Taps Coogan – January 14th, 2022

Enjoy The Sounding Line? Click here to subscribe for free.

Over the years, we have written a lot about the changes to monetary policy that arose from the trillions of dollars of excess reserves that quantitative easing has created.

The punchline is that the Fed Funds rate has become of secondary importance because major domestic depository institutions’ need to borrow reserves is negligible in an excess reserve regime. Much more important to policy and markets has been the level of excess reserves and the Interest on Excess Reserves rate (IOER), the rate that the Fed pays banks to not lend their trillions of dollars of excess reserves. Those two factors, excess reserve levels and the IOER, are what actually controls liquidity. The Fed Funds rate is best thought of as an output of those two variables, not an input.

Within that context, Dr. Judy Shelton, controversial former Fed Board Nominee and Senior Fellow at the Independent Institute, recently spoke with CNBC to remind everyone that if the Fed actually wants to get inflation under control and ‘normalize’ policy, it’s best to just reduce the balance sheet and avoid the acrobatics of first raising the Fed Funds rate, a rate which will only have real relevance again when there aren’t excess reserves in the first place.

 

Some excerpts from Dr. Shelton:

“The Fed’s primary tool for raising the interest rate is to pay a higher rate of return to banks, depository institutions, who are required to keep reserve accounts at the Federal Reserve… The way the Fed plans to do those 25 basis point hikes… is to raise that rate. Now, they are paying banks to keep that money idle, to not make loans with it. So I don’t see how that is going to help increase supply, which is our inflation problem… You are effectively inducing banks to not get involved in providing loans… I think it would be much better to start to reduce that gargantuan balance sheet. They added more than $4.4 trillion since Covid started in March of 2020… The Fed is too prominent in Financial markets. It’s too powerful… and too political…”

Indeed, the best way to get back to a ‘normal’ monetary policy regime and away from endless quantitative easing and ZIRP, would be… to get back to a normal monetary policy regime. That cannot be done without eliminating the glut of excess reserves.

Yours truly is in agreement with Dr. Shelton that reducing the balance sheet before raising interest rates avoids the expensive theatrics of paying banks not to lend so that you can raise the Fed Funds rate, a rate that depository institutions won’t be using until the excess reserves are gone.

That being said, let’s not kid ourselves. Reducing the balance sheet will constrict liquidity and sink markets. It is not a less painful path, just a less contrived one. Given the magnitude of the bubble that the Fed has created, any balance sheet runoff would have to be glacially slow, lest it spark a panic that leads the Fed into even more QE. 

In any case, the Fed’s not going to lead with the balance sheet. Returning to ‘normal’ monetary policy is not their objective, so it’s all hypothetical.