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Federal Reserve Watch: The New Regime

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by: John M. Mason
Summary

The Federal Reserve did a remarkable job helping the US economy recover from the Great Recession, expand for 10 years, and return closer to "normalcy."

Now, the Fed has entered a new phase - one that will have to rely more on market feel and intuition, and making policy moves on a more incremental basis.

There is a lot of uncertainty in the world, and we must rely on the Fed to be there, supporting continued economic growth but positioned to avoid any market surprises.

The Federal Reserve has entered a new period of policymaking. Federal Reserve officials have never been in a position like they are now. Going forward, it is going to be “trial and error.”

Financial markets and financial institutions are going to have to watch closely and listen to what the Fed officials say, and respond as best they can to changing conditions.

Over the past ten years or so, the Federal Reserve’s policy has been pretty transparent. Ben Bernanke, former Fed Chair, got the ball rolling by producing a monetary policy that was aimed at stimulating the stock market, thereby creating a wealth effect that would underwrite consumer spending. In addition, Mr. Bernanke made sure that the Fed always erred on the side of too much monetary ease so as to avoid any disturbances to occur in the banking system.

After three rounds of quantitative easing, the Fed began to lift its policy rate of interest in December 2015. Eight more increases have taken place since then, with the last rise coming in December 2018. The Fed continued to make it clear, however, that it would keep monitoring the situation and would continue to err on the side of monetary ease, if necessary.

In October 2017, the Federal Reserve began a program to systematically reduce the size of its securities portfolio. Again, it continued to state it would still err on the side of monetary ease.

Federal Reserve officials wanted to make it very clear that they wanted to avoid a situation in which raising the policy rate of interest or reducing the size of its securities portfolio might, for whatever reason, disrupt the banking system that might produce another downturn in the economy. This concern arose from the 1937 situation in which the Federal Reserve raised bank reserve requirements, which disrupted bank liquidity needs and resulted in a drop in bank lending, producing the 1937 Depression.

The commercial banking system has responded well to the actions of the Federal Reserve during the current recovery. In terms of a liquidity cushion, commercial banks saw their excess reserves peak in August 2014 at $2,700 billion. In December 2014, excess reserves dropped to $2,524 billion. Following this, excess reserves were $2,331 billion in December 2015, $1,925 billion in December 2016, $2,121 billion in December 2017 and $1,568 billion in December 2018. In March 2019, the total of excess reserves in the financial system was $1,533 billion.

The banking system seems to have sufficient liquidity to avoid any kind of disruption, and commercial bank lending has proceeded at a reasonable, although not excessive, pace.

In terms of what this means to the whole economy, we look at the December-over-December rate of growth of the M2 money stock. In December 2014, the year-over-year rate of growth of the M2 money stock was 5.9 percent; in December 2015, the growth rate dropped to 5.7 percent; in December 2016, the rate was 7.1 percent; in December 2017, the rate was 4.9 percent; and in December 2018, the rate was 3.9 percent.

From these figures, one can make a strong argument that the Federal Reserve was accomplishing what it had set out to do. The economy, through nine and one-half years of recovery, had produced a compounded 2.2 percent annual rate of growth. The banking system appeared to have sufficient liquidity to supply loans to the economy to help it steadily grow. The M2 money stock was growing at a very adequate pace to sustain the economic growth, and the stock market indexes continued to hit new historic highs, the latest coming in October 2018. The unemployment rate is now below 4.0 percent, a level not reached for several decades.

Furthermore, the large banks seem to be in a very good place for the Fed to move on to adjust to the current market environment.

One could argue that the Federal Reserve has done a very good job during the past decade or so. I certainly believe that it should get a lot of credit for how this recovery has progressed. But now we are in a different place. It is a place where there is a lot of uncertainty about what the Federal Reserve should do next.

In this environment, Fed officials have ceased to raise their policy rate of interest over announced intervals as they have in the past couple of years. Earlier, these officials had wanted to see the policy rate get a little higher. Right now, the upper limit to the policy range is 2.50 percent. The Fed had argued that it hoped to get this up to a “more normal” level, something closer to 3.5 percent. But it doesn’t look like that is going to happen now.

Also, officials have overseen a reduction in the Fed’s securities portfolio. The reductions are now scheduled to stop by the end of this year. The Fed will still have a pretty full balance sheet.

So, what do Fed officials do now? Given that a central bank has never been in a position like this before, one can guess that they might want to be very careful.

Signaling to the markets through efforts at “forward guidance” seems entirely useless now. Too much uncertainty. I believe that what the Fed does is going to will have to be intuitive and incremental, based upon the data and the feel of the financial markets.

At an earlier time, the short-run management of the Fed’s position was done using the “feel” of the marketplace. The Fed operated to keep markets “taut,” like a rope used to tie a boat to a dock. It did not want the market to be too tight, such that the rope might break, and it did not want the market to be too loose, such that the boat just floated here and there given the currents. Fed officials wanted the market “taut” so that they could move to supply reserves if the market seemed to be getting “too tight” or could act to remove reserves if the market seemed “too loose.”

It would seem as if the Federal Reserve should be moving to an operating procedure more like this one where they respond to financial market conditions, but intuitively and incrementally. I don’t believe that its statistical models are up to the task of dealing with the current situation.

How the Fed will work this out, of course, is up to it. But it needs to move carefully. Big jumps in policy to conform to political needs will not be the best way to move forward.

Because Federal Reserve officials have to work this out, they must do it on their own terms. The Fed has tremendous resources, tremendous economists and a tremendous legacy.

I believe that we are going into a time when the Fed has to operate more on “feel” rather than on received theoretical beliefs. I believe that this Fed will be more transparent and open than Federal Reserves of the past have been. But it will be a much different environment than we have ever seen before.

There is a lot of uncertainty in the world today. The Federal Reserve situation just adds to this.

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.