Tag: Monetary Policy

Elham's Money View Blog Hot Spots and Hedges

Hot Spots and Hedges #2: Has March 2023 Banking Crisis Exposed Interest Rate Risk as the New Liquidity Risk?

Post author By Elham Saeidinezhad
Post date March 21, 2023

“Street Speaks in Swap Land” — Marcy Stigum

The collapse of Silicon Valley Bank (SVB), and its aftermaths, in March 2023, showed a structural change in the business model and the risk structure of deposit-taking institutions. In 2008, Great Financial Crisis (GFC) revealed that the banking system’s balance sheets are ingrained with liquidity risk. Bankers borrowed in the short-term, liquid money markets to invest in long-term illiquid assets with high yields. In contrast, the March 2023 crisis showed that deposit-taking institutions had shifted their gear towards investing in liquid assets such as government bonds. In doing so, they have become hedge funds in disguise. Nonetheless, instead of noticing such changes in banking structure, regulators assessed commercial banks based on the lessons of the GFC. They were considered safe as long as they had healthy liquidity and leverage ratios and were funded by deposits. By over-relying on the lessons of the GFC, the regulators and bankers’ risk managers alike disregarded a risk that every hedge fund manager and fixed-income investor is alerted by: interest rate risk.

Interest rate risk was disregarded in the narrative of financial stability. Moreover, GFC was partially to blame. GFC exposed the extent of liquidity risk in the banking system. The liquidity mismatch between the banks’ assets (long-term illiquid assets) and liabilities (short-term money market instruments) became known as the hot spot of banking. The liquidity mismatch would cause a solvency problem if the bank, for instance, needed to sell some of its assets quickly to manage its daily survival constraints and cash flows. In this case, illiquid assets would go through a fire sale process not because they had lost their potential income or become less attractive but simply because they did not have a liquid market. Such circumstances led to Bagehot’s dictum that to avert panic, central banks should lend early and freely (i.e., without limit), to solvent firms, against good collateral, and at “high rates.” In this context, it should not be surprising that the Fed and FDIC provided extensive liquidity provisions, including offering blanket deposit insurance, after the March 2023 banking crisis started.

Nevertheless, such facilities have yet to calm the market. The failure of liquidity provision to stabilize the market in the March 2023 banking crisis is partially generated by the intellectual mismatch between the root of the banks’ vulnerability (interest rate risk) and the proposed remedies (liquidity backstops). The reason is the change in the banks’ business model. Commercial banks started to hold excessively safe assets, such as government bonds, to prevent a GFC-like crisis and escape regulatory pressure. Government bonds may not have default risk. They are also liquid. However, their market value goes down when rates rise. In addition, rising interest rates generally force banks to raise deposit rates or lose funds to alternatives such as money-market funds. For banks, that was only an issue if the bonds were not adequately hedged and had to be sold to redeem deposits, which is exactly what happened to SVB. The signature relied more on loans, but it also experienced a run on its uninsured deposits.

Regional banks’ business model exposes them to unusually high interest rate risks. Regional banks’ liabilities are mostly deposits from modern corporates such as Venture Capitals (VCs), Startups, and Crypto firms. These corporate depositors do not need a bank loan. Instead, they can raise cheap funding through equity, IPOs, and other capital market techniques. As a result, banks use their cash to purchase a very high level of interest-sensitive fixed-income assets such as bonds. The classic problem with holding a large portfolio of fixed-income assets is that when rates go up, they fall in value, as with SVB’s assets. At the same time, as deposits pay competitive rates, higher rates increase the value of banks’ liabilities. This is called “interest rate risk.” All types of deposit-taking activities involve a certain level of interest rate exposure. However, commercial banks’ portfolios used to be more diversified as they also made floating-rate corporate loans. As a result, their balance sheets were less sensitive to interest rate changes in the past.

The heightened sensitivity of banks’ assets to interest rate risks could stay unrecognized by more traditional depositors who treat checkable deposits as safe as government liability. However, like equity investors, corporate clients use all the available information to continuously mark-to-market bank assets. When interest rate is volatile, as was the case in the past few years as a result of the Fed’s policies, bond prices change dramatically. If these assets are marked to market, their fair value sometimes falls below their book value. More informed and rational depositors are impatient and reactive to such developments. As was the case for the SVB, they could hugely penalize the banks by collectively withdrawing their funds and creating a run on a bank. The SVB-derived banking crisis showed that compared to other depositors in history, these new and individually rational types of corporate depositors could collectively create a more unstable banking system.

As a result, regulators are deciding how to secure this segment of the banking system that is unusually exposed to interest rate risk. Nonetheless, regulators should consider more innovative risk management approaches instead of returning to the standard regulatory toolkits, such as stress tests. For example, they could require the banks with such a business model to use interest rate swaps (IRS). First, from a risk management perspective, IRS can provide interest rate hedges. As corporate depositors continuously mark-to-market banks’ financial positions, neutralization could help calm their nerves when interest rates are highly volatile. IRS could also act as a cash management tool. The parallel loan structure of the IRS synthetically transforms the banks’ fixed-income assets into floating-rate- assets to match deposits’ cash flows.

From a classic risk-management perspective, swaps would neutralize the interest rate risks. To understand this point, let us go through an example. Suppose a regional bank tends to issue a $ 1 million deposit at a floating rate. The bank uses this fund to purchase a fixed-income bond. However, additional liability (deposit) at the variable rate will undermine compliance between interest rate-sensitive assets and liabilities. In the event of rising interest rates in the market, banks’ cash outflows and cash inflows increase. The cash outflow increases as the banks make higher interest payments to the depositors. The value of the cash inflow increases too. Even though the bonds generate fixed cash flows, these payments will be reinvested at a higher interest rate and earn a higher income. However, let us assume that the value of the liabilities will be greater than the increase in the income value by one million dollars. The result is a decline in the net interest margin and bankers’ profitability.

To avoid this risk, the banker can convert $ 1 million of liabilities with variable interest rates in the $ 1 million liability insensitive to interest rate movements, tiding interest-sensitive assets to interest-sensitive liabilities. Entering into an interest rate swap will enable her this. Therefore, the banker will contract an interest rate swap under which she will be required to pay at a fixed rate and receives at a variable rate. Variable income from the swap will equal the losses from the additional variable liability, and the net result will be a fixed obligation from the swap. In other words, profit/loss in swap would neutralize variable income from bonds, and the net result will be an interest-insensitive asset and liability because of the swap.

Another way to think of the swap is as a tool that matches cash inflows and outflows synthetically. The mechanics of the swaps can allow the banks to convert their bond holding (that earns fixed income) into repo lending (that earns a floating rate), albeit synthetically. Buying an IRS (being a fixed-payer, floating-receiver) by the bank is like borrowing in the bond market to lend the proceeds in the short-term money market. Banking is the equivalent of borrowing short and lending long. In contrast, IRS is equivalent to borrowing long and lending short. In this scenario, the swap position increases in value when the floating interest rate rises and generates the cash flows required to neutralize the cash flow mismatch between the banks’ assets and liabilities.

Historically, risk managers and regulators have often tried treating such risk as an “accounting” problem. As a result, positions were converted into risk equivalents and added together. For example, in fixed-income markets, participants have, for many years, scaled their positions into units of a common duration. Each position is converted into a basis—for example, a number of “10-year duration equivalents”—which should have equal sensitivity to the main source of fixed income risk, a parallel movement in interest rates. In this case, risk managers and regulators use indicators such as the delta (the net interest rate sensitivity), the vega (the net volatility sensitivity), and the gamma (change in delta concerning a one bp change in interest rates).

While these bits of information are essential to understanding and managing the position, they do not provide an adequate basis for risk management. Over the past several years, the accounting approach to risk management has been largely supplanted by using “stress” tests. Stress tests are the output of an exercise in which positions are revalued in scenarios where the market risk factors sustain significant moves. No doubt, using stress tests improves a situation of not knowing what might happen in such circumstances. However, significant limitations in stress testing need to be recognized.

What are their important limitations? First, it is sometimes unclear which dimensions of risk need to be considered. Also, stress tests do not reveal the relative probabilities of different events. For example, a position with negative gamma that loses money in significant moves in either direction will look bad in extreme scenarios but generally look very attractive when only local moves are considered. In any case, the shrewd banker can tailor his positions to look attractive relative to any particular set of scenarios or, given the opportunity, can find a set of scenarios for which a particular set of positions looks attractive. Moreover, in complex portfolios, there are many scenarios to look at; in fact, it may be virtually impossible to know which risk factors need to be considered. Furthermore, even if an exhaustive set of scenarios is considered, how does the trader or risk manager know how to consider the risk reduction resulting from the diversification of the risk factors? Thus, while stress testing is useful, it often leaves large gaps in understanding risk.

The ongoing banking crisis shows that while we mistakenly disregarded liquidity risk as an anomaly before the GFC, we made the same mistake regarding the interest rate exposure until the collapse of the SVB. As long as banks held safe, liquid assets, the interest rate mismatch between assets and liabilities was considered systemically unimportant. It is true that in modern finance, liquidity kills banks quickly, and liquidity facilities save lives. Nonetheless, the SVB crisis shows that we are also moving towards a parallel world, where interest rate risk evaporates a whole banking ecosystem. In this environment, looking at other instruments, such as swaps, and other players, such as swap dealers, that can neutralize the interest rate risk would be more logical. The neutralization aspect of the IRS can provide a robust financial stability tool to hedge against systemically critical hot spots.

Nonetheless, at least two critical issues should be extensively discussed to better understand swaps’ potential as a tool to strengthen financial stability. First, the economic benefit of the interest rate swaps results from the principle of comparative advantage. Interest rate swaps are voluntary market transactions by two parties. Nonetheless, this comparative advantage is generated by market imperfections such as differential information and institutional restrictions. The idea is that significant factors contribute to the differences in transaction costs in both the fixed-rate and the floating-rate markets across national boundaries, which, in turn, provide economic incentives to engage in an interest-rate swap, is true “a market failure.” Second, any systemic usage of swaps would engage swap dealers and require expanding the Fed’s formal relationship with such dealers.

Tags Banks, Dealers, Derivatives, FINANCIAL CRISIS, Interest Rate, March 2023 Banking Crisis, Monetary Policy, Money View, SVB, Swaps

Elham's Money View Blog

The Fed is the Treasury’s Bank. Does it Matter for the Dollar’s Global Status?

Post author By Elham Saeidinezhad
Post date August 28, 2021
3 Comments on The Fed is the Treasury’s Bank. Does it Matter for the Dollar’s Global Status?

By Elham Saeidinezhad

There is a consensus amongst the economist that the shadow banking system and the repurchase agreements (repos) have become the pinnacle of the dollar funding. In the repo market, access to liquidity depends on the firms’ idiosyncratic access to high-quality collateral, mainly U.S. Treasuries, as well as the systemic capacity to reuse collateral. Yet, the emergence of the repo market, which is considered an offshore credit system, and the expectations of higher inflation, have sparked debates about the demise of the dollar. The idea is that the repo market is becoming less attractive from an accounting and risk perspective for a small group of global banks, working as workhorses of the dollar funding network. The regulatory movement after the Great Financial Crisis (GFC), including leverage ratio requirements and liquidity buffers, depressed their ability to take counterparty risks, including that of the repo contracts. Instead, large banks are driven to reduce the costs of maintaining large balance sheets.

This note argues that the concerns about the future of the dollar might be excessive. The new monetary architecture does not structurally reduce the improtance of the U.S. government liabilities as the key to global funding. Instead, the traditional status of the dollar as the world’s reserve currency is replaced by the U.S. Treausies’ modern function as the world’s safest asset and the pinnacle of the repo market. Lastly, I put the interactions between the Fed’s roles as the manager of the government’s debt on the one hand and monetary policy architect on the other at the center of the analysis. Recognizing the interconnectedness could deepen our understanding of the Fed’s control over U.S. Treasuries.

As a result of the Bretton Woods Agreement, the dollar was officially crowned the world’s reserve currency. Instead of gold reserves, other countries accumulated reserves of dollars, the liability of the U.S. government. Till the mid-1980s, the dollar was at the top of the monetary hierarchy in both onshore and offshore financial systems. In the meantime, the dollar’s reserve status remained in an natural way. Outside the U.S., a few large global banks were supplying dollar funding to the rest of the world. This offshore bank-oriented system was called the Eurodollar market. In the U.S., the Federal Funds market, an interbank lending market, became the pinnacle of the onshore dollar funding system. The Fed conducted a simple monetary policy, detached from the capital market, and managed exclusively within the traditional banking system.

Ultimately, events never quite followed this smooth pattern, which in retrospect may not be regretted. The growth of shadow banking system meant that international investors reduced their reliance on bank loans in the Eurodollar markte. Instead, they turned to the repo market and the FX swaps market. In the U.S., the rise of the repo market implied that the U.S. monetary policy should slowly leak into capital market and directly targe the security dealers. At the heart of this structural break was the growing acceptance of the securities as collaterals.

Classical monetary economics proved to be handicapped in detecting this architectural development. According to theories, the supply of the dollar is determined in the market for the loanable funds where large banks act as financial intermediaries and stand between savers and borrowers. In the process, they set the price of the dollar funding. Regarding the global value of the dollar, as long as the Fed’s credibility in stabilizing prices exceeds its peers, and Treasury keeps its promises to pay, the global demand for the dollar will be significant. And the dollar will maintain its world reserve currency status. These models totally overlooked the role of market-makers, also called dealers, in providing short-term liquidity. However, the rise of the shadow banking system made such an abstraction a deadly flaw. In the new structure, the dealers became the de facto providers of the dollar funding.

Shadow banking created a system where the dealers in the money market funded the securities lending activities of the security dealers in the capital market. This switch from traditional banking to shadow banking unveiled an inherent duality in the nature of the Fed. The Fed is tasked to strike a balance between two rival roles: On the one hand, the Fed is the Treasury’s banker and partially manages U.S. debt. On the other hand, it is the bankers’ bank and designs monetary policy. After the financial crises of the 1980s and 1990s, the Fed tried to keep these roles divided as separate arms of macroeconomic policy. The idea was that the links between U.S. debt management and liquidity are weak, as the money market and capital market are not interconnected parts of the financial ecosystem. This weak link allowed for greater separation between monetary policy and national debt management.

The GFC shattered this judgment and exposed at least two features of shadow banking. First, in the new structure, the monetary condition is determined in the repo market rather than the banking system. The repo market is very large and the vast majority of which is backed by U.S. Treasuries. This market finances the financial market’s primary dealers’ large holdings of fixed-income securities. Second, in the new system, U.S. Treasuries replaced the dollar. The repo instruments are essentially short-term loans secured by liquid “collateral”. Although hedge funds and other types of institutional investors are important suppliers of collateral, the single most important issuer of high quality, liquid collateral, is the U.S. Treasury.

U.S. Treasury securities have become the new dollar. Hence, its velocity began to matter. The velocity of collateral, including U.S. Treasuries, is the ratio of the total pledged collateral received by the large banks (that is eligible to be reused), divided by the primary collateral (ie, sourced via reverse repos, securities borrowing, prime brokerage, and derivative margins). Before the GFC, the use (and reuse) of pledged collateral was comparable with the velocity of monetary aggregates like M2. The “reusability” of the collateral became instrumental to overcome the good collateral deficit.

After the GFC, the velocity of collateral shrank due to the Fed’s QE policies (involving purchases of bonds) and financial regulations that restricted good collateral availability. Nontheless, the availability of collateral surpassed the importance of private credit-creation in the traditional banking system. It also started to leak into the monetary policy decision-making process as the Fed started to consider the Treasury market condition when crafting its policies. At first glance, the Treasury market’s infiltration into monetary policy indicates a structural shift in central banking. First, the Treasury market is a component of the capital market, not the money market. Second, the conventional view of the Fed’s relationship with the Treasury governs that its responsibilities are mainly limited to managing the Treasury account at the Fed, running auctions, and acting as U.S. Treasuries registrar.

However, a thorough study of the traditional monetary policy would paint a different picture of the Fed and the U.S. Treasuries. Modern finance is only making the Fed’s role as a de-facto U.S. national debt manager explicit. The Fed’s primary monetary policy tool, the open market operation, is essentially monetizing national debt. Essentially, the tool enabled the Fed to monetize some portion of the national debt to control the quantity of bank reserves. The ability to control the level of bank reserves permitted the Fed to limit the level of bank intermediation and private credit creation. This allowed the Fed to focus on compromising between two objectives of price stability and full employment.

What is less understood is that the open market operation also helped the Fed’s two roles, Treasury’s bank and the bankers’ bank, to coexist privately. As private bankers’ bank, the Fed designs monetary policy to control the funding costs. As the Treasury’s bank, the Fed is implicitly responsible for U.S. debt management. The open market operation enabled the Fed to control money market rates while monetizing some portion of the national debt. The traditional monetary system simply helped the Fed to conceal its intentions as Treasury’s bank when designing monetary policy.

The point to emphasize is that the traditional central banking was only hiding the Fed’s dual intentions. The Fed could in theory monetize anything— from gold to scrap metals—but it has stuck largely to Treasury IOUs. One reason is that, unlike gold, there has never been any shortage of them. Also, they are highly liquid so the Fed can sell them with as much ease as it buys them. But, a third, and equally important reason is that in doing so, the Fed explicitly fulfilled its “role” as the manager of the U.S. national debt. All this correctly suggests that the Fed, despite its lofty position at the pinnacle of the financial system, has always been, and is, none other than one more type of financial intermediary between the government and the banking system.

The high-level relationship between the Treasury and the Fed is “inherent” and at the heart of monetary policy. Yet, nowhere along the central banking learning curve has been a meaningful examination of the right balances between the Fed’s two roles. The big assumption has been that these functions are distinctly separated from each other. This hypothesis held in the past when the banks stood between savers and borrowers as financial intermediaries. In this pre-shadow banking world, the money market and capital market were not interconnected.

Yet, the GFC revealed that more than 85 percent of the lending was based on securities lending and other credit products, including the repo. In repo, broker-dealers, hedge funds, and banks construct short-term transactions. They put up collateral—mostly U.S. Treasury securities —with an agreement to buy them back the next day or week for slightly more, and invest the proceeds in the interim. The design and conduct of the monetary policy intimately deepened on the availability and price of the U.S. Treasuries, issues at the heart of the U.S. national debt management.

The U.S. debt management and monetary policy reunion happened in the repo market. In a sense, repo is a “reserve-less currency system,” in the global funding supply chain. It is the antithesis of the reserve currency. In traditional reserve currency, central banks and major financial institutions hold a large amount of currency to use for international transactions. It is also ledger money which indicates that the repo transactions, including the securities lending of its, are computed digitally by the broker-dealers. The repo market is a credit-based system that is a reserve-less, currency-less form of ledger money.

In this world of securities lending, which has replaced traditional bank lending, the key instrument is not the dollar but the U.S. Treasury securities that are used as collateral. The U.S. national debt is being used to secure funding for private institutional investors. Sometimes lenders repledge them to other lenders and take out repo loans of their own. And the cycle goes on. Known as rehypothecation, these transfers used to be done once or twice for each posted asset but are now sometimes done six to eight times, each time creating a new money supply. This process is the de-facto modern money creation—and equally depends on the Fed’s role as Treasury’s bank and bankers’ bank.

Understanding how modern money creation works has implications for the dollar’s status in the international monetary system. Some might argue that the dollar is losing its status as the global reserve currency. They refer to the collateralized repo market and argue that this market allows international banks operating outside the supervision of the Fed to create US dollar currency. Hence, the repo, not the dollar, is the real reserve currency. Such statements overlook the repo market’s structural reliance on the U.S. Treasury securities and neglect the Fed’s role as the de-facto manager of these securities. Shadow banking merely replaced the dollar with the U.S. Treasuries as the world’s key to funding gate. In the meantime, it combined the Fed’s two roles that used to be separate. Indeed, the shadow banking system has increased the importance of U.S. institutions.

The rising dominance of the repo market in the global funding supply chain, and the decline in collateral velocity, implies that the viability of the modern Eurodollar system depends on the U.S. government’s IOUs more than any time in history. US Treasuries, the IOU of the US government, is the most high-quality collateral. When times are good, repos work fine: The agreements expire without problems and the collateral gets passed back down the chain smoothly. But eventually, low-quality collateral lurks into the system. That’s fine, until markets hit an inevitable rough patch, like, March 2020 “Dash for Cash” episode. We saw this collateral problem in action. In March credit spreads between good and junkier debt widened and Treasury prices spiked as yields plummeted because of the buying frenzy. The interest rate on one-month Treasurys dropped from 1.61% on Feb. 18 to 0.00% on March 28. That was the scramble for good collateral. The reliance on the repo market to get funding indicates that no one will take the low-quality securities, and everyone struggles for good collateral. So whenever uncertainty is high, there will be a frenetic dash to buy Treasurys—like musical chairs with six to eight buyers eagerly eyeing one chair.

Tags Federal Reserve, Monetary Policy, Money View, Treasury Market

Elham's Money View Blog Search For Stable Liquidity Providers Series

Do Distributional Effects of Monetary Policy Passthrough Debt than Wealth?

Post author By Elham Saeidinezhad
Post date July 2, 2021

By Elham Saeidinezhad

Who has access to cheap credit? And who does not? Compared to small businesses and households, global banks disproportionately benefited from the Fed’s liquidity provision measures. Yet, this distributional issue at the heart of the liquidity provision programs is excluded from analyzing the recession-fighting measures’ distributional footprints. After the great financial crisis (GFC) and the Covid-19 pandemic, the Fed’s focus has been on the asset purchasing programs and their impacts on the “real variables” such as wealth. The concern has been whether the asset-purchasing measures have benefited the wealthy disproportionately by boosting asset prices. Yet, the Fed seems unconcerned about the unequal distribution of cheap credits and the impacts of its “liquidity facilities.” Such oversight is paradoxical. On the one hand, the Fed is increasing its effort to tackle the rising inequality resulting from its unconventional schemes. On the other hand, its liquidity facilities are being directed towards shadow banking rather than short-term consumers loans. A concerned Fed about inequality should monitor the distributional footprints of their policies on access to cheap debt rather than wealth accumulation.

Dismissing the effects of unequal access to cheap credit on inequality is not an intellectual mishap. Instead, it has its root in an old idea in monetary economics- the quantity theory of money– that asserts money is neutral. According to monetary neutrality, money, and credit, that cover the daily cash-flow commitments are veils. In search of the “veil of money,” the quantity theory takes two necessary steps: first, it disregards the payment systems as mere plumbing behind the transactions in the real economy. Second, the quantity theory proposes the policymakers disregard the availability of money and credit as a consideration in the design of the monetary policy. After all, it is financial intermediaries’ job to provide credit to the rest of the economy. Instead, monetary policy should be concerned with real targets, such as inflation and unemployment.

Nonetheless, the reality of the financial markets makes the Fed anxious about the liquidity spiral. In these times, the Fed follows the spirit of Walter Bagehot’s “lender of last resort” doctrine and facilitates cheap credits to intermediaries. When designing such measures, the Fed’s concern is to encourage financial intermediaries to continue the “flow of funds” from the surplus agents, including the Fed, to the deficit units. The idea is that the intermediaries’ balance sheets will absorb any mismatch between the demand-supply of credit. Whenever there is a mismatch, a financial intermediary, traditionally a bank, should be persuaded to give up “current” cash for a mere promise of “future” cash. The Fed’s power of persuasion lies in the generosity of its liquidity programs.

The Fed’s hyperfocus on restoring intermediaries’ lending initiatives during crises deviates its attention from asking the fundamental question of “whom these intermediaries really lend to?” The problem is that for both banks and non-bank financial intermediaries, lending to the real economy has become a side business rather than a primary concern. In terms of non-bank intermediaries, such as MMFs, most short-term funding is directed towards shadow banking businesses of the global banks. Banks, the traditional financial intermediaries, in return, use the unsecured, short-term liquidity to finance their near-risk-free arbitrage positions. In other words, when it comes to the “type” of borrowers that the financial intermediaries fund, households, and small-and-medium businesses are considered trivial and unprofitable. As a result, most of the funding goes to the large banks’ lucrative shadow banking activities. The Fed unrealistically relies on financial intermediaries to provide cheap and equitable credit to the economy. In this hypothetical world, consumers’ liquidity requirements should be resolved within the banking system.

This trust in financial intermediation partially explains the tendency to overlook the equitability of access to cheap credit. But it is only part of the story. Another factor behind such an intellectual bias is the economists’ anxiety about the “value of money” in the long run. When it comes to the design of monetary policy, the quantity theory is obsessed by the notion that the only aim of monetary theory is to explain those phenomena which cause the value of money to alter. This tension has crept inside of modern financial theories. On the one hand, unlike quantity theory, modern finance recognizes credit as an indispensable aspect of finance. But, on the other hand, in line with the quantity theory’s spirit, the models’ main concern is “value.”

The modern problem has shifted from explaining any “general value” of money to how and when access to money changes the “market value” of financial assets and their issuers’ balance sheets. However, these models only favor a specific type of agent. In this Wicksellian world, adopted by the Fed, agents’ access to cheap credit is essential only if their default could undermine asset prices. Otherwise, their credit conditions will be systemically inconsequential, hence neutral. By definition, such an agent can only be an “institutional” investor who’s big enough so that its financial status has systemic importance. Households and small- and medium businesses are not qualified to enter this financial world. The retail depositors’ omission from the financial models is not a glitch but a byproduct of mainstream monetary economics.

The point to emphasize is that the Fed’s models are inherently neutral about the distributional impacts of credit. They are built on the idea that despite retail credit’s significance for retail payment systems, their impacts on the economic transactions are insignificant. This is because the extent of retail credit availability does not affect real variables, including output and employment, as the demand for this “type” of credit will have proportional effects on all prices stated in money terms. On the contrary, wholesale credit underpin inequality as it changes the income and wealth accumulated over time and determines real economic activities.

The macroeconomic models encourage central bankers to neglect any conditions under which money is neutral. The growing focus on inequality in the economic debate has gone hand in hand to change perspective in macroeconomic modeling. Notably, recent research has moved away from macroeconomic models based on a single representative agent. Instead, it has focused on frameworks incorporating heterogeneity in skills or wealth among households. The idea is that this shift should allow researchers to explore how macroeconomic shocks and stabilization policies affect inequality.

The issue is that most changes to macroeconomic modeling are cosmetical rather than fundamental. Despite the developments, the models still examine inequality through income and wealth disparity rather than equitable access to cheap funding. For small businesses and non-rich consumers, the models identify wealth as negligible. Nonetheless, they assume the consumption is sensitive to income changes, and consumers react little to changes in the credit conditions and interest rates. Thus, in these models, traditional policy prescriptions change to target inequality only when household wealth changes.

At the heart of the hesitation to seriously examine distributional impacts of equitable access to credit is the economists’ understanding that access to credit is only necessary for the day-to-day operation of the payments system. Credit does not change the level of income and wealth. In these theories, the central concern has always been, and is, solvency rather than liquidity. In doing so, these models dismiss the reality that an agent’s liquidity problems, if not financed on time and at a reasonable price, could lead to liquidations of assets and hence insolvency. In other words, retail units’ access to credit daily affects not only the retail payments system but also the units’ financial wealth. Even from the mainstream perspective, a change in wealth level would influence the level of inequality. Furthermore, as the economy is a system of interlocking balance sheets in which individuals depend on one another’s promises to pay (financial assets), their access to funding also determines the financial wealth of those who depend on the validations of such cash commitments.

Such a misunderstanding about the link between credit accessibility and inequality is a natural byproduct of macroeconomic models that omit the payment systems and the daily cash flow requirement. Disregarding payment systems has produced spurious results about inequality. In these models, access to liquidity, and the smooth payment systems, is only a technicality, plumbing behind the monetary system, and has no “real” effects on the macroeconomy.

The point to emphasize is that everything about the payment system, and access to credit, is “real”: first, in the economy as a whole, there is a pattern of cash flows emerging from the “real” side, production and consumption, and trade. A well-functioning financial market enables these cash flows to meet the cash commitments. Second, at any moment, problems of mismatch between cash flows and cash commitments show up as upward pressure on the short-term money market rate of interest, another “real” variable.

The nature of funding is evolving, and central banking is catching up. The central question is whether actual cash flows are enough to cover the promised cash commitments at any moment in time. For such conditions to be fulfilled, consumers’ access to credit is required. Otherwise, the option is to liquidate accumulations of assets and a reduction in their wealth. The point to emphasize is that those whose access to credit is denied are the ones who have to borrow no matter what it costs. Such inconsistencies show up in the money market where people unable to make payments from their current cash flow face the problem of raising cash, either by borrowing from the credit market or liquidating their assets.

The result of all this pushing and pulling is the change in the value of financial wealth, and therefore inequality. Regarding the distributional effects of monetary policy, central bankers should be concerned about the effects of monetary policy on unequal access to credit in addition to the income and wealth distribution. The survival constraint, i.e., agents’ liquidity requirements to meet their cash commitments, must be met today and at every moment in the future.

To sum up, in this piece, I revisited the basics of monetary economics and draw lessons that concern the connection between inequality, credit, and central banking. Previously, I wrote about the far-reaching developments in financial intermediation, where non-banks, rather than banks, have become the primary distributors of credit to the real economy. However, what is still missing is the distributional effects of the credit provision rather than asset purchasing programs. The Fed tends to overlook a “distributional” issue at the heart of the credit provision process. Such an omission is the byproduct of the traditional theories that suggest money and credit are neutral. The traditional theories also assert that the payment system is a veil and should not be considered in the design of the monetary policy. To correct the course of monetary policy, the Fed has to target the recipients of credit rather than its providers explicitly. In this sense, my analysis is squarely in the tradition of what Schumpeter (1954) called “monetary analysis” and Mehrling (2013) called “Money View” – the presumption that money is not a veil and that understanding how it functions is necessary to understand how the economy works.

Tags Asset Prices, Credit, Debt, Federal Reserve, Funding Liquidity, Inequality, Monetary Policy, Money Market Fund

Elham's Money View Blog Search For Stable Liquidity Providers Series

Monetary Framework and Non-Bank Intermediaries: RIP Banking Channel?

Post author By Elham Saeidinezhad
Post date June 23, 2021

By Elham Saeidinezhad

The Fed is banking on non-bank intermediaries, such as money market funds (MMFs), rather than banks for monetary normalization. The short-term funding market reset after the famous FOMC meeting on June 16, 2021. The Fed explicitly brought forward forecasts for tighter monetary policy and boosted inflation projections. However, it is essential to understand what lies beneath the Fed’s message. Examining the “timing” of the Fed’s normalization and the primary “beneficiaries” unveils a modified FRB/US model to include the structural change in the intermediation business. Non-bank intermediaries, including MMFs, have become primary lenders in the housing market and accept deposits. In doing so, they have replaced banks as credit providers to the economy and have boosted their role in transmitting monetary policy. Following the pandemic, the timing of the Fed’s policies can be explained by the MMFs’ balance sheet problems. This shift in the Fed’s focus towards non-bank intermediaries has implications for the banks. Even though normalization tactics are universally strengthening MMFs, there are creating liability problems for the banking system.

A long-standing trend in macro-finance, the increased presence of the MMFs in the market for loanable funds, alters the Fed’s FRB/US model and informs this decision. The FRB/US model, in use by the Fed since 1996, is a large-scale model of the US economy featuring optimizing behavior by households and firms and detailed descriptions of the real economy and the financial sector. One distinctive feature of the Fed’s model compared to dynamic stochastic general equilibrium (DSGE) models is the ability to switch between alternative assumptions about economic agents’ expectations formation and roles. When it comes to the critical question of “who funds the real economy?” it is sensible to assume that non-bank financial entities, including MMFs, have replaced banks to manage deposits and lend. On their liabilities side, MMFs have become the savers’ de-facto money managers. This industry looks after $4tn of savings for individuals and businesses. On their asset sides, they have become primary lenders in significant markets such as housing, where the Fed keeps a close watch on.

Traditionally, two essential components of the FRB/US model, the financial market and the real economy, depended on the banks lending behavior. The financial sector is captured through monetary policy developments. Monetary policy was modeled as a simple rule for the federal funds rate, an interbank lending rate, subject to the zero lower bound on nominal interest rates. A variety of interest rates, including conventional 30-year residential mortgage rates, assumed to be set by the banks’ lending activities, informs the “federal funds target.” To capture aggregate economic activity, the FRB/US model assumed the level of spending in the model depends on intermediate-term consumer loan rates, again set by the banking system. The recent FOMC announcement sent a strong signal that the FRB/US model has been modified to capture the fading role of the banks in funding the economy and setting the rates.

One of the factors behind the declining role of the banking system in financing the economy is the depositors’ inclination to leave banks. Notably, most of this institutional run on the banking system is self-inflicted. After the pandemic, the Fed and government stimulus packages pointed to an influx of deposits that could enter the banking system. However, due to banks’ balance sheet constraints, managing deposits is costly for at least two reasons. First, the scarcity of balance sheet space implies banks have to forgo the more lucrative and unorthodox business opportunities if they accept deposits. Second, as the size of banks’ balance sheets increases, banks are required to hold more capital and liquid assets. Both are expensive as they reduce banks’ returns on equity. These prudential requirements are more binding for the large, cash-rich banks. Thus, post COVID-19 pandemic, cash-rich banks advised corporate clients to move money out of their firms and deposit them in MMFs. Pushing deposits into MMFs was preferable as it would reduce the size of banks’ balance sheets. The idea was that non-bank money managers, who are not under the Fed’s regulatory radar, would be able and willing to manage the liquidity.

Effectively, bankers orchestrated run on their own banks by turning away deposits. Had the Fed overlooked such “unnatural” actions by banks, they could undermine financial stability in the long run. Therefore, after the COVID-19 pandemic, the Fed expanded access to the reverse repo programs to include non-bank money managers, such as MMFs. In doing so, the Fed signaled the critical status of the MMF industry. The Fed also crafted its policies to strengthen the balance sheet of these funds. For example, Fed lifted limits on the amount of financial cash the companies could park at the central bank from $30bn to $80bn. The absence of profitable investments has compelled MMFs to use this opportunity and place more assets with the reverse repurchase program. The goal was to drain liquidity from the system, slow down the downward pressure on the short-term rates, and improve the industry’s profit margin. The Fed’s balance sheet access drove the MMFs to a higher layer of the monetary hierarchy.

The Fed might have improved the position of the MMFs in the monetary hierarchy. However, it could not expand the ability of the MMFs to invest the money fast enough. The mismatch between the size of the MMFs and the amount of liquidity in circulation created balance sheet problems for the industry. On the liabilities side, the money under management has increased dramatically as the large-scale economic stimulus from the Fed and the US government created excess demand for short-dated Treasuries and other securities. Therefore, assets in so-called government MMFs, whose investments are limited to Treasuries, jumped above $4tn for the first time. But, on the asset side, it was a shortage of profitable investments. The issue was that too much money was chasing short-term debt, just as the US Treasury started to scale back its issuance of such bills. This combination created downward pressure on the rates. The industry was not large enough to service a large amount of cash in the system under such a low-interest-rate environment.

The downward pressure on rates was intensified despite the Fed’s effort to include the MMFs in the reserve repurchase (RRP) facility. The dearth of suitable investments has compelled MMFs to place more assets with an overnight Fed facility. Yet, as the RRP facility paid no interest, it could not resolve a fundamental threat to the economics of the MMF industry, the lack of profitable investment opportunities. Once the post-pandemic monetary policy stance made the economics of the MMF industry alarmingly unsustainable, the Fed chose to start the normalization process and increase the RRP rates. The point to emphasize is that the timing of the Fed’s monetary policy normalization matches the developments in the MMF industry.

This shift in the Fed’s focus away from the banks and towards the MMFs yields mixed results for the banks, although it is unequivocally helping MMFs. First, the increase in RRP has strengthened the asset side of MMFs’ balance sheets as the policy has created a positive-yielding place to invest their enormous money under management. Second, other normalization policies, such as the rise in the federal funds rate and interest on excess reserve (IOER), are increasing rates, especially on the short-term assets, such as repo instruments. This adjustment has been critical for the smooth functioning of the MMFs as the repo rate was another staple source of income for the industry. Repo rate, the rate at which investors swap Treasuries and other high-quality collateral for cash in the repo market, had also turned negative at times. Overall, the policies that supported MMFs also improved the state of the short-term funding as the MMF industry plays a crucial role in the market for short-term funding.

The Fed policies are creating problems for the liabilities side of specific types of banks, bond-heavy banks. As Zoltan Pozsar noted, the Fed’s recent move to stimulate the economy through the RRP rate hurts banks’ liabilities. Such policies encourage large corporate clients to direct cash into MMFs. The recently generated outflow following the normalization process is being forced on both cash-rich and bond-heavy banks. This outflow is in addition to the trend above, where cash-rich banks have deliberately pushed the deposits outside their balance sheets and orchestrated the “run on their own banks.” The critical point is that while cash-rich banks’ business model encourages such outflows, they will create balance sheet crises for the bond-heavy banks, which rely on these deposits to finance their long-term securities. The Fed recognizes that bond-heavy banks can not handle the outflows. Still, the non-bank financial intermediaries have become the center of the Fed’s policies as the main financiers of the real economy.

The Fed is relying on non-bank intermediaries rather than banks for monetary normalization. To this end, the Fed has modified its FRB/US model to capture MMFs as the source of credit creation. The new signals evolve within the new monetary framework are suggesting that new identification is here to stay. First, the financial market echoed and rewarded the Fed after making such adjustments to assume financial intermediation. The market for short-term funding was reset shortly after the Fed’s announcements. The corrections in the capital market, both in stocks and bonds, were smooth as well. Second, after all, the Fed’s transition to primarily monitor MMFs balance sheet is less of a forward-looking act and more of an adjustment to a pre-existing condition. Researchers and global market-watchers are reaching a consensus that non-bank financial intermediaries are becoming the de-facto money lenders of the first resort to the real economy. Therefore, it is not accidental that the policy that restored the short-term funding market was the one that directly supported the MMFs rather than banks. Here’s a piece of good news for the Fed. Although the Fed’s traditional, bank-centric, “policy” tools, including fed funds target, are losing their grip on the market, its new, non-bank-centric “technical” tools, such as RRP, are able to restore the Fed’s control and credibility.

Tags Banks, Federal Reserve, Funding Liquidity, Monetary Policy, Money Market Fund

Elham's Money View Blog Search For Stable Liquidity Providers Series

Is Cryptocurrency Neutral?

Post author By Elham Saeidinezhad
Post date June 9, 2021

“Money is pre-eminently a sanctuary, a haven for resources that would otherwise go into more perilous uses.” Gurley and Shaw

Cryptocurrencies, which first emerged in the wake of the global financial crisis, offered a vision of “money” free from central bank and intermediaries’ control. The idea is that crypto liberates both private parties and non-major central banks from the fundamental need to be as close as possible to the Fed, the ultimate controller and issuer of the world’s means of the final settlement. In other words, crypto flattens the monetary hierarchy and creates a structural break from Money View’s claim that money is inherently hierarchical. In this essay, I argue that cryptocurrency is not flattening the “existing” monetary system. It creates a parallel, unstable monetary arrangement based on personnel, such as Elon Musk, rather than institutions, including central banks, and false economic prophecies. First, it assumes “scarcity of money” is the source of its value. Second, it “eliminates intermediaries,” such as dealers and banks, and relies on crypto exchanges that act as brokers to set prices. And third, it aims at stabilizing the crypto prices by guaranteeing “convertibility” while liberating itself from the central banks who make such guarantees possible under distress.

Crypto is built on a virtual hierarchy. When it comes to instruments, though, the system is mostly flat. Different cryptos are treated equally. Yet, it remains hierarchical when it comes to the relative position of its players. Similar to the original monetary system, different agents belong to different layers of the hierarchy. In contrast to it, a few high-net-worth individuals rather than institutions are at the top of it. However, the most fundamental problem is its economic foundations, which are mostly misguided monetary prophecies.

The Crypto market is built on weak foundations to support the “value,” “price,” and “convertibility” of the virtual currency. To preserve the value of the virtual currency, advocates often point to the limited supply of bitcoin and the mathematics which governs it in stark contrast to fiat money’s model of unlimited expansion regardless of underlying economic realities. It’s an unpopular position with Money View scholars who don’t view scarcity as a pressing issue. Instead, the fundamentals such as liquidity or convertibility determine the value of these monetary instruments. However, the convertibility guarantor of the last resort is the central bankers, who are circumvented in the crypto-mania.

The degree of liquidity or “moneyness” depends on how close these instruments are to the ultimate money or currency. Ultimately, the Fed’s unlimited power to create it by expanding its balance sheets puts the currency at the top of the hierarchy. The actual art of central banking would obviously be in response to shocks, or crises, in the financial and economic environment. During such periods, a central bank had not only to ensure its own solvency but the solvency of the entire banking system. For this reason, they had to hold disproportionate amounts of gold and currency. The point to emphasize is that while they stood ready to help other banks with cash and gold on demand, they could not expect the same service in return.

Further, central bankers’ unique position to expand their balance sheets to create reserves allow them to accommodate liquidity needs without the risk of being depleted. Yet, if a central bank had to protect itself against liquidity drain, it has tools such as discount-rate policy and open market operations. Also, central bankers in most countries can supply currency on-demand with reciprocal help from other banks. In this world, the Fed was and will remain first among equals.

The mistake of connecting the value of money to limited supply is as old as money itself. In 1911, Allyn Young made it tolerably clear that money is not primarily a thing that is valued for itself. The materials that made money, such as gold, other metals, or a computer code, are not the source of value for money. The valuable materials merely make it all the more certain that money itself may be “passed on,” that someone may always be found who is willing to take it in exchange for goods or services. The “passing on” feature becomes the hallmark of Allyn Young’s solutions to the mystery of money. Money’s value comes from holders’ willingness to pass it on, which is its purchasing power. It also depends on its ability to serve as a “standard of payment” or “standard of deferred payments.” Therefore, any commodity that serves as money is wanted, not for permanent use, but for passing on.

What differentiates the “means of payment” from the “purchasing power” functions is their sensitivity to the “macroeconomic conditions.” Inflation, an essential barometer of the economy, might deteriorate the value of the conventional monetary instruments relative to the inflation-indexed ones as it disproportionally reduces the former instruments’ purchasing power. Yet, its impact on their function as “means of payments” is less notable. For instance, we need more “currency” to purchase the same basket of goods and services when inflation is high, reducing currency’s purchasing power. Yet, even in this period, the currency will be accepted as means of payment.

Young warned against an old and widespread illusion that the government’s authority or the limited quantity gives the money its value. Half a century later, Gurley and Shaw (1961) criticized the quantity theory of money based on similar grounds. Specifically, they argued against the theory’s premise that the quantity of money determines money’s purchasing power, and therefore value. Such a misconception, emphasized in the quantity theory of money and built in the crypto architecture, can only be applied to an economic system handicapped by rigidities and irrationalities. In this economy, any increase in demand for money would be satisfied by deflation, even if it will retard the economic development rather than by growth in nominal money. Paradoxically, similar to the quantity theory of money, crypto-economics denies money a significant role in the economy. In other words, crypto-economics assumes that money, including cryptocurrency, is “neutral.”

Relying on the “neutrality” of money, and therefore scarcity doctrine, maintain value has real economic consequences. Monetary neutrality is objectionable even concerning an economy in which the neoclassical ground rules of analysis are appropriate on at least two grounds. First, the quantity theory underestimates the real impact of monetary policy in the long run. The theory ignores the effects of the central bank’s manipulation of the nominal money on permanent capital gains or losses. These capital gains and losses enduringly affect the aggregate spendings, including spending on capital and new technologies, and hence come to grips with real aspects of the economy in the long run.

Second, monetary neutrality overlooks the role of financial intermediaries in the monetary system. In this system, financial intermediaries continuously intervene in the flow of financial assets from borrowers to lenders. In addition, they regulate the rate and pattern of private financial-asset accumulation, the real quantity of money, and real balances desired, hence any demands for goods and labor that are sensitive to the real value of financial variables. In the quantity theory of money, financial intermediaries that affect wealth accumulation and the real side of the economy are reduced to a fixed variable, called the velocity.

To stabilize the prices, crypto economists rely on a common misconception that crypto exchanges set prices. Yet, by design, the crypto exchanges’ ability to set the prices and reduce their volatility is minimal. These exchanges’ business model is more similar to the functions of the brokers, who merely profit from commissions and listing fees and do not use their balance sheets to absorb market imbalances and therefore stabilize the market prices. If these exchanges acted like dealers, however, they could set the prices. But in doing so, they had to use their balance sheets and be exposed to the price risks. Given the current price volatility in the cryptocurrency market, the exchanges have no incentive to become dealers.

This dealer-free market implies that the exchange rate of a cryptocurrency usually depends on the actions of sellers and buyers. Each exchange merely calculates the price based on the supply and demand of its users. In other words, there’s no official global price. The point to emphasize is that this feature, the lack of an official “market price,” and intermediaries— banks and dealers–, is inherent in this virtual system. The absence of dealers, and other intermediaries, is a natural consequence of the virtual currency markets’ structural feature, called the decentralized finance (DeFi).

DeFi is an umbrella term for financial services offered on public blockchains. Like traditional intermediaries, DeFi allows clients to borrow, lend, earn interest, and trade assets and derivatives. This service is often used by clients seeking to use their crypto as collateral to increase their leverage and return. They borrow against their crypto holdings to place even larger bets in this market. In the process, they expose the lenders to the “credit risk.” In non-crypto segments of the financial market, credit risk can be contained either through intermediaries, including banks and dealers, or swaps. Both mechanisms are absent in the crypto market even though the risk and leverage are intolerably present.

In the market for monetary instruments, intermediation has always played a key role. The main reason for all the intermediation for any financial instrument is that the mix of securities, or IOUs, issued by funds-deficit agents is unattractive to many surplus agents. Financial intermediaries can offer such attractive securities for several reasons. First, they pool the funds of many investors in a highly diversified portfolio, thereby reducing risk and overcoming the minimum denominations problem. Second, intermediaries can manage cash flows. Intermediaries provide a reasonable safety in the payments system as the cash outflows are likely to be met by cash inflows. The cryptocurrency is not equipped to circumvent intermediaries.

Historically, major banks with their expertise in analyzing corporate and other credits were a natural for the intermediary business, both in the traditional market for loanable funds and the swaps market. The advantage of the swaps is that they are custom-tailored deals, often arranged by one or more intermediaries. Banks could with comfort accept the credit risk of dealing with many lesser credits, and at the same time, their names were acceptable to all potential swap parties. The dealers joined the banks and became the modern intermediaries in the interest rate, FX, and credit default swaps market. Similar to the banks, they transferred the risks from one party to the other and set the price of risk in the process. DeFi cuts these middlemen, and the risk-transfer mechanism, without providing an alternative.

The shapers of crypto finance also rely on “stablecoins” to resolve the issue of convertibility. Stablecoins have seen a massive surge in popularity mainly because they are used in DeFi transactions, aiming to eliminate intermediaries. They are cryptocurrencies where the price is designed to be pegged to fiat money. They are assumed to connect the virtual monetary system and the real one. The problem is that the private support to maintain this par, especially during the crisis, is too invisible to exist. Most recently, the New York Attorney General investigation found that starting no later than mid-2017, Tether, the most reliable Stablecoin, had no access to banking anywhere in the world, and so for periods held no reserves to back tethers in circulation at the rate of one dollar for every Tether.

The paradox is that the stability of the crypto market and DeFi ultimately depends on centralized finance and central bankers. Like traditional banks, DeFi applications allow users to borrow, lend, earn interest, and trade assets and derivatives, among other things. Yet, it differs from traditional banks because it is connected to no centralized system and wholesale market. Therefore, unlike banks, DeFi does not have access to the ultimate funding source, the Fed’s balance sheet. Therefore, their promises to maintain the “par” between stablecoins and fiat currencies are as unstable as their guarantors’ access to liquidity. Unless Elon Musk or other top influencers in the virtual hierarchy are willing to absorb the imbalances of the whole system into their balance sheet, the virtual currency, like the fiat one, begs for the mercy of the Fed when hit by a crisis. The question is whether Elon Musk will be willing to act as the crypto market’s lender and dealer of last resort during a crisis?

Those who have long positions in crypto and guarantee convertibility of the stablecoins, like traditional deficit agents, require constant access to the funding liquidity. Central banks’ role in providing liquidity during a crisis is central to a modern economic system and not a mere convenience to be tolerated. Further, the ongoing dilemma to maintain the “par” between deposits and currencies has made the original payment system vulnerable. This central issue is the primary justification for the existence of the intermediaries and the banks. Without fixing the “par” and “convertibility” problems, the freedom from intermediaries and central banks, which is the most ideologically appealing feature of crypto, will become its Achilles Hill. The crypto market has cut the intermediaries, including central banks, banks, and dealers, in its payment system without resolving the fundamental problems of the existing system. Unless crypto backers believe in blanket immunity to a crisis, a paradoxical position for the prodigy child of the capitalist system, crypto may become the victim of its ambitions, not unlike the tragedy of Macbeth. Mcbeth dramatizes the damaging physical and psychological effects of political ambition on those who seek power for its own sake.

Tags Cryptocurrency, Federal Reserve, Future of Money, Monetary Policy, MONEY, Money View

Elham's Money View Blog

The Paradox of the Yield Curve: Why is the Fed Willing to Flatten the Curve but Not Control It?

Post author By Elham Saeidinezhad
Post date October 1, 2020

By Elham Saeidinezhad

“From long experience, Fed technicians knew that the Fed could not control money supply with the precision envisioned in textbooks.” Marcy Stigum

In the last decade, monetary policy wrestled with the problem of low inflation and has become a tale of three cities: interest rate, asset purchasing, and the yield curve. The fight to reach the Fed’s inflation target started by lowering the overnight federal funds rate to a historically low level. The so-called “zero-lower bound restriction” pushed the Fed to alternative policy tools, including large-scale purchases of financial assets (“quantitative and qualitative easing”). This policy had several elements: first, a commitment to massive asset purchases that would increase the monetary base; second, a promise to lengthen the maturity of the central banks’ holdings and flatten the yield curve. However, in combination with low inflation (actual and expected), such actions have translated into persistently low real interest rates at both the yield curve’s long and short ends, and at times, the inversion of the yield curve. The “whatever it takes” large-scale asset purchasing programs of central banks were pushing the long-term yields into clear negative territory. Outside the U.S., and especially in Japan, central banks stepped up their fight against deflation by adopting a new policy called “Yield Curve Control,” which explicitly puts a cap on long-term rates. Even though the Fed so far resisted following the Bank of Japan’s footsteps, the yield curve control is the first move towards building a world that “Money View” re-imagines for central banking. The yield curve control embraces the “dealer of last resort” role of the Fed to increase its leverage over the yield curve, a chain of the private dealers. In the meantime, it reduces the Fed’s trace in the capital market and does not create as many dislocations in asset prices.

To understand this point, let’s start by translating monetary policy’s evolution into the language of Money View. In the traditional monetary policy, the Fed uses its control of reserve (at the top of the hierarchy of money) to affect credit expansion (at the bottom of the hierarchy). It also controls the fed funds rate (at the short end of the term structure) in an attempt to influence the bond rate of interest (at the long end). When credit is growing too rapidly, the Fed raises the federal fund’s target to impose discipline in the financial market. In standard times, this would immediately lower the money market dealers’ profit. This kind of dealer borrows at an overnight funding market to lend in the lend in term (i.e., three-month) market. The goal is to earn the liquidity spread.

After the Fed’s implementation of contractionary monetary policy, to compensate for the higher financing cost, money market dealers raise the term interest rate by the full amount (and perhaps a bit more to compensate for anticipated future tightening as well). This term-rate is the funding cost for another kind of dealer, called security dealers. Security dealers borrow from the term-market (repo market) to lend to the long-term capital market. Such operations involve the purchase of securities that requires financing. Higher funding cost implies that security dealers are willing to hold existing security inventories only at a lower price, and increasing long-term yield. This chain of events sketches a monetary policy transmission that happens through the yield curve. The point to emphasize here is that in determining the yield curve, the private credit market, not the Fed, sets rates and prices. The Fed has only some leverage over the system.

After the GFC, as the rates hit zero-lower bound, the Fed started to lose its leverage. In a very low-interest-rate condition, preferences shift in favor of money and against securities. One way to put it is that the surplus agents become reluctant to” delay settlement” and lower their credit market investment. They don’t want promises to pay (i.e., holding securities), and want money instead. In this environment, to keep making the market and providing liquidity, money market, and security dealers, who borrow to finance their short and long-term inventories, respectively, should be able to buy time. During this extended-time period, prices are pushed away from equilibrium. Often, the market makers face this kind of trouble and turn to the banks for refinancing. After GFC, however, the very low-interest rates mean that banks themselves run into trouble.

In a normal crisis, as the dealer system absorbs the imbalances due to the shift in preferences into its balance sheet, the Fed tried to do the same thing and take the problem off the balance sheet of the banking system. The Fed usually does so by expanding its balance sheet. The Fed’s willingness to lend to the banks at a rate lower than they would lend to each other makes it possible for the banks to lend to the dealers at a rate lower than they would otherwise charge. Putting a ceiling on the money rate of interest thus indirectly puts a floor on asset prices. In a severe crisis, however, this transmission usually breaks down. That is why after the GFC, the Fed used its leverage to put a floor on asset prices directly by buying them, rather than indirectly by helping the banks to finance dealers’ purchases.

The fundamental question to be answered is whether the Fed has any leverage over the private dealing system when interest rates are historically low. The Fed’s advantage is that it creates reserves, so there can be no short squeeze on the Fed. When the Fed helps the banks, it expands reserves. Hence the money supply grows. We have seen that the market makers are long securities and short cash. What the Fed does is to backstop those short positions by shorting cash itself. However, the Fed’s leverage over the private dealer system is asymmetric. The Fed’s magic mostly works when the Fed decides to increase elasticity in the credit market. The Fed has lost its alchemy to create discipline in the market when needed. When the rates are already very low, credit contraction happens neither quickly nor easily if the Fed increases the rates by a few basis points. Indeed, only if the Fed raises the rates high enough, it can get some leverage over this system, causing credit contraction. Short of an aggressive rate hike, the dealer system increases the spread slightly but not enough to not change the quantity of supplied credit. In other words, the Fed’s actions do not translate automatically into a chain of credit contraction, and the Fed does not have control over the yield curve. The Fed knows that, and that is why it has entered large-scale asset purchasing programs. But it is the tactful yet minimal purchases of long-term assets, rather than massive ones, that can restore the Fed’s control over the yield curve. Otherwise, the Fed’s actions could push the long-term rates into negative territory and lead to a constant inversion of the yield curve.

The yield curve control aims at controlling interest rates along some portion of the yield curve. This policy’s design has some elements of the interest rate policy and asset purchasing program. Similar to interest rate policy, it targets short-term interest rates. Comparable with the asset purchasing program, yield curve control aim at controlling the long-term interest rate. However, it mainly incorporates essential elements of a “channel” or “corridor” system. This policy targets longer-term rates directly by imposing interest rate caps on particular maturities. Like a “corridor system,” the long-term yield’s target would typically be set within a bound created by a target price that establishes a floor for the long-term assets. Because bond prices and yields are inversely related, this also implies a ceiling for targeted maturities. If bond prices (yields) of targeted maturities remain above (below) the floor, the central bank does nothing. However, if prices fall (rise) below (above) the floor, the central bank buys targeted-maturity bonds, increasing the demand and the bonds’ price. This approach requires the central bank to use this powerful tool tactfully rather than massively. The central bank only intervenes to purchase certain assets when the interest rates on different maturities are higher than target rates. Such a strategy reduces central banks’ footprint in the capital market and prevents yield curve inversion- that has become a typical episode after the GFC.

The “paradox of the yield curve” argues that the Fed’s hesitation to adopt the yield curve control to regulate the longer-term rates contradicts its decision to employ a corridor framework to control the overnight rate. Once the FOMC determines a target interest rate, the Fed already sets the discount rate above the target interest rate and the interest-on-reserve rate below. These two rates form a “corridor” that will contain the market interest rate; the target rate is often (but not always) set in the middle of this corridor. Open market operations are then used as needed to change the supply of reserve balances so that the market interest rate is as close as possible to the target. A corridor operating framework can help a central bank achieve a target policy rate in an environment in which reserves are anything but scarce, and the central bank has used its balance sheet as a policy instrument independent of the policy interest rate.

In the world of Money View, the corridor system has the advantage of enabling the Fed to act as a value-based dealer, or as Mehrling put it, “dealer of last resort,” without massively purchasing assets and constantly distorting asset prices. The value-based dealer’s primary role is to put a ceiling and floor on the price of assets when the dealer system has already reached their finance limits. Such a system can effectively stabilize the rate near its target. Stigum made clear that standard economic theory has no perfect answer to how the Fed gets leverage over the real economy. The question is why the Fed is willing to embrace the frameworks that flatten the yield curve and reduce its influence. In the meantime, it is hesitant to adopt the “yield curve control,” even though this framework boosts the Fed’s leverage by empowering the Fed to set an explicit cap on longer-term rates.

Tags Banks, Dealers, Federal Reserve, Monetary Policy, Money View, Yield Curve

Elham's Money View Blog

Is the New Chapter for the Monetary Policy Framework Too Old To Succeed?

Post author By Elham Saeidinezhad
Post date September 14, 2020

By Elham Saeidinezhad

Bagehot, “Money does not manage itself.”

In this year’s Jackson Hole meeting, the Fed announced a formal shift away from previously articulated longer-run inflation objective of 2 percent towards achieving inflation that averages 2 percent over time. The new accord aims at addressing the shortfalls of the low “natural rate” and persistently low inflation. More or less, all academic debates in that meeting were organized as arguments about the appropriate quantitative settings for a Taylor rule. The rule’s underlying idea is that the “market” tends to set the nominal interest rate equal to the natural rate plus expected inflation. The Fed’s role in this equation is to reduce or increase this market rate by changing the short-term federal funds rate whenever the inflation deviates from the target. The goal is to stabilize the long-run inflation. The Fed believes that the recent secular decline in natural rates relative to the historical average has constrained the power of the federal funds rate to achieve this mandate. The expectation is that the Fed’s decision to tolerate a temporary overshooting of the longer-run inflation to keep inflation and inflation expectations centered on 2 percent following periods when inflation has been persistently below 2 percent will address the framework’s constant failure and restore the magic of central banking. However, the ongoing issue with the Taylor rule-based monetary policy frameworks, including the recent one, is that they require the Fed to overlook the trends in the credit market, and only focus on the developments in the real economy, such as inflation or past inflation deviations, when setting the short-term interest rates. Rectifying such blind spots is what money view scholars were hoping for when the Fed announced its intention to review the monetary policy framework.

The logic behind the new framework, known as the average inflation targeting strategy, is that inflation undershooting makes achieving the target unlikely in the long run as it pushes the inflation expectations below the target. This being the case, when there is a long period of inflation undershooting the target, the Fed should act to undo the undershooting by overshooting the target for some time. The Fed sold forecast (or average) targeting to the public as a better way of accomplishing its mandate compared to the alternative strategies as the new framework makes the Fed more “history-dependent.” Translated into the money view language, however, the new inflation-targeting approach only delays the process of imposing excessive discipline in the money market when the consumer price index rises faster than the inflation target and providing excessive elasticity when prices are growing slower than the inflation target.

From the money view perspective, the idea that the interest rate should not consider private credit market trends will undermine central banking’s power in the future, as it has done in the past. The problem we face is not that the Fed failed to follow an appropriate version of Taylor rule. Rather, and most critically, these policies tend to abstract from the plumbing behind the wall, namely the payment system, by disregarding the credit market. Such a bias may have not been significant in the old days when the payment system was mostly a reserve-based system. In the old world, even though it was mostly involuntarily, the Fed used to manage the payment system through its daily interventions in the market for reserves. In the modern financial system, however, the payment system is a credit system, and its quality depends on the level of elasticity and discipline in the private credit market.

The long dominance of economics and finance views imply that modern policymakers have lost sight of the Fed’s historical mission to manage the balance between discipline and elasticity in the payment system. Instead of monitoring the balance between discipline and elasticity in the credit market, the modern Fed attempts to keep the bank rate of interest in line with an ideal “natural rate” of interest, introduced by Knut Wicksell. In Wicksellians’ world, in contrast to the money view, securing the continuous flow of credit in the economy through the payment system is not part of the Fed’s mandate. Instead, the Fed’s primary function is to ensure it does not choose a “money rate” of interest different from the “natural rate” of interest (profit rate capital). If lower, then the differential creates an incentive for new capital investment, and the new spending tends to cause inflation. If prices are rising, then the money rate is too low and should be increased; if prices are falling, then the money rate is too high and should be decreased. To sum up, Wicksellians do not consider private credit to be intrinsically unstable. Inflation, on the other hand, is viewed as the source of inherent instability. Further, they see no systemic relation between the payment system and the credit market as the payment system simply reflects the level of transactions in the real economy.

The clash between the standard economic view and money view is a battle between two different world views. Wicksell’s academic way of looking at the world had clear implications for monetary policy: set the money rate equal to the natural rate and then stand back and let markets work. Unfortunately, the natural rate is not observable, but the missed payments and higher costs of borrowing are. In the money view perspective, the Fed should use its alchemy to strike a balance between elasticity and discipline in the credit market to ensure a continuous payment system. The money view barometer to understand the credit market cycle is asset prices, another observable variable. Since the crash can occur in commodities, financial assets, and even real assets, the money view does not tell us which assets to watch. However, it emphasizes that the assets that are not supported by a dealer system (such as residential housing) are more vulnerable to changes in credit conditions. These assets are most likely to become overvalued on the upside and suffer the most extensive correction on the downside. A central bank that understands its role as setting interest rates to meet inflation targets tends to exacerbate this natural tendency toward instability. These policymakers could create unnaturally excessive discipline when credit condition is already tight or vice versa while looking for a natural rate of interest.

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Tags Credit, Federal Reserve, Inflation, Monetary Policy, Money View

Elham's Money View Blog

Is Monetary Policy Divorcing from Money Market and Uniting with Capital Market?

Post author By Elham Saeidinezhad
Post date August 28, 2020

By Elham Saeidinezhad

“The pronouncements and actions of the Federal Reserve Board on monetary policy are a charade.” Fischer Black

As the US Department of Treasury builds the points along the yield curve, the bank reserves are losing relevance in explaining short-term money market rates’ behavior. Central banks assume that they can create a close link between the best form of money (reserve) and monetary policy. They use the supply of reserves precisely to achieve the target interest rate. Since the 2008-09 Great Financial Crisis (GFC), however, the relationship between money and monetary policy has become unstable. After the COVID-19 pandemic, for instance, the Fed’s actions more than doubled the supply of bank reserves, from approximately $1.5 trillion in March to more than $3 trillion in June. In theory, such a massive increase in the supply of reserves should reduce the money market rates. Yet, short-term money market rates have been surprisingly steady, despite the enormous increase in reserves during the great lockdown. Fed economists recognize the over-supply of short-term US Treasury bills (a money market instrument) as the leading cause of the puzzling behavior in money market rates and call it “friction.”

However, for the Money View scholars, dividing the money market from the capital market, assuming that prices in each market are solely determined by its supply and demand flow, has never been an effective way of understanding interest rates. In the Money View world, similar to Fischer Black’s CAPM, the arbitrage condition implies that both the quantity and the price of money are ultimately determined by private dealers borrowing and lending activities that connect different markets rather than the stance of monetary policy alone. Dealers engage in “yield spread arbitrage,” in which they identify apparent mispricing (i.e., temporary fluctuations in supply or demand) at one segment of the yield curve, and takes a position. Dealers take “positions,” which means they speculate on how prices of assets with similar risk structure but different term-to-maturity, will change. In the meantime, they hedge interest rate exposures by taking an opposite position at another segment of the yield curve.

The point to emphasize is that short-term money markets and long-term capital markets are, in fact, not separate. As a result, prices in each market are not solely determined by the flow of supply and demand in that particular market. By taking advantage of the arbitrage opportunity, the dealers act as “porters” of liquidity from one market to another and connect prices in different markets in the process. The instruments that allow the dealers to transfer liquidity and solidify markets are repos and reverse repos, where capital market assets are used as collaterals to borrow from the money market, or vice versa. The Money View’s strength in understanding price dynamics comes from its ability, and willingness, to understand the dealers whose business connects different points of the yield curve and determines the effectiveness of the monetary policy.

During the COVID-19 pandemic, two separate but equally essential developments (aka distortions) occurred along the yield curve. In the long-term capital market, the Treasury has introduced a new class of safe assets, a 20-year Treasury bond, with a high yield (corresponding to the lowest accepted bid price) of 1.22 percent. Effectively, the US Treasury added a new point to the long-term end of the yield curve. In the short-term money market, the Fed injected a massive amount of reserves to reduce money market rates. The standard view suggests that such an increase in the supply of reserves would reduce the money market rates. The idea is that banks are the only institutions that hold these extra reserves. Due to balance sheet constraints, such as banks’ regulatory requirements, higher reserve holding implies higher banks’ costs. Therefore, banks reduce their short-term rates to signal their willingness to lend. In practice, however, short-term rates remained unchanged.

This dynamic in money market rates can be explained by the recent developments in the Treasury market, a segment of the capital market, and actions of the dealers who took advantage of the consequent arbitrage opportunity along the yield curve, i.e., the high spread between the short-term money market and the long-term risk-free Treasury rates. The dealers increased demand in the short-term money market both for hedging, and financing the newly issued Treasury bonds, put upward pressure on short-term rates. In contrast, the Fed’s activities put downward pressure on these rates. Observe that an increase in private demand for short-term funding (due to yield spread arbitrage) and an increase in the supply of reserves by the Fed (due to monetary policy) have opposing effects on short-term rates. Thus, it should not be surprising that despite the excessive reserve supply after the pandemic, the money market rates have remained stable. Understanding this kind of arbitrage along the yield curve is essential in understanding the behavior of short-term rates and the monetary policy’s effectiveness.

What is missing in this literature, but emphasized in the Money View framework, is acknowledging the hybridity between the money market and the capital market. The close link between the US Treasury market and the money market is a feature of the shadow banking or the new market-based finance. It is no friction. More importantly, the dealers’ search for “arbitrage” opportunities implies that individual securities markets are not separate. Speculators are joining the different markets into a single market. In doing so, they bring about a result that is no part of their intention, namely liquidity. As the Treasury creates an additional risk-free, liquid, point along the yield curve, it creates more arbitrage opportunities. Such developments make the yield curve an even more critical tool of examining the monetary policy effects. In the meantime, the traditional framework of supply and demand for bank reserves to control the short-term money market rate is losing its pertinence.

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Tags Banks, COVID-19, Dealers, Monetary Policy, Money View, Shadow Bnaking

Elham's Money View Blog Search For Stable Liquidity Providers Series

Can Central Bank Digital Currency Contain COVID-19 Crisis by Saving Small Businesses?

Post author By Elham Saeidinezhad
Post date April 24, 2020

By Elham Saeidinezhad and Jack Krupinski

This Piece Is Part of the “Search For Stable Liquidity Providers” Series. It is also a follow up to our previous Money View article on the banking system during the COVID-19 crisis.

The COVID-19 crisis created numerous financial market dislocations in the U.S., including in the market for government support. The federal government’s Paycheck Protection Program offered small businesses hundreds of billions of dollars so they could keep paying employees. The program failed to a great extent. Big companies got small business relief money. The thorny problem for policymakers to solve is that the government support program is rooted in the faith that banks are willing to participate in. Banks were anticipated to act as an intermediary and transfer funds from the government to the small businesses. Yet, in the modern financial system, banks have already shifted gear away from their traditional role as a financial intermediary between surplus and deficit agents. Part l used the “Money View” and a historical lens to explain why banks are reluctant to be financial intermediaries and are more in tune with their modern function as dealers in the wholesale money markets. In Part ll, we are going to propose a possible resolution to this perplexity. In a monetary system where banks are not willing to be financial intermediaries, central banks might have to seriously entertain the idea of using central bank digital currency (CBDC) during a crisis. Such tools enable central banks to circumvent the banking system and inject liquidity directly to those who need it the most, including small and medium enterprises, who have no access to the capital market.

The history of central banking began with a simple task of managing the quantity of money. Yet, central bankers shortly faced a paradox between managing “survival constraint” in the financial market and the real economy. On the one hand, for banks, the survival constraint in the financial market takes the concrete form of a “reserve constraint” because banks settle net payments using their reserve accounts at the central bank. On the other hand, according to the monetarist idea, for money to have a real purchasing power in terms of goods and services, it should be scarce. Developed by the classical economists in the nineteenth and early twentieth centuries, the quantity theory of money asserted that the quantity of money should only reflect the level of transactions in the real economy.

The hybridity between the payment system and the central bank money created such a practical dilemma. Monetarist idea disregarded such hybridity and demanded that the central bank abandon its concern about the financial market and focus only on controlling the never-materializing threat of inflation. The monetarist idea was doomed to failure for its conjectures about the financial market, and its illusion of inflation. In the race to dominate the whole economy, an efficiently functioning financial market soon became a pre-condition to economic growth. In such a circumstance, the central bank must inject reserves or else risk a breakdown of the payments system. Any ambiguity about the liquidity problems (the survival constraint) for highly leveraged financial institutions would undermine central banks’ authority to maintain the monetary and financial stability for the whole economy. For highly leveraged institutions, with financial liabilities many times larger than their capital base, it doesn’t take much of a write-down to produce technical insolvency.

This essential hybridity, and the binding reality of reserve constraint, gave birth to two parallel phenomena. In the public sphere, the urge to control the scarce reserves originated monetary policy. The advantage that the central bank had over the financial system arose ultimately from the fact that a bank that does not have sufficient funds to make a payment must borrow from the central bank. Central bankers recognized that they could use this scarcity to affect the price of money, the interest rate, in the banking system. It is the central bank’s control over the price and availability of funds at this moment of necessity that is the source of its control over the financial system. The central bank started to utilize its balance sheet to impose discipline when there was an excess supply of money, and to offer elasticity when the shortage of cash is imposing excessive discipline. But ultimately central bank was small relative to the system it engages. Because the central bank was not all-powerful, it must choose its policy intervention carefully, with a full appreciation of the origins of the instability that it is trying to counter. Such difficult tasks motivated people to call central banking as the “art,” rather than the “science”.

In the private domain, the scarcity of central bank money significantly increased the reliance on the banking system liabilities. By acting as a special kind of intermediary, banks rose to the challenge of providing funding liquidity to the real economy. Their financial intermediation role also enabled them to establish the retail payment system. For a long time, the banking system’s major task was to manage this relationship between the (retail) payment system and the quantity of money. To do so, they transferred the funds from the surplus agents to the deficit agents and absorbed the imbalances into their own balance sheets. To strike a balance between the payment obligations, and the quantity of money, banks started to create their private money, which is called credit. Banks recognized that insufficient liquidity could lead to a cascade of missed payments and the failure of the payment system as a whole.

For a while, banks’ adoption of the intermediary role appeared to provide a partial solution to the puzzle faced by the central bankers. Banks’ traditional role, as a financial intermediary, connected them with the retail depositors. In the process, they offered a retail payment- usually involve transactions between two consumers, between consumers and small businesses, or between two small to medium enterprises. In this brave new world, managing the payment services in the financial system became analogous to the management of the economy as a whole.

Most recently, the COVID-19 crisis has tested this partial equilibrium again. In the aftermath of the COVID-19 outbreak, both the Fed and the U.S. Treasury coordinated their fiscal and monetary actions to support small businesses and keep them afloat in this challenging time. So far, a design flaw at the heart of the CARES Act, which is an over-reliance on the banking system to transfer these funds to small businesses, has created a disappointing result. This failure caught central bankers and the governments by surprise and revealed a fatal flaw in their support packages. At the heart of this misunderstanding is the fact that banks have already switched their business models to reflect a payment system that has been divided into two parts: wholesale and retail. Banks have changed the gear towards providing wholesale payment-those made between financial institutions (e.g., banks, pension funds, insurance companies) and/or large (often multinational) corporations- and away from retail payment. They are so taken with their new functions as dealers in the money market and originators of asset-backed securities in the modern market-based finance that their traditional role of being a financial intermediary has become a less important part of their activities. In other words, by design, small businesses could not get the aid money as banks are not willing to use their balance sheets to lend to these small enterprises anymore.

In this context, the broader access to central bank money by small businesses could create new opportunities for retail payments and the way the central bank maintains monetary and financial stability. Currently, households and (non-financial) companies are only able to use central bank money in the form of banknotes. Central bank digital currency (CBDC) would enable them to hold central bank money in electronic form and use it to make payments. This would increase the availability and utility of central bank money, allowing it to be used in a much more extensive range of situations than physical cash. Central bank money (whether cash, central bank reserves or potentially CBDC) plays a fundamental role in supporting monetary and financial stability by acting as a risk-free form of money that provides the ultimate means of settlement for all payments in the economy. This means that the introduction of CBDC could enhance the way the central bank maintains monetary and financial stability by providing a new form of central bank money and new payment infrastructure. This could have a range of benefits, including strengthening the pass-through of monetary policy changes to the broader economy, especially to small businesses and other retail depositors, and increasing the resilience of the payment system.

This increased availability of central bank money is likely to lead to some substitution away from the forms of payment currently used by households and businesses (i.e., cash and bank deposits). If this substitution was extensive, it could reduce the reliance on commercial bank funding, and the level of credit that banks could provide as CBDC would automatically give access to central bank money to non-banks. This would potentially be useful in conducting an unconventional monetary policy. For example, the COVID-19 precipitated increased demand for dollars both domestically and internationally. Small businesses in the U.S. are increasingly looking for liquidity through programs such as the Paycheck Protection Program Liquidity Facility (PPPLF) so that those businesses can keep workers employed. In the global dollar funding market, central banks swap lines with the Fed sent dollars into other countries, but transferring those dollars to end-users would be even easier for central banks if they could bypass the commercial banking system.

Further, CBDC can be used as intraday liquidity by its holders, whereas liquidity-absorbing instruments cannot achieve the same, or can do so only imperfectly. At the moment, there is no other short-term money market instrument featuring the liquidity and creditworthiness of CBDC. The central bank would thus use its comparative advantage as a liquidity provider when issuing CBDC. The introduction of CBDC could also decrease liquidity risk because any agent could immediately settle obligations to pay with the highest form of money.

If individuals can hold current accounts with the central bank, why would anyone hold an account with high st commercial banks? Banks can still offer other services that a CBDC account may not provide (e.g., overdrafts, credit facilities, etc.). Moreover, the rates offered on deposits by banks would likely increase to retain customers. Consumer banking preferences tend to be sticky, so even with the availability of CBDC, people will probably trust the commercial banking system enough to keep deposits in their bank. However, in times of crisis, when people flee for the highest form of money (central bank money), “digital runs” on banks could cause problems. The central bank would likely have to increase lending to commercial banks or expand open market operations to sustain an adequate level of reserves. This would ultimately affect the size and composition of balance sheets for both central banks and commercial banks, and it would force central banks to take a more active role in the economy, for better or worse.

As part 1 pointed out, banks are already reluctant to play the traditional role of financial intermediary. The addition of CBDC would likely cause people to substitute away from bank deposits, further reducing the reliance on commercial banks as intermediaries. CBDC poses some risks (e.g., disintermediation, digital bank runs, cybersecurity), but it would offer some new channels through which to conduct unconventional monetary policy. For example, the interest paid on CBDC could put an effective floor on money market rates. Because CBDC is risk-free (i.e., at the top of the money hierarchy), it would be preferred to other short-term debt instruments unless the yields of these instruments increased. While less reliance on banks by small businesses would contract bank funding, banks would also have more balance sheet freedom to engage in “market-making” operations, improving market liquidity. More importantly, it creates a direct liquidity channel between the central banks, such as the Fed, and non-bank institutions such as small and medium enterprises. Because central banks need not be motivated by profit, they could pay interest on CBDC without imposing fees and minimum balance requirements that profit-seeking banks employ (in general, providing a payment system is unprofitable, so banks extort profit wherever possible). In a sense, CBDC would be the manifestation of money as a public good. Everyone would have ready access to a risk-free store of value, which is especially relevant in the uncertain economic times precipitated by the COVID-19.

Tags Banks, COVID-19, Digital Currency, Federal Reserve, Monetary Policy, Money View

Elham's Money View Blog

Is Monetary System as Systemic and International as Coronavirus?

Post author By Elham Saeidinezhad
Post date March 17, 2020

This piece was originally part of “Special Edition Roundtable: Money in the Time of Coronavirus” by JustMoney.org platform.

By Elham Saeidinezhad

The coronavirus crisis has sparked different policy responses from different countries. The common thread among these reactions is that states are putting globalization on pause. Yet, re-establishment of central bank swap lines is making “money,” chiefly Eurodollars, the first element that has become more global in the wake of the Coronavirus outbreak. This is not an unexpected phenomenon for those of us who are armed with insights from the Perry Mehrling’s “Money View” framework. The fact that the monetary system is inherently international explains why the Fed reinstalled its standing U.S. dollar liquidity swap line arrangements with five other central banks just after it lowered its domestic federal fund’s target to zero percent. However, the crisis also forces us to see global dollar funding from a lens closer to home: the fact that the Eurodollar market, at its core, is a domestic macro-financial linkage. In other words, its breakdown is a source of systemic risk within communities as it disrupts the two-way connection between the real economy and the financial sector. This perspective clarifies the Fed’s reactions to the crisis in hand. It also helps us understand the recent debate in the economics profession about the future of central bank tools.

The Great Financial Crisis of 2008-09 confirmed the vital importance of advancing our understanding of macro-financial linkages. The Coronavirus crisis is testing this understanding on a global scale. Most of the literature highlights the impact of sharp fluctuations in long-term fundamentals such as asset prices and capital flows on the financial positions of firms and the economy. In doing so, economists underestimate the effects of disturbances in the Eurodollar market, which provides short-term dollar funding globally, on real economic activities such as trade. These miscalculations, which flow from economists’ natural approach to money as a veil over the real economy, could be costly. Foreign banks play a significant role in the wholesale Eurodollar market to raise US dollar financing for their clients. These clients, usually multinational corporations, are part of a global supply chain that covers different activities from receiving an order to producing the final goods and services. Depending on their financial positions, these firms either wish to hold large dollar balances or receive dollar-denominated loans. The deficit firms use the dollar funding to make payments for their purchases. The surplus firms, on the other hand, expect to receive payments in the dollar after selling their products. The interconnectedness between the payment system and global supply chains causes the Eurodollar market to act as a bridge between the real economy and the financial sector.

The Coronavirus outbreak is putting a strain on this link, both domestically and globally: it is disrupting the supply chain, forcing every firm along the chain to become a deficit agent in the process. The supply chain moves products or services from one supplier to another and is essentially the sum of all firms’ sales. These sales (revenues) are, in effect, a measure of payments, the majority of which occur in the Eurodollar market. A sharp shock to sales, as a result of the outbreak, precipitates a lower ability to make payments. When an output is not being shipped, a producer of final goods in China does not have dollar funding to pay the suppliers of intermediate products. As a result, firms in other countries do not have dollars either. The trauma that the coronavirus crisis injects into manufacturing and other industries thus lead to missed payments internationally. Missed payments will make more firms become deficit agents. This includes banks, which are lower down in the hierarchy, and the central banks, which are responsible for relaxing the survival constraints for the banking system. By focusing on the payments system and Eurodollar market, we are able to see the “survival constraint” in action.

The question for monetary policy is how far central banks decide to relax that survival constraint by lowering the bank rate. This is why central banks, including the Fed, are reducing interest rates to zero percent. However, the ability to relax the survival constraint for banks further down in the hierarchy depends also on the strength of foreign central banks to inject dollar funding into their financial system. The Fed has therefore re-established the dollar swap line with five other major central banks. The swap lines are available standing facilities and serve as a vital liquidity backstop to ease strains in global funding markets. The point to hold on to here is that the U.S. central bank is at a level in the hierarchy above other central banks

Central banks’ main concern is about missed payments of U.S. dollars, as they can deal with missed payments in local currency efficiently. In normal circumstances, the fact that non-U.S. central banks hold foreign exchange reserves enables them to intervene in the market seamlessly if private FX dealers are unable to do so. In these periods, customer-led demand causes some banks to have a natural surplus position (more dollar deposits than loans) and other banks to have an inherent deficit position (more dollar loans than deposits). FX dealers connect the deficit banks with the surplus banks by absorbing the imbalances into their balance sheets. Financial globalization has enabled each FX dealer to resolve the imbalance by doing business with some U.S. banks, but it seems more natural all around for them to do business with each other. During this crisis, however, even U.S. banks have started to feel the liquidity crunch due to the negative impacts of the outbreak on financial conditions. When U.S. banks pull back from market-making in the Eurodollar market, there will be a shortage of dollar funding globally. Traditionally, in these circumstances, foreign central banks assume the role of the lender of last resort to lend dollars to both banks and non-banks in their jurisdiction. However, the severity of the Coronavirus crisis is creating a growing risk that such intermediation will fracture. This is the case as speculators and investors alike have become uncertain of the size of foreign central banks’ dollar reserve holding.

To address these concerns, the Fed has re-established swap lines to lend dollars to other central banks, which then lend it to banks. These particular swap lines arrangements were originally designed to help the funding needs of banks during 2008. However, these swap lines might be inadequate to ease the tension in the market. The problem is that the geographic reach of the swap lines is too narrow. The Fed has swap lines only with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank. The reason is that the 2008-09 financial crisis affected many banks in these particular jurisdictions severely and their economies were closely intertwined with the US financial system. But the breadth of the current crisis is more extensive as every country along the supply chain is struggling to get dollars. In other words, the Fed’s dollar swap lines should become more global, and the international hierarchy needs to flatten.

To ease the pressure of missed payments internationally, and prevent the systemic risk outbreak domestically, the Fed and its five major central bank partners have coordinated action to enhance the provision of liquidity via the standing U.S. dollar liquidity swap line arrangements. These tools help to mitigate the effects of strains on the supply chain, both domestically and abroad. Such temporary agreements have been part of central banks’ set of monetary policy instruments for decades. The main lessons from the Coronavirus outbreak for central bank watchers is that swap lines and central bank collaborations are here to stay – indeed, they should become more expansive than before. These operations are becoming a permanent tool of monetary policy as financial stability becomes a more natural mandate of the central banks. As Zoltan Pozsar has recently shown, the supply chain of goods and services is the reverse of the dollar funding payment system. Central banks’ collaboration prevents this hybridity from becoming a source of systemic risk, both domestically and internationally.

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Update: On March 19, 2020, the Fed announced the establishment of temporary U.S. dollar liquidity arrangements with other central banks such as Reserve Bank of Australia, the Banco Central do Brasil, the Danmarks Nationalbank (Denmark), the Bank of Korea, the Banco de Mexico, the Norges Bank (Norway), the Reserve Bank of New Zealand, the Monetary Authority of Singapore, and the Sveriges Riksbank (Sweden).

Tags Banks, COVID-19, Federal Reserve, Monetary Policy, Payment System