No Magic in the Monetary Policy Wand

Despite the fact that the Federal Reserve has likely done far more harm than good over the course of the past few decades, investors remain convinced that our nation's central bank has magical powers. That is one reason why equity investors, for instance, have remained steadfastly bullish despite the economic and financial earthquake that has been shaking the ground around them. Unfortunately, as Dr. John Hussman, president and principal shareholder of Hussman Econometrics Advisors, notes in "An Irrelevant Fed: Thimbles of Water in a Forest Fire," that confidence seems terribly misplaced.

Pop Quiz

How much “liquidity” has the Federal Reserve “pumped” into the $12.7 trillion U.S. banking system since March 2007?

a) $1.2 trillion, which banks have used to firm up their balance sheets

b) $600 billion, which banks can now use to make new loans

c) $16 billion, all of which has been drawn out of the banking system as currency in circulation

If you answered c, move to the head of the class. Investors who answered a or b have not only been misled by analysts and media stories, but have no idea how irrelevant the Fed's actions are likely to be, except on short-term market psychology. More charts and data below.

A good opportunity to reduce excess risks

Last week, the stock market enjoyed a typical clearing rally from an oversold low - “fast, furious, and prone to failure.” This presents a good opportunity for investors to reduce positions that they would not be able to tolerate through a complete market cycle, with the S&P 500 only about 5% below a record high.

Let me preface this analysis by stressing again that my intention is not to drive investors out of well considered investment plans. There is nothing wrong with a buy-and-hold approach provided investors are aware of how strong the impulse is to abandon that strategy only after deep declines. I appeared briefly on CNBC last week to discuss recession risk, but beforehand, I was asked to put a positive tone on my comments, to which I responded – “Look, my interest is in making sure that investors have positions that they are able to hold through the complete market cycle, including a potential 30% bear market loss off the highs, without having their financial security endangered. If they're carrying more risk than they could endure through the course of a bear market, they should cut back now. I'm not going to wave my arms around about doom and gloom, but I think it's a crucial time for investors to think about the risk they're taking, and if you don't want me to say that, please don't have me on.” Well, I went on, and though we ran short of time, that's still my message.

In economic developments, durable goods orders came in below expectations last week, while new claims for unemployment shot higher. The ECRI Weekly Leading Index fell to its most negative growth rate since the last recession, as the ECRI commented “US growth prospects have deteriorated further.” Credit spreads widened again, well beyond the highs of a few months ago, and LIBOR (the interest rate to which much floating-rate debt is pegged) rose to just slightly below the level it was at early this year, before the Fed began cutting its own interest rates. While the entire Treasury yield curve is currently below the Fed Funds rate, it's clear that this due to a flight-to-safety in Treasuries. The Fed can certainly penalize savers by pressuring deposit rates lower, but it isn't having a measurable effect on the market-determined interest rates that borrowers actually face. Nor can the Fed significantly affect the solvency of the mortgage market.

As for stocks, I noted a couple of weeks ago (extending Jim Stack's analysis) that in each instance that the market declined materially after successive discount rate cuts, S&P 500 earnings were down sharply a year later. Given that a large portion of S&P 500 profits are from financials, that profit margins in other industries are well above historical norms, and that profit margins have always collapsed during recessions, my impression is that S&P 500 earnings could easily fall by 40% over the next 18 months (investors who view this as impossible haven't examined earnings history). This could become far worse than a 5% decline off the high, which is where the S&P 500 is now.

It's possible that investors could adopt a fresh willingness to speculate on the hopes and eventuality of a Fed rate cut (the economic news this week will determine the likelihood of 25 vs. 50). Regardless, given the economic backdrop, my impression is that any such speculation would be short-lived - as it has after other Fed cuts this year. For now, we don't have evidence to support any amount of bullish speculation. Our own investment position doesn't rely on a recession or a bear market, but those outcomes are increasingly probable rather than simply possible. In the Strategic Growth Fund, we are fully-hedged, but with a “staggered strike” hedge configuration that provides somewhat stronger defense against market losses (largely financed out of the “implied interest” we earn on our hedge). Though I believe that potential market losses could become deep, our investment position isn't driven by that expectation. It is enough that stocks have underperformed Treasury bills, on average, in similar conditions. In any event, historically, investors would have considered themselves lucky to clip off their excess risk so close to all-time highs, even after market action and economic news began to sour.

The Fed – thimbles of water in a forest fire

My greatest concern at present is that investors are being bombarded with empty hope that the Fed will save them by “injecting liquidity” into the banking system. Time spent examining these false perceptions is not time wasted.

Very simply, the impact of Fed actions is sorely exaggerated. The amount of liquidity that the Fed provides is minuscule in relation to the U.S. banking system, and also in relation to the volume of capital inflows (about $2 billion daily) that the U.S. relies on from foreigners, thanks to our massive fiscal deficits and low savings rate.

What strikes me as particularly absurd is that the analysts who wax rhapsodic about “Fed liquidity” speak in a way that makes it obvious that they have no understanding of how these Fed operations work. Then again, it's precisely because we do understand how they work that we're convinced that they're irrelevant (aside from boosting short-term market psychology and accommodating short-term spikes in the demand for currency).

Let's start with a basic fact. There is only one monetary aggregate that the Fed directly controls: the monetary base – consisting of currency in circulation plus bank reserves. Here's the data.

Monetary Base : http://research.stlouisfed.org/fred2/data/AMBSL.txt

= Currency in Circulation : http://research.stlouisfed.org/fred2/data/CURRCIR.txt

+ Total Reserves : http://research.stlouisfed.org/fred2/data/TRARR.txt

In the early 1990's, reserve requirements were abolished on everything but demand deposits (checking accounts). Since then, the quantity of bank reserves has gradually declined, and has no relationship with the volume of bank loans or total bank assets – again look at the data. In recent months, as has been the case since the early 1990's, virtually all of the increase in the U.S. monetary base has represented the gradual and predictable increase of currency in circulation, held outside of the banking system.

So how does the Fed increase the monetary base? There are three sources of “liquidity” managed by the FOMC: permanent open market operations, temporary open market operations, and loans through the discount window. Let's take a look at each. Again, here are the Fed's own statistics:

Permanent Open Market Operations:
http://www.ny.frb.org/markets/pomo/display/index.cfm?showmore=1

Temporary Open Market Operations:
http://www.ny.frb.org/markets/omo/dmm/temp.cfm?SHOWMORE=TRUE

Discount Window Borrowings:
http://research.stlouisfed.org/fred2/data/TOTBORR.txt

The Fed uses permanent open market operations primarily to finance the gradually increasing stock of U.S. currency in circulation. The Fed buys Treasury securities (which become an asset on the Fed's balance sheet) and pays for them by printing money (a liability of the Fed, as evidenced by the words “Federal Reserve Note” on top of the pieces of paper in your wallet). The Fed has not engaged in any permanent open market operations since May.

Next, the Fed can use temporary open market operations to vary the amount of day-to-day reserves in the banking system, in order achieve the targeted Federal Funds rate (which is the interest rate that banks charge to lend reserves overnight to other banks that are temporarily short). What's important is that these are temporary operations, in the form of “repurchase agreements”: the Fed provides reserves to the banks, usually for periods of 1-14 days. It purchases Treasuries or government-backed mortgage securities from the banks as collateral, and at the end of the period, the banks are obligated to buy them back from the Fed, at the purchase price plus interest.

What's important here is that every time a repo matures, the Fed generally enters a new one for a similar amount. The average maturity of these repos is only about 7 days, so there is a lot of activity. These transactions are constantly reported by the media as if they are “new injections” of liquidity – but they are just rollovers. If the Fed does a $20 billion 7-day repo one day, you can pretty much bet that the Fed will be doing another $20 billion in repos a week later when the outstanding one comes due. What matters is the total amount of repos outstanding. The chart below presents the 30-day average of Fed repos outstanding since March (see the above link for source data - thanks to Brooke Steinau for tying all of these figures out).

Note that the total amount of liquidity added by the Fed since March is only about $16 billion (it turns out that all of this has been drawn out of the banks as currency in circulation, probably for good, so at some point in the coming months, the Fed will undoubtedly do about $10-$15 billion in “permanent” open market operations to recognize this withdrawal, and will simultaneously reduce the outstanding amount of these “temporary” repos).

The third way the Fed can “inject liquidity” is to make loans to banks through the “discount window,” for which it charges interest at the “discount rate.” While market participants behave as if changes in the discount rate are wildly important, the fact is that even at their peak last summer, total loans to banks through the discount window only rose to about $3 billion. Currently, the total amount of “liquidity” being lent by the Fed through the discount window is $55 million. Yes, million.

Last week, investors made a great deal about an $8 billion 43-day repo that the Fed initiated. While this was reported as an extraordinary measure to stabilize the financial markets, the fact is that the Fed regularly enters a long-dated repo every year, just before the holidays, in order to accommodate a moderate increase in the demand for currency (in 1999, the amount was massive because of year-2000 fears, and was quickly reabsorbed after the new year). The $8 billion repo the Fed entered last week amounts to roughly $25 per American in extra cash to carry around the malls. To frame this as some sort of extraordinary effort to stabilize the banking system is absurd.

Again, the problem with the U.S. financial system here is not liquidity, but the solvency of mortgage loans and securitized debt. The Fed's actions are not likely to have material impact on this. To believe otherwise is mindless sheep-like superstition. Do investors really want to bet their financial security on the hope for “Fed liquidity” promised by uninformed analysts who don't understand monetary policy because they can't be bothered to look at the data?

Comments

[Harleydog]

Mike

Another great post Mike. Interesting that CNBC asked Mr. Hussman to put postive spin on his comments prior to his apprearance. Just jives with what many have long suspected about the mainstream financial media spin. This credit and markets FLUSHING will dispell many fallacies that many have come to be accepted as gospel. I cannot remember the author whose quote was "men go mad in crowds but regain their sanity one by one".

[jeff finsley]

Can you now comment on the permanent operations begun at the beginning of march whereby daily the Fed is supposedly taking in billions of cash out of the market? Does this make sense? are they selling these bill and coupons at inflated rates? looks like it to me. does this postpone reckoning while adding costs in the future via inflation? I havent seen POMO's like this in any of the archives what is happening?

thank you