Powell's Paradox: Curing Inflation Will Create A Money Shortage
Can The Fed Control What They Do Not Comprehend?
While Jay Powell has dug in his heels on inflation, determined to crush inflation by any means necessary, economic recession be damned, a counter-intuitive fear has begun to build on Wall Street: the Fed’s anti-inflation strategy means there will not be enough cash money available to resolve market obligations when they occur.
That’s right. The Wall Street casino is fearful of not having enough cash on hand to settle up all bets when the market crashes—so it constantly wants more cash from the Fed (and gets it).
With the Fed doubling the pace at which its bond holdings will “roll off” its balance sheet in September, some bankers and institutional traders are worried that already-thinning liquidity in the Treasury market could set the stage for an economic catastrophe — or, falling short of that, involve a host of other drawbacks.
In corners of Wall Street, some have been pointing out these risks. One particularly stark warning landed earlier this month, when Bank of America BAC, -0.17% interest-rate strategist Ralph Axle warned the bank’s clients that “declining liquidity and resiliency of the Treasury market arguably poses one of the greatest threats to global financial stability today, potentially worse than the housing bubble of 2004-2007.”
The Fed Wants To Shrink Its Balance Sheet And Wall Street Is Scared
Specifically, Wall Street is terrified about what will happen as the Fed begins to shrink its ginormous balance sheet—which it has barely begun, with scant progress thus far.
Just the small reduction made this year is enough to give Wall Street a case of the vapors.
Short of an all-out blowup, thinning liquidity comes with a host of other drawbacks for investors, market participants, and the federal government, including higher borrowing costs, increased cross-asset volatility and — in one particularly extreme example — the possibility that the Federal government could default on its debt if auctions of newly issued Treasury bonds cease to function properly.
Waning liquidity has been an issue since before the Fed started allowing its massive nearly $9 trillion balance sheet to shrink in June. But this month, the pace of this unwind will accelerate to $95 billion a month — an unprecedented pace, according to a pair of Kansas City Fed economists who published a paper about these risks earlier this year.
The Federal Reserve has been printing money like mad since 2008, and went off the deep end with it in 2020, and the markets are worried there won’t be enough as the Fed tries to pull some of that back.
Just how much money does Wall Street need?
The Challenge: Liquidity
The crux of the issue is that, despite all the dollars the Fed has wished into being over the past 14 years, the markets are concerned about point-in-time dollar shortages known as “liquidity crises”.
To understand why this is, a couple of definitions are in order:
Regardless of how much cash money is in the money supply overall, if that cash is not where it needs to be when assets need to be a liquidity crisis develops. A “liquidity crisis”2 occurs when market actors do not have cash available to complete a transaction.
Regardless of how much money the Federal Reserve creates, if it’s not in the “right hands” at the “right time”, asset transactions cannot be completed, and financial markets lock up. That the banks which support Main Street businesses are the same banks playing on Wall Street expands that problem to Main Street.
Most economists view the 2008 Great Financial Crisis (GFC) as a liquidity crisis.
Even with these very divergent origins, the GFC and pandemic crisis impacted financial markets in some similar ways.
First, both resulted in an extraordinary increase in the demand for dollar liquidity. The demand arose out of both immediate funding needs and the desire to raise precautionary liquidity. The supply of liquidity was also curtailed as firms that normally lend instead stockpiled liquidity to meet potential future payment needs. During both crises, this surge in demand for U.S. dollars was global in nature and had significant spillovers to domestic funding conditions.
The concern within financial markets today is that, as the Fed tightens the money supply to control inflation, there will not be enough dollars at crucial points to satisfy dollar liquidity demands. In other words, there is a perceived risk on Wall Street that, as the Fed reduces the overall supply of money, that there will not be sufficient dollars available to participants in various asset transactions to allow those transactions to be completed.
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