About the Author: Karen petrou is Managing Partner of Federal Financial Analytics and author of Driving Inequality: The Fed and America’s Future of Wealth
Although Jay Powell delivered his all-important annual address atop a virtual mountain in Wyoming, the Federal Reserve is nonetheless mired in the Big Muddy. This mythical river has been described in a Song by Pete Seeger mobilization of the opposition to the Vietnam War. In it, soldiers led by politicians start in a small, crystal-clear stream, ford and, as the waters rise and the mud deepens, continue because they don’t and can’t do it anymore. turn around. All they do is walk toward a surely grim fate. The same goes for US monetary policy: it is high time to turn around, but it is still essential that the Fed do it quickly.
There are three key elements to the Fed’s policy, none of which has worked as intended. The recovery after 2010 was the weakest since World War II; inflation constantly surprises the central bank; and markets continue to reach troubling and sometimes disastrous heights even as economic inequalities in the United States become increasingly acute.
The Fed relies primarily on ultra-low rates set through its long-standing open market operations. These low, low rates make it more difficult for middle-class families to save while increasing the fortunes of the ultra-rich. And although the Fed does not recognize its share in the inequality, it has set rates so low that there is no margin for error above the “zero lower bound” at which rates run out. term would become negative in nominal terms, just inflation – adjusted to which we have become too familiar. He thus added quantitative easing to his toolbox, advancing even further from shore and known and safe territory.
In QE, the Fed buys trillions of treasury and agency assets. Now these have become $ 8.3 trillion or about a third of US GDP. The Fed believed that all of those trillions would make a major macroeconomic difference in part by giving banks money to lend, thus spurring growth. However, bank lending as a percentage of GDP has steadily declining even as the markets rise more and more. a important study shows that the Fed’s portfolio had ten times more impact on stock prices than on production.
The reason? The more safe assets the Fed removes from financial markets, the greater the demand for them, the lower the rates that safe issuers such as the Treasury have to pay, and the more investors desperately seek above-zero real yields in financial markets. high risk stocks and bonds. markets. The Fed estimated that interest on reserves that banks hold at the Fed as part of QE would bolster traditional rate-setting operations by placing a floor below short-term rates. But the floor continues to sink even as the Fed continues to change the rate it pays banks to park funds with the Fed.
Even these fixes did not work as hoped. In 2013, markets shook and the Fed sank even deeper into the river. He created an overnight repo program to recycle cash from banks and money market funds. These are not small programs. Banks now hold $ 3.9 trillion to the Fed and the ONRRP have just received record amounts $ 1.08 trillion. Because none of this worked as hoped, the Fed just created another window, a Permanent pension facility.
By fixing rates since 2008, stepping up QE since 2020 and instituting market intervention after market intervention, the Fed has still failed to achieve stable, sustained and shared prosperity. He did, however, effectively exercise the “Greenspan put“, setting a floor under financial markets in the hope that the fallout from the” wealth effect “will eventually materialize.
While waiting for this victory, the Fed has sunk so deep into uncharted waters that it has become not only the lender of last resort, once seen as the sole mandate of central banks in the market, but also the market maker and even the broker. of last resort.
Does the Fed like to be wet and dirty? Of course not. He wants the banks to lend him his money and knows that saving, not speculation, is the best guarantee of financial stability. He also knows that his huge portfolio distorts the markets, making them far more dependent on statements from central bank officials than on any fundamental profit or loss. And the Fed also knows that supporting markets with billions and trillions encourages behavior that is reckless at best on the part of yield-seeking investors.
What he doesn’t know is how to step back, turn around, and return to the shallows where his presence has made a significant difference in ensuring shared prosperity and financial stability.
There are, however, paths to the shallow end. First, the Fed should understand the US economy as income and wealth inequality is now defining it. It should set employment and price stability goals that reflect the nation as a whole, not the segments of it that speak through financial markets.
Second, it should move quickly beyond Powell’s August promise of some sort of suspension of a certain amount of new Fed asset purchases in the near future. The distortions due in large part to these purchases push key markets to dangerous levels – see for example the price of American houses, which grew 17.4% year-on-year and an astonishing 4.9% between the first and second quarters. Reducing the Fed’s huge holdings would help rates go up a bit, as the artificial demand created by the Fed’s trillion bond purchases eased. More normal rates mean more normal markets, moving the United States away from the dangerous dividing line beyond which lies real negative rates and the harm they would do to so many investors and whoever is still enough. crazy to consider saving for the future.
And, finally, Greenspan’s bet should get the boost. Central banks should only intervene if the instability of the financial markets threatens more than the financial bonuses at the end of the year and withdraw as soon as the macroeconomic danger has passed. The more windows and facilities the Fed creates to stabilize more and more corners of the financial market, the less likely it is that markets will discipline themselves.
The problem with political quagmires is not knowing you have to get out; it comes out. Like the American presidents who faced Vietnam, Iraq and – now and at least tragically – Afghanistan, the Fed knows it needs to get out of the Big Muddy. Each exit seems blocked so it goes deeper and deeper, but always deeper is always more dangerous. The more the Fed perpetuates markets that depend only on the largesse of central banks, and not on price discovery and disciplinary correction, the greater the risk that an inevitable pullback leads to costly losses.
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