The Fed Did It Again!

Includes: DIA, IWM, QQQ, SPY
by: Shareholders Unite


There is a cottage industry blaming the Fed for everything that goes wrong in financial markets and the economy.

Most of these argue that the Fed's easy money was the cause of the crisis but some argue it was actually tight money that caused it all.

While we feel both views are deeply mistaken but the latter is simply factually wrong and that's not difficult to demonstrate.

We are used to people blaming the 2008 financial crisis and subsequent deep recession on the Fed's easy money policies. We think these views are misguided (see here).

But we haven't yet seen people blaming the 2008 financial crisis and subsequent deep recession on the Fed's policies being too tight. But that's exactly what Elazar Advisors are doing.

Here is Elazar Advisors with a challenge:

Please review the above if you too are not yet shaking, because it is material. We're not like other media outlets that have to say what the Fed wants us to say. We say what our work shows us and it shows us that The Fed may have caused the 08-09 collapse and recession. Look and see for yourself and decide for yourself.

Well, we're not shaking yet and we're also not "like other media outlets that have to say what the Fed wants us to say" either, so we took up the challenge and we had a look at the article, with the proviso that we have bad experience when people with a finance background write about macroeconomics, and this turns out to be no exception.

Despite the verbiage, Elazar's theory can be summed up rather quickly:

  • Changes in Fed provided liquidity correlate with stock market movements.
  • This correlation is assumed to be causation.
  • Changes in Fed liquidity are also deemed to have crashed the economy in 2008/9.

So simply put, the theory states that financial markets and the economy are driven by Fed liquidity. Open market operations (OMO) are deemed an all powerful instrument.

Then a commenter ("SteveMDFP") in a previous article pointed to the Fed as the culprit for the 2008 crisis, and he's latching onto that.

Elazar seems to think he is onto something entirely new here, and indeed, almost all Fed critics blame easy monetary policy for the crisis, not tight monetary policy.

However, perhaps Elazar has heard of a guy called Milton Friedman, who wrote (together with Anna Schwartz) "A Monetary History of the United States" and what that says about the Great Depression.

We'll leave Friedman (already forgotten as Austrian economics, for which Friedman had very little respect, is the new flavor du jour) for another moment, and try to pry the evidence from Elazar's article:

The Fed pulling liquidity from the market tumbled banks and forced a Fed bail out. The Fed caused the crash and caused the need for its own bailout. Does that make any sense to you? Frankly, I'll be surprised if this article doesn't get pulled by some banking authority for being too thoughtful

The Fed pulling liquidity from the market. Let's see. Here is the Fed's 2007 report on Domestic Open Market Operations:

The FOMC maintained a fed funds target of 5¼ percent set in June 2006 until September 2007, at which point it cut the target rate by 50 basis points. It cut the target rate by a further 25 basis points at each of its next two meetings scheduled for the year (Table 1).

As stress in the interbank market emerged in August 2007, the Fed responded the very next month, and within a couple of months interest rates were lowered by 100 basis points, a fairly aggressive easing.

Now, you might want to realize that Open Market Operations flow from that (from the same report, although this is basically monetary policy101):

To influence the fed funds rate, the Desk conducts open market operations to align the supply of balances held by depository institutions at the Federal Reserve - or Fed balances - with banks' demand to hold balances consistent with maintaining the fed funds rate around the target.

OMO is the instrument, the Fed funds rate the target. But this setup ran into some stress in 2007 (from the same report, bold is ours):

Beginning in August 2007, the Desk's general operating procedures were less effective than they had been in recent years in maintaining the fed funds rate around its target, reflecting market developments that exerted upward rate pressures that emerged in the overnight market and the Desk's response to these pressures. In the first maintenance period in which these pressures appeared, the period ending August 15, the Desk effectively suspended its normal approach to controlling the funds rate. In order to combat severe and persistent upward rate pressures that were threatening to become even more deeply embedded in market expectations, the Desk provided a level of excess reserves significantly above any amount banks would have chosen to hold at rates anywhere around the target. This extraordinary measure was taken in order to restore a more normal balance between risks of upward and downward rate pressures. In subsequent maintenance periods, the Desk returned to a more normal approach for providing period average levels of reserves.

So, to recapitulate, the Fed lowered the Fed funds target by 100 basis points in two months, then provided significant excess reserves via OMO to combat the upward pressure on rates.

This doesn't sound like tightening liquidity to us, rather the contrary (and there were additional easing measures like a 50 basis point reduction in the primary credit rate and the provision of term financing for as long as 30 days and a host of other measures, all available in the report).

To understand the Fed balance sheet, you might want to keep the following in mind (Liberty Street Economics):

The Fed's balance sheet before the crisis was relatively simple; at the end of 2006, nearly 90 percent of its assets were U.S. Treasuries, broadly matching the amount of outstanding currency

These asset holdings can be further divided (OMO report 2007):

The Federal Reserve holds two general types of financial assets in its domestic financial portfolio that it may adjust through open market operations, at the direction of the FOMC, to achieve monetary policy objectives: outright holdings of Treasury securities, which account for the bulk of the portfolio and temporary repurchase (NASDAQ:RP) agreements (Chart 9 includes the Term Auction Facility and Swaps). The Federal Reserve may also issue temporary liabilities by delivering Treasury securities under reverse repurchase agreements (RRPs).

And indeed at the end of 2007 there was a modest decrease in these outright holdings of Treasuries:

During 2007, the value8 of the permanent holdings in the SOMA portfolio decreased by $39.3 billion, ending the year at $735.7 billion.9 The contraction was comprised of $50.4 billion in redemptions offset by $10.7 billion in outright purchases and $0.5 billion in realized TIPS inflation compensation.10 Redemptions consisted of $1.2 billion in Treasury coupon securities and $49.2 billion in Treasury bills.

But that's a 5% reduction, mainly through redemptions (there were still outright purchases, as it happens). Nobody can seriously suggest that a central bank letting 5% of its Treasury holdings expire will cause a gigantic economic crisis.

So we have to look at 2008, with the proviso that the financial crisis was already well underway and monetary policy is functioning with a considerable (9-12 months) lag.

The following is all from the 2008 OMO report (bold is ours). First, not the aggressive rate decline in 2008, the January 75 basis point decline was even the result of an unscheduled meeting, which only occurs in crisis times:

Click to enlarge

This isn't tightening, this is aggressive easing. This idea is further strengthened by:

When assessing the implementation of monetary policy, the calendar year can loosely be divided into two time-frames: before and after September 15. Prior to mid-September, the Desk had been able to offset the effect of the additional reserve balances provided through new or expanded liquidity facilities, and it relied upon its traditional framework and operating procedures to control the federal funds rate. During this period, the Desk experienced considerable success in keeping fed funds trading around the target on average, although at times there was significant volatility in rates around the target. Even during this period, as the financial crisis intensified and put upward pressure on rates, the Desk occasionally suspended its normal approach of controlling the fed funds rate for brief periods in order to provide levels of excess reserves that were significantly above amounts typically demanded by banks, to prevent this bias from becoming deeply embedded in market expectations.

Even before the acute (or 'melt-down') phase of the crisis, the Fed supplied excess liquidity when required by banks. OMO tells the following:

The creation of numerous liquidity facilities, the opportunity for both depository institutions and primary dealers to obtain term funding from the Federal Reserve, the sizable increases in the Term Auction Facility (TAF),4 and drawings on reciprocal dollar swap lines often mitigated the need for conventional RPs and prompted the Desk to reduce much of its Treasury portfolio holdings through both redemptions and outright sales in the secondary market (Chart 2). Strains in the Agency and Agency mortgage backed securities (MBS) repo and cash markets prompted the creation of the single-tranche RP program and SOMA purchases of Agency debentures.

Yes, holdings of Treasuries reduced, as you can see by the following picture (SOMO stands for Systems Open Market Account, the permanent holdings of Treasuries). But the decline in SOMA (pink) is compensated by a host of other liquidity measures, and a rapid decline in the Fed funds rate.

Click to enlarge

The two biggest of these initially are:

We've given the Investopedia links to these instruments for those not versed in the fine detail of monetary policy. Of course by September one sees a ballooning of most of these instruments in the acute, freeze (or melt-down) phase of the crisis.

In short, the whole idea that the Fed caused the financial crisis by reducing its permanent holdings of Treasuries doesn't pass minimal scrutiny, for various (and dare we say, obvious) reasons:

  • The permanent holdings of Treasuries are looked at in isolation, other monetary policy instruments are completely ignored.
  • The correlation between the decline in Fed Treasury holdings and the market collapse (let alone the economic collapse) is simply assumed, no evidence is provided.
  • Looking at other monetary instruments, one can only come to the conclusion that the Fed reacted early, and fairly aggressively to the deterioration in the markets. The Fed funds rate was slashed from 5.25% to 0%-0.25% in 14 months and a host of new policies to reduce the stress and provide liquidity were put into action.
  • By the same logic, the increase in Treasury holdings as a result of QE is at least an order of magnitude bigger than the decline before the crisis. This should have created the mother of all asset bubbles and an unprecedented economic boom. While shares are fairly expensive and there has been a decent recovery (apart from wages), this isn't quite what happened.

There has been no Fed tightening from 2007, quite the contrary. As the Elazar article also subsumes monetary policy under fiscal policy by treating it as part of G (public expenditures), that argument doesn't strike us as one we would favor on monetary policy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.