The Federal Reserve's Toolkit is broken, except nobody's told them yet. by Bill Gee
(centrist)
Monday, June 20, 2011
After the Federal Reserve had no choice but to recognize that the Great Recession was upon us in 2008, Ben Bernake and the Board of Governors broke out their traditional toolkit and got to work. Three years later, the Fed is under increasing pressure to put the Expansionary tool kit away but things did not exactly go according to plan.
Expansionary Monetary Policy
When faced with a Recession, the Federal Reserves toolkit consists of the following actions:
1) Buy US Treasury Bonds
Theory: By buying US Treasury Bonds from Commercial Banks, Banks will theoretically have more money to distribute to lenders. More money will be created and therefore private business enterprises will end the recession, lower unemployment and boost domestic production.
Distortion: Quantitative Easing used the Fed's money-printing ability to buy US Treasuries directly from the Federal Government in an effort to keep the government funded and to prevent holders of US Debt from dumping their bonds on the market as a potentially worthless promise.
Result: Commercial Banks remain reluctant to lend money to everyday people and businesses and are still able to maintain high profits through the investment income derived by holding onto US Treasury Bonds.
2) Lower the Reserve Ratio
Theory: By decreasing the amount of money Commercial Banks have to deposit into the Federal Reserve System, they will have more money available to lend to customers. More money will be created, and therefore private business enterprises will end the recession, lower unemployment and boost domestic production.
Distortion: The Reserve Ratio only applies to a very small proportion of commercial lending in this country. Thanks to the securitization of private debt such as mortgages, student loans, credit cards and other forms of debt, the reserve ratio has become irrelevant.
Result: Mortgage lending, which is by far the most relevant indicator of economic recovery, has remained stagnant due to the INVESTOR's lack of risk appetite. Declining home values continue this trend as each decline in value further increases the risk of foreclosure.
3) Lower the Discount Rate
Theory: By lowering the interest rate that banks pay to the Fed for borrowing money, they can lower the cost of providing further liquidity in the commercial loan department. Increased liquidity means more money can be given to loan customers, etc., etc., etc.
Distortion: With banks already awash in cash from government bailouts and lowered reserve ratios, the ability to borrow even greater amounts of reserve cash from the Fed becomes irrelevant.
Result: Lending remains sluggish despite interest rates remaining at near zero levels for three years.
The New Menace: Inflation
Now the Fed is faced with a new problem. Despite the fact that the economic recovery remains sluggish, inflation is on the rise, which is placing further pressure on the unemployed and underemployed.
The inflation rate for food products are expected to be anywhere between 4% to 11% this year (depending on who you ask) while at the same time manufacturing is starting to slide into negative territory again.
The official Unemployment Rate remains stubbornly high at 9.1% while the unofficial unemployment rate is closer to 22%.
Restrictive Monetary Policy
When faced with the problem of inflation, the Fed as three tools at its disposal to control the problem.
1) Sell Bonds
Theory: By selling US Treasury Bonds to Commercial Banks, they will have less money in their reserves to lend to customers. Less money will be created while banks continue to realize profits from investment income.
Distortion: The deadly combination of Quantitative Easing and a possible ratings downgrade from S&P will limit the available market for US Treasuries. Since the Fed was buying the Bonds on their own, Commercial Banks already have all the Treasuries they need. If the Governments ability to pay the interest on Treasuries is ever called into question, even more Treasuries will flood the market as institutional investors divest themselves.
Result: No reduction of fiat currency in the money supply.
2) Raise the Reserve Ratio
Theory: The same as lowering the ratio except in reverse.
Distortion: Securitization ignores the reserve ratio.
Result: Small and medium businesses will be even more restricted from getting a loan, which will further force businesses to lay off workers and cut down on production, while having no effect on the money supply.
3) Raise the Discount Rate
Theory: Same as lowering the rate except in reverse.
Distortion: Derivative products and loan-backed securities are not subject to the discount rate.
Result: Commercial paper and other lines of credit for small businesses will be restricted, while having little impact on food and fuel prices since these are usually backed by derivatives.
Conclusion
The Federal Reserve as the agency charged with controlling inflation while reducing unemployment has failed. Some may argue that it was doomed to failure from its inception, but one thing that is clear is that they have been either unable or unwilling to prevent the worlds largest banks from controlling the economy from the very top levels of government. The fact that most of the members of its Board of Governors have worked for the biggest banks only proves the point.
It needs to go away along with its printing press.
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The views expressed
in this article are those of Bill Gee only and
do not represent the views of Nolan Chart, LLC or its affiliates.
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