Well, that didn’t take long! Four days ago, I stated the following in an article titled “Why are Bonds Going for Broke?“:
Central banks are losing control, and are admitting they don’t even understand what is happening.
I quoted St. Louis Reserve Bank president, James Bullard, who commented
“Something is going on, and that’s causing I think a total rethink of central banking and all our cherished notions about what we think we’re doing…. We just have to stop thinking that next year things are going to be normal.”
There is an awful lot of thinking about the need to rethink the way they think in that statement from which I concluded,
The [central] banks appear to be losing control of interest rates and to be, themselves, controlled by market forces they can no longer contain or fully manipulate.
I noted that reserve bank presidents who say things like “something is going on” do not instill confidence that the Fed knows what is going on or how to deal with it, especially when they add that the Fed is “rethinking” how it thinks things work. I suggested the large swings in the bond market this month may be related to problems developing concurrently in our financial underpinnings, now showing up as massive cracks on the surface of the economy all around the economy’s fundamental interest rate. That’s not good.
Even Wall St. now agrees: The Federal Reserve Bank of New York delivered major jolts of evidence this week that the Fed is, in fact, losing control over interest rates.[For anyone who doesn’t understand how the Fed governs interest rates via repurchase agreements, I wrote the following article as a companion to this one: “BOND PRIMER: How the Fed’s Machinery Works.” You may want to read it first and then come back here.]
Fractures in the system cracked wide open this week
At its last meeting, the Fed’s FOMC, which sets interest policy, downshifted its Interest-on-Excess-Reserves gear by lowering the interest it pays banks on their excess reserves. The IOER both entices banks to maintain excess reserves by paying higher interest on the excess than on the mandatory reserves, and sets an effective floor on bank overnight loan interest by establishing a rate the Fed will pay to keep that money in reserves. Banks have no reason to loan their excess reserves to each other for less than that rate because they can get totally secure interest from the Fed at that rate.
Dropping that rate last week accomplished absolutely nothing because banks were already lending well above that rate! An exercise in futility at this point. I suppose the Fed thought lowering the interest it pays on excess reserves would encourage banks to get flush out some of their excess reserves by loaning them to other banks, but that only works if there actually is enough money in excess to make a dent. Apparently there was not.
Throughout the first half of this year, the Fed Funds Rate set a target range for overnight loans of 2.25-2.50% (set at its December 2018 meeting as its last rate increase), and the effective rate for loans cruised smoothly along the IOER floor. (See chart below where “Effective Fed Funds Rate” means the median overnight loan rate that actually happens, not just the stated target.) By late March the effective rate began to bounce above its floor. A hint of a problem but not an actual problem so long as the effective rates stays within the target range, but it shows pressure building toward the top of the range, versus a smooth ride along the Fed’s floor. By May it was spiking fairly erratically.
At the end of July, The Fed reset the Fed Funds Rate lower to 2.0-2.25%, and it lowered the floor rate by which I don’t mean the bottom of the Fed’s stated range, but the IOER it sets, which banks are not inclined to loan below. Rates settled down a little but stayed above the IOER. Then on Tuesday of last week, while the Fed’s target range was still 2.0-2.25%, the overnight interest banks charge each other rose above that to 2.3%. During its subsequent FOMC meeting, the Fed lowered its target to a 1.75-2.0% range, but what meaning does that have if the effective rate is already above the old target? For the rest of the week, the effective overnight interest rate kept bursting above the Fed’s bounds, raising questions all over Wall Street about whether or not the Fed had lost its ability to establish interest rates, even at the most foundational level! At one point, the rate went astronomically higher, skyrocketing to 10%!
Read the rest here: The Great Recession