In December, the Fed hiked its target for the federal funds rate, which is
the interest rate banks charge each other for overnight loans of reserves.
Since 2008 the Fed’s target for the Fed Funds Rate had been a range of 0
percent – 0.25 percent (or what is referred to as zero to 25 “basis points”).
But last month they moved that target range up to 0.25 – 0.50 percent. Ending
a seven-year period of effectively zero percent interest rates.
From our vantage point, we already see carnage in the financial markets,
with the worst opening week in US history. This of course lines up neatly
with standard Austrian business cycle theory, which says that the central
bank can give an appearance of prosperity for a while with cheap credit, but
that this only sets the economy up for a crash once rates begin rising.
However, there is something new in the present cycle. The Fed is trying to
raise rates while simultaneously maintaining its bloated balance sheet. It is
attempting to pull off a magic trick whereby it can keep all of the
“benefits” of its earlier rounds of monetary expansion (i.e., “quantitative
easing” or “QE”) while removing the artificial stimulus of ultra-low interest
rates. As we’ll see, this attempt will not end well, for the Fed officials or
for the rest of us. In the meantime, Ben Bernanke will look on with concern,
writing the occasional blog post and perhaps giving a speech about poor Janet
Yellen’s tough predicament.
Austrian Business Cycle Theory
One of the seminal contributions of Ludwig von Mises was what he called
the circulation credit theory of the trade cycle. In our times, we simply
call it Austrian business cycle theory, sometimes abbreviated as ABCT. The
Misesian theory was subsequently elaborated by Friedrich Hayek, and it was
partly for this work that Hayek won the Nobel Prize in 1974.
In the Mises/Hayek view, interest rates are market prices that perform a
definite social function. They communicate vital information about consumer
preferences regarding the timing of consumption. Entrepreneurs must decide
which projects to start, and they can be of varying length. Intuitively, a
high interest rate is a signal that consumers are “impatient,” meaning that
entrepreneurs should not tie resources up in long projects unless there are
large gains to be had in output from the delay. On the other hand, a low
interest rate reduces the penalty on longer investments, and thus acts as a
green light to tie capital up in lengthy projects.
So long as the interest rate is set by genuine market forces, it gives the
correct guidance to entrepreneurs. If consumers are willing to defer
immediate gratification, they save large amounts of their income, and this
pushes down interest rates. The high savings frees up real resources from
current consumption — things like restaurants and movie theaters — and allows
more factories and oil wells to be developed.
However, if the interest rate drops not because of genuine saving, but
instead because the central bank electronically buys assets with money
created “out of thin air,” then entrepreneurs are given a false signal. They
go ahead and take out loans at the artificially cheap rate, but now society
embarks on an unsustainable trajectory. It is physically impossible for all
of the entrepreneurs to complete the long-term projects they begin.
In the beginning, the unsustainable expansion appears prosperous. Every
industry is growing, trying to bid away workers and other resources from each
other. Wages and commodity prices shoot up; unemployment and spare capacity
drop. The economy is humming, and the citizens are happy.
Yet it all must come crashing down. In a typical cycle, price inflation
eventually rises to the level that the banks become nervous. They halt their
credit expansion, allowing interest rates to start rising to a more correct
level. The tightening in the credit markets causes pain initially for the
most leveraged operations, but gradually more and more businesses are in
trouble. A wave of layoffs ensues, with large numbers of entrepreneurs
suddenly realizing they were too ambitious. The painful “bust,” or recession,
sets in.
This Time Is Different (Sort of)
Since the financial crisis of 2008, the stock market’s surges have
coincided with rounds of QE, and the market has faltered whenever the
expansion came to a temporary halt. The sharp sell-off in August 2015
occurred when investors thought the first rate hike was imminent (it had been
scheduled for September 2015). That particular hike was postponed, but after
it went into effect in December, we soon saw the market tank to 2014 levels.
As we would expect in times of Fed tightening, the official monetary base
has fallen sharply in recent months, but this doesn’t mean that the Fed is
selling off assets (as it would in a textbook tightening cycle). Indeed the
Fed’s assets have been constant since the end of the so-called taper in late
2014.
This is unusual since the monetary base and the Fed’s total assets
typically move in tandem. Yet since late 2014, there have been three major
drops in the monetary base that occurred while the Fed was dutifully rolling
over its holdings of mortgage-backed securities and Treasuries, keeping its
total assets at a steady level.
The explanation is that the Fed has been testing out new techniques to
temporarily suck reserves out of the banking system, while not reducing its
total asset holdings.
Meanwhile, the Fed in December bumped up the interest rate that it pays to
commercial banks for keeping their reserves parked at the Fed. I like to
describe this policy as the Fed paying banks to not make loans to their customers.
What Does It All Mean?
So why is the Fed trying to tighten the money supply without selling off
assets as it has done in the past? It boils down to this: In order to bail
out the commercial and investment banks — at least the ones who were in good
standing with DC officials —as well as greasing the wheels for the federal
government to run trillion-dollar deficits, the Federal Reserve in late 2008
began buying trillions of dollars worth of Treasury debt and mortgage-backed
securities (MBS). This flooded the banking system with trillions of dollars
of reserves, and went hand in hand with a collapse of short-term interest
rates to basically zero percent.
Now, the Fed wants to begin raising rates (albeit modestly), but it
doesn’t want to sell off its Treasury or MBS holdings, for fear that this
would cause a spike in Uncle Sam’s borrowing costs and/or crash the housing
sector. So the Fed has increased the amount that it is paying commercial
banks to keep their reserves with the Fed (rather than lending them out to
customers), and — for those institutions that are not legally eligible for
such a policy — the Fed is effectively paying to borrow the reserves itself.
By adjusting the interest rate the Fed pays on such transactions, the Fed can
move the floor on all interest rates up. No institution would lend to a
private sector party at less than it can get from the Fed, since the Fed can
create dollars at will and is thus the safest place to park or lend reserves.
We thus have the worst of both worlds. We still get the economic effects
of “tighter monetary policy,” because the price of credit is rising as it
would in a normal Fed tightening. Yet we don’t get the benefit of a smaller
Fed footprint and a return of assets to the private sector. Instead, the US
taxpayer is ultimately paying subsidies to lending institutions to induce
them to charge more for loans, while the big banks and Treasury still benefit
from the effective bailout they’ve been getting for years.
It Can’t Last
Will the Fed be able to keep the game going? In a word, no. We’ve already
seen that even the tiniest of interest rate hikes has gone hand in hand with
a huge drop in the markets. Furthermore, the Fed’s subsidies to the banks are
now on the order of $11 billion annually, but if they want to raise the fed
funds rate to, say, 2 percent, then the annual payment would swell to more
than $40 billion. That is “real money” in the sense that the Fed’s excess
earnings would otherwise be remitted to the Treasury. Therefore, for a given
level of federal spending and tax receipts, increased payments to the bankers
implies an increased federal budget deficit.
Janet Yellen and her colleagues are stuck with a giant asset bubble that
her predecessor inflated. If they begin another round of asset purchases,
they might postpone the crash, but only by making the subsequent reckoning
that much more painful.
You don’t make the country richer by printing money out of thin air,
especially when you then give it to the government and Wall Street. The Fed’s
magic trick of raising interest rates without selling assets can’t evade that
basic reality.
