Bagehot & Deflation: Interview with David Kotok

rcwhalen's picture

Last week, I published two articles, on Zero Hedge and Breitbart, respectively, that highlight the issue of “financial repression” via low interest rates. Below is an exchange with my dear friend and mentor David Kotok, Chairman of Cumberland Advisors. We discuss the question of whether the current policy of the Federal Open Market Committee is feeding deflation via low rate policy. This question has great significance since the stated goal of FOMC policy is to raise inflation to ~2% annually and boost employment. From my perspective working in the housing sector, the combination of current Fed policy and new regulatory strictures such as Dodd-Frank and Basel III are clearly thwarting efforts by the FOMC to reflate the housing sector and the wider US economy. --- RCW

Whalen: David, I really appreciate your comments on the ZH article last week, “Default, Deflation and Financial Repression.” In particular, your focus on ultralow interest rates, Federal Deposit Insurance Corporation premiums and the flow of cash from the banks to the Federal Reserve System is very illuminating – and disturbing. As you know, I have long maintained that the FDIC’s fiscal need to fund the deposit insurance scheme is a separate matter from monetary policy, but when we have near-zero interest rates, the average FDIC premium of 7-10bp does become significant. Can you talk first about what is happening in the US money markets from your perspective?

Kotok: You wrote a very important article last week, especially the part about the Fed taking billions out of the economy and away from savers in order to subsidize the banking industry. But there is another and more nuanced part of the puzzle that we need to consider. We have a Fed Funds target of 0-0.25% in place presently. The Fed is also paying 0.25% per annum on excess reserves. This means the reserve rate is higher than the actual Fed Funds rate while the lower bound is maintained at zero. The GSEs, who are large sellers of Fed Funds, cannot legally deposit directly with the Fed. So, they sell Fed Funds, and the banks buy them and redeposit the cash with the Fed. The FDIC levies an asset-based fee on each bank and that includes the reserve deposit assets which are under their FDIC jurisdiction. So the actual Fed Funds rate, inclusive of the FDIC insurance levy, is below the gross (0.25%) reserve deposit rate. Some larger, riskier banks pay even higher FDIC fees than the average and are effectively losing money on this trade. Meanwhile the US subsidiaries of foreign banks, which are not subject to the FDIC levy, have an advantage in the short-term markets.

Whalen: So your basic point is that the fact that rates are so low in absolute terms is distorting the US money markets, in part due to structural costs like the FDIC insurance premium? The nineteenth-century economist Walter Bagehot maintained that in order to prevent bank panics a central bank should provide liquidity to the market at a very high rate of interest. Yet today the neo-Keynesian tendency that controls the FOMC believes that the fact the Fed has the virtually unlimited ability to temporarily expand the money supply refutes Bagehot’s dictum. In today’s terms, Bagehot was warning us against keeping rates too low for too long because real money would flee from financial repression.

Kotok: Antoine Martin of the Federal Reserve Bank of New York, in his important 2005 paper “Reconciling Bagehot with the Fed’s Response to September 11,” argues that Bagehot had in mind a commodity money regime in which the amount of reserves available was limited. Thus, keeping rates high was a way to draw liquidity, that is gold, back into the markets. Bagehot also understood that low interest rates fuel bad asset allocation decisions – what we call “moral hazard.” In the age of fiat money, however, economists have taken the opposite view, namely that an unlimited supply of reserves obviates the need to attract money back into the financial markets.  Remember that Martin’s paper was written two years before the start of the subprime crisis.

Whalen: His timing was impecable.

Kotok:  Bagehot’s classic text advocated a penalty interest rate secured by good collateral. He was envisioning a form of discount window mechanism similar to what central banks used in the pre-QE era. That mechanism has been mostly replaced with QE, which is a policy that we are still in the early stages of learning about.  More recent Fed papers have delved into the impact of QE on otherwise neutral interest rates. It certainly lowers them for a while and in the early stages of QE. Other researchers have noted how the central bank’s remittances to the Treasury alter the fiscal authority budget balance. And others have focused on the potential methods for terminating QE and getting to a neutral position. Still others are trying to solve the mystery of how to reduce the impact of QE and restore a more neutral policy. Lastly there are the inflation hawks, who forecast an inflationary outcome of QE. They may eventually be right, but after five years the evidence suggests that excess reserves are not by themselves very inflationary. It takes an acceleration of growth to turn post-crisis disinflation force around,.  That means rising demand is needed to obtain  rising price pressures. So far, we haven’t seen much of either in the course of our grand experiment with QE. My colleagues and I have written about these various research papers, and the links can be found on our website, www.cumber.com.

Whalen:  Well, the 2001-2007 period certainly suggests that Bagehot’s concerns about low interest rates fueling moral hazard have not been refuted. The FOMC’s aggressive easing of interest rates, combined with deregulation of the financial markets and the FDIC's safe harbor with respect to bank asset sales between 2000 and 2010, fueled a speculative binge that nearly destroyed the western world. When Lehman Brothers failed, we had created some $60 trillion in toxic assets that were not supported by the $13 trillion asset US banking system. Now almost seven years since the bust, a large portion of that pile of crap has yet to be remediated.

Kotok: Very true, but the past is past. We must focus on the future. Whether or not you believe that a flexible reserve system like the Fed's addresses Bagehot’s concern about attracting liquidity back into the markets, the fact is that very low interest rates do distort money flows. That is why your point about the Fed taking $100 billion per quarter out of the hands of savers is so important. But what do the banks do with that money? They deposit it with the Fed. And what does the Fed do with that money? They pay the banks 0.25% and then invest in US Treasury debt and mortgage-backed securities (MBS) at a higher rate, and thereby generate what they call a “profit.”

Whalen: So your point is that the $100 billion per year that the Fed is taking from the hands of consumers, meaning savers, is actually passing through the banking system and going to the Treasury via remittances from the Fed?

Kotok: Precisely. The practice of the Fed calling the spread they earn on their nearly $3 trillion portfolio of securities “profits” is a monstrous distortion of the word. What they are doing is feeding deflation in the real economy by reducing savers' income while pushing down the federal budget deficit. Between budget sequestration and the spread arbitrage created by the low interest rate paid on excess bank reserves, US government policy is clearly operating with a deflationary bias. As you and I have discussed for several years with respect to the higher FDIC deposit insurance premiums, we need to take a holistic view of government policy. The whole playing field gets level if the Fed’s excess-reserve deposit rate is set higher and thus eliminates the false profit they now recognize via remittances to the Treasury.

Whalen: Well, you are assuming that the banks would actually lend out the additional profit that they earned in higher rates on excess reserves. Wouldn’t we need to also raise the target for Fed Funds to say 0-1% from the current 0-0.25% in order to give some of the benefit back to savers of all stripes?

Kotok: As we wrote last week in our Market Comment, in the Fed there are those who argue that the rate should be lowered or maybe go to zero. It is currently 0.25%. Others argue that the rate should be raised or that the amount of required reserves should be changed, thereby changing the excess reserves composition. All sides of this debate are passionately argued by skilled agents in monetary economics. But the real question the FOMC needs to ask is, what are we going to do if inflation continues to fall? That is, if we find ourselves in a deflationary trap. Many commentators argue that we are in one or near one. I am worried about it.

Whalen: It is perhaps not surprising that commercial bankers are against lowering the rate paid on the $2.3 trillion plus in excess reserves sitting on deposit at the Fed.  That is 20% of the assets of the entire US banking sector, again another sign of deflation.  Given the sharp drop in net interest margins in the US banking industry, the Fed may need to boost interest paid on reserves just to keep the industry from imploding.  Just as in the 1930s the Fed fueled deflation by not making credit available, today the opposite seems to be the case – low rates are fueling deflation and impeding the creation of credit to support the economy.  Where are you on the issue of when FOMC policy is likely to change?

Kotok: At Cumberland we believe the short-term interest rate will be kept low for a long period of time, which we measure in years, not months. We do not expect the Fed to deliberately shock the economy by any action that would cause another recession. The June press conference has served to chasten members of the FOMC. Some members of the Fed are already worrying about the possibility of recession. There is evidence of deflationary and/or disinflationary forces at work now. That evidence has raised the eyebrows of some policymakers and commentators. We are among those who worry about this issue. We do not think Japanese-style deflation will happen, but we worry that it could happen. We keep watching commodity prices and oil prices. Oil is especially important because it flows through so any sectors of the economy. And changes in the oil price quickly translate to gasoline prices, and that means a consumption tax increase or decrease. At an annual rate, a 1-cent change in the gasoline price adds up to about $1.4 billion in raised or lowered consumer expenditures.

Whalen: That is a big change. Let’s get back to the deflation issue. For the past year and more I have been writing about the deflationary impact of Dodd-Frank and Basel III, which are effectively offsetting the low rate policy of the FOMC in terms of consumers and households. Companies and leverage investors benefit from low rates, but the sharp drop in mortgage loan origination volumes is a huge red flag regarding deflation in my book. Imagine what the debt and equity markets will do when we see a negative print on the monthly Case-Shiller Index? Our friend Michelle Meyer at Bank America Merrill Lynch says that Q2 2013 was the peak in home price appreciation in this cycle. I agree and think a big part of the reason that housing is now slowing are the excessive regulatory constraints on lending.

Kotok: You are right to worry about housing and the banks, as usual. Many observers look only at the price level, and they miss the fact that it is the rate of change that counts at the margin. That said, the key piece of the puzzle we need to make people understand is the deflationary effect of low rates. If the FOMC increased the target for Fed Funds gradually, say a quarter point per quarter to 1%, and likewise raised the deposit rate for excess reserves, I think that move would go a long way toward curtailing the deflationary threat we now see building. The Fed could do this by widening the band from 0.0% bottom and 0.25% top to 0.0% bottom and 1.00% top. Then raise the reserve deposit rate to 0.50%. That would allow the markets to clear after the distortion of the FDIC fee. It would also allow a slightly positive numerical interest rate to be attached to REPO and to large deposits. Right now, the very large depositors are actually paying a negative rate cost to have their money in the bank. Your point about low-rate policy hurting consumers is right on target, but look at the short-term funds markets for these large institutional folks. Very low rates and structural impediments such as the FDIC insurance premium are preventing the markets from clearing and functioning in a normal fashion. We cannot rebuild the short-term funds markets until the FOMC allows rates to rise. And the longer we wait, the more painful and dangerous the adjustment process will be.  And we haven’t discussed added cost such as those coming from the FDIC’s Orderly Liquidation Authority.  I believe that public release is due soon.

Whalen: Well, if you had a 1% overnight Fed Funds rate, the 7-10bp FDIC insurance premium would be irrelevant. If we translate the fundamental concerns of Bagehot into today’s terms, he probably would agree with your view that low rates are preventing the efficient flow of capital in the markets. But our friends at the Fed just don’t seem to understand their own limits and how policy decisions create future crises. The members of the FOMC led by Janet Yellen believe that they can manipulate interest rates and the economy to a satisfactory income, but in fact the current policy mix may be leading us to another crisis – just as the FOMC did between 2001 and 2007.

Kotok: I’m not as harsh on the FOMC members. Janet Yellen knows the difficulties, and she will use her skills and experience to try to manage the transition from QE at $85 billion a month to something less and eventually to zero. A target for Fed Funds is of no significance in terms of monetary policy when we are at a zero boundary. You can make the target 0-1.00 instead of 0-0.25, and I would do that at once if I were in the decision chair. But it makes no difference until the FOMC neutralizes its balance sheet by raising the rate paid on excess reserves and by reaching a neutral position on QE. Remember that they may also have to term out the reserves to show the markets that they can manage the eventual decline in balance sheet size. Market agents are very skeptical about that. Sometimes I wonder if our colleagues at the Fed don’t really listen to comments from outside of the temple – from the markets and from private economists and market pundits. The FOMC missed a very valuable opportunity in September to slowly begin to change policy and to start the process of adjusting market expectations. The Fed believes they can eventually manage a gradual transition from the current, extreme policy stance to something more moderate and stable. The market reaction to the unwise June 19th press conference by Chairman Ben Bernanke suggests otherwise. In September, the markets had adjusted to an expectation for some tapering. The Fed had a free shot to do something. They failed to take it.

Whalen: Look at the carnage that the Bernanke press conference caused in the mortgage market. Many banks, non-banks got slaughtered in the TBA market for mortgage financing. PennyMac Mortgage Investment Trust (PMT) missed their hedging for mortgage funding by 16% and lost half of their gain-on-sale margin. The Q3 2013 FDIC data also suggests huge hedging losses by commercial banks. The reference securities in the housing market moved 2-3x vs. the 10-year bond. As you noted earlier, only about 1% of the audience actually understands the utterances of central bankers. Obviously this does not include bond traders or most economists, who were caught flat-footed in June and then wrongly predicted tapering of Fed securities purchases in September. So David, if you were on the FOMC, what would you recommend to your colleagues?

Kotok: First, I would strongly reject the idea that lowering the interest paid on excess reserves is a viable option. Fed remittances to the Treasury are $100 billion per year and rising. If the FOMC takes interest paid on excess reserves to zero, remittances to Treasury will rise unless tapering of bond and MBS purchases resolves and ends completely and abruptly. That would shock markets and weaken the economic recovery, which is still fragile. The FOMC must be very careful here. Even if they could simply stop quantitative easing, remittances will rise since the Fed will not sell and must run off the portfolio over a number of years. The Fed could raise the reserve rate paid to 50bp for a start. That clears the FDIC fee hurdle and allows banks to earn small arbitrage on GSE cash. It also allows markets to clear above zero by a small amount, and that restores repo to neutrality. My guess is that bond yields would fall if the bond market saw this action by the Fed. Market agents would accept that the Fed’s QE would peak in 2014, and the process of discounting a return to a more normal neutral Fed could therefore commence.

Whalen: Agreed. A more enlightened FOMC would be issuing bonds to individual savers with the old 6% coupons of Series E bonds to help blunt the impact of financial repression instead of handing the supposed profit to the Treasury. Issue the bonds in $1,000 increments, with a $100,000 limit and make them non-transferable. So we both agree that the folks clamoring to reduce the rate on excess reserves don’t get it?

Kotok: I do not expect any quick return to 6%. Not even close. I guess the US Treasury could issue a small saver bond with a limit but I doubt it will happen.  Chris, we are at a zero boundary for the cost of funds in the US markets, so the only way to go is up. We are also at the near-zero bound in most of the rest of the developed world. That means the global clearing system of interest rates is distorted. Forcing an imposed negative policy under these conditions is very dangerous. Positive incentives are usually a better policy prescription than are negative rules. If we raise excess reserve rates and get the financial system to clear, we start to relieve financial repression. Savers gain; hence, consumers gain. Some banks and non-banks start to rebuild earning assets. Poorly managed banks fail or are merged by regulators. You and I both know some of these banker players. They bear shame for launching new banks a decade ago and then watching the erosion of their investors' capital by as much as 90%. The managements and boards of these banks own some of this outcome. They point fingers at the regulators or the Fed. Meanwhile they haven’t been fired, and they haven’t paid a penalty, and few have been jailed for fraud.

Whalen: No argument here.

Kotok: Chris, your focus in your writings over the past year on falling net interest margins for banks is crucially important here. Now, if you had a counterparty as a prosecutor and if the board-management policing mechanism didn’t protect the embedded imbeciles who ran their institutions into the ground, you would really have a team approach to addressing these issues. If I were czar, excess reserve rates would be higher and terming out. The zero boundary for rates makes the US economy dysfunctional. And the longer we are in it, the worse it becomes. Japan is the proof.  And lastly, I would use Singapore law to regulate our politicians and our financial services.

Whalen: Thanks David