A Trapped Fed II

The Fed creates money based on a monetary standard.  Think of a monetary standard as the Fed’s carburetor that regulates how much liquidity gets injected into the economic engine.  To maintain a standard requires adjusting base money supply to hit a specific target.  Prior to 1971, the U.S. was on a gold standard and the Fed targeted a fixed dollar price of gold, $35 per ounce.  After the 2008 financial crisis, the Fed abandoned any semblance of a fixed standard and defaulted to what Jim Grant terms the Ph.D. standard.  The Ph.D. standard is as malleable to academic whim as the gold standard is rigid in proven stability.  A handful of Fed academics flit wherever the economics wind takes them.  The Fed is now making it up as it goes along.

Regardless of the monetary standard, the Fed can only hit one target at a time.  It can’t shoot its sole monetary arrow—maintenance of the value of the dollar—into two targets.  The Employment Act of 1946 and the Full Employment and Balanced Growth Act (Humphrey-Hawkins) of 1978 formalized the Fed’s “dual mandate” of stable prices and maximum employment.  The Acts require the Fed to hit two targets with one arrow.  The ongoing money mischief from 1946 forward can be traced back to this dual mandate.  The Fed attempts to hit its employment mandate with “easy money” which conflicts with its stable money mandate.  The Employment Act of 1946 was a key element to what eventually blew up Bretton Woods.

The Fed used its monetary arrow to target gold during Bretton Woods, monetary M aggregates during Friedman’s monetarism, the funds rate after abandoning monetarism, and interest rates since the 2008 financial crisis.  The Fed attempts to achieve its dual mandate by fiddling with the value of the dollar to stimulate economic activity but ends up accomplishing neither.  The result is 1970s stagflation, 1997-2001 deflation and the Asian crisis, 2008 financial crisis, post-2008 secular stagnation, and today’s trapped Fed that cannot exit from its QE monetary experiment.

IOR (interest on reserves) allowed the Fed to purchase large-scale assets (LSAP), drive interest rates toward the zero bound, quintuple its balance sheet, and create massive excess reserves (ER) without the expected inflation.  This disconnected the traditional direct relationship between a change in base money supply and demand.  Yet, most economic commentary assumes this relationship still exists.  A hike in the funds rate is assumed to directly change the supply of base money relative to demand.  It doesn’t.  The Fed affirms this in its November 8, 2018 minutes.

The staff highlighted how changes in the determinants of reserve demand since the crisis could affect the tradeoffs between two types of operating regimes: (1) one in which aggregate excess reserves are sufficiently limited that money market interest rates are sensitive to small changes in the supply of reserves and (2) one in which aggregate excess reserves are sufficiently abundant that money market interest rates are not sensitive to small changes in reserve supply.

Prior to 2008 and IOR, banks held required reserves with only nominal amounts of excess reserves.  It was a cost to banks to hold excess reserves.  With the onset of QE, the Fed began creating excess reserves with LSAP.  It paid interest on the excess reserves.  With few excess reserves, there is an opportunity cost—based on their balance sheet—on whether banks choose to hold them.  As the Fed increases excess reserves, the opportunity cost decreases until it declines to a flat line.  (It is depicted by the blue line in the below graph.)  The Fed terms this the saturation point.  Between zero/nominal excess reserves and the saturation point, the supply of base money retains a decreasing relationship with demand.  Beyond the saturation point, the relationship does not exist.  Any new supply is simply additional ER that the Fed can create in theoretically unlimited quantity.  Therefore, the opportunity cost for ER beyond the saturation point becomes negligible.  Banks can hold them in any amount and earn IOR.  There is no long-term bank demand for ER.  ER is a residual product of IOR and Fed QE policy that the Fed forced on depository institutions.  It is a distortion of the Fed’s traditional operating mechanics going back to its creation in 1913.  The last time prior to 2008 that other than nominal ER was held was during the Great Depression.    

Graph depicting the relationship between excess reserves and their opportunity cost.  The vertical axis is the opportunity cost of holding excess reserves.  The horizontal axis is the amount of excess reserves.  Vr is required reserves.  Vs is the saturation point.

The Fed created $2.7 trillion excess reserves at its peak.  Normalization shrinks the Fed’s balance sheet through a decline in excess reserves.  The Fed expected that it would taper normalization when it reached the saturation point with around $1 trillion of excess reserves remaining.  The December 2018 market volatility changed the Fed’s estimate.  The Fed now believes it will need a large buffer of excess reserves beyond the saturation point.  The Fed explained it in its December 18, 2018 minutes.

However, reducing reserves to a point very close to the level at which the reserve demand curve begins to slope upward (saturation point: my addition) could lead to a significant increase in the volatility in short-term interest rates and require frequent sizable open market operations or new ceiling facilities to maintain effective interest rate control. These considerations suggested that it might be appropriate to instead provide a buffer of reserves sufficient to ensure that the Federal Reserve operates consistently on the flat portion of the reserve demand curve so as to promote the efficient and effective implementation of monetary policy.

In other words, the Fed believes it is already near the limit of normalization.  Cleveland Fed President Loretta Mester warned the market of this change on Tuesday, Feb 12.  Guided by Keynesian demand-side theory, the Fed will never return to traditional pre-2008 monetary policy.  Already, Fed officials are floating trial balloons of negative interest rates and new QE LSAP to manage the next crisis.  This is the new monetary normal.  The Fed will maintain ER, IOR, and a distorted balance sheet indefinitely.  Powell reiterated this belief in his January 30, 2019 press conference. 

The implication is that the normalization of the size of the portfolio will be completed sooner, and with a larger balance sheet, than in previous estimates.

There is no reason for the Fed’s abnormal QE monetary experiment to exist.  It is unnecessary and destructive.  The Fed can’t extract itself from the monetary corner it has painted itself into because it ignores the only true monetary standard, gold.

If the Fed can’t normalize, neither will the other major central banks.  Central banks will perpetually intervene in markets to attempt to hold the global monetary system together.  We are all the Bank of Japan now.

In Part III, I will look at Fed operating mechanics in the new normal.

A Trapped Fed 

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