The Fed never flooded the US with money 9 years ago – it just toyed with its price
If it’s true we’ll now see Fed reserves wound way down, then the mainstream economy may in fact be looking at easier money or, at least, easier access to it
The age of easy money is nearly over
– Bloomberg headline, November 3
Above is a common reading of what the US Federal Reserve Board means by unwinding its asset purchase programme, commonly referred to as quantitative easing.
It gives you the impression Fed governors decided nine years ago to help their country out of its financial crisis by conjuring a flood of money out of thin air and using it to stimulate the economy back into growth.
This has now been achieved, so the reading goes, and thus it is now time to soak all that money up again and get it out of the way so that it does not cause an over-stimulus. But this is not quite the story.
The Fed never actually toyed with the supply of money, which you could know anyway by that the annual growth rate of the money supply on the M2 measure averaged about 6.5 per cent over the last 10 years, virtually unchanged from the previous 10 years.
You could also know it from the fact these same Fed governors are still bemoaning their inability to get consumer inflation up to their 2 per cent target.
A flood of money would have driven inflation well into double digits. Just ask the people of Venezuela what printing money does to inflation.
What the Fed actually did was toy around with the price of money. It bought government bonds from commercial banks and, instead of paying for them, told these banks to deposit equivalent sums with the Fed as bank cash assets. The chart below shows how closely matched these two have been over the last nine years.
This depleted the supply of these bonds in the market and induced the market to bid up their prices. The practical effect of this in turn was to lower the yield, the coupon interest rate expressed as a percentage of the prevailing price.
Lower the yield of government bonds, the Fed governors reckoned, and the result will be to push down interest rates across the board, particularly if the Fed discount rate is also dropped to zero bound.
They were right. It was exactly what happened and the US entered an extended period of artificially low interest rates.
But this also had some unintended effects. When the banks were forced to stash away a sizeable proportion of their assets as Fed reserves, they found themselves with less money for other purposes. There was a definite slowing impact on lending and other operations.
This just dampened the supposed stimulus. Yes, interest rates were lower but the banks had less money to advance at these low interest rates. They could afford to pick and choose among borrowers and mainstream industrial borrowers were not always the best risk.
Wall Street was a better one. The prices of all securities were rising with an extended period of low yields. Advancing money for the purchase of financial assets was not only easier in this environment but less risky and more profitable. Financial speculators therefore became the biggest beneficiaries of quantitative easing.
And when the money did go into industry it tended to go into Wall Street speculative favourites. Tesla Inc, for instance, which has again just reported record losses, could never have lasted so long in an environment of honest pricing of money. It would have been cleared out as deadwood long ago.
Thus if it is true that we are now to see these Fed reserves wound way down – and I am by no means a firm believer – then the mainstream economy may in fact be looking at easier money or, at least, easier access to money.
It will be bad news for financial speculators. But don’t cry any big tears for them.