The Fantasies of the Federal Reserve

By at 11 June, 2020, 3:28 pm


by Raymond J. Keating-

Economic recovery and expansion do not depend on the Federal Reserve running monetary policy. This vision more closely resembles fantasy, rather than sounds economics.

The Federal Open Market Committee statement released on June 10 featured an understandably sober assessment of the economy, along with a pledge to keep the federal funds rate near zero:

“The ongoing public health crisis will weigh heavily on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term. In light of these developments, the Committee decided to maintain the target range for the federal funds rate at 0 to 1/4 percent. The Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”

The Fed also noted that it “is committed to using its full range of tools to support the U.S. economy in this challenging time, thereby promoting its maximum employment and price stability goals.”

In addition, Fed Chairman Powell in a press conference spoke a lot about the Fed’s “tools” and “toolkit” to aid the economy, and mentioned (though did not completely commit to) the idea that the fed funds rate could stay at zero through 2022.

For the record, the Fed has no idea what the economy is going to look like in six months, never mind more than two years from now.

The reality is that the Fed can do very little to help the economy in a substantive way. Economic growth comes from the private sector via entrepreneurship and investment, and the only way that the Fed contributes to that effort is by maintaining price stability. As noted by the U.S. Bureau of Labor Statistics’ Consumer Price Index release, CPI inflation has been nonexistent over the past three months. In fact, in March, April and May, we experienced deflation (i.e., falling general prices).

Meanwhile, monetary policy has been unprecedented since late summer of 2008, in that is has been so loose that there is no historical comparison in U.S. history. And since the pandemic hit the U.S., monetary policy has managed to get even looser. But while the monetary base has skyrocketed, so have bank reserves. (See the following chart showing the monetary base (currency in circulation plus bank reserves) and bank reserves.)

Source: Federal Reserve Bank of St. Louis, FRED

This raises the question that I have been bringing up for the past dozen years: What does loose money accomplish when the bulk of the expansion in the monetary base winds up in record levels of bank reserves? What’s the point?

The great risk of the past dozen years was that this vast expansion in the monetary base would trigger inflation. But that largely didn’t happen because of the historic increase in reserves. That was aided by the fact that the Fed was granted the power to pay interest on those excess reserves.

So, the primary result of the Fed’s monetary reaction to the economic/credit mess of 2008 was to increase uncertainty in the economy, while also reallocating resources based on political rather than market decisions. That contributed to deepening the Great Recession, and undermining growth during the subsequent recovery/expansion period.

Now, we’re back. In reaction to the coronavirus and related economic shutdowns, the Fed has increased the monetary base by some $1.8 trillion over the past three months, and with it, bank reserves have jumped by $1.6 trillion. That leaves us, again, with uncertainty and the threat of slower growth. And that uncertainty includes wondering if loose money eventually will result, this time, in a diminished dollar and rising inflation.

The price for monetary policy gone awry will be paid for one way or another – or in myriad ways. To think otherwise is to partake in economic fantasy.

Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council. 



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