Arthur Hayes: Why is the Fed doomed to fail?

Author: Arthur Hayes

Original compilation: GaryMa Wu said blockchain

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Everyone who manages money today is delving into the analogy between how the Fed dealt with inflation in the early 1980s and what it does today. Powell believes he is the Paul Volker of this moment (the Fed chair credited with ending inflation in the 1970s), so we can expect him to try the same approach (bold rate hikes) to get rid of America's inflation. He has said so in a number of interviews since first revealing in late 2021 that the Fed would start tightening monetary policy by raising rates and shrinking its balance sheet.

The problem is that economic and monetary conditions in the US are very different today than they were in 1980. What worked under ideal conditions in the past will not succeed in today's tough, competitive times.

Through this article, I want to show readers why the Fed is doomed to fail, and how the more they try to use Volcker Economics to correct the "course", the more they will push the United States in the opposite direction from their intended goal . The Fed wants to reduce internal inflation in the United States, however, the more they simultaneously raise interest rates and reduce their balance sheets, the more they provide incentives to wealthy asset holders. The U.S. federal government will be asking the Fed for a change in strategy, and I'll be citing a paper written by Columbia University economics professor Dr. Charles Calomis, published by the Federal Reserve Bank of St. Louis. The Federal Reserve System is quietly telling the market that it made a mistake and charting a path to redemption. The road to salvation as we know it always requires more financial repression and money printing. Good for Bitcoin!

Control currency quantity or price?

The Federal Reserve currently wants to control the quantity and price of money, but it can't grasp the sequence.

The Fed controls the quantity of money by changing the size of its balance sheet. The Fed buys and sells U.S. Treasury securities (UST) and U.S. mortgage-backed securities (MBS), which causes its balance sheet to rise and fall. When the balance sheet goes up, they call it quantitative easing (QE); when it goes down, they call it quantitative tightening (QT). The Trading Department of the New York Fed manages these open market operations. Because of the trillions of dollars worth of US Treasuries and MBS held and traded by the Fed, I don't think the US fixed income market is free anymore because there is an entity that can print money at will, change banking and financial rules unilaterally, always in Trade in the market and fix rates at politically convenient locations. Don't fight the Fed unless you want to get hurt.

When Volcker became Fed chairman, he proposed what was considered insane at the time: target quantity and let the price of money (the federal funds rate "FFR," or short-term interest rate) move with the market's desires. Volcker doesn't care if short-term rates spike, as long as money/credit is removed from the financial system. This is very important to understand; in the 1980s, the Fed could raise or lower its policy rate, but it wasn't trying to force markets to trade at that level. From the Fed's perspective, the only thing that has changed is the size of its balance sheet.

More recently, the Fed wants to ensure that short-term market rates match its policy rate. The Fed achieves this by setting rates between its reverse repurchase program (RRP) and interest on reserve balances (IORB), keeping its policy rate between its upper and lower bounds.

Approved participants, such as banks and money market funds (MMFs), are allowed to deposit dollars with the Fed on an overnight basis and receive the reverse repurchase (RRP) rate set by the Fed. That means retail and institutional savers won't buy dollar-denominated bonds for less than that rate. Why take on more credit risk and earn less interest than depositing with the Fed on a risk-free basis?

To keep a certain amount of bank reserves at the Fed, the Fed bribes the banks by paying them interest on those balances. The Interest on Reserve Balance (IORB) rate is another limiting factor, banks will not lend to individuals, corporations or the U.S. government at rates lower than they can get risk-free from the Fed.

There is also an argument that the Fed must pay interest to RRP and IORB depositors to reduce the flow of money. In total, nearly $5 trillion is sitting in these facilities; imagine the level of inflation if those funds were actually used to create loans in the real economy. The Federal Reserve created so much money through its quantitative easing (QE) program after the 2008 financial crisis that it paid billions of dollars in interest every month to keep that money sequestered and prevent it from being injected into the monetary system in its entirety. Whatever the reason, in order to “save” the fiat currency banking system from destruction time and time again, they have created a terrible situation for themselves.

Currently, the Fed sets short-term interest rates and manages the size of its balance sheet. Powell has already diverged from his idol Volker in one very important way. To effectively manipulate short-term interest rates, the Fed must print money and give it to depositors in the RRP and IORB. The problem with this, however, is that if the Fed believes that in order to curb inflation, it must raise interest rates and reduce the size of its balance sheet at the same time, then this is tantamount to cutting flesh to cure the elbow.

First, let's look at the banking system in isolation to understand why the Fed's current policies are counterproductive. When the Fed does quantitative easing (QE), it buys bonds from banks and credits them in reserve (i.e., the IORB increases) in reserve accounts maintained with the Fed. The opposite is true when doing quantitative tightening (QT). If the Fed just does QT, then the IORB will fall steadily. That means banks have to lend less to the real economy and demand higher rates for any loans or investments in securities they hold billions of dollars in high-yield bonds they buy from the Fed. This is one side.

Banks, on the other hand, still hold about $3.2 trillion in IORB that they don't need, which is parked with the Fed and earns interest. Every time the Fed raises interest rates, the Fed hands billions of dollars to the same banks every month.

The Fed is constantly adding (QE) and subtracting (QT) reserves to banks as it tries to control the quantity and price of money. Later, I'll show mathematically how futile this is, but I wanted to provide some background first before presenting some tables.

Quantitative tightening (QT) does not directly affect ordinary individual and corporate savers; however, by distributing billions of dollars each month to RRP depositors, the Fed is also affecting these groups. The reason the Fed is handing out cash to these people is because they want to control the price of money. This also directly counteracts the contractionary effect of QT, as the Fed distributes free money to wealthy rentiers (individuals, corporations, and banks). If you have a big pile of cash, and you want to do zero financial analysis and take zero risk, you can deposit at the Fed and get almost a 6% yield. Every time the Fed raises rates, I cheer because I know I'm getting more free money in my money market fund account.

To summarize how the Fed is contradicting each other, here are some handy tables.

Looking at these two tables, you would conclude that the Fed is still tightening, as a total of $57.47 billion in monthly liquidity has been drawn. However, I left out one important source of free money release: interest payments on U.S. Treasury bonds. In the next section, I explain how the Fed's actions affect the way the U.S. government raises funds through bond sales. When that factor is factored in, Mr Powell's efforts look even more fanciful.

The era of simply raising interest rates to solve inflation is gone

A historical background for Paul Volcker to end inflation by raising interest rates in the 1970s is that in 1980, the debt-to-GDP ratio of the United States was 30%, but now it is 118%. Such a large debt will have a great effect on raising interest rates. As a result, the U.S. Treasury needs to issue more new debt to pay off old debt, fund interest payments on current debt, and pay for government spending, ultimately causing the Treasury to pay huge amounts of interest.

CPI index: service components account for a large proportion

Why is the U.S. economy growing like hell, while regional banks are struggling and indicators point to the troubles of the small businesses that drive the U.S. economy? That's because the wealthy are spending more on services.

Although according to normal logic, when people receive subsidies, they will buy daily necessities under the guidance of the government's thinking, thereby promoting commodity inflation. But the rich already have all of these things. When you give money to rich people, they spend more on services and buy more financial assets.

Services make up a large portion of the consumer price index (CPI) basket. The Fed has come up with a "supercore" measure of inflation, which basically means services.

Powell and his team are focused on significantly reducing this measure of inflation. But how can this inflation go down if every time they do something (increase interest rates) it actually makes the biggest consumers of services richer?

Differentiation of asset returns

Before I move on to looking ahead, let's take a look at some recent developments.

We need to know that even if the Fed is injecting liquidity into the market, it does not mean that all assets will rise.

Using March 8, 2023 as the benchmark (the day Silvergate Bank filed for bankruptcy), I looked at the U.S. Regional Bank Index (white), the Russell 2000 Index (green), the Nasdaq 100 Index (yellow), and Bitcoin ( magenta) performance.

In addition to the too-big-to-fail banks, regional banks performed poorly, down 24%.

The regional banks themselves are in jeopardy, and the businesses that employ their workers and drive the U.S. economy rely on regional banks for credit that they can't do while their balance sheets are so damaged. As a result, these businesses will continue to be unable to expand and in many cases will go bankrupt. That's what the Russell 2000, which is mostly made up of smaller companies, tells us. Over the past quarter, the index has barely risen.

The tech giants are not heavily reliant on banks and have benefited from the recent boom in AI. Tech companies don't care if the U.S. banking system is unhealthy. People with idle capital are willing to chase high-tech stocks again and again. That's why the Nasdaq 100 is up 24% since the banking crisis.

One of Bitcoin’s value propositions is that it is the antidote to a broken, corrupt and parasitic fiat currency banking system. Therefore, with the collapse of the banking system, Bitcoin's value proposition becomes stronger. Therefore, as the denominator of fiat money grows, Bitcoin also increases in terms of its value against fiat money. That's why Bitcoin is up 18% since March.

In trouble

Inflation is always a top concern for any population. If people can work hard and buy more with less, they actually don't care about the personal characteristics of those in power. But when gasoline or beef prices are high, politicians who have to run for re-election run into trouble. Good politicians know that if there is inflation, they must get it under control.

The Fed will continue this ridiculous strategy of trying to control the quantity and price of money because politics demand it. Powell can't stop until politicians give him the signal to fix everything. With the 2024 US election looming, the Federal Reserve is more paralyzed than ever. Powell does not want to change Fed policy between now and next November for fear of being accused of supporting a certain political party.

But the math doesn't hold. Something has to change. Take a look at the chart below - depositors continue to withdraw funds from banks with low deposit rates and deposit them in MMFs, essentially depositing funds into the Fed. If this continues, small U.S. banks will continue to fail one after the other, which will be a direct effect of Fed policy.

In addition, the US Treasury is increasing the amount of bonds it issues as tax revenues fall and the fiscal deficit soars. As money prices rise (provided by the Fed) and debt issuance increases, interest payments will get bigger and bigger. There must be a way to solve this puzzle...

The best thing about running things right now is that while they may be intellectually dishonest, they won't lie to you. Fortunately, they'll also tell you what they're up to in the future. You just have to listen.

Fiscal Leadership

For those who want to understand how the Fed and the U.S. Treasury do both the math and the politics so well, there's an excellent read: the most important paper published earlier this year by the St. Louis Fed. They have a research facility that allows well-known economists to publish papers. These papers influence Fed policy. If you are serious about investing, you must read this paper in its entirety. I will only excerpt some of them.

Dr. Calomiris has explained in detail what fiscal dominance is and what it actually means, I would like to give readers a brief summary:

● Fiscal dominance, ie the accumulation of government debt and deficits, may have the effect of increasing inflation, which "dominates" the effect of the central bank's intention to keep inflation low.

● Fiscal dominance occurs when the central bank must set policy, not to maintain stable prices, but to ensure that the federal government can raise funds in the debt market, at which point the government's bond auctions may "fail" as the market reacts to new bond issuance The interest rates required were so high that the government withdrew the auction, opting instead to print money as an alternative.

● Since the government needs debt yields below nominal GDP growth and/or inflation, investors are not interested in buying this debt. This is the definition of a negative real yield.

● In order to find a "fool" to buy these debts, the central bank needs to require commercial banks to deposit large amounts of reserves with it. These reserves pay no interest and can only be used to buy government bonds. (So the "fool" here is the commercial bank)

● As commercial banks' profitability declines, they are unable to attract deposits for lending because they are allowed to offer deposit rates that are well below nominal GDP growth and/or inflation.

● Since depositors cannot earn real yields in banks or government bonds, they turn to financial instruments outside the banking system (such as cryptocurrencies). In many cases, commercial banks themselves are actively involved in moving funds to different jurisdictions and/or asset classes for fees from their customers. This is called financial disintermediation.

● An unsolved mystery is whether commercial banks have enough political power to protect their customers and enable this financial disintermediation to occur.

So why go to all that trouble and not just tell the Fed to cut rates? Because, in the words of Dr. Carlo Miris, it's a "stealth" tax that most Americans won't notice or understand. It is politically more convenient to keep interest rates higher at a time when inflation is still destroying the American middle class, rather than publicly instructing the Fed to start cutting rates and stimulating markets again, or worse, cutting government spending.

Dr. Carlo Miris' paper presents a very solid "solution" to the Fed and US Treasury's problem, namely that weakening the banks is the best policy option if one moves toward fiscal dominance.

Then, the Federal Reserve may require that most of the deposits in the reserve be kept as reserves, cancel the payment of interest on reserves, terminate the payment of RRP balances, etc. Government agencies should not offer higher yields than long-term Treasury bonds. Given that the entire purpose of this move is to keep long-term Treasury yields below inflation and nominal GDP growth, this will no longer entice investors to park their money in money market funds (MMFs) and/or buy US Treasuries. As a result, the current fat yields that cash earns will disappear.

In essence, the Fed would end trying to control the price of money and instead focus on the quantity of money. The quantity of money can be changed by adjusting bank reserve requirements and/or the size of the Fed's balance sheet. Short-term interest rates will be slashed, likely to zero. This helps bring regional banks back to profitability, as they can now attract deposits and earn lucrative spreads. It also makes financial assets other than Big Tech attractive again. As the stock market generally rallied, capital gains taxes rose, helping to fill government coffers.

Why is weakening the banks the best policy choice?

First, reserve requirements are a regulatory decision dictated by financial regulators, in contrast to new taxes enacted by legislation (where the legislature could be blocked). It can be implemented quickly, assuming that regulators, who can be influenced by the pressure of fiscal policy, have the power to change policy. In the case of the U.S., the decision on whether to require reserves to maintain reserves on deposits and whether to pay interest is up to the Fed's board of directors. "

The Fed is not accountable to the public like elected representatives. It can do as it pleases without voter approval. Democracy is great, but sometimes dictatorships are faster and stronger.

Second, because many people are unfamiliar with the concept of an inflation tax (especially in societies that have not experienced high inflation), they have no idea that they are actually paying it, which makes it very popular among politicians.

Financial Disintermediation

Financial disintermediation is the flow of cash out of the banking system for paltry yields and into alternatives. Bankers have come up with all sorts of novel ways to offer their clients higher yields, as long as the fees are decent. Sometimes regulators are not happy with this "innovation".

Fiscal dominance happened before in the US during the Vietnam War. To keep interest rates steady in the face of high inflation, U.S. regulators imposed a cap on banks' deposit rates. In response, U.S. banks established branches outside, mostly in, London, outside the control of U.S. banking regulators, that were free to offer market rates to depositors. Thus was born the Eurodollar market, which and its associated fixed-income derivatives became the most traded financial market in the world.

Interestingly, often the struggle to control something often leads to the creation of a larger, harder-to-control monster. To this day, the Fed and the U.S. Treasury hardly fully understand all the nuances of the Eurodollar market that U.S. banks have been forced to create to protect their profitability. Something similar can happen in the world of encryption.

The heads of these large traditional financial intermediaries, such as banks, brokerage firms, and asset managers, are some of the smartest people on the planet. Their entire job is to anticipate political and economic trends in advance and adapt their business models to survive and thrive in the future. Jamie Dimon, for example, has for years highlighted the unsustainability of the US government's debt load and fiscal spending habits. He and his ilk knew a reckoning was coming, and the result would be that the profitability of their financial institutions would be sacrificed to fund the government. So they have to create something new in today's monetary environment similar to the euro market in the 1960s and 1970s. I believe cryptocurrencies are part of the answer.

The ongoing crackdown on cryptocurrencies in the U.S. and the West has largely targeted operators in non-traditional financial circles, making it difficult for them to do business. Ponder this: Winklevii (Two Tall, Handsome, Harvard Educated, Tech Billionaire Men) - Why They Can't Get Bitcoin ETF Approved in the US, But It Seems Larry Fink of Larry Fink of Old Blackstone But it will be smooth sailing? In fact, the cryptocurrency itself was never the problem - the problem was who owns it.

Do you now understand why banks and asset managers suddenly became enthusiastic about cryptocurrencies, not long after their competitors collapsed? They know that the government is about to attack their deposit base (i.e. the aforementioned weakening of the banks), and they need to ensure that the only available antidote to inflation, cryptocurrencies, are under their control. Traditional finance (TradFi) banks and asset managers will offer cryptocurrency exchange-traded funds (ETFs) or similar types of managed products, exchanging clients’ fiat currencies for cryptocurrency derivatives. Fund managers can charge extremely high fees because they are the only players that allow investors to easily convert fiat currencies into cryptocurrencies for financial returns. If cryptocurrencies have a greater impact on the monetary system than the euro market over the next few decades, traditional finance can recoup losses due to unfavorable banking regulation by being the crypto gateway to its multi-trillion dollar deposit base .

The only problem is that traditional finance is already creating such a negative image of cryptocurrencies that politicians actually believe it. Now, traditional finance needs to change the narrative to ensure that financial regulators give them the space to control capital flows, as the federal government needs to do when it imposes this implicit inflationary tax on bank depositors.

Banking and financial regulators can easily find common ground by restricting in-kind redemptions for any offering of cryptocurrency financial products. This means that those who hold any of these products will never be able to exchange and receive physical cryptocurrencies. They can only exchange and receive dollars, which are immediately reinvested into the banking system.

The deeper question is whether we can maintain Satoshi's values at a time when trillions of dollars of financial products are likely to be flooded within the traditional financial system. Larry Fink doesn't care about decentralization. What impact will asset managers like Blackstone, Vanguard, Fidelity, etc. have on Bitcoin improvement proposals? For example, proposals to improve privacy or resist censorship? These big asset managers will be eager to offer ETFs that track an index of publicly traded cryptocurrency mining companies. Soon, miners will find that these large asset managers will control large voting rights in their shares and influence management decisions. I wish we could remain true to our Founder, but the devil is waiting, offering temptations that many cannot resist.

Trading plan related

The question now is how do I adjust my portfolio, sit tight, and wait for fiscal dominance to push the policy prescription Dr. Carlo Miris describes into effect.

Right now, cash is a good bet because, broadly speaking, only the tech giants and cryptocurrencies beat it in terms of financial returns. I have to make ends meet, and unfortunately, owning tech stocks or most cryptocurrencies basically doesn't generate income for me. Tech stocks don't pay dividends, and there are no risk-free bitcoin bonds to invest in. Earning almost 6% yield on my fiat backup funds is great because I can cover living expenses without selling or lending my crypto. Therefore, I will continue to hold my current portfolio, which includes both fiat and cryptocurrencies.

I don't know when the US Treasury market will crash and force the Fed to act. Given the political demands that the Fed continue to raise interest rates and reduce its balance sheet, it is reasonable to assume that long-term interest rates will continue to rise. The 10-year U.S. Treasury yield recently topped 4%, putting yields at local highs. This is why risky assets such as cryptocurrencies have been hit. The market sees higher long-term interest rates as a threat to indefinite assets such as stocks and cryptocurrencies.

In his recent note, Felix predicted an imminent severe market correction in various assets, including cryptocurrencies. His point of view is still worthy of attention. I must be able to earn an income and be able to deal with the market volatility of cryptocurrencies. My portfolio is set up for just that.

I believe I have the correct forecast for the future because the Fed has said that bank reserve balances must grow, and predictably, the banking industry is not happy about that. The rise in long-term U.S. Treasury yields is a symptom of a deep-seated corruption in the market structure. China, oil exporters, Japan, the Fed, etc. are no longer buying US Treasuries for various reasons. With the usual buyers on strike, who is going to buy the trillions of dollars of debt the US Treasury will have to sell in the coming months at low yields? The market is heading towards the scenario predicted by Dr. Carlo Miris, which could end up with a failed auction that forces the Fed and Treasury to act.

The market has yet to appreciate that the sooner the Fed loses control of the Treasury market, the sooner it will resume rate cuts and quantitative easing. This has already been demonstrated earlier this year when the Fed abandoned monetary tightening by expanding its balance sheet by tens of billions of dollars in a matter of trading days to "save" the banking system from defaults by banks across the region. A dysfunctional U.S. Treasury market is good for risky assets with limited supply, like Bitcoin. But that's not how investors have traditionally been trained to think about the relationship between fiat risk-free yield bonds and fiat currency risky assets. We have to go downhill to go up. I'm not trying to fight the market, just sit back and accept this liquidity grant.

I also think that, at some point, more investors will do the math and realize that the combined Fed and US Treasury are handing out billions of dollars every month to wealthy savers. That money has to go somewhere, and some of it will go to tech stocks and cryptocurrencies. While the mainstream financial media may be disastrously vocal about issues related to sharp price drops in cryptocurrencies, there is a lot of cash to find suitable investments in financial assets with limited supply such as cryptocurrencies. While some believe that the Bitcoin price will drop below $20K again, I tend to think we will be hovering around $25K early in Q3. Whether cryptocurrencies can weather this storm will directly correlate to the amount of interest income for new interest earners.

I will not fear the weakness of this cryptocurrency, I will embrace it. Since I'm not using leverage in this portion of the portfolio, I don't mind a big drop in price. Using an algorithmic strategy, I will patiently buy several "altcoins" that I believe will do well when the bull market returns.

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