Money Market Fund – Love Thinking about Finance, Monetary Economics, and Money View

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.

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.