The clearest way to understand current Fed policy and its effect on markets is to view it through interest rates. Interest rates are the price of credit. Credit is not money. When a bank creates credit, it does not create money. Credit is a contract denominated in dollars. At the end of a credit contract, no new money is created. Therefore, the creation of credit is neither inflationary nor deflationary. The only bank that creates money is the Federal Reserve. The 1913 Federal Reserve Act established the Fed’s power to create money. The Fed creates money by purchasing assets with money created out of thin air. Congress gave the Fed a “magic checkbook.” The Fed creates money through open market operations (OMO). In normal Fed OMO prior to 2008, the Fed purchased interest rate bearing assets—traditionally short-term U.S. Treasuries. In this case, the Fed exchanged non-interest bearing assets created with its “magic checkbook”—cash and reserves—for interest-bearing assets—U.S treasury bonds. This is how the economy’s required exchange medium, dollars, come into circulation. Cash and reserves are base money. This is the only way that money comes into existence. Fractional reserve banking does not create money. It creates credit. The Fed’s balance sheet expands with its asset purchases. The Fed can also shrink its balance sheet by reversing the process and selling assets. When the Fed sells assets it extinguishes money.
While interest rates are the price of credit, the price of money is its purchasing power. Purchasing power is stable when inflation and deflation are non-existent. To eliminate inflation and deflation requires a monetary standard. Inflation and deflation have the same definition. They are a decline in the monetary standard. Gold has proven itself as the monetary standard over millennia. The Fed ignores the monetary reference of gold and continuously errs by creating too much money or too little money. Purchasing power changes along with changes in the value of the dollar. Despite occasional deflationary bouts, the Fed is overwhelmingly inflationary. Since 1971 when the Fed abandoned gold as the monetary standard, the dollar has lost 97 percent of its value. Inflation and deflation have nothing to do with how many people are working or how fast the economy is growing. Inflation and deflation result when the Fed errs in its primary legislated role to maintain the value of the dollar. To match the supply of base money to demand requires targeting gold as the monetary standard of reference. Instead, the Fed wanders down monetary rabbit holes like the Phillips Curve. The Phillips Curve posits a trade-off between employment and inflation. The Fed also views economic growth as inflationary. In bizarro Fed world, lots of people working and economic growth are bad.
With a decline in money’s purchasing power,—inflation—individuals are more reluctant to extend credit. Contracts require added risk premium to compensate for changes in purchasing power. The price of credit increases with increased interest rates. The stagflation 1970s defined rising interest rates combined with declining purchasing power. Until the 2008 financial crisis, the market set the price of credit the same as it set any other free market price.
This changed after the financial crisis. The Emergency Economic Stabilization Act of 2008 allowed the Fed to pay interest on reserves. The practical effect is that the Fed can buy unlimited assets and depository institutions will withhold a significant portion of the newly created money as excess reserves for which they earn interest. It is free money for banks. The Fed’s balance sheet composition changed from safe, short-term Treasuries to longer-term Treasuries and mortgage-backed assets. Through the expanded purchase of interest rate sensitive assets, the Fed drove interest rates to the zero bound. Negative interest rates, unheard of when the market sets the price of credit, became the new normal.
The price of credit is the primary signal that allows a free market to efficiently allocate resources. When the Fed manipulates the price of credit, all market signals get distorted. Capital flows from where it is most productive to where manipulated interest rates reward it. Those closest to the levers of power, big banking and corporate institutions, get first access to distorted capital over entrepreneurs and small businesses—the lifeblood of an economy. Banks, primarily the too big to fail, receive free money in the form of interest on excess reserves. Interest rates manipulated to the zero bound incentivize stock buybacks, M&A, foreign exchange trading, interest rate derivatives, carry trade, and any other form of financialization over future productive investment. New businesses coming into the marketplace via IPOs are a sign of a healthy economy. IPOs have virtually dried up since 1995. Capital misallocation shrinks the investment timeline from the future to the immediate and economic growth stagnates. This is the hypertrophy of finance described by George Gilder in The Scandal of Money. Financialization has become the world’s biggest industry with traders churning $5.3 trillion of central bank created monetary chaos daily. None of this acts as a positive force to advance the productive economy. Central bank manipulation is a dead weight anchor on the productive economy.
Based on market indices, central bank manipulation of the price of credit appears successful. Since 2008, market indices have risen in parallel with central bank money creation. (Indices also rise with a reduction in exchange-listed companies and shares outstanding. Shares outstanding are half the amount of the mid-1990s and the number of public companies has declined over the same period.) Market indices flatlined in February 2018 soon after the Fed started its normalization policy to remove excess reserves. When viewed from fundamental economic indicators, QE and manipulated interest rates have achieved economic growth well below historical norms.
Central banks are finding that they have no way to extract themselves from their liquidity flood interest rate manipulation. The December 2018 market volatility forced Fed Chairman Powell to announce the end of fed funds rate hikes and presumably normalization. Capital misallocation distortion and resultant debt cannot withstand rising interest rates. Central banks will have to maintain interest rate manipulation indefinitely. This is not compatible with normalization. The Fed reached a point in normalization where a continued reduction in excess reserves resulted in rising interest rates and concurrent volatility. The greater the Fed shrinks its balance sheet, the more the market determines the price of credit. A decade of capital misallocation based on manipulated interest rates cannot withstand a return to market set rates.
A frequently used metaphor is that central bank QE and manipulated interest rates are monetary heroin. It resulted in indices highs but requires a continuous monetary fix from the Fed to maintain the highs. The Fed attempted normalization but gave up at the first sign of the market’s December 2018 volatile withdrawal sickness. Like its pharmaceutical counterpart, Fed monetary heroin eventually subsumes the host body and renders it into complete dependency.
In Part II, I will take a detailed look at how Fed policy is attempting to normalize its balance sheet and the intellectual constraints that prevent it from getting there.