Raising Rates and Monetary Inflation

The last 7 years have been quite unique in terms of the U.S. economy. It is almost like a new experiment, but unfortunately it isn’t going to end well.  Our optimism should lie in the fact that hopefully most people will recognize the failure of the experiment.

Since the fall of 2008, the Fed has quintupled the adjusted monetary base.  This alone is unprecedented for the modern-day United States.

But the massive monetary inflation has not translated into massive price inflation.  Part of it is due to the continued fear by Americans who are a little less anxious to spend money than in the past.  But the main reason is that banks have not lent out most of the new money.  It has piled up in excess reserves.

Due to the huge excess reserves, the federal funds rate has been virtually meaningless.  This is the overnight lending rate for banks.  When we hear about the Fed possibly raising interest rates, this is the rate that people are referring to.  It has been targeted between zero and a quarter percent since late 2008.

Since the banks have massive piles of excess reserves, there is little need for overnight borrowing.  Therefore, the rate stays low.

Historically, the federal funds rate was important because it dictated the Fed’s monetary policy.  To lower the rate, the Fed would generally have to buy U.S. Treasuries.  This would create money out of thin air.  To raise rates, the Fed would typically have to contract the money supply.

With the huge excess reserves, this no longer holds true.  The Fed can inflate or deflate the money supply and it isn’t going to have much effect on the federal funds rate, unless it massively deflated, which we know isn’t going to happen.  The only way for the Fed to realistically increase its key rate is by paying a higher interest rate on bank reserves.

Now that U.S. stocks are in turmoil, many analysts are questioning whether the Fed will raise rates in September, or even this year at all.  But there are some who think the Fed may go ahead with their plan so that they don’t look weak and indecisive.  It may look worse for the economy if the Fed doesn’t follow through.

Meanwhile, I have already seen a few calls for more quantitative easing (QE).  This simply means more monetary inflation.  It means increasing the money supply.

So while there are still some people saying the Fed could still raise rates, there are a few who are already calling for more digital money printing.  How do you reconcile these opposing views?

In the past, this would have been completely contradictory.  Higher rates meant a tighter monetary policy.  Lower rates meant a looser monetary policy.  But that is no longer the case today.

So I am asking the question that I have yet to see asked:  Is it possible that the Fed may raise the federal funds rate and start another round of quantitative easing at the same time?

With the huge excess reserves, this is quite doable.  The Fed could pay banks a slightly higher rate on reserves, thus increasing the overnight lending rate.  Meanwhile, it can resume its program of monetary inflation by buying more U.S. government debt or by bailing out the banks even more through purchases of mortgage-backed securities.

We could actually see a double bank bailout with barely anyone recognizing that it is happening.  The Fed can pay more to banks to keep excess reserves sitting with the Fed that they would have kept there anyway.  And the Fed can buy bad assets from the banks and relieve them of their bad loans.

While I think the economy is in trouble, simply because the Austrian Business Cycle Theory is playing itself out, at least we won’t see the same banking problems as we did in 2008.  How could we?

The Fed has been bailing out the banks for the last 7 years.  First it was direct, and nearly everyone was mad.  Then the Fed got smart about it and bailed out the banks through interest payments on reserves and by buying their bad assets.  The banks have to be far sounder today than they were 7 years ago.

I don’t think we are done seeing these crazy and unprecedented moves in monetary policy.  Let’s see if it is possible for the Fed to raise rates and create monetary inflation at the same time.

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