Thread by @conksresearch

After a pandemic and multiple financial crises, we've finally entered a lengthy period of rising interest rates. But while most are aware of the ominous outcomes this could create, those who know how the Fed actually controls rates will gain an edge in predicting the future... 1/

Due to exceptional circumstances, recent textbooks describing how the Fed controls interest rates are already outdated. Until recently, officials could simply raise/lower the Federal Funds rate by decreasing/increasing the level of bank reserves in the financial system...

Bank reserves are "interbank" money, which can only be used by entities with reserve accounts at the Federal Reserve. JPMorgan, for instance, can pay Goldman Sachs for prime NY real estate using reserves, while we must use bank deposits or "Reserve Notes," posh jargon for cash...

Before the Great Financial Crisis (GFC), the Federal Reserve had enough power to move interest rates toward its target, commonly known as Federal Funds. It did so by adding and removing a specific amount of these interbank reserves to and from the financial system.

Like so...

By lowering the supply of bank reserves, the Fed forced financial institutions to bid up the price of Federal Funds (the rate at which banks lend each other reserves), resulting in higher interest rates throughout markets...

Conversely, by increasing the supply of bank reserves, the Fed lowered the Fed Funds rate. The following graphic from the St. Louis Fed illustrates these forces at work...

Everything went somewhat smoothly. The Fed set a target range in which interest rates could fluctuate and made the necessary adjustments to keep rates within set boundaries. Conveying and implementing its latest monetary policy stance was a cakewalk...

Then, in 2008, the Great Financial Crisis (GFC) hit, transforming the central banking paradigm and the Federal Reserve System forever. The primary catalyst that fueled a permanent alteration was Fed officials' decision to flood the system with bucketloads of bank reserves...

The amount was staggering. In 2007, the system held a total of $15 billion in reserves. Today, it's roughly $3.2 TRILLION. The Fed's latest QT program has been aggressively removing reserves from the system. Still, it's long before we return to "normal" levels...

With a system becoming full to the brim with reserves, the Fed could no longer control interest rates through its previous policy of increasing/decreasing levels of interbank money...

As shown in the graphic below, the Fed flooding the system with reserves meant that even sizeable adjustments to supply no longer influenced demand. The U.S central bank needed a new mechanism to take back control of Federal Funds, and quickly...

Enter the Fed's "Ample Reserves" regime, where Fed officials ceased using OMOs (open market operations), which involved buying and selling government securities to alter reserve levels, as its primary tool to adjust interest rates...

Instead, on October 6th, 2008, the Fed began paying reserve account holders, mostly large banks and government-sponsored enterprises, interest on their balances. IOER (Interest On Excess Reserves), as it was called then, was now the Fed's chief tool to manage interest rates...

By offering banks IOER, which was in theory a "risk-free" investment option, the Fed gained the power to control money markets through two mechanisms.

First, through the "reservation rate"...

This is the lowest rate that banks are willing to loan out funds to other banks. Because the Fed had started handing out a risk-free investment that paid superior interest (IOER), no entity would want to lend to others at rates lower than the Fed's...

This set a ceiling on how high rates could go, alongside the Fed's second mechanism: arbitrage. Fed Funds rarely dropped beneath IOER because entities could create a risk-free arbitrage, borrowing Fed Funds at say 1% and depositing it at the Fed, paying 1.5%...

This 0.5% gap would eventually narrow to near zero, as Fed Funds participants competed to arbitrage the spread away.

With these two new levers, the Fed thought it had successfully reigned in markets...

If it wanted to alter rates, the Fed simply adjusted the discount rate and IOER at the same time by the same level. If the FOMC (Federal Open Market Committee) was indicating that rates should rise, money markets could adjust, preemptively pricing in tightening...

From then on, the Fed had set a ceiling on interest rates, but a slight issue remained.

They needed to establish a floor on rates too...

Influential participants in the Fed Funds market, such as Federal Home Loan Banks (FHLBs), were ineligible to earn interest on their reserves. This meant they sometimes pushed money market rates below the Fed's targets...

To counteract this, the Fed created the overnight reverse repo facility, ON RRP. This offered another risk-free investment at a set rate to parties ineligible for IOER, thereby fixing the bug and setting a lower bound on interest rates. Money markets obeyed with minimal fuss..

After implementing a trio of policy rates (IORB, ON RRP, and the discount rate), the Fed once again felt it had total control of money markets.

Though, it still had one weakness: the repo market, where parties temporarily transform safe assets into quasi-cash deposits...

By 2019, barely any entities other than a few government-sponsored enterprises (GSEs) still participated in the Federal Funds market, as most institutions now had all the reserves they needed.

Instead, animal spirits and regulations pushed market participants into repo...

On September 17th, 2019, rates in repo exploded higher. Everyone wanted cash, but there was a shortage. Corporate tax payments and increases in Treasury issuance meant a large decline in reserves. Banks had to cut back on repo lending, so nobody could provide...

Responding to this demand-supply mismatch, the Fed created what it eventually called the "Standing Repo Facility". This allowed specific entities to obtain cash from the Fed at a set rate using U.S. Treasuries, agency debt, or agency mortgage-backed securities as collateral...

The Fed's gambit worked. Since everyone started borrowing from the Fed, SOFR or the Secured Overnight Financing Rate (which tracks the cost of transactions in the repo market) fell from over 5% to within the Fed's target range...

Fast forward to July 2021, after COVID and QE Infinity, IOER along with IORR (interest on required reserves) had grown redundant. The Fed retired these measures in favor of a single benchmark: IORB (Interest on Reserve Balances).

"Excess reserves" was now a futile measure...

Since then, finally it's been plain sailing for the Fed. For now, it has eliminated potential crises in rates markets. If rates soar above its target range, the Fed adjusts IORB or fires up the Standing Repo Facility, bringing rates into its desired range...

At the lower bound, entities barely want to borrow under the Fed's ON RRP, because they're missing out on a risk-free investment from an entity that can issue debt with no credit or default risk. The Fed's rate floor has been "leaky" a few times, but everytime it's been fixed...

By implementing a trio of policy rates (IORB, ON RRP, and the discount rate), and using its Standing Repo Facility, the Fed has gained a solid grip on money markets. Ever since the repo market blowup, minus a few "hurdles", the status quo has evolved into stability...

Now, claiming the system is "stable" is what many will deem contrarian. But contrary to popular belief, the Fed has created a more durable system and increased resilience. Fed analysis is mostly ideologically driven, not based on validities, so it's hard to acknowledge...

This, however, does not mean financial markets have been stripped of hazards. With the Fed being able to prevent domestic money market crises, the danger now lies offshore in exotic areas of the financial system.

Though, once again, the U.S is slowly gaining control...

By providing central bank swap lines and foreign exchange swaps to its closest allies, opening a FIMA facility to seemingly supply emergency dollars to China, and issuing $1 trillion in Treasuries every year till at least 2055, America will increase its grip on global finance...

It’s for these reasons that Concoda sees the end game as not a collapse but the Fed gobbling up every shadow banking paradigm to maintain financial stability. The REM Industrial Complex (Repo, Eurodollars, and Money Market Funds) will continue to fall under the Fed's umbrella...

The U.S dollar hegemony requires a complex, ever-changing financial system, and as it becomes ever more elaborate and intricate, the Fed must increase its oversight to maintain authority and power...

If and when another financial or monetary threat emerges it can -- and will -- adapt, changing the rules of the game once again to keep the global monetary system functional and stable...

And everyone, Fed critics, average citizens, even crypto advocates, will go along with the U.S central bank's new policies, because the alternative is a financial catastrophe that not even collapsitarians can stomach. The Great Financial Reset™ will become a distant daydream.

Thanks for reading!

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