Whoever planned the Federal Open Market Committee (FOMC) calendar gave us a real treat and put the Fed in a rather difficult position.
The FOMC wrapped up its latest meeting on Wednesday, July 14, 2017 and released its statement on monetary policy. This was followed by a press conference by Janet Yellen.
It was widely expected that the Fed would raise its federal funds target rate by one-quarter percent, which it did. The rate is now between 1% and 1.25%. The Fed will now pay banks 1.25% on their reserves.
The problem for the Fed is that the statement on monetary policy was released after the CPI report had come out earlier in the day. The consumer price index numbers were lower than expected.
For May, the CPI actually came in at -0.1%. The year-over-year decreased to 1.9% after being above 2% for several months before. Even the usually-steady median CPI went lower. The year-over-year median CPI dropped to 2.3%. It was 2.5% back in March. This may not seem like much of a deceleration, but the median CPI has barely moved for a long while now.
If consumer prices are increasing at a slower pace, or even decreasing, it is not likely due to massive productivity gains. Although this would be likely in a true free market environment, it is hard to believe that there are major productivity gains right now that are driving down consumer prices. In the electronics industry, this has been happening for decades, despite the continual inflation.
A deceleration in consumer prices is mostly due to an increase in the demand for money. Put another way, velocity is slowing. Money is changing hands less frequently. It indicates a likely softening in the overall economy. This is in spite of the fact that the stock indexes are hitting all-time nominal highs.
The FOMC was expected to hike its target rate in June. If it had failed to do so, I think people (especially investors) would have mostly reacted negatively. They would have seen it as a sign that Fed officials see a weak and vulnerable economy.
On the other hand, the CPI numbers are indicating a possible softening of the economy. So the Fed had to hike its target rate in the face of a softening economy. Is this the beginning of the end for this phase of the bubble?
In addition, the Fed is now addressing its bloated balance sheet, which approximately quintupled between 2008 and 2014. How is the Fed going to drain off assets of trillions of dollars? This is especially difficult with mortgage-backed securities, some of which are now virtually worthless.
You can read the Fed’s plan here, if you want to call it that. It “anticipates” that it will reduce Treasury holdings by $6 billion per month, and then increase its reduction in increments of $6 billion at three-month intervals until it reaches $30 billion per month.
For mortgage-backed securities, it will reduce its holdings by $4 billion per month initially, and then increase it in $4 billion increments every three months until it reaches $20 billion per month.
In other words, the Fed – if it follows through – will eventually be reducing its overall balance sheet by $50 billion per month. This will be monetary deflation. It will do this by not reinvesting the principal payments on maturing securities. It will technically not be selling off assets. It just won’t roll over as much each month.
I don’t think anybody thinks the Fed will reduce its balance sheet to anywhere near the level that it was prior to the fall of 2008. The Fed’s statement itself says this. But I have bigger doubts than just the size of the reduction in the balance sheet. If the latest CPI numbers are indicating a softening economy, what happens to the Fed’s plan if we hit a recession? Imagine that stocks go into a massive downturn. Is the Fed really going to engage in monetary deflation while this happens?
I hope the Fed does follow through, but you can see that I remain extremely skeptical. If we hit a big enough recession, not only do I think there will be no monetary deflation, but I also think we may see more quantitative easing (monetary inflation).
The Fed has actually gotten off rather easy over the last several years. It was able to engage in massive monetary inflation, yet consumer prices have been rather tame. The massive increase in excess reserves at commercial banks accounts for much of this.
Sometimes when things just hum along, you assume that they will stay that way for a long while. Sometimes it is true. This bubble has lasted longer than I thought it would. But at some point, something gives. The Fed has already kept the monetary base stable for the last 2 and a half years. If it goes into monetary deflation mode now, I don’t know what is going to support the stock markets. Stocks seem to be the biggest of the bubbles in this economy.
If stocks hold up for a while longer, then maybe we will get to this phase of monetary deflation. If stocks give out, I don’t expect the FOMC’s plan to come to fruition. It will be back to its Keynesian ways of creating money out of thin air.
We need a good correction for the benefit of consumers. We need a reallocation of capital that is in accordance with consumer demand. Unfortunately, if and when we get such a correction, I don’t think the Fed will do nothing.