US financial system flooded with Fed money

The magnitude of the wave of money surging through the US financial system resulting from the Fed’s ongoing massive purchases of financial assets, at an annual rate of more than $1.4 trillion, was underscored last week.

Last Thursday it was revealed that a facility for money market funds to place their excess cash with the Fed stood at $485.3 billion, an all-time high that eclipsed the previous record high of $474 billion. $6 billion recorded on New Year’s Eve in 2015.

The parking of nearly half a trillion dollars with the Fed at zero rate was the result of short-term Treasury yields falling below zero. The yield on short-term Treasury debt moved into negative territory because the price of the assets was pushed so high that an investor would suffer a loss if they held them to maturity.

Treasuries with maturities of less than a month were trading at yields between minus 0.01 and 0.02 points, making the Fed’s reverse repurchase program (RRP) the better option.

John Canavan, an analyst at Oxford Economics, told the FinancialTimes (FT): “The increase in demand for Fed RRP operations has been incredible. It’s not over either. »

Gennadiy Goldberg, senior analyst at TD Securities in New York, said the RRP facility was “the only safety valve” for the pressure building up in money markets and “simply held back the flood of liquidity ahead”.

The central role of the Fed in money market operations was highlighted by Priya Misra, global head of rate strategy at TD Securities.

“The Fed’s role in the markets is only growing,” she told the FT. “It is clear that the market does not work on its own.”

A major element of the massive accumulation of dollars in the money markets is the Fed’s $120 billion-a-month asset purchase program, including $80 billion in government debt and $40 billion in backed securities. to mortgages, which was implemented after the market collapsed in March 2020 at the start of the COVID-19 pandemic.

There is now mounting pressure on the Fed to start scaling back its asset purchases in an attempt to restore some degree of “normalcy” to financial markets. Rising inflation is adding to that pressure, but at this point the Fed insists its extraordinary interventions will continue until it begins to see a “substantial improvement” in the economic outlook.

Critics of this position argue that this improvement is already visible as evidenced by rising inflation and a tightening labor market. They warn that if the Fed continues with its current policies, it will be forced to tighten the monetary brakes, causing a crisis in financial markets and possibly triggering a recession.

Although some Fed officials have called for opening a discussion on halting asset purchases – the so-called “stall” – the majority still believe that the effects of the inflation are “transient” and that the labor market has not fully recovered with employment. numbers still 8.2 million lower than they were before the pandemic hit.

The fear is that, such is the reliance of financial markets on the supply of cheap money, tapering will trigger significant turbulence.

Commenting on the surge in money, Subadra Rajappa, strategist at French financial firm Societe Generale, said: “I don’t think the cut is going to solve this problem. Tapering will only add to the confusion. If they reduce their asset purchases, it will upset global markets.

This fear is fueled by experience. In 2013, there was severe turmoil in global markets when then-Fed Chairman Ben Bernanke suggested that the central bank might begin to “reduce” post-crisis financial asset purchases. world of 2008.

More recently, at the end of 2018, the stock market experienced a major downturn – the worst December since the depths of the 1931 depression – in response to indications from Fed Chairman Jerome Powell that there would be further hikes in the Fed’s base interest rate in 2019, following four hikes in 2018, and the gradual reduction of assets held would continue at the rate of $50 billion per month.

In response to the market downturn, Powell quickly reversed course. Asset liquidation was halted and the Fed began cutting rates from mid-2019, six months before the outbreak of COVID.

The extent of the Fed’s intervention since March last year is evidenced by the fact that its balance sheet has doubled in size since the start of 2020 and now stands at $8 trillion. And according to estimates released by the Federal Reserve Bank of New York last week, its holdings of financial assets will reach $9 trillion by 2023, an amount equivalent to 39% of gross domestic product.

Comments reported in the FT by analysts and reports from banks on the current situation focused on the dilemmas facing the Fed and other central banks.

According to Matt King, global market strategist at Citigroup: “The paradox is that the more central banks manage to drive up the valuations of risky assets using stimulus, the harder it becomes for them to exit.

He noted that it was “much more likely” that an interest rate hike could prove destabilizing as there was more outstanding debt.

According to some estimates, the effect of a 1% rise in bond rates is in fact equivalent to a 3% rise in the past.

A Barclays Bank study said the restoration of economic activity in the wake of the pandemic raised questions about the extent to which central bank support would be withdrawn and noted that “the risk of disorder appears significant to United States, where policy responses have been particularly forceful” and “the prospect of a disorderly outcome could emerge for the Federal Reserve”.

If inflation started to rise after the “transitional” effects had subsided, it “would likely involve painful trade-offs between prolonged unemployment and longer-term inflation.” In other words, controlling inflation would amount to imposing a major recession.

The continuing turmoil in the money markets and the development of highly abnormal conditions are the expression of two important developments.

First, the “free market” mechanisms that functioned in times once considered “normal” have completely broken down and the entire financial system is dependent on the capitalist state in the form of the central bank.

Second, after intervening to save the system in response to last year’s collapse, the world’s most important central bank, the Fed, is now caught up in the ever sharper contradictions that this intervention produced.

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Don F. Davis