Thoughts from the Frontline: The Third and Final Transformation of Monetary Policy

By: John_Mauldin

The law of unintended consequences is becoming ever more prominent in the economic sphere, as the world becomes exponentially more complex with every passing year. Just as a network grows in complexity and value as the number of connections in that network grows, the global economy becomes more complex, interesting, and hard to manage as the number of individuals, businesses, governmental bodies, and other institutions swells, all of them interconnected by contracts and security instruments, as well as by financial and information flows.

It is hubris to presume, as current economic thinking does, that the entire economic world can be managed by manipulating one (albeit major) subset of that network without incurring unintended consequences for the other parts of the network. To be sure, unintended consequences can be positive or neutral or negative. This letter you are reading, which I’ve been writing for over 15 years and which reaches far more people than I would have ever dreamed possible, is partially the result of a serendipitous unintended consequence.

But as every programmer knows, messing with a tiny bit of the code in a very complex program can have significant ramifications, perhaps to the point of crashing the program. I have a new Microsoft Surface Pro 3 tablet that I’m trying to get used to, but somehow my heretofore reliable Mozilla Firefox browser isn’t playing nice with this computer. I’m sure it’s a simple bug or incompatibility somewhere, but my team and I have not been able to isolate it.

However, that’s a relatively minor problem compared to the unintended consequences that spill from quantitative easing, ZIRP, and other central bank shenanigans. We have discussed the problem of how the Federal Reserve has pushed dollars on the rest of the world and is playing havoc with dollar inflows and outflows from emerging markets. More than one EM central banker is complaining aggressively.

My good friend Dr. Woody Brock makes the case that an unintended consequence of QE is that the Federal Reserve’s normal transmission of monetary policy through periodic changes in the fed funds rate has been vitiated. He contends that soon we will no longer care about the fed funds rate and will be focused on other sets of rates.

This is an important issue and one that is not well understood. Woody has given me permission to reproduce his quarterly profile. For Woody, this is actually a fairly short piece; but as usual with Woody’s work, you will probably want to read it twice.

Woody is one of the most brilliant economists I know, and I make a point of spending time with him as our schedules permit. We are making plans to get together at his Massachusetts retreat in August. He is restructuring his business in order to spend more time writing and less time traveling, and he intends to lower the price of his subscription. It will still be pricey for the average reader, but for funds and institutions it should be a staple. You can find his website at www.SEDinc.com or email him at SED@SEDinc.com. 

Before we go to Woody’s letter, if you’re going to be at my conference this coming week, you’ve already made arrangements. I know a lot of people wanted to go but just couldn’t work it into their schedules. I won’t say it’s the next best thing to being there, but you can follow me on Twitter, where my team and I will be sending out real-time tweets about the important ideas and concepts we are hearing, not just from the speeches but from all the conversations that spring up during the day and late into the evening. If you’re curious as to who will be there, here’s a page with the speakers. If you’re at the conference, look me up.

The Fed Funds Rate: R.I.P.
‒ The Third and Final Transformation of Monetary Policy

By Woody Brock, Ph.D.
Strategic Economic Decisions, Inc.

The policy announcements of the US Federal Reserve Board are dissected and analyzed more closely than any other global financial variable. Indeed, during the past thirty years, Fed‐Watching became a veritable industry, with all eyes on the funds rate. Within a few years, this term will rarely appear in print. For the Fed will now be targeting two new variables in place of the funds rate. One result is that forecasting Fed policy will be more demanding.

To make sense of this observation, a bit of history is in order. During the last nine years, US monetary policy has been transformed in three ways. To date, only the first two have been widely discussed and are now well understood. The third development is only now underway, and is not well understood at all. To review:

First, the Fed lowered its overnight Fed funds rate to essentially zero, not only during the Global Financial Crisis of 2008–2009, but throughout nearly six years of economic recovery thereafter. The average level of the funds rate at the current stage of recovery was about 4% during the past dozen business cycles. It was never 0% as it is in this cycle. In past essays, we have argued that this overutilization of “ultra‐easy monetary policy” reflected the failure of the government to utilize fiscal policy correctly (profitable infrastructure spending with a high jobs multiplier), and to introduce long‐overdue incentive structure reforms. It was thus left to monetary policy to pick up the pieces after the global crisis of 2008. This development was true in most other G‐7 nations, not just in the US.

Second, the Fed inaugurated its policy of Quantitative Easing whereby it increased the size of its balance sheet five‐fold from $900 billion to $4,500 billion. Such an expansion would have been inconceivable to Fed watchers during the decades prior to the Global Financial Crisis. In the US, QE is now dormant, and the only remaining question (answered below) is how and when the Fed will shrink its bloated balance sheet back to more normal levels.

Third, the way in which the Fed conducts standard monetary policy (periodic changes in the funds rate) is currently undergoing a complete makeover. In particular, the traditional tool of changing the funds rate via Open Market operations carried out by the desk of the New York Fed no longer works. For as will be seen, the vast expansion of the size of its balance sheet (bank reserves in particular) has rendered traditional policy unworkable. From now on, therefore, the Fed will conduct monetary policy via two new tools that were not even on the drawing board of the Fed prior to 2008.

Summary: In this PROFILE, we explain in Part A why traditional (non‐QE) monetary policy has been vitiated by QE. In Parts B and C respectively, we discuss the two new tools that will be used in the future to conduct standard (non‐QE) monetary policy: what exactly are these tools, and how do they work? In Part D, we discuss why these new tools will not be required by the European Central Bank, which has a different institutional structure than the US Fed. Finally, in Part E, we turn to QE and discuss when and how the Fed will shrink its balance sheet back to a more traditional size in the years ahead.

In this write‐up, we largely rely on the remarks set forth in a recent paper by Fed Vice Chairman Stanley Fischer, formerly chief economist of the IMF, Governor of the Central Bank of Israel, and professor of economics at MIT. We also benefitted from clarifications by Professor Benjamin Friedman at Harvard University.

Part A: So Long to Setting the Funds Rate via Open Market Operations

Prior to the financial crisis, bank reserve balances with the Fed averaged about $25 billion. With such a low level of reserves, a level controlled solely by the Fed, minor variations in the amount of reserves via Fed open market sales/purchases of securities sufficed to move the Fed funds rate up or down as desired. Analytically, the market for bank reserves (Fed funds) consisted of a demand curve for bank reserves reflecting the nation’s demand for loans, and a supply curve reflecting the supply of reserves by the Fed. The so‐called Fed funds rate is the point of intersection of these two curves (the interest rate). If the Fed targeted, say a 2% funds rate, it achieved and maintained this rate by shifting the supply curve left or right by adding to/subtracting from the quantity of reserves. As the Fed was a true monopolist in the creation/extinction of reserves, it could always target and sustain any funds rate it chose.

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