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Back in the day, I would go into some FOMC meetings with firm views and a relatively closed mind and into others with tentative views and a greater willingness to be persuaded. I would go into today’s meeting with a mixture of firm and tentative views.

Firm Views

Contrary to popular opinion, the Fed has not been all that easy lately, short-term interest rates notwithstanding. The reserves created by past open market purchases are being held by banks as excess reserves, and have not been used to make sufficient loans and investments to promote significant money growth. As the recovery has weakened and as inflation has continued to decline, the FOMC needs to speed up money growth. My going-in position would be that the Fed needs to purchase Treasury securities in such quantities not only to replace maturing mortgage-backed securities but to add to total securities held.

Tentative Views

For some reason I don’t fully understand, the markets will make too big a deal of it if the purchases can be classified as “quantitative easing.” That is likely if the Treasury securities purchases are longer term. However, even traditional purchases of Treasury bills may also get exaggerated attention if it is announced in the statement. The Fed has somehow got itself into a position of having promised the market it would shrink its balance sheet—or at least that is the market’s view.

This is unfortunate because under most circumstances a shrinking balance sheet means a tighter monetary policy—something not called for under current circumstances.

My open mindedness has to do with what to purchase and how to announce or not announce it.

A Technical Note

It’s not Fed assets that matter for monetary policy; it’s the corresponding change in liabilities. The two principal liabilities are “monetary liabilities” in the form of bank reserves (an asset of banks but a liability of the Fed) and currency outstanding. Those two things together with a minor modification make up the monetary base, which may be considered the raw material for money. Of the two, bank reserves are the more important.

The formula is that monetary liabilities equal Fed assets minus nonmonetary liabilities. In other words, Fed assets supply reserves, but nonmonetary liabilities absorb potential reserves. If the Fed, for example, cancelled a swap agreement with foreign central banks, then its assets and nonmonetary reserves would decline together without affecting monetary liabilities or bank reserves. That kind of balance-sheet shrinkage would be benign in terms of policy. It would not be a tightening of policy. However, it is more usual that a reduction in total Fed assets would be accompanied by a reduction in monetary liabilities, mainly bank reserves. That is precisely what we don’t need in a weak economy, but most pundits don’t seem to understand that.