Is the Federal Reserve really not needed?

The takeaway ….

A couple nights ago, I listened to investor George Gammon opine on YouTube about the need for the Federal Reserve System. Mr Gammon’s main thesis was that the Federal Reserve does not control liquidity or interest rates. If the Federal Reserve did have total control over liquidity and interest rates, argues Mr Gammon, yields on the two-year and ten-year Treasuries would go up dramatically along with the federal funds rate.

Mr Gammon believes that between 1995 and 2000, two-year and ten-year Treasuries did not react to the Federal Reserve’s decisions on the federal funds rate. Mr Gammon believes the opposite; that changes in the federal funds rate, the rate banks charge each other for overnight borrowing of reserves, follows changes in two-year and ten-year yields.

Mr Gammon summarizes that interest rates that matter move in the direction opposite of where the Federal Reserve moves its rates. Not only is the Federal Reserve irrelevant, the decisions of America’s central banking system may even lead to distorted rates.

I found Mr Gammon’s argument to be outside the box, thus interesting. We hear critics of the Fed posit a number of arguments, from conspiracy to replace governments and totally control the lives of depositors to purposefully distorting the currency to making the wrong decisions on rates.

Observing the actions of the Federal Reserve over the last three years, I myself have concluded that the Federal Reserve plays three roles. First, as an independent agent of the Congress, it helps to construct a narrative around the currency that attracts investors to U.S. Treasuries. Congress has punted the ball on its Constitutional responsibility to regulate the money and its value thereof. The Federal Reserve reports to the Congress and the general public on the state of the economy and the monetary policy and where the economy is not doing well, provides an action plan for stable prices and maximum employment.

Second, the Federal Reserve provides a backstop to the American banking system by providing various lending facilities when needed to keep banks operational and in distribution mode for the currency. A failed banking system that includes a payment system for moving money across the country would invalidate the American government that issues the currency.

Last, the Federal Reserve regulates the interbank market via the target range for its federal funds rate and the interest it pays on bank reserves held in the vaults of its Federal Reserve banks. The higher the rates assessed on reserves, the higher the likelihood that money will be pulled out of circulation and kept in the vaults. This control of the money supply is crucial to the exercise of monetary policy.

Listening to Mr Gammon’s argument, it sounds like the Federal Reserve is either the lady at the window in a casino that exchanges chips for cash or via its fed funds rate decisions, simply a source of information used in the futures and options betting markets.

The lady cashing chips at the casino is likened to the Fed’s discount window where banks, as a last resort, borrow money (on good collateral) when it has short term obligations to meet i.e., reserve requirements or depositor payouts to make.

I would argue that a platform for the betting markets is as plausible at the risk of a little cynicism. The CME Group’s FedWatch and federal funds futures and options traders hang their next one or two moves on all the Fed speak that occurs weeks leading up to a Federal Open Market Committee meeting.

I do find annoying the mainstream media’s hardon for the Federal Reserve. If Mr Gammon is right, then their thirst is misplaced. Under the Gammon theory it would not be the Fed leading the rate charge but the banks. I can’t tell from the data whether the Fed is following bond markets or vice versa, but the data does show that rates on the one-month bill are being capped by the fed funds rate and interest on reserve balances, a Fed rate that has quietly taken the status of prime monetary policy tool away from the fed funds rate.

Date (end of quarter)	Interest on Reserve Balances	Effective Fed Funds rate	One-month bill	Two-year note	Ten-year note	Reserves (billions of dollars)
9/29/2023	5.40%	5.33%	5.29%	5.03%	4.59%	3,239.4
6/30/2023	5.15%	5.08%	5.08%	4.87%	3.81%	3,265.6
3/31/2023	4.90%	4.83%	4.60%	4.06%	3.48%	3,258.4
12/30/2022	4.40%	4.33%	3.95%	4.41%	3.88%	3,107.3
9/30/2022	3.15%	3.08%	2.70%	4.22%	3.83%	3,131.4

There is also some correlation between bank reserves held in federal reserve bank vaults, interest on reserve balances, and the effective federal funds rate. The correlation gives the impression that banks see an incentive to keep more reserves in vaults as long as the IORB and the effective fed funds rate increase to compensate them, at least for very short maturities.

The issue for me is whether the Federal Reserve is acting as a regulator of the interbank market or are banks regulating themselves, using the fed funds rate and IORB as caps and borrowing from the discount window when there is no other choice.

I am leaning towards Federal Reserve as regulator of the interbank via its rate setting regime. Whether I tilt the other way depends on what I find when it comes to bank influence on the ratemaking process including any firewalls between regulation and interbank behavior.

Alton Drew

20 November 2023

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The stats ….

30-day Federal Funds rate: 94.73. (as of 9:39 pm, EDT)

Discount Window rate: 5.50%.

Interest on Reserve Balances: 5.40%.

Effective Federal Funds rate: 5.33%.

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