The Federal Reserve: Banker To The World

Summary

Ben Bernanke has emphasized how important it is for the Federal Reserve to provide sufficient liquidity for the financial markets in the US but also for other major financial markets.

We are going through a period, right now, where we see how closely US financial markets are connected to other world markets.

We are seeing that the world is linked not only by interest rates, but by the liquidity that exists in the US and in the world.

Concern is growing about how the attempt of the Fed to reduce the size of its securities portfolio and the increases in federal government debt might cause world liquidity problems.

Like it or not, the Federal Reserve System in the United States is, more or less, a central banker to the world.

This is most obvious in times of financial turmoil.

Just go back and re-read the memoir of former Federal Reserve chairman Ben Bernanke, “The Courage to Act: A Memoir of a Crisis and Its Aftermath,” (W. W. Norton & Company: 2015).

There are many times that Mr. Bernanke discusses how he and the Federal Reserve had to keep in touch with major central banks throughout the world to make sure that there was sufficient US dollar liquidity in the world so that banks and financial systems could continue to function.

This was a vital part of how Mr. Bernanke and the Fed navigated the threat of an even greater breakdown that took place.

But, it shows, in time of crises, how dependent the rest of the world is on the central bank of the United States.

We are seeing some of that interconnectedness coming out in many places throughout the world right now. And, the question that comes up is that the top Fed officials are different than they were back then, they seem to be more domestically orientated, and the new Fed chair, Jay Powell, is not an economist by training.

The growing concern around the globe with respect to the Federal Reserve these days is about how current Federal Reserve actions might be impacting the liquidity of world markets.

Initially, recent attention has been given to how the Federal Reserve has been increasing interest rates and how they plan to increase interest rates into the near future.

The continued increase in the Fed’s policy rate of interest had a major impact on the value of the US dollar, and the rise in the value of the US dollar resulted in substantial movements in money from emerging markets back into the United States. I wrote a series of articles, beginning with this one, “What Does the Rising US Dollar Mean for Emerging Markets?“. The focus, at that time, was specifically on Argentina.

Since then, Argentina has dramatically raised interest rates and has just received a $50 billion bailout from the International Monetary Fund.

Turkey, another country mentioned in my series of articles mentioned above, has been raising interest rates, amongst other things, in order to settle down or stop the decline in its currency.

Now, Brazil's Selloff Feeds Global Emerging-Markets Retreat has been drawn into the picture.

Then there is the political situation in Italy, a situation that has not only impacted the value of the Euro but has also re-arranged interest spreads in the eurozone.

At the beginning of May, for example, the spread between the yield on the 10-year Italian government bond and the yield on the 10-year German Bund was about 175 basis points. Yesterday, at the market’s close, the spread was 300 basis points. There is now a lot of shorting of Italian bonds.

Furthermore, it seems as if the Swiss National Bank, Switzerland’s central bank, has been impacted by what is happening to Italian bonds and the movement for foreign exchange monies.

It seem as if Gillian Tett, writing in the Financial Times, has hit the nail on the head in her most recent column, “Watch the Fed’s Balance Sheet, not Interest Rates.”

Major market focus has been on the interest rates in the United States and what the Fed is doing to continue to raise its policy rate of interest.

But this is not the only thing that the Federal Reserve has been doing. As I have written about for months, the Federal Reserve has been reducing the size of its securities portfolio, which, of course, has ramifications for the size of its balance sheet.

The reductions began last October, with plans to continue the reductions into 2019. Up through the end of May, the Fed has reduced the size of its securities portfolio by $125 billion. Right now, the Fed is attempting to reduce the portfolio size by $30 billion each month. In July, for the third quarter of 2018, this number will be raised to $40 billion each month. In the fourth quarter, the number goes to $50 billion.

As Ms. Tett writes, “US markets seemed so impervious to the unwinding that many investors have almost forgotten that it is happening.”

In shifting the discussion, Ms. Tett picks up on an article written in the Financial Times earlier this week by Urjit Patel, governor of India’s central bank, which focuses upon the Fed's balance sheet and not on the Fed’s effort to raise interest rates.

The argument: The Federal Reserve actions are resulting in more and more US government debt entering financial markets, both those of the United States, but also those of the rest of the world. This is reducing the liquidity of world markets.

Added on top of this, the large US government budget deficits resulting form last December’s tax reform bill and the current year’s fiscal budget.

These actions, Mr. Patel predicts, will overwhelm world financial markets, especially those where securities are denominated in US dollars, and result in major problems for India, other emerging nations, and even for Europe.

“Sucking billions of dollars out of the system creates a liquidity squeeze for global bond investors.”

Will the Federal Reserve pay attention to this situation?

Ms. Tett writs that Mr. Powell, in recent comments, “will have little sympathy if emerging market economies try to blame the Fed for any market turmoil, or ask it to change course.” She goes on, “he, like other senior officials, seems (justifiably) very keen to stay on the same path at this point, to ensure that the Fed has firepower when the next recession hits.”

Ms. Tett believes that the Fed will not “accept the plea” of Mr. Patel to back off reducing its balance sheet. As a consequence, “Investors in emerging market assets should be warned.”

But this shows up some of the role that the Federal Reserve System plays in world economics and finance. That what the Fed does to liquidity impacts not only the United States but it also affects many different parts of the world. Liquidity in the United States is very important. Liquidity in the world is important.

I believe that not only should the investors in emerging market assets be warned about this situation but I also firmly believe that investors in United States assets should be warned about this situation.

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.