Rates are the Sight: Money is the Real Target

By: Michael Ashton | Wed, Mar 2, 2011
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A relatively quiet trading session for equities on Wednesday probably represents the reluctance to make big bets prior to Employment on Friday more than anything else. There was news to trade. Oil prices rallied another 2.4% with WTI over $102 on reports that Libya's strongman had come close to bombing oil facilities in the part of the country that rebels control. Even when it became apparent that he had missed (presumably intentionally since if he manages to win he would want to have those facilities, wouldn't he?) oil prices refused to retreat. The tension will not soon break, I expect.

The ADP report was a little better than expected at 217k (expectations were for 180k), but that's easily within the normal error. Since last month saw a severe weather impact on Payrolls but not on ADP, it isn't clear what implication the stronger ADP this month has for Friday's data.

Higher energy prices and better data (the Beige Book was also perceived as being upbeat) helped drive nominal yields 7bps higher today, putting the 10y at 3.46%. That marked the biggest close-to-close decline, such as it was, in more than three weeks.


I have mentioned many times before that one of the reasons I have been writing a comment like this for many years is because of the valuable insight and feedback I receive from readers around the world. Strategists, investors, and traders spend lots of time going around looking for information, and separating the useful information from the useless information. To the extent that I can reverse that flow so that the information comes to me, it is arguably worthwhile to write a commentary (the other reason to do so is to clarify my own thoughts by forcing myself to put them into prose, but I needn't do that publicly of course).

For example, one reader today drew my attention to an article published late last year by George Kahn of the Kansas City Fed. Dr. Kahn is a well-respected Fed economist (just based on sheer numbers, there ought to be some well-respected economists at the Fed); I wrote about some of his arguments on inflation targeting in a column in December. The article he wrote in 2010Q4 was entitled "Monetary Policy under a Corridor Operating Framework" and was published in the Kansas City Federal Reserve's quarterly Economic Review.

The article is a good, readable explanation of how a "corridor operating framework" employed by a central bank works. In such a framework, the central bank essentially stands ready to lend all that banks need to borrow at a certain spread above the intended policy rate and to borrow (and pay interest on) all that banks want to lend at a certain spread below the intended policy rate. By doing so, the bank creates a "corridor" outside of which the market overnight rate (the Fed funds rate in the case of the Fed) should rarely trade.

This is not a new idea; I first remember encountering this concept quite a long time ago in the form of the Bundesbank's discount rate/Lombard rate duo and there are a number of other central banks that employ these concepts. What is new is that once the Fed began to pay interest on reserves (and Kahn provides a brief but interesting history of reserves policy in the United States as well) they essentially had established a corridor system as well. The Fed will supply any amount of reserves through the discount window, and will pay interest on any amount of reserves through their policy of interest on reserves. So Kahn is examining the implications of this new set-up, which seems a worthy endeavor.

The purpose of having such a system, rather than having a single policy rate that the NY Fed attempts to maintain through open market operations, is that "In theory, a corridor system could limit volatility in the policy rate and isolate interest rate policy from the size of the balance sheet."

Kahn demonstrates how this allows the central bank to control the level of short-term interest rates and the level of reserves separately (or to operate in an environment with no reserves at all). I have only one quibble with the article.

"The corridor system and, in particular, the corridor floor, allow the central bank to separate interest rate policy from liquidity policy. This separation can be important in a liquidity crisis when the central bank might need to pump an unusually large quantity of reserves into the banking system. Without the interest rate floor established by the corridor, such an injection of reserves could push the policy rate well below its target."

But as my collegiate rhetoric teacher would have said, "so what?" What Kahn never addresses is why that is important. He never explains why there is a need to control the target rate at all.

Remember, controlling the rate was a substitute for controlling the money supply directly. The Fed tried to do that in the so-called "monetarist experiment," and found that it couldn't do so very effectively. Accordingly, the institution called a tactical retreat and began to target what they could target reasonably successfully: the short-term interest rate. If the supply and demand functions for reserve balances are known or can be reasonably inferred, the Fed can adjust the supply of reserves so that the amount of reserves supplied and demanded is able to clear at the target rate. If the Fed raises the target interest rate, it supplies fewer reserves so that the market clears at the higher interest rate.

But the rate in that case is just a proxy for the amount of reserves the Fed wants in the system. Interest rates don't cause inflation and grease the wheels of growth: money does. MV≡PQ. There's nothing there about the overnight interest rate.[1] For the Fed, the overnight rate isn't the target; it's the gun sight.

In any event, though, the Kahn article is useful and reasonably quick reading. I really like the clarity with which he writes. The policy significance of the article is less in this case than with the inflation-targeting article, because the policy-corridor approach is not exactly untried and untested but merely a new approach for the Fed.


On Thursday the data calendar lists Initial Claims (Consensus: 395k from 391k) and the final revision to the Nonfarm Productivity and Unit Labor Cost figures for Q4. At 10:00ET the Non-Manufacturing ISM (Consensus: 59.3 from 59.4) is due out. Of these, Initial Claims is probably the most important, since as the volatility of the weekly data begins to diminish the confidence we can have in establishing where the new equilibrium level of Claims is will increase. Many analysts don't think that there is an "equilibrium" level right now but that rather Claims are on a steadily-improving trend. I have been reluctant to embrace that view, partly because the initial proclamations of the downtrend were triggered by the illusion caused by the spike higher in August. But the fact that the initial proclamations happened for the wrong reason doesn't mean that they were themselves wrong. If 'Claims drips towards 380k in the next couple of weeks I will have to revise my opinion.

The main event data-wise, though, is plainly on Friday with the Employment Report. I don't think that necessarily means we are in for a quiet day, because there are many non-data crosscurrents to keep tabs on. But it does tend to increase the probability of a quiet day.


[1] I don't want to make it sound with this argument that I think interest rates generally don't matter; I am talking here about the overnight rate. Clearly the term structure of rates has implications for how capital is deployed and subsequent growth rates, but the Fed doesn't control the term structure. What is fairly unimportant in my view is the overnight interest rate as a policy tool. Money, money, money makes the world...go...'round.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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