“The normal” was Fed operating policy from 1913 – 2008. The Fed had direct control of the supply of base money and the ability to match it to demand. By direct control I mean when the Fed created or extinguished base money, it directly influenced the relationship between the supply and demand for base money. The Fed creates out of thin air non-interest bearing debt that acts as circulating medium—cash (Federal Reserve notes) and reserves. It can do this by various means, but the primary method since the Great Depression is through the OMO (open market operations) purchase of treasury debt.
The Fed’s supply of base money should directly relate to demand. This is the only way the Fed can maintain direct control over the value of the dollar. In the normal, it is the Fed’s supply of base money relative to demand that determines inflation or deflation. A gold standard eliminates inflation and deflation because it links the dollar with the stable value reference of gold. On a gold standard, supply is adjusted to maintain a link with a fixed dollar price of gold. With fiat, supply is adjusted by whim by a small group of elites meeting in secret eight times a year. This is the PhD standard. The PhD standard ignores base money demand, and the value of the dollar constantly changes. This explains the last 48 years of monetary error since Nixon terminated Bretton Woods and abandoned gold as the monetary reference.
In the normal, it doesn’t matter whether the Fed targets gold, commodities, monetarism M targets, the feds funds rate, the Phillips Curve, dot plots, inflation indexes, or any other academic whim. When the supply of base money changes, it has a direct relationship on demand.
The New Normal
“The new normal” began with the financial crisis of 2008. Fed Chair Benjamin Bernanke presaged the new normal in his speech at Milton Friedman’s ninetieth birthday celebration on November 8, 2002. Bernanke closed his speech with this ominous warning to Fed watchers.
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.
Bernanke’s faux apology was for his long-held academic theory that the Fed could have prevented the Great Depression by injecting liquidity. This theory defined Bernanke’s academic career. The Fed would have had to abandon the gold standard to accomplish Bernanke’s Great Depression theory. Instead of the Great Depression, we would have had the Great Inflationary Depression.
There was no wide-held academic, economic, or political belief during the GD that the gold standard was anything other than a proven and reliable standard for maintaining the value of the dollar. At the onset of the GD, the U.S. had maintained a gold standard since 1792. With a stable monetary foundation, the U.S. rose to the top of the global economic pyramid. It was only after the passing of a half-century that economists began to rewrite GD monetary history. Various schools of economic thought blamed the gold standard for the GD. There are polar opposite views that the GD was due to deflation, while others say inflation. The Fed maintained a dollar fixed to gold at $20.67/oz until 1933 when FDR confiscated gold and devalued the dollar to $35/oz.
The GD Fed error view fits in with today’s academic monetary centric belief that central banks can guide economic growth. It is a fallacy. A central bank can only determine the value of its currency. It is fiscal policy that incentivizes growth. It was fiscal policy that caused the GD. The Smoot Hawley global tariff tax wall caused a fiscal contraction and market collapse. The natural consequence of Smoot Hawley was for prices to fall to liquidate built-up inventory that was no longer in demand. This was an economic contraction, not a deflation. A follow-on decade of Hoover and FDR tax hikes, socialist policy, and monetary devaluation turned the initial contraction into the GD.
Bernanke was good on his Friedman birthday promise. With the onset of the 2008 financial crisis, the Fed used various policy tools to inject massive amounts of dollar liquidity into the financial system and bail out large banks and corporate entities. Excess reserves (ER) that are a function of QE and IOR define the new normal. When the Fed changes base money supply in the new normal, it indirectly changes the amount of ER, which has no direct relation with dollar demand. TBTF banks and U.S. subsidiaries of large foreign banks are the primary holders of ER. The big banks maintain their ER accounts to receive free money from the Fed and comply with the alphabet of regulations created by or delegated to the Fed after 2008. Basel III, LCR, HQLA, RLAP, and Dodd-Frank add regulatory capital requirements that did not exist before the financial crisis.
There was always the underlying assumption that the new normal was temporary and the Fed balance sheet would return to pre-financial crisis normalcy. Normalcy is defined by the elimination of IOR and banks holding only nominal amounts of ER. Nearly a decade passed before the Fed finally began its attempt at normalization with QT, quantitative tightening. The Fed reduced its balance sheet from a high of $4.5 trillion to $3.76 trillion. Prior to the financial crisis, the Fed balance sheet was $0.8 trillion. Normalization ended ignominiously in the market turmoil of December 2018. Market chaos caused the Fed to throw in the towel on further rate hikes and balance sheet reduction. This signaled the beginning of the “new new normal.”
The New New Normal
In the new new normal there is no pretension that the Fed will ever return to a pre-crisis balance sheet. The Fed has entered an era of permanent balance sheet expansion. This is the beginning of the end game for the fiat dollar. A permanent expansion of the Fed’s balance sheet will never allow the Fed to regain control of the supply of base money relative to demand. The Fed is now making it up as it goes along in an attempt to control the monetary Frankenstein that it created and exported to the world with the onset of QE. Monetary stress began to evidence itself in the repo market, with overnight rates rising to 10 percent. The need for continuous daily repo liquidity injections resulted in the Fed announcing QE4.
It is no coincidence that NGDP targeting and MMT are gaining popularity as monetary solutions. Obvious Fed failure leads to even more extreme academic laboratory monetary theories that are the natural progression for a permanent expansion of the fiat dollar. With MMT there is no theoretical limit to base money creation.
Gold remains the antidote for dollar instability and the new new normal because its value remains stable.