified by the
widespread use of repos.
The money
deposited by commercial banks at the central bank
is the real money in the banking system; other
versions of what is commonly thought of as money
are merely promises to pay real money. These
promises to pay are circulatory multiples of real
money. For general purposes, people perceive money
as the amount shown in financial transactions or
amount shown in their bank accounts. But bank
accounts record both credit and debits that cancel
each other. Only the remaining central-bank money
after aggregate settlement is real. Real money,
more properly called final money, can take only
one of two forms: 1) physical cash, which is
rarely used in wholesale financial markets, and 2)
central-bank money. The currency component of the
money supply is far smaller than the deposit
component.
Currency and bank reserves
together make up the monetary base, sometimes
known as high-powered money. The US Federal
Reserve has the power to control the issuance of
both of these components of the monetary base. By
adjusting the levels of banks' reserve balances,
the Fed can achieve a desired rate of growth of
deposits and of the money supply over time. When
market participants and banks change the ratio of
their currency and reserves to deposits, the Fed
can offset the effect on the money supply by
changing reserves and/or currency. The Fed and the
US Treasury supply banks with the currency their
customers demand, and when their demand falls,
accept a return flow from the banks. The Fed
debits banks' reserves when it provides currency,
and credits their reserves when they return
currency. In a fractional reserve banking system,
drains of currency from banks reduce their
reserves, and unless the Fed provides adequate
additional amounts of currency and reserves, a
multiple contraction of deposits results, reducing
the quantity of money in the economy.
Banks can create loan money out of
central-bank high-power money from a partial
reserve regime. For example, $1,000 of high-power
money with a bank reserve requirement of 10% can
create $7,922 of new loans, each time holding back
10% reserve from the resultant deposit from the
borrower before lending it out again. As the bank
reserve requirement falls, the amount of
bank-created loan money rises. Money deposited by
customers with a commercial bank is not final
money, as it is merely a promise to pay by one
party to another. When a bank customer writes a
bank check to pay another party, the money in his
account shifts to the payee's account within the
banking system, even if the shift is between
banks. No money is added or removed from the money
supply. Money is merely shifted from one account
to another within the same bank or from one bank
to another within the banking system.
The
US central bank, the Federal Reserve System, is
composed of 12 regional reserve banks, and money
at any of these regional reserve banks is final
money. Most banks use an account at the Federal
Reserve Bank of New York to settle US dollar
activities in the wholesale financial markets. The
European Central Bank (ECB) is part of the
European system of national central banks, which
includes the Bundesbank (Germany's national
central bank), the Banque de France, the Banca
d'Italia, and others in the eurozone. Money
denominated in euros at any one of the eurozone's
national central banks (NCBs) is final money. In
sum, the monetary definition of "money" is money
on account at the central bank. Any other form of
money is really just a promise to pay central-bank
money before final clearing.
The main
purpose of an interbank deposit market, a money
market, is to equalize the payment system among
banks. Banks attract deposits by offering interest
payments. They make a profit out of deposits from
customers by lending the deposited money at a
higher rate to other customers or to other banks.
Banks lend money to one another in all major
currencies of market relevance in globalized
financial markets at agreed interest rates and
agreed maturities. Typical maturities for
interbank money range from one day for overnight
money to six months, and even out to one year,
though with much less active trading in the longer
maturities. Funds at each bank are swept
electronically at the end of each business day for
interbank lending.
The money market is so
important that many banks maintain active screens
showing the latest prices at which they are
willing to borrow and lend. At any time on a
trading day, a major money-center bank would post
a particular rate at which it is willing to accept
three-month deposits, say 3.4%, and to lend to
other high-quality banks for the same period at a
higher rate, say 3.45%. The bank is making a
market in these deposits, bidding for three-month
funds at one rate and offering three-month funds
at a higher rate. The intent of such market-making
is to profit from the bid-offer spread. Banks lend
to customers at prime rate plus, usually a few
percentage points higher than they can borrow at
interbank rates. A bank with excess funds that
cannot be lent at prime rates will lend to other
banks with needs to lend more than funds at their
disposal.
An institutional/corporate
borrower that wants to borrow funds for six months
has several options. One would be to borrow funds
for six months from the commercial bank at the
screen price of, say, 3.53%. But there are
alternatives. It can borrow the money for only
three months (at the rate of 3.45%), and after
three months re-borrow the money, or roll over the
loan at the higher or lower prevailing rate. Why
do this? To have the same cost as a six-month
loan, the re-borrowing would have to be at 3.58%,
as the six-month rate is the average of 3.45% and
3.58%, the rates for the first and second
three-month periods respectively. If the borrower
thinks that in three months time, the cost of
three-month money will be less than 3.58%, then it
would be cheaper overall for it to borrow now for
three months at 3.45%, and then in three months to
re-borrow at the rate then prevailing. If it
thinks that in three months time the cost of
borrowing for three months is likely to be higher
than 3.58%, it should borrow for the entire
six-month period now.
So the break-even
cost of three-month money in three months time
is 3.58%. This is the forward price of money. The
current price, also known as the spot price, of
three-month money is 3.45%; the three-month
forward price of three-month money is 0.13% over
spot. Market prices are implying that short-term
interest rates are rising. The borrowing
institution or corporation has still more choices.
If it believes that rates are unlikely to rise,
then it might be cheapest to borrow for one day,
and re-borrow the money each subsequent day. Or if
it thinks that rates are about to rise to very
high levels, the best course would be to borrow
money for one year (at 3.65%), and in six months
to lend at the then-prevailing rate, which it
hopes will be much higher then.
No matter
which view it takes, by choosing to borrow money
at one maturity rather than another, the borrower
is implicitly expressing an opinion on the future
path of short-term rates. That opinion is
measured, and can only be measured, against the
current forward prices. A long-term borrower
cannot avoid some form of implicit speculation; by
choosing to borrow at one maturity rather than
another, it is taking a view on the future path of
interest rates, and that view should be measured
against the market's forward prices. Thus risk is
inherent in any financial commitment over time,
even if both the rate and duration are fixed, in
which case the risk is in opportunity cost. The
risk for each market participant is related to the
opinions of other market participants. Contrarians
to market sentiment risk profit and loss.
This is the basic logic of technical
analysis, which is concerned with market behavior
resulting from market sentiment, as opposed to
fundamental analysis, which is concerned with
economic fundamentals of supply and demand. As
John Maynard Keynes famously said, markets can
stay irrational longer than market participants
can stay liquid. The only exception is the central
bank operating in a fiat currency regime. Only the
Fed has the power to defy market sentiments, which
explains why market participants try desperately
to second-guess pending Fed decisions on interest
rates by informing on the ideology and
decision-making rationale of the Fed.
The
same applies to exchange rates of currencies. By
selecting which currency to borrow or lend and the
rates and maturities at which loans are
structured, borrowers and lenders express their
views on the future path of exchange rates of
particular currencies. The aggregate effect of
market-participant opinions determines the market
price of money and the exchange value of all
freely convertible and floating currencies. This
is how currencies are at times attacked by
speculators who manage to create market sentiments
against particular currencies regardless of
fundamentals.
Central banks intervene from
time to time to defy market sentiments by making
market speculation unprofitable. In recent
decades, the spectacular increase of the size of
the foreign-exchange market has made central-bank
intervention less effective. Though not the
biggest market participants, central banks have
unlimited funds denominated in their national
currencies to effectuate short-term rates within a
policy framework. For US dollars, the Fed calls
all the shots, as it alone can print dollars at
will. And since the US dollar is the world's major
reserve currency for international trade and since
all key commodities are denominated in dollars,
the Fed commands a disproportional influence on
the global money markets.
Insolvency risk,
also known as credit or default risk, is faced by
all market participants except the Fed, which
alone can print dollars at will. Foreign central
banks can print national currencies but they
cannot print US dollars. Thus all foreign central
banks face insolvency risks on dollar obligations.
When that happens, foreign central banks have to
turn to the International Monetary Fund (IMF) as a
lender of last resort to avoid default on their
dollar obligations. Banks deal not only with one
another and not only with top-quality financial
institutions from countries with clear and
competent financial supervision, but also with
riskier entities (individuals, trusts,
partnerships, companies, or even governments).
With some of these entities, the risk of
insolvency is significant and sometimes
unpredictable.
A solution to credit risk
can be found in the repo market. The bank lends
money to a borrower collateralized by government
bonds of the same market value. Under normal
circumstances, after the loan matures, the
borrower returns the money plus interest, and the
bank returns the collaterals. But if the borrower
should become insolvent or is forced to default on
the loan for any reason, the lender can recover
its loss by selling the collateral that it holds.
Interest-rate volatility affects the
market value of securities, even government
securities. Thus the Fed's interest-rate policy
affects the risk level of the repo market. So the
money market is a game in which market
participants guess the future decisions of the
Fed, and their implication on market forces. Both
the supply of money and the demand for money as
affected by its price (interest rates) are set by
the Fed based on macroeconomic theories that are
ideologically derived, not scientifically
validated. On this arbitrary monetary foundation
set by a handful of appointed individuals is built
free-market capitalism. On one level, the
institution of central banking is politically
independent; on a more fundamental level, central
banking defies the most basic principles of
democracy and free markets. For the lender, the
advantage of collateralization is that it almost
eliminates credit risk. For the borrower, the
disadvantage is that collateral must first be
found. The borrower's disadvantage and the
lender's advantage are reflected in the price of
the loan. The interest rate on a collateralized
loan is below that on a non-collateralized loan.
Within the same currency, the spread varies across
maturities and according to the quality of the
collateral and the counterparty, but a typical
unsecured-secured differential is 0.1% to 0.5% for
borrowers of equal credit rating.
Commercial-bank accounts with the central
bank are subject to different rules about
overdrafts in different countries. Some central
banks prohibit overdrafts; at the end of each day
no account may be overdrawn. Other central banks
are less strict, specifying that every account
must have a positive balance on average, where the
averaging is conducted over a period of time known
as a reserve period. Whichever the case,
commercial banks need to avoid having an overdraft
at the central bank, either on average or every
day by borrowing money from another bank.
Bank-to-bank borrowing can only relocate
rather than extinguish the aggregate overdraft in
the banking system. The escape to systemic
aggregate overdraft is to borrow money directly
from the central bank or from the repo market when
the Fed injects money into it through the
monetizing of sovereign debt by lending against
government securities held by non-bank entities.
Government securities sold to private buyers
caused money to be withdrawn from the economy.
This money re-enters the economy when the
government spends it. When the holders use such
securities as collaterals to secure new loans in
the repo market, new money is in fact created.
The discount rate The greatest
power bestowed on the Federal Reserve is the
setting of the discount rate - the rate of
interest charged by the Reserve Banks when lending
to member institutions, collateralized by
government securities. Raising the discount rate
generally increases the cost of borrowing and
tightens the money supply and slows the economy,
while dropping it expands the money supply and
stimulates economic activity, since banks set
their loan rates above the discount rate, and not
by market forces. Fed discount rates and Fed funds
rate targets are inputs into market conditions,
not outputs from market forces
The term
"discount rate", although widely used, is an
anachronism. Since 1971, Reserve Bank loans to
depository institutions have been secured by
advances. Interest is computed on an accrual basis
and paid to the Fed at the time of loan repayment.
The interest rate charged by a Federal Reserve
Bank on short-term loans to depository
institutions is referred to as the discount rate.
The discount rate is important for two
reasons: (1) it affects the cost of reserves
borrowed from the Fed and (2) changes in the rate
can be interpreted as an indicator of monetary
policy. Increases in the discount rate generally
reflect the Fed's concern over inflationary
pressures, while decreases reflect a concern over
economic weakness or deflation. Discount-window
lending, open-market operations to effect changes
in reserves to set Fed funds rates, and bank
reserve requirements are the three main
monetary-policy tools of the Federal Reserve
System. Together, they dictate the short-term cost
and availability of money and credit in the US.
Usually, the discount rate is less than
the federal-funds and other money-market interest
rates. However, the Fed does not allow banks to
borrow at the discount window for profit. Thus it
monitors discount-window and federal funds
activity to make sure that banks are not borrowing
from the Fed in order to lend at a higher rate in
the federal funds market.
During periods
of monetary ease, such as now, the spread between
the federal funds and discount rates may narrow or
even disappear briefly because depository
institutions have less of a need to borrow
reserves in the money market. Under these
conditions, the Fed may adjust the discount rate
in order to reestablish the customary spread.
Discount-window loans are granted only
after Reserve Banks are convinced that borrowers
have fully used reasonably available alternative
sources of funds, such as the federal funds market
and loans from correspondents and other
institutional sources. The latter sources include
the credit programs that the Federal Home Loan
Banks and the Central Liquidity Facility of the
National Credit Union Administration provide for
their members. Usually, relatively few depository
institutions borrow at the discount window in any
one week. Consequently, such lending provides only
a small fraction of the banking system's total
reserves. All depository institutions that
maintain reservable transaction accounts or
non-personal time deposits are entitled to borrow
at the discount window. This includes commercial
banks, thrift institutions, and US branches and
agencies of foreign banks. Prior to the passage of
the Depository Institutions Deregulation and
Monetary Control Act of 1980, discount-window
borrowing generally had been restricted to
commercial banks that were members of the Federal
Reserve System.
Changes in the discount
rate generally have been infrequent. From 1980
through 1990, for example, there were 29 rate
changes, and the duration of the periods between
adjustments ranged from two weeks to 22 months.
However, after those 22 months without a change,
the Fed cut the discount rate seven times in the
period of economic sluggishness from December 1990
to July 1992 - from 7% at the start of the period
to 3% at the end. From May 1994 to February 1995,
when the Fed was concerned about the threat of
inflation, it raised the discount rate four times
- from 3% to 5.25%. Changes in the discount rate
often lag changes in market rates. Thus, even
though the Fed pushed the federal funds rate down
25 basis points in July 1995, as of December it
had not cut the discount rate.
Since 1980,
the changes in the discount rate have been by
either one-half or a full percentage point,
although quarter-point changes were made in
earlier years. The lowest discount-rate charged by
the New York Fed was 0.5%, which was in effect
from 1942 through 1946; the highest rate was 14%,
which lasted from May to November 1981. In 1999,
the discount rate was 4.5%, while the Fed funds
rate was 4.75% and the three-month Treasury-bills
rate was 4.27%. On September 13 this year, the
discount rate was 4.5% (effective since August 9)
while Fed funds rate target was 3.5% (also
effective since August 9), the overnight repo rate
was 3.45%, three-month T-bill was 3.45%, GE
30-44-day commercial paper was 3.68% and
three-month LIBOR (London interbank offered rate)
was 3.87%. Effective September 20, the discount
rate was raised to 4.75%; the Fed funds rate
target was raised to 3.75%. On October 19, the
overnight repo rate was 3.70%, three-month T-bill
was 3.785%, GE 30-44-day commercial paper was
3.90% and three-month LIBOR was 4.35%.
Today, while the spread between the
discount rate and the Fed funds rate is zero, the
repo market continues to expand, giving evidence
that the borrowing is not being done by depository
institutions. In other words, the credit market
has largely run away from banks.
Fed
funds Federal funds include funds deposited
by commercial banks at the Federal Reserve Banks,
including funds in excess of bank reserve
requirements. But Fed funds can be created at will
by the Fed now that the dollar is a fiat currency,
not backed by gold, its status since 1971.
Commercial banks may lend federal funds to
one another on an overnight basis at the Fed funds
rate, which is the most sensitive indicator of the
direction of interest rates since it is set daily
by the market in response to the Fed's open-market
operation: the buying or selling of government
securities in the repo market to meet Fed funds
rate targets. Thus the real function of sovereign
debt is to provide an instrument through the
buying and selling of which the Fed can inject
money into or withdraw money from the money supply
without appearing to create or destroy money while
actually doing so.
Notwithstanding
conventional perception, sovereign debt is not
incurred by fiscal deficits, which are created by
government reluctance to raise taxes to cover
expenditure. Fiscal deficits are government's way
to inject money into the economy independent of
the central bank, to avoid raising taxes, which is
government's way of withdrawing money from the
economy. A government fiscal surplus shrinks the
economy in two ways: it drains money from the
money supply and it prevents money from
re-entering the economy through government
spending. Thus fiscal deficits are not inherently
bad for the economy, especially for an economy
that is underperforming. It all depends on how the
deficit spending is used. If it is used for
increasing employment and improving infrastructure
or education or health care, thus expanding the
slowing economy, it is good; if it is used to make
war or speculation, thus contributing to debt
bubbles, it is bad.
The US money market is
basically for short-term debt instruments
generally collateralized by Treasury bills as
default-free securities. Short-term interest rates
are basically determined by the Fed's action in
the money markets, in which instruments such as
Treasury bills, commercial deposits,
euro-deposits, commercial paper, and repurchase
agreements are traded. It is in the money markets
that the Federal Reserve conducts most of its
transaction activity and attempts to meet its
short-term interest-rate target.
Two key
interest rates dominate the activity of the US
money markets, the federal funds rate and the repo
rate. These two rates, though closely connected,
serve opposite functions. In normal usage, both
are overnight rates based upon a 360-day year. The
federal funds rate is the interest rate that banks
charge when they lend reserves to one another.
Money-supply calculations are dominated by
consideration of bank demand and time deposits,
which lie on the liability side of a commercial
bank's balance sheet. Reserves make up a part of
the bank's assets. Banks that are members of the
Federal Reserve System are required to hold cash
reserves against their deposit liabilities. The
rules for the reserve requirements, once very
simple, are now quite entangled.
Even if
reserves were not a legal requirement, prudence
would ensure that banks would hold a certain
percentage of their assets in the form of cash
reserves. It is common to think of commercial
banks as passive receivers of deposits from their
customers and, for many purposes, this is still an
accurate view. This passive view of bank activity
is misleading when it comes to considering what
determines the nation's money supply and credit.
Loan activity by banks plays a fundamental role in
determining the money supply. As economists know,
when a loan is made between parties, money is
created. The effects of bank-created money are
well understood by economists, but the effects of
non-bank-created money are not.
The
banking system as an institution is the venue
through which the Fed, as a central bank, manages
the money supply in the US economy. The instrument
to effectuate this management is the Fed funds
rate, which sets the price of funds when banks
borrow from one another. The repo market is a
venue through which banks and other market
participants can bypass the Fed's money-supply
policy targets. Thus Fed funds are institutional
opposites of repo proceeds, each serving opposite
functions. Fed funds are used by the Fed to
control the money supply created by bank lending,
while the repo market is where banks and other
market participants can seek to free themselves
from the Fed's control. In practice, it is
commonly assumed that the Fed sets the federal
funds rate while in reality, the Fed sets a
federal funds rate target and tries to move the
federal funds rate toward the target by
influencing the repo rate with open-market
operations.
Money
supply Concepts of the money supply are
meant to identify the quantity of the one
commodity (money) that is decreed as legal tender
for settling financial obligations within the
economy as a whole.
Like other economic
concepts, there is no perfect conceptual
definition of money supply. Most economists have
come to accept some vague intuitive understanding
of the notion. Measuring the money supply, in
practice, is mostly opinion-based, and a variety
of money-supply measures are currently in use. The
most frequently cited measures are M1 and M2. M1
includes demand deposits and coin and currency
held by the non-bank public. M2 is M1 plus
commercial deposits. M2 is the most widely
followed money-supply measure. M3 is equal to M2
plus time deposits over $100,000 and term repo
agreements. A fourth category, known a L, measures
M3 plus all other liquid assets such as Treasury
bills, savings bonds, commercial paper, bankers'
acceptances and Eurodollar holdings of US
residents (non-bank).
Banks hold cash
reserves in proportion to their deposit
liabilities. If a bank's cash reserves increase,
then the bank may be able to increase its demand
deposit liabilities correspondingly. The total
cash reserves of the commercial banking system
serve to constrain the total deposit liabilities
of the system. The daily ebb and flow of
commercial and private transactions is constantly
shifting cash reserves from bank to bank. Total
cash reserves are also mildly affected as coins
and notes held by the public are altered through
daily transactions. Broadly speaking, the daily
transaction activity does not affect the total
cash reserves held by the commercial banking
system, merely the distribution of those reserves
among the various individual commercial banks.
If cash reserves of a commercial bank
begin to decline, it will eventually be deemed,
legally or prudentially, inadequate for the
outstanding demand deposit and time deposit
liabilities. The bank must then either rebuild its
cash reserve levels or cut back on its deposit
liabilities. If it cannot stem the decline in cash
reserves, then the bank ultimately must reduce
deposit liabilities. Since these deposit
liabilities are the most important component of
the money supply, the money supply ultimately must
decline if cash reserves of the banking system
fall sufficiently. A sufficient decline in
commercial-bank cash reserves will ultimately
cause a drop in the money supply. Conversely,
expansion of the money supply is ultimately
limited by the aggregate cash reserves of the
commercial banking system. At least that is how it
worked theoretically before the spectacular growth
of structured finance (derivatives), the impact of
which on the virtual money supply is not well
understood even by experts.
The Fed is
frequently mentioned as having a major influence
on the US economy mostly because it has the
ability to change the cash reserves of the
commercial banking system easily and in essence
immediately, through its open-market operation in
the repo market. Normally, open-market operations
are transactions that involve the central bank in
buying or selling (with money) government
securities. The Fed effects open-market purchases
by buying Treasury bills or notes or bonds on the
open market and paying central-bank money. It
really doesn't make any difference what the Fed
buys so long as it pays money that will be
deposited in the private banking system. The point
is that the money goes from the Fed, which has an
unlimited amount, to the private banking system,
which has a limited amount. Whether the money is
given freely, dropped from helicopters or in
exchange for Treasury securities is irrelevant
because fiat money itself has no intrinsic value -
the value lies in what fiat money can buy. And
that value is determined by the aggregate money
supply in relation to the aggregate amount of
assets.
Prices go up or down only when the
relationship between the money supply and the
amount of assets changes. When more money is
issued along with a growth of assets, there will
be no asset-price changes, or no inflation even if
the economy expands. When asset prices rise, it
reflects a change in the money supply/asset
relationship, meaning more money chasing the same
number of assets. Thus when asset prices rise, it
is not necessarily a healthy sign for the economy.
It reflects a troublesome condition in which
additional money is not creating correspondingly
more assets. It is a fundamental self-deception
for economists to view asset-price appreciation as
economic growth. A housing bubble is an example of
this.
When prices fall, economists call it
deflation. Deflation is not always caused by the
economy not having enough money. It can be caused
by an excessive liquidity preference on the part
of market participants. When that happens, a
liquidity trap develops in which market
participants withhold money waiting for still
lower prices. The Japanese economy in the 1990s
was the clearest example of a liquidity trap, in
which even negative interest rates failed to cure
deflation.
Financial markets are obsessed
with Fed activities. It is common to hear or read
that the Fed has eased or tightened. Wall Street
thinks of a lowering of the federal funds rate as
Fed easing. Little or no attention is paid to
money-supply aggregates or Fed balance-sheet
aggregates by Wall Street commentators. The error
of Wall Street's view is that the Fed does not
directly participate in any way in the federal
funds market, which is strictly an inter-bank
market for cash reserves.
The federal
funds rate is determined, during the course of a
market day, by supply and demand by commercial
banks - the Fed funds rate is a restricted
market-determined rate. It is not set by the Fed
or by anyone. The Fed merely sets a Fed funds rate
target. The reason that Wall Street monitors the
federal funds rate target as an indication of Fed
policy is that the federal funds rate closely
tracks the repo rate that the Fed actively
influences during most market days. Every
business-day morning at 11:45 Eastern Time, the
New York Fed announces what it intends to do in
the repo market. Changes in the repo rate are
normally quickly followed by changes in the Fed
funds rate. Thus, indirectly, the Fed appears to
be able to influence the federal funds rate
through its impact upon the repo rate.
Monetarists consider the money supply, and
even more so the growth rate of the money supply,
to be the main instrument of Fed policy. Thus if
money-supply growth is increasing, then the Fed is
said to be easing. If money-supply growth is
decreasing, then the Fed is tightening. This
concept of easing and tightening has the virtue
that the Fed is known to control, with varying
degrees of precision, the growth rate of the money
supply. In other words, whatever the path of the
money supply, there is no question that the Fed
has the instruments at its disposal to control
(with some error) the growth rate of the money
supply.
But the rapid growth of structured
finance has created questions on the validity of
this view. Money now, especially virtual money, is
created quite independently of Fed action, and
money creation has become much less sensitive to
interest-rate fluctuations. This explains why the
measured pace at which the Fed has been raising
the Fed funds rate target has little direct or
immediate effect on the housing bubble.
Non-monetarists subscribe to the view that
Fed easing means the Fed lowers interest rates.
They are often not very specific about how these
rates are lowered or how the Fed should go about
doing this. There are often periods (eg 1990-91)
when interest rates drop but money growth falls.
Non-monetarists (and Wall Streeters) view periods
like these as Fed easing episodes, while
monetarists argue that these are (implicitly)
periods of Fed tightening.
There is no
generally accepted empirical test of Fed easing or
tightening when money growth and interest rates
are moving in the same direction, as appears to be
happening now. The Federal Reserve is active on
almost any given day in the repo market.
Commercial banks can sell assets to raise cash
(possibly liquidating loans); or they can borrow
the cash. The repo market provides a way to do the
latter while making it appear that they are doing
the former.
Repos increase systemic
risk It is a good question why a loan is
called a repo. The answer is that the notion of a
repurchase agreement was a fiction dreamed up to
minimize the impact of such transactions on bank
and broker-dealer capital requirements. If these
transactions had been called loans, then banks
(and broker-dealers) would be required to set
aside cash (or perhaps other capital if a
broker-dealer) against such loans. By inventing
the fiction of calling what is actually a loan by
some other name, banks and broker-dealers were
able to bypass banking regulation and reserve less
cash/capital against such activities.
Convertible bonds are another type of loan
that can be incurred by corporations off the
books. Repos obviously increase systemic risk in
the banking system as well as in the monetary
system, particularly when the daily repos volume
has grown to $5 trillion and is rising by the
week.
To raise cash, a commercial bank
normally sells so-called secondary reserves
consisting of Treasury bills and other short-term
debt assets, before resorting to other more
drastic measures such as the liquidation of loans,
selling fixed assets of the bank and so forth. Or
a bank can borrow reserves directly from other
commercial banks in the federal funds market. The
rate for such borrowings would be the prevailing
federal funds rate that follows the law of supply
and demand set by Fed open-market operations.
Or a bank can do reverse repos.
Mechanically, it would send out secondary reserves
to some third party in exchange for a cash loan.
When the loan terminates, the bank will receive
back its secondary reserves that had been pledged
for the repo. Such transactions will occur at the
prevailing repo rate. A default will saddle the
creditor with a loss equal to the spread between
the old and new prevailing repo rate. Or a bank
can issue commercial deposits (cd) to the public
(which will simultaneously increase reserves and
deposits). Such issuance (sales, really) will be
transacted at the prevailing cd rates corrected
for the credit quality of the issuing bank. Or a
bank can borrow from the Fed at the Federal
Reserve Discount Window. This type of borrowing
takes place at the Fed discount rate, an announced
rate that the Fed changes from time to time.
Because banks are looking at these two
alternatives as ways of raising cash, there will
be a tendency for rates to move together. If the
Fed funds rate is high, but the repo rate is low,
then banks will be more likely to raise cash by
doing reverse repos than by borrowing funds. This
will tend to move those rates together, similarly
with cd rates. Thus if the Fed is able to raise or
lower the repo rate, this should have an impact on
the Fed funds rate in the same direction (It also
should impact the cd rates through similar
reasoning). The Fed is likely to be able to
control the federal funds rate if it can control
the repo rate. Most observers seem to feel that
the Fed can routinely control the daily federal
funds rate because the Fed, in their eyes, can
control the repo rate.
Until recently, it
was not obvious that doing repos and reverses had
any real impact, other than very temporarily, upon
either the cash reserves of the banking system or
the repo rate. These conditions have fundamentally
changed. The Bond Market Association reports that
the average daily volume of total outstanding
repurchase (repo) and reverse repo agreement
contracts totaled $5.47 trillion in the first half
of 2005, an increase of 17.4% from the $4.66
trillion from the daily average outstanding during
the same period a year ago. The repo market has
become the biggest runaway credit window outside
of the control of the Fed. Yet the prevailing
consensus view remains that Fed activity in the
repo market should in essence be the mechanism for
targeting the federal funds rate in the manner
outlined above.
John Kambhu, vice
president of the New York Federal Reserve Bank,
observes that convergence trading, in which
speculators trade on the expectation that asset
prices will converge to their fundamental, or
normal, levels, typically stabilizes markets. By
countering and smoothing price shocks, these
trades can enhance market liquidity. However, if
convergence traders close out their positions
prematurely, asset prices will tend to diverge
further from their fundamental levels.
Both stabilizing and destabilizing forces
in the market are attributable to convergence
trading. The swap spread tends to converge to its
fundamental level more slowly when the capital of
traders has been weakened by trading losses, while
higher trading risk can sometimes cause the spread
to diverge from its fundamental level. Although
convergence trading typically absorbs shocks, an
unusually large disruption can be amplified when
traders close out their positions prematurely.
Destabilizing shocks in the swap spread are
associated with a fall in repo volume consistent
with the premature closing out of convergence
trading positions. Repo volume also falls in
response to convergence trading losses. Kambhu
explains that taken together, these results are
consistent with the argument that while
convergence trading tends to be a stabilizing
force, the risks in trading, as reflected in repo
volume, on occasion can lead to behavior that
destabilizes the swap spread. That occasion will
occur as unpredictably but surely as a devastating
hurricane hitting New Orleans.
And the
rate at which the central bank lends money can
indeed be chosen at will by the central bank; this
is the rate that makes the financial headlines. In
the US, the central-bank lending rate is known as
the Fed funds rate. The Fed sets a target for the
Fed funds rate, which its Open Market Committee
tries to match by lending or borrowing in the
money market. Thus fundamentally, the money market
is not a free market, but one dictated by the
central bank with a particular preference for the
resultant state of the economy. The so-called
free-market capitalism operates through this
command money market. Thus at the heart of the
free-market ideology is a fiat money system set by
command of the central bank. The Fed is the head
of the central-bank snake because the US dollar is
the key reserve currency for international trade.
The global money market is a US dollar market. All
other currencies markets revolve around the US
dollar market.
When a government's
Treasury issues sovereign debt, the money proceeds
go to finance the portion of the fiscal budget not
covered by taxes. When government runs a fiscal
deficit, it takes money from the private sector by
issuing sovereign debt and spends the money back
in the private sector. Thus the important issue is
not if the government runs a fiscal deficit, but
how the fiscal deficit is spent. A fiscal deficit
does not reduce the total money supply; it only
increases the amount of debt. But monetary
economists such as Hyman Minsky assert that
whenever credit is issued, money is created. Thus
the issuing of government bonds is the
government's way of issuing money without the
involvement of the central bank. This is why
Federal Reserve Board chairman Alan Greenspan is
always warning about the fiscal deficit.
Yet the notion that government borrowing
crowds out private borrowing is controversial.
Fiscal deficits do not even directly affect
short-term interest rates, which are set by the
central bank. If the government wishes, it can
take money directly from the central bank, which
is legislatively authorized to issue money by fiat
as the sole legal tender in the nation. A
country's fiat money enjoys currency because the
government accepts it for payment of taxes.
Fiat money is in fact a form of tax
credit, or sovereign credit. Sovereign debt
instruments do have a market function: they
provide the assets that a central bank can buy or
sell in the repo market to meet its Fed funds rate
targets.
Next: The global money and
currency markets
Henry C K Liu is
chairman of a New York-based private investment
group.
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