Former Fed chairman Ben Bernanke once observed, “monetary policy is 98% talk and only 2% action.” This comment accurately characterizes the Fed’s influence on liquidity flows, in our view. While the US financial press tends to reinforce a view of Fed omnipotence over the economy, this public relations effort does not do justice to the very real constraints on the Fed’s power that now exist post-GFC.
How We Track Federal Reserve Policies
Trying to read Federal Reserve “tea leaves” has become a cottage industry in the financial world; typically with no clear consensus. So rather than anticipate policy moves based on statements (the tea leaves) we look a level deeper — particularly at hedge fund strategies. If an identifiable hedge fund strategy congregates around an expected economic event, that carries more weight than random interpretation of Fed statements alone.
Federal Reserve before GFC
Before the Great Financial Crisis (GFC) and accelerated rise of wholesale money markets and PBoC influence, the Federal Reserve exercised tight power and control over financial markets. But with increasing influence of money markets and the rise of People’s Bank of China (PBoC), the Fed’s control over the financial system has diminished. The Fed still exercises tremendous power over liquidity creation, simply by its power to expand or contract its balance sheet. But the Fed’s power over liquidity creation falls short of the exercise of control that it previously enjoyed.
The Fed’s Liquidity Creation
Conceptually, the Fed can supply as much liquidity, at a fixed policy rate, as deemed necessary for the efficient functioning of the financial system through monetary operations. But liquidity creation by the Fed is not without knock-on effects that act as a damper on new liquidity injections. Chief among these is inflation. As central banks inject more and more liquidity into a stale financial system, inflation becomes a serious challenge — such as is the case presently (2023). And the Fed must now also worry about PBoC policies and the private market incentives of the wholesale money markets that have a significant impact on global liquidity.
Changes in Interest Rates
An indirect, yet powerful, influence over liquidity is the Fed’s ability to raise and lower its federal funds interest rate, and thereby affect all other rates of interest, from Treasury bonds to mortgages, to car loans and the like. As the Fed exercised “quantitative easing” from 2000 to 2021, access to liquidity was freed up across the board, for US consumers and corporations. Cheaper borrowing costs encourage new purchases, which expands liquidity in the financial system.
The converse is also true — more expensive borrowing costs damper spending, which contracts liquidity in the financial system. This is what has happened in 2022, continuing to the present.
The Fed’s ability to influence interest rates is a power with far-reaching, if delayed, effect on the financial system. As we have observed, it typically takes around 6 months for a financial event to work its way through the financial system. The Fed’s recent interest rate increases show an increasing impact in terms of bank failures, corporate bankruptcies, higher consumer default rates on credit cards and auto loans and other debts. All these negative factors drain liquidity from the US economy.
Fed Swap Lines
To provide liquidity beyond the confines of the United States, the Fed has created new emergency swap lines through which it can provide emergency liquidity to central banks of other countries. As these swap lines expand, the Fed effectively becomes central banker to the world. Thus far, swap lines have not been extensively used. But if the Fed is called on to provide extensive liquidity to other countries, the functional limits of its liquidity power are bound to be tested.
The Fed’s Unspoken Policy — Asset Stability
The federal reserve is said to have a dual mandate: controlling inflation and supporting full employment. But we see a different priority emerging: stability of asset markets, particularly the US stock markets, and more particularly, the S&P 500 stock index. It is a powerful US stock market that keeps the economy running.
The Fed’s Inflation Mandate
Notwithstanding the Fed’s public posture about controlling inflation, the fact remains that inflation is tremendously helpful in reducing the Fed’s balance sheet. Inflation makes debt worth less in real terms. Therefore, any increase in inflation works as a decrease in Treasury debt.
On the whole, because of the effect inflation has on reducing the real value of debt, we see sustained inflation on the horizon, notwithstanding Fed pronouncements to the contrary.
Competition from Wholesale Money Markets
In the post-GFC world, wholesale money markets have arisen to challenge the Fed’s control over liquidity. Global wholesale money markets control around half of all global liquidity. The money markets are independently controlled by sovereign wealth funds of nations as well as huge pension funds, like those controlled by Bank of New York Mellon. The net effect of all this extra money sloshing around outside of central banks has been a loss of central bank control over the financial system.
To be sure, central banks — particularly the Fed and the PBoC — still exercise significant power over creation of liquidity; but that power has limits, in light of the blocking power of independent entities in the money markets.
Summary — the Complex Power of the Federal Reserve
Federal Reserve is constrained by the need to support financial system stability on one hand, while avoiding sweeping liquidity flows of the wholesale money markets on the other; and while accounting for PBoC policies at the same time.
The Fed sets US interest rates which have a definite impact on liquidity in all US (and many) global markets. The Fed also has emergency powers to expand liquidity to US banks (through balance sheet expansion) and to foreign countries (through swap lines).
Virtually lost in this high-stakes competition to control liquidity flows is the Fed’s original mandates to control inflation and ensure stable US employment. In prioritizing its competition with global money markets together with maintaining asset stability in the US, any pronouncements by the Fed concerning inflation or employment appear to be of secondary importance.
This is the expanded lens through which we evaluate Fed policies. In spite of much talk and many obfuscated actions, the Federal Reserve is largely constrained by competing demands that are anything but clear. The Fed seems reticent to issue emergency liquidity, unless absolutely necessary; and is also acutely aware of the impact higher interest rates have on the US economy.
In a nutshell, the Fed is surely aware that its power for economic destruction is as great as its power for economic creation. So, going forward, we predict the Fed will do everything possible to avoid a new large-scale emergency response or more abrupt changes to the interest rate; opting instead for “jawboning” over large “actions.”