There are lots of fun things about being a talking head on TV, not the least of which is having people who ought to know better think that your IQ goes up when you go on the tube. It does not. The thing is sometimes called an Idiot Box for a reason. For example, on August 7, 2001, with the Fed targeting the Fed funds rate at 3 3/4%, I uttered the following line on CNBC:

"Greenspan has tightened for the last time of his career."

The Fed funds rate is now 1 3/4%, and the Fed is openly threatening to “take back” the easing implemented after the September 11 Tragedy, when the Fed funds rate stood at 3 1/2%. Thus, I must eat those words spoken back on August 7, 2001: unless Chairman Greenspan retires soon, he is likely to tighten again in his career. And I must eat the words twice, because I foolishly reiterated them in the December 2001 Fed Focus, written on November 28, 2001, when the Fed funds rate stood at 2%. Hubris is the handmaiden of human nature, and I’m as human as they come.

As Forrest Gump sagely noted, stupid is as stupid does, and TV expands the capacity for Gumption. But it is also true that Forrest’s penchant for running out of the football stadium begat him the opportunity to drink free Dr Pepper at the White House. Thus, I can still dream that my penchant for running off at the mouth on CNBC about the Fed might some day beget me an invitation to the Fed’s exclusive ice cream social in Jackson Hole . Happens every August, and as former Fed Vice Chairman Blinder once told me, it is the place “ to see and be seen.” And I’m willing to pay for ice cream and Dr Pepper for all!  

In The Matter Of Knowing When To Say When,
The FOMC Has Zero Credibility:
See May 17, 1994 and November 16, 1999

Figure 1 is a line graph of the 10-year U.S. Treasury yield and the fed funds rate, from 1992 to 2002. The 10-year Treasury yield trends downward over the period, to about 5.4% in early 2002, down from its most a recent peak of around 6.8% in late 1999, and down from 7% at the beginning of 1992. The fed funds rate trends upward for most of the time span, rising to 6.5% in 2000, up from a bottom of 3% in 1993. But in 2001 the target rate staircases down, dropping to 1.75% by 2002, including several steep drops following the 9/11 terror attacks. The chart also highlights 13 dates, marking Fed easing and tightening of the target rate.

Figure 1
Source: Federal Reserve

But enough of that. Chairman Greenspan most likely does have one more tightening fling in him. And since I said last summer that he didn’t, I was wrong. See, that wasn’t hard: I said it, and actually feel better for having said it. Before the end of this year, maybe before the end of this summer, the Fed is going to start tightening.

The Fed will almost certainly declare, however, that it is not “tightening.” Rather, the Fed will declare that it is “taking back easing” that proved to be unneeded. That’s not “tightening,” Fed officials will reassuringly assert, just moving the level of the Fed funds rate from “accommodative” towards “neutral.” The Fed will simply be “un-easing.” They would be “tightening” only if they were moving the Fed funds rate to a “tight” level, and that’s not on their mind, officials will argue.

Indeed, perhaps I could demonstrate my fitness for an invitation to Jackson Hole by declaring that I wasn’t really wrong in what I said last summer: I said Greenspan wouldn’t “tighten” when the Fed funds rate was 3 3/4%; and since 3 3/4% wasn’t a “tight” level for the Fed funds rate, any Fed action to lift Fed funds back toward 3 3/4% won’t be “tightening.” Therefore, I could argue, there is no need for me to eat last summer’s words, unless and until Greenspan gets the Fed funds rate back to at least 3 3/4%.

Yep, I could argue that. And yep, you not only could, but would tell me where to put that argument. Dissembling is called slicing the bologna too thin, not parsimoniously parsing the rhetoric. And rate-hiking by the Fed is called “tightening,” not “un-easing.” Bologna is bologna, my friend Forrest privately tells me.

So, when does the un-easing start? I don’t know. My hunch is that it will be later than the market presumes, probably not before the August 13 FOMC meeting. But the start date for the tightening campaign is really not all that terribly important. What matters is the Fed’s rationale for the campaign and how it sells that rationale to the markets.

Theoretically, of course, the rationale should not need to be sold, but rather simply stated. But in practice, that’s not how the Fed works. Therefore, for the next few pages, I offer a refresher course in the ways and means of the Fed, and its interaction with the banking system and the capital markets. No need to read this, unless your neck is pencil-shaped, like mine. For those seeking to cut to the chase, skip over to the Bottom Line on page seven: I expect a doubling from the current 1 3/4% Fed funds rate by the end of 2003 (note, 2003, not 2002!).

Central Banking 101 Re-Visited

The Fed is a legally-established monopolist, granted such power by Congress, which is constitutionally given the power to create money. Accordingly, the Fed has the fiat power to peg the price of borrowing money overnight: the Fed funds rate. And since the monetary value of all assets – stocks, bonds, currency and lawn mowers – is ultimately their exchange value in terms of money, the Fed exercises massive influence over all asset markets: at the end of the day, an asset is worth what somebody is willing to pay for it, or to receive for it, in terms of money. And only the Fed can create money. Barter exists, to be sure, but modern day economies and financial systems are not founded on barter. Rather, they are founded on fractional reserve banking systems, which are founded on a special relationship between central banks and commercial banks.

Focusing on the United States , banks, and only banks (savings and loans, too, but they are just banks by a different name) can have reserve accounts at the Fed, which are effectively  “checking accounts” at the Fed. Some of these deposits are legally-mandated “required reserves,” an important part of the Fed’s power as a legal monopolist: the law requires banks to hold something that only the Fed can create, giving rise to a statutory demand for its “checking accounts.” Hell of a business, you say, when the government says your consumers are legally required to buy your product! True, but nothing nefarious about it at all; it’s just the way the “plumbing” of a fractional reserve banking system must work.

A fractional reserve banking system offers to the individual depositor that which it cannot, by definition, offer to all depositors. The individual, of course, wants to know that he/she can turn bank deposits into money on demand: either cold hard currency, or a legal claim to cold hard currency that can be transferred, via either a check or a wire transfer. But in a fractional reserve banking system, banks cannot, as a matter of arithmetic, collectively honor all depositors’ claims for hard cold currency, which only the Fed can create (yes, counterfeiting remains a crime!). Thus, even if there were no legal requirement that banks hold a “checking account” at the Fed, they intrinsically would want to have one.

But in a going-concern economy, there is no logical reason to expect all depositors to want to turn their deposits into hard cold cash at the same time. Currency does not, after all, pay interest, so rational (law-abiding!) people minimize their holdings. This microeconomic rational behavior is, in turn, the foundation of the macroeconomic profits of the banking system: earning a profit from providing a service – the offer of cold hard cash on demand – that individual depositors ex ante value, but do not collectively ex post demand. In the language of finance, the banking system intrinsically makes money by shorting liquidity to the public in excess of that which it could/can provide the public.

Again, nothing wrong with this. Indeed, there is something very right about it: the banking system satisfies the individual’s ex ante demand for liquidity, which is cumulatively greater than individuals’ collective ex post demand for liquidity, and can thus create credit! This is the alchemy of banking, and it is very, very cool: banks stand in the middle between those that are long of liquidity (depositors) and those that are short of liquidity (borrowers), satisfying both to the macroeconomic advantage of all. (If you don’t believe me on this, pick up a copy of Mr. Capra’s It’s A Wonderful Life, when you go out to rent a copy of Forrest Gump!)

A fractional reserve banking system could not work, however, if the public did not believe that there was a way for the system to “cover” its intrinsic short-liquidity position. Without such a belief, a fractional reserve banking system would be under constant threat of runs (which are the consequence of individuals each acting rationally to produce a collectively irrational outcome). The “cover” is the Federal Reserve, which can create liquidity (the liability side of its balance sheet) by buying or lending against anything (the asset side of its balance sheet).

The Fed does not, of course, buy or lend against just “anything,” even though there is no technical reason (and with a vote of five Fed governors, no legal reason!) that it couldn’t. The Fed’s intrinsic job is to “monetize” assets: taking assets onto its balance sheet, and paying for them with money that it creates out of thin air. As a routine matter, the Fed only monetizes “good assets,” overwhelmingly federal government securities (outright or via repurchase agreements) and “eligible” collateral offered by banks for discount window loans. The Fed limits the scope of that which it will “monetize,” so as to stay out of the “credit allocation” business, which would inevitably put it squarely in the fiscal policy business, a function that Congress reserves for itself.

Deposit Insurance Dissected

In fact, a key function in a fractional reserve banking system is actually a joint venture of fiscal and monetary policy functions: the role of deposit insurer. In the first instance, this function is a fiscal function, in which Congress promises the public that whatever happens to the banking system, or indeed to individual banks, the fiscal authority will redeem deposits in hard cold cash. That very promise reassures the public of the “money goodness” of deposits, effectively eliminating the risk of a Main Street-driven run on the banking system (a cascading of Jimmy Stewart’s woes!).

As a theoretical matter, however, the deposit insurance system could be part of the Fed’s mandate. And indeed, with Congress effectively eliminating the systemic risk of Main Street-driven bank runs, the deposit insurance system is de facto under the Fed’s umbrella. Note I said “ de facto” not “ de jure.” Deposits above $100,000 per depositor are not technically insured to be “money good” by either Congress or the Fed.

But as a practical matter, the fractional reserve banking system could not work without a general public understanding – more specifically, a general understanding amongst institutional investors – that the Fed stands ready, in times of extraordinary public demand for liquidity, to create liquidity equal to those demands — plus some! It is this understanding, made “official” with the Fed’s 1984 funding of the institutional investor-driven run on Continental Bank of Illinois, that is the foundation of today’s capital market-dominated financial system.

Indeed, the “mechanics” of the run on Continental Bank wonderfully demonstrated how the “plumbing” works: putatively-uninsured depositors – institutional investors with deposits greater, much greater than $100,000 – did not like what they saw in Continental’s energy loan book, and decided to not  “roll over” their deposits, demanding that they be paid out on maturity. And so Continental Bank did, sending out the “money” over the Fed’s wire system, even though Continental Bank’s reserve deposit – checking account! — at the Fed was not sufficient to “cover” all those outgoing wire transfers. The Fed honored Continental’s request to keep “sending,” however, and at the end of the day (days, actually, as it was a multi-day run), Continental’s overdrafts became discount window loans to Continental. To wit, the Fed “monetized” the deposits of Continental Bank.

But since the discount window funds granted to Continental were simultaneously flowing to other banks’ reserve accounts, the Fed needed to take offsetting “de-monetizing” activities to prevent the aggregate level of reserves from rising, inducing a falling Fed funds rate. And so the Fed did, “sterilizing” the reserve creation effect of the discount window loans to Continental by selling off its assets, “de-creating” reserves in an equal amount. Indeed, the Fed actually underwrote a 100 basis point increase in the Fed funds rate (tightened!) over the subsequent months, as banks other than Continental Bank eschewed the discount window, putting upward “technical” pressure on the Fed funds rate that the Fed declined to offset (the Fed’s operating regime at the time was to indirectly peg the Fed funds rate – actually, the Fed funds rate spread over the discount rate — via a target for non-emergency discount window borrowings).

After the fact, of course, the FDIC “took out” the Fed’s discount window loan to Continental Bank, thereby re-establishing the proposition that it is the fiscal authority, not the monetary authority, that “insures” bank deposits (and in the case of Continental, non-deposit liabilities, giving rising to the “too big to fail” doctrine). But since the fiscal authority cannot create money, but only get it via taxes or borrowing, there should be no mistake as to who was, and is, the straw that stirs the drink in preventing and stopping institutional investor-driven bank runs: the Fed, and its willingness, nay commitment, to let its member banks send out “money” over its wire transfer system, with the Fed itself ensuring “finality of payment.”

Yet again, nothing wrong with this, but something very right: the macroeconomic efficiency gains that come from maximizing the amount of credit that the banking system can create (or support, more about which later) per unit of money. And you don’t have to have gray hairs from 1984 to see this efficiency gain in operation: the Fed’s beautiful “insurance” operations around the time of Y2K, when it actually sold call options on its balance sheet; and even more recently, the Fed’s masterful opening of the discount window — through its guarantee of “finality of payment” over its wire transfer system – in the days following the September 11 Tragedy.

Substitutes or Complements?

Indeed, to me, the most intriguing and ironic aspect of America’s embrace of free-market, global capitalism over the last two decades is just how much more, not less, important the nexus between the banking system and the Fed has become. The capital markets are highly efficient in distributing risk to those who want it. The capital markets cannot, however, create liquidity. They can only redistribute the existing stock of liquidity.

To be sure, the capital markets are masters at creating the illusion of liquidity for all. But by definition, the capital markets cannot substitute for the banking system, because the capital markets do not have access to the Fed, except through the banking system. Thinking about it in the extreme, the capital markets cannot create cold hard cash, literally currency carrying the pictures of dead presidents. Everybody minimizes the amount that they carry, because it pays no interest, but everybody also wants to know that all their assets could be turned into those green pictures of dudes with bad hair.

Which brings us to the matter of the inherent difference between bank deposits and money market mutual fund shares. Day to day, the public looks at them as substitutes. And in fact, money market mutual funds were birthed some twenty-five years ago as substitutes for bank deposits, when interest rates on bank deposits were capped by Regulation Q ceilings, and inflation soared above those ceilings. Indeed, it is an ironic piece of history that soaring inflation, the bane of the capital markets, was actually the progenitor of the modern day capital markets, by triggering dis-intermediation of bank deposits into money market mutual fund shares. With that outflow of deposits from banks, money market mutual funds needed to buy assets, which begat the parallel dis-intermediation of banks’ assets: commercial and industrial loans, transformed into commercial paper.

Commercial paper had, of course, existed long before the advent of money market mutual funds. But it was the creation of money market mutual funds that birthed the modern day commercial paper market. More broadly, money market mutual funds, by providing deposit-like services to shareholders and loan-like services to commercial borrowers, became the vaulting pad for wholesale dis-intermediation of the inherent function of the fractional reserve banking system: liquidity on demand for depositors and “relationship” loans for corporate borrowers.

From that beginning, capital market entrepreneurship flourished, giving us today’s sophisticated financial services landscape, where any and all assets and cash flows are considered fair game for securitization (including David Bowie’s future royalties!). In isolation, there is nothing wrong with this, and in fact, something very right: the slicing and dicing of risk, unbundling it so that it can be bought and sold by those who are best suited to buy and sell it.

Indeed, Fed Chairman Greenspan constantly applauds, in almost reverent fashion, the macroeconomic efficiency gains wrought by the capital markets’ de-composition and re-distribution of risks. And Mr. Greenspan is right. But only up to a point: the more that capital markets do their slicing and dicing thing, the more important – not less! – the commercial banking system becomes. And the reason is simple: the banking system is not obligated to mark to market its commercial loan portfolio. In contrast, money market mutual funds must mark to market their commercial paper, so as to strike a nightly net asset value. Which had damn well better not “break the buck”! Thus, liquidity lending by banks and commercial paper investing by mutual funds are not substitutes, but complements in the financial firmament. Banks serve a unique function that cannot be replicated by the capital markets: banks, as conduits for the Fed’s fiat power to create money, can do that which the capital markets can never do: put hard, cold cash behind the illusion of liquidity for all.

This verity always becomes apparent in financial crises, when the Fed and its handmaiden, the banking system, come to the rescue of the capital markets, creating liquidity. Most important in those times, banks stand ready to lend to companies that “ordinarily” borrow in the commercial paper market, via pre-arranged commitments, known as “back-up lines.” This is something that the money market mutual fund complex simply cannot, by definition, do. In fact, in periods of stress, money market mutual funds must be prepared to sell, not buy commercial paper, so as to be prepared to redeem shareholders' demands for liquidity “at the buck.” For borrowers in the commercial paper market, such times bring home the value of having a “relationship” banker, who has – for a fee, of course! – committed to lending when it’s the last thing he/she wants to do.

Yet over the last two decades, as crises have passed and the Fed has done its job well, the secular march of dis-intermediating the banking system to the capital markets has actually accelerated: commercial paper has soared relative to banks’ commercial and industrial loans, and total non-financial debt has soared relative to banks’ “checking accounts” at the Fed. Take a look at Figures 2 and 3 below for the proof. The illusion of liquidity for all has become ever bigger, and the reality of illiquidity has become more real .

Corporations Snub Their Bankers And Fall In
Love With Commercial Paper

The figure is a line graph showing the ratio of U.S. domestic commercial paper outstanding to C&I (commercial and industrial) loans outstanding, from 1969 to 2001. The metric trends steadily upward over the time period, ending at around 1.4 in 2001, just off a peak of about 1.5 around 2000. The trajectory is a particularly steep rise from 1996 onwards to 2000. The ratio is about 0.25 in 1969, its lowest level on the chart, also seen in the mid 1970s, after which it trends steadily upward.
Figure 2
Source: Federal Reserve


A Thin Slice Of Reserves At The Fed Supports
A Huge Loaf Of Debt

Figure 3 is a line graph showing the ratio of U.S. non-financial business debt outstanding to depository institution reserves held at the Federal Reserve, from 1960 to 2001. The ratio is around 160 in 2001, just off its peak on the chart of close to 180 around the beginning of 2001. The metric trends upward over the period, starting at about 18 in 1960, rising to an interim peak of about 90 by the late 1980s, then dipping to around 60 by 1993. After that it climbs steeply to its peak of near 180 in late 2000 to early 2001.
Figure 3
Source: Federal Reserve

Reality Here At PIMCO

One of my jobs here at PIMCO is running our money market/liquidity operations, where we own on our clients’ behalf over $20 billion of commercial paper. In this arena, PIMCO is, just like everybody else, a servant in the Fed’s kingdom, with the entire money market complex priced versus where the Fed pegs the Fed funds rate. But we do have two small areas of free will: (1) the duration of our assets (either absolutely, or relative to our liabilities, or relative to our benchmarks), and (2) the credit quality of our assets (again, either absolutely, or relative to our liabilities, or to our benchmarks).

In the matter of duration risk, we are, just like all other investors – both retail and institutional – free to make a “bet” as to where the Fed will peg the Fed funds rate: lengthening durations as a bet on easing, and shortening durations as a bet on tightening. We like to think we’re better than the next dude in doing that, and I think we are. But regardless of our skill, or lack thereof, a duration bet in the money market arena is nothing more than the PIMCO house making a bet against the Fed house, or the markets’ discounting of the Fed house. In contrast, we do have sovereignty as to when and where we “dip down” in credit quality. On this score, we are not price takers, even if we are also not price makers. We decide, not the Fed, who goes on our “approved list” for corporate issuers of commercial paper, the cornerstone of the private, unsecured money market firmament.

Over two years ago, we decided to structurally strengthen the approval process for Tier Two commercial paper issuers – those rated A2/P2. Henceforth, we declared, we would not use such names unless the issuer was willing to provide documented evidence that it had bank back-up lines for its commercial paper that (1) exceeded the size of current and potential issuance; and (2) had little or no room for the banks underwriting the back-up line to refuse to fund on demand. Simply put, we declared that we would not be “lenders of last resort” for Tier Two issuers, and before they could be included on our “approved list,” we must have hard copies of their bank back-up line documentation, “proving” that the banking system, not our clients, was playing the role of “lender of last resort.” And in honor of President Ronald Reagan, we dubbed this process PIMCO’s “trust but verify” commercial paper standard.

This standard has served us well, and remains very much in place. The only question has been whether to also apply it to Tier One commercial paper issuers – those rated A1/P1. As it turns out, I doubt we will, at least on a comprehensive basis, as Moody’s - bless them! - has taken up our charge that bank loans and commercial paper are not substitutes, but complements. To wit, that companies need solid bank back-up lines of credit behind their commercial paper programs. To me, Moody’s initiative is a profoundly positive step forward, which will undergird a secular improvement in Corporate America’s balance sheets: companies must restore their liquidity health by issuing more long-term debt and less short-term debt, while also renewing and strengthening the vows of “relationship lending” with their bankers.

As this process unfolds, short-term credit spreads will remain wide, perhaps go even wider, as banks dis-intermediate (once again!) the credit risk of larger bank back-up lines to the capital market’s credit-default swap mark. And, no doubt, companies will not be happy with the higher fees that banks will be charging for those lines. But in the end, this is what is supposed to happen: the capital markets and the banking system have been jointly under-pricing liquidity “insurance” — as evidenced by too many companies skating too close to the edge of the liquidity lacuna.

This process will also be a “headwind” to vigorous growth in corporate spending, notably for investment that creates jobs. But again, in the end, this is what is supposed to happen: investment and job creation founded on the financial kindness of capital market strangers is not sustainable — as evidenced by too many companies in too many places on the way to 5,000 for the NASDAQ.

The journey to corporate prudence will not be fun, but the destination will make the effort worthwhile. And along the way, the Fed’s duty is to be accommodative.

The Bottom Line

An overwhelming majority of the Fed’s Federal Open Market Committee (FOMC) believes that last fall’s easing of the Fed funds rate south of 3 1/2% was a stepchild of its more elemental function in the wake of the September 11 Tragedy: restoring liquidity, and more important, the confidence of liquidity to the capital markets, in particular to the epicenter of the capital markets, the stock market. Central banking in a fractional reserve banking system is, after all, about running a confidence game, which in polite, politically-correct circles is called “ having credibility.

The Fed has it. And with the economy cyclically recovering, the FOMC now wants to “re-level” the Fed funds rate back up. Chairman Greenspan is likely to go along, but only begrudgingly. Why? First and foremost, as discussed last month 1, Mr. Greenspan sees no need to pre-empt a modest cyclical increase in inflation: secular “price stability” has been achieved, and a “take back” of the deflationary corporate pricing of the recession is not a problem to be solved, but rather a path to improved corporate profit margins, and ultimately, renewed business investment. Thus, there is no need for the Fed to aggressively tighten (or “un-ease,” if you prefer): the prevailing Fed funds rate is not causing any manifest problem.

Yes, the yield curve is steep, leading some market observers to worry about rising inflationary expectations. And indeed, some of that might be happening, though I think the dominant reason that long-term rates are up is rising expectations of Fed tightening – to wit, rising real short-term rates (the exact opposite of what happened in 2000, when long-term rates fell on rising expectations of Fed easing – to wit, falling real short-term rates). Whichever the case may be, it is also true that a steep yield curve is beneficial in breaking the “headwinds” of balance sheet repair in Corporate America, just as it was beneficial to breaking the “headwinds” of balance sheet repair in the banking system in 1992-93. Thus, Mr. Greenspan is doubly incentivized to temper the FOMC’s tightening proclivities.

Bottom line: I expect 25 basis points of tightening per quarter – on average! – over the next seven quarters, doubling the Fed funds rate to 3 1/2% by the end of 2003. I further expect that around the time Mr. Greenspan embarks on such a tightening course, he will “go public” with a framework revealing that the FOMC not only knows how to start tightening, but also how to stop tightening, unlike the case in 1994 and 2000 (as vividly shown on the cover.)

Jackson Hole in August would be a most pleasant place to hear him deliver that speech .

Paul A. McCulley
Managing Director
April 01, 2002

1 See "Trade Your NAIRU Jacket For Some CAPRI Pants," Fed Focus, March 5, 2002


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