A flurry of reporting this week on the Federal Reserve’s ongoing repo problem strikes a worrying tone. Experts including JPMorgan Chase (JPM) CEO Jamie Dimon are warning of future problems in the overnight money markets similar to what happened on Sept.17th , 2019, when overnight rates skyrocketed to as high as 10%. What the Fed is doing now is no long term solution, they say.
We are also told that these interventions are unconventional, though that may not be the case, at least not qualitatively. Daily repo interventions by the Fed can be more accurately described as a return to convention. What the Fed has been up to since September has actually been its bread and butter for decades. A historical search of daily Fed repo operations going back to July 2000 reveals that before 2008, the level of excess reserves in the banking system was consistently negligible, so the Fed was the main source of overnight liquidity.
In that case, what is the reason for the repo hiatus since 2008? It is simply because repo interventions have been unnecessary since then. Overnight lending operations became redundant in the face of all the quantitative easing the central bank embarked upon. Banks had so much excess reserves that more liquidity wouldn’t have accomplished anythin, so for the last 11 years, the Fed has shut down those operations.
The question that these experts are now concerned with is why the Fed has been forced to return to its old ways when there are still over $1.34 trillion in excess reserves in the banking system.
Although liquidity has the same economic effect regardless of why it’s being created, what should really concern investors is the question of how much and for how long. A look at a long term chart of the Fed’s balance sheet since 2002 shows that prior to the financial crisis, the balance sheet was expanding at an even pace of about $200 billion over a six year period.
That slow, steady expansion was the result of continuous repo operations of various lengths and sizes that went on prior to the financial crisis. Zoom in to the daily data at any date from 2000 to September 2008 and you’ll find that that those previous operations were much smaller than they are today. What that means is that the Fed only needed relatively small daily liquidity injections in order to keep the fed funds target in range. Those needs have become much bigger now.
A search back to July 2000, the earliest date the New York Fed has records for, shows that the largest single repo operation conducted between then and September 2008 (excluding the immediate aftermath of the September 11th attacks) was $27 billion. The daily average for all those years was $6.35 billion, while the daily average since the Fed restarted repo operations has been $54.88 billion.
Interest rates want to head higher in order to replenish the depleted savings of Americans, but the Fed is preventing them from doing so with ever larger doses of liquidity. Interest rates have been suppressed for so long now that the doses will almost certainly have to get continuously larger until the dollar supply grows so fast that inflation becomes obvious, at which point a controlled rise in interest rates to suppress inflation could prove impossible.
In short, we could at some point end up seeing a sudden, violent move higher in rates just like we saw back in September, but next time it could last for much longer than a single day. The only long term solution can be to stop inflating and let the chips fall where they may, which of course is politically impossible.
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