Federal Reserve Update

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Generally, if you are a senior official of the Federal Reserve, in the past few years, you can look forward to the Kansas City Federal Reserve’s currency seminar in Jackson Hole, Wyoming at the end of August. There, you can enjoy an unimpeded chat with your peers while bathing in the mountain air of the wealthiest town in the United States.

On the contrary, this weekend’s Jackson Hole seminar will be a virtual event, partly due to a surge in Covid-19 cases caused by the bad effects of the Delta coronavirus variant.

Bankers may miss those moments of relaxation on the mountainside. Given that the US stock market is hitting historical highs and inflationary pressures are spreading throughout the economy, members of the Federal Reserve Board of Directors have many concerns. If there is any serious market instability in the traditional season of financial disasters this fall, the Fed will become the focus of attention.

I think the planners of the Jackson Hole Party should focus this meeting on some immediate currency stability issues. Frankly speaking, few people will remember any valuable comments from the Fed on the response to climate change. But if the world’s financial pipelines start to shake, what will the Fed do?

There have been some worrying grunts in the system. The Federal Reserve has been working to ensure that there are large deposit reserves in the bank of the United States. However, there are trillions of unfinished transactions around the world that are not directly funded by U.S. bank loans. In recent months, these have become increasingly expensive and uncertain.

The international monetary system increasingly relies on the availability of collateral to support trillions of dollars in foreign exchange swaps or interest rate swap agreements. These all support trade and investment. Regulators hope that any participant pledges “original” assets, cash or equivalents that are not used as collateral elsewhere to guarantee the performance of their contracts. U.S. Treasury bills are usually needed, but short-term debt instruments of European governments are also needed, or gold occasionally.

For the Fed, the most important source of liquidity is its deposit reserves, or its holdings of nearly $1.4 trillion in overnight reverse repurchase (reverse repurchase) agreements with money market funds or banks. Reverse repurchase allows institutions to use high-quality collateral to borrow money, such as U.S. Treasury bills.

However, these reserves and reverse repurchases require an account with the Federal Reserve. They cannot be re-lent before maturity to earn fees and attract other businesses. This requires collateral such as Treasury bills.

These mortgage chains provide an important source of liquidity in the international market. Manmohan Singh, a financial collateral expert at the International Monetary Fund, studied this subject. After the 2008 financial crisis, the international liquidity provided by the re-transfer of these original assets has shrunk significantly.

How much collateral is reused in the system provides a measure. Singh said that the world’s largest dealer bank held US$10 trillion in collateral in 2007, but only received US$3.8 trillion from hedge funds and securities lending, with a reutilization rate of 3.0 times.

By 2016, the commitment figure had fallen to only 6.1 trillion U.S. dollars, while the source of collateral was 3.3 trillion U.S. dollars, and the reuse rate had dropped to 1.8 times. Fewer institutions trust their peers to return these collaterals, thereby promoting the deleveraging of the financial system. In fact, the available credit has decreased.

In the end, mutual trust came back. By the end of 2020, this reuse rate has risen to 2.5 times, which is still lower than the exciting day in 2007.

Unfortunately, we can only obtain these trend data retrospectively. Therefore, we must infer today’s situation from the market prices of Treasury bills and other popular sources of collateral.

But there is another complication. The supply of publicly issued Treasury bills has declined. The debt ceiling imposed by the US Congress limits issuance. In addition, the Fed’s asset purchases and demand from major banks have also reduced supply. As a sign, the yield of one-month Treasury bills this year has fallen.

This indicates an increase in demand for original collateral. Although we do not have data yet, as institutions are more worried about counterparties, indicating that credit conditions are tightening, the re-lending ratio may shrink again.

Strange market phenomena such as the sharp drop in gold prices on August 10 suggest that the system is tense. Some gold market and central bank experts believe that when institutions cannot provide enough Treasury bills, the sudden liquidation of gold collateral will occur.

I suggest adding an agenda item to Jackson Hole. The Fed should promise to provide part of its holdings of US$326 billion in Treasury bills to the market when there is a shortage of collateral in the fall. This will provide some additional liquidity to the world’s financial pipelines.