On the face of it, a 25 basis point (bp) increase in the US federal funds rate (the interest rate at which banks trade their excess reserves) looks pretty benign and inconsequential. Janet Yellen appeared to play down the consequences, but any student of economics knows that a little bit of tightening can go a long way under extreme circumstances.
Unfortunately, these are extreme circumstances and, in combination with liquidity developments outside the US, the US Fed just tightened global liquidity conditions very aggressively.
The first chart shows the relationship between the monetary base (under the control of the Fed: notes and coins + required bank reserves + excess bank reserves) and the short term interest rate.
On the vertical axis is the interest rate and on the horizontal axis something economists call the “liquidity preference”, which is simply the amount of monetary base per unit of GDP (or, in other words, how much “money” supports each dollar of gross domestic product).
- At very low levels of interest rates the opportunity cost of holding money becomes trivial/near zero and so more money is willingly held.
- At very high levels of interest rates the opportunity cost of holding money is very punitive so less money is willingly held.
Money moves faster around the economy (works harder) when interest rates are high and more slowly around the economy (works less hard) when interest rates are low.
Where are we now?
Well, unfortunately for the Fed, we are out at the far right of the chart with rates near 0 and liquidity preference at a record 22/23 cents per dollar of GDP.
Well, as we noted, money works harder when interest rates go up so for the Fed to actually tighten monetary policy they need to remove liquidity (“monetary base”) from the system. Otherwise, paradoxically, by raising rates they will have eased monetary policy (made money work harder).
How much liquidity do they need to remove?
Well, let’s look at the chart. A 25 bp short rate implies liquidity preference (money/GDP) about 30% below the current level, around 16 cents from 22/23 cents per dollar.
Given that excess bank reserves held at the Fed are $2.58 trillion, or 65% of the total monetary base, it would imply that the Fed needs to remove around $800 billion in liquidity from the system.
Note: the relationship between interest rates and liquidity (the size of the Fed’s balance sheet) is non-linear. In short, each successive 25 bp of tightening requires less liquidity removal; the liquidity removal is highly front-loaded (this was noted by former Fed Board member Professor Charles Plosser as far back as 2011). So, the first 25 bp is the hardest, requiring the better part of $1 trillion of liquidity removal. The next 25 bp are a further $200 billion (approximately) and so on.
Indeed, that’s a lot of liquidity taken out of the system. That must have an impact on market liquidity, asset prices and the US dollar.
However, it gets worse. Look at the drawdown in global foreign exchange reserves (essentially, capital leaving the emerging markets).
Emerging markets are losing liquidity at an almost unprecedented rate just at the point where the US Fed is likely to be taking the best part of $1 trillion out of the system – global liquidity conditions are tightening severely.
As always, we will observe and respond as/when/if the Fed follows the path.
MONOGRAM CAPITAL MANAGEMENT