HOW BIG IS THE PANIC AT THE AMERICAN CENTRAL BANK? The Federal Reserve has lost control of the policy rate

The most important central bank in the world is trying to find out what has happened last week, when interest rates on the repo market reached intraday all time high, of approximately 10%, even though the surplus reserves in the banking system amount to 1.4 trillion dollars.

Amid a high liquidity deficit, the median daily rate of the overnight repo in the US surpassed the 6% level reached on September 17th, 2019, which was also an all time high, according to data from Depository Trust & Clearing Corporation (DTCC).

Furthermore, an extremely concerning evolution was seen for the actual policy rate, which rose above the upper value of the range announced by the central bank.

In the United States, the Federal Reserve announces a target interval for the "Fed funds rate". The commercial banks registered in the US conduct overnight funding operations without collateral at close rates, and the Central Bank calculates the actual policy rate as a median weighted with the transaction volume (the median represents the value of a series ordered in ascending or descending order which splits the series into two equal parts; it should not be mistaken for the average).

The Federal Reserve can intervene through open market operations, in order to keep the actual interest rate within the target range.

It seems that last week major deadlocks were seen in the functioning of the interbank market, as banks which had excess liquidity available at the Fed did not even want to grant overnight loans secured with government bonds.

While analyst Sven Henrich was wondering, on his Twitter account, whether the Federal Reserve has lost control of the interest rates, other economists from financial institutions and investment funds were not shy in saying that was already the case.

Mark Cabana, of Bank of America, wrote in a note addressed to customers that "the dam of dollar financing has been broken".

To American analyst Martin Armstrong "the interest rate panic is only beginning", and the main cause of the new trend is the "flawed management of the fiscal policy".

In his opinion, "the Federal Reserve has indeed lost the control of short term interest rates", and "Trump can ask for zero or negative interest rates as long as he wants", because "the markets show that something else is waiting for us".

One of the harshest positions was expressed by Michael Schumacher, director at Wells Fargo.

"The situation isn't looking too good. You set your target. You are the all-powerful Fed. It is assumed that you can control it, but you are unable to do that on the day of a monetary policy decision ", Schumacher told CNBC.

At the press conference which followed the last monetary policy session, where a new 25 bp cut was decided, Chairman Jerome Powell said that the liquidity problems on the interbank market do not represent a reason for concern for the real economy.

This statement brought back memories for some, who remembered how Ben Bernanke, the chairman of the Federal Reserve between 2006 and 2014, was saying that "the spread of the problems on the subprime market has been limited".

Chairman Powell's optimistic statement was "completed" by the massive intervention of the Fed on the interbank market. In four consecutive daily repo operations, the Federal Reserve Bank of New York (FRBNY) injected 53 billion dollars on the first day, and then 75 billion each round with an overnight maturity, amid greater demand from banks.

Data from the FRBNY shows that the volume of repo operations was the highest in September 18th, 2008, when the combined value of 105 billion was offered in three separate operations.

Daily liquidity injections of over 70 billion have only been conducted after the September 2001 attacks in New York, and the "need" disappeared after the launch of the quantitative easing programs.

Amid the repo operations of 75 billion dollars at the end of last week, Federal Reserve has also announced their program by the end of October 10th, 2019.

Aside for daily overnight operations of at least 75 billion, the American central bank has also announced three repo operations with a 14 day maturity, whose individual volume will be at least 30 billion. This may be the first step towards the replacement of temporary open market operations (TOMO) with permanent operations (POMO), a precursor to the resumption of cash printing.

The overnight repo rate, the actual funds rate and the SOFR (Secured Overnight Financing Rate), which was introduced in April 2018 by the FRBNY to replace the LIBOR rate, "recovered" after the massive liquidity injections, but the problems remain.

In an interview granted to Financial Times, FRBNY president, John Williams, said that the officials of the central bank have launched an investigation to determine the role of banks in this liquidity crisis.

More specifically, the Fed is trying to determine "why banks with excess liquidity did not grant overnight loans", according to FT.

"Today we need to focus not so much on the level of the reserves, but on the manner in which the market works", said Williams.

What does that mean? That the Federal Reserve doesn't know how the interbank market works? But can there even be any talk of "markets", after more than ten years of massive interventions by the central banks?

"It's great that the Fed is showing an interest in the way the banking system functions", an FT reader ironically wrote on the interview with John Williams.

What the Federal Reserve "discovers" following the investigation might provide additional reasons for concern, especially since the "corrective" measures are far from being obvious.

Zoltan Poszar, executive director at Credit Suisse, told The Telegraph, but also recently wrote in FT, that "as super massive black hole has accumulated" for dollars financing at the level of international repo markets, and the only solution is a major cut of the policy rate in the US.

"Jay Powell's disastrous week is over, but not his nightmare", is the conclusion of an analysis by Jeffrey Snider, research director at investment fund Alhambra Investments.

In his opinion, the banks' surplus reserves have not been and are not relevant for the current liquidity crisis, and the problem is again found when it comes to dollar funding on the international markets, with an additional emphasis on the demand for dollars from China.

Snider further said that "the quantitative easing program represents an abject failure".

Perhaps that should be the starting point in the investigation of the Federal Reserve, so that no one else asks how it is possible to lose control of the monetary policy.