After recent bruising encounters with President Trump and the Global Economy, regime change is coming to the Fed. Powell Doctrine I is in the process of being toppled and perhaps with it its namesake’s reputation. With great mendacity and many pieces of legally acceptable empirical data, former and current Team Fed members are reconstructing its replacement. Having eschewed academics in Powell Doctrine I, the Fed Chairman is now eating the humble pie that they are spoon-feeding him as a dish best served cold. What goes around comes around as they say. Sadly it may already be too late for Powell Doctrine II, because the Fed is failing to act as swiftly as it talks.
Powell Doctrine I thought domestically and acted gradually. Powell Doctrine II, assuming that its author survives so that it keeps its name, is in the process of being redrafted. It is now thinking more globally. Whether it acts faster will depend on how fast its namesake can understand and adapt to the new environment that he and his team find themselves in. Currently, Powell Doctrine II under construction is a hybrid of reduced/paused balance sheet run-off and paused/one-more rate hike this year. This vagueness apparently provides the Fed with flexibility. Unfortunately, this comes at the cost of creating uncertainty by looking vague and incoherent. Data dependency is flawed by the very uncertainty from which it devolves.
The sheer vagueness evinced by those who are crafting Powell Doctrine II shows how uncertain they are about unfolding economic conditions. It also shows just how difficult it is for them individually and collectively to quickly change their minds and outlook. It is clear that some of them are still struggling to shed the credible commitment to and hence innate tightening bias of Powell Doctrine I.
Some of this inertia also correlates with a desire to build as large a conventional interest rate cushion as possible to deal with the next recession. Those who desire a larger balance sheet, have already accepted that building such an interest rate cushion is now unfeasible in the current global Lowflation environment. This inertia attenuates the risk, of the Fed remaining behind the curve, unless global and domestic US growth suddenly rebounds.
Being “patient” and hence inert may be serving the Fed well, by its dual mandate yardstick, but it is not serving the global economy at all. Fed patience is a global monetary policy tightening. The risks for the global economy are higher from this inertia, especially as global trade conditions deteriorate. Consequently, capital will remain attracted to the US economy and the US Dollar. The US economy can thus sputter along for a little longer, making the inert ones even more confident that they are doing the right thing. This may manifest itself as over-confidence and cognitive blindness.
This means that the US economy will hit a weakened global economy at higher speed. This speed vector means that it will hit the weakened global economy sooner and with more force than the inert ones at the Fed have assumed. They are thus in for an ugly surprise; which means that they will have to consider easing, at the point in time in the future when they thought that they would have been tightening. Faced with this inertia, the more creative regime-changers are proselytizing and nudging like never before; straying into the realms of speculation without empirical economic data.
(Source: San Francisco Fed)
The last report set the stage for a shift in Fed policy to allow an inflation target overshoot combined with a permanently expanded Fed balance sheet. Acting as a leak, former New York Fed president Bill Dudley unofficially confirmed that such a transition is underway. This transition will involve some fine tuning, to avoid giving the impression that the Fed doesn’t care about inflation. The Fed must be seen to be trading off a little bit of inflation for significantly more growth.
(Source: San Francisco Fed)
During this transition period, the thought leaders at the San Francisco Fed keep up the pressure on Chairman Powell’s limited academic ability, with new pieces of evidence to support the thesis.
The first part of their latest evidence trail involved some textual analysis of Fed guidance. The analysts find that between 2000 and 2012 the Fed’s loss function, intuited by way of communicated policy, actually meant that it was targeting an inflation rate of 1.5%. They also find a policy shift towards the 2% target, since it was officially adopted in 2012. Reading between the lines, however, the Fed’s inflation targeting all seems too little too late; or perhaps this is what the report’s authors would have us believe.
This analysis implies a lost decade, of tight monetary policy, that can only be re-balanced through adherence to an inflation overshot for at least a decade into the future. Furthermore, there is also a suspicion that the 2% inflation target is still being viewed as a ceiling rather than as a symmetrical one. It may then require more than a decade, for all of this to be communicated by the Fed and understood by Mr. Market as a credible commitment to a symmetrical inflation target. By default wisdom, the Fed’s balance sheet may need to remain expanded for a commensurate period of time, in order for this process to occur.
(Source: San Francisco Fed)
The San Francisco Fed then swiftly followed up its breaching move, with a new piece of evidence to connect the dots to a regime change in Fed policy-making. The new regime involves adopting inflation targeting as the necessary policy step, in a transition from a high growth to a low growth economic environment. This transition sounds suspiciously like what the Fed is calling the US economy’s recent headlong crash, into the slowing global economy and the sudden burning out of the Trump fiscal tailwind.
Atlanta Fed president Raphael Bostic took great care to emphasize that this brave new strategy does not involve an expansion of the Fed’s balance sheet, nor a cut in interest rates in his view. In other words, he is not buying into the San Francisco Fed’s new ideas just yet. Addressing the strong growth vector, that will sustain the economy and the inflation overshooting, he characterized growth as still above trend even with the recent weakness. Notwithstanding this strong growth, based on the current global uncertainty, the economic environment 12 to 18 months is not as easy for him to predict as it has been thus far.
Despite his uncertainty, Bostic still sees one rate hike this year and another next year. His uncertainty therefore only translates into the spreading out of interest rate increases on the way to the neutral rate. His neutral rate does not seem to have fallen significantly in the face of Powell Doctrine II. Once could say that he is an inert one by default.
In the last report, Cleveland Fed president Loretta Mester was involved in signalling the new “game changer” that is regime change. She followed up recently on this signal, by confirming that she supports the vote for balance sheet run-off to end this year. She believes that signalling this in advance will avoid having to taper this taper. Whilst she wishes to end balance sheet run-off, she still sees the possibility of raising interest rates later this year. This would make her an inert one also.
Mester also signaled that Fed communications will move away from forward guidance; towards a default risk management approach, that is data dependent over the medium term. The Fed won’t get jerked around by short-term data fluctuations; however, it will fine-tune its communication and policy stance in relation to accumulated short-term data over a medium-term horizon. In particular, confidence and uncertainty limits and estimations will be attached to projections and forecasts. It sounds like the much maligned Dot Plots are just about to get a makeover.
Minutes of the last FOMC meeting show just how difficult its members are finding the process of drafting and executing Powell Doctrine II. Whilst there was a growing consensus to end the balance sheet run-off, there was still a great deal of uncertainty over what to do with interest rates. The inert ones still feel driven to raise interest rates, even though they concede that balance sheet run-off is tightening liquidity conditions.
Philadelphia Fed president Patrick T. Harker is a classical inert one. Whilst he accepts the low growth and low inflation thesis, he has yet to translate this into ending interest rate hikes. Although he has cut down the number and pace of rate hikes, he still believes that there will be one later this year and then also in the next.
San Francisco Fed president Mary Daly made it clear that she is not one of the inert ones. In fact, she wishes to coordinate the Fed’s balance sheet size with its target interest rates. Such coordination confirms the last report’s suggestion that Daly in fact wishes the balance sheet to be adopted as conventional monetary policy tool. Her logic is consistent, since she sees that the neutral rate is extremely close on one hand and no risk of recession on the other. She views those who want to end the run-off and raise interest rates as working the balance sheet (thus monetary policy in general) at “cross-purposes.”
St. Louis Fed president James Bullard has taken a more assertive approach, to his new voting tenure this year, following the resistant tone adopted by Minnesota Fed president Neel Kashkari in the last report.
Kashkari rebuked Chairman Powell for being an inert one. Bullard’s most recent criticism was aimed at all inert ones. In his personal opinion, monetary policy is now “too tight” as clearly signaled by the market reaction to the last interest rate hike. He admits that he is in a minority on this one, but this only seems to make him feel in more of a persuasive mood. Balance sheet run-off and further rate hikes are thus off the table as far as he is concerned. The fact that he thinks policy is too tight does leave room for him to call for an easing later in the year.
The recently released FOMC minutes also pointed to the tactical changes envisaged by the Fed in order to enable regime change. These tactical changes were hidden under the unassuming titles of Additional Matters. The New York Fed figures highly in these additional matters, as one would expect when policy making shifts directly from guidance to actual market operations. The New York Fed’s mission is to be the market agency of regime change.
The New York Fed first had its legal authority to perform market operations in securities and foreign exchange reconfirmed. This pedantic legal step is entirely consistent with Chairman Powell’s strict legal interpretation of his job description.
What then followed was some tactical skulduggery. This in effect gives the New York Fed total independence and discretion on how to play its market operations to achieve the FOMC’s tactical objectives of ending the balance sheet run-off without giving a clear verbal confirmation of this fact. This independence and discretion in effect make the New York Fed Chairman John Williams the proxy Chairman of the Federal Reserve. He can now play it as he sees it, without taking his FOMC colleagues or the Chairman’s instructions into account if he so wishes.
Furthermore, another under-reported Additional Matter now allows the New York Fed and not the US Treasury the full power to move the US Dollar around. Clearly, given the switch in policy stance under the current global circumstances, the US Dollar is going to enjoy some healthy speculation against its currency pairs. Since this comes as a result of monetary policy, the New York Fed (via transubstantiation from the Washington Fed) will be given sole discretion and independence in trying to set the level for the US Dollar.
John Williams is Mr. Balance Sheet, Mr. Fed Funds and Mr. Dollar all at once. He is literally “Johnny on the Spot.” With great power comes great responsibility. One hopes that he has the nation’s best interests, rather than any zany new normal monetary policy agendas, at heart. We wish him well and remind him that the world and Mr. Market will be watching.
Williams recently presented the underlying thesis for Powell Doctrine II to the assembled global economist community. He framed the current sub-trend US economic growth and inflation combination, which underlies Powell Doctrine II, as a “new normal” rather than a “cause for alarm.” He re-framed the recent Fed U-turn, after the December FOMC mistake, as necessary to bring about the change in financial conditions that will enable Powell Doctrine II. His audience was and still remains agnostic and suspicious.
(Source: Federal Reserve)
The official signal that Powell Doctrine II is now under construction was delivered to Mr. Market by Fed Vice Chairman Richard Clarida. The reason given by Clarida, for the canning of Powell Doctrine I, was not its obvious failure characterized by the market chaos following the last rate hike. Powell Doctrine I was apparently too successful according to his view, unintentionally killing the Phillips Curve and lowering R* in the process, so that it can now be closed down.
Powell Doctrine II will allegedly improve the Fed’s ability to follow its statutory dual mandate according to Clarida. Powell Doctrine II is thus like Powell Doctrine I, but with more employment. Apparently, the Fed has been indulging in “flexible inflation targeting” until now. This has been such a success, that it can now apply the explicit letter of the law of the employment mandate without risk of being compromised by an inflation spike.
Clarida alleges that Powell Doctrine II is required, because Lowflation is real even though the labor market is extremely tight. Far from being a cause for concern to the Fed, the economy is actually in a “good place.” Powell Doctrine II is intended to maintain it in this “good place” for as long as it can if Lowflation obliges.
Clarida is especially wary of being prompted into further monetary policy tightening based on existing Fed economic models. Evidently, the Fed trusts its judgement better than its models these days; after the ones predicated on the Phillips Curve turned out to be the models that cried wolf on inflation.
Any review of the Fed’s monetary policy framework must be constrained by the dual mandate. Clarida’s reference to low inflation suggests that the Fed will attempt to raise the priority and thus bias in policy making towards the growth mandate, as suggested in the last report.
Having introduced Powell Doctrine II, Clarida then followed up with some more nuanced explanation of its difference from Powell Doctrine I. Powell Doctrine II is more than just an emphasis of the employment mandate as stated above.
(Source: Fed Board of Governors)
Whereas Powell Doctrine I thought domestically and acted gradually, Powell Doctrine II will think globally and act patiently. The last report noted that the Fed’s current risk management approach is not an international rescue yet. Clarida has now signaled that it has the potential to become international rescue at any time it needs to be. He directly conflates global growth with US domestic economic security, thus breaking the domestic constraints of the domestic dual mandate whilst seeking to preserve them simultaneously.
Chairman Powell has shown that he is a stickler for legally applying the dual mandate, so going forward FOMC communications will have to state that thinking globally still obeys this legal commitment.
Speaking after the release of the Fed minutes, Philadelphia Fed president Patrick T. Harker owned up to being the individual who put ending balance sheet run-off onto the FOMC’s agenda. He now needs to be the one who gets a firm date approved for this to begin.
Dallas Fed President Robert Kaplan then made it clear that Powell Doctrine II will be aimed at the members of the American polity who thus far have not participated fully in the economic recovery.
Kaplan dangerously frames Powell Doctrine II as Populist, in direct challenge to the President’s fighting brand of the same. This adversarial note was embellished by a panel interview involving Bernanke, Yellen and Powell; the latter of whom then eviscerated the President’s intellect and understanding of the dual mandate. The Fed needs to be careful with these media games. President Trump’s call on the economy and interest rates thus far has been better than the Fed’s.
John Williams as the key market interface, where Powell Doctrine II meets Mr. Global Market, is going to need some luck and support with President Trump on the warpath. The President has immediately tweeted pressure on Williams as Mr. Dollar.
(Source: Vanity Fair)
Having noted that John Williams is de facto responsible for the Dollar, the President immediately called for him to weaken the currency. This is very amusing, since Janet Yellen recently accused the President of ignorance for believing that the Fed controls the level of the Dollar. Apparently, the President has figured out that “Johnny on the Spot” is also Mr. Dollar. He is also acutely aware that his trade agenda boosts the value of the Dollar. “Johnny on the Spot” is thus tomorrow’s useful idiot.
(Source: St. Louis Fed)
The President’s track record on calling the economy is so far better than the Fed’s, so Yellen is courting disaster. Having understood that the Fed is now in control of the Dollar the President is about to embarrass the central bankers again.
President Trump has promised to make the economy run at 4% GDP. The Fed initially countered with Powell Doctrine I, which adhered to the Phillips Curve and the tighter monetary policy that it dictates. The Fed is now quickly dropping Powell Doctrine I and the Phillips Curve, for a Powell Doctrine II that looks suspiciously like what President Trump promised. The Fed’s knee jerk reaction looks like fear of admitting that the President was correct. This could easily backfire if it makes one more bad call.
Also speaking after the release of the FOMC minutes, Fed Governor Randal Quarles provided some more context and color about what the New York Fed will be doing with the balance sheet. First, he confirmed that he agrees with the policy to end the run-off later, in H2 of this year. Then he signaled how balance sheet composition will change. Ultimately, the Fed will get rid of its mortgage backed securities (MBS). In addition, it will change the duration of its balance sheet to shorter dated Treasuries. This balance sheet should also closely correlate, with the universe of outstanding bonds in circulation, to avoid market and hence yield curve distortions.
The removal of MBS signals that the Fed is no longer targeting the housing market for support. Great timing (or not) as the housing market is just starting to slow! The duration switch confirms that the Fed is seeking to make its balance sheet control money market rates and the slope of the yield curve. This also supports the thesis in the last report, that the balance sheet is now becoming a conventional monetary policy tool. Quarles then confirmed this by his denial that the balance sheet and interest rates are “competing” tools.
Quarles also noted that demand for Reserves by the commercial banks has not returned to pre-GFC levels. This indicates that things have not returned to normal. It therefore means that the Fed will have to maintain an enlarged balance sheet, comprised of shorter dated securities going forward. There will therefore be an innate bias towards lower short-term interest rates in the Fed’s new balance sheet strategy, especially if inflation remains low and/or even falls further. This implies an intention to steepen the yield curve going forward.
Talk is cheap in Chairman Powell’s Fed. As noted in a previous report, he attaches more importance to legal evidence by way of guidance to prove unequivocally that the Fed is doing its best to follow its dual mandate. Quarles needn’t have worried about tipping off Mr. Market about the New York Fed’s expected markets actions. The New York Fed published its own evidence and signal of these intentions and capabilities.
(Source: New York Fed)
This evidence was given a title (Stressed Outflows and the Supply of Central Bank Reserves) which leaves nothing to Mr. Market’s imagination by way of strong signal indication. The researchers find that the banks are currently hooked, on a high level of Reserves, to avoid cannibalizing their liquid assets and selling them into a falling market during an ensuing crisis.
Chairman Powell only has to turn his memory back, as far as his little slip of the tongue and rate hike on December 19th, for an example of what the researchers discuss. The bottom line is that if Powell leaves it to the New York Fed to call the shots (as the latest FOMC meeting has voted to do) there will be ample Reserves left in the banking system. The Reserve side of the Fed’s balance sheet will thus be large. This liability will have to be balanced by a large number of assets on its balance sheet, to complete the bookkeeping financial balancing act that all central banks must do to avoid being called money printers.
New York Fed president John Williams sounded suitably vigilant and cautious, when he got to speak about the mission ahead. He attempted to frame himself as cautious and trustworthy, despite the fact that he is an advocate of and will soon be executing a strategy aimed at overshooting an inflation target. Taking him at face value, always a dangerous thing to do with a central banker, one may expect him to remain vigilant about the risk of inflation suddenly spiking.
Williams is still clinging onto the balance sheet run-off remnants of the previous regime. With his latest guidance he is happy to go some of the way with the new regime, but only as far as halting the rate hike process at what he currently believes is the new low bound of the neutral rate range. He is thus leaving himself time and space, to evaluate the current headwinds working their way from the global economy into the US economy. What is striking is his downplaying of these headwinds.
As for the balance of the regime change, which wishes to stop balance sheet run-off this year, Williams still believes that it should run-off into next year. He would therefore like to leave some residual reserves in the system, but not on the scale envisaged by the other less inert would-be regime changers. Williams is still taking his commitment to avoid a sudden inflation spike occurring very seriously. He is doing this by maintaining balance sheet run-off.
Dallas Fed president Robert Kaplan has reminded Mr. Market not to get too far ahead of himself and the Fed’s process for Powell Doctrine II. Whilst agreeing that the interest rate hike pause is done, the balance sheet run-off pause will not necessarily be communicated and delivered at the March FOMC meeting. It will still take some time to assess the current situation based on new developments and previous rate hikes/balance sheet run-off impacts. He also revealed that he is also in favor of the adoption of an expanded balance sheet as a conventional rather than unconventional monetary policy tool.
(Source: Dallas Fed)
Kaplan also gave an interesting signal, on how the Fed is going to manage the American debt pile associated with the capital market bubble that Mr. Market is intent on building during Powell Doctrine II’s lifetime. Kaplan has no intention of bursting this bubble, because of the ensuing negative growth impact. He therefore intends to sustain it, and allow for more debt to be strapped on. This debt bubble and low inflation are his principle motivations for pausing interest rate hikes here.
Presumably, the debt pile is also a good reason to stall balance sheet run-off. If Kaplan has his way, there is no chance of the Fed triggering another GFC with rising interest rates as Bernanke did. Instead, it will let the bubble burst under its own un-sustainability and then will try to sustain it further. Monetary policy is the New Keynesianism and vice versa.
Atlanta Fed president Raphael Bostic has adjusted his guidance, in order to provide full support for the embedded inflation targeting component of Powell Doctrine II. Speaking recently, he articulated his concern that the Fed’s credible commitment to maintaining a dynamic equilibrium around a symmetrical inflation risks being undermined by observers’ doubt.
Boston Fed president Eric Rosengren can always be relied upon to be right on new message. In Powell Doctrine I, only back in October 2018, he was “mildly restrictive.” Things have changes since then.
(Source: Boston Fed)
Now, in Powell Doctrine II, Rosengren finds that his earlier concerns about overheating are less pressing so that he can be “patient.” Being “patient” is an essential component of the risk management approach inherent to Powell Doctrine II. He also has the temerity to suggest that the recent stock market sell-off, in response to the FOMC’s rate hike too far in December, has had nothing to do with his change of view.
Minnesota Fed president Neel Kashkari has already set out his stall to bring Chairman Powell closer to his own mode of thinking. His latest input into Powell Doctrine II, touched on the subject matter of increasing labor force participation. This is a subject close to Chairman Powell’s heart. Kashkari’s recent reference to this apparent reservoir of economic potential almost gave the Fed’s covert populist game away. He references it as a signal that the labor market is not tight at all. If one thinks about what he is saying, then it becomes clear that this reservoir can become both a tailwind for growth and a headwind for wage inflation. All that is required is legislated supply side reform and workforce training.
Richmond Fed president Thomas Barkin confirmed that the Fed is particularly interested in blunting the pitchforks being brandished by Trump heartlands in rural America. He opined that Powell Doctrine II will be aimed at, although not exclusively, at the rural population that has been left behind in the recovery.
Fed Governor Lael Brainard conflates economic slowing in some domestic sectors with the wider global slowdown. In response, she prefers an initial “softer” touch in the application of Powell Doctrine II. Said “softer” touch will involve a lower trajectory, if any at all, for interest rate rises and an end to balance sheet run-off this year.
Chairman Powell’s Humphrey Hawkins prepared testimony should be dubbed the Uriah Heep soliloquy. The Chairman played the role of “Your ‘umble servant,” so grateful for the chance to serve the American people, by following the excellent dual mandate that the wise founding fathers in Congress have provided him with thank you so much.
Whilst enacting this lubricious performance, Chairman Powell mendaciously framed the disastrous December FOMC meeting as a preparation for the successful January one at which the current pause was signaled. If his memory serves correct, he correctly identified all the developing global headwinds and softening domestic conditions back in December, which then came to pass in time for the January meeting.
Mr. Market along with many others must have been watching and reacting to a different FOMC and Fed Chair back in December. This FOMC and Chair tightened and provided scant evidence for doing so at the time, other than a slavish adherence to pre-committed normalization schedule and balance sheet run-off on auto pilot. Powell then threw in some humble anecdotal evidence for the panel of lawmakers, to support his framing of Powell Doctrine I as a success and the need to expand on this success in Powell Doctrine II.
The increasing labor-force participation rate that Powell discerns convinces him that he can give the economy too much of a good thing by letting it run faster. The unexplained downside of this, for the returning workers, is that they will suppress wage levels. This consequence intended or otherwise, will at least vindicate the Fed’s policy of letting things appear to heat up. Powell is therefore pretending that the Fed is all for higher wages, when in fact he understands that increasing the size of the labor pool has the opposite effect. It’s great news for American companies and their share prices though.
(Source: Federal Reserve)
Following his ’umble performance, Chairman Powell took his act on the road for the American people. He chose to use this venue as a pulpit to broadcast the Fed’s sincere intentions and capabilities, to support the economy if the politicians behave themselves.
Powell Doctrine II is a declaration of intentions and capabilities from the Fed, to sustain the current economic expansion, even at the risk of slightly higher inflation. This promise will hold for as long as the elected policymakers respond with alacrity - in the form of structural and fiscal reforms that support growth and higher productivity.
Powell Doctrine II thus ostensibly removes the Fed from the political arena and puts pressure on politicians to deliver what they were elected to do. Powell Doctrine II may appear to be Populist but it is strictly apolitical when it comes to execution.
Wealth disparity, something that Powell and the Fed say that they are anxiously trying to narrow, will thus widen even further in this new golden age of American capitalism. Powell Doctrine II is thus Faux Populism.
For those who missed the Uriah Heep act, Chairman Powell followed up with some concluding remarks in the public domain, to frame perceptions of Powell Doctrine II in advance before it is fully delivered. His comments hinted at his offer of a grand bargain with both/either Congress and/or the President.
Evidently, Powell Doctrine II requires reciprocal legislated supply side reforms, if it is going to be successful. The Chairman concluded that “policies that bring prime-age workers into productive employment, particularly those who may have been left behind because of low skills or educational attainment, could bring great benefits both to those workers and to our economy.”
The Fed will deliver on its expanded balance sheet and low interest rates only if lawmakers and the White House play their part. Fed Faux Populism thus contrasts strongly with the rival fighting brands of populism that the demagogues to the right and left of the aisle have polarized behind. This political polarization puts Powell Doctrine II at risk.
In response to this political threat, Chairman Powell has adopted what he calls a “common-sense risk-management approach.” This “patient” approach is not only for the data but also for the mercurial populist lawmakers. The inert ones wisely trust no politician and no single data input. Trusting the former in the run-up to new presidential elections would be a fool’s bargain, as they are apt to over-promise everything to everybody.
You don’t need a Ph.D. to deal with American politicians. You need to be streetwise, media-savvy and lucky. Being an ’Umble Public Servant is also a good disguise to disarm them. Chairman Powell would seem to have the first two attributes and also the disguise in spades, but as yet not the third. Sometimes it is better to be lucky than smart.
(Source: St. Louis Fed)
Research from the St. Louis Fed has found that, since Keynesianism arrived in WW2, the chances of avoiding recession in a maturing economic expansion have improved significantly. History favors the patient. The new expansion prolonging thesis of Powell Doctrine II still has a good probability of success if it remains patient.
(Source: St. Louis Fed)
The best way to look at Powell Doctrine II is as an insurance policy against the risk of another recession derailing the Fed’s commitment to maintaining the economic expansion. This insurance policy is combination of banking regulations and unconventional monetary policy. The Fed has tightened liquidity and regulatory capital adequacy standards for the banks since the GFC. The corollary effect of this raising the bar is that the banks are now demanding a higher level or Reserves from the Fed. A higher level of Reserves creates a higher liability for the Fed that it must match with a higher level of assets. Said assets are the zero risk capital weighted Treasuries that the banks could hold instead of Reserves.
The Fed’s balance sheet is thus a function of its own insurance policy against the event of a future financial crisis. Before the GFC, the banks had about $20 billion in Reserves. Now they are demanding about $1.4 Trillion. The Kansas City Fed estimates that the residual level of Reserves will be circa $1.5 Trillion. Assuming that it concurs, the Fed’s balance sheet size must be commensurate with this huge requirement for Reserves. That’s quite an insurance policy. The bigger the balance sheet, the greater the level of insurance in theory. Or is it the bigger the balance sheet the bigger the financial bubble itself? We’ll just have to wait and see.
Despite all the talk, about ending balance sheet run-off and speculation over ultimate balance sheet size, the inescapable fact is that monetary policy is still tightening. The Fed’s balance sheet and Reserves are still being shrunk on auto pilot. The longer that this continues the less chance that Powell Doctrine II will be sufficient to stop the global and domestic rot. The first casualties of this tightening are global trade partners and adversaries of America. Global blow-back is the headwind for the delayed impact upon the domestic economy.
Powell Doctrine III and some more QE anybody?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.