In a recent column for the Financial Times, I criticized the Fed’s endless repo-liquidity backstop on moral-hazard grounds. The Fed has established emergency-liquidity backstops clearly authorized in law that could and should have been used to stabilize the market over a very short period after which market discipline could and should have reasserted itself. In response, some have said that the Fed couldn’t use the discount window because banks don’t like the shame associated with discount -window borrowing. Maybe so, but the Fed’s decision to provide a discreet backdoor to repo-market liquidity is no different than a speakeasy’s decision to offer valued customers a side door through which they can enter unobserved for unlimited liquid refreshment. A little shame might induce a little less demand for such free-flowing libation.
The Fed opened the repo barroom because markets under seemingly nothing more than a single day’s worth of coincidental factors went very, very haywire. Having convinced itself that post-crisis reserve normalization could comport with post-crisis regulation, the Fed was blindsided by turmoil and opened every keg and tap it could find not governed by the emergency-liquidity transparency mandated in the Dodd-Frank Act. Congress required all this transparency for both the discount window and 13(3) emergency liquidity precisely because it wants the Fed to strictly restrict liquidity support to short-term liquidity kerfuffles, not to stand behind financial markets month in, month out if yield-chasing or quarter-end window-dressing incentives drive rates in inconvenient ways.
That the Fed’s largess has led to continued market speculation is beyond question. As Brian Chappata detailed in Bloomberg, markets are pushing past the Fed every day in every way even as the Fed expands its intraday and term repo backstops. Last Friday, the Wall Street Journal reported that, secure in Fed liquidity largess, lenders are looking for year-end repo rates well above three percent.
Where does all this end? The Fed clearly doesn’t know – it keeps waiting for market normalization even though markets will never normalize as long as the Fed funds abnormal activity outside the reach of market discipline. To speed the reserve build-up the Fed thinks might somehow restore repo tranquility, the central bank has also restarted its portfolio of Treasury securities, building it close to the all-time $4.5 trillion high in just the last few weeks. The central bank protests that these purchases aren’t quantitative easing – just a bit of reserve normalization, if you please.
However, the more the Fed purchases Treasuries, the more the Fed redefines the Treasury market. This is convenient to Treasury – more demand reduces at least some of the cost of the huge U.S. deficit. But, also it’s destructive to economic growth and equality – see our EconomicEquality blog for why and how much.
Just as central-bank liquidity is central-bank liquidity no matter the Fed’s label, so too are central-bank asset purchases central-bank asset purchases that change the market no matter the Fed’s protestations. Central-bank market activity is governmental market control no matter the lofty purpose. It is for this reason that the Fed once sought to limit its open-market operations to asset holdings just large enough to alter rates without being so big as to redefine fundamental supply-and-demand dynamics. Now, the Fed so fears the market that it has decided to become the market. This may move markets in ways more to the central bank’s liking, but whether the rest of us come to like the security of a government-controlled financial system is very much to be doubted.