The United States of America’s Federal Reserve System (aka Fed) was created in 1913. The mandate given to it, as per the Federal Reserve Act, 1913, as amended up to date, is as follows:
The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
In the common understanding and parlance, Fed’s two main goals are keeping the unemployment at or below natural rate of unemployment, and inflation at a healthy level. By the way, no country aims, or should aim, zero inflation.
The natural rate of unemployment is a sort of by choice unemployment rate as not all working age population may be seeking employment. The natural rate of unemployment in USA has been accepted as 5%- 5.5%. A healthy rate of inflation in USA has been accepted as 2%- 2.5%.
Interestingly, there is no mention, in its mandate, of calming or reviving the stock market or responding to bursting of economic bubbles. And monetary authorities, all over the world, are expected to keep away from that.
Incidentally, the unemployment rate in USA in recent periods have been at an historic low. The inflation has been well within or below targeted healthy level.
So why this panic at the Fed? Fed buying ETFs for the first time ever!
Hey, it is Coronavirus. It is hitting millions across the globe including USA. Life is coming to a standstill. As a natural consequence, economic growth should hurt. It is therefore, to be proactive, that the Fed is in panic. It is working in tandem with Administration, Treasury and Congress. We have, both, monetary policy and fiscal policy in action for maximum impact.
The memories of 2008 have yet not faded from our mind scape. What was that then worked? It may be debatable, but the visible consensus is that lowering of federal funds rate worked. Federal funds rate is the rate at which banks may borrow from each other, to meet their short term liquidity needs. The recipe, simple and time tested, has been when in economic crisis, inject liquidity. The injection of liquidity may be through expansionary or accommodative monetary policy or deficit financing or both.
Ben Bernanke, the then Chairman Fed, had claimed in his 2010 lecture that the US economy has recovered faster from Great Recession of 2007-2009, than Great Depression of 1929-1932, and what worked was nearly zero fed funds rate. Interestingly, nearly zero fed funds rate took seven years, from 2008 to 2015, to get back to natural rate of unemployment of 5%. The real magic that happened was with the Tax Cut and Jobs Act, 2017. Now, in addition to monetary policy, fiscal policy was in action.
So great, this time both the policies are in action from the very early. Expansionary or accommodative monetary policy is in action. Congress’s package is getting ready to be out the door soon. Forward guidance about these actions has been the other main tool actively deployed by both Fed and the Administration.
Fact of the matter is that lowering of fed funds rate had worked at snails’ pace. Between 2008- 2015, to keep fed funds rate close to zero, fed had created reserves that quadrupled, from less than a trillion dollar to almost 4 trillion dollar. But, during this period, both, money multiplier and velocity of money had declined. Money supply grew, but not at the rate of monetary base. Credit take off lacked behind. Should it be a matter of surprise? No. GDP is the sum total of Consumption Expenditure (C), Investment Expenditure (I), Government Expenditure (G) and Net Exports (NX). Of these four components of GDP, it is C that is significantly interest sensitive. Now in 2020, with $2 Trillion Coronavirus relief package, even for consumption, between credit and grants, Americans may prefer grants.
Alan Taylor, based on his research of financial crisis in 40 countries over 100 years, in 2012, offered five lessons for policy makers. The key most was, ‘In a financial crisis with large public debt, and large run-up in private sector credit, mark down growth/ inflation even more’.
We have everything of the like. We have large public debt, which will further shoot up, thanks to the relief package of the Congress. We are injecting liquidity at unprecedented scale. We were already sitting on the mountain of monetary base with low money multiplier and velocity. We had no issues of unemployment or inflation. Stock market has, yes, collapsed, in days.
The Quantitative Easing of 2008-2015, followed by fiscal stimulus of Jobs and Tax Cut Act, provided pure octane for the stock market. The investors, particularly, institutional, built positions on pure octane, and now Fed is offering to buy those positions. Isn’t circular monetary policy? First you inject liquidity to build overvalued financial market positions and then you finance those overvalued positions.
Did any other economy do it before us? The answer is yes. Please look up Japan, where national debt is almost 238% of their GDP. That is the highest in the world. The elections in Japan are contested on the issue of reinjecting inflation. They tried negative interest rates, and it boomeranged. People saw it as a signal of deeper mess. Today, Bank of Japan’s balance sheet has direct holding of corporate securities. That has been the case exactly of what I like to call, Circular Monetary Policy. You first do quantitative easing to help create overvalued financial assets and then do quantitative easing to fund those.
Are we pushing ourselves into that kind of future?
Let’s not forget that though economics is considered a tool of politics, but ultimately good economics prevails.
Center for Safe and Sound Banking 