WTF: What The Fed

Public pronouncements by the Federal Reserve (the Fed) so often come across as some zen koan, like what's the sound of one hand clapping or describe your face before your mother and father were born. Alan Greenspan began the fine art of riddle-speak as Fed chair ('87-'06) --  see how many simple declarative sentences you can find amidst his nineteen years of testimony -- laying the groundwork for successors Bernanke, Yellen, and Powell.
  
But, if fedspeak has truly devolved into an exercise of obfuscation, one is entitled to ask why that would be, given the Fed's central role in a properly operating state. Perhaps the reason goes to loss of direction and confusion of purpose.  

Our discussion is centered around the proposition that the Fed, established in 1913 (after the market crash of 1907) to backstop lending to companies facing liquidity issues (i.e. solvent companies facing the need for temporary access to cash), has now morphed into an unaccountable institution largely unfettered in its ability to create money for purposes that go well beyond those traditional concerns about inflation and employment. We are now grappling with the consequences of this unleashed power.

First, though, the easiest way to understand a central bank (as is the Fed) is to see it as a simple stand-alone balance sheet. The creation of money shows up as a liability on the right side of the balance sheet  -- that's why the dollar bill in your pocket is labeled as a Federal Reserve Note, an asset to you and a liability to the bank. Money is created by the equivalent of a keystroke entry, without the need for any congressional approval, without the need to raise taxes (these being so-called fiscal, as opposed to monetary, matters). In fact, the very name Federal Reserve is misleading as there's nothing federal about it. Perhaps it would be better labeled the Bank Consortium Reserve. 

On the left side of the balance sheet is the list of assets. The main asset here includes purchased U.S. Treasury Securities. And this raises an extremely important point. Were the U.S. to finance its tremendous (and growing) deficit on a straight-forward basis it would have to find real buyers for these debt securities. The potential third-party buyers e.g. the domestic public and foreign governments (think China and Japan) wouldn't come close to supporting this market. All things being equal the resulting glut (much bigger supply than demand) of these issued securities would drive prices down through the floor. Stated differently, the effective interest rate owed by the U.S. to these holders would skyrocket. 

But all things are not so equal. Enter the Fed with its key-stroke ability to conjure money to fill the massive shortfall of buyers. So what could go wrong?  Plenty. That's the subject of our focus article, an unusually candid assessment for a banker-tied ex-politician. Long story short, all that Fed money has to go somewhere. Were it to go directly into the "real" economy the result would be massive inflationary pressure. Instead, the money goes into the bowels of the Fed's constituent banks' balance sheets in a category called "excess reserves." 

These excess reserves then seep into the real economy via the commercial banks through a process known as fractional reserve lending, so named because this brand new money (which is created by these loans) is limited only by the necessity that those excess reserves be a certain fraction of the the aggregate loan amounts. While, as now, there is a low demand for loans the seepage is of limited concern but, once the economy starts to recover, loan demand could easily translate into an outpouring of new money entering the real economy with consequent inflationary effect. That's the essence of what's stated in the article.

Of far greater significance, however, is what is not stated. The co-author of the article, Phil Gramm, is the same Phil Gramm who, as the former chairman of the Senate Banking Committee, ushered in the repeal of the those portions of the Glass-Steagall Act  that had previously distinguished commercial banking from investment banking. Removal of this distinction opened the way for the Fed (with the constituent banks) to mainline conjured money directly into the economy. School's out.

As such, the concern about seepage through commercial bank lending is absolutely bush league compared to what was thereby enabled. Want proof? The next time you hear that inflation, as measured by producer prices, seems subdued, just direct your attention to asset inflation in the form of the stock market and real estate. Per JPMorgan CEO Jamie Dimon, "The Fed's liquidity, bringing out the bazooka, is propping up stock prices (as well as all other asset classes)." Then add in the artificial suppression of long-term interest rates (courtesy of the previously-mentioned Fed purchases of Treasury Securities) which facilitated things like corporate share repurchases, heavy corporate debt levels, evaporation of your savings account rates, along with other misallocations of capital and you'll begin to see the genesis of America's wealth inequality.

The problem with discussing things in terms of millions, billions, and trillions is that they sound the same. So just consider that when you hear the Fed  "expanded its balance sheet" by another $3.276 trillion. That works out to $22,600 for every taxpayer of which "your" share was $1,200 with the other $21,400 applied to who-knows-what. One hint of where it might be going is through the recently-announced "special purpose vehicles" between the Fed and the Treasury to finesse the purchase corporate securities, high yield bonds (junk), ETFs and such other instruments that would otherwise fall outside the Fed's charter. 

Obfuscation indeed. So much for accountability. So much for clear statement of purpose. So much for the heralded Fed independence. And that's exactly why this topic is worthy of discussion for our further enlightenment. 

This should be a most interesting, frustrating, and meaningful discussion topic as there are so many angles to explore. A stunning observation in a recent Bank of America report has it that the expansion of the money supply (with the intent to drive down interest rates and thereby fire up growth) actually had a deflationary effect as the loss of interest income translated into the reduction of consumption and increase in savings as households prepared to meet retirement goals. 

Up is down and down is up. Was hoping Greenspan might clear all this up for us.