Speaker 1: Hello, and welcome to another episode of the Odd Thoughts podcast.
Speaker 1: I'm Tracy Alloway. My co host Joe Wisenthal is away,
Speaker 1: and if I could just begin the show with a
Speaker 1: small disclaimer, which is that apparently I have broken my
Speaker 1: foot in three different places. So if I sound a
Speaker 1: little bit distracted today, that is why. Um Now, speaking
Speaker 1: of difficult situations, you all know are all Thoughts listeners
Speaker 1: are aware that the debt ceiling drama continues in the States.
Speaker 1: Joe and I just recorded an episode on the Mint
Speaker 1: the coin debate, which is one idea of how to
Speaker 1: bypass the debt limit on a temporary basis at least.
Speaker 1: But I think it's fair to say that there are
Speaker 1: a lot of challenges out there at the moment, especially
Speaker 1: for the Federal Reserve the Central Bank. So not only
Speaker 1: are they still trying to navigate an unprecedented economic cycle
Speaker 1: in the wake of the global pandemic, but they're also
Speaker 1: now having to deal with higher inflation to decide whether
Speaker 1: or not it is indeed transitory. And meanwhile they are
Speaker 1: also facing the fallout from what's going on in d C.
Speaker 1: So every time there is the sort of debt ceiling brinkmanship,
Speaker 1: we generally see some feed through into the treasury market,
Speaker 1: you know, money market funds stop buying up short term
Speaker 1: bills around the date, the so called drop dead date
Speaker 1: that the US is actually supposed to run out of money,
Speaker 1: and the FED has to figure out all these different
Speaker 1: ways to try to keep things going along with the
Speaker 1: treasury while the politicians do get out. Um, so there
Speaker 1: was a lot going on in the FED. I haven't
Speaker 1: even mentioned the insider trading scandal, but that of course
Speaker 1: is an issue as well. Suffice it to say, the
Speaker 1: Central Bank faces many, many challenges, and today I am
Speaker 1: very happy to say we are going to be speaking
Speaker 1: with the perfect person to discuss some of those issues.
Speaker 1: It's someone who actually used to work at the FED
Speaker 1: as a trader, and he runs a blog right now
Speaker 1: called fed Guy, and it's one of my favorite reads.
Speaker 1: I highly suggest you check it out if you haven't
Speaker 1: been reading it already. Joseph Wang, Welcome to the show. Hi, Tracy,
Speaker 1: thanks so much for in biding me. I'm through it
Speaker 1: to be here. Oh, thank you so much for coming on. Um,
Speaker 1: Joe and I have wanted to get you on for
Speaker 1: a long time, so I'm happy you could make it
Speaker 1: maybe just to begin with, could you describe your background
Speaker 1: at the FED? What exactly where are you doing there? Sure,
Speaker 1: I worked on the Open Markets desk at the New
Speaker 1: York FED, and so what the open market that's does.
Speaker 1: It's basically the FEDS trading desks, so we conduct operations UM.
Speaker 1: So all the QUI O, the REPO operations are done
Speaker 1: by the desk. I focus on money markets, so I
Speaker 1: run the repo operations, and I studied the banking system.
Speaker 1: A lot of my work has to do with setting
Speaker 1: how the financial system works, money market funds, just the
Speaker 1: plumbing of the system basically. So when we have something
Speaker 1: like a debt ceiling crisis, do you start getting flashbacks
Speaker 1: to previous episodes. Well, I think one of the main
Speaker 1: mechanisms of the dead ceiling does impact the markets is
Speaker 1: through the money markets. So yes, that's probably the direct
Speaker 1: way that the death ceiling impacts UM. And you can
Speaker 1: see it right now. Actually, if you look at the
Speaker 1: short term builder, if you can already see bills that
Speaker 1: mature around the job dead date are selling off quite
Speaker 1: a bit. So usually you see market impacts first the
Speaker 1: money market sector when it comes to the debt ceiling.
Speaker 1: So how do you think money markets and I guess
Speaker 1: the wider treasury market should feel about debt ceilings and
Speaker 1: this kind of political brinkmanship. And the reason I asked
Speaker 1: that is because you know, we we do tend to
Speaker 1: see these bouts of debt ceiling drama every once in
Speaker 1: a while, or at least you know, in recent years,
Speaker 1: we've seen them every once in a while. But on
Speaker 1: the other hand, you know, when it gets really bad,
Speaker 1: we tend to see treasuries rally because people go into
Speaker 1: safe haven assets, and treasuries are still considered that even
Speaker 1: if the cause of market turmoil is because of the
Speaker 1: US itself, which is kind of ironic, But how do
Speaker 1: you think treasuries feel about these sorts of issues and
Speaker 1: has it evolved in recent years? So you're exactly right,
Speaker 1: And I think that the way that I would think
Speaker 1: about this is that I think overall, of course, the
Speaker 1: investment community understands that this is a passing thing. The U. S.
Speaker 1: Treasury has a printing press, right, so they can always
Speaker 1: make their obligations. But on a more nuts on both sides,
Speaker 1: there are classes of investors that are not able or
Speaker 1: constrained in their holdings of things that are defaulted, most
Speaker 1: notably the four point five true and dollar money market
Speaker 1: fund complex. So under the regulations, they are highly constrained
Speaker 1: in holding defaulted securities, and they also don't want they
Speaker 1: don't want to be able to They want to be
Speaker 1: able to tell their clients when they clients read about
Speaker 1: the dead selling on the US that you know, we're
Speaker 1: not exposed to this at all. So even though I
Speaker 1: think the investment community understands that this is the passing thing,
Speaker 1: there are mandate constraints that come into play, and that's
Speaker 1: why you still actually see sell offs in the in
Speaker 1: the short term turchy markets. Addition, I think that we've
Speaker 1: been through the death seeing a few times over the
Speaker 1: past decade, and what we can learn from a lot
Speaker 1: of public documents that were either disclosed by the FED
Speaker 1: or through subpoenas that the official sector actually has a
Speaker 1: lot of plans just just to avoid and you fall
Speaker 1: out in the trojan market. So it would be I
Speaker 1: think reasonable to not for the trogury market to not
Speaker 1: be too much afraid of the dead sailing um. But
Speaker 1: a lot of these backup plans do have economic impacts,
Speaker 1: and so it's not in reasonable for the troges to
Speaker 1: actually rally in that context. Well, so one of the
Speaker 1: things I want to ask you is how much the
Speaker 1: r r P, the reverse repot program might make a
Speaker 1: difference this time around. So you know, we know that
Speaker 1: the Fed has been running this UM. Recently, they they
Speaker 1: upped the amount that they could take. I can't remember
Speaker 1: what it was. What the cap is now, do you remember? Yeah,
Speaker 1: it's a hun sixty billion per counterparty. So earlier in
Speaker 1: the year it was thirty billion, and then was up
Speaker 1: to eighty and now it's too un sixty But in practice, though,
Speaker 1: I would just think a bit as a full lotment facility,
Speaker 1: So there really is no limit. So one of the
Speaker 1: reasons they've raised it is in preparation, presumably for money
Speaker 1: market funds having to move into this thing because they
Speaker 1: have to avoid bills or they're unable to buy bills
Speaker 1: because Treasury can't issue them. UM. So how much does
Speaker 1: that help in a scenario like this? I think it
Speaker 1: helps tremendously in terms of rate control. So heading into
Speaker 1: the debt seling, one of the ways that the US
Speaker 1: Treasure prepares is by paying down bills. The way they
Speaker 1: manage your debt is they have they manage under a
Speaker 1: regular and predictable issue and schedule, and in practice that
Speaker 1: means maintaining coupon issuants as much as they can and
Speaker 1: meeting short term cash flows through bill issuants. If you
Speaker 1: think back last March when we suddenly had a lot
Speaker 1: of emergency COVID expenditures, what happened is that they met
Speaker 1: those expenditures issuing two trillion dollars in bills. Now in
Speaker 1: the same way as we're heading into dead selling and
Speaker 1: they're trying to maintain space on the dead selling, what
Speaker 1: they're doing is the reducing the amount of bill issuance
Speaker 1: to reduce the amount of dead outstanding. The main investors
Speaker 1: in the bill markets are the money market funds, and
Speaker 1: now that money market funds don't have as many bills
Speaker 1: to invest in, there's a buffer there where they can
Speaker 1: invest in the overnight reverse reple operation that helps us
Speaker 1: that maintain rates even as the amount investments available in
Speaker 1: the money market space decreases. Without the overnight report facility,
Speaker 1: I think short term rates would definitely be below zero.
Speaker 1: How much does it matter that the Fed now pays
Speaker 1: interest on our rps, because I remember that was a
Speaker 1: big deal in the summer when they started to do that,
Speaker 1: I think it was an extra five basis points UM
Speaker 1: something like that. Five base points, whereas previously they had
Speaker 1: been paying almost nothing. But why the need to do
Speaker 1: that and how much UM? Did that sort of change
Speaker 1: things for money market funds? So the reverse report facility
Speaker 1: is one of the fed's key tools for short term
Speaker 1: rate control. One of the Fed's goals or any center
Speaker 1: being skills, is to control rates. In the US, we
Speaker 1: choose the overnight rate. Before the crisis, it was primarily
Speaker 1: controlled by adjusting reserve balances within the banking system. After
Speaker 1: the crisis, now that we have so many more reserves,
Speaker 1: that's just not a feasible way. So in practice, the
Speaker 1: FED controls overnight rates by paying interest on the reverse
Speaker 1: report facility as basically boundary lower bound rate. That means
Speaker 1: that if you're an investor with sir M funds and
Speaker 1: you can always invest in the FED risk free at
Speaker 1: the RP rate, that puts a lower boundary of what's
Speaker 1: you're willing to accept in other investments. So if you
Speaker 1: can invest in the FED at five basis points, there's
Speaker 1: never a reason for you to buy to invest in
Speaker 1: any lower rates. And that's how that's basically a crucial
Speaker 1: tool to FED now uses to control interest rates. So
Speaker 1: let's say we get to I mean, I think the
Speaker 1: consensus right now is that the US um Treasury could
Speaker 1: run out of money sometime around mid October. I think
Speaker 1: the one day I've seen consistently come up as October eighteen.
Speaker 1: I should just say that we are recording this on
Speaker 1: October five. So maybe something changes between now and then.
Speaker 1: But if we get to October eighteenth and treasury runs
Speaker 1: out of money, the debt limit isn't raised, what would
Speaker 1: you expect to actually happen in the treasury market, in
Speaker 1: money markets, and how would the FED respond? So this
Speaker 1: scenario has happened quite a few times in the past decade,
Speaker 1: and from public documents have been disclosed, you can kind
Speaker 1: of see that the FED and Treasury have basically been
Speaker 1: wargaming this for for the past ten years. So the
Speaker 1: path forward is basically prioritization. But before before they actually
Speaker 1: drop that date, there's this is basically a political political process,
Speaker 1: right It's in negotiation within Congress, So the FED doesn't
Speaker 1: really want to step in or say anything, and administration
Speaker 1: has an incentive to maximize I guess fear to encourage
Speaker 1: a compromise, but when the drop dad it actually happens.
Speaker 1: What was discussed during was that the FED and what
Speaker 1: that was that the treasure would actually prioritize principal interest
Speaker 1: payments to U S tursury holders as well as Social Security.
Speaker 1: The thing is, when the trishy runs out of space
Speaker 1: under the debt limit, it still has a lot of
Speaker 1: cash receipts. If you look at data from the past
Speaker 1: five years, the US Treasure usually has cash receipts so
Speaker 1: about let's say eight hundred to nine hundred billion during
Speaker 1: the fourth quarter, so that's pretty steady. So they have
Speaker 1: a lot of money coming in, but they don't have
Speaker 1: enough money to pay everything that that's that's due. But
Speaker 1: if they only focus on paying principle and interest, that's
Speaker 1: about two in over a quarter four If they only
Speaker 1: paid social Security, that's probably three billion. So they have
Speaker 1: enough money to pay some bills but not everything. And
Speaker 1: was discussed in the past was just prioritization, So the
Speaker 1: trophy market will actually be fine. There will not be
Speaker 1: a default. And what would happen, I think is that
Speaker 1: once they hit the dead scene, sitting the absolute drop
Speaker 1: dead date in order to calm the markets. They will
Speaker 1: announce their plan to prioritize surgery payments and others, more
Speaker 1: humanitarian payments, social security, veterans benefits, food stamps, and so forth,
Speaker 1: and that should actually immediately calm the trgury market down
Speaker 1: because they know that to fault us off the table
Speaker 1: heading into it. You can already see the disruptions. Some
Speaker 1: short term bills are selling off. But I think once
Speaker 1: we red reach the drop dead date oddly enough, I
Speaker 1: think that prioritization announcement will solve everything. Of course, there
Speaker 1: would be some economic impact from this, because trojury does
Speaker 1: a lot of things. They also have pay it's to
Speaker 1: let's say, doctors, hospitals, farm studo comple companies, defense companies,
Speaker 1: and those companies will have some liquidity problems. But the
Speaker 1: trugy market I think will be fine, and maybe they
Speaker 1: rally as you mentioned before, understanding that when there's a
Speaker 1: liquidity crisis in the non financial sector, maybe if they're
Speaker 1: liquidity to get squeezed a bit, that affects the economy.
Speaker 1: Even if Turgury doesn't prioritize or they decide not to.
Speaker 1: Ultimately it's a political decision by by the Treasury and
Speaker 1: it's the one that makes a lot of sense. The
Speaker 1: FED also has a plan just to step in in
Speaker 1: case anything bad happens, just just as I mentioned a
Speaker 1: bit earlier. So a lot of investors have mandate restrictions
Speaker 1: where they can't hold treasures that defaulted. The biggest investor
Speaker 1: that has these meant these mended restrictions, these are legal,
Speaker 1: are the money market fund industry. So if by any
Speaker 1: chance there was like a technical default, a lot of
Speaker 1: the money market fund industries will not be able to
Speaker 1: hold treasuries. And that's a huge problem because they don't
Speaker 1: just church of those, but they are also enormous investors
Speaker 1: in the report market. The report market is a multi
Speaker 1: trillion dollar market for basically overnight secured loans, and a
Speaker 1: lot of those loans are in treasuries with tregary crap Claro.
Speaker 1: So if you're a money market fund based on sec data,
Speaker 1: probably investing a trillion dollars in turgy backed repot every
Speaker 1: day to the private sector, excluding FED, and because of
Speaker 1: your mandates, you're not able to accept or unwilling to
Speaker 1: accept without a waiver from your board of directors, default
Speaker 1: to Claro. So a lot of people who are getting
Speaker 1: funding in the report market using treasuries may lose access
Speaker 1: to that funding. And you know, that's classic bank one
Speaker 1: lefe scenario because if you're buying turguries on leverage using
Speaker 1: overnight money and suddenly you lose access to that financing,
Speaker 1: and that could be very disruptive um effectively, I think
Speaker 1: in practice of default and technical default would probably buy
Speaker 1: furycate the turgy mark between those that are at risk
Speaker 1: of not receiving principle and interest in the coming months
Speaker 1: and those that are safe let's say they're interest due
Speaker 1: dates are next year. If you do the math, the
Speaker 1: amount of treasuries outstanding that have principal and interest payments
Speaker 1: during the this quarter about a bit over a trillion.
Speaker 1: So there's potential for enormous disruption when let's say investors
Speaker 1: have to shuffle out of at risk treasuries into treasuries
Speaker 1: that are not at risk because this has never happened before.
Speaker 1: Oh in addition to that, once there's a technical to thought,
Speaker 1: I imagine the ratings agencies would have to follow up
Speaker 1: and to downgrade the US. And in addition to the
Speaker 1: money market events, there are also many classes of investors
Speaker 1: that have trouble holding securities that are not let's say
Speaker 1: rated triple A by two or more end agencies that
Speaker 1: maybe they have trouble holding U S reasuries. There's some
Speaker 1: discretion there depending on how their mandates are written. Um,
Speaker 1: so it could be a very destructive event. And that
Speaker 1: is something that has never happened before, and no one
Speaker 1: really knows how it will happen, but which is kind
Speaker 1: of why no one will allow it to happen. You
Speaker 1: have the Treasury prioritizing and if for whatever political reason,
Speaker 1: they don't prioritize P and I payments, The FED has
Speaker 1: discussed in October of what their game palent plan would be,
Speaker 1: and it's uh, they have the tools and the motivation
Speaker 1: to be able to fix everything. So but they would
Speaker 1: do is they would still accept the defaulted Collardo in
Speaker 1: their repo market operations, so they would be able to
Speaker 1: provide liquidity against that, even if the money market funds
Speaker 1: cannot or do not want to. They would be able
Speaker 1: to accept defaulted Collardo and their securities lending operations. So
Speaker 1: if you had let's say ann at risk treasury, you
Speaker 1: could stop it out with the FED. Or, of course,
Speaker 1: if that's not enough, they could just do outright purchase
Speaker 1: QWI style to purchase at risk Collardo. So you have
Speaker 1: these two tiers of plants from the triedurgy and from
Speaker 1: the FED to make sure basically the trigy market will
Speaker 1: be protected. And so going forward to Dassling, I don't
Speaker 1: really worry about anything because there's just this is something
Speaker 1: that happens so many times. And if you're in the market,
Speaker 1: you know that something that people wanticipate, risk that people
Speaker 1: anticipate usually don't materialize because they prepare for them. And
Speaker 1: I think this is one of those cases. So I
Speaker 1: mean I get the point that the FED is sort
Speaker 1: of prepared to step in as lender of last resort um,
Speaker 1: you know, if it really has to. And I get
Speaker 1: that it also attempts to be politically neutral, um, you
Speaker 1: know when these types of situations come up. But I'm wondering, like,
Speaker 1: what do people at the Central Bank actually think when
Speaker 1: politicians are arguing with each other And we sort of
Speaker 1: get to this point like you know, again, you were
Speaker 1: on the open markets desk, you were a trade or
Speaker 1: does everyone they're kind of like roll their eyes and
Speaker 1: go like, oh no, now we have to work on
Speaker 1: on a and plan B and how is this going
Speaker 1: to affect the market and do we have to factor
Speaker 1: this into our economic predictions and things like that, Like
Speaker 1: I guess, how do people actually think about it? So
Speaker 1: the Central Bank is a very conservative and organization. It's
Speaker 1: I think even more as a utility, so it wants
Speaker 1: to make sure the basic plumbing of the system works,
Speaker 1: and that includes the trojan market. Trades are basically a
Speaker 1: full of money or financial system. If you look at
Speaker 1: class de classified documents, this scenario of payment prioritization. There
Speaker 1: were simulations of this run in eleven and again, and
Speaker 1: I'm not I'm absolutely sure that it's being run right now.
Speaker 1: So people there, I think don't think they worry about
Speaker 1: the market impact, but it does create an enormous amount
Speaker 1: of work for them and so they don't like that.
Speaker 1: And I think that they understand that this is part
Speaker 1: of the political process. Though another declassified memo that features
Speaker 1: let's say someone speaking with chir Paul basically inside the
Speaker 1: fact that they understand that part of this is the
Speaker 1: political process, and it's also partly trying to put pressure
Speaker 1: on Congress to do something. So even though this probably
Speaker 1: won't happen, having this in the news. Talking about very
Speaker 1: bad scenarios is something that serves a purpose. So let's
Speaker 1: let's shift gears um slightly and talk about some other
Speaker 1: challenges that the Central Bank faces at the moment. And
Speaker 1: you know, there isn't a shortage of new things, new
Speaker 1: developments to actually wrap their heads around and address. But
Speaker 1: one of the interesting things that you brought up in
Speaker 1: a recent post on your blog was this notion of
Speaker 1: um wealth effects and maybe wealth effects that haven't necessarily
Speaker 1: been understood or taken into account by the Fed. Could
Speaker 1: you walk us through your thesis there. And you know,
Speaker 1: a lot of people tend to complain, well, some people
Speaker 1: complain about the fed's emergency liquidity feeding into risk assets
Speaker 1: like or financial assets like stocks and bonds, and making
Speaker 1: people who are already wealthy even richer. But you point
Speaker 1: out that not only is that happening, but there's also
Speaker 1: a sort of unaccounted for wealth effect through cryptocurrency. So
Speaker 1: could you maybe describe that? Sure? So, so, I think
Speaker 1: the labor market is a very confusing market to analyze
Speaker 1: right now, because you have lots of indications of tight
Speaker 1: labor market with you have help wanted signs everywhere. We're
Speaker 1: just going higher, and at the same time, the unemployment
Speaker 1: rate is still pretty elevated. So I think one of
Speaker 1: the reasons just thinking about this has to do with
Speaker 1: the wealth effect, and there are actually academic papers finding
Speaker 1: something similar and common sense, and I think you should
Speaker 1: understand that the more money you have, the less you
Speaker 1: need to work, the less you're motivated to search that
Speaker 1: you won't you're less willing to set uluer wages. And
Speaker 1: one of the things that has happened over these two
Speaker 1: years is that the wealth effect, basically the wealth people
Speaker 1: hold it has been supercharged. If you just look at
Speaker 1: residential real estate, it's up over the past two years,
Speaker 1: and a little bit over six of the Americans own
Speaker 1: a home, and that's your largest asset, so a lot
Speaker 1: of people have a lot more equity in their in
Speaker 1: their homes. If you own stocks, um, you know that's
Speaker 1: uh SMP is up over the past two years. When
Speaker 1: you look at FED data and you break it down,
Speaker 1: one of the things you notice is that you know
Speaker 1: what everyone says, it's true, it's really the rich people
Speaker 1: getting much much richer. However, because the wealth effect, the
Speaker 1: growth and asset value is so extreme this time around,
Speaker 1: if you were actually just top halfen wealth. You saw
Speaker 1: significant gains in your in your paper wealth, So that
Speaker 1: has to have an effect on whether or not you're
Speaker 1: willing to work and what wages you're willing to accept.
Speaker 1: And that's just what's what you see in official data.
Speaker 1: There is also an enormous wealth boom that you don't see,
Speaker 1: and that's in the cryptocurrency. Is you alluded to the
Speaker 1: cryptocurrency that they are, they exist on decentralized letters, so
Speaker 1: they don't show up anywhere in official data. But we
Speaker 1: see just from public data sources of where cryptocurrencies are
Speaker 1: treating and no. Cryptocurrencies have gone from basically nothing that
Speaker 1: a couple of years ago to two trillion dollars in
Speaker 1: total assets size. And we know Bitcoin and Ethereum are
Speaker 1: the most well known ones, but just behind them there
Speaker 1: are hundreds of these all coins that have also grown
Speaker 1: to billion dollar market caps, and none of this shows
Speaker 1: up an official data, but it's it's being held by
Speaker 1: by the general public, likely younger people. Enthusiasm for cryptocurrencies
Speaker 1: is palpable. If you look at coin based user data,
Speaker 1: it's just surging, and so that has to have an
Speaker 1: impact on the motivation of young people to work as well.
Speaker 1: If you can just stay at home and trade cryptocurrencies,
Speaker 1: or if you held a little bit of crypto um,
Speaker 1: then you you are a bit bothier than you were before.
Speaker 1: Maybe you're not as desperate for a job. Just anecdotally,
Speaker 1: I remember that I took a cab from l a
Speaker 1: airport from lax in my uper driver at the time.
Speaker 1: He was driving a ten year old camera and he
Speaker 1: was telling me that he put thirty dollars into bitcoin
Speaker 1: because bitcoin only goes off, and you know, he did
Speaker 1: not seem to look like a wealthy person, so actually
Speaker 1: encouraged him to diversify a bit. And he also told
Speaker 1: me he bought them dodge coin. So this is this phenomenon.
Speaker 1: So the phenomena I think is real and it's something
Speaker 1: that that it's not captured in official data. This wealth effect,
Speaker 1: I think fundamentally changes the dynamics of labor market. And
Speaker 1: if that's true, though, then you know, maybe maybe the
Speaker 1: FED is actually a bit behind in raising rates and
Speaker 1: so far as raising rates close it down inflation. Yeah,
Speaker 1: there's I mean, there's a ton of irony um in
Speaker 1: thinking that cryptocurrency might be the reason that the FED
Speaker 1: ends up overheating um the economy me but or letting
Speaker 1: the economy run too hot. But do you think the Fed?
Speaker 1: This is kind of an unfair question because I don't
Speaker 1: think anyone really understands crypto. But do you think the
Speaker 1: FED understands crypto? Or is it making a good faith
Speaker 1: effort to understand the market? I don't think the FED
Speaker 1: understands crypto. I think one of the things that I
Speaker 1: would take away from my time and the FED is,
Speaker 1: I guess how surprising how few things said management understands.
Speaker 1: And I think that it's kind of apparent from even
Speaker 1: if you look back, let's say twenty years ago during
Speaker 1: the financial crisis, the FED was not really aware of
Speaker 1: what was happening in shadow banking either. Now I only
Speaker 1: speak from my experience at the New York FED, but
Speaker 1: if you really think about it, New York FED is
Speaker 1: basically a government agency with unlimited money and no government oversight.
Speaker 1: So I think a lot of strange things happening there.
Speaker 1: And in my own experience, let's say, the person who
Speaker 1: ran the money markets as at the New York FED
Speaker 1: didn't have any experience or expertise in money market at all,
Speaker 1: and that was very common throughout the open market desk,
Speaker 1: because you know, you don't really have any external pressure
Speaker 1: to to know or do anything. So I don't think
Speaker 1: the FED is very much in tune with what's happening
Speaker 1: in cryptocurrencies. So speaking of the FED, UH not necessarily
Speaker 1: being in tune with the economy right now. UM. I
Speaker 1: wanted to ask you also about inflation. So this is
Speaker 1: probably the biggest question currently facing central banks and investors
Speaker 1: at the moment. Uh, To what degree are these inflationary
Speaker 1: pressures that we've been seeing some of the gridlock in
Speaker 1: supply chains and supply shortages and things like that, To
Speaker 1: what degree are they transitory? And to what degree should
Speaker 1: central banks actually be worried about them? Should central banks
Speaker 1: be responding to them? Is an interest rate hike the
Speaker 1: appropriate way to fix? Um? You know the problem of
Speaker 1: not enough shipping births in Los Angeles and things like that. Um. So,
Speaker 1: I guess my question is, like, number one, how do
Speaker 1: you think the FED is thinking of inflation at the moment?
Speaker 1: A number two, to what extent is the flexible average
Speaker 1: inflation target still in play? I think the FED is
Speaker 1: really worried about inflation. After telling everyone was transitory, you
Speaker 1: no longer share that word anymore. And I think that's
Speaker 1: it's a really hard it's a really hard question for
Speaker 1: the FED right now because you know, a lot of
Speaker 1: this inflation, it's it appears to be driven by supply
Speaker 1: side effects that you have. You know, we read about
Speaker 1: the energy crunch, we have, you know, congestion at ports
Speaker 1: says this hasn't been discussed at this on the podcast. Um,
Speaker 1: there is also a big demand first as well. You know,
Speaker 1: we kind of printed and spent a lot of money
Speaker 1: and that increases demand. A lot of the supply constraints
Speaker 1: will be changed by interest rate hikes, but interest rate
Speaker 1: hikes do damp in demand. So if you high rates,
Speaker 1: you can really hurt demand. And so you know, reducing
Speaker 1: demand that you know, lowers inflation. However, it costs your
Speaker 1: other mandate, which is unemployment. So it's a very very
Speaker 1: difficult time for the Fit to choose right now. And
Speaker 1: I would also that though that just mechanically speaking, looking
Speaker 1: at the financial system, it's really hard for the FED
Speaker 1: high rates without having a tremendous financial impact. And the
Speaker 1: reason for that is when you have a very high
Speaker 1: level of debt in the system, your interest rate hikes
Speaker 1: are magnified in their effect. So there's interest rate risks
Speaker 1: not in let's say fixed income debt, and when you
Speaker 1: hike rates, you kind of basically destroy some of that value.
Speaker 1: And when you're thinking about tresuries, you're basically kind of
Speaker 1: pulling away money out of the system. If you think
Speaker 1: about tresuries as a form of money, then what we've
Speaker 1: been doing in the past, let's say decade, when we
Speaker 1: reduced rates, all those hyderation assets, they become their market
Speaker 1: price arises, they become enriched. People have more money through
Speaker 1: that which they can repo or sell and then they can,
Speaker 1: you know, buy the stuff. Or if you're let's say,
Speaker 1: let's say a sixty proo, the manager of your bonds
Speaker 1: appreciate you have to buy more equities to balance, then
Speaker 1: that makes equity markets go higher. But when you're hiking rates,
Speaker 1: you're doing the reverse. And because the level of debt
Speaker 1: is so much higher, then I think there's some very long,
Speaker 1: nonlinear impact, so that Collado channel from thro wish money
Speaker 1: monetary policy is transmitted that I think it really sets
Speaker 1: a constraint as on the fattest whether or not they
Speaker 1: could just high rates like they did in the seventies
Speaker 1: because you could have very, very large impacts on the
Speaker 1: financial markets, so I don't think they're in a position
Speaker 1: to do much. If there is a solution to inflation,
Speaker 1: I think it probably has to come from the fiscal side,
Speaker 1: maybe through taxation by let's say, more progressive income taxes
Speaker 1: for example. So when you have when it seems like
Speaker 1: we're moving towards the world where the fiscal authorities play
Speaker 1: much greater role in demand right there spending trillions of dollars,
Speaker 1: and when you have a large market constraining the central bank,
Speaker 1: I think one of the ways that you could solve
Speaker 1: inflation is just through taxation, basically draining away money selectively
Speaker 1: out of the financial system, instead of something blunt like
Speaker 1: an interest rate increased wholesale lopping of market value of
Speaker 1: fixed income debt. That's really interesting because I always thought
Speaker 1: of fiscal as you know, one way to boost demand. Obviously,
Speaker 1: you know, the government announces some big infrastructure spending program
Speaker 1: and hopefully Congress passes it instead of arguing about it
Speaker 1: for a long time, and voila, you know, the economy
Speaker 1: gets a demand boost. But I hadn't actually considered that
Speaker 1: the reverse could also be true. That fiscal could act
Speaker 1: as a sort of demand constraint if it has to. Yes,
Speaker 1: we can, and I think but the problem of course
Speaker 1: is that the fiscal, the Congress, who you know, the
Speaker 1: sets of fax laws is, can't act as quickly as
Speaker 1: the feed and the fat can. You know, Luck last March,
Speaker 1: instantly you rolled out liqudity facilities and cut rates. It's
Speaker 1: very difficult for for the legislature to to be able
Speaker 1: to act as quickly. So what is decision making actually
Speaker 1: like at the FED? Because I mean, on the one hand,
Speaker 1: we have seen the Central Bank praised in recent years
Speaker 1: for putting together a very very quick response to the
Speaker 1: market crash that we saw in and you know, the
Speaker 1: turmoil in the treasury market specifically. But on the other hand,
Speaker 1: it does get a lot of criticism for basically being outside,
Speaker 1: um the sort of democratic process. You know, it's it
Speaker 1: operates without political oversight, I guess, and you know, there's
Speaker 1: a perception that it's just a bunch of economists doing
Speaker 1: their own things. So I'm curious what internal decision making
Speaker 1: actually looks like at the FED. Is it really just
Speaker 1: you know, one or two senior people making decisions or
Speaker 1: is there some sort of um committee like process in
Speaker 1: doing these things. So the FED is very very consensus driven,
Speaker 1: so everything is done by community committee. Uh, it's just
Speaker 1: that what happens in practice is the most senior person
Speaker 1: says something and everyone just nods. So it's it is
Speaker 1: it is by consensus. And you can kind of see
Speaker 1: this in at the highest levels, at the level in
Speaker 1: the sea, for example, you have a FED chair who
Speaker 1: basically you know, says something and everyone agrees, and what's
Speaker 1: happening is behind the scenes, just lots of evolving so
Speaker 1: that when we actually make it to the decision, everyone
Speaker 1: is on the same page. Um. But I think well
Speaker 1: when in practice also, I mean, the power is heavily
Speaker 1: tilted towards let's say the FED chair and the two
Speaker 1: wise chairs, so in practice those people have a disproportionate
Speaker 1: amounts of power. But I think you're concerned about FED
Speaker 1: governments and lack of oversight is valid, especially since the
Speaker 1: FED seems to be becoming more powerful that has over time,
Speaker 1: and you can see this I think in their reaches
Speaker 1: to or it's expanding their mandate to say the climate
Speaker 1: change impacts on the financial system, because when you can
Speaker 1: make it that argument because climate change affects the financial system,
Speaker 1: therefore we must have oversight of it. Then there's no
Speaker 1: limiting principle there. Then, right, everything affects the financial system,
Speaker 1: doesn't that mean that the FED could have its influence
Speaker 1: on anything. It reminds me to let's say, the early
Speaker 1: days of our country, when the federal government was very limited,
Speaker 1: but then through the Commerce Clause, they vastly expanded their
Speaker 1: power because basically everything is affected interest comments. Even if
Speaker 1: you were growing wheat in your own backyard for your
Speaker 1: own consumption, that meant that you weren't buying wheat in
Speaker 1: the interesting markets, so that affected interstate commers. So this
Speaker 1: expansion of part that the FED is doing through through
Speaker 1: basically being able to touch everything that affects the financial system,
Speaker 1: has no limiting principle. And if that's the way that
Speaker 1: they are going to go, then I think they do
Speaker 1: need more oversight. Just going back to the inflation discussion,
Speaker 1: there was one more thing that I want to ask you,
Speaker 1: which is another big mystery that is sort of bedeviling
Speaker 1: markets at the moment, is the fact that we still
Speaker 1: have relatively low bond yields and specifically nominal yields, but
Speaker 1: we also have higher levels of inflation, even though it
Speaker 1: looks like inflation expectations haven't moved that much recently. I'm
Speaker 1: looking at tips, they've been pretty flat. I think, how
Speaker 1: do you think about this, this puzzle of low yields.
Speaker 1: I think that's a puzzle if you assume that bond
Speaker 1: yields are basically a reflection of economic conditions and inflation expectations,
Speaker 1: and there are definitely people who buy bonds with that framework,
Speaker 1: but there are also many people who buy bonds without
Speaker 1: that framework. And um for example, a view are a
Speaker 1: commercial bank to receiving io R and new reserves fifteen
Speaker 1: basis points. Under the regulations, surgeries and reserves are considered equivalent.
Speaker 1: So what do you do, well, I I just sapp
Speaker 1: out my reserves and buy a whole bunch of sruguries.
Speaker 1: And you see commercial banks doing that to the tunes
Speaker 1: of hundreds of billions at a time. So it's not
Speaker 1: because of any fundamental view and growth and inflation. It's
Speaker 1: just that under their constraints, you know, treuguries are better
Speaker 1: than reserves that will by struguries and will hedge the
Speaker 1: interest rate risk. Um. You also have a lot of
Speaker 1: actors let's say the FED buying eighty billion a month.
Speaker 1: If that does not care about growth of inflation. They're
Speaker 1: buying it because it's their mandate to do so. And
Speaker 1: you have also many other I would say foreign central banks.
Speaker 1: You're very conservative Investment managers who were buying trujuries because
Speaker 1: they need to save the assets are maybe they're regulatorily
Speaker 1: bound by their regulations to do that. So I think
Speaker 1: that tugs are just the financial asset. They go higher
Speaker 1: because there are a lot of people buying it, and
Speaker 1: I think it's a mistake to infer economic conditions from them.
Speaker 1: The analogy I would use this I let's say you're
Speaker 1: looking at Tesla stock. Let's say you can forecast earnings
Speaker 1: and you can put that into a dividend discount model.
Speaker 1: You can come up with a fundamental value of Tesla. Right,
Speaker 1: that's your framework. You forecast earnings, you value based on
Speaker 1: the fundamental way. But you can't really take the price
Speaker 1: of Tesla into as an input in your model and
Speaker 1: back out supposedly market expectations for revenue growth because people
Speaker 1: are buying tests up for momentum, or maybe you're an
Speaker 1: options dealer, you got to buy Testla to head your
Speaker 1: options right, and in the same way, you really can't
Speaker 1: take price as an input for let's say treasuries and
Speaker 1: try to back out what the treasury market is saying
Speaker 1: about economic conditions because not everyone approaches treasuries as an
Speaker 1: investment on that basis. So this is one of the
Speaker 1: areas where I kind of see overlap between some of
Speaker 1: the research you do and some of the research one
Speaker 1: of our other, uh, you know, recurrent money market guests,
Speaker 1: Saltan Posar, actually does where you know, he's well known
Speaker 1: for calling up banks and you know, speaking to people
Speaker 1: in the money markets and trying to gather color on
Speaker 1: what exactly they are doing. And I see a lot
Speaker 1: of that in the post that you do on your
Speaker 1: blog as well, like actually digging into the numbers to
Speaker 1: see what treasuries at large banks have been buying, and
Speaker 1: then you know, charting the fact that they've been buying
Speaker 1: a lot more bonds over the past year or so.
Speaker 1: How much does that sort of inform your thinking? Do
Speaker 1: you still keep in contact with a lot of people
Speaker 1: in the market and try to get as much information
Speaker 1: as you can from them. You're right that a lot
Speaker 1: of the work that I did at the FED was
Speaker 1: basically the same as what Salton did, And I have
Speaker 1: great respect result and I read everything he writes. It's
Speaker 1: great and I'm glad you have them on your show.
Speaker 1: Sometimes I think a lot of my information I actually
Speaker 1: I get through Twitter these days, and what I've realized
Speaker 1: is set fin Twitter. It's just test amazing resource. You
Speaker 1: can access the thoughts of some of the I think
Speaker 1: best managers, expert subject matter experts in the world, and
Speaker 1: it's all an available on Twitter. And you don't get
Speaker 1: certain things that you could get, let's say, if you
Speaker 1: had relationships with your Treasury desk. But I think once
Speaker 1: you understand how the system actually works, there's just enough
Speaker 1: from public data and from let's say, anecdotal reports through
Speaker 1: outlets like Bloomberg or fin twit that you can actually
Speaker 1: have a very good picture as to what's happening. There's
Speaker 1: one more question that I want to ask you, which
Speaker 1: is maybe it's a sensitive one. I don't know, but
Speaker 1: let me know if it is. But why did you
Speaker 1: ultimately decide to leave the fund? I think it goes
Speaker 1: back to what I was mentioning about the open market sex.
Speaker 1: The FED is a phenomenal place to work on the
Speaker 1: open Market's desk. You have access to tremendous amounts of
Speaker 1: confidential data. You can call up big banks or dealers
Speaker 1: or just hitch funds or money market funds and they'll
Speaker 1: speak to you and you get to understand. But it's
Speaker 1: a really good place to learn, but it's not a
Speaker 1: really good place to work. It's not a good place
Speaker 1: to work because well, just looking in the money market, says,
Speaker 1: no one on the management, almost no one on the
Speaker 1: management has any expertise or experience in money markets. It's
Speaker 1: kind of basically purely based on your seniority, so it's
Speaker 1: impossible to grow. It's kind of just like a I guess,
Speaker 1: the big piggy bank for the people who got there first.
Speaker 1: And so it's a good place to grow, but it's
Speaker 1: not a good place to learn. And we have tremendous turnover.
Speaker 1: I can tell you from just this past year on
Speaker 1: the money market. Says turnover was like some of them
Speaker 1: go to other divisions and the fed, some of them
Speaker 1: go to the street. So I felt that I had
Speaker 1: learned all there is to learn, and there is really
Speaker 1: no point of being there anymore. Mh um. One more
Speaker 1: question for you, and then we're going to have to
Speaker 1: wrap up. But what do you think the biggest challenge
Speaker 1: is that the FED is facing at the moment. I
Speaker 1: think the FED is seen a moment where they have
Speaker 1: to choose between their two mandates, employment or inflation, and
Speaker 1: that's a very difficult choice, and it's going to be
Speaker 1: a political choice depending on the composition of who's on
Speaker 1: the m C. You have inflation that you can control
Speaker 1: and a few raised rates or try to tamp down
Speaker 1: and demand, you're going to have higher unemployment. That's a
Speaker 1: very very difficult choice and there's just no good way
Speaker 1: to do it. So they're going to have to Basically,
Speaker 1: it's going to be a political thing, and it's going
Speaker 1: to be based on their values. What are they value
Speaker 1: more employment or inflation? And we'll have to see the
Speaker 1: composition of the FMC. Looks like it's changing with all
Speaker 1: these revelations and resignations, So we're going to see how
Speaker 1: the composition of the flom SE is next year to
Speaker 1: see how they might rule. Yeah, certainly a lot going
Speaker 1: on in interesting times. UM for the FED. Well, Um,
Speaker 1: Joseph wag uh The the writer at the Fed Guy blog,
Speaker 1: thank you so much for coming on and just for
Speaker 1: our listeners, if you haven't checked out that guy yet,
Speaker 1: I highly recommend that you do. It's fed got dot com. Joseph,
Speaker 1: thanks so much, Thank you so much to happen you, Tracy.
Speaker 1: So here's the part where I talked to myself because
Speaker 1: Joe isn't here. But um, I'm trying to think how
Speaker 1: to sort of synthesize that conversation. I mean, part of
Speaker 1: me is just relieved that I don't actually work at
Speaker 1: a central bank and have to be on the hook
Speaker 1: for solving a lot of these problems at the moment.
Speaker 1: And you know, I obviously don't think the FED is
Speaker 1: a perfect institution, um, and certainly we're seeing that recently
Speaker 1: with the news about the insider training scandal. But it
Speaker 1: is clear that they are facing a number of new
Speaker 1: situations that they've been thrust into after COVID and after
Speaker 1: the big market crash, and I don't necessarily envy them
Speaker 1: having to figure out how the world works in current conditions,
Speaker 1: you know, trying to figure out whether or not hiking
Speaker 1: interest rates would actually do anything to damp down supply
Speaker 1: pressures um that are caused by transportation gridlock and supply
Speaker 1: chain issues that just seems really difficult to me. And
Speaker 1: also Joseph some idea of bitcoin and a sort of
Speaker 1: unaccounted for wealth effect maybe changing the composition of the
Speaker 1: labor market. That again is something brand new, and I
Speaker 1: doubt that the vast majority of central bankers, you know,
Speaker 1: many of whom are quite old at the moment and
Speaker 1: probably haven't been following bitcoin for that long or that much.
Speaker 1: I doubt that they've really wrapped their heads around that phenomenon.
Speaker 1: So yeah, I guess the message is, uh, don't envy
Speaker 1: the people at the FED, and there's a lot going
Speaker 1: on and a lot of new challenges that they are facing,
Speaker 1: and that I am going to leave it there. One
Speaker 1: thing I would say is, if you are enjoying odd Thoughts,
Speaker 1: if you do appreciate the work that Joe and I
Speaker 1: put into the show, and here I will just go
Speaker 1: ahead and mention that I am recording this with a
Speaker 1: triple fracture in my left foot. If you appreciate all thoughts,
Speaker 1: please go over to Apple Podcasts and give us a review,
Speaker 1: hopefully you know, a five star one. It would be
Speaker 1: much appreciated, and Joe and I enjoy seeing that kind
Speaker 1: of feedback, So thank you so much and I will
Speaker 1: leave it there. So this has been another episode of
Speaker 1: add Thoughts. I'm Tracy Alloway. You can follow me on
Speaker 1: Twitter at Tracy Alloway. You can follow my co host
Speaker 1: Joe Wisenthal at The Stalwart, and you can follow Joseph
Speaker 1: Wang at fed Guy twelve. Can also check out his
Speaker 1: blog at fed guy dot com. And you should follow
Speaker 1: our producer Laura Carlson. She is at Laura M. Carlson.
Speaker 1: And you can follow Bloomberg Podcasts at podcast Thanks for listening.