Stewart Cowley - Nigel Lawson’s Diet

Stewart Cowley, Investment Director, Fixed Income and Macro, Old Mutual Global Investors

I had dinner with the former UK Chancellor of the Exchequer Nigel Lawson once. For those of you too young to remember, Lawson was a physical and intellectual behemoth of the early Margaret Thatcher government who championed shadowing the Deutschemark at DM3 to the pound as a precursor to a fixed exchange rate regime in Europe. Mrs. Thatcher didn’t like this, brought in her own new best friend as her personal economic advisor, Professor Alan Walters, to second-guess Lawson and everybody fell out.

At dinner I noticed, you couldn’t miss it, that he was literally half the man he was. He confessed to drinking a bottle of wine at lunch and the same in the evening whilst chancellor. To shed the pounds he designed a diet that cut out alcohol but more importantly, changed his eating habits. “Eat something of everything that is put in front of you but not all of it.”, was the basic message. In other words, a little very, often, is better than crash dieting.

Which brings me to our friends in the United States. I can’t work out if they will be able to increase interest rates when they want to.

US excess reserves

The problem goes back to 2008 when, during the height of the banking crisis, the Federal Reserve said, for the first time, that if banks lodged their excess reserves with them, they would receive interest on them at a rate called Interest On Excess Reserves (IEOR) set at 0.25%. Money flooded into the Fed.  

The effect was no doubt, exaggerated by the process of quantitative easing that followed: however, in whatever way monetary policy works, in the years that followed, lots of excess money flowed into the Fed. Currently there is about US$2.5trn sitting inside the Fed.

What you have to bear in mind is that we are talking about excess reserves: the money that is left over after your required reserves are in place to make sure that your bank can function normally and within its regulatory controls. This should give you a warm fuzzy feeling about the state of the US banking system. But banks that have lots of money turn out to be very difficult to control.

When they were a bit short of cash, banks used to go to the Fed and borrow money at the Fed Funds rate. This was the main policy tool to control and set rates throughout the system. The Fed “window” is the place you go to beg for money. But what if you don’t need any money? Trading at the Fed Funds window dwindles considerably, as has been observed and you lose your influence on the system.

To solve this, the Fed has said that they are most definitely NOT going to use their vast collection of securities to move market rates. They are going to target a range for Fed Funds and change the IEOR to pull up the Fed Funds rate like a magnet. This might not be enough because not everybody is a bank and there is a lot of money in the system in non-banks. To put a floor under the whole thing they will use Overnight Reverse Repurchase Agreements (selling US Treasuries into the market to drain money out of the system). Combining the IEOR with the ON RRP creates the range in which Fed Funds is now targeted.

You will forgive me for making a detour into this rather technical world but I think we are going to be hearing quite a lot about these terms in the future so you might as well get used to them. What should be obvious to you is that this is no longer a straightforward case of announcement and immediate market adjustment, mainly because there is so much money that is not needed and unused in the system.

I have long suspected that Janet Yellen is a reluctant rate increaser and I’ve speculated on a number of occasions before that she may prefer NEVER to raise interest rates during her entire tenure as head of Federal Reserve. She has stated that she sees unemployment as a bigger scourge on society than inflation. In that case it would be consistent if she were to fight tooth and nail before raising rates especially when doing so may be quite difficult.

Also, the US credit cycle isn’t firmly established and you need a credit cycle for a fully functioning capitalist system. It would make a lot more sense for some of those excess reserves to be lent, increasing the quantity of money in society and consequently allowing the Fed to finesse the system with more control. This will take more time than people are anticipating.

This leads me to my final point and why I started with Nigel Lawson’s diet. The Lawsonian gradualist approach of a large number of small interest rate moves to slim the system may not work in the world of massive excess reserves. I have no doubt that when the first move is made there will be much wailing and gnashing of teeth. But it will settle down quite quickly and not in the expected place. Instead, we may find ourselves in a place where the Fed has to take very drastic actions to normalize interest rate policy which is something people are just not thinking about right now.

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