Why This Money Market Madness Looks Like a Bad Sign for the Economy, But Isn't | Opinion

The optics aren't good. For the first time in a decade—since the financial system was about to collapse—the Federal Reserve Bank turned to its "repo window" this week to make up for a shortfall of cash in the money market. The operation raised fears that we are headed for another crash.

But it's crucial to put this news into context.

Back in 2007, housing prices began to plummet. Banks and other lenders had made several fortunes writing the mortgages that had allowed prices to bubble up, and now the bubble was bursting. Banks had packaged these loans into Mortgage Backed Securities that promised high return with minimal risk, but the banks had held onto the riskiest of these MBSs and now were threatened with huge losses.

Banks wanting to secure their positions began accumulating a safety cushion of reserves of money. The main way that banks get reserves is to borrow them from other banks—but when there is more demand for reserves than there are reserves available, interest rates in the inter-bank lending market known as the Federal Funds Rate spike, because most of the reserves are held as deposits with the Federal Reserve Bank. As a consequence of an increasing Federal Funds rate, most other interest rates increase too, since banks have to maintain a wedge between the price they pay for money and what they earn when they lend it out.

Managing the supply of money to the economy is one of the Federal Reserve's most important jobs. With the economy heading into a recession, rising interest rates were the last thing the Federal Reserve wanted and a sure sign that more money was needed.

As the situation worsened and banks' problems worsened, the banks that were sound began worrying about lending to other banks: they had no way to know whether those other banks were good credit risks. The pressure on interest rates in the Federal Funds market became extreme and through 2008, the Fed poured more and more money into the market to keep interest rates stable.

In the end it proved impossible to stop the panic. When major financial institutions began going bankrupt, no one wanted to lend to anyone. In the Fall of 2008, credit markets froze. The recession became the worst since the great depression.

The situation now is very different from that in 2007-2008. Yes, last week the Federal Funds market was again experiencing extreme pressure on the interest rate and the Federal Reserve was forced to take some unusual steps to keep interest rates in their target range. But rather than building reserves, banks have been reducing them as the economy has steamed ahead with low unemployment and moderate-to-good growth of the Gross National Product. Despite talk of a possible recession, the banking system seems healthy and no one seems particularly concerned about its viability.

Rather, the sudden spike in interest rate pressure probably has more to do with a confluence of factors that increased the demand for money. Firms and people needed money to pay a large corporate tax bill coming due while they also needed money to buy a new issue of U.S. government bonds. The bond issue was unusually large because of the need to fund the exploding deficit caused by the recent Republican tax cuts. Bank reserves would be more than enough to satisfy this demand, but banks have been slow to part with them. Why they hold such large quantities of reserves is a mystery. But given their apparent desire to keep their reserves at high levels, the surging pressure in the Federal funds market in response to the spike in demand for money is not a mystery.

Are we likely to see more events like this in the future? It's possible. Markets aren't used to handling the demand for money being created by our unprecedented deficits. While the tax cuts have not delivered the promised investment surge—in fact, investment has slowed—they may be behind the current chaos in the market for money. While unprecedented peacetime deficits and ongoing uncertainty about trade policy may be reasons for concern in the longer run, this minor turbulence in the money market is not.

William T. Dickens is the University Distinguished Professor, Northeastern University and former Senior Economist to Clinton's Council of Economic Advisers

Robert K. Triest is Chair, Department of Economics, Northeastern University

The opinions expressed in this essay are the authors' own.