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Tossing coins: The Vaccine v The Fed

AstraZeneca, Pfizer, Moderna and other drug makers are finalising their ‘warp speed’ vaccine trials in order to stop the infection and spread of the dreaded Covid 19.  Simultaneously, the Federal Reserve in the US is set to roll out its new Monetary Policy operating procedures for all to behold. Both the vaccine designers and the Fed risk abject failure.  Which of these actors have the best chance of success?

Success?  Vaccine design and Monetary Policy are surprisingly similar when it comes to delivering real results.  Comforting both may be when it comes to the collective security blanket that ‘…the government is doing something…’, but in terms of actual results, Vaccines and Monetary Policy often fail to deliver.  Success is better measured in terms of bedside manner…

Lets flip a coin and deal with what comes up first… heads for Vaccine, tails for Monetary Policy.  Heads!

The anecdotal evidence is that the Oxford vaccine elicits an immune response in 40-60% of recipients.  This means its a coin toss! Should we celebrate a vaccine that fails half the world’s population?  Of course, simply because a vaccine is needed primarily to provide policymakers with an escape hatch from the straitjacket that they have gotten the world into.  Covid 19 is a problem, the magnitude of which should not be underestimated, but neither should it be a reason to inflict undue economic pain on society. Governments have drawn lines in the sand that they can only cross once a vaccine is approved. Get innoculated and get back to normal.

The Fed, on the other hand, has a tough job. Some of the most basic questions in economics – what causes inflation? what causes unemployment? – have left policymakers stranded for the last 30 years.  Back in the 1970s and 1980s, the Economics community had pretty much decided that prices were determined by the money supply in the long-run while there was disagreement over whether employment could be stimulated or not in the short-run.  This led most Central Bankers to adopt stable monetary rules over the long run experimenting with short-term stimulatory policies.  The problem is that the policymakers have neither achieved their long run inflation objectives nor have they been able to systematically influence short term employment or output.  The success of a monetary action is a coin toss!

The Fed’s new approach unveiled on Friday would seem to focus more on achieving the long run inflation objective, now targeted at 2%, as opposed to focusing on short term fine tuning.  I don’t claim to understand this but the link between money and inflation has failed us for 3 decades so why should it suddenly just appear again because the Fed wants it to?  The popular press interprets the new approach as a justification for keeping interest rates at zero for a long time.  Again, I don’t understand this.  The empirical evidence in my view is that the ability of the Fed to impact the real economy through monetary activity depends on how the banking system responds to the event provoking the policy action.  The Fed gives money to the banking system and then the banks decide whether to lend or not.  If they don’t, which seems to be the pattern, then the money flows straight back to the Fed.  A better way would be to simply increase everyone’s bank account directly.  (A contractionary policy action would reduce everyone’s bank balance – imagine the riot that would cause!)

Success?  It would seem that a Covid 19 vaccine has a better chance of returning society to ‘normal’ than does the Fed’s policy rule have of returning the economy to ‘normal’.  This is because the vaccine only has to convince a small number of regulators to ease up restrictions on travel and interaction whereas the Fed’s job is to convince hundreds of millions (actually billions) of people to do something different.

 

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Crypto just joined the establishment and sunk the Fed

Many traders and portfolio managers began their careers on the Cash desk. This is a place where you can learn the markets without getting into too much trouble. Cash is variously defined as fixed income securities with maturities ranging from 91 days for the most secure portfolios out to 397 days for portfolios with slightly more flexibility.  The short maturity and the dominance of government securities in the Cash markets make the sector low risk.  After 6 months or a year on the Cash desk boredom sets in and the traders/PMs gravitate to the more exciting markets that get them into trouble…

Money Market Funds are critical to the Fed’s policy implementation

Money Market Funds (MMFs) are the quintessential example of this boring asset class.  MMFs, however, are extremely powerful investors that virtually control the Reverse Repo Market (basically they lend money to the US Federal Reserve).  MMF’s account for roughly $2Trillion of short term investments whereas Reverse Repo weighs in at $500billion, meaning that the Fed relies on MMF’s to successfully execute their monetary policy actions.  Unlike the Primary Dealers, who largely do what the Fed wants by virtue of their privileged position, MMFs are completely independent of the Fed and under no compulsion to trade at the levels the Fed chooses.  It is a little known fact that the Fed was concerned with the systemic risk of a run on the MMFs during the Financial Crisis (there was no panic in hindsight) and the MMFs were also a wildcard in the Fed’s plans to wind down the Quantitative Easing policy as well as its ability to raise interest rates by borrowing from the MMFs.

Uh-oh…MMFs just went crypto

Last week, the boring old MMF suddenly became the future for crypto and with it the Fed’s public enemy #1.  Franklin Templeton’s “Blockchain Enabled US Government Money Fund” sought registration with the US Securities and Exchange Commission. The Fund is identical in all respects to Franklin’s existing MMF, including all the administration functions recording subscriptions, redemptions and balances. The only difference is the addition of a blockchain feature shadowing the centralised primary records.  [In the event of a discrepancy between the blockchain records and the centralised records, the latter prevail.] The “Blockchain enabled” MMF has been created entirely within the established regulatory framework.  While there is no intention to issue a token to each investor at present, the structure clearly anticipates a….

…STABLECOIN !  This is a massive step forward for the general acceptance of a private currency.    The standout aspects of the structure are (i) the MMF pays interest (this knocks Libra off the shelf), (ii) the MMF is registered to deal directly with the Federal Reserve (iii) the use of traditional record keeping together with blockchain record keeping.

Franklin Templeton are part of the establishment.  They are not techno-zealots or crypto-crusaders.  They simply recognise that electronic transactions between their MMF account holders can be facilitated on the blockchain (Anne’s MMF pays Bob’s MMF)  rather than through the traditional route (Anne’s MMF pays Anne’s bank Anne withdraws cash to pay Bob cash Bob deposits cash in Bob’s bank and transfers to Bob’s MMF).

So what does this mean for the Fed?

Franklin Templeton might be first to market but my guess is that every other MMF provider will follow and eventually club together so that i can buy coffee using my MMF provider transferring to the cafe’s  MMF provider over blockchain. This transaction completely bypasses the existing payments system, cutting out the banks and the Fed’s control.

The subtle implication is that the MMF blockchain effectively replaces the traditional payment system while at the same time continuing to trade with the Federal Reserve. This is starkly in contrast with any other attempt at stablecoin that held deposits with some unheard of custodian or dodgy bank account in Malta.

So here’s the rub: MMFs operate outside of the Fed’s official influence yet are a critical element of the Fed’s funding programs and the Fed’s ability to implement monetary policy.  MMFs have $2Trillion of existing power at their disposal and they could easily push the Fed around. Whereas the Fed has been hostile toward the other stablecoins by refusing access to the payments system and directing their primary dealers not to engage, the Fed now finds itself borrowing from an established main stream crypto currency and this will only become more prevalent over time. The Fed becomes hamstrung in its ability to influence the money supply since the demand for its reverse repo is driven by MMF flows rather than forced on primary dealers. When the Fed wants to drain liquidity by selling reverse repo the primary dealers dip into bank reserves. MMFs on the other hand only agree if they have the cash to invest and the interest rate is competitive. Put another way, unlike banks,  MMFs are not in the business of creating money so that the Fed will lose control of monetary policy.

…the end of fiat money is nigh

The next step in crypto development is for the established Fund houses to offer blockchain enabled mutual funds which can also be used for day-to-day purchases. This is the ultimate fully convertible currency backed by a market portfolio of claims to real assets. That is the logical extension of the private currency market and will drive the demand for fiat currency of any kind (traditional fiat and digital fiat) to zero. Franklin Templeton, Blackrock, ( even First Degree!) will have their role to play in the reform of the international monetary system.

 

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