On March 26, I wrote the following on the issue of how the Fed will raise rates:
This is a subject that I have been ranting about for months. The mainstream media has avoided it assiduously in spite of me constantly haranguing various Fed reporters about it. Now that Spicer has broken the story, the floodgates will open. You can be sure that the Wall Street Journal’s Jon Hilsenrat will be on it like a fly on horseshit to get all the credit for it next week. He’ll report the Fed authorized, whitewashed, rubber stamped, and promoted version of the story.
My timing was off by just a week. Hilsy was out today with a WSJ blog post that reports but, as predicted, soft pedals, the issue.
Minutes released by the Federal Reserve of its March policy meeting were a reminder that the central bank could face real operational challenges when it decides to start raising short-term interest rates.
I’ll say. Their unconventional tools of increasing IOER, or RRP and TDF, won’t work because they will pay an additional subsidy to the banks, increasing their income and reducing their cost of funds. ‘Splain to me again how that will induce them to raise rates.
As part of its bond-buying programs, the Fed has flooded the banking system with $2.7 trillion of funds known as reserves. Bank reserves are like a dollar in your pocket – they pay no interest.
Come on Jonny Boy. You know that’s not true. You know that the Fed is paying interest on those balances. The media even coined an acronym, IOER. And it’s coming right out of taxpayer pockets because it reduces the surplus interest income the Fed recieves which it returns to the Treasury.
This abundance of funds is a giant weight keeping short-term interest rates near zero. When it comes time to raise interest rates the Fed will need to either a) eliminate those reserves or b) pay a higher interest rate than zero to private financial institutions in exchange for them. The Fed has chosen the latter route for the early stages of the rate hike cycle, but the minutes showed Fed officials are still struggling to define the tools they’ll use to pull this off.
Because they KNOW, but are not saying, that paying interest to the banks won’t induce the banks to raise rates. Au contraire.
Paying higher rates to banks is simple since they have accounts with the Fed. But the reserves seep out of the banking system into other financial institutions like money market mutual funds and officials are reluctant to use a new instrument – overnight reverse repo trades – designed to manage rates outside of the banking system. Last September they set a $300 billion cap on these trades. In March they agreed they might need to ignore their own cap, according to the minutes.
This is laughable gibberish. Reserves do not “seep out of the banking system.” They are cash assets on the books of the commercial banking system. They can move from bank to bank, but like the Hotel California, they can’t leave unless the Fed extinguishes them. The only way to do that is for the Fed to sell assets. That results in the liquidation of the reserve deposits on the Fed’s balance sheet as the banks exchange their cash for the paper which the Fed sells to them.
Fed officials also entertained ways to eliminate reserves more quickly than planned, including by selling some securities before they mature or allowing some to mature without reinvesting the proceeds. It is striking that they discussed new strategies for eliminating reserves at the March meeting.
Dude! They discussed it in January! Did you not read those minutes. They had pages of discussion on it. No one in the mainstream media reported it. Not you. Not anyone. Just one crazy, lone, independent analyst, waving his fist at the sky in a raging lightning storm. Everybody else just played through, as if the sun were shining, no thunder crashing around them.
For months it had sounded like Fed officials were settled on their plans on this front – no asset sales and continued reinvestment of proceeds from maturing securities until after the Fed had already started raising rates. Now they don’t sound so sure about that strategy. “A number of participants suggested that it would be useful to consider specific plans for these and other details of policy normalization under a range of post-liftoff scenarios,” the minutes said.
This is where I get to say I told you so. I said that you’ll know the Fed is serious about raising rates when they start floating trial balloons about shrinking the balance sheet. Because that’s the only way they can get rates to go up.
For years, Fed officials have sought to reassure the public that they had all the tools they would need to raise interest rates when the time came, even with all of these reserves in the banking system. The minutes show that even now the mechanics of how they’ll do this are very much a work in progress, and a possible source of market uncertainty as the Fed looks toward rate increases later this year.
The truth is that they know that their “unconventional tools” won’t work. They need to start shedding assets. Whether they do that by allowing them to run off or selling is the question. My guess is that allowing paper to mature won’t have much effect initially. They would need to start selling assets. There are those who would argue that that will never happen because markets would disintegrate. They may be correct. Will the Fed be willing to test that?
From March 17-
And the February 18 video.