Jackson Jambalaya

Kingfish note: Colonel Hapablap penned this little column.

First, a quick primer on the Federal Reserve and interest rates:


The Federal Reserve is a private bank, and like any other private company, has a balance sheet. The liabilities & equity side is filled with Federal Reserve Notes (Dollars) and the asset side is filled with U.S. Treasuries, Agency (GSE) paper, and other mortgage debt. The Federal Reserve's balance sheet is approximately $1 Trillion. As a part of its management of the money supply, the Federal Reserve conducts daily open market operations, loaning out dollars for short term duration, often one or 2 days. Collateral, in the form of Treasuries, Agency paper, or other mortgage paper, is required to be posted in order to receive one of these loans.


These overnight operations are the mechanism by which the Fed "sets" overnight interest rates. Ultimately, all interest rates are determined by supply and demand in credit markets. Despite what they might have you believe, the Fed doesn't just tell the market what overnight interest rate to use when they make a policy decision. If there is more money out there to be loaned than demand for that money, interest rates go down as lenders compete to lend available dollars to a finite group of borrowers. The interest rate moves until either more borrowers are drawn in by the lower interest rate or more lenders give up on lending at such low rates. Similarly, if there is more demand for money than there is available money, interest rates move up. So, in order to consistently maintain a given interest rate day after day regardless of minor fluctuations in the overnight credit markets, the Fed conducts open market operations, draining or adding liquidity (cash) to or from the system as is necessary to keep the rate where they want it.


Remember, the Fed has a finite balance sheet, so it can only play this game so much. For instance, the Board of Governors has no ability to force the overnight rate to 20% for tomorrow. With current overnight rates hovering in the 2% range, a massive amount of liquidity would have to be drained from the system in order to make the overnight supply and demand for money balance be 20%. Similarly, if the credit markets suffered a huge shock tonight that took the natural supply/demand balance up to 20%, there is no way for the Fed to bring it back down to 2% via open market operations with the balance sheet available to them.


Now that we all basically understand how all this mess works, and presuming that I haven't confused you even more than you already were, let's look at some interesting data from the last several days:


http://www.gmtfo.com/reporeader/OMOps.aspx




This is the Slosh Report. It shows, essentially, how much liquidity the Fed has outstanding on any given day. Noticee a few things. First, look at the amount of liquidity that has been drained (Net Add column) in the last 5 days. If you go to the page yourself, you can mess with the start date to show you liquidity going back for a while. Through most of August and the beginning of September, the Slosh hovered between $100B and $120B. Today's total was $63B. The Federal Reserve has DRAINED $60B of outstanding system liquidity. But why? I thought that the problem was a LACK of liquidity in the system. If there are financial institutions teetering on bankrupcy, one would expect the Fed to be ADDING liquidity to the system.





http://newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm


This is data from the Federal Reserve Bank of New York, showing historical overnight rates. As you can see, the overnight rate for the last 4 days has been markedly below 2%. In fact, it's been much closer to 1.5%. So, clearly, the Fed is unable to defend its target 2% rate. In fact, as I mentioned before, the Fed shouldn't WANT to defend the 2% rate, as it would require a liquidity drain that the system clearly does not need right now. So, why haven't we seen a target rate cut?


Now, I am generally not a Tin-Foil-Hat type of guy. In fact, that kind of stupidity generally makes me mad. But this is just inexplicable to me. The credit markets have already decided that the overnight rate needs to be no higher than 1.5%. Yet, the Fed continues - for a week now - to drain liquidity from the system in an effort to keep the rate higher than the market wants. And they're doing it at a time when Ben Bernanke and Hank Paulson are in front of congress, testifying under oath that the system is on the brink of collapse due to a lack of systemic liquidity. Why? Why would you engage in something that could very well cause the bank failures that you claim you want to prevent? Maybe for the same reason that you would, in the previous week, tell America that you had to get a financial bailout bill done before the markets opened in Asia on Sunday or else there would be financial calamity.


The easiest way to get something done in Washington is to create panic. I bet a few banks going under would do it.


Hattip to Karl Denniger on this one.
http://www.tickerforum.org/cgi-ticker/akcs-www?post=62791