Fed watchers need to stop panicking when they look at the new supersized Fed balance sheet and monetary base. The Fed’s balance sheet doesn’t necessarily mean runaway inflation is in our future or that the Fed is out of control. The Fed got supersized because Bernanke & Company came to appreciate the U.S.’s special role in the world economy. The U.S. dollar is the world’s primary reserve currency and a supersized Fed is what this special status requires.
Many Fed watchers believe in a “cause and effect” relationship exists between the rapid buildup in the size of the Fed’s balance sheet and both runaway inflation and a debasement of the U.S. dollar. I don’t agree.
Old school Fed watchers need to set aside their decades old Fed expectations and relearn their trade. “Game changing” shocks of the past few years have made the Fed a very different and more complicated central bank than in the past.
While it’s great to look back on the simpler good old days of a small Fed balance sheet, the lack of Fed assets limited policy options. Since the U.S. dollar is the de-facto reserve currency for the world, like it or not the Fed has responsibility to provide liquidity for all dollar denominated trade in the world, whether or not it takes place within the U.S. A puny balance sheet that limits policy options is inconsistent with the reality of the Fed’s extended mission.
The issue that the Fed has to work through is that if it doesn’t have a large enough balance sheet and monetary base for global trade there will be acute U.S. dollar shortages around the world that will shut down the U.S. and global economy. Bernanke & Company adjusted to this reality by putting in place several new policy tools, all of which point to a bigger balance sheet.
Perhaps the biggest new Fed policy tool is one of its most technical; the Fed’s new ability to pay interest on reserves. Basically, that means that when banks deposit cash at the Federal Reserve, these deposits earn interest. In the past, bank deposits at the Fed didn’t earn interest. As a result, banks didn’t deposit their excess cash at the Fed and excess reserves for decades were stuck at a very low amount. But now that the Fed can pay interest on cash deposits, banks have a good reason to deposit their excess cash at the Fed and excess reserves, i.e., excess cash deposited at the Fed, has skyrocketed.
Fed watchers look at the new large excess reserve balances and conclude that these balances are evidence of an out of control Fed. They disregard the fact that the Fed can now pay interest on reserves. There is a great article written by David Altig, Senior Vice President and Research Director for the Atlanta Fed, that discusses the new level of excess reserves and explains why large levels of excess reserves aren’t necessarily bad or inflationary.
By getting excess cash balance deposited at the Fed, Altig argues that policy makers have many more options to implement monetary policy and quicker methods to withdraw reserves from the system. The ability to pull reserves from the monetary base is important when money supply rises as a result of an acceleration of the velocity of money (which may occur when bank lending accelerates).
Bernanke & Company learned a tough lesson during 2007 and much of 2008. They learned that if they don’t provide enough liquidity to the global trade and banking system the rest of the world will take down the U.S. economy. In February the Bank for International Settlements published research that discussed how the European banks had a $2 trillion shortage of US dollars and couldn’t settle their debts because of an acute shortage of dollars. This resulted in LIBOR rocketing upward, even for government insured interbank deposits where there was no credit risk. The LIBOR spike ripple effects started to swamp the U.S. economy through a large rise in effective interest rates for U.S. loans tied to LIBOR and the near collapse of the banking and trade system which started to destroy export and import businesses.
Even the Chinese Central Bank Governor Zhou Xiaochuan understands that the Fed needs to make sure that its balance sheet and monetary base has to be supersized to provide liquidity for global commerce and banking. Zhou was quoted suggesting that use of the U.S. dollar as the primary medium for global trade has created special burdens for the Fed which cause irresolvable conflicts. Zhou recently wrote…
Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries’ demand for reserve currencies. On the one hand, the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities; on the other hand, they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists.
The Fed is trying to prove Zhou wrong by “threading the needle” and creating enough liquidity so that global trade and international banks don’t die because of a lack of liquidity while at the same time not over stimulating the domestic economy or over expanding money supply.
So far Bernanke & Company seems to be getting it right but only time will tell if they will be able to satisfy both the domestic and international needs for money without tipping too far in the direction of inflation or deflation, liquidity or crisis. And, only time will tell if Zhou is correct that the competing demands of the domestic economy and international trade are inconsistent and cannot be reconciled. Either way, I am pretty sure that the new normal of a supersized Fed balance sheet and monetary base is going to be with us for a while and is necessary to prevent a meltdown of the global banking and trade system.
Even before posting this article I can already hear the purveyors of the conventional wisdom accusing me of incompetence for not realizing that the current crisis is the Fed’s fault because they kept interest rates too low for too long after 9/11 and they are at it again.
I don’t believe in the conventional wisdom. Monetary policy, interest rates and money supply aren’t the proximate cause of the current crisis. The causes are much easier to recognize and don’t take a PhD in economics to understand. Fraud, mismanagement and overleverage (along with a good dose of white collar crime) put us in the predicament we are in. Too much money supply has about as much to do with the current crisis as Eve blaming her weakness on too many apples in the Garden of Eden. Post 9/11 monetary policy is a convenient scapegoat for those that are trying to deflect attention from their own misdeeds and incompetence.
After publishing my last article suggesting that the Fed may not be running up money supply like a drunken sailor I was roundly criticized for not understanding that even though the results of the Fed’s irresponsible actions weren’t showing up in M1, M2 or estimated M3, the bad effects of Fed policy can be found if I just look hard enough. So, in the next few days I will take a look at recently distributed data to see if there is any evidence of “money” and “credit” being out of control.
