Is the repo market more important than the Fed’s tapering? According to Manmohan Singh and his paper, “Collateral and Monetary Policy,” an IMF Working Paper, it seems that the Fed’s efforts to pare down its vast balance sheet will be much more significant for the markets. This work by Singh is critical to dealing with the issue of money and its velocity, or the lack of velocity of money that has kept the inflation rate down (despite all the predictions of rampant price increase due to the huge liquidity creation by the FED). The FED‘s vast $3.5 trillion balance sheet has kept high-grade collateral from providing the lubrication to the credit/repo markets.
Singh writes: “The collateral/repo rate will need to be contained below the policy rate to avoid inflationary dynamics. Thus repo rates will remain an important gauge if central banks chose to unwind. Analogous to a coiled spring, the larger the QE efforts the lesser the control central banks may have on the ‘WEDGE’ between repo rates and their policy rate [e.g. IOER]. This is likely to result in very little collateral release to the markets …” This is not an easy concept to understand but it has significance in understanding the FED‘s present dilemma. As long as high-quality collateral is scarce and markets push repo rates below the FED FUNDS rate, banks will continue to park their excess reserves as the FED and not lend in the open market. But if the repo rates move higher then the IOER banks and others will be utilizing collateral to fund lending in the market and unleash a massive amount of liquidity.
It is for this reason that the FED has raised the issue of letting the financial assets on its balance sheet just reach its expiration date rather then unload massive amounts of high quality paper and watching the repo rates go higher as financial intermediaries are inundated with liquidity. Repo rates are now close to zero because of the lack of good collateral in the market. As Mr. Singh concludes, “The Fed cannot let the ownership of these securities go back to the private market until the economy is strong enough to handle the duration [which is why they leak out slowly].”
I want to make it clear that the road ahead for the Fed is fraught with very dangerous and uncertain outcomes. The issue of using regulatory tools to curtail the leverage of the financial system becomes of major importance, which means that the next Fed chairman is of more importance than the financial pundits would lead us to believe. The market outcomes of the Fed’s balance sheet are very uncertain. We will measure various scenarios as the saga unfolds.
***Earlier, the Reserve bank of New Zealand announced that it was holding its Official Cash Rate (OCR) steady at 2.5%. The KIWI currency went BID as Governor Graeme Wheeler let it be known that “OCR increases will likely be required next year. The extent and timing of the rise in policy rates will depend largely on the degree to which the momentum in the housing market and construction sector spills over into broad demand and inflation pressures. We expect to keep the OCR unchanged in 2013.”
The projections by the RBNZ are subject to change as Governor Wheeler again cites the overvalued KIWI as an economic headwind. The RBNZ warns that it can calm the problem of rising home prices with regulatory tools rather than the blunt instrument of interest rate policy, which results in adding strength to an already too strong currency. Just another piece in the arsenal of central bankers.