The Federal Reserve was caught flat-footed in September when the supply of funds available for overnight lending fell far short of demandOpens a new window , leading to a spike in short-term rates that disrupted the central bank’s management of its benchmark interest rate.
Fed officials tried to get themselves off the hook by saying market participants themselves were surprised at the volume of demand as tax payment day, Treasury auction day and a Japanese holiday created a perfect storm to dry up available funding. But market participants expect the Fed to know better. The events leading up to the shortage had largely been known for weeks.
Primary role of New York Fed
The Federal Reserve Bank of New York is primus inter pares – first among equals — among the 12 regional Federal Reserve banks because it’s responsible for the central bank’s activities in the market. In fact, when the Fed was founded in 1913, the New York Fed was to all intents and purposes the central bank of the United States.
It was the reform of 1933 that strengthened the role of the board of governors in Washington and shifted the locus of decision-making to the capital.
Even now, the New York Fed’s role makes its president the vice-chair and only permanent member of the Federal Open Market Committee, which meets every six weeks or so to determine interest rates and other aspects of monetary policy, while the other regional bank heads rotate into a voting position every two or three years.
Jarring lapse
So markets felt left down when the New York Fed failed to anticipate a cash shortage that emerged just the day before a Federal Open Markets Committee meeting. Just as the Fed was supposed to be demonstrating its competence in its most important function in Washington, there was turmoil in the money markets before the New York Fed finally decided to inject $75 billion by buying up government securities on an overnight basis through repurchase agreements, or repos.
The delay in taking or or even announcing action became another sore point with market participants. The Fed had to follow up its interventionOpens a new window with further liquidity injections in subsequent days to meet overnight demand.
It was the first time the central bank had to resort to emergency repo measures since 2008 and the financial crisis. This time, however, there was no crisis, and Fed officials began to realize there may be a bigger underlying problem.
The Fed inflated its balance sheet in the wake of the crisis, creating trillions in reserves through quantitative easing. When the Fed reversed the process and started reducing its balance sheet, it reduced the available reserves and the amount of liquidity available in money markets.
The repo facility is still in placeOpens a new window and probably will remain so until a fix is found.
Pointing fingers
Fingers quickly pointed at John Williams, the new head of the New York Fed, who succeeded William Dudley last year. Williams had worked his way up through the San Francisco Fed to become chief economist under then president Janet Yellen. The suspicion among market participants is that Williams, for all his theoretical expertise, lacks the market savvy of his predecessor, who spent 21 years at Goldman Sachs.
Such disruption had never occurred under Dudley.
Whether or not this is a fair judgment, the damage has been done. As President Donald Trump hammers away about the Fed’s competence on monetary policy, the central bank seemed to drop the ball on its key market function.
Williams and Fed chairman Jerome Powell continue to claim they were blindsided and reacted with appropriate swiftness but market participants aren’t buying it. The Fed now needs to figure out whether this is a systematic problem that needs a long-term fix. But it will take longer to repair the damage to its reputation.