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Current Views

The Market versus The Fed

A divided Federal Open Markets Committee (FOMC) meets this week. Federal Reserve members recently issued divergent statements as to their desired course of action for the Fed funds rate. For instance Governor Brainard, who does not often speak publicly, laid out the case for the FOMC to stand pat, given “greater slack than anticipated” in the economy . At the same time, Boston Fed President Rosengren observed that “tightening is likely to be appropriate” while making a case that we risk overheating inflation in the near future.

Both of these views come from looking at economic models and forecasts. Yet to many observers, the models simply have not been working. Expected economic expansion and corresponding anticipated increases in the Fed funds target rate have consistently missed the Fed’s expectations over the last several years. Kansas City Fed President Bullard has as much as said the models are not working. As a result, he thinks that we simply need to see where the economy is at each meeting, but cautions that he does not believe it is gaining much traction.

The FOMC meeting this week will include a post-meeting press conference. At those, Federal Reserve Chair Janet Yellen usually seeks to present a balance of the entire committee’s views to the media and the world. Regardless of the outcome of the meeting, with hawk and dove camps becoming more firmly entrenched, it will be interesting to see how she softens these conflicts.

The markets also have conflicting views. First, they are fading any expectations that the Fed funds rate will be increased at the meeting. Based on Fed funds futures, expectations indicate a 15% chance of a rate hike. In addition, there is a clear signal that has relegated the Fed to spectator status. The markets have repriced a critical asset, LIBOR, which serves as a proxy for short-term credit funding. It is a benchmark for credit borrowing, with most lenders charging debtors some spread above LIBOR for their borrowing needs. LIBOR has escalated recently, by itself raising the price of credit to many borrowers, or “tightening” in Fed language. This increase does not appear to be a signal of stress in the financial system or bank lending, or an indication of deterioration in borrower credit quality.

A major cause cited by market observers for the increase in LIBOR is the change in money market fund regulations. Adopted by the Securities and Exchange Commission in 2014, the new rules go in effect on October 14, 2016. Going forward, the structure of “prime” money market funds, those that invest largely in corporate debt securities, changes from a fixed $1 net asset value (NAV) to a floating NAV. There is also the possibility of redemption fees or lock-out periods.  

 

Source: FRED, accessed September 20, 2016

In anticipation of this change, there is an asset flight in brokerage sweep accounts from prime funds to government-only money market funds. Government funds will retain their $1 NAV. While this upward pressure on LIBOR comes from an unusual market force, it’s had a significant impact. As shown in the graph, with hundreds of billions of dollars on the move, LIBOR has increased as much from this force as it did from last December’s Fed-engineered rate rise. As a result, the market impact is the same as a move from the Fed: borrowing costs are higher for LIBOR-based borrowers. This means that banks and borrowers are paying more for funds. Given this, one wonders if it would make sense for a conflicted Fed to also increase the Fed funds rate, as such a move would likely in turn push LIBOR higher still.

We see the new money market rule as indicative of a more complicated economic landscape where the Fed’s demand-based macroeconomic models are not providing the complete story. The change in money market fund structure, like a host of other post-financial crisis remedies, has caused encumbrances that have detracted from growth. In this case, it is higher borrowing costs, despite no change in the Fed’s base rate.

At the same time, other headwinds, including tax and regulatory burdens, appear to be the culprit for reductions in productivity and other losses in economic growth. Compliance is the fastest growing field in banking and finance. The price of perhaps safer money market funds and a more robust compliance structure may ultimately be worthwhile. But collectively, these factors reflect structural issues that macroeconomic models have trouble seeing. Perhaps Bullard is right and the models need to be shelved for a while. This would not be a popular solution within the economics profession, but right now the Fed is certainly in doubt of their trend line. 



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