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Friday March 5, 2010 - 20:46:50 GMT
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Monetary Policy Pulling on a String

Monetary Policy Pulling on a String


Liquidity Traps turn monetary policy into “pushing on a string” which much of the last 2 years demonstrated (in this case MP was effective in driving risk asset prices up, not creating credit which is the main function of monetary policy and the transmission mechanism).  However, now that most central banks fear the wall of liquidity pumped into the banking system and shadow banking system globally will start the credit creation process ahead and hence lay the seeds for a serious inflation problem in the future, officials are pulling on a string…taking the liquidity back out of the system before the velocity of money and multiplier effects are seen closing the output gap and inflation becomes embedded into expectations.


Keep in mind central bankers do not treat liquidity adds as an easing of monetary policy nor liquidity drains as a tightening of monetary policy.  Indeed the Fed has gone through all sorts of contortions to educate markets and the public that lifting the discount rate February 18 was not a tightening of monetary policy, though in theory it could impact access to liquidity in the system.  A week after hiking the discount rate, the Treasury announced it was increasing the Supplementary Funding Program to $200bln from $5bln – this is a collateral providing program that is run on behalf of the Fed.  It allows the Fed through Treasury placement to put bills (GC) into the repo market and take funds out of the banking system and leave them in the Fed’s account.  This is in part a draining tool.  Bloomberg reported today that the program put some $50bln into the banking system over the last two weeks and as a result effective Fed funds and repo rates are higher and the highest since last fall.  Again this is not a tightening of monetary policy but a drain on liquidity even if monetary conditions tighten some (a higher dollar all else being equal also tightens monetary conditions). 


My point is that as the Fed moves to pull on the liquidity string that did not work (did not lead to credit creation) when pushed apart from driving asset prices, will work when being tugged.  Liquidity drains at the margin will at the margin tighten monetary conditions and I think take asset prices lower in due course short of a V-shaped recovery in economic activity led by the private sector (something few in the market are calling for). 


But the string is also being pulled as the Fed’s MBS support program wraps up (needs to start selling these assets to reverse the money stock effect and this is not in the cards given fragility of the mortgage market and its securitization sausage machine…indeed so badly impaired US Tsy is expected to pick up the Fed’s supportive role when the Fed stops). 


We also have heard rumors of the Fed conducting reverse repos with Fannie and Freddie, which currently play a large role in repo market (overnight funding) and give the Fed another avenue for draining reserves from the banking system (were also rumors that GSEs may cut lines of credit with non-US banks ahead as well which could be another indirect way for the Fed to tweak the cost of overnight funding and limit liquidity in the banking system.  Fed is on record with term and reverse repos ahead for the primary dealers, though apart from some trial runs on reverse repos these operations have yet to be deployed.


Interest on reserves held at the Fed is expected to be the new policy transmission rate of the Fed – lift it and banks will move more excess cash to the Fed and will in theory take high powered money out of the banking system.  But this would be a tightening of monetary policy and not a liquidity measure even though it would impact banking system liquidity directly.  Because there is so much liquidity in the system, the Fed is unable to adequately target the Fed funds rate (what the NY Fed open markets desk did on a near daily basis pre-crisis). So Fed funds rate is really more the lower end of a new corridor rate system with IOR the focal point of policy ahead.  We can expect to see changes here in 2011 though the market is signaling this could come later this year. 


Okay so the Fed is taking back what it put into the banking system, however incrementally.  But it is not just the Fed and the US banking system.  The ECB this week announced it was wrapping up its third of four long-term refinancing operations (liquidity measures put in place after the crisis broke out) …only remaining full allotment, fixed rate refi operation left is the 1-month and this could be wound down in the next meeting or two.  Keep in mind the long-term refi’s remain but they are no longer full allotment (however much bank asks for is given) and will be done on an auction basis using average rates from the term of the refi…more punitive for sure and aimed at pulling on the liquidity string. 


In the UK we have seen the BOE hit the pause button on quantitative easing (GBP200bln in purchases of gilts).  While it remains to be seen if the UK government can sell gilts at or near QE-era rates when facing an onslaught of new supply, the current hold on buying gilts will impact monetary conditions, risk free rate and asset prices more directly. 


In Canada the BOC has moved to wrap up its emergency liquidity measures as well. 


Central bank USD swap lines with the Fed have been ended (played a key role in meeting USD shortages globally when the meltdown in risk assets was at a peak). 


China, less a part of the global capital market directly as foreign banks have little to no access to local funding, has moved measurably to get banks to lend less and lend less to customer eager to buy real estate and stocks.  The reserve requirement rate has been hiked several times as well. 


The RBA is way out in front on policy tightening – economy was never hit as severely by the credit crisis and recession as was the rest of the developed world (China commodity option largely in play).  RBA has hiked rates 4 times. 


Central banks in India and Brazil are quite close to raising rates. 


Surely I am not suggesting that these measures will cause a key reversal in all risk assets ahead…my guess is officials are not eager to do this at a pace that would threaten asset price rallies.  But if liquidity is the oxygen for the rallies and it is being turned down gradually, I think it is safe to say that there is not much upside from here in risk and in time decent downside.


David Gilmore


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