The Federal Open Market Committee (FOMC) released its latest monetary policy statement. As expected, the FOMC raised the federal funds rate, which is the overnight lending rate for banks. The new target range will be from 2% to 2.25%. You can see the changes made from the last statement here.
More interesting than the FOMC statement itself is the implementation note.
First, in order to raise the target federal funds rate, the Fed must raise the interest rate paid on bank reserves. It cannot easily raise the interest rate any other way barring a massive deflation in the money supply or a massive hike in reserve requirements for banks. Neither of those things is going to happen, at least to the extent that would be necessary. Therefore, the Fed must pay interest to banks to hike its target interest rate. This is more bailing out of the banks, although we do not generally hear this policy referred to in those terms.
The implementation note reads:
The Board of Governors of the Federal Reserve System voted unanimously to raise the interest rate paid on required and excess reserve balances to 2.20 percent, effective September 27, 2018.
The rate paid to banks is actually slightly below the upper limit of the target rate. This was also done in the previous hike in order to achieve the targeted range.
The second interesting thing in the implementation note is regarding the Fed’s draining of the balance sheet. They are allowing some maturing assets to mature without rolling them over. This is basically the equivalent of selling off assets, at least in terms of the size of the balance sheet, which is the base money supply.
The implementation note reads:
Effective in October, the Committee directs the Desk to roll over at auction the amount of principal payments from the Federal Reserve’s holdings of Treasury securities maturing during each calendar month that exceeds $30 billion, and to reinvest in agency mortgage-backed securities the amount of principal payments from the Federal Reserve’s holdings of agency debt and agency mortgage-backed securities received during each calendar month that exceeds $20 billion.
Therefore, starting in October, the Fed will not be rolling over up to $50 billion per month in maturing debt. Broken down, this is $30 billion per month in Treasury securities and $20 billion per month in mortgage-backed securities. It is still not completely clear on what the Fed does with non-performing mortgage-backed securities.
Overall, the Fed is in monetary deflation mode. This is after an unprecedented growth in the base money supply from 2008 to 2014. The balance sheet will never return to anywhere near what it was in early 2008.
We don’t know what will happen to the massive excess reserves built up by the commercial banks. We should expect them to go down with the Fed’s deflation of the base money supply. The excess reserves actually look to be going down faster, which could offset some of the Fed’s deflationary policy.
However, they did trick us on the way up. When the Fed was creating money out of thin air like crazy starting in late 2008, many people were predicting severe consumer price inflation. We have gotten some high asset price inflation (particularly in stocks and housing), but consumer prices have been relatively tame in comparison to the digital money printing that happened. One of the reasons for this was that banks held on to the new money and did not lend out a lot of it. The fractional reserve lending process did not multiply the effects of the Fed’s loose monetary policy.
After the FOMC released its latest statement and people digested the words of the Fed chair, long-term rates on U.S. Treasuries went down a bit. The short-term rates were relatively flat. For the month of September, the yield curve stopped flattening and actually steepened a little. On September 26, 2018, this slightly reversed.
I still think that the yield curve is our best source of data right now. A flat or inverted yield curve is the best predictor of recessions, and I see no reason why it would fail us this time.
If we are to believe the Austrian Business Cycle Theory, then there should be a liquidation of the bubble activity that sprang up on the back of the Fed’s loose monetary policy. While the Fed’s target interest rate is still historically low, it is going up. And in terms of the monetary base, the Fed is currently deflating. This means that the artificial boom activity that relied on loose money and artificially low interest rates should be exposed in the somewhat near future. We don’t know how long this thing can play out. I have to admit that the boom has lasted longer than I would have thought.
The boom is only a boom for those who have been able to benefit from the asset price inflation. For the average guy who doesn’t own a lot of stocks, and especially for those who don’t own a house, there isn’t much of a boom.
When the boom finally goes bust, the people hurt the most will be those who lose their job, and those who own a lot of assets, especially if they are leveraged. For most everyone else, the bust may not be that bad. In fact, it may help make life a little bit more affordable once again.