The Fed Knows Not What It Does, Never Has
When the Fed Makes Headlines, You Know We're In TroubleThe Federal Reserve is like a nuclear power plant. It is very powerful, and when it starts making headlines, you can be sure that we are in deep trouble. Unfortunately, under Ben Bernanke, the Fed has become the economic equivalent of Chernobyl. It is making headlines every day, and none of the news is good.
At this writing, it is only twelve days since the announcement of QE3 on September 13, and already the euphoria is fading. By the end of trading on September 25, the Dow Jones Industrial Average had lost 82.31 of the 206.51 points that it gained on September 13.
Meanwhile, the Real Dow (the Dow divided by the price of gold), which lost 0.65% on September 13, has continued to fall. It ended on September 25 at 7.63. This is down by 1.14% from September 12(the day before QE3 was announced), by 16.26% from the start of Obama’s (so called) “economic recovery”, and by 81.97% from its all-time monthly closing high, in August 1999. The Real Dow is important, because it is a measure of the impetus for productive investment. A falling Real Dow means less investment, which means lower GDP growth, which means lower total employment.
A look at history suggests that, as a general rule, the Fed has no idea what it is doing. Time and time again, the Fed has been taken completely by surprise by the results of its actions and inactions.
In the face of the worst liquidity crisis in U.S. history, the Fed allowed the monetary base to contract by 6% from November 1929 to October 1930, thus precipitating the Great Depression. In 1937, the Fed drastically increased reserve requirements for no obvious reason, thereby producing the second leg of the Great Depression, as well as untold misery.
During the late 1960’s the Fed increased the size of the monetary base by more than was consistent with maintaining the Bretton Woods gold standard. For the sake ofcreating a tiny excess amount of base money, probably only about $3 billion, the Fed destroyed the foundation of America’s post-war prosperity.
More recently, the Fed was caught completely by surprise by the popping of the housing/mortgage bubble in 2007-2008, even though they were the ones who created it in the first place.
The Fed, which employs thousands of economists, did not seem to notice that gold prices rose from $255.95/oz in April 2001 to $1011.25/oz in March 2008, and then fell back to $740.75/oz in September 2008. Or, if they did notice this, they didn’t realize that a seven-year, 74.7% devaluation of the dollar, followed by a seven-month, 36.5% revaluation, was guaranteed to produce a huge, hard-asset, speculative bubble and bust, and that the bust would precipitate a financial crisis.
The Fed’s September 13 press release regarding QE3 was bizarre. The Fed seemed to express shock at today’s high unemployment rate, even though, when adjusted to the labor force participation of December 2008, the “true” unemployment rate has been essentially unchanged for the past three years. (It was 11.2% in October 2009, and 11.3% in August 2012.)
The Fed also seemed to be surprised by the slow pace of economic growth, even though it is solely responsible for nominal GDP (NGDP).
Since 2Q2007, the Fed has allowed NGDP to fall farther and farther below its “trend” 5% growth rate. If the Fed had maintained the 5% trend growth rate since 2Q2007, 2Q2012 NGDP would have been $2.3 billion, or 14.8%, higher than it actually was. Because NGDP per worker is about$200,000, this NGDP shortfall is equivalent to 11.6 million average jobs.
The strangest thing about the Fed’s QE3 press release was the promise to target monetary policy against the unemployment rate. Total employment is a real variable, and monetary actions can only impact nominal variables. It was as if the Fed wanted to finally “do something”, but that it didn’t want to admit that the analysts (like Scott Sumner) that have been calling for the Fed to target NGDP were right all along.
Tragically, QE3 is not likely to accelerate our current anemic NGDP growth, much less close the (currently $2.3 billion) NGDP gap vs. trend. This is because the Fedcontinues to be oblivious to the impact of its “interest on reserves” (IOR) policy, which automatically “sterilizes” all of the Fed’s asset purchases.
Currently, the Treasury yield curve ranges from 0.11% for 3-month T-bills, to 2.85% for 30-year T-bonds. Right now, we have a normal yield curve, with interest rates rising with length of maturity. Arbitrage insures that, to the market as a whole, all maturities of Treasury securities are equally attractive as investments.
Now, imagine that the Treasury started selling one-dayT-bills that yielded 0.25% interest. If they auctioned them off, they would sell for above par value, because the market would bid up the price of these securities until they yielded perhaps 0.02%.
However, let’s say that the Treasury didn’t hold an auction for these special T-bills, but instead just sold them to its friends at par, with the proviso that they could not be resold for their true market value.
Under these circumstances, the favored buyers would take all of these special T-bills that they could get, and they would never resell them. This is what happens when you offer something valuable (and completely liquid) at a price that is below market.
Now, let’s say that every time the Fed bought $40 billion worth of agency mortgage-backed securities (as they have promised to do every month during QE3), the Treasury sold $40 billion worth of their special T-bills. Obviously, the monetary impact of the Fed’s QE3 would be neutralized. There would be no impact upon NGDP, and therefore no impact upon employment.
Well, with the Fed paying 0.25% interest on bank reserves, the Fed itself is basically doing exactly what has been described above. When the Fed buys $40 billion worth of mortgage-backed securities, it pays for those assets by creating $40 billion of excess bank reserves, which command 0.25% interest. Those reserves then just sit there. No bank is going to trade an asset paying above-market interest for one paying at-market interest.
Unfortunately, the impact of “sterilized QE3” is actually worse than if the Treasury was neutralizing the Fed’s asset purchases rather than the Fed doing this itself. This is because the bank reserves that the Fed creates are considered money, rather than T-bills.
Although with the IOR rate above the Treasury yield curve, the $1.5 trillion of excess reserves are not actually inflationary today, they are potentially inflationary. In other words, they represent a threat.
The markets react to this threat by bidding up the price of gold, and other commodities (like oil) that can serve as inflation hedges. The result is that QE3 raises the cost of living for ordinary people, even while IOR holds down NGDP, and therefore employment and wages.
Economic history provides compelling evidence that the Fed has never understood what it is doing, and that it still does not. The Fed’s combination of QE3 and IOR, reflecting both its tremendous power and its utter cluelessness, very much resembles a nuclear power plant with crumbling control rods. Unfortunately, America and the rest of the world will suffer from the economic fallout.