I am not sure if the logic in this blogpost is correct as I haven’t completely thought it through. But I think it is correct.
I have argued several times in previous posts that the Federal Reserve’s QE initiatives failed because velocity collapsed. While the QE policies expanded the monetary base, the additional liquidity was not taken up and spent by the private sector as would be expected. Instead, the liquidity injections found their way back to the Fed, which consequently reflects as lower velocity of circulation. With money demand unstable and unpredictable, the Fed’s primary monetary policy tool has become ineffective – operating on the monetary base has no systematic effect on liquidity.
In recent weeks, the Fed has made reference to its plans to target the ‘shadow’ banking system – most notably the large pools of liquidity in US Money Market Funds (MMF’s) – when it comes time to tighten policy. How it plans to interact with the MMF’s is not clear, but it could take the form of offering a deposit facility for MMF’s with the Fed which offers an interest rate consistent with its targeted cash rate. The idea is that it can influence interest rates by trading with the MMF’s directly, instead of indirectly through the banks who keep reserves with the Fed.
Now here is the rub: the Fed is less likely to control liquidity dealing with MMF’s than with banks. Banks have to deal with the Fed by virtue of their priveleged position as Primary Dealers whereas MMF’s do not. When the Fed ‘eases liquidity’, they buy bonds from the banks who then increase their lending to secondary market participants and this flows down the financial chain. MMF’s, on the other hand, are constantly searching for investments and there is no compulsion to deal with the Fed, and therefore the desired liquidity effect may not eventuate. This is clear from the following two examples.
Example 1: attempts at tightening liquidity to avert inflation. Suppose the Fed wants to raise rates from 25bp to 50bp, to reduce the money supply, and so offers a MMF a deposit rate of 0.50%. A corporate issuer who had attracted MMF investors at 30bp, observes the new higher Fed deposit rate, now decides to offer 55bp to retain the MMF’s funding. Interest rates ratchet up 25bp but the money supply is unaffected, so money driven inflation risk remains.
Example 2: attempts at easing liquidity in a crisis. A financial crisis develops and the Fed wants MMF’s to withdraw their deposits to inject liquidity, and so lower the interest rate to Zero %. But the MMFs are feeling risk averse, and instead they increase their deposits with the Fed. The net effect is tightening of the system’s liquidity position.
Clearly, Example 2 is the disaster scenario for the Fed’s new policy tool and, more worryingly, exactly how MMF’s are likely to behave in a financial crisis. While the Fed can instruct their Primary Dealers in a crisis to ‘…go out and lend, keep the system liquid and we will support you…’, they are in no such position of control when it comes to dealing with the MMF community. In fact, during a crisis, MMF’s could rightly argue that they have a fiduciary duty to protect their investors by keeping their assets with the Fed.
The proposed procedures do not address the core issue of why velocity has collapsed, or equivalently, why money demand has collapsed. If the Fed thinks dealing with MMF’s is going to make their operations easier, they have a shock ahead. Monetary policy is desperately in need of a total re-think.