One of the chief missions of this letter is to expose the shenanigans of Wall Street and the banking industry.
And behind most of these shenanigans is none other than the Federal Reserve.
The Fed is the private banking cartel in charge of the country’s monetary policy. The Treasury prints the currency, but the Fed “prints” the money. Given that the dollar is a fiat currency — they can be created at will — there’s really nothing to stop them.
Ostensibly the stated purpose of our glorious central bank is to promote price stability and maintain low unemployment.
I’ve been writing in our free letter that the Fed has become solely focused on combating inflation because if people don’t believe they can keep inflation at around 2%, if they start thinking that 3 or 4 or 5% inflation will become the norm, then their collective belief will raise prices.
Which is a crock. We can go into more depth another time but the Fed itself issued a paper on it titled Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)
Spoiler alert: No we shouldn’t.
The real reason is that if the Fed doesn’t get inflation back down around the 2% range pronto, it’ll lose its credibility.
Think about it, if the Fed can’t do what it’s been mandated to do, then why do we have a central bank at all?
Well… it pays the interest on the government’s overspending for one thing.
And it props up Wall Street when they’ve misbehaved too badly.
But as an individual investor, you gotta be wondering, “What’s in it for me?”
The answer: Not much.
In a world of TBTF banks, what’s good for THEM is good for you.
And so that brings me to the latest little charade that the Fed has been propagating on you and the economy: Dealing with inflation.
They’ve slammed the brakes on QE. And there’s talk of spooning about $700 billion from the balance sheet every year. (Which, in very round numbers, would take over a decade to clear.)
They talk about inflation as such a threat, they’ve basically taken us to economic Defcon 5 waiting for the recession mushroom cloud.
Their message has been unequivocal:
“NO MORE FREE MONEY!! This is what got us in all trouble so NO MORE!! We’ve got to get this inflation monster under control. WE’RE SERIOUS, DAMMIT!! DON’T YOU MAKE FUN OF US! This is our job!! Inflation is first and foremost… and we’ll even risk a recession if we have to. The public MUST BELIEVE that 2% inflation is achievable.”
Well, it would appear that the Fed, now projecting itself as a newly minted Uncle Scrooge McDuck, who wouldn’t hand another penny out even if you were down to your last sticky bun…
…Is actually quietly shoveling a quarter of a billion dollars (that’s $250,000,000 for those more visually oriented) to its banker boys EVERY SINGLE DAY!!
How are they managing this monetary sleight of hand? Let me explain…
A Peek into the Fed’s Operations
To understand how the Fed does this magic, we need to start by taking a quick look into how they manage their main interest rate known as the Fed Funds rate.
Since the dawn of time (actually before 2007) the Fed did this through something called a “limited reserves” monetary framework. Banks were required to hold a certain percentage of their deposits as reserve capital at the Fed. Under this system, banks didn’t receive any kind of interest on this money. That meant they were incentivized to keep their deposits as close to their reserve requirement as possible.
However, a bank’s reserve requirements could fluctuate on a daily basis. And based on their needs, they often found they needed to borrow money to meet those requirements. Enter banks (or the Fed) who held excess reserves. The bank who was short cash could borrow an amount overnight at a specified rate — the Fed Funds rate.
The supply of reserves (or how much money was available to lend) was tweaked by the Fed through a process called Open Market Operations. The Fed could increase that supply by buying treasuries thus adding reserves to the system and ticking the funds rate lower. Conversely, if they needed to raise the funds rate they sold treasuries draining liquidity and nudging the rate higher.
What could be simpler?
Then in 2008, the financial world as we knew it ended (almost). With the world dangling at the precipice, the Fed took some drastic steps.
First they lowered the Fed Funds rate to zero. (They actually started using a 25 basis point range of 0% to .25% rather than a hard target rate.)
Second, they set up a number of funding facilities that provided additional liquidity to banks and nonbanks alike.
Finally they started their most recent QE program of buying treasury and mortgage backed securities at a monthly clip.
To make things even looser money-wise, in 2006 Congress passed the Financial Services Regulatory Relief Act, which authorized Fed banks to:
…pay interest on required reserve balances (that is, balances held to satisfy depository institutions’ reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances).
This was originally to take effect in 2011, but as the world was already melting down, they moved the effective date to 2008.
So now it cost nothing to borrow money, the Fed was offering handouts at every turn, AND as a bank you were getting paid on your reserves. What could be better if you were a bank?
Under this program reserve deposits exploded as you might expect. Just five years before the crisis, the Fed’s aggregate reserve supply averaged $11 billion (with just $1.7 billion in excess reserves). By 2014, total reserves averaged — hold on for this — $2.6 TRILLION! And nearly all of it was excess reserves.
The Fed Solves Another Serious Problem
So you’ll recall the original mechanism for managing the funds rate was done in something called a “limited reserves” framework.
By now, as reserves were obviously no longer “limited,” the Fed switched their strategy to something called an “ample reserves” framework. They needed to do this because under the conditions they created, it was basically impossible to tweak the supply of reserves (and thus keep the fed funds rate in their target range) through simple open market operations alone.
Instead, they believed they could do this via the interest rate they paid on reserve deposits — the IORB (or Interest on Reserve Balances)
[As a side note: in March of 2020, given all the money sloshing around at the Fed, they reset their reserve requirement for banks to ZERO (a popular number in financial circles) and did away with what was formerly called Interest on Required Reserves (IORR) and Interest on Excess Reserves (IOER) replacing them both with Interest on Reserve Balances (IORB).]
Since a bank could earn IORB virtually risk free, there would be no incentive for any bank to lend reserves at a rate below it putting a virtual floor on the fed funds range. And if the Fed funds rate somehow did fall below the IORB, banks could borrow at that lower rate and simply deposit the money back with the Fed. A “free money” arbitrage that would keep the funds rate in line.
But nothing is that simple.
Not all institutions with accounts at the Fed were eligible to earn interest on deposits (like money market funds (MMFs), nonfinancial corporations, and government-sponsored enterprises (GSEs)). Since they weren’t, these institutions could be motivated to lend excess funds at or below the lower end of the Fed’s range. And they didn’t care who played the “arb” because something’s better than nothing.
So to work around this, in 2014 the Fed introduced a new tool they called an Overnight Reverse Repurchase agreement (ON RRP or “overnight reverse repos”). (Emphasis mine.)
In the Policy Normalization Principles and Plans announced on September 17, 2014, the Federal Open Market Committee (FOMC) indicated that it intended to use an overnight reverse repurchase agreement (ON RRP) facility as needed as a supplementary policy tool to help control the federal funds rate and keep it in the target range set by the FOMC. The Committee stated that it would use an ON RRP facility only to the extent necessary and will phase it out when it is no longer needed to help control the funds rate.
These reverse repos allowed a broader set of counterparties (i.e. those who might otherwise lend reserves below the IORB) to participate in the party.
Their mechanism is pretty simple. The Fed sells securities to a counterparty and then buys them back the next day paying a rate of interest at or just above the IORB. Now all those not eligible for IORB can earn interest on their excess funds and are no longer incentivized to push rates below the Fed’s lower range.
Problem solved. Well almost… According to the Bank Policy Institute:
When the Fed introduced the facility, it acknowledged that the ON RRP could have some negative implications for financial stability, since large and sudden increases in usage could occur and amplify flight-to-safety flows during periods of financial stress. For this reason, the limit on the amount each counterparty could bid to the facility was set at $30 billion per day when the facility was introduced back in 2014. Notably, on March 17, 2021, the FOMC increased the counterparty limit to $80 billion.
Is This Going Anywhere?
By now you’re probably waiting for me to say, “If you don’t understand all this, don’t worry. It’ll all become clear in a second.”
Unfortunately it won’t. I’ve tried to simplify the internal workings of the Fed as much as I can. Hopefully, you do have a little better understanding of how they work. But thanks to all the mechanisms and constantly changing rules, the Fed ain’t a simple organization.
Instead, let’s move on to the moral of this story, starting with the ON RRP.
From the time they first launched the program, and prior to April 2021 with rates near zero, action in the reverse repo market was fairly tame.
Overnight Reverse Repurchase Agreement Facility
But then, as the Fed announced their rate-raising mission, things heated up substantially (remember, the ON RRP rate as well as IORB rate both move in line with the Fed Funds rate)…
There is currently $2.1 TRILLION on the books at the Fed reverse repo facility — now earning 1.55%!
Overnight Reverse Repurchase Agreement Rates
Add to that the rest of the reserves on account with the Fed…
…which currently totals $3.13 trillion and is earning just over 1.6%!
Interest on Reserve Balances (IORB)
Add it all up and the Fed is shelling out somewhere in the range of $250 million in interest payments to its banking cronies every day! And that’s with the Fed funds target at 1.75%
Wait’ll the end of this year when they’ve bumped it to their target of 3%.
Suddenly their cries of “stop the money and crush inflation” seem a little hollow when you see what they’re really up to…
Make the trend your friend,
Editor, Streetlight Confidential