Monetary Policy: Part 2 - The Stable Decades

This next few posts discuss the operation of monetary policy from WWII through to 1980 when NOW accounts were suddenly introduced. These were the stable decades in terms of the operating environment, although they were anything but stable in terms of the results. The instability of results had nothing to do with the operating system, but everything to do with the operators, for the operators simply didn't understand how the system actually functioned.

The Perceived Role of Interest Rates

For most of the Fed's existence up through 1980 the economic theory relied upon, and espoused, by the Federal Reserve held that the level of interest rates govern economic activity. This remains true to the present day, by the way.

Thus, if the economy was slowing, the Fed would cut interest rates, while if it was growing too fast and inflation was beginning to surge, it would raise interest rates. Actually it would cut or raise the interest rate, that rate being the rate of interest paid on federal funds in the interbank market. The theory essentially states that rising rates will slow economic activity whereas falling rates will encourage economic activity. Of course, this is true as the activity in the housing market often demonstrates. But it's the wrong theory upon which to base the operation of monetary policy. It's a reactionary policy, and therefore too slow, leading inevitably to large swings in economic activity and inflation.

The Essential Role of Interest Rates

There is only one interest rate that really matters to monetary policy, and that rate is zero percent, for that is the one and only rate that should be allowed on all transaction balances, or what we know as demand deposits, or checking accounts. It's also the rate paid on cash, incidentally. No one earns interest on the cash in their pockets, nor should they be permitted to earn interest on balances in their banks that they intend to be used for immediate purchases.

Why is this important? Why is paying interest on checking a terrible idea? Because it renders the operating mechanism of a fractional reserve system useless. And how does it do that? It makes holders of checking account balances indifferent to how much they hold in checking and how much they hold in savings.

When interest was only paid on savings deposits, people rationally minimized their checking account balances, even when interest on savings was relatively low. Some interest is better than no interest, after all. Similarly, they minimized the cash in their pockets. Importantly, this remained true regardless of the level of interest rates on savings. Again, some interest is better than none and a lot of interest is even better yet, but checking accounts and cash were always minimized by their holders. And as long as they were minimized at the outset, the level of interest rates on savings and other alternatives mattered little to monetary policy. The key to an operational fractional reserve system is the minimization of cash and demand balances by their holders.

Where the Fed Erred in the Stable Decades

Because both cash and checking balances earned no interest, the fractional reserve system in place since the Fed's founding could operate as planned. The problem is that the Fed didn't operate it as planned. Instead, because they followed the economic theory that put the cart of interest rates ahead of the monetary horse, and decided to manage interest rates instead of required reserves. But doing so was painfully slow-acting and often just plain wrong. Time after time, the Fed could be shown to have been tightening (raising rates) well after the economy had already gone into recession.

It generally takes four to six months before a recession is even suspected, much less acknowledged. Acknowledgement might take several quarters. Similarly, the Fed can be shown many times in the past to have been easing well after the economy had already been heating back up. The operating policy using interest rates as a lever of policy suffered from too much lag time to be truly effective. In fact, because of that lag time the Fed really never knew if it had tightened enough but would worry that it had and pause in the effort. This often prolonged the entire process until the Fed finally got ahead of things (or so they thought) and the economy would finally slow (with the Fed still in tightening mode several months after.)

What those operating the Fed at the time failed to realize is that they possessed all they needed within the reserve requirement mechanism itself. Interest rates needed no consideration whatsoever, other than the need to keep short term rates somewhat positive at a minimum, a trivial exercise given their control over the fed funds market.

The next post or two will seek to explain how monetary policy actually operated in the stable decades. Without the Fed's knowledge, it was exceptionally effective at producing the results obtained during that time. That the results were less than optimal is no fault of the operating system, for it performed exactly as programmed by the operators at the time.

Continue to Monetary Policy: Part 3 - The Stable Decades (cont.)

Monetary Policy Theory: Part 1 - Fractional Reserves

The next few posts will describe the operation of monetary policy prior to late 1980 when NOW accounts were first widely authorized. NOW accounts enabled banks to begin paying interest on demand deposits, that is, on what were essentially just checking accounts. Prior to the authorization of NOW accounts, checking accounts could not draw interest. NOW accounts were a concession to the rapid growth in money market accounts during the high-interest era of the late 1970's.

How a Fractional Reserve System Works

Under a system of fractional reserves each bank is required to hold a certain percentage of its deposit base in the form of reserves at the Federal Reserve System. For example, if the only form of deposits were checking accounts (demand deposits) and the reserve requirement was 10%, then a bank with demand deposits of $1 million would have to deposit $100,000 at the Fed in a "Required Reserve" balance.

Now assume that only demand deposits are permitted and that the reserve requirement is 10%. If total demand deposits in the system are $10 billion, then the required reserves at the Fed would have to be $1 billion. But the Fed can change the level of reserves in the system at will. All it has to do to add, say, $10 million in reserves, is purchase that dollar amount of securities from the banking system. The bank sends in the securities to the Fed and receives a $10 million increase in its reserve balance at the Fed in return. Because those reserves are not currently needed to be held against deposits they are considered "excess reserves."

And, since the bank doesn't need that additional $10 million as required reserves, it lends out the money either to a customer or by lending it in the fed funds market. As the money circulates from bank to bank, and from customer to customer, and as the economy grows, eventually the total demand deposits in the banking system will rise by $100 million and the $10 million in excess reserves would be converted to required reserves. Thus, by adding reserves to the banking system, the Fed will have allowed the overall banking system (and perhaps the economy) to grow. This is known as a Fed easing.

Effecting a Tightening

To reverse the process, perhaps to cool off an overheating economy or to suppress a rising inflation rate, the Fed withdraws required reserves from the banking system. It does this by selling securities from its portfolio to a bank in the system. Say the Fed wants to reverse the above action. It then sells $10 million of it securities to a bank in the system. The bank takes in the securities and to pay for them has its balance of required reserves at the Fed reduced by $10 million.

Now the banking system has a deficit of required reserves. If the Fed refuses to accommodate that deficit, interest rates will tend to rise and banks will make less loans because they are scrambling for reserves. Ultimately, the deposits in the banking system will diminish to the point where the lower level of reserves is sufficient to meet the reserve requirement.

In theory, this is how a fractional reserve system is supposed to work. That is, to keep the money supply, and consequently the price level of goods and services, stable, the Fed simply provides a constant level of reserves.

Complications

The first complication is that all deposits aren't demand deposits. In fact, savings deposits used to be commonly called time deposits to distinguish them from demand deposits. Each holder of a savings account received clear notification when opening an account that the money couldn't necessarily be withdrawn on less than a few day's notice. Demand deposits, in contrast, could be withdrawn (demanded) immediately.

Because time deposits were judged to be a more stable component of the deposit base of any bank, the Fed set a lower reserve requirement on them. In our present example, let's say that's only 2%. When interest rates were low as was the case for most of the Fed's existence up until the late 1970's, savings balances did remain quite stable, growing along with the economy and not reacting to the level of interest rates.

Once interest rates started rising significantly in the 1970's people started looking for ways to maximize the income on their checking balances. Mutual funds began offering Money Market Funds to people in response. In the beginning, they only permitted the withdrawal of relatively large sums at one time, say $500 or $1,000, so that people wouldn't use them in place of their traditional checking accounts.

However, in time the banks managed to convince the regulators to let them compete with money market funds. That led to the introduction of NOW accounts which were essentially interest-bearing checking accounts with some modest restrictions. Once they came onto the scene most people converted their checking accounts to NOW accounts and many blended both their checking and savings accounts into one NOW account instead.

The Problem Posed by Differing Reserve Requirements

Because NOW accounts were really a blend of demand deposits and savings (time) deposits, they more or less destroyed the fractional reserve system in place until that time because of the differing reserve requirements on demand deposits and savings deposits. Suddenly savings deposits weren't stable anymore. Instead they were mixed in with interest-bearing checking accounts. Furthermore, as will be discussed later in more detail, checking accounts (demand deposits) were no longer minimized by their holders since they now earned interest. That, as will be covered in the next post, had major negative implications for monetary policy as it had been conducted up to that time.

The next post will discuss the period between WWII and the introduction of NOW accounts and will describe how the Fed once had a monetary tool that worked exceptionally well, but let it slip out of their grasp with the introduction of NOW accounts because they never actually understood how it worked. In fact, if they had understood, NOW accounts would never have been authorized and money market funds would have had their usage in daily transactions restricted.

Continue to Monetary Policy: Part 2 - The Stable Decades

The Fed's Massive Conflict of Interest

What explains the Federal Reserve's reluctance to raise rates today? The conventional wisdom is that the economy remains soft and inflation hasn't yet shown signs of increasing. While both of these points are to an extent true, the soft economy could well be at least partly due to the serious hit that retirees have taken to their portfolio of fixed income investments, including the near-zero income they've earned on their typical Certificate of Deposit portfolios for the past six years.

Meanwhile, the current administration continues to pile regulation upon regulation to hamstring healthy industries while doing little to encourage economic activity otherwise.

As for inflation, it clearly hasn't spiraled out of control as feared by many monetarists, including myself, although I will argue in a future post that the Fed has relinquished its control over the price level by implementing its recent policies of paying interest on reserves, driving the fed funds rate to near zero, and expanding excess reserves into the trillions (from a few hundred million dollars previously, skipping right past the billions.)

The Conflict the Fed Now Faces: Huge Losses When Rates Go Up

First, let me say that I'm not going to do the sort of research that needs to be done to accurately quantify my claims here. No one is taking this issue seriously yet, so that level of examination of the problem is not yet needed. Others will do it should this conflict finally be taken seriously.

It's sufficient to say that the Fed's current portfolio of long-maturity debt instruments will take a significant hit if they ever return short rates to a reasonable level of, say, 5%. On a long treasury, the hit could be on the order of 25% to 35% of the Fed's original purchase price. And if inflation were to head toward 5% the resulting 8% or so rate on long treasuries could drive the loss to well over 50% of their purchase price.

If we assume the Fed's portfolio has $3 trillion of long securities subject to just a 25% loss in value from their purchase price, the loss would be $750 billion. Now, the Fed has been making money for the past several years by means of a massive carried interest trade since they've effectively financed their long portfolio with funds bearing almost a zero cost, i.e., the fed funds rate. Again, assuming a $3 trillion portfolio yielding, say, 3%, would mean that they've been clearing almost $100 billion per year on their position.

Incidentally, one argument that could be made for the Fed's reluctance to raise rates the past few years it that they want to bank that $100 billion per year for as long as possible so that they have a defense against the criticisms they will receive  over their inevitable losses when they someday are forced to raise rates.

Interest on Reserves Will Aggravate the Losses

The conflict deepens when the relatively new policy of paying interest on reserves is considered. There are only two obvious ways to neutralize the impact of over $2.5 trillion in excess reserve in the banking system. The Fed can either drain them or pay banks to continue to hold them.

Obviously, if they attempt to drain the reserves, they will have to commence selling their massive long portfolio. Such an action would further drive down prices of the securities they still hold, deepening the losses described above.

More likely, however, the Fed will decide to continue paying banks to hold their excess reserves. Currently banks receive a nominal rate, 0.25% (1/4 of one percent) to hold the over $2.5 trillion in excess reserves. That still amounts to a cost to the Fed of over $6 billion a year, however. But if the Fed were to raise rates by 1%, to 1.25%, each increase of said 1% will cost the Fed $25 billion in fees they would have to pay the banks to continue holding their excess reserve balance. Otherwise, they would simply sell them in the fed funds market.

Of course, banks attempting to liquidate $2.5 trillion in reserves they don't need would drive the fed fund rate back to zero again. Therefore, the Fed absolutely must either drain those reserves or pay the banks a high enough rate to continue to hold them. Thus, a 5% funds rate would imply that the Fed must assume a $125 billion annual operating expense if they are to neutralize the current excess reserve balance.

Conceivably, the Fed could do a massive reverse repurchase operation wherein they would lock in a longer-term rate for a time, alleviating the initial impact on their income statement. That is, they might convince the banking system to hold, via a, say, one-year repurchase agreement priced at 1%, the Fed's security portfolio, thereby draining the excess position for a year at a cost of only $25 billion. However, if rates at the end of that year were, say, 5%, the cost of a repeat operation would put the cost up to the $125 billion level for the following year.

Conclusion

The Federal Reserve has created a situation, via the various QE's, that now saddles it with a massive conflict of interest should they need to raise rates. That conflict is comprised of two parts, both parts amounting to hundreds of billions of dollars each in conceivable costs to the Fed.

It would not be at all hard to conceive of a situation in which the Fed's long portfolio is $500 billion underwater all while they are paying the banking system over $100 billion per year to neutralize the excess reserve position they generated when purchasing that long portfolio. One would think that prospect has received some internal consideration when the discussion of raising the fed funds rate comes up.

What is surprising is the lack of any such consideration in the financial markets and the political world. This is especially ironic since it has been the U.S. Treasury's intent to lengthen the maturity of the public debt at this time of exceptionally low interest rates, and yet the Fed has effectively reversed that decision by implementing its massive QE's.

Sadly, the policy hasn't even worked out as intended, enriching bond investors, stock investors, art investors, and real estate investors, but doing little to get the economy and the job markets growing again. And yet it continues. Perhaps the above-described conflicts have more than a little to do with that?