“What is the Fed doing?”
Lately, I get asked that question rather frequently.
My response is invariably, “I have no idea. I don’t think even the Fed knows what it is doing.”
And, therein lies an interesting problem, both economic and philosophical.
The economic background. In 2008, faced with that Financial Crisis you probably heard something about, the Fed did the right thing in flooding the markets with liquidity. What we now know was happening was an old-fashioned bank run. But the run was happening in the Shadow Banking System.
The Shadow Banking System sounds ominous and mysterious, but it isn’t. And that too requires a bit of background.
In the Great Depression, the United States separated commercial and investment banking because Congress was completely confused about what caused the Great Depression. Commercial Banks could have checking accounts, which are money, so that is where all the subsequent attention went.
Over time, investment banks developed things that looked like checking accounts for large depositors, but technically were not checking accounts. (These accounts were called repo accounts.)
In 2008, there was a run on the repo accounts. (Gary Gorton deserves much credit for figuring this out.) That bank run was the reason the financial crisis turned into a recession.
(It is worth noting: financial crises are quite common. Most do not turn into recessions.)
So, when in 2008, the Fed flooded the system with reserves, it did a good thing. They were literally following the textbook on how to deal with a bank run: Walter Bagehot’s Lombard Street. (Trivia: the last name is pronounced Badge-It).
So far, so good.
Then the Recession started. The Fed, still reeling from the trauma of the financial crisis, decided to get in the game of trying to help end the recession. It added more and more reserves to the system, thereby driving interest rates lower and lower.
It didn’t work, so they added more reserves and interest rates went even lower. It still didn’t work. So, they did it again. And again. (By the way, this is all Quantitative Easing was, another phrase which sounds mysterious, but isn’t.)
Now, to return to the original question, the Fed is currently stuck. They have kept short term interest rates near zero for over a decade. Think about that. If you graduated from college in 2009 and went to work in the financial sector, you are now 32 and you have never seen a world with short-term interest rates at anything other than functionally zero.
Now look at the Fed. What is the job of the central bank? The Fed has two goals mandated by Congress: keep unemployment low (check) and keep inflation low (check). Why aren’t Fed officials dancing in the streets or spending their lives at the opera?
The tools of monetary policy are slow acting. If the Fed responds to current conditions, it will always be too late. So, the Fed has to base its decisions today on what it thinks economic conditions will be in the future. That is hard even in the best of times.
But, what do you do when the economy is in this weird artificial state where interest rates have been kept so low for so long that you really can’t lower them much even if you wanted to do so? At the same time, bank reserves are so incredibly high that if financial institutions ever start loaning out the excess reserves, we are looking at double digit inflation.
The Fed is paralyzed. If they ever decide to allow short term interest rates to rise, then two things happen simultaneously.
First, the higher interest rates could cause a slowdown in economic activity, and maybe even a recession. That is not good.
Second, if interest rates rise, then banks may stop holding onto all the excess reserves. When they start lending them out, there could be inflation. That is also not good.
There is an even worse possibility. Because of the staggering volume of excess reserves, it is possible for an increase in short term rates to simultaneously cause a slowdown in economic activity and induce banks to reduce excess reserves by lending more. Then we would have more money and less economic activity. Higher unemployment and higher inflation. That is really, really not good.
It is, of course technically possible that the Fed could manage things just right and everything would be perfect and wonderful. That is the Goldilocks Outcome.
(Alas, Goldilocks at the Fed is a fairy tale. Someone really ought to write that book, by the way.)
So, which of these things happens in the economy if the Fed goes down this route? Nobody has any idea. We have never done this before.
So, should the Fed just keep interest rates low, trying to make sure we don’t find out what happens if interest rates rise? That just leaves a bigger problem for the next set of Fed officials, which seems to have been the plan for the last decade.
It’s even harder though. As economic conditions change, the current level of interest rates could end up being high enough to start the unknowable process above. So, the Fed has to keep talking about its willingness to lower interest rates. They can’t really lower them very much, but they do have to keep people thinking that interest rates aren’t going to increase.
That is why the Fed kept saying “be patient” and then suddenly changed its tune. They are panicking. They have no idea where “neutral” is any more.
The worst thing for the Fed is a recession in a Presidential election year. The second worst thing—finding out that when whatever exactly it is that has kept inflation so low gets relaxed, inflation doesn’t calmly rise to 2%; it shoots up much higher.
It’s a mess. Maybe the Fed figures a way out of this mess. But, it isn’t entirely clear that it is even possible to painlessly get out of this mess.
The philosophical problem. What do you do if you are in charge of making a decision which will literally affect hundreds of millions of people and there are no good options? Imagine that there is no way out, that you have spent a decade looking for a way out and are now convinced there is no way out. No matter what you decide, a half a billion people or more will be negatively affected in some way.
Could you make that decision?
Leave a Reply