Now Goldman Sachs Clueless as to Effects of Fed Policy

As discussed recently here and on EPJ Central, mainstream economists--even those anointed by the heavens--just don't have a handle on the enormous implications of Fed policy. Goldman Sachs' Jan Hatzius writes as follows:

Chairman Bernanke also outlined three possible tools for further easing: (1) to strengthen the commitment to keep short-term rates "exceptionally low for an extended period;" (2) to cut the interest rate on excess reserves (IOER) from its current 25-basis-point level; and (3) to resume asset purchases. He also said that the FOMC would review all of its options, including the possibility of reinvesting MBS prepayments and redemptions. Currently, these proceeds are not being reinvested, with the result that the Fed's balance sheet is set to shrink slowly over time. This amounts to a slight tightening bias in the current policy stance, albeit one that may not have much effect given the enormous volume of excess reserves in the system. With the IOER already close to zero, we see little to be gained from cutting it further, other than to signal a switch in policy orientation. The incentive for banks to make new loans would increase only marginally, while money market funds would have a tougher time eking out positive returns as yields on other short-term assets moved even closer to zero. Besides, the FOMC could send the same signal by taking up the MBS reinvestment option. Although it is a close call, we now expect this to occur at next week's meeting.

To his credit, we are in agreement with many of Hatzius' assessments, including the fact that MBS cash flows into the Fed have a slight policy-tightening bias, as we discussed the other day. However, there are several hidden and incorrect assumptions in the statement, "IOER is already close to zero". "Zero" is largely unimportant as both an absolute level and from the perspective of what is relevant to measure IOER against. As interest rates are manipulated by the Fed, we do not know what real interest rates are (that is, interest rates absent government intervention that reflect actual time preference and inflation expectations). Similar to temperature (on a non-Kelvin scale), the zero level is more important as a psychological boundary, and not the all-important inflection point it is made out to be. [And, there is really no reason why IOER could not be negative--thus no downside limit. In the topsy turvy world of quantitative easing, we have already surpassed the level once considered undoable.]

What is relevant is the spread of IOER to other short term rates on the lower end of the yield curve--namely, (1) the Federal Funds rate paid on uncollateralized overnight loans between banks and other large financial institutions and (2) short term Treasury Bill rates. As of Friday, August 5, the Fed Funds rate was 0.19%, and the 1, 3 and 6 month T-Bills were yielding between 0.15% and 0.19%. Even 1 to 2 month investment grade commercial paper has been yielding less than the IOER.

This means that banks can leave their excess money at the Fed and get paid 0.25% every night, as opposed to lending to another bank at the lower rate of 0.19% or locking the money up in Bills or commercial paper for a month or more. [It's also important to know that the reason the Fed Funds rate, which is uncollateralized, is less than the IOER is largely because the biggest lenders are Fannie and Freddie, both ineligible to park their money at the Fed because they are not banks.]

Accordingly, were the Fed to lower the IOER to say 0.10%, several investment options would immediately become more attractive to banks and a material amount would likely leave the custody of the Fed. How much and in which directions cannot be known, but the implications should not be ignored simply because the spread is seemingly small. We're talking over $1 trillion of leveragable cash held by banks. They might not loan it to businesses and consumers, as Hatzius concurs, but never underestimate the influence of vast amounts of digital zeroes suddenly searching for a new home.

The danger is that, because a change in Fed policy with respect to the interest on excess reserves is incorrectly being discounted as relatively innocuous, it has tremendous power to inflict unforeseen effects on the economy. Leave it to Ben and his sandbox of tools? No thanks.

Via ZeroHedge