It’s a new ball game
In October 2018, four years will have passed since the Federal Reserve System ended its third round of quantitative easing.
So far, the Federal Reserve officials have been remarkably disciplined in its efforts to move back to a “more normal” level of interest rates and a smaller securities portfolio.
During this time, the Federal Reserve has raised the target range for the Federal Funds rate, its policy rate of interest, seven times.
Although quantitative easing ended in October 2014, the Fed did not make its first move of its interest rate target until December 17, 2015. It has raised the policy range six more times since then so that the current range for the Fed Funds rate is now at 1.75 percent to 2.00 percent.
Currently, the weekly average effective Federal Funds rate is 1.91 percent.
The Federal Reserve did not begin to reduce the size of its securities portfolio until the start of the third quarter of 2017. It has not sold securities into the open market to reduce the portfolio, but achieved its goals by not fully replacing the amount of securities that matured each month from its portfolio.
From October 15, 2014, the Fed’s securities portfolio has dropped by $137 billion, to a level of $4,072 billion.
Over this time period, the total assets of the Fed fell by $192 billion, to a level of $4,325 billion.
To put these numbers into perspective, the total assets of the Fed in the fall of 2007, just before the beginning of the Great Recession, were around $930 billion.
In terms of the liquidity position of the commercial banking system, Reserve Balances held at Federal Reserve Banks, a proxy for excess reserves in the banking system, have fallen by $873 billion to $1,947 billion last week.
To put this measure of “excess reserves” into perspective, “excess reserves” totaled just under $15 billion.
Yes, that’s right…$15 billion!!!
Federal Reserve officials have achieved these numbers in a methodical, disciplined manner. And, their plans are to continue this effort…if the markets allows…and make two more movements in the Fed’s policy rate of interest this year, followed by three more increases in 2019.
This would bring the upper limit to the Fed’s policy range to 3.25 percent.
Furthermore, the Fed will continue to reduce the size of its securities portfolio for the next year or so, continuing to increase the amount taken each month on a scheduled path.
In my mind, Fed officials are to be commended for the way that they have pursued their goals over the past, almost, four years.
Where does trouble loom?
The answer: In the area of the US Federal Government’s fiscal policy.
The Republican Party has thrown off any claims it ever had to be the party of fiscal discipline and responsibility.
First, the Republicans who control the White House, the House of Representatives, and the Senate, passed a tax reform bill that included substantial increases in the debt of the federal government. Then in February it passed a budget that increased deficits even further.
Now, there is the possibility that the government will spend $12 billion to “bail out” farmers that are suffering from the tariff increases supported by President Trump and, to add to this, US Treasury Secretary Mnuchin is looking at a tax reduction package of $100 billion for wealthier Americans.
Even before these latter items were presented to the public, the Congressional Budget Office had reported that the federal budget deficit over the next 10 years would average nearly 5 percent of GDP, and this compares with a 3.5 percent level in 2017.
Over the nest ten years, the federal debt will rise to equal nearly 100 percent of GDP…its highest level since the end of World War II.
And, all this is hitting the economy just at the time that the economy begins its tenth year of the current expansion. Next year at this time, if the economy is still growing, the recovery will become the longest one in US history.
And, this is happening at a time when the unemployment rate is around a full employment level and wage increases are starting to rise more rapidly.
It is hard to say that President Trump and the Republican Congress are acting in a disciplined and responsible way. Their actions are in marked contrast to the performance being put on at the Federal Reserve.
This is an out-of-balance, out-of-equilibrium situation.
It is hard to see how the officials at the Federal Reserve System will be able to continue their methodical and disciplined approach to “normalizing” interest rates and its balance sheet.
All the fiscal action and the increasing deficits will put more and more pressure on an already stretched economy and labor market. This credit inflation will tend to support further asset bubbles that already exist…like the US stock market…and may actually create some real increases in consumer prices and wholesale prices…something that has not really been seen for a while.
The question is, therefore, how will the Federal Reserve act in such an environment?
One unknown within the Federal Reserve is how the new Governors on the Board will behave in this environment. Remember, President Trump has appointed the current Chair of the Board of Governors, although President Obama had appointed Jerome Powell to the Board. But, one of the other two existing Board members is a new Trump appointee…and…there will be four more new members…all appointees of President Trump.
It’s a new ball game.