In response to my commentary on Monday, a reader opined that there were even more basic implications of the Fed’s reverse repo experiment than I had suggested. Indeed, his comments triggered even more thoughts, which I include below. The reader put the issue much more succinctly than I could hope to, so I’ve taken the liberty of providing his thoughts verbatim:
But isn’t the issue even more basic than you say? It seems to me that the Fed and regulators are moving away from a bank-centered monetary system to a market-based system, where “money” is not just bank liabilities but any liquid asset? There are other examples:
I have to admit I see some positives in this trend. Technology has largely destroyed the boundary between banks and other financial intermediaries. We cannot go back. But, the risk is exactly as you say. We are regulating and conducting policy without good understanding of this new world. And, in the case of reverse repos, without being honest with the public and markets about what is going on.
- Several of the Fed’s crisis interventions were on markets, not with banks.
- Regulators now want to regulate activities, not just institutions, for example by setting minimum repo haircuts independent of the parties involved, or forcing OTC derivatives onto central clearing.
- Asset managers like Blackrock really are systematically important, given their size and dominance in certain markets.
- QE seems to have “failed” because the extra “money” has stayed at banks.
The observation about the morphing of the policy focus away from banks to markets is prescient. The new focus on markets and non-bank institutions is a quantum change that has significant implications because of their cross-border reach, the kinds of institutions involved, and the potential effects on other countries and their economies. Any movement to a new policy instrument, be it asset sales and purchases or the repo rate, should be rooted in a clear understanding of the channels through which a change in that policy instrument might operate. This would include an understanding of the linkages to policymakers’ objectives for the real economy and inflation. In addition, however, such a move also requires a thorough consideration of the externalities to other countries and their economies, should that instrument have a cross-border reach. This includes the possible need for a structure for central bank policy coordination if required.
One important way to gain an understanding of these linkages and their implications would be through the use of models. As we understand, much of the FOMCs current policy approach is rooted in accepted contemporary macroeconomic theory and associated simplified models. Witness the heavy reliance upon communications and forward guidance as a recent addition to the Fed’s toolbox. Unfortunately, the assumptions concerning policy credibility and what policymakers and market participant know about the future are only loosely linked to real-world behavior. As such, the predictions about policy effectiveness may or may not be realized, and policymakers may misread potential market responses, as was the case in June with the tapering discussion.
The problem of assessing the potential effects of a new, globally significant target instrument such as the repo rate is magnified because cross-country models in which such a rate plays an important role do not exist. We have no idea about what would happen, either domestically or internationally, when a dominant central bank like the Fed manipulates a policy rate for its own domestic policy purposes that may also have significant negative externalities for other countries and institutions. Think of the policy problem this way: a homeowner flips a switch in his or her home to turn on the lights only to discover that the house had been cross-wired to his neighbor’s house. Rather than the expected reaction, the lights go off in the neighbor’s house or perhaps the neighbor’s sprinkler system goes on.
The reader’s observation that “we can’t go back” is correct. But the answer may not lie in taking the obvious or easy way out. Furthermore, an incremental or piecemeal approach may be fraught with unintended consequences. The task in the present case should be to identify both the policy instrument and markets that are most closely linked to domestic economic objectives. This may require a totally new mindset when it comes to markets such as the primary dealer market. As we have documented before, that market has become dominated by foreign institutions whose activities are only loosely linked to the credit channel in the US economy. Moreover, because of the fees levied by the FDIC, US banks have essentially been driven out of the federal funds market, thereby reducing or destroying the historical links to the term structure and the real economy in the US. We must also be careful that an attempt to fix one problem doesn’t create other problems that may be even more consequential. For example, we are also already hearing about the negative and likely unintended consequences that the new Volcker rule is having on the domestic municipal securities market.
Maybe it is time to think about recreating a domestic federal funds market in which the key participants are domestic US banking institutions across the country. This approach would require opening up the ability of all federally insured domestic banks to deal directly with the open market desk. This arrangement combined with continuous trading on an intraday basis by the desk in that market would largely eliminate the need for domestic banks to deal in the repo market.