Inflation-Hawk Lacker Was the Fed's Fall Guy

04/11/2017Tho Bishop

One of the great Federal Reserve scandals in recent history seemed to resolve itself last week as Jeffrey Lacker of the Richmond Fed resigned for his role in the Medley Leak.  But as Pedro Nicolaci da Costa, (perhaps the best reporter on this story) points out, the finely scripted statement from Lacker shows that he was not Medley’s original source for the market-moving information.

Lacker’s statement reads:

During that October 2, 2012 discussion, the Analyst introduced into the conversation an important non-public detail about one of the policy options considered by participants prior to the meeting. Due to the highly confidential and sensitive nature of this information, I should have declined to comment and perhaps have ended the phone call. Instead, I did not refuse or express my inability to comment and the interview continued.

When Medley published a report by the Analyst the following day, October 3, 2012, it contained this important detail about one of the policy options and I realized that my failure to decline comment on the information could have been taken by the Analyst, in the context of the conversation, as an acknowledgment or confirmation of the information.

As da Costa points out:

What Lacker admitted to was unwittingly confirming key information about deliberations on whether and when the Fed should purchase large quantities of government and mortgage bonds to keep long-term interest rates down.

That means "the Analyst" at Medley actually obtained the market-moving details about the Fed's decision-making from someone else.

The identity of the initial source remains a mystery.

While laws against insider trading should be abolished, there is an obvious difference between dealing with non-public information about private companies and central bank officials tipping off a select group with valuable information. In spite of such behavior undermining institutional credibility, the Fed has seemed disinterested in properly investigating it. They did conduct an internal investigation which  largely cleared itself of any wrongdoing, but the the FBI and Congressional oversight disagreed with those findings. In fact, this decision to handle the matter internally, rather than working with outside organizations, has raised more questions than answers.

Whether the original source of the Medley leak is found, the entire episode should plainly illustrate the need for greater oversight and transparency at the Federal Reserve.

On Monday, Yellen took the opportunity during a public event at the Ford School of Business to reiterate her position to Congressional attempts to increase Fed transparency, her own actions during the Medley scandal validate the need for changes to be made. The Fed’s utter inability to conduct a credible investigation into blatant mishandling of public information demonstrates that mythical “Fed independence” shouldn’t be enough to prevent public transparency over the Fed’s monetary policy. Especially, as Jonathan Newman noted last week, considering the truly radical nature of the Fed's post-crisis policy.

It’s also worth pointing out that Lacker’s resignation, correct or not, is a significant loss for those skeptical of the Fed’s post-crisis action. Lacker was perhaps the strongest inflation hawk among the members of the FOMC, and has claimed that if he had full control of the Fed he would have never attempted Quantitative Easing in the first place. He has also publicly questioned whether QE has made unemployment worse.

Lacker’s replacement will not be decided by President Trump, but does represent yet another open seat in the FOMC. Who ends up filling these seats will be very important as the Fed seeks to normalize interest rates and unwind its balance sheet. Hopefully Lacker’s successor will share his sensibilities while Trump’s own Fed appointees resemble his campaign rhetoric more than his emerging tax plan does

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Is the Demand for T-bills Driving Treasury Deposits at the Fed?

03/30/2017Frank Shostak

[Editor's note: Shostak employs a different measure of the money supply than the Rothbard-Salerno money supply measure used here. For a more full explanation, see here.]

On October 2016, the US Money Market Fund (MMF) industry underwent a reform with new requirements for US institutional prime and municipal MMFs becoming effective.

Under the new US MMF regulations, institutional prime and municipal MMFs are required to change from a fixed net asset value (NAV) to a floating NAV and adopt provisions to consider liquidity fees and redemption gates. However, government and Treasury MMFs were given a reprieve from these structural changes because of their perceived low risk and high liquidity.

RELATED: "Money Supply Growth Falls to 17-month Low in February

The changes that took place in October were announced two years earlier. In response to this since the end of 2015, there was a massive increase in the demand for Treasury bills. Consequently, government deposits, or the cash balances, with the Federal Reserve jumped from $75 billion in October 2015 to $394.6 billion by November 2016 — an increase of 426.1%. An increase in government deposits with the Fed reduces the supply of cash in the federal funds market, all other things being equal.


Consequently, this puts an upward pressure on the federal funds rate. In order to keep this rate at the target, which was set by Fed policymakers, the US central bank is compelled to lift the money supply by buying assets.


Note that while the increase in government deposits does not change the money supply, the Fed’s policy to protect the federal funds rate target results in an increase in money supply. Indeed the yearly growth rate in AMS jumped from 3.4% in October 2015 to 16.7% by November 2016.

Using our model, we forecast that government deposits are likely to follow a horizontal trend during 2017 to 2018. After closing at $323.9 billion in February, the level of deposits is forecast to close at $359 billion by December. By November next year, the level is forecast to climb to $445 billion before settling at $388 billion by December next year. According to our model, which incorporates the effect of government deposits among other variables, the yearly growth rate of AMS forecast is to close at 7% by December versus 8.5% in January before settling at 8% by December next year.

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Is the Size of the Fed's Balance Sheet More Important than the Target Rate?

03/22/2017C.Jay Engel

In a recent interview on CNBC's Squawk Box, Neel Kashkari explained his dissenting position on the March rate hike. His position was that there is not yet enough inflation. In fact, he thinks that the Fed's 2% inflation target shouldn't be seen as a hard ceiling. He even stated that predictions of coming inflation worries are baseless:

For the last five or six years, the Federal Reserve keeps predicting inflation is around the corner. And those predictions end up being wrong.

Of course, with the massive expansion of the Fed's balance sheet going into areas like the stock, bond, and housing markets, the Fed's measures of inflation don't even reveal what is happening to the economy's capital structure. Distortions in the capital markets are far more serious than than the PCE represents. It's frustrating enough that the central bankers are trying to increase the cost of living. But then we are reminded that they don't even know how credit expansion impacts the boom and bust cycle.

What is interesting though, is Kashkari's opinion that addressing the gigantic balance sheet should come prior to any further rate hikes:

As we move forward, we allow the balance sheet to start running off. Then we can return to fed funds rate hikes when the data call for it. The balance sheet should be the next move.

This preference of balance sheet before rate hikes is also unique among the FOMC members — everyone else wants the balance sheet scaled back to follow additional rate hikes. It will be interesting to see whether Kashkari's opinion on this gains any ground among the other members. Perhaps we will get a further indication as we approach the May and June Fed meetings.

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Is the Era of Ultralow Interest Rates Coming to a Close?

03/14/2017C.Jay Engel

The Wall Street Journal writes on tomorrow's FOMC rate announcement that "[a] long era of ultralow interest rates and bond-buying programs may be drawing to a close." This is remarkable. The minuscule uptick from the .5-.75% range to a .75-1% range is hardly leaving behind ultralow interest rates. As can be seen in the chart below, a quarter percent rise in the federal funds rate will barely show up, when looking at rates from a longer-term perspective.


With the latest GDPNow forecasts coming in at a paltry 1.2%, the idea that the Fed is simply going to continue any sustained effort to bring rates up to historically normal levels seems quite the exaggeration at the moment. The entire model relied upon by the Fed's economists assumes that raising rates into a slow growth environment is precisely the opposite of what must be done. Of course, their models rest on indefensible foundations and they therefore can't even explain where either real economic growth or artificial booms originate (nor can they distinguish between them). 

Our era of suppressed interest rates is here to stay (at least while the Fed still has the delusion of control). That's what the whole "lower for longer" theme is about. Aside from the fact that the "Professionals" who run our monetary policy subscribe to variations of the Keynesian vision and therefore "advise" low interest rates, there also remains the cozy relationship between the Treasury (government) and the Fed. Explained by David Howden:

For the US Treasury, Fed remittances are something of a free lunch. When someone buys a Treasury bond, the government must pay them interest. This applies to the Fed as well, but then at year-end the Fed remits the interest back to the Treasury.

The federal government paid out $223 billion in interest payments last year. The Fed remitted almost $100 billion back, leaving the net interest expense at around $125 billion. It’s not just historically low interest rates that are making it easier for the Treasury to borrow in a way that, if it were done by anyone else, would classify them as subprime. The Fed is also chipping in and helping out where it can. ...

Consider that since Treasury debt is almost never repaid in net terms (old issues are retired but replaced with new debt issuances), the true cost of financing the US government’s borrowing is not the gross amount of debt outstanding but the annual interest expense it faces. Viewed this way, nearly half of the Treasury’s borrowing was financed by the Fed last year. Absent these Fed remittances, Congress would need to look at either an alternative funding source (though I am not sure how many takers there are for the Fed’s $2.5 trillion Treasury holdings) or make some serious cuts.

Regardless of what happens tomorrow (and it looks like there's going to be a hike), the idea that this signals the close of the Fed-induced low interest rate era is quite the exaggeration.

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