Financial media, pundits, economists, government officials, and pretty much everyone else continue to categorize rate hikes as if the Fed were still conducting policy under normalized, traditional operating procedures. Bernanke tore asunder normalized Fed operating procedures after the 2008 financial crisis. The result is a quintupling of the Fed’s balance sheet to $4.4 trillion and an explosion of excess reserves from a nominal $2 billion to $2 trillion. This is not your dad’s Fed.
In normalized Fed operating procedures, there is a balance between the Fed’s creation of base money and the economy’s demand for base money. Base money is cash and reserves that support the economy, backed up by required reserves mandated by regulation. Under normalized operating procedures, the Fed can alter this balance by creating or extinguishing base money through open market operations. The Fed targets indicators to determine when to create or extinguish base money. Traditionally this has been a fixed price of gold, monetary aggregates, or the funds rate. After 2008 traditional Fed operating procedures went out the window. Congressional legislation gave the Fed the ability to pay interest on reserves IOR, and Dodd-Frank gave the Fed new regulatory power over depository institutions. Wielding these powers, the Fed exploded the monetary base. The Fed created $3.6 trillion of new base money buying treasuries, agency debt, and MBS. This lowered interest rates to the zero bound. Gold ran up to $1900 in tandem with expected runaway inflation. What eventually became apparent is that a large portion of the newly created base money would remain locked out of the economy indefinitely as excess reserves. Banks got free money in the form of IOR in return for complying with the Fed’s regulatory desires on lending. Gold sold off in line with the monetary base that remains locked out of the economy.
The funds rate hikes that began in December 2015 are not equivalent with previous funds rate hikes. Yet, all financial and economic commentary are treating them the same. Since Oct 2014, the Fed has maintained “its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way.” Previously the Fed changed the funds rate with the intent of changing its balance sheet, i.e. to create more or less base money. When the Fed tightened, its balance sheet contracted, or it reduced the supply of base money relative to demand, and when the Fed loosened, it did the opposite. Now when the Fed raises the funds rate that historically tightened, the only real thing it influences is the amount of excess reserves held. The size of the Fed’s balance sheet remains the same under its reinvesting and rolling over policy. This is why, since the first funds rate hike in July 2015–despite the misnomer of Fed “tightening”, the POG has risen. The POG is tracking the optimum price of gold duration level.
There are four things that affect the amount of excess reserves held.
- Cash in circulation
- Economic activity
- Fed reverse repo, RRP
- Treasury deposits held at the Fed
When the Fed raises the funds rate, it may change the dynamic between the four events in relation to each other. What the Fed is not doing is contracting its balance sheet, or tightening.
Total reserves as of March 15, 2017 is $2.35 trillion. When the Fed raises the funds rate, it has to also raise the interest it pays on reserves by a like amount. This is the only way with excess reserves that the Fed can manipulate the funds rate up. The Fed also has to manipulate the shadow banking lending rate by the same amount. It accomplishes this through RRP. The result of the Fed’s perverse monetary policy is a transfer of roughly $23.5 billion to depository institutions–almost half of which are U.S. subsidiaries of foreign banks–in the form of IOR, at a funds rate of one percent. It’s a great deal if you can get it. The Fed creates money out of thin air, shoves it into your account, then pays you to not lend it. Each subsequent rate hike increases the incentive for banks not to lend. Why risk a loan to the economy when you can receive risk-free money for doing nothing?
Yellen hinted at what the real purpose of rate hikes without normalization is in her December 14, 2016 press conference. When asked by Justine Underhill under what circumstances would the Fed wind down its balance sheet, Yellen in part answered,
“We want to feel that if the economy were to suffer an adverse shock, that we have some scope through traditional means of interest rate cuts to be able to respond to that. Now, there’s no mechanical rule about what level of the federal funds rate we might deem appropriate to begin that process (Normalization). It’s not something that only depends on the level of the federal funds rate. It also depends on our judgment of the amount of momentum in the economy and possible concerns about downside risks to the economy.”
Yellen stated that the Fed wants to raise interest rates for the purpose of lowering them in the event of another financial crisis. But if the Fed is not tightening by raising the funds rate, it won’t ease by lowering them in the next financial crisis. What then? When the string finally runs out on the efficacy of funds rate manipulation with a distorted balance sheet, the PhD Fed will have to come up with something new. This is what demand-side Keynesian PhD economics looks like as it approaches the outer limit of errant theory put into practice.
For further background on funds rate manipulation with excess reserves see Man on the Margin Fed Rate Hikes and Excess Reserves.