Thursday, August 20, 2015

Has the Federal Reserve Made Itself Irrelevant?

The previous Monetary Policy posts explained why the Fed has essentially lost control of the money supply. By "lost control," I don't mean that it's out of control to the upside, but that the Fed simply doesn't control the level of the money supply any longer due to the operational changes they've made since the 2008 financial panic.

How Does the Fed Control Money? Their Answer

The Fed has always operated as though they controlled the money supply and ultimately the price level, i.e., the rate of inflation, by manipulating short term interest rates. If the short term rate was too low, people borrowed more, the economy grew faster, and the money supply and possibly the inflation rate would increase in response. To slow the process, the Fed would raise rates.

Today, under their own view of how monetary policy operates, clearly the Fed has to a considerable extent lost its power to influence economic growth. The short-term rate is essentially zero and has been for years now, but the economy continues along a slow growth path with low inflation. And even to achieve that, the Fed had to augment its normal operating procedures with the QE's.

As some are now beginning wonder, what would the Fed do if the economy slowed today?  With short rates nearly zero, driving them a bit lower is unlikely to change anything. More Quantitative Easing, perhaps? Negative interest rates for savers? Or just admit that the current operating procedures don't work because, clearly, they don't.

How Does the Fed Control Money? The OnTrack Economics Answer

The previous posts on monetary policy described a "strong form" of monetary policy by which the Fed has direct control over the level of the money supply. Following an injection of excess reserves, money grows. Then the economy responds and eventually the price level (inflation) responds. Similarly, withdrawing reserves shrinks money, causes the economy to contract, and puts downward pressure on the inflation rate. This is a model that can be shown to have worked in the past. Furthermore, it's the most obvious operating procedure to deploy in a system of fractional reserves, but one the Fed has apparently never consciously adopted.

Unfortunately, because the Fed chose to implement the QE strategy, it now finds itself in a position where it will be extremely costly (to the Fed itself and, by extension, to the taxpayers) to adopt the approach indicated by the strong form of monetary policy. An earlier post explains how the Fed is now exposed to losses of both portfolio value and annual income on the order of hundreds of billions of dollars should it attempt to return to a time when the level of excess reserves in the banking system averaged just a few hundred million dollars, as would be required to implement the strong form.

The Obvious Conclusion: The Fed Is Now Irrelevant to its Purpose

Sure, the Fed can still cause all sorts of economic mischief. It can leave rates low, penalizing savers, pumping asset markets, and protecting the most massive positive carry trade of all time (on its own books), or it can seek to drive them into negative territory by issuing regulations that deter large banks from taking on additional deposits. Alternatively, it can start raising rates, but to what purpose? The increases it suggests it will take are extremely modest and will have little effect on either the economy or the inflation rate, so why bother, except perhaps to reduce political pressure from savers incensed by ridiculously low interest rates?

Meanwhile, as a testament to the Fed's current irrelevance, the money supply, the economy, and prices, will fluctuate unimpeded by anything the Fed does. The $2.5 trillion of excess reserves in the banking system assures that. If the economy starts to heat up, the reserves are there to permit a rapid expansion of the money supply, an expansion that the Fed will be unable to halt without neutralizing the entire balance of excess reserves. Until those reserves are somehow neutralized the money supply can grow unimpeded, without any sort of a governor to keep it in check. That doesn't mean it will, but it can, and it might.

And if the economy starts to once again contract, they're out of ammunition. The banking system could contract and nothing is in place to halt the contraction because the Fed has rendered the level of excess reserves irrelevant. Ironically, in doing so, the Fed unwittingly made itself irrelevant as well, as we are now seeing.

Perhaps it's finally time to bring this grand, failed, financial experiment to an end and rewrite the Fed's mandate?

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