The Fed Is Deep in Uncharted Waters. Danger Ahead.
By Karen Petrou
Sept. 9, 2021 4:30 am ET
Jerome Powell spoke virtually during the Jackson Hole economic symposium in August.
About the author: Karen Petrou is managing partner at Federal Financial Analytics and the author of Engine of Inequality: The Fed and the Future of Wealth in America
Although Jay Powell delivered his all-important annual address atop a virtual Wyoming mountain, the Federal Reserve is nonetheless mired in the Big Muddy. This mythical river was described in a high-impact Pete Seeger song mobilizing Vietnam War opposition. In it, soldiers led by politicians start out in a small, clear stream, wade on and, as the waters rise and the mud deepens, keep going because they don’t and then can’t turn around. All they do is march on to a surely-grim fate. So too with U.S. monetary policy: It’s past time to turn around but still critical that the Fed quickly do so.
Fed policy has three key components, none of which have worked as planned. The post-2010 recovery was the weakest since the Second World War; inflation constantly surprises the central bank; and markets keep rising to troubling and sometimes disastrous heights even as U.S. economic inequality gets steadily more acute.
The Fed first relies on ultra-low rates set via its longstanding open-market operations. These low, low rates are making it harder for middle-class families to save while boosting the fortunes of the ultra-rich. And while the Fed won’t own up to its part in inequality, it has set rates so low that there’s no room for error above the “zero lower bound” at which short-term rates would become negative in nominal terms, just the inflation-adjusted ones to which we’ve become all too familiar. It thus added quantitative easing to its toolkit, striding even farther off the shore and from known, safe territory.
In QE, the Fed buys trillions of Treasury and agency assets. Now, these have grown to $8.3 trillion or about one-third of U.S. GDP. The Fed thought that all these trillions would make a major macroeconomic difference in part by giving banks cash with which to lend, thus boosting growth. However, bank lending as a percentage of GDP has gone steadily down even as markets go ever upward. An important study shows that the Fed’s portfolio has had ten times more impact on equity prices than output.
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The reason? The more safe assets the Fed takes out of financial markets, the greater the demand for them, the lower the rates safe issuers such as Treasury need to pay, and the more investors desperate for real returns above zero head into high-risk equity and bond markets. The Fed thought that interest on the reserves banks hold at the Fed in the course of QE would bolster traditional rate-setting operations by placing a floor under short-term rates. But the floor keeps sinking even though the Fed continues to tinker with the rate it pays banks to park funds with the Fed.
Even these fixes haven’t worked as hoped. In 2013, markets trembled so the Fed stepped still deeper into the river. It created an overnight reverse-repo program to recycle cash from banks and money-market funds. These are not small programs. Banks now hold $3.9 trillion at the Fed and the ONRRP just took in record amounts of as much as $1.08 trillion. Because none of this worked as hoped, the Fed just created yet another window, a Standing Repo Facility.
As it set rates since 2008, bulked up QE since 2020, and established one after another market interventions, the Fed still could not achieve stable, sustained, shared prosperity. It has, though, effectively exercised the “Greenspan put,” setting a floor under financial markets in hopes that the trickle-down benefit of the “wealth effect” will eventually materialize.
While waiting for this victory, the Fed strode so deep into uncharted waters that it has become not just the lender of last resort, once considered the sole remit of central banks in the market, but also the market-maker and even the broker-dealer of last resort.
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Does the Fed like getting this wet and dirty? Of course not. It wants banks to lend out its cash and knows that savings—not speculation—best ensures financial stability. It also knows that its huge portfolio distorts markets, making them far more dependent on utterances from central-bank officials than any profit-or-loss fundamental. And the Fed also knows that backing markets with billions and trillions encourages behavior that is at best unwise from yield-chasing investors.
What it doesn’t know is how to step back, turn around, and go back to the shallow waters in which its presence made a meaningful difference toward ensuring shared prosperity and financial stability.
There are, though, ways to the shallow end. First, the Fed should understand the U.S. economy as income and wealth inequality has now come to define 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 go quickly beyond Powell’s August promise of some sort of suspension of some amount of new Fed asset purchases sometime soon. The distortions due in large part to these purchases are pushing key markets to dangerous heights—see for example the price of U.S. homes, which grew 17.4% year-over-year and an astonishing 4.9% from just the first to the second quarter. Tapering the Fed’s huge holdings would help rates to rise a bit because the artificial demand created by the Fed’s trillions of bond purchases would ease. More normal rates mean more normal markets, bringing the U.S. further from the dangerous dividing line beyond which lies real negative rates and the harm these would do to so many investors and to anyone still foolish enough to contemplate saving for the future.
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And, finally, the Greenspan put should get the shove. Central banks must step in only if financial-market instability threatens more than financier year-end bonuses and step out as soon as 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 policy quagmires isn’t knowing you should get out; it’s getting out. Like the U.S. presidents who confronted Vietnam, Iraq, and—now and at least as tragic—Afghanistan, the Fed knows it needs to get out of the Big Muddy. Each way out seems blocked so it gets in ever deeper, but ever deeper is ever more dangerous. The more the Fed perpetuates markets that depend only on central-bank largesse, not price discovery and disciplinary correction, the greater the risk that inescapable retreat leads to costly casualties.