You said the Federal Reserve is going to start expanding its balance sheet.

My guess is that my guess is that they will have to otherwise they will lose control over the the repo market and they don't want that to happen.

Joseph, great to see you. Welcome back to Monetary Matters.

Thanks so much for inviting me. It's a pleasure to be here and congratulations on the success on your show. Such great guests over the past few months.

Appreciate you saying that. Joseph, obviously you're writing at fedgu.com. You used to be a senior trader for the New York Federal Reserve, which is where, you know, the bulk of the monetary operations go. Just coming out of the Federal Reserve meeting, we had the interest rate cut from 4.1% roughly to to 3.8% roughly. A lot of questions about what the the Federal Reserve is going to do in December. Is there going to be a cut? The market was pricing a cut. Pal said, "Not so fast." Uh his exact words were a cut in December is not a foregone conclusion. Far from it. which for Jay Powell that's basically saying like did I stutter? You know that's a that's a big big bombshell.

But Joseph want to set aside rates for a second. You know the 20 minute 30-minut mark we we'll talk more about rates. Want to start out with the balance sheet and money market which is your expertise. That's what you were doing at at the New York Fed. Powell dropped a big announcement that the Federal Reserve's reduction in its balance sheet or quantitative tightening QT is going to be effectively over on December 1st. So break this down for our audience here today. what's the significance of it and what's your interpretation of the the specific mechanics?

First, I'll talk a little bit about why they start they're stopping QT and then I'll talk about the much more much bigger question that is what the final composition of the Fed's balance sheet is going to be going forward because that's the part that's actually going to have a market impact. So, the Fed has been shrinking its balance sheet through QT for some time. And when they shrink their balance sheet, what they're doing is they're solely withdrawing liquidity out of the financial system. Now they want to make sure that their balance sheet is just small enough so that the banking system has enough uh cash to function. Now a bank holds deposits at the Fed. They're called reserves. So that's what they're thinking about.

Now the problem is that the Fed doesn't actually know what the right size uh well right size for their balance sheeting is or another way of saying this is how many reserves banking system needs. Now they have models and so forth but at the end of the day they don't really know. Now, the last time they did QT, they kept shrinking their balance sheet. And in September of 2019, there was a tremendous spike in the repo market that forced them to intervene. Now, the Fed thinks that one of the reasons why there's that huge spike in the repo market back then was because they overdid QT. So, they're very eager to avoid that right now.

So, when they're looking at whether or not they're shrinking their balance sheet too much, they look at market rates, specifically market rates in short-term funding markets like repo rates and the federal funds rate. Now, over the past few months, what we've seen is that uh the reverse repo facility balances have gone down slowly and now are basically around zero. So reverse repo facility is basically a place where money market funds park their excess cash and the Fed looks at it as kind of a repository of excess liquidity in the financial system. So when that facility went to zero repo rates began to gradually drift higher and over the past few weeks they've traded higher than Fed funds and higher than interest on reserves. That sends a strong signal to the Fed that you know maybe we should stop doing this QT and that's what Cher Powell mentioned today.

Now QT has actually uh been tapered over the past few months. So it's really not a big deal in the market anymore. Uh but they noted today that they're going to stop it effective December. So that's kind of the big thing they did with their balance sheet.

Now from my perspective when I look at repo rates and since the Fed likes to focus on this, if you're at the Federal Reserve, one of the most important things you can do is you have to control short-term interest rates because that's how you adjust policy, right? you're trying to toggle short-term interest rates to adjust the financial conditions through the wider uh market and impact the real economy. So, your bread and butter is being able to control short-term interest rates.

So, repo rates are part of that complex and it's driven by supply and demand like anything else. Part of the supply of funding available to lend and repo is related to the size of the Fed's balance sheet. That's that's definitely true there. But the demand though, that's largely because the United States runs a 2 trillion fiscal deficit and at the end of the day, some of the people who buy the Treasury debt finances those purchases uh in the repo market.

So that's kind of necessary because let's say that you're issuing $2 trillion in debt. Let's say that you you're you're um you know the US Treasury, you show up to the market, you sell like 10 billion. Most people don't have that lying uh you know under a couch or in their pocket or something like that. So you need someone who's be able to elastically expand their balance sheet. So buy that on leverage because if you buy it on leverage you get the money instantly, right? You don't have to rely on you know inflows from your investors or premium payments from your uh insurance people who buy insurance from you.

So at the end of the day uh a lot of the purchases in the cash treasury market uh to finance the US Treasury are funded in the repo market and as you have tremendous uh issuance demand for repo increases. So the Fed right now they're stopping their balance sheet thinking that you know this is this is going to have an impact on uh repo rates but at the end of the day as long as the fiscal deficit continues to grow you have increasing demand for repo funding. And so rates are going to go higher.

So my expectation is that uh they're going to have to be adding liquidity into the financial system shortly. And they can do this in a couple ways. One thing that's different this time compared to the past is that they have something called a standing repo facility. And what that means is that uh if you are a securities dealer, you can go and borrow from the Fed uh in borrow repo from the Fed basically anytime you want. and they've been doing that but really not a lot and also obviously not enough to constrain the repo rates and there are probably technical technical reasons for that um with regard to

okay super in the weeds but if if you're an SRF you're barring in triparty repo and that's not balance sheet friendly it's not netible and so I think that's part of reason uh but what they're likely to do going forward is once they realize that stopping QT uh does not put downward pressure on repo rates. Once they see rep rates continue to rise, they're probably going to be buying a lot of bills to add liquidity into the financial system. They call these reserve management purchases and they did that in 2019 as well.

So that could happen actually maybe as soon as December. I mean it's really hard to say about about these things because so much of it is uh opaque. Um like the spike in repo markets in September 2019 came kind of out of the blue. I I was there at that time. It was kind of exciting. Um so I I expect them to be expanding their balance sheet again shortly.

But you know that that's actually pretty technical. The really really big picture that's going toffect impact markets going forward is just what the ultimate composition of the Fed's balance sheet will be. Now, that's kind of important because the way that the Fed impacts market pricing through their balance sheet is through the supply and demand of Treasury securities to the private sector. So, if the Fed, for example, is going out and buying a bunch of 10ear treasuries, there's less treasury treasuries available for the private sector, right? Less supply, uh lower lower interest rates.

Now, right now, the Fed has a portfolio whose duration is pretty high, much higher than the overall markets. That's by design. They bought all these Treasury securities because they wanted to put downward pressure on longdated interest rates. So, they swallowed out a whole bunch of duration

on the FOMC right now, and this is something they're still discussing. But from what we've heard, and we've heard from a couple governors right now, is that they're going to be pretty hawkish on the balance sheet. Uh, Governor Waller, for example, would like to, you know, maybe just hold uh, you know, hold a lot more Treasury bills, as many Treasury bills as they have reserve balances. So, that'd be upping it significantly by over a couple trillion.

So, what does that mean? Well, if you're holding uh, if you have to hold, let's say, three trillion bills, that means you're going to have to hold fewer coupons, and that means that the private sector is going to have to hold a lot more duration. So, you know, that's kind of uh super hawkish um in that it will increase the supply of duration to the market and maybe they'll do that solely and really depends on uh who's on the committee. Another member uh Governor Bowman has actually even suggested that the Fed should outright sell mortgage back securities.

Now, I mean that's going to be, you know, so if you sell mortgage back securities, the market's going to have to absorb it. that means higher mortgage rates and uh you know that's that that could be potentially pretty disruptive and uh I think it's going to make a lot of people in the White House unhappy.

But listen, I think what I've taken away from this so far is that the people who have been very hawkish on the balance sheet uh have been the Trump appointees, the same people who have been clamoring for rate cuts over the past, you know, few meetings. So I think that suggests that maybe there's there's the Fed is still functioning as a you know pretty independent organization. I'm just talking about Governor Bowman invol and governor uh Waller because they were the people who have been climbing for rate cuts in the past recent month going so far as to descent.

So there's a narrative out there that all these guys because they're Trump appointees that they're just going to you know cut rates and do what the boss says. But, uh, what they're saying with the balance sheet is very hawkish. So, I think that it's it's more complicated than that narrative.

So, I I'll get back to the balance sheet in a second, but what you're saying is that the President Trump appointees on the Federal Reserve Board are uh uh they are not being super dovish and doing whatever the president wants on the balance sheet. Counter to the narrative that they are doing whatever the president wants on the interest rate story. How are you evaluating that narrative?

So, what I'll just add one more thing here. So in in uh the in 2019 the Fed had a confidential memo that was subsequently declassified to the public and in that memo they said that you know if we were more hawkish on the balance sheet longer dated interest rates would go up and we could cut more on the front end. And my sense is that rather than you know these these Trump appointees just you know trying to please the big man uh they are being very political and diplomatic in that they are giving the president the rate cuts he wants but on the other hand taking it away by being more hawkish on the balance sheet. So you end up with a steeper curve but the impact on the economy is about the same.

So I I think that's actually what's happening at the Fed. So it doesn't seem like the Fed is uh completely uh part of the executive uh just yet. Probably will be in the coming years and maybe it should be. I I don't know, but not yet.

Now on the interest rate part, I think we should kind of level set a little bit. So the last time we had a Fed meeting, we had the dot plot and the dot plot guided towards two more cuts this year. So a rate cut today and a rate cut in December.

Now, between then and now, it's been a difficult time because of the government shutdown. The Fed has been basically flying blind, not receiving a lot of the important data that would usually inform their decisions. Now, they do have access to private data like ADP, like Adobe data, and they have their own internal network where they go and they talk to people and they write the Beechbook about it.

Now between then and now it seems like the uh well inflation has come in a little bit better than expected but at the end of the day it's still around 3%. And the labor market still, you know, kind of slow, trudging along, low hiring, low firing, not doing anything there, but not deteriorating.

And heading into today, the market was fooling pricing in one cut today and one cut in December. But the papa surprised the market by just openly pushing back against that. I think his memorable words were not a foregone conclusion, forcefully suggesting that maybe he's not going to cut rates in December.

I think the rationale for that seems to be that the labor market is not deteriorating as much and if you look at these GDP now casts it looks like growth is you know growth is okay so that leads us to and you know not fully pricing in a December cut maybe it won't be there and that I think that's where we are in rates right now

so going into today there there was fully priced as you said that there would be a cut in December that cut has been taken away a good chunk of those odds. So the interest rate market has changed. Interesting when Powell said that not a foregone conclusion about December. You know the market stock S&P was down around 76 basis points regained a lot of that. So just goes to show we are not in 2022 anymore and you know the days of Jay Powell's hawkishness causing the stock market to decline two three 4% in a day and you know a large bare market in 2022 was we were not in that day. we not those those days are over you know um at least at least so far.

Joseph want to get back to the balance sheet your your first comment. So the Federal Reserve has been withdrawing liquidity since the middle of 2022. Um just $8.9 trillion to around $6.5 trillion. So you know 2.2.3 trillion of liquidity removal balance sheet uh reduction. And it's been a a long and slow and somewhat steady process. That process is going to go on for 30 to 32 more days, but it is going to end on December 1st. And the uh the treasuries are going to just constantly be reinvested. So held steady. The mortgage back securities that the Federal Reserve owns are going as they mature, they are going to be reinvested into Treasury bills. So the aggregate balance sheets, the Federal Reserve's assets are going to stay flat, but the composition is going to change and mortgage back securities are going to basically be converted as they mature into Treasury bills. That itself is kind of a form of tightening, right? Because mortgage back securities have more duration and convexity risk and just replacing, you know, treasury bill has almost no risk at all. So you're you're supplying the private sector with an increased uh mortgage back security. So it's it is still somewhat a form of tightening, right?

Well, I I would point out that mortgage back securities that the Fed holds have very low coupons. So they're not going to prepay quickly. So someone who so mortgage back securities get paid down either monthly as principal payments go go go through and that takes 30 years or if someone refinances their mortgage that is to say takes out a new loan to repay the old loan. Now because the Fed bought these mortgages during the very low interest rates of the pandemic uh these are like you know 2 and a half 3% mortgages and no one's going to u you know take out a new mortgage to repay that. So the monthly principal payments that the Fed is receiving each month, it's really low. It's like, you know, say 14 15 billion a month. So it's I don't think it's going to have a big impact.

Uh but but when it comes to the mortgage portfolio though, the Fed would like to have no mortgages on its balance sheet. It wants to have a final portfolio that's old treasuries. The rationale for that is that they feel that owning mortgages is basically the Fed allocating credit to the private sector and they don't want to do that even though they've been doing that for for quite some time and to an enormous enormous size too, right? They have a couple trillion under balance sheet. So if they wanted to go to an old Treasury portfolio, uh they probably have to wait 30 years. Now that's a long time and you don't really set goals and just take 30 years to achieve them. So there is a possibility that they could try to speed that up a little bit by selling mortgages. I think that's really unlikely. It'd be a very hawkish outcome. We haven't seen them do that before. Uh looking across the world, the Bank of England has uh shrink their balance sheet by by selling outright, but uh usually people just let them roll off. So that that is a possibility. So I think that's a that is one of the interesting things that happened today. mortgage principal principal is going to reinvest it in not just treasuries but treasury bills and Paul noted that's part of the effort to reduce the duration of their overall portfolio but again it's going to be so slow and and so minor it's not going to be meaningful I don't think it'll affect the market

and and now let's connect the balance sheet to repo as you said the Federal Reserve's reverse repo facility which are liabilities of the Federal Reserves has been shrinking down and are now effectively at zero. So the excess cash parked at the Federal Reserve has been deployed into the financial system as the Treasury has increased a lot of Treasury bills that have been bought by the money market funds that were buying um the the uh that were investing in in the repo facility. Um and and so now they are lending to hedge funds who are now buying the treasuries on on credit you know 10 50 100 times levered um I've heard 200 300 400 times levered um in the in the so-called basis trade

so Joseph you know broad painting painting with a very broad brush the US deficit and US increased treasury issuance from 2000 to 2010 bought was funded a lot by foreigners a lot of which were China let's say 2010 to 2022 was financed by the Federal Reserve in yeah a ton but also domestic banks, domestic households, domestic corporates. A lot of the financing of the treasury and you know you've pointing this out on fedgu.com has been now from the hedge funds. So it's it's levered like a bank buying treasuries, but they're borrowing in the repo market and they're borrowing from money market funds and as a result the demand for borrowing as you say is insatiable. So the the repo rates are spiking and ever so slightly. So, you know, as Powell noted today, over the past three weeks, there have been elevated signs of I'll call it stress where sofur rates are 10, maybe 20 basis points above the the Federal Reserve rates. And, you know, I'll go both for the New York Fed as well as your website to get the exact data, but uh even the effective federal funds rate, which is supposed to be the most vanilla rate in the world, is like three to five basis points above where it should. So, stress is in the the money markets.

Tie this all together. explain this to me as well as to the audience because I I really need your your expertise here. And then also uh expl you know in on your uh your most recent piece on fat.com balance sheet dominance you talk about how the Federal Reserve is losing control of its balance sheet policy to the growing fiscal deficit. Explain explain that as well.

Well well Jackie you you actually had a really good description on what's happening. US Treasury issuing a lot of debt. The marginal buyer of that debt finances in repo at the moment it's these guys who are financing it uh buying treasuries selling treasury futures and their basis trade and so as long as the US as in this current configuration as long as the fiscal deficit grows there's going to be more demand for repo financing

okay demand continues to grow what about the supply of funds well we exhausted all the money market funds and right now the marginal lenders are the the commercial banks and Because repo rates are trading above interest on reserves, you have some commercial banks that are happily taking money that they have on deposit at the Fed and lending it in repo instead, but they're the amount of cash they have is is not unlimited. So eventually they're going to run out of cash, too.

And so repo rates will continue to go higher and maybe spike. If you're the Fed, you have to control short-term interest rates. So, that means you're committed to continuing to add liquidity into the financial system to keep these short-term interest rates under control. And that means you lose control of your balance sheet because by pitting rates, you you lose control over quantities. You that's just how this is set up here.

So, that seems to be the game we've been in actually the past few years. We didn't see it. So when the Fed first lost control over short-term interest rates in 2019, uh they added a whole bunch of uh reserves by buying by buying Treasury bills and then we had 2020 where they just kind of threw in the kitchen sink and you know increase the amount of liquidity in the financial system by by trillions. But we've burned through all that.

So uh we're back to where we are in 2019 where you have to just keep adding otherwise you'll lose control for short-term interest rates. So, that's kind of an interesting, I think, conundrum they have. They really have no way out of it. Uh because it is absolutely essential for a central bank to be able to control short-term interest rates.

Yeah. And just to underscore that point, like if the Federal Reserve cuts interest rates to zero on its statement, but actual interest rates in the market are still at 4%. Then they have no control whatsoever. Like they're basically that's like if you or me on a podcast said interest rates are 0%. It's it's what actually happens in the market. And, you know, 99.9% of the time, the Federal Reserve has close to perfect control over these short-term interest rates, but you're starting to to see a discrepancy where those those interest rates are are going up.

And I I have the the data from the New York Fed and from you that the the uh sofur over the OBFR over overnight something you you could explain it is uh now 10 to 15 basis points wide. So, those repo rates are going up marginally. And interestingly, we're it's it's in the middle smack riddle smack in the middle of the quarter. It's not like it's June 30th and all the banks are pulling out, you know, they're they're repo financing to make it look good for investors and and regulators for their quarterly reporting. This is, you know, there's no window dressing at all. Um, and these these repo rates are going up a lot. Is do you think this is what really drove the Federal Reserve to make this decision of boom, December one, we are stopping quantitative tightening? And also explain the framework. Powell talked about that framework. Um maybe it was Roberto Pley's thing. I know this from you. Talk about that that framework for reserve scarcity.

Yeah, I think it's from Roberto. Roberto is the solo manager. So Roberto or his team came up with a really interesting graph. I think it's like a hexagon or octagon or something like that that has different corners trying to measure out when uh liquidity in the financial system is scarce. So he'll look at things like how sensitive is the Fed funds rate to changes in in reserves? How high are repo rates? uh let's say uh are pe are banks holding back their payments throughout the day trying to conserve liquidity uh is there increased uh let's say you know intraday intraday overdraft things like that uh so that's kind of the indicators it look

but it looks like they looked at all those and decided that yes indeed report rates trading far above IR that's not good I don't want September of 2019 to re to reoccur again so I'm going to stop it uh in December 1st So that's the end of the balance sheets QT story for now. Jack, I think we've been through a QE and QT before. This is like the entire cycle, right? So we're right back uh back back uh back to where we were a few years ago, I guess.

And do you think the Federal Reserve I think you already said yes, you I think you said the Federal Reserve is going to start expanding its balance sheet.

My guess is that my guess is that they will have to otherwise they will lose control over the repo market and they don't want that to happen. So I think what they misunderstand is that you know de repo rates rise not because reserves are scarce but because you have a tremendous tremendous fiscal deficit that's financed and repo and without paying attention to the demand side of that uh you are going to uh be misled and end up in a situation where repo rates do once again spike like they did in 2019 and hopefully they'll realize that be again because it would be very embarrassing to make the same mistake twice.

And how are they going to expand their balance sheet? Are they going to be themselves buying treasuries?

Yeah, they'll buy Treasury bills. So, a lot of people think that the Fed expanding their balance sheet is QE and it's easing, but that's not how the Fed looks at it. So, the Fed looks at QE in a specific way that they're taking duration out of the market. So, they're buying longerdated uh Treasury securities. So the private sector has less of a supply and longerdated Treasury securities putting downward pressure on interest rates. Now from this perspective when the Fed is buying Treasury bills which are shortdated, it's it's neutral. It's not having an impact on the market even though many people will perceive it as such.

So that's probably what they'll begin to do. I suspect they'll have to do it I I think in size too because if you look at how well you look at a couple things. One is you look at the fiscal deficit. It's two trillion a year roughly speaking. The second thing you want to look at is the growth in repo volumes. Now silver volumes grew 800 billion a year. So that's telling you that you know there's a tremendous demand for leverage repo financing. Where is that cash going to come from? So it looks like you're probably going to be have to add well expand your balance sheet by a few hundred billion a year to be able to to meet all that demand.

Thank you, Joseph. How are you thinking about the stock market right now?

Obviously, we're in a huge bubble, right?

yeah, obviously I mean things only go up. Everything goes up. So when I look at the stock market, I it kind of reminds me as to how gold traded the past few weeks, right? You go into a period where you just go straight up, straight up, screw up, look like you're going parabolic, and then suddenly you decline.

So I feel like when I look at the markets, we're entering this phase with it it seems like it we stocks only go up. I've noticed that when we have, you know, bad data, oh that means rate cuts, market go up. If you have good data, that means the economy is good, market go up. And there's a lot of people pouring in here just chasing momentum. They have a lot of different narratives, but at the end of the day, you know, people are just buying because the market goes up.

And it's been working very well. And I I think feel like when you're in this phase in the market, you can it's hard to say how high you can go. You know, maybe you really just follow the com blueprint and go higher than anyone imagined. Uh but at the end of the day though, it's most likely followed by a sharp uh decline. And that worries me a little bit because so much of the economy is dependent upon the wealth effect. if we do actually go have some kind of blowoff top and afterwards we have a decline that almost guarantees us to be in a recession

and not just that I think from a there's so many people who have basically just spending their day just buying stuff in the market right I go to a a cafe I see this nice old man sit down open his laptop I think he's looking at photos of his grandkids but actually he's you know he's drawing candles and trying to figure out you know when to buy and when to sell so it's really very much a speculation nation here. And usually speaking, most of these guys, they lose money. And I think that's going to upset a lot of people.

So, uh, I understand the president likes the stock market higher, likes to claim credit when it goes higher. It's definitely making people like him, but you know, if you take credit on the way up, you will get blamed on the way down. So, that may not be super wise.

Well Jose, I guess let's just talk about this issue of Federal Reserve independence. You know, if President Trump is appointing people who are going to be calling for interest rate reductions, which the president wants, that would be a Federal Reserve that is no longer independent. That is a strong influence um by by the executive branch by by government. And you know, President Trump himself has said, "I think I should have a say about interest rates." That's kind of declaring that he doesn't believe in central bank independence. That's my interpretation. a lot of people view number one do you think that that is a a departure from central bank independence number two do you think that that is a bad thing which you know I'd say a lot of economists think is a bad thing

so obviously the president would like to set interest rates what president doesn't right so I'll say this about central bank independence now I think central bank independence can be a really good thing because we are in a political process where know the executive would always like to have lower interest rates to temporarily boost the economy And we've seen that happen with Nixon, for example, trying to get lower interest rates, boost his chances in the election, and then afterwards, you know, maybe we have inflation, but hey, I'm not up for re-election anymore. So, I think that's the fear there.

But that tells you one thing very clearly in that a central bank is never really independent. It's always operates under uh the elected government. So, we've had an independent central bank in the US since the 1950s. And yet we did have that episode happen with Nixon and we have this episode happening right now. So central bank is composed of people and they always operate under uh political constraints. So that's one thing.

But more broadly speaking though, if you look across the world, so let's say that you have central bank independence in the UK and France, they didn't get that until the 1990s. And it wasn't because they had a whole bunch of inflation and finally the legislator said, "We can't take this anymore. we got to give our centric independence. It was they were having you know low inflation leading up to the independence and they just decided to change the system probably just to you know uh get in line with what other people are doing. So even without central bank independence you can still have low inflation

and you can even look across the world uh to China which has a you know very complicated managed economy. They don't have central bank independence and they still have low inflation. So you can have a central bank independence and still get inflation and you can not have an independent central bank and have low inflation. So it's not necessary and it's not sufficient.

Now this is but the last point that I'm going to make is I think it's more important and that the central banks today are very different from the central banks in the past. Today the Fed is super super powerful much more powerful than the central bank has ever been. you not only have interest rate policy, you have balance sheet policy where you can go and buy you know trillions of mortgage back securities, get mortgage rates super low, uh make uh you know a whole generation of people locked out of the housing market today.

And of course you also have regulatory power over banks whereas you can control who gets access to credit. You know maybe uh in some countries they could do this uh make sure that loans are given to green endeavors for example. So a central bank today is super super powerful.

Although the Federal Reserve has abandoned that I should note, right?

Yes. But you know I'm just talking about central the Fed as an example. So the ECB also super powerful as well. Central banks in general today are much more powerful than they are in the past. And when you look at the political issues today as a society, the one of the most pressing ones is like home ownership, right? a whole bunch of people can't afford homes because a whole bunch of people uh well home prices have gone up in part because mortgage rates are low and of course it's wealth inequality. People who own financial assets well they're doing pretty well. We have this K-shaped economy.

So some of the most important distributional things in our society are basically determined by a a small group of people sitting at the central bank. So if you believe that we should have a democratic society, it seems to me that it makes sense for the public to have some say in matters that have huge distributional impacts on the society.

So you can make the argument that because central banks today are much more powerful than the past, they have to be less independent or you could pair them down, maybe separate regulatory power out, maybe make them single mandate, inflation only and so forth. So uh yeah I think you can make a good argument that uh central bank is too powerful to not have any kind of democratic say simply you know so I think that's an argument you can make and so it's not super unreasonable for from my perspective uh for you to say that uh maybe the Fed shouldn't be independent and I understand that um you know it's a it's a policy decision right there they're there pluses and minuses it's not just oh my god God, we have independent central bank, these guys would be so wise and smart and everything will be okay. That's just not how the world works.

Joseph, you got this phenomenal chart uh on an issue I've actually you know been pleased to cover a lot on monetary matters. The commercial bank loans to non-bank financial institutions. a huge amount of loans, commercial and industrial loans that banks were making actually, you know, disappeared overnight because they were reclassified as loans to non-banks. So, the old model of a bank lends to a company or an industrial facility, a factory, that's kind of out the window. Now, the bank is lending to a a private credit company or a business development company. Uh, and then those companies make the loan.

So, the banks you could say is derisks. It has a more senior position. But uh you know increasingly banks are are not really lending to the economy. Um and I was actually at a conference so you know this data is recent that uh like nine to 10% of bank loans are to non-bank uh financial institutions or non-depository financial institutions. Uh what do you think is the significance of this and do you think it makes in any way the Federal Reserve's jobs harder?

No, it makes the Federal jobs much easier because it derisks the banking sector. In the past, you if you were a bank, you would lend to a company and you know, you'd have some risk there. Now, what you do if you're a bank, you lend to a a private credit fund or some kind of private investor. They're usually teams of people from very highly regarded companies, you know, your big asset managers like a like a Black Rockck or or something like that. And then those guys then take the money and they lend to other companies.

So, let's say that the company has a default. What happens? Well, uh the private credit lender deals with it. And when the private credit fund has exhausted their resources, then it becomes the bank's problem. So, the bank has this extra layer between them and the ultimate borrower that insulates them from credit risk. And that's the reason why they do it because it's uh from a because there's less risk. It's cheaper. There's less it it costs the bank less capital uh to make that loan uh to the NBFI than it is to the ultimate borrower.

So we have this basically this shadow banking sector that gets his financing from the commercial banking sector and then lends it to the real economy. So it makes the Fed's job more difficult in that it doesn't really know where the money goes, but it makes the banking system safer. And I think that's really what the Fed cares about. Uh because when the banking system fails, you know, that affects everyone. When you have some private credit fund in the shadows that fails, you know that they're not tradable. So they don't really cause panic in the market. And also no one has deposits there. I mean they borrow from wealthy individuals and so forth, but it's not like a systemic event that impacts the broader public.

Yeah. Um, all right, Joseph, can you just give us just a a brief overview of where do you think the the what do you what what are you going to be tracking for the Federal Reserve over the coming weeks and months?

I think the trend this year is less about the Fed, more about what happens with the White House and the AI companies. So, unfortunately, as a Fed watcher, it's just not that important. But if you were to focus on the Fed, it will be about the ultimate composition of the Fed's balance sheet. Whether or not they really will significantly shorten their duration and how quickly will they get there. Will they actually sell securities to get to their final composition? Uh that's what I would be looking for in the next few months.

All right, Joseph. Well, we'll leave it there. Um, people can find you on FedGuy2. Your your excellent writing is at fedgu.com. And I'll also say, Joseph, that next week, so very early November, I will be interviewing a very high-profile guest. Uh, and I by very high profile, I mean very, very important. So, a true VIP, definitely the most powerful and influential person uh, who I've ever interviewed on my show, Monetary Matters, on my previous show forward guidance, in my entire career. And, uh, so people should stay tuned to Monetary Matters in early November. they will want to be paying attention. This is not one you want to miss.

Thanks Jack.