“The pronouncements and actions of the Federal Reserve Board on monetary policy are a charade.” Fischer Black
By Elham Saeidinezhad – As the US Department of Treasury builds the points along the yield curve, the bank reserves are losing relevance in explaining short-term money market rates’ behavior. Central banks assume that they can create a close link between the best form of money (reserve) and monetary policy. They use the supply of reserves precisely to achieve the target interest rate. Since the 2008-09 Great Financial Crisis (GFC), however, the relationship between money and monetary policy has become unstable. After the COVID-19 pandemic, for instance, the Fed’s actions more than doubled the supply of bank reserves, from approximately $1.5 trillion in March to more than $3 trillion in June. In theory, such a massive increase in the supply of reserves should reduce the money market rates. Yet, short-term money market rates have been surprisingly steady, despite the enormous increase in reserves during the great lockdown. Fed economists recognize the over-supply of short-term US Treasury bills (a money market instrument) as the leading cause of the puzzling behavior in money market rates and call it “friction.”
However, for the Money View scholars, dividing the money market from the capital market, assuming that prices in each market are solely determined by its supply and demand flow, has never been an effective way of understanding interest rates. In the Money View world, similar to Fischer Black’s CAPM, the arbitrage condition implies that both the quantity and the price of money are ultimately determined by private dealers borrowing and lending activities that connect different markets rather than the stance of monetary policy alone. Dealers engage in “yield spread arbitrage,” in which they identify apparent mispricing (i.e., temporary fluctuations in supply or demand) at one segment of the yield curve, and takes a position. Dealers take “positions,” which means they speculate on how prices of assets with similar risk structure but different term-to-maturity, will change. In the meantime, they hedge interest rate exposures by taking an opposite position at another segment of the yield curve.
The point to emphasize is that short-term money markets and long-term capital markets are, in fact, not separate. As a result, prices in each market are not solely determined by the flow of supply and demand in that particular market. By taking advantage of the arbitrage opportunity, the dealers act as “porters” of liquidity from one market to another and connect prices in different markets in the process. The instruments that allow the dealers to transfer liquidity and solidify markets are repos and reverse repos, where capital market assets are used as collaterals to borrow from the money market, or vice versa. The Money View’s strength in understanding price dynamics comes from its ability, and willingness, to understand the dealers whose business connects different points of the yield curve and determines the effectiveness of the monetary policy.
During the COVID-19 pandemic, two separate but equally essential developments (aka distortions) occurred along the yield curve. In the long-term capital market, the Treasury has introduced a new class of safe assets, a 20-year Treasury bond, with a high yield (corresponding to the lowest accepted bid price) of 1.22 percent. Effectively, the US Treasury added a new point to the long-term end of the yield curve. In the short-term money market, the Fed injected a massive amount of reserves to reduce money market rates. The standard view suggests that such an increase in the supply of reserves would reduce the money market rates. The idea is that banks are the only institutions that hold these extra reserves. Due to balance sheet constraints, such as banks’ regulatory requirements, higher reserve holding implies higher banks’ costs. Therefore, banks reduce their short-term rates to signal their willingness to lend. In practice, however, short-term rates remained unchanged.
This dynamic in money market rates can be explained by the recent developments in the Treasury market, a segment of the capital market, and actions of the dealers who took advantage of the consequent arbitrage opportunity along the yield curve, i.e., the high spread between the short-term money market and the long-term risk-free Treasury rates. The dealers increased demand in the short-term money market both for hedging, and financing the newly issued Treasury bonds, put upward pressure on short-term rates. In contrast, the Fed’s activities put downward pressure on these rates. Observe that an increase in private demand for short-term funding (due to yield spread arbitrage) and an increase in the supply of reserves by the Fed (due to monetary policy) have opposing effects on short-term rates. Thus, it should not be surprising that despite the excessive reserve supply after the pandemic, the money market rates have remained stable. Understanding this kind of arbitrage along the yield curve is essential in understanding the behavior of short-term rates and the monetary policy’s effectiveness.
What is missing in this literature, but emphasized in the Money View framework, is acknowledging the hybridity between the money market and the capital market. The close link between the US Treasury market and the money market is a feature of the shadow banking or the new market-based finance. It is no friction. More importantly, the dealers’ search for “arbitrage” opportunities implies that individual securities markets are not separate. Speculators are joining the different markets into a single market. In doing so, they bring about a result that is no part of their intention, namely liquidity. As the Treasury creates an additional risk-free, liquid, point along the yield curve, it creates more arbitrage opportunities. Such developments make the yield curve an even more critical tool of examining the monetary policy effects. In the meantime, the traditional framework of supply and demand for bank reserves to control the short-term money market rate is losing its pertinence.
Elham Saeidinezhad is Term Assistant Professor of Economics at Barnard College, Columbia University. Previously, Elham taught at UCLA, and served as a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”. Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory