The Fed Just Lost Control

November 23 2016

Do you remember? That darn “quantitative easing?” According to naïve gold bugs, this expansion of central bank liabilities (dollar bills and commercial bank deposits at the central bank) would lead to hyperinflation. By the way, whenever you hear the term “monetary base” (M.B.), then this term refers to the amount of central bank liabilities. This week I met the former chairman of the Federal Reserve in Cleveland, the creator of the monetary base as statistic, and he showed me why the Federal Reserve has just lost control over its monetary policy.

This Was “Quantitative Easing” in the U.S.

“Quantitative easing”, or QE, began in the U.S. shortly after the 2008 crisis. Since interest rates were already lowered until zero, the Fed-chairman at the time, Ben Bernanke, moved to a more extreme measure. QE consisted of purchases of long-dated U.S. Treasuries (sovereign debt) and mortgage backed securities (MBS; a bunch of illiquid mortgages turned into a security) for a fixed amount and a fixed duration. The Federal Reserve also began to pay interest on deposits that central banks held at the Fed, something completely new in U.S. monetary policy.

The result was the famous “hockey stick”-chart, in which the monetary base rose a few hundred percent. For many, this was the moment to declare that we were on the verge of hyperinflation, Zimbabwe style.

What Are the Consequences of QE for Monetary Policy?

The problem, however, is that ever since QE the objectives and indicators that the central bank use no longer work. They no longer provide the information that policy makers require to make the right decisions. Let us look at a few concrete examples of the negative consequences of QE:

  • QE increased the monetary base manifold, primarily by creating deposits that commercial banks hold at the central bank. These deposits are “reserves” for commercial banks. These banks, thanks to QE, are now sitting on a huge pile of “excess reserves” or, in other words, much more bank reserves than the minimum level banks are required to hold.

    Whatever the case, in early days the Fed used this market for “bank reserves” to influence short-term interest rates. To push this interbank interest rate up, the Fed would remove reserves from the system. To move this interbank interest rate down, the Fed would create additional reserves, increasing the total supply of bank reserves. In brief, supply and demand.

    This is no longer possible. The Fed can no longer determine interbank interest rates by adding or removing bank reserves.

    An example: last year, the Fed raised interest rates in December (almost twelve months ago already). What happened with interest rates on U.S. Treasuries? They dropped.
     
  • The Fed can only change the interest rate it pays on deposits of commercial banks at the central bank and thus influence market interest rates. While the Fed previously would influence the interest rates between banks, it nowadays influences market interest rates in a much more direct way.
     
  • Nowadays, regulators require bank to comply with “liquidity coverage ratios.” Depending on the assets a bank holds, a commercial bank is forced by the regulator (not the Fed!) to keep a certain percentage of their assets as bank reserves. That means, however, that the objective to enforce “stability in the financial sector” goes at the expense of the effectivity of the monetary tools the Fed has at its disposal. In a certain sense, regulators now enforce minimum levels of required bank reserves, and no longer the Fed.

    On a side note, it was ironic to hear the joke that sometimes it appears as if banks have only reason to exist: simply to NOT go bankrupt. At times, it seems that for regulators that is actually the main reason of existence for a bank.
     
  • The Federal Reserve, and central banks in general, have insufficient knowledge and experience with these new tools they are now forced to use ever since the start of Quantitative Easing.

In sum, thanks to QE, the old monetary tools of the Fed no longer allow the Fed to achieve its objectives. Today, they rely on a new tool: changing the interest rate they pay on deposits that commercial banks hold at the Fed. The reduced influence of the Fed became painfully clear when the central bank raised interest rates in December, while important market interest rates such as the yield on U.S. Treasuries actually fell. We will have to wait and see whether the Fed in a situation of rapid and massive change, an increase in inflation or a new crisis for instance, has got itself into trouble and lost the control over monetary policy. That would be the great paradox of the enormous purchase programs labeled QE and would mean the definite end to central bank omnipotence.

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