Sometime in 2001, in the course of working out the logic for a Global Clearing House1, I came across a 1999 paper by Benjamin Friedman, The Future of Monetary Policy: The Central Bank as an Army with only a Signal Corps? that made a lasting impression on me. The exploration that engaged me was his discussion of the tools via which central banks (at that time) implemented their policies – the channels by which they actualized their will in the real economy.
He began with an artful metaphor drawn from "the mid-1960s Henry Levin film Genghis Khan". He casts "Robert Morley, at his plump and pompous best as the Chin emperor Wang Wei-shao" in the role of central banks, employing their courtly and arcane skills similarly to the emperor, "composing a poem...to express his displeasure at the Mongol barbarians who have lately been creating a disturbance on the Chin empire’s western frontier, and, by so doing, cause them to desist."
His development of the metaphor was exquisite and short of quoting it at length I can't do it justice. I bring it up now though because of his takeaway message.
Thus far the central banks of the larger industrialized countries have not faced serious inability to control their short-term interest rates...
If the central bank cannot affect interest rates—in other words, the prices of financial assets—in its country’s financial markets, because borrowing and lending in those markets proceed independently of whatever amount of reserves it chooses to supply, it cannot affect the price level of goods and services in the nonfinancial economy either...Of course, central banks will still always be able to announce what they want interest rates, or inflation, or output and employment to be. Private economic agents, and especially participants in the financial markets, will continue to pay attention. But without the ability to implement a policy with some independent means of making those intentions come about, such pronouncements will be just that. With nothing behavioral to back them up, they will have about the same force over events as Wang Wei-shao’s splendid poems.
In recent years all sorts of folks have warned about a hypothetical future scenario in which the Fed and other central banks lose control. The dire aftermath usually involves loss of confidence in "fiat money", a spike in interest rates and hyperinflation. Since none of this has happened in the seven years or so since the Kraken of unconventional policy measures was released, Neo-Keynesians, most notably Paul Krugman, can get a lot of mileage pointing out how stupid such predictions are.
But here's the thing. What's with this behavior?
Lots of lines, I know, but let's walk through this.
The lines cluster in four groups:
- The bottom-most line is actually a pair of lines, the Effective Fed Funds Rate, and, the new Overnight Bank Funding Rate (OBFR). The OBFR is the spiky bits on the far right. These two rates represent the shortest maturity (overnight), the interest rate most directly targeted by the Federal Open Market Committee (FOMC).
- The second-lowest pair is 3-month money – London Interbank Offered Rate (LIBOR) and eurodollar deposit rates.
- Second-highest is 6 month LIBOR and eurodollars, and,
- The top line is just 12 month LIBOR. (FRED doesn't seem to have a 12 month eurodollar series).
The fact that longer maturity obligations are trading at a higher interest rate is of course normal. Likewise, the fact that 3, 6 and 12 month rates stepped up when the Fed increased its target for Fed Funds in late 2015 is normal.
The weird thing is the ramp at the far right, where 3, 6 and 12 month rates are rising further even though Fed Funds and OBFR haven't been bumped up. What does it mean?
Before addressing the recent divergence of 3-12 month interest rates above overnight rates, resulting in an increased spread between short and less-short rates, lets focus on the widening that occurred late 2011 and into 2012. In that instance, the rise in 3-12 month rates most likely reflected an increase in perceived risk in the banking sector, especially in Europe. The usual sources for bank funding, including other banks, demanded a higher interest rate. This was part of the motivation in the Fed implementing additional measures around September 2012, notably QE3.
But why is the spread between overnight and maturities in the 3-12 month range widening now?
One very real factor relates to impending regulatory changes affecting Money Market Mutual Funds, particularly the so-called Prime Funds available to institutional investors. This has been addressed by many others. If it is an unfamiliar topic, I'd recommend working through the excellent explanations by "Heisenberg" published at SeekingAlpha.
Is this just a blip due to changes in regulation? If so, one could reasonably expect the divergence to diminish after the market adjusts to the new rules.
Another possibility is that this uptick in 3-12 month rates is an instance of the market signaling an impending rise in interest rates across the board. For many decades, at least back when markets functioned, well, as markets (providing signals regarding the economy and so forth), that was what a steepening of the yield curve tended to predict. But that doesn't square well with the barrage of recent analyses dithering about the natural rate of interest being deeply in negative territory. [I started drafting a post several months ago that addresses this recent renewal of chatter about the natural rate of interest. Maybe now I will finish it up.]
A typical focus of analyses focusing on interest rate topics is to speculate regarding what the Fed may or may not do. But that sort of Fed-watching is not my area of interest or expertise. My task in this blog is to contrast existing price discovery processes (especially with respect to the price of money), which I regard as inherently dysfunctional, with the automatic self adjustment mechanisms built into Better Money. Nevertheless, this apparent lift-off of rates will pose a challenge as Fed officials confer this week at Jackson Hole and as the FOMC re-convenes in September. Does this uptick threaten renewed stress in bank funding, perhaps warranting further prolongation of accommodation? Or does it mean they must raise rates, chasing a train that may have already left the station?
The possibility I find most intriguing is that this could represent the first harbinger of a loss of control. Returning to Friedman's elegant tale:
Circumstances change over time, however, and when they do the fictions that once described matters adequately may no longer do so. A later scene in Levin’s film shows Morley still magnificently clothed but now lying in the mud, face blackened by gunpowder, in the wake of a Mongol attack on the Chin capital. There may well have been an earlier time when the might of the Chin empire was such that the mere suggestion of willingness to use it was sufficient to make potential invaders reconsider and withdraw. But by Wang Wei-shao’s day that time had evidently passed.
1 Another post I have partially drafted and need to finish is a compilation of emails and notes I had written up circa 2000 - 2003. I'll probably call it "Memory Lane". It includes an introduction to something I call a Global Clearing House.
2 graph copyright citations:
ICE Benchmark Administration Limited (IBA), 3-Month London Interbank Offered Rate (LIBOR), based on U.S. Dollar© [USD3MTD156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/USD3MTD156N, August 21, 2016.
ICE Benchmark Administration Limited (IBA), 6-Month London Interbank Offered Rate (LIBOR), based on U.S. Dollar© [USD6MTD156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/USD6MTD156N, August 21, 2016.
ICE Benchmark Administration Limited (IBA), 12-Month London Interbank Offered Rate (LIBOR), based on U.S. Dollar© [USD12MD156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/USD12MD156N, August 21, 2016.
Board of Governors of the Federal Reserve System (US), Effective Federal Funds Rate [FEDFUNDS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FEDFUNDS, August 21, 2016.
Federal Reserve Bank of New York, Overnight Bank Funding Rate [OBFR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/OBFR, August 21, 2016.
Board of Governors of the Federal Reserve System (US), 3-Month Eurodollar Deposit Rate (London) [DED3], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DED3, August 21, 2016.
Board of Governors of the Federal Reserve System (US), 6-Month Eurodollar Deposit Rate (London) [DED6], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DED6, August 21, 2016.
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