September 9, 2024 | Updated | Apparently the Fed has decided to end the battle against inflation a little early, a remarkable development given that the central bank has barely reduced the level of bank reserves and home prices have not fallen significantly. Yet the fact is that the Fed is unwilling to reduce liquidity for fear of causing another systemic market event a la December 2018 or March 2020.
Even though the Fed goosed home prices with a sharp decrease in interest rates from 2019 to 2022, for example, bank reserves are essentially where we started pre-COVID. Indeed, the Fed tightening cycle this time around has not even stopped the appreciation of existing homes and land.
“It’s been a funny such cycle to say the least,” writes Simon White of Bloomberg. “Chastened by the repo-market flare-up in 2019 that put an end to its last attempt to shrink its balance sheet, the Fed’s current tightening cycle has proceeded along different lines. In fact, from the market’s perspective there has arguably been no tightening as reserves – a primary determinant of market liquidity – are unchanged since QT began in June 2022.”
Lest we forget, the collapse of the Treasury market in March 2020 was a seminal event that has forever changed the way that the Fed conducts monetary policy. Yet few market observers or economists are even aware of the messy details. Lev Menand and Joshua Younger described the scene facing the Treasury in an important 2023 paper for Columbia Law School:
“In March of 2020, as the COVID-19 pandemic spread, Treasury markets became so impaired that simple transactions were difficult (if not impossible) to execute. Prices dropped rapidly even as investors moved toward, not away from, low-risk assets. A financial crisis loomed. To prevent what some warned could be a catastrophe rivaling the 2008 collapse, the U.S. monetary authority, the Federal Reserve, intervened with a massive program of “market functioning purchases.” It bought more than $2 trillion of Treasuries and offered to finance trillions more as part of an unprecedented and open-ended commitment to stabilize the market. Although the effort was successful, it raised questions about the line between money and debt issue as mechanisms of public finance, and whether there in fact was one at all.”
The official view of monetary policy from the Fed and other central banks does not make room for what is the elephant in the room, namely the US Treasury and the federal deficit. When the Treasury is creating so much new “near money” in the form of short-term government debt, the idea that the Fed can combat inflation by merely changing the target for Fed funds is laughable. John Cochrane describes the official view of Fed policy, real and imagined, in his latest survey of the monetary policy world:
“There is a Standard Doctrine, explained regularly by the Fed, other central banks, and commentators, and economics classes that don’t sweat the equations too hard: The Fed raises interest rates. Higher interest rates slowly lower spending, output, and hence employment over the course of several months or years. Lower output and employment slowly bring down inflation, over the course of additional months or years. So, raising interest rates lowers inflation, with a 'long and variable' lag.”
Cochrane notes that Monetarist theory requires that money and Treasury bonds be distinct assets. But is this true? Menand and Younger make a compelling case that the fiat currency first created by President Abraham Lincoln to finance the Civil War and Treasury debt are essentially interchangeable. That is, we're all 100% MMT right now when the Treasury is in deficit. Thus how can the Fed profess to control the “money supply” when the Treasury is issuing trillions of dollars a year in new "near-money" debt? Good question.
To believe the Fed’s claim to be able to control inflation, you must accept the claim by all of the major central banks, Cochrane notes, that they can control inflation by merely raising interest rates without any money supply control. Since 2008 and the start of massive asset purchases by the Fed, the central bank has largely lost control of its balance sheet. Thus when Powell and other FOMC members talk about tapering the runoff of the Fed's balance sheet, the correct reply is: "What runoff?"
It is useful to recall that the Fed used to depend upon a chief transmission mechanism – housing – to control economic activity and deflation. The policy mistakes made by the Powell FOMC in 2018 and 2020 have contributed to boosting home prices 40% in the past four years, a massive increase of consumer inflation that has not been addressed by the Fed’s modest tightening. The Fed has been unwilling to use deflation to fight rising prices since the FOMC under Alan Greenspan.
The unspoken issue for the Fed, however, was whether elevating the cost of buying a home by raising the cost of finance was having any impact on home prices. In such a scenario, the fact of higher funding costs might actually be inflationary and impact the final cost to consumers as lenders tried to limit losses on loans. Lenders have been giving consumers subsidies on new loans, creating market risk in exotic servicing assets now as interest rates fall.
The other issue created by the Fed's actions is the lock-in effect on the 60% of all homeowners that refinanced during COVID and now have below market mortgages. Mark Palim and Rachel Zimmerman of Fannie Mae described the damage done to the housing market by Fed policy in a 2023 comment:
“An unintended consequence of the policy response to the COVID-19 pandemic was a dramatic decline in mortgage rates that allowed millions of homeowners to refinance their mortgage at rates well below current levels. Additionally, as housing needs changed and mortgage rates moved lower, home sales jumped, growing approximately 14% from 2019 to 2021 compared to a much slower 1% increase from 2018 to 2019. In 2022, mortgage rates doubled. Consumers adjusted to those rising rates, in part, by purchasing fewer homes, and so homes sales declined nearly 18% year over year. This year, while new home sales have rebounded, the paucity of existing home sales has persisted, declining from a peak annualized sales pace of 6.6 million units in January 2021 to 4.0 million annualized in August 2023. In fact, as of August, the number of existing homes for sale hovered around 1.1 million, 40 percent below the level seen in August 2019, pre-pandemic1. As of this writing, in 2023, the 30-year fixed-rate mortgage is at 7.79 percent, more than one full percentage point above where they were at the end of 2022."
A larger question raised by Bill Nelson at Bank Policy Institute, George Selgin at CATO and Cochrane in his great blog, is that the Fed pretends to have control over the short-term credit markets, but in fact does not. Few economists and investors appreciate how little control the FOMC has over interest rates or markets given the size of the public debt. We are only a few moments away from another systemic slip a la December 2018 and March 2020, when the Fed essentially had to cross the line and bail out the Treasury in a way not seen since the eve of WWII in 1941.
As former FRBNY President Gerry Corrigan taught us years ago, a systemic event is when markets are surprised -- or in this case, merely clueless. Again Cochrane:
“But the bigger problem is that this [Standard Doctrine] theory just doesn’t apply to today’s world. The Fed does not control money supply. The Fed sets interest rates. There are no reserve requirements, so ‘inside money’ like checking accounts can expand arbitrarily for a given supply of bank reserves and cash. Banks can create money at will. The Fed still controls the (immense) monetary base (reserves+ cash). The ECB goes further and allows banks to borrow whatever they want against collateral at the fixed rate. The Fed lets banks arbitrarily exchange cash for interest-paying reserves. Most ‘money’ now pays interest, so raising interest rates doesn’t make money more expensive to hold.”
We’ll leave the discussion of the Fed’s decision to end reserve requirements for banks for another time, but you can count us as skeptics on paying interest on bank reserves at the Fed, at least at rates at or above yields on Treasury debt. The Fed should never compete with its sponsor, even if the members of the Federal Open Market Committee may believe that doing so is a good idea from a macro economic perspective. The rate on Federal Reserve Bank deposits should always be slightly below Treasury yields.
Nelson noted in a comment that “the Federal Reserve recently released an FAQ about bank’s required internal liquidity stress tests that may lead to a reduced demand for reserve balances and so longer duration for QT. In short, banks can now plan on using the Fed’s discount window and standing repo facility as the means by which they would monetize their liquid assets rather than just sales or market repo of the securities. As a result, banks can hold Treasuries, agencies, or agency-guaranteed securities to meet their immediate stress funding needs rather than just reserve balances.”
In other words, our esteemed colleagues at the Fed are no longer going to discriminate against banks for holding Treasury bills, Ginnie Mae MBS and agency debt vs reserve deposits at the Fed. This is an appropriate concession, after all, since the Fed is now counterparty on most repurchase transactions with nonbank dealers. Since 2008, when more than half of the nonbank primary dealers were annihilated, the Fed has become the center of the money markets.
We asked Bill if the change in treatment for Treasuries and agencies meant that the Fed was finally creating a level playing field for Treasury and agency debt vs bank reserves for liquidity rules. “Yes, that’s a good way to put it. The next step is getting credit for borrowing capacity against non-HQLA collateral,” he opined.
But the real point of this discussion is that even as the Fed declares success on inflation, the central bank's assets and liabilities are likely to rise with the federal debt. Back in 2018, David Beckworth and George A. Selgin mused about the Fed's balance sheet perhaps falling back to $2 trillion, but today post-COVID the Fed owns more than $2 trillion in MBS alone. As the federal debt rises, bank reserves must rise as well and with it inflation.
In 1959, Milton Friedman told a joint session of Congress that monetary policies “operate with a long lag and with a lag that varies widely from time to time.” Over the past half century, the Standard Doctrine followed by the Fed was “leaning against the wind.” If the economy is getting too hot in terms of inflation, the Fed should proactively raise interest rates to try to slow it down. But Friedman believed that the effects of monetary policy were too uncertain for this to be an effective strategy.
“We know too little about either these lags or about what the economic situation will be months or years hence when the chickens we release come home to roost, to be able to be effective in offsetting the myriad of factors making for minor fluctuations in economic activity,” he told Congress.
Or as John Cochrane wrote earlier this week: "Higher money growth means higher inflation, immediately. Higher interest rates mean higher inflation, immediately. That’s exactly how a “frictionless” model should work. Except the sign is wrong relative to the Standard Doctrine we’re trying to chase down. Higher interest rates raise inflation? Are you out of your mind? You won’t get invited back to Jackson Hole if you say that out loud."
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