Dangerous Tools

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 |  Includes: DIA, IWM, QQQ, SPY
by: Acting Man

Pitfalls of the “Exit Strategy”

This is simply too funny. Here are a few excerpts from a recent Reuters article on the planned “normalization” of monetary policy (which will likely never happen, and if it against all expectations actually does happen will be reversed again at warp speed…):

“Federal Reserve officials are cautiously nearing completion of a new plan for managing interest rates, concerned that some of the new tools they are likely to rely on could pose unintended risks in a crisis.

The central bank has devoted extensive debate to the matter over the past two months and officials "have made a lot of progress" on a strategy to return monetary policy to a more normal footing after years of coping with crisis, Chicago Federal Reserve Bank President Charles Evans said on the sidelines of an economic conference here.

However, the sheer magnitude of the amounts of money used to combat the crisis – $2.6 trillion sitting at the Fed as bank reserves and $4.2 trillion held by the Fed in various securities – may complicate the U.S. central bank's ability to control its target interest rate once the decision is made that it should be raised. A decision to begin increasing interest rates is expected in the middle of next year.

In recent weeks, the Fed has neared consensus that its workhorse tool will be the interest it pays banks on excess reserves on deposit at the Fed – giving the central bank a direct way to encourage banks to either take money out of circulation and leave it at the Fed, or lend it elsewhere.

Another tool would have a similar impact but apply more broadly, using overnight repurchase agreements that would let money market funds and other institutions as well as banks essentially make short-term deposits at the Fed.

The worry is that if financial conditions tighten, those large funds of money would flee to the repo facility as a safe haven, depriving the economy of credit and making a potential crisis even worse.

Still, the repo tool, which is being tested by the New York Fed, is expected to form part of the new exit strategy, although it is likely to be in what Lockhart described as a "supporting role." The minutes from the Fed's June meeting said that restrictions could be placed on the use of the repo tool to limit the potential risks.

(emphasis added)

Who writes this stuff? This sentence is simply complete nonsense: “…giving the central bank a direct way to encourage banks to either take money out of circulation and leave it at the Fed, or lend it elsewhere.”

Bank reserves have nothing to do with money being "taken out of circulation" and certainly cannot be "lent elsewhere". There are only two (count 'em) things that can be done with bank reserves besides leaving them parked at the Fed: they can be lent to other banks that are short of reserves (not many of those around after years of QE), or they can be transformed into cash currency when customers withdraw cash from demand deposits. And that's it. No "lending elsewhere".

Bank reserves can be used as the basis for pyramiding credit – money the commercial banks literally create from thin air. It is only in that sense that raising the interest rate on excess reserves can potentially put a brake on new credit creation, by making it comparatively less attractive to take the risk of extending credit and by undermining interbank lending of reserves.

Click to enlarge

Assets held by the Federal Reserve after 6 years of QE – via St. Louis Federal Reserve Research. These are in the main the securities the Fed has bought – in the process, the broad true money supply in the US economy has nearly doubled (approx. from $5.3 trillion in 2008 to $10.25 trillion today) – and that is not counting dollars that have "leaked out" into dollar accounts held abroad. On the liabilities side there are mainly bank reserves (both excess and required), currency in circulation and a tiny smidgen of capital. If the Fed were hedge fund, it would be the most highly leveraged one ever.

Reverse repos on the other hand can indeed be used to drain liquidity from the economy. What strikes is as so funny is the notion that they could be used by money market funds and others to escape the risks of a crisis. Are Fed members indicating that in spite of their careful application of a finely calibrated "scientific" monetary policy there could be – gasp! – another crisis?

How is such a thing possible? Just last week Ms. Yellen told us that there is nothing to worry about, that there are no bubbles in sight anywhere, and that the occasional pockets of excessive risk taking can be safely ignored.

And desperate fund managers using repos with the Fed in an attempt to take shelter from risks need to be subjected to restrictions because such action by itself represents – a risk? What?

Is any more confirmation needed that this rickety and completely overextended joke of a monetary system is as collapse prone as ever?

As to the “exit strategy”, we best let someone else comment on it:

Dr. Evil and his henchmen shortly after being apprised of the “exit strategy"