MOPEing up liquidity

News out the US yesterday was that the Fed increased the discount rate by 25 bps to 0.75%. Human Action reckons this is purely a cosmetic move to signal tightening to the market, but behind the scenes the Fed is still loosening monetary policy through QE.

The discount rate is the rate at which banks borrow from the discount window at the Fed.  The fed funds rate is the rate at which banks can borrow money from other banks which are held at the Fed.  The amount of excess reserves in the banking system makes fed funds and the discount rates somewhat meaningless compared to pre-2008.

The high level of excess reserves in the system means banks don’t need to borrow much from the Fed, and the chart below shows that discount window borrowing has in fact been declining since late 2008 to some $100 billion in January 2010. Raising the discount rate by 25 bps on 5% of total Fed assets is hardly tightening.

The economic implications of widening the discount rate – fed funds spread from 25 to 50 bps is also somewhat meaningless. Pre-2008 the spread was 100 bps, now the Fed’s taken it back to 50 bps. At the end of the day, it may be perceived by the market as signalling the beginning of Fed normalisation, but there is a distinction between that and actual Fed tightening.

If the Fed was serious about tightening monetary policy by raising the fed funds rate, it should be reducing the size of its balance sheet or total assets held. But data out yesterday shows a $54 billion jump in total assets of Fed to $2.29 trillion – the largest weekly jump since November (hat tip Zero Hedge).  This increase in the size of the balance sheet is directly related to extent of monetary loosening. The fed funds rate is manipulated by the fed through open market operations. The reason the Fed’s balance sheet has grown so much in size is because it bought up a trillion dollars worth of toxic assets (MBS and agencies, etc) and government debt to avoid a financial meltdown in 2008. The only way to increase the fed funds rate is to sell a significant amount of their toxic paper in the market, which will bring on the same problems it tried to prevent in the first place.

Of course the Fed knew the market would initially take the announcement as dollar bullish. Especially if it was announced to have been a unanimous Fed vote 9-0; which it was. Throw the IMF open market gold sale announcement from yesterday into the mix and clearly there is intention to talk down gold and equities, in the process talking up treasuries. Also bearing in mind last week’s 10Y  treasury issuance didn’t go down so well and with some big issuance coming up – over $100 billion in issuance next week alone – what we’ve got here is Management of Perspective Economics, aka MOPE. The fact that the discount rate was increased before the scheduled FOMC meeting on March 16 supports this argument. It looks as if the market is giving direction to Fed policy and not the other way round. Hiking the discount rate creates the perception that the fed is managing the currency well, while in reality they’re not. In this sense their hawkish posturing will facilitate the absorption of Treasury issuance. But they won’t necessarily be paying higher interest on those issuances – because there is no real connect between the discount rate and the fed funds rate.

The only tool the Fed now has to prevent excess reserves from entering the economy through bank lending is by paying interest on reserve balances held at the Fed. But if the excess reserves remain high and the banks’ opportunity cost of keeping reserves on deposit with the Fed becomes too high, the Fed will have to pay higher and higher interest rates on reserves. This will mean that the Fed will need to create more money out of thin air to pay off this interest, which will be even more inflationary over the long-run.

Until we see tightening of the fed funds rate to the extent of 100 – 200 bps increases being accompanied by disposal of MBS and othet toxic paper into the market, the Fed is not serious about tightening.

Long-term perspective remains dollar and treasury bearish, and commodity, equity and EM currency bullish.