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The Fed Is Killing Money Market Mutual Funds, On Purpose or Collateral Damage?

Negative demand for deposits hit a new record high on August 31. Yet the Fed continues to pump unwanted liquidity into the markets.
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Reverse Repos 2021-09-01

Repos and QE Q&A

Repos are a cash injection by the Fed to banks. The Fed gives cash to banks in return for collateral, typically short-term treasuries. The Fed's QE program is accomplished by outright purchases (but that is effectively the same as short term repos continually applied).

Reverse repos are the opposite. It's a cash drain from banks. Thus, the Fed has unwound over $1 trillion of its QE program

Cracks Emerge in the Fed’s Floor as Key Target Rate Slides

Bloomberg reports Cracks Emerge in the Fed’s Floor as Key Target Rate Slides

The effective fed funds rate, which the central bank is currently aiming to keep within a range of 0% to 0.25%, slipped by 1 basis point to 0.08% on Aug. 27, the Fed said Monday. That’s closed the gap to the offering yield on the Fed’s overnight reverse repurchase agreement facility, which is supposed to act like a floor for the front end, to just 3 basis points. 

Money-market rates have been under pressure all year as a result of the central bank’s long-standing asset purchases and drawdowns of the Treasury’s cash account, which is pushing reserves into the system.

At the same time, supply has been dwindling, especially as the Treasury cuts bill supply to create more borrowing room under the debt ceiling, leaving investors scrambling for places to park cash. Those that have access to the Fed’s so-called RRP facility have opted to leave money there, pushing balances to all-time highs in recent days. 

Fed’s Ability to Set Rates Floor Is Weakening on Cash Deluge

A week ago, Bloomberg reported Fed’s Ability to Set Rates Floor Is Weakening on Cash Deluge

The pressure pushing down overnight rates toward zero is proving a major headache for money-market funds. It hampers their ability to invest profitably, and can lead to further disruptions as they begin to waive fees to avoid passing on negative rates to shareholders. A number of firms including Vanguard Group shut down prime money-market funds last year after struggling to cover operating costs in the low-interest-rate environment.

Fed's Balance Sheet

Fed's Balance Sheet 2021-08-25

The recession ended in May. Yet for four months the Fed continues to add to its balance sheet (QE) at $120 billion a month.

This is despite the fact that markets are choking on excess liquidity. 

Free Money 

The Fed pays 0.15% interest on reserves. So banks are making out like bandits.  

However, only banks get that 0.15%. Money Market Mutual Funds don't.

Breaking the Buck

To prevent breaking the buck (money markets charging interest on deposits), the Fed recently started paying 0.05% on Reverse Repos.

So while the Fed is doing $120 billion a month in QE, the lead chart shows how much it is taking back. 

And if the Fed did not pay interest on reserves to banks, it would be forced to take back nearly all of that $8.3 trillion balance sheet.

Will the Fed Balance Sheet Get Spent into Circulation Causing Inflation?

QE, fiscal spending, and stimulus all add to M2. But the QE portion of M2 is fake. QE is not spendable money, nor money that was ever spent, nor money that ever will be spent!

Since QE never enters the economy. M2 is overstated by the amount of QE. 

I covered the idea in detail in Will the Fed Balance Sheet Get Spent into Circulation Causing Inflation?

Smooth Functioning!?

The Fed has been pumping $120 billion a month into banks and has now taken back nearly a year's worth of QE.

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Nonetheless, New York Fed President John Williams said that the reverse repo system “was working really well,” and that there were “really, no concerns about that. We expected that to happen. It’s working exactly as designed."

On Purpose or Collateral Damage?

This absurd situation has now gone on so long that questions abound.

  1. Is Williams a liar or does the Fed really believe it's working well? 
  2. Working well for whom? 
  3. On purpose or collateral damage?

To answer question 2, it's free money to banks but "a number of firms including Vanguard Group shut down prime money-market funds last year after struggling to cover operating costs in the low-interest-rate environment."

Next consider question 3. 

The Fed is clearly struggling to not break the buck. Is this to avoid blame and Congressional inquiries if all the money markets shut down? 

Fine Line

Is the Fed walking a fine line of trying to escape blame while simultaneously hoping consumers pull cash and spend it (tired of collecting 0% on their money)?  

The problem with that question is simple: Someone must hold every dollar 100% of the time. 

Even if people spend money, those dollars have to sit somewhere. If the dollars don't sit at Money Markets, they will sit as bank deposits instead, while collecting 0.15% interest instead of 0.05% interest.

Meanwhile, the Fed continues to add to its balance sheet while simultaneously subtracting from it. 

One Final Possibility

The Fed may know full well its distortions are not at all working well. If so, why does it do them? 

The Fed is a big believer in overshooting its inflation target. It may know full well QE is counterproductive to Money Markets but hopes to manage it.

Twisted Minds

The longer the Fed can keep this charade of QE and Negative QE going, the longer it can avoid hiking rates. 

This line of thinking suggests the Fed is doing this on purpose while simultaneously attempting to minimize collateral damage and avoid killing the money markets.

The Fed's groupthink minds are so twisted it's entirely possible they actually believe the setup is working well despite the distortions and the fact that QE has not increased bank lending. 

QE is Not Harmless

QE sponsors bubbles by artificially lowering interest rates, it's free money to banks, distorts money markets, and central banks are addicted to it.

For discussion, please see The House of Lords is Concerned Over a Dangerous Addiction to QE.

And for a discussion of the monetary aspect of QE please see What is the Best Measure of Monetary Inflation?

Finally Here's a Quick Check as to How the Fed's Balance Sheet Helps Spur Lending

Here's a hint: It doesn't. 

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