Monday, July 27, 2015

Beginning Again

It's been over six years since the last post I made here at OnTrack Economics. Whether this post is the beginning of a new series, we'll have to see, but if it is here's what I hope to accomplish:

1. Explain what has happened to monetary policy options since my last post in 2009.

2. Explain the box the Fed now finds itself trapped within.

3. Explain the theory of monetary policy that the Fed abandoned.

4. Describe a better, strong form theory of monetary policy that should be used instead.

5. Attempt to explain how the former monetary policy control levers might be restored, in time. 

Changes in Monetary Policy Since 2009

Taking point #1 as the remainder of this post, the Federal Reserve essentially abandoned the normal means of controlling total reserves and the money supply when it

a) started paying interest on reserves,

b) allowed the fed funds rate to go to essentially zero percent, and

c) instituted the process of Quantitative Easing that goes by the acronyms QE1, QE2, and QE3.

Interest on Reserves

When the Fed started paying banks interest on the reserves they hold to back deposits, they in effect disabled their ability to generate controlled monetary growth. Prior to doing so, a small change in the balance of excess reserves in the banking system, on the order of a few hundred million dollars, always affected the amount of money in the banking system. Today, the existence around $2.5 trillion of excess reserves in the banking system clearly indicates that the system no longer reacts to the level of excess reserves.

Driving the Funds Rate to Zero

The Fed, and many monetary economists as well, assume that there is a zero boundary problem that crops up whenever the economy will not support a positive interest rate. When, no matter how low the Fed drives the fed funds rate, the money supply and economy fail to improve, zero is eventually reached, according to this thinking. And at the zero boundary it is no longer possible to drive rates lower, so the Fed loses it's ability to grow the economy by driving an increase in the money supply.

Side note: In fact, after several years of zero rates now, some central banks have indeed learned that rates can drop below zero with the proper inducements, such as charging a fee for holding deposits, rather than paying interest. This is a novel concept, sort of a new and improved mattress, if you will. That is, don't put that billion dollars under your mattress where you could lose it. Instead, deposit it with us and we will ensure that you get at least 99.5% of it back in one year's time. Well, a billion is a lot to mess with, so some institutions have done just that.

And still, monetary policy has been frustrated. What to do?

Enter the QE's, #1, #2, and #3

Finally, the powers that be at the Federal Reserve decided that if you can't get the economy revived with a zero short rate, then they should get to work on long rates. The net result is that the Fed's portfolio now contains trillions of dollars in long maturity debt including the lion's share of most long maturity U.S. Treasury issues.

But while Quantitative Easing has done wonders for the stock market, the bond market, the art and other collectible markets, and has even got houses selling like it's 2006 again, the economy remains soft and inflation shows no sign of accelerating, thereby giving the Fed little reason to raise rates under its monetary model.


Unable to justify a continual transfer of the bulk of the long treasury market to the Fed's portfolio given the failure of three such episodes to generate economic growth, and unable therefore to justify a return to a more normal level of fed funds, the Fed just sits and waits, promising that a tiny rate increase will be due soon. (The definition of "soon" is apparently somewhat loose at today's Fed, however.)

The next post will explain the box that the Fed now finds itself trapped within, and why "soon" really means "not until we really have to."