This week’s economic calendar is focused on Thursday when the Fed is expected to announce the first hike in US interest rates. Saying so and achieving it are two different things and we examine the cunning plan by which the Fed intends to realize higher interest rates in practice. Meanwhile, objective global economic conditions are creating cashflow problems and some large players, such as governments, have started selling assets.
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Sun 13 September
China Industrial Production y/y (actual:6.1% expected:6.3% previous:6.0%)
Mon 14 September
Switzerland Retail Sales y/y (actual:-0.1% expected:1.5% previous:-1.2%)
Tue 15 September
Australia Monetary Policy Statement
Japan Monetary Policy Statement
UK CPI y/y (expected:0.0% previous:0.1%)
US Retail Sales m/m (expected:0.4% previous: 0.6%)
Wed 16 September
US CPI m/m (expected:-0.1% previous:0.1%)
Thu 17 September
UK Retail Sales m/m (expected:0.2% previous:0.1%)
US Unemployment Claims (expected:276K previous:275K)
US FOMC Economic Projections
US FOMC Statement
US Federal Funds Rate (expected:<0.50% previous:<0.25%)
Fri 18 September
Canada Core CPI m/m (previous:0.0%)
Despite warnings, begging and pleading from big wigs at institutions such as the World Bank and the IMF, the Fed is dead set on pushing US (and, therefore, global) interest rates higher and their planning reveals this intention. The New York Times interviewed some key Fed actors and published details of exactly how the Fed intends to pull off its latest trick. Readers are referred to the original article, a summary of which is presented below.
In response to the 2008 credit crisis, the Fed pushed its ability to conjure money to new limits. By applying massive quantitative easing – buying enough securities and pumping enough reserves into the banking system – the Fed was able to drive interest rates on short-term loans to a near-zero 0.25%. As a result the US federal government pays about $0.05 to borrow $1,000 for one month.
The ground had been prepared by the lowering of bank reserve requirements during the Greenspan era, and since 2008 the creation of credit (by a process that can only be described as alchemy) has seen trillions of fiat dollars magically spring into existence throughout the banking system – on both US soil and in their overseas branches or subsidiaries.
The Fed kept buying Treasuries (debt) and mortgage bonds (debt) to – as the New York Times frames it – “eliminate safe havens” and discourage saving. The net policy effect is to force money into higher risk investments that might generate economic activity, namely equities (stock markets). Two of the outcomes are: a 7-year miraculously levitating stockmarket and (to quote the New York Times again) a banking system “almost comically awash in money”. Whereas banks had approximately $10.1 billion in their Fed accounts in 2008, this year the total stands at $2.6 trillion.
When the Fed announces the go-ahead for a US rates increase, whether this week or next year, it will be doing so within the paradigm and language of QE, but with a very different back-end mechanism.
If something is going to go wrong, I haven’t been able to figure out what, but there’s a lot of reason for caution. We’ve never done this before.
– Stephen G. Cecchetti, former chief economist at the Bank for International Settlements
Until now, the Fed had encouraged financial risk-taking as a means of raising productivity: stimulate business lending to increase employment and economic growth. Now, in order to raise interest rates, the Fed must gradually discourage risk-taking.
To discourage risk-taking, the Fed must limit borrowing and want to enforce this outcome by persuading banks not to make loans. But there is a system challenge.
The current 0.25% interest rate refers to the Fed Funds Rate, whereby banks can get cheap overnight loans at low interest. Since all US banks have centralized accounts with the Fed, the Fed can lend money from liquid bank accounts to those banks that require the liquidity for overnight shenanigans.
Traditionally, the Fed controlled the interest rate on these overnight loans by modulating the supply of reserves: It lowered interest rates by buying Treasury securities from banks and crediting their accounts, thereby, increasing the supply of reserves; and the Fed raised rates by selling Treasuries to banks and debiting their accounts.
However, the Fed does not control all borrowing and lending. With a financial system literally awash in credit, banks have been able to borrow money elsewhere (i.e. not from the Fed) for an average of 0.13% interest (as at July 2015). Willing low-interest lenders are plentiful the shadow banking system (mutual funds, money market funds, investment banks, etc) and this is where the Fed intends to target its new interest raising policy.
The Fed will harness the same overnight lending mechanism – turned on its head – by borrowing from the shadow banking system at a minimum interest rate. In other words, the Fed will pay the largest and most influential financial players not to use the massive amount of credit poured into their reserves during the past 7 years.
The mechanism is known as the overnight reverse repurchase agreements, and it encourages the largest willing lenders to lend to the Fed while the regular banks then have no lucrative alternative to the existing Fed funds rate mechanism, and so, control of interest rates falls back into the hands of the Fed.
It sounds ingenious, given the precarious economic environment, but there are concerns for the integrity of this model. The shadow banking system is unregulated and had been the culprit responsible for the 2008 credit crisis, in the first instance. Secondly, away from economic modeling and theoretical contortion, the fact remains that interest rates are a natural part of the normal functioning of free markets, and should continually be discovered by markets. Manipulation of interest rates through conjuration and tricks reminds of the Sorceror’s Apprentice and the destructive forces he unleashed by assuming that he had the power to harness them.
Perceiving question marks over its credibility, the Fed is likely to continue using the familiar language of its past role and say that it is raising the Funds Rate. That the heavy lifting is being done, behind-the-scenes, by borrowing from (and paying interest to) private unregulated bank-like companies will most likely not get too much limelight – until something goes wrong.
China’s foreign exchange reserves, the world’s largest, registered their biggest monthly decline on record during August. Reserves decreased by $93.9 billion to $3.557 trillion, according to PBoC data released last Monday.
Beijing presumably sold reserves during attempts to stabilize stock markets and fund margin lending during June and July when domestic stocks wiped trillions of yuan from equity markets and foreign capital outflows surged due to fears of an economic slowdown and amid prospects of a US rates hike.
A leading Chinese economic planning agency bolstered the view that the world’s second largest economy is stabilizing, saying that China’s power consumption, rail freight and property sectors have shown improvements during August.
Amid a production slowdown? PMI figures will show if the up-talk is true.
Saudi Arabia also began selling foreign reserves, this year, to stop-gap cashflow deficiencies and to support the ailing riyal following an oil and commodities decline. In February and March, the world’s largest oil producer sold $30 billion worth of foreign assets, the biggest two-month drop on record.
Currency reserve sales put downward pressure on the US dollar and upward pressure on Treasury bond yield rates, thereby effectively doing the Fed’s job on its behalf.
When you absolutely, positively have to be sure…
My sense is we’re better off making sure we can maintain control.
– James Bullard, St. Louis Fed president
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