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The
Hussman Funds explains why the Federal Reserve is irrelevant.
(emphasis mine) [my
comment]
Why
the Federal Reserve is Irrelevant
Alan Greenspan isn't the "Maestro." He's Oz.
By John P. Hussman, Ph.D.
This article was first published in August 2001
The Federal Reserve is irrelevant [I disagree, especially with today's
quantitative easing. However, this article has many good points and should
help people understand the fed better]. We don't just mean ineffective,
though that is certainly likely to be true here. Rather, because of a change
in the application of reserve requirements over the past decade, Fed actions
have virtually zero impact on lending activity in the U.S. banking system.
The main job of the Federal Reserve is to determine the mix of
government liabilities held by the public. When the Fed "eases monetary
policy" or "cuts interest rates", it accomplishes this as
follows. The Fed goes into the open market, buys a bunch of Treasury
securities from banks (who have drawers full of them), and pays for them by
creating new bank reserves.
Pull a dollar bill out of your wallet. Look at the very top line on the
front. It says "Federal Reserve Note." That dollar bill is
essentially a liability of the Federal Reserve. The Fed also has a
corresponding asset - the Treasury securities it buys.
When the Fed "cuts interest rates", what it is really doing is replacing
one government liability held by the public - Treasury securities - with
another government liability: currency and bank reserves (monetary base).
That's all the Fed does. It determines the mix - but not the total amount
– of government liabilities held by the public. Since the
operations of the Fed are executed by buying or selling securities on the
open market, the group at the Fed responsible for these decisions is called
the Federal Open Market Committee, or FOMC.
Banks are required to hold reserves as a percentage of all checking
accounts outstanding. These reserves prevent overdrafts, and provide for
day-to-day withdrawals of currency and the like. On any given day, some banks
will have a reserve shortfall, while others will have excess reserves. These
excess bank reserves are lent back and forth between banks on an overnight
basis, at an interest rate known as the Federal Funds Rate.
Essentially, the Fed lowers the Federal Funds rate by purchasing Treasuries
from banks and increasing the "monetary base" - bank reserves plus
currency in circulation. The only thing that the Fed can control with
certainty is the monetary base. Alternately, it can try to
control the Federal Funds rate (and passively adjust the monetary base by
whatever amount is required to keep Fed Funds on target). However, the Fed
cannot control the Federal Funds rate with certainty. For example, if
inflationary pressures were high and interest rates were moving up, the Fed
could not predictably lower the Fed Funds rate by easing monetary policy [Key
point]. Not surprisingly, central banks always target money growth,
not interest rates, when inflation is high. That's why Volcker
targeted money supply, while Greenspan targets interest rates. But
ultimately, the only thing that the Fed can directly control is the monetary
base.
The "money multiplier" loses its magic
Alright. So when the Fed is easing, it increases the monetary base by
purchasing Treasuries on the open market. When the Fed is tightening, it
reduces the monetary base by selling Treasuries on the open market. Now that
we're clear on what the Fed does, let's take a look at why it is irrelevant.
Activist monetary policy is based on the assumption that there is a
predictable relationship between bank reserves and bank lending. The
operative notion of easy money is that the Fed creates new bank reserves, and
banks lend them out. These loans get spent, and the proceeds get deposited at
other banks as new checking accounts. Whatever is not required to be held as
reserves is then lent out again, and through the magic of the "money
multiplier", loans and bank deposits go up by many times the initial
injection of reserves.
That's the theory. But a change came in the 1970s with the emergence of money
market funds, which require no reserve requirements. Then in the early 1990s,
reserve requirements were dropped to zero on savings deposits, CDs, and
Eurocurrency deposits. At present, reserve requirements apply only to
"transactions deposits" - essentially checking accounts. The vast
majority of funding sources used by banks to create loans have nothing - nothing
- to do with bank reserves.
These days, commercial and industrial loans are financed by issuing large
denomination CDs. Money market deposits are largely used to lend to
corporations who issue short term commercial paper. Consumer loans are also
made using savings deposits which are not subject to reserve requirements.
These loans can bunched into securities and sold to somebody else, taking
them off of the bank's books.
 
The point is simple. Commercial, industrial and consumer loans no longer
have any link to bank reserves. Since 1995, the volume of such loans has
exploded, while bank reserves have actually declined . Look at the one
monetary aggregate that the Fed can directly control - the monetary base. Every
bit of increase since January 1994 is accounted for by currency in
circulation, not bank reserves. [most of this growth in
“currency in circulation” came from foreign demand for dollars.]
Over the past year, the Fed has eased very aggressively, buying about $32
billion in Treasuries, with a corresponding $32 billion increase in the
monetary base. Now look closer. Total bank reserves actually declined by
$1 billion while currency in circulation has increased by $33 billion.
[Remember that 70% of those dollars in circulation are overseas]
Alan Greenspan isn't the "Maestro". He's Oz - working behind
the curtains, leaning into the microphone, pressing buttons that blow smoke
and fire, but not really having much power at all. Scarecrow already has a
brain. For the past several years, commercial and industrial loans and
consumer credit exploded quite simply because rabidly eager borrowers were
able to find rabidly eager lenders. And now, both forms of credit (as well as
commercial paper issuance) are declining because borrowers are saturated with
debt and lenders are increasingly skittish of credit risk.
The Fed certainly played an important psychological role in recent
years, and certainly has a role to play during bank runs and other
crises where the demand for monetary base soars. But the rest of the time,
open market operations are almost completely sterile. In recent years, the
irrelevance of open market operations has also been argued (for slightly
different reasons) by academic economists renown for their work in the theory
of “rational expectations”, including Thomas Sargent and John
Muth.
Inflation follows unproductive government spending
One might respond that even if the Fed doesn't affect credit, surely changes
in the monetary base affect inflation. But if you look at the statistical
evidence, the relationship between monetary growth and inflation is very weak
[I disagree. Factors like dollars flowing oversea can distort statistical
evidence]. Instead, our research indicates that inflation is primarily the
result of growth in unproductive forms of government spending (basically
defense spending, entitlements and other expenditures that fail to stimulate
the supply of goods). The evidence both from the U.S. and other countries
clearly demonstrates this relationship.
As Milton Friedman has noted, the burden of government is not measured by how
much it taxes, but by how much it spends. The impact is particularly
severe when growth in entitlements is high and growth in productivity is low.
This is why inflation exploded after the late 60's, and why it came down
after the early 1980's. This is why the Germans suffered hyperinflation after
World War I when its government decided to keep paying workers who had gone
on strike.
Always and everywhere, rapid inflation is produced by excessive creation
of government liabilities without a corresponding increase in the amount of
goods produced by the economy. The Fed doesn't control this. It
doesn't even matter much what form the liabilities take. If the Germans had
decided to issue bonds to striking workers instead of money, bond prices
would have been driven to ridiculously low levels, driving interest rates to
extremely high levels, creating an unwillingness to hold non-interest bearing
money, resulting in a rapid deterioration in the value of money, and
hyperinflation just the same.
Except for the Federal Funds rate, the Fed does not determine short-term
interest rates. Most of the time, it simply follows them. Statistically, the
Federal Funds rate consistently lags market interest rates such as Treasury
bill yields. Indeed, changes in market rates have far more predictive power
to forecast the Federal Funds rate than vice versa.
The main exception is the Prime Rate. Changes in the Prime Rate follow
changes in the Federal Funds rate largely because 1) competition forces
equality of lending rates; 2) the Fed Funds rate tracks other short term
rates, and; 3) changing Prime in unison at any other time than a discrete Fed
move would be considered evidence of collusion among banks.
So don't place too much faith in the Federal Reserve. Again, in a banking
panic, where the demand for the monetary base soars, the Fed is essential.
But here and now, the Fed is, and probably will be, hopelessly ineffective.
In his recent testimony to Congress, Alan Greenspan described his job as
difficult. In our view, he might as well have quoted Prime Minister Giovanni
Giolitti. When asked in the early 1900's whether it was difficult to govern
Italy, Giolitti replied, “Not at all, but it's useless.”
While on the
topic of the fed, Wikipedia explains the fed’s open market operations.
Open
market operations
Open market operations are the means of implementing monetary policy by
which a central bank controls its national money supply by buying and selling
government securities, or other financial instruments. Monetary
targets, such as interest rates or exchange rates, are used to guide this
implementation.
Since most money is now in the form of electronic records, rather than paper
records such as banknotes, open market operations are conducted simply by
electronically increasing or decreasing ('crediting' or 'debiting') the
amount of money that a bank has, e.g., in its reserve account at the central
bank, in exchange for a bank selling or buying a financial instrument.
[Think
of the fed as a (central) bank at which all other banks are required to keep
checking accounts (called reserve accounts).
These reserve accounts work for banks the exact same way as checking accounts
work for you and me.
The balances in reserve accounts at fed ARE EXACTLY THE SAME AS CASH.
Whenever the fed credits/debits a bank’s reserve account, it is
essentially depositing/withdrawing money from a fed-owned checking account at
that bank, much in the same way you or me deposit/withdraw money from our
checking accounts via ATMs.
Here is an example of how the fed might buy assets. First it credits the
reserves of a bank, let’s say JPMorgan. In exchange, JPMorgan credits
an equal amount into a checking account own by the fed. The fed then uses the
money in its JPMorgan checking account to buy assets like mortgage backed
securities.]
Newly
created money is used by the central bank to buy in the open market a
financial asset, such as government bonds, foreign currency, or gold. If
the central bank sells these assets in the open market, the amount of money
that the purchasing bank holds decreases, effectively destroying money.
The process does not literally require the immediate printing of new
currency [If a bank credits money into your bank account, it
doesn’t mean you immediate have more money in your wallet. First you
have to go to an ATM and get the money. This is the same principle at work]. A
central bank account for a member bank can simply be increased electronically.
However this will increase the central bank's requirement to print currency
when the member bank demands banknotes, in exchange for a decrease in its
electronic balance. Often, the percentage of the total money
supply consisting of physical banknotes is very small. In the United States
only around 10% of the "M2" money supply actually exists in the
form of physical banknotes or coins. The rest exists as credits in
computerized bank accounts. See Money supply.
Possible targets of open market operations
*** Under inflation targeting, open market operations target a specific
short term interest rate in the debt markets. This target is changed
periodically to achieve and maintain an inflation rate within a target range.
However, other variants of monetary policy also often target interest rates:
both the US Federal Reserve and the European Central Bank use variations on
interest rate targets to guide open market operations.
*** Besides interest rate targeting there are other possible targets of open
markets operations. A second possible target is the growth of the money
supply, as was the case in the U.S. in the late 1970s through the early 1980s
under Fed Chairman Paul Volcker.
*** Under a currency board open market operations would be used to achieve
and maintain a fixed exchange rate with relation to some foreign currency.
*** Under a gold standard, notes would be convertible to gold, so there
would be no open market operations. However, open market operations could be
used to keep the value of a fiat currency constant relative to gold.
*** A central bank can also use a mixture of policy settings that change
depending on circumstances. A central bank may peg its exchange rate (like a
currency board) with different levels or forms of commitment. The looser the
exchange rate peg, the more latitude the central bank has to target other
variables (such as interest rates). It may instead target a basket of foreign
currencies rather than a single currency. In some instances it is empowered
to use additional means other than open market operations, such as changes in
reserve requirements or capital controls, to achieve monetary outcomes.
Economist Robert Mundell has stated that when using open market operations
it is only possible to pursue a single target at any given time. One cannot
use open market operations to target interest rates while being on a gold
standard. Likewise if you are targeting interest rates then the exchange
rates will fluctuate. [Finally, if you are targeting interest
rates then you can’t control the money supply.]
My reaction: I
actually disagree that the fed is irrelevant (especially with the way it is
printing money), but I do believe that the fed has a lot less influence and
control then it did in the past.
1) Due to changes in the application of reserve requirements, Fed actions
have virtually zero impact on lending activity in the US banking system.
2) Commercial, industrial and consumer loans no longer have any link to bank
reserves.
3) Central banks use open market operations to control its national money
supply by buying and selling government securities and other assets.
4) Open market operations are the means of implementing monetary policy by
which a central bank controls its national money supply by buying and selling
government securities, or other financial instruments. Monetary targets, such
as interest rates or exchange rates, are used to guide this implementation.
5) Targets used by central banks for their open market operations include:
A) Specific short term interest rate. (Federal Funds rate)
B) Growth of the money supply (Volcker’s fight against inflation)
C) A fixed exchange rate with some foreign currency. (China’s dollar
peg)
D) A fixed exchange rate with gold. (Gold standard)
6) When a central bank expands the monetary base by electronically increasing
reserve accounts of a member bank, the process does not literally require the
immediate printing of new currency. The central bank's requirement to print
currency will only increase when the member bank demands banknotes in
exchange for a decrease in its electronic balance.
7) Central banks always target money growth, not interest rates, when
inflation is high. This is why the market value of assets on the
fed’s balance sheet is so important, because it determines how much the
fed could shrink the money supply when selling those assets.
Conclusion: Changes in the application of reserve requirements help
explain how the 262 Billion US monetary base could
support a 10 trillion money supply.
Eric
de Carbonnel
Market Skeptics
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