Why the Federal Reserve Must Become the World’s ‘Dealer of Last Resort’
The U.S. central bank could be left holding an elephant-sized bag as a global dollar-shortage bites.
As President-elect Donald Trump threatens to turn away from the rest of the world, the Federal Reserve will find itself under increasing pressure to extend a helping hand outwards.
That’s the prognosis from Credit Suisse AG Director of U.S. Economics Zoltan Pozsar, who contends that the U.S. central bank needs to take a much more activist approach to ensuring adequate availability of the world’s reserve currency in light of recent regulatory changes that have raised bank funding costs and constrained sources of dollar funding.
The liquidity financial institutions can draw upon has been drained by new rules that require banks to hold vast buffers of easy-to-sell assets, on the one hand, and a larger-than-expected exodus from prime money-market funds linked to financial reforms implemented in October, on the other. That’s induced a pick-up in bank funding costs that looks to be permanent, the analyst said.
That means that when foreign banks need dollars, they’re increasingly forced to procure them through currency swaps from U.S. banks and asset managers — who are themselves balance-sheet constrained. The cost of converting local currency payments in euros and yen into dollars is now at its most expensive since 2012, as implied by persistently negative cross-currency basis swap rates.
The net result is an “existential trilemma” for the Federal Reserve, as it is forced to choose between two of the following three objectives: shoring up banks’ balance sheets, stabilizing costs for onshore and offshore dollar borrowing, and an independent monetary policy.
The best possible solution, according to Pozsar, is for the U.S. central bank to let its own balance sheet go: serving as a “dealer of last resort” by way of “elephant size quantitative eurodollar easing,” in other words, that it should allow the unlimited use of its dollar swap lines to prevent foreign banks’ dollar borrowing costs from getting too high in an environment of constrained bank balance sheets.
“The tool to use is the Fed’s dollar swap lines but the aim would no longer be to backstop funding markets, but to police the range within which various cross currency bases trade,” Pozsar writes, arguing for the “fixed-price, full-allotment broadcast of eurodollars globally” by the U.S. central bank.
“In a way, quantitative eurodollar easing is the missing piece in a mosaic where the European Central Bank and the Bank of Japan continue on with QE at an aggressive pace, and investors in their jurisdictions are filling their duration gaps with higher-yielding U.S. dollar assets on a hedged basis,” he explains. “But the private provision of [currency] swaps to hedge these flows can’t possibly keep pace with the public creation of euros and yen on massive scale.”
A failure to engage in such ‘QEE,’ he argues, would kneecap the Fed’s tightening cycle. Higher dollar funding costs imply tighter financial conditions and therefore slower economic growth abroad, which could impact the U.S. Meanwhile, higher currency conversion costs make it harder for foreign investors to meet their return targets and forces them to buy riskier assets, which could impact financial stability. Both those risks also tend go “hand-in-hand” with further appreciation of the dollar, Zoltan writes, which Fed officials see as reducing the need to tighten monetary policy by raising interest rates.
But in the near-term, Pozsar sees funding stresses for foreign banks swelling, with the three-month cross-currency basis for dollar-yen hitting negative 150 basis points.
One elephant in the room for the Pozsar’s pachydermic expansion of the Fed’s swap lines is the huge shift in U.S. politics augured in by President-elect Donald Trump. Analysts at Deutsche Bank AG last week pointed out that while Trump’s protectionist policies could exacerbate a global dollar shortage, they could also hamper the Fed’s ability to provide dollar liquidity to the rest of the globe via currency swap facilities. “In a world of rising protectionism and anti-globalization sentiment it is doubtful that the commitment to such facilities can be taken for granted in the future,” the Deutsche Bank analysts wrote. “The provision of dollar liquidity caused material political backlash in the U.S. during 2008 and tolerance from a Trump-led administration is likely to be even smaller.”