I think that it was Henry Kissinger that once said that "academic politics is so vicious because the stakes are so low". However, when academic politics affects economic policymaking, the stakes are far from low.

The New York Fed was slow to recognize the Global Credit Boom / Bad Maths that led to the Global Financial Crisis. We believe that this failure was first and foremost due to staff problems / possible conflicts of interest within Geithner’s office. If there was communication from Wall Street ahead of the crisis – and we have been told that there was – it was not acted upon, but the situation turned 180 degrees with Dudley’s appointment in 2008. Indeed, by the middle part of Dudley’s presidency, the institution might have been accused of being too friendly with Wall Street.

However, under Williams the NY Fed has taken a significant step towards being an ivory-tower academic institution that stands aloof from its constituency. Certainly, it has become too model dependent and academically focused, if anything put me off being an academic economist, it was the type of environment that Kissinger was alluding to. Academics don’t like being (proved) wrong and only the very best seem to admit when they are wrong. While it has been suggested that former Hedge Fund managers make poor central bankers, because they can change their minds too fast; academics seem to have the opposite problem (no when the facts change, I change my opinion…). We fear that the inertia that this will bring to policy will sentence the US to a deeper recession than would be required to “solve” the current inflation. Indeed, it is our sense that even the Chairman is becoming rather frustrated by the situation; not only has he diverged in public from staff forecasts and the committee consensus, but we hear that he has been looking outside for explanations for what is going on at present…. We suspect that his current compromise position of becoming ever more data dependent implies that, not only will markets have to play data roulette for a few more weeks, but that the risk of the Fed overtightening has increased. Powell may yet rue the hawkish guidance that (arguably) he provided at this week’s meeting.

The Buck Stops With the Fed

To our mind, the Federal Reserve has made a number of fundamental errors since 2020, and arguably since 2015. The first error – that one can certainly have some sympathy with given the circumstances – is their badly calibrated response to the Pandemic.

Inasmuch as they were responding to an unknown threat to the economy in 2020, they can perhaps be forgiven but if some of the QE was in fact designed to help out a number of funds who had been caught the wrong way in the UST market, as has been suggested, then that is another matter. Whatever the rationale, the result of the 2020 Panic QE was a 25% or more increase in the deposit base of the domestic banking system. Of course, there was simply no way that the commercial banks could acquire a quarter more risk assets (certainly not without massive rights issues that they didn’t want to do) and so the banks were obliged to park the incoming funds into US Treasury-type assets. Hence, their holdings of T bonds rose dramatically as their deposits swelled, but they were of course being compelled into buying bonds at the wrong prices…

USA: Commercial Bank Holidays of UST

USD billion; % share deposits


% pa

Traditionally, US commercial banks have kept the equivalent of 15-20% of the value of their deposit liabilities in US Treasuries as an ongoing liquidity buffer / rainy day fund. There have been moments when they have held more: the Post S&L Crisis witnessed a sharp rise in their holdings (which was of course followed by the 1994 Bond Market Debacle when they tried to exit…); the Post 9-11 Deflation Scare (followed by the back up in yields that preceded the GFC…); and more recently.

Print More, Worth Less

By the end of 2021, the Federal Reserve had added a third more money to an economy that could produce no more than it could in 2019 (due to falling labour participation & weak productivity). That the value of money fell relative to goods and services is therefore hardly surprising, and this burst of inflation quite naturally undermined bond prices, albeit perhaps not quite as badly as one might have expected. Nevertheless, the Fed’s unfettered QE between 2020-21 has left the banks very long of bonds at the wrong price that they cannot now dispose of without suffering what would be crippling hits to their capital bases.

USA: Real M3 - Up then Down...

Deflated by PCE deflator to 2023 Q1

Unrealized Losses – the February “Problem”

The academics at the Fed seem to have woken up to this mark-to-market issue / threat to bank capital last February (the famed presentation), but even so they seem remarkably slow to recognize that, by “zombie-fying” the banks’ bond portfolios, they have made the banks’ savings in the T bond markets effectively useless. Now, the banks’ rainy-day funds must be rebuilt and held in cash & cash-like instruments, such as bank reserves. This undoubtedly represents a huge change in the banks’ modus operandi and in particular in their demand for reserves. This is not a change that any econometric model will have been able to capture.

Moreover, the banks are also facing an economy that is intermittently haemorrhaging deposits through its current account deficit. The Federal Government’s cash balances (the “TGA”) is oscillating by hundreds of billions of dollars a quarter, and now we have the threat of “instant bank runs”. Relatedly, there is the change in investment behaviour by the MMF. Five years ago, MMF generally acquired investment securities when they received inflows, and these bill acquisitions implicitly returned funds to the banks (the seller of the T bill received funds into their brokerage account held at a bank; or the government spent the money in the real economy that was received when it issued T bills). However, as QE inflated the financial assets of the private sector (including the MMF), the MMF simply became too big relative to the markets that they invest in and, as a result, they have become the largest counterparties to the Fed’s RRP scheme. This was not the intention of the RRP and, unfortunately, when the Fed sells T bonds to the MMF, it locks away the proceeds sterile in its own vaults, thereby preventing them from finding their way back to the commercial banks.

Chart 3: Government MMFs have substituted into ON RRP from Treasury bills and private repo

Trillions of U.S. repo

USA: Federal Reverse Repo Operations

USD million outstanding

Currently, we now have a “bunch of academics” debating whether MMF are part of the M2 money supply or not. Of course they are, but it is not the MMF’s liabilities that are the issue here, it is the change in their asset mix that is the problem for the system. In our view, the academics are fixated on the wrong side of the MMF balance sheets. However, in order for the Fed to admit that this problem exists, it would have to explain just how the MMF got to be so large in the first place (i.e. it did too much inflationary QE), and why the Fed has implicitly and accidently used the MMF/RRP nexus as a form of unintended QT that has hamstrung the banking system.

Is the Fed Waking Up to the MMF Problem? Changing the Rules

So, instead of admitting the problems, we have the Chairman saying that the activities of the MMF are ‘not a problem’, while quietly in the background changing the rules on which MMF can continue to access the RRP facility. Since the 25th of April, an MMF has to show that it is entering into a repo with the Federal Reserve as part of a diversified investment portfolio and not simply so that it can have an account at the Fed. We are not sure as to how significant this rule change will prove to be (probably not very…) but the contrast between what the Fed is saying and what it is doing is interesting nonetheless…

Who Would Be a Bank?

Faced with this loss / potential loss of funds to the MMF, the banks that have already had the utility of their T bond holdings nullified now need even more cash on their balance sheets in order to feel secure. We doubt that the Fed’s reserve models have caught up with this issue either (or at least they can’t admit to it) and so the Fed is still labouring under the misconception that there are excess reserves in the system and that it should therefore continue with QT. In fact, there probably aren’t enough reserves in the system even now. Finally, there is also the not unimportant question of just how big is the banking system in reality? On paper, the US banking system is roughly a $20 trillion behemoth but in reality, the Post GFC regulatory blitz led many banks to pursue off balance sheet business lines. If the recent studies by the BIS have any validity, the banking system may be very much larger than the authorities realize, implying that it has an even bigger internal effective demand for settlement cash and precautionary cash balances than the Fed realizes. In order to support their true balance sheets, the banks probably need much more cash than the on-balance sheet models capture.

FX Debt Owed by Non US Banks

USD trillion

Is the Fed Blind to What is Happening?

We find it virtually inconceivable that the Fed’s models will have been able to capture the effects of these quite fundamental changes in the way in which banks have – and have had to - operate over recent years. In practice, we suspect that very few banks themselves now how much cash / how many reserves they need at present…

In Dudley’s era, they could at least communicate this problem to the NY Fed, but the communication channels seem to have been blocked, thereby leaving the authorities only finding out about things when they break (the December 2018 and September 2019 funding spikes, SVB etc etc), and quite possibly blindly tightening into what looks likely to be one of the worst credit crunches / monetary slowdowns in the modern era. We can only assume that this will cause quite a few things to “break”, including economic growth, credit markets and ultimately the labour market. Weirdly, none of the assembled journalists seem to want to challenge Chairman Powell on this particular issue during the press conference…

USA: Credit Conditions Indices

USA: Real M2

% YoY

The Q&A session of the last FOMC did not see anyone ask about the significance of the amazing collapse in money growth (or how the previous surge in liquidity fed inflation…). No longer can we “hide” behind the notion that the weak flow of money given the inflated stock post pandemic; inflation has eroded the real value of M2 back to its early 2020 level and even real M3 is almost back to its pre pandemic levels. At the press conference, there were lots of micro questions about bank regulation & blame games over SVB, as well as the usual pointless “what will you do with the Fed Funds at the next meeting?” type questions, but evidently there was no appetite to address the obvious elephant in the room, namely that this Federal Reserve has presided over some of the worst monetary instability in living memory. Having inflated the money supply, and hence the nominal economy, then crashed the banks and pushed them into deflation (to be followed by the nominal economy in 2024?), you might have thought that someone in the room might have wanted to ask the Fed some difficult questions…

G3 Too Easy in 2021; Too Tight in 2023.

An out-of-touch Fed that looks set to overtighten, some of the worst money and credit data since the worst of the Great Depression, and markets being hoodwinked into giving a strong “FCI signal” by a very narrow credit boom within short term bank lending to other financials (banks will lend overnight against T bond collateral..) sounds to us like a recipe for a deeper than necessary recession in the second half of this year. In terms of the outlook for economic growth, we would now be preparing for the worst. Meanwhile, and not to be forgotten, we have a BoJ that recently returned to QT even as recessionary forces mount, and an ECB that may not be doing much QT but which is unwinding the TLTROs even as its banking system loses deposits to heavy bond issuance by governments and a degree of deposit flight. We suspect that Europe’s falling money supply / rising public debt issuance will support the EUR for a few more weeks but that by H2 the ECB will be looking at a very different outlook to the one that it seems to be expecting currently.

Key Points: The Worst Monetary Instability in Ninety Years?

  • The Federal Reserve has been hijacked by “academic” economists and is allowing money and credit conditions to over tighten.
  • The last FOMC meeting yielded a hawkish statement along with a commitment to continue with QT and the RRP scheme, although quietly behind the scenes it does appear that the MMF’s access to the RRP is coming under closer scrutiny.
  • We expect a deep recession to begin during the second half of this year.
  • The ECB and BoJ also look to have become awkwardly procyclical.
  • A needlessly severe global recession awaits.
  • Having lurched from too accommodative and inflationary in 2020-21, central banks now risk becoming deflationary.
  • Presumably, next year they will swing back to inflationary – we are back in the 1970s’ narrative but perhaps with even more amplitude!
  • We would favour the 3 – 12 month part of the yield curve.
  • The Major Currencies look to be driven at present by a Hicksian Model – issuing large amounts of sovereign debt into a tightening monetary environment will yield a stronger exchange rate in the near term. This is supporting the EUR at present (to Germany’s discomfort) but once the Debt Ceiling is raised (?) the USD should take over the running.

  • Disclaimer: The information in this report has been taken from sources believed to be reliable but the author does not warrant its accuracy or completeness. Any opinions expressed herein reflect the author’s judgment at this date and are subject to change. This document is for private circulation and for general information only. It is not intended as an offer or solicitation with respect to the purchase or sale of any security or as personalised investment advice and is prepared without regard to individual financial circumstances and objectives of those who receive it. The author does not assume any liability for any loss which may result from the reliance by any person or persons upon any such information or opinions. These views are given without responsibility on the part of the author. This communication is being made and distributed in the United Kingdom and elsewhere only to persons having professional experience in matters relating to investments, being investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005. Any investment or investment activity to which this communication relates is available only to and will be engaged in only with such persons. Persons who receive this communication (other than investment professionals referred to above) should not rely upon or act upon this communication. No part of this report may be reproduced or circulated without the prior written permission of the issuing company.