Fed Normalization

The Fed learned from the taper tantrum that in our hybrid central bank commanded/market economy it is best not to surprise the market.  This requires notifying the market far in advance of any change in Fed policy.  The Fed has rolled over maturing securities and reinvested principle since it ended QE in October 2014.  This policy has maintained the Fed balance sheet at approximately $4.4 trillion with excess reserves around $2.1 trillion.  The Fed wants to normalize and return to a traditional balance sheet.  To do this requires removing excess reserves.  The Fed is now firing advance balance sheet reduction PR shells in an attempt to soften the market beachhead for its normalization landing.  

In its Addendum to the Policy Normalization Principles and Plans as adopted effective June 13, 2017, the Fed added details to its normalization intentions.

“The Committee intends to gradually reduce the Federal Reserve’s securities holdings by decreasing its reinvestment of the principal payments it receives from securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps.” 

The Fed details the specific amounts and their scheduled increase over time.  There are a couple of caveats to the Fed’s normalization plan.  The Fed plans to begin balance sheet reduction

“…once normalization of the level of the federal funds rate is well under way.” 

There is no defined meaning for what normalization of the level of the federal funds rate means.  This falls into the current debate among competing theories for Fed policy about a natural rate of interest.  The Fed desires that the federal funds rate approach the natural rate of interest.  The only problem is, nobody has any idea what it is or how to determine it.

If the Fed returned to stable money based upon the reliable reference of gold, the market would set the funds rate—as it did from the Fed’s creation until 1971—which would automatically be the natural rate of interest.  Millions of people making decisions every second in a free market are much more adept at determining the correct, natural price of interest than a handful of Ph.D academics descended down from an ivory tower to centrally manage markets.

The second caveat to normalization is:

“However, the Committee would be prepared to resume reinvestment of principal payments received on securities held by the Federal Reserve if a material deterioration in the economic outlook were to warrant a sizable reduction in the Committee’s target for the federal funds rate.”

In other words in the event of markets acting like markets and actually declining, the Fed will default to the only thing it knows how to do, print more money. (See Fed Rate Hikes II)  This goes back to Janet Yellen’s answer in her December 16, 2014 press conference that the purpose of funds rate hikes is so the Fed can lower them in the event of another financial crisis.

The absurdity of Yellen’s answer should be abundantly clear.  The Fed is not tightening by raising the federal funds rate.  The Fed’s balance sheet has remained at $4.4 trillion since October 2014 despite four funds rate hikes.  Gold has risen $200/oz since the Fed began funds rate hikes in December 2015.  A rise in the dollar POG is always a sign of a weaker dollar.  If the Fed is not tightening by raising the funds rate, it cannot loosen by lowering it back to zero.  Only when the Fed removes excess reserves can it directly affect the balance between the supply of base money relative to demand, i.e. tighten or loosen.  Yet, almost all mainstream financial commentary is now discussing potential Fed error from tightening in a slowing economy.  At least they are able to recognize a slowing economy among distorted, rigged hindsight data and perpetually rising market indices. Instead, Fed funds rate hikes are causing a flattening of the yield curve, a traditional indicator of recession. 

The Bank of International Settlements BIS has issued a warning that central bank policy coordination is necessary to reverse the global liquidity flood.  Despite its adherence to the Ph.D standard of CB management, the BIS at least has a clue that there is an end limit to fiat money creation as a means to stimulate growth.  

“These challenges strengthen the case for enhanced central bank cooperation during normalisation. Depending on the severity of the spillovers and spillbacks, enhanced cooperation can take different forms. At a minimum, it could involve close dialogue so as to reach a better understanding of the perceived trade-offs, the reasoning behind decisions and the consequences of those decisions across the world.”

Meaning, the BIS along with everyone else has no idea what will happen when the great monetary liquidity flood experiment comes to an end, but central banks better damn well start talking to each other.

The PBOC links the renminbi to the dollar (with occasional, minor re-pegs) so it will directly import the Fed’s balance sheet reduction.  The ECB and BOJ are still expanding their balance sheets at the combined rate of $200 billion a month.  Something among central banks will have to give if the Fed begins reducing its balance sheet.  The dollar, as the world’s reserve currency, drives international monetary policy in a fiat world.

The good news is that there is nothing to worry about.  Yellen just announced that we will not have another financial crisis ‘in our lifetimes’.  This would define hubris, if delusional was not a word.         

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