Wosh wants to reduce idle funds? First, overcome the interest rate hurdle
I came across a viewpoint stating that now two-thirds of the new currency derived in the US merely circulates within the financial system. To reverse this situation, Walsh will compress banks’ excess reserves, forcing banks to lend, preventing them from earning interest effortlessly, and forcing funds to flow from the financial system into the real economy and consumption. As a result, US stock investors have started speculating on defensive consumer staples sectors with strong cash flow, such as Coca-Cola and Walmart, which have seen notable gains recently.
This all sounds very familiar! Isn’t this the spirit of the National Financial Work Conference in July 2017? Could it be that Walsh secretly studied the conference’s principles, calling for the financial industry to serve the real economy and reduce idle circulation of funds?
Regardless of whether he will actually do this, let’s analyze logically what impact such actions would have.
Here is my viewpoint: When the natural interest rate drops to a low level, both the real economy and equity markets lack good investment opportunities, and a large amount of funds will remain idle within the banking system, even becoming part of leverage. At this point, money market rates remain low. If the central bank attempts to withdraw liquidity from the interbank market to reduce idle funds, it will inevitably cause money market rates to rise rapidly.
Why is that? Isn’t there ample liquidity?
Indeed, liquidity is abundant, but the problem is that all these funds are already in use, even forming part of the leverage. If liquidity is withdrawn, financial institutions will immediately sell their fixed income holdings, reduce leverage, and seek cash, causing money market rates to rise. To use an analogy: if you build a tall building with bricks and, after completion, try to remove 5% of the bricks from the foundation or load-bearing walls, the building will collapse and the residents will rush out to beat you up.
The current “monetary policy implementation framework” of the Federal Reserve is known as the “ample reserves framework.” There is a complete set of monitoring indicators regarding the appropriate level of reserves. If Walsh tries to require commercial banks to reduce excess reserves—for example, by announcing that the Fed will no longer pay interest on excess reserves, or even charging a “management fee”—and forces commercial banks to lend to the real economy, this will immediately lead to a shortage of reserves. Financial institutions in need of funds will have to raise rates to obtain liquidity. This, in turn, will cause stock and bond markets to fall, and could even trigger a minor liquidity crisis similar to what happened in mid-March 2020.
Ultimately, when the natural interest rate is low, the central bank is forced to maintain ample liquidity—especially during crises. Consider the Bank of Japan’s QE starting in March 2001; the Federal Reserve’s QE1 on November 25, 2008, QE2 on November 3, 2010, QE3 announced in September 2012, QE4 in December 2012, the $700 billion QE on March 15, 2020, and the unlimited QE announced on March 23, 2020.
Currently, Federal Reserve board member Stephen I. Miran believes the US neutral interest rate will drop significantly. If this is true, then in the future the Federal Reserve will have to continue maintaining ample liquidity. Walsh’s desire to reduce idle funds cannot be fulfilled.
Additionally, as I’ve said before, his wish to shrink the Fed’s balance sheet will also be difficult to achieve. Only rate cuts are relatively easy.
Disclaimer: The content of this article solely reflects the author's opinion and does not represent the platform in any capacity. This article is not intended to serve as a reference for making investment decisions.
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