Summary
This report briefly examines the Federal Reserve’s Repurchase Agreement [RP] mechanism and its near-term relationship to the DOW Jones Industrial Average. The RP issuance and expiration schedules create a pool of temporary investment funds available to select financial entities that can exceed $30 Billion. A correlation between the RP pool totals and the DOW is found and charted since December 2002. In addition, a sharp August 2002 increase in RPs is noted with an apparent correlation to changes in the Major Currency Dollar Index [MCDI]. Finally, the debt-trap dynamics of Japan, proposed re-flationary solutions and similarities to the US are briefly discussed.

Background

The New York Federal Reserve Bank issues or buys repurchase agreements to qualifying members of the banking community [primary dealers] in order to manage the money stock. Purchasing securities from a primary dealer and paying for them with cash adds liquidity to the banking system. Temporary Open Market Operations [TOMOs], bearing maturity ranges from over-night to as long as 28 days are posted each day by the Federal Reserve Bank of New York.

E-Analytics.com offers a good background discussion to the Federal Reserve’s Open Market Operations

One of three basic tools used by the Federal Reserve to reach its monetary policy objectives are open market operations. The other tools involve changing the terms and conditions for borrowing at the discount window and adjusting reserve requirement ratios. The Federal Reserve's most flexible means of carrying out its objectives is by the purchase or sale of securities in the open market. The open market is also known as the secondary market and is the same market the rest of us buy and sell securities. The Fed can offset or support seasonal or international shifts of funds and thereby influence short-term interest rates and the growth of the money supply. This is done by adjusting the level of reserves in the banking system through open market operations.

Historical data describing the RP issuances can be found Monthly, Weekly and daily at:
Federal Reserve Bank of New York - Temporary ... and at their ftp transfer site: POMO Statistics

Methods

In order to track the issuance of repurchase agreements it is necessary to construct, in addition to recording daily temporary and permanent RPs, a maturity schedule in order to account for the changing aggregated temporary RP totals. For example, a large RP injection on a given day may not be significant [to the pool totals] in light of a simultaneous expiration of the same magnitude. Conversely, small additions without balanced expirations will add to the total RP pool available to the primary dealer banking community. Moreover, large, scheduled expirations presage possible falls in the RP pool or, if the FOMC decides to maintain the RP pool totals, additional large RP injections.

Because of the 28-day nature of some temporary repurchase agreements it is also necessary to initially tabulate the daily issuance and expirations for 28 days before meaningful trends can begin to be viewed. This time requirement shields the RP totals pool from any quick analysis. We have all seen reports in the lay press about large RP injections but without an historic record of expirations or knowledge of the RP pool totals, conclusions about the Federal Open Market Committee [FOMC’s] open market actions are not trustworthy.

Permanent Open Market Operations [POMOs] are usually much smaller in magnitude than Temporary operations but have a far greater effect on the market. Experts have suggested that there is a nine times market multiplier effect inherent in permanent open market operations. In this brief report, I use no multipliers for POMOs and do not include them in the RP totals pool [The POMOs are included in historical RP data used in charts later in this report].

Table 1 [Below] shows an excerpt from a daily record the writer maintains:

Table 1

The multiple expiration columns are maintained in order to avoid commingling entries. The values are $USD Billions except for the DOW.

REPOS and the DOW

Does a relationship exist between the DOW and the repurchase agreement totals? Looking only at the above table one would be hard pressed to draw any conclusions except the RP totals tripled between Feb 7^th and Feb 18^th while the DOW rose by 283 points. Let’s have a look at the bigger picture for more clues.

Figure 1

The temporary RP totals are shown above [Figure 1] in red, the DOW in green while the daily RP issues are shown in blue with yellow diamonds. The much more effective permanent open market operations are shown in orange as larger circles. The DOW scale is on the right axis. The POMO entries from left-to-right are shown bottom to top in the table to the right of the chart.

Discussion

There are several interesting patterns seen in the above chart of the RP totals and DOW.

1. The DOW began a steep fall in mid-January from over 8,800 ending near 7,500 in mid-March.

2. A steep spike upwards in Temporary Open Market Operations [TOMOs] occurred a few days after the DOW began its large drop that apparently had no effect on the DOW. This TOMO was followed by another steep spike up in late February and the DOW did respond this time by rising 283 points from Feb 13^th to the 18^th [Seen in Table 1 above]

3. There were four closely spaced Permanent Open Market Operations just prior to the 1,000-point mid-March DOW launch. In addition, there was another POMO on March 13^th of $710 Million coupled with a net TOMO injection of $3.25 Billion which resulted in a 303 point DOW gain on that day.

4. Compared with earlier brief dwells, the RP totals have, except for two days, stayed over $30 Billion since March 31rst. And finally,

5. There have been nine permanent open market operations since February 19th with none prior to that date [in the charted interval].

Nearly all Wall Street pundits attributed the DOW’s March 2003 gain to the “Iraq War Rally”. The above examination suggests there were also other powerful factors at work.

Repurchase Agreement History

Looking at a small interval in high temporal resolution is useful in discerning patterns but a wider frame of reference is needed to draw out meaningful trends. For example, has there been a recent defensive change in the Fed’s RP policies? If so, why? Moreover, would such a policy change reveal important clues to the true health of the US economy, its currency and the Fed’s potency?

Figure 2

Judging by the spike shown in the above figure, the FOMC reacted sharply by aggressively issuing RPs in August 2003 in order to counter what they must have viewed as a serious fiscal threat. What was that threat? Fed officials have recently spoken of potential trouble.

Governor Bernanke’s anti-deflationary “Printing Press” comment occurred on Nov 21, 2002:

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent) that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Was the Fed already months deep into its War on Deflation when Governor Bernanke shocked the finance world with this statement? The Federal Reserve Chairman’s Jackson Hole comments on August 30, 2002 may shed some additional light on why the FOMC chose to launch their repurchase agreements upward in that month:

Moreover, it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity–the very outcome we would be seeking to avoid.

Prolonged periods of expansion promote a greater rational willingness to take risks, a pattern very difficult to avert by a modest tightening of monetary policy. In fact, our experience over the past fifteen years suggests that monetary tightening that deflates stock prices without depressing economic activity has often been associated with subsequent increases in the level of stock prices [Emphasis added].

Little can be gleaned from this quote unless one takes the opposite of the Chairman’s remarks. Specifically, by easing FOMC policy with a big increase in RPs, he seems to have levitated stock prices in the face of manifestly worsening economic conditions. Was the “Greenspan Put” now on steroids? Are additional clues underlying the rapid RP injections in August 2002?

Linking RPs to changes in the Major Currency Dollar Index [MCDI]

In today’s massive credit issuance era the FOMC must keep the total supply of money [M3] growing or else face a potential systemic seizure. The M3 trend growth is disturbingly down, signifying deflation. But the M3 growth problem didn’t just snap into existence in August 2002-it has been deteriorating for some time as the chart at the aforementioned link shows. In addition to M3 growth, a leading member of the Fed’s food chain of important fiscal metrics is the Major Currency Dollar Index [MCDI]. Let us look for clues there to help explain the sharp August 2002 Repurchase Agreement spike.

Figure 3

The Major Currency Dollar Index is shown with red markers with its 200-day Moving Average [MA] attached [black trend line]. The arrows indicate jumps in RPs.

In late 1998 the LTCM crisis shook the financial world. We can see a sharp drop in the MCDI for four months after breaking its 200-day moving average [MA] before the Fed responded with a small up-tick in RPs in the first quarter of 1999. This response was sufficient to get the MCDI moving back up above its 200-day MA. The next time the MCDI fell below the 200-day moving average there was another small RP up-tick [not arrowed, hidden by data markers] that also corrected the fall in MCDI, again after a short lag-time. Then in early 2001 and late 2001 after the MCDI just touched its respective 200-day MA, the Fed responded again with Repurchase Agreement up-ticks which halted the fall and kept the MCDI moving upwards [second and third arrows from the left].

Moving to August 2003 we see the 200-day MA was again broken sharply down this time with a much more forceful RP issuance–it is almost vertical. Note the immediate reversal upwards of the MCDI direction with this RP spike. However, the marked difference this time around is the failure of the MCDI to fully respond back over its MA to very large RP interventions. There is now an ominous divergence between the MCDI and Federal Reserve FOMC RP issuances.

Has the Fed lost control?

Interest rates are low and the FOMC talks of going lower, repurchase agreements rising geometrically as the MCDI keeps falling far below its 200-day moving average, the DOW is barely able to stay above 8,000 even with large and increasing RP support. One can see great trouble ahead even without factoring in the Middle East turmoil, a burgeoning Euro-centric economic coalition, oil producer threats to re-price their crude in Euros or any of the other traditional economic indicators that we know to be badly deteriorating. Previously effective RP utilization seems no longer effective.

Intervention in otherwise free markets historically leads to scarcity and falling liquidity. One need only look to the price control regime of Richard Nixon for examples of this type of government interventional failure. The penultimate failure in then Fed Chairman Arthur Burn’s price control regime was the forced closing of the gold window. Today the Fed seems rapidly headed towards a similar event.

Russia has $50 Billion in $USD foreign exchange reserves and on April 18^th media sources warned its citizens:

According to the Nezavisimaya Gazeta, the current financial instability leaves no choice for private investors: nobody can be sure that this or that investment will return profits or at least protect from inflation. In this situation, saving in dollars becomes pointless.

China has also made official statements that it will begin adjustment of their many billions in $USD reserves. This trend to the Euro is gaining worldwide momentum. We can see from the chart below [current April 22^nd] that since Dec 6^th the MCDI is down over 10.97%, the yen down 5.05% while the Euro is up over 17.5%. Euro buyers have therefore posted a 28.4% differential gain over the dollar since Dec 6^th. 

Figure 4

The Federal Reserve is doing much more than “Credibly threatening” to increase the number of dollars in circulation. Money of zero maturity [M1] MZM Money Stock: FREDII is rocketing upward in parallel with RPs. The Fed seems to be following through on Governor Bernanke’s comments of November 2002 with an anti-deflationary blizzard of printing press RP paper. These adverse inflationary monetary events are accelerating and can only increase the weight bearing down on the MCDI. As the dollar falls, the upward pressure on gold rises. The Fed’s RP actions reveal they are deeply concerned.

Walking Into Japan’s Liquidity Trap?

Finally, in an April 2003 highly technical article The Case for Open Market Purchases in a Liquidity Trap, Professors Maurice Obstfeldt and Alan Auerbach described solutions to the liquidity trap dynamics in which Japan finds itself:

The Bank of Japan has already expanded the monetary base from a 1999 annual average of ¥63.5 trillion to a 2002 annual average of ¥90 trillion, an increase of 42 percent, with no discernible inflationary impact. Is the seeming failure to ignite inflation evidence of deflationary expectations so entrenched that open-market policy cannot be effective? Not necessarily. Japan's price level could well have fallen even more absent the monetary ease. Our findings suggest that the Bank of Japan's quantitative operations have had a positive welfare effect, and would help the economy further if fully maintained and carried out even more aggressively [Emphasis added] p.34.

This well documented and formula-rich article seems to lay the theoretical groundwork for a reflationary policy in Japan as it brushes aside inflationary concerns of rapid growth in monetary aggregates. The parallels to the US today are implicitly read between the lines.

The sine qua non of inflation detectors is the gold price. Against a backdrop of a proven manipulated gold market the elders in Japan, who hold some $600 Billion in yen reserve cash, now largely uninsured, began to seriously buy physical gold in early 2002 as the yen weakened and breached 133 to the dollar [Currently ¥ = 120]. Stories spread quickly across the pages of the financial press of inflation, kilo bar hoarding and long lines at bullion dealers. Any return to ¥ =133 will most certainly re-ignite Japanese gold demand which could spread elsewhere. Moreover, falling real interest rates due to rising energy costs are another spur towards gold.

Japan therefore has a dilemma. They must sell their mountainous $USD denominated assets in order to avoid further currency losses due to the falling MCDI, but in doing so Japan will strengthen the yen, something they wish to avoid.  We can see this manifested in figure 4 [above] as a growing divergence between the MCDI and the Yen.

With the NKK225 making new-20 year lows, Japan is caught between a dangerous golden ceiling at ¥ =133 and the purgatory of continued crushing deflation. The Auerbach and Obstfeldt solution to Japan’s deflationary debt trap dynamics would have been correct had it recognized the absolute requirement for a rising, un-manipulated gold price. Like so many other leading macro economists before them they ignored the most important issue. Moreover, the towering US derivatives colossus, wherein gold is intricately intertwined and the Japanese are surely counter parties, seems also to have been too big to talk about.

Contrary to Obstfeld’s assertion of “No discernable inflation” in Japan, there is clear and present inflation there [e.g., Oil at $29/bbl.] and everywhere else in the dollar’s sphere. The existence of hidden price controls on gold ruins this complex academic prescription whether its inflationary medicine is intended for Japan or the US. Claiming no inflation when gold’s barometer is suppressed further warps the future consequences of bad policy. Indeed, a recent report from James Turk [Freemarket Gold & Money Report] has again confirmed through direct export receipt data that the central banks have sold half their bullion in the gold price control charade.

Others disagree with Obstfeldt and Auerbach’s  solution. In an April 18^th essay Does a Falling Money Stock Cause Economic Depression?  Frank Shostak makes a strong case that the 1930’s depression wasn’t the result of too little money injection. He shows to the contrary that the Fed provided ample funding reserves.

However, a close examination of the historical data shows that contrary to Friedman the Fed was extremely loose and pumped reserves into the system in its attempt to revive the economy (on this see Murray Rothbard's America's Great Depression). The extent of monetary injections is depicted by changes in the Fed's holdings of U.S. government securities. Thus on January 1930 these holdings stood at $485 million. By December 1933 they had jumped to $2,432 million—an increase of 401% (see chart). Moreover, the average yearly rate of monetary injections by the Fed during this period stood at 98%.

So it seems that the accelerated monetary debasement prescription apparently in progress at today’s Federal Reserve runs afoul of history and the principles of a free market. Unfortunately, a runaway world currency disaster can only be avoided by the continued inappropriate sale of a dwindling western central bank resource—gold. This is the dark legacy of misguided interventional planners who drifted from the Constitution’s stipulation for sound money. Judging by the rocketing Fed repurchase agreements, falling M3 growth rates, a vulnerable DOW and a falling Major Currency Dollar Index, the Federal Reserve may finally appreciate that it is nearly out of viable paper options.

© 2003 Michael Bolser
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Michael Bolser
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Valrico, Florida 33594
April 24, 2003

NOTE: Figures 1 and 4 have been updated to May 28, 2003