The Fed’s Great Unwind: Will It Sink Us? | Mises Institute

The Fed’s Great Unwind: Will It Sink Us?

12/08/2017 Thorsten Polleit

In the eyes of many people, the Federal Reserve (Fed) is an indispensable institution. We are told it supports growth and employment, fends off the negative shocks, and fights inflation. Nothing could be farther from the truth. The Fed’s fiat money regime is economically and socially highly destructive — causing far-reaching societal and political consequences that extend beyond what most people would imagine.

Fiat money is inflationary, it debases the purchasing power of money; it benefits a few at the expense of the many; it causes boom-and-bust cycles that hurt many people economically; it makes people run into too much debt, leading to over-indebtedness; it corrupts society’s morals; it makes government grow at the expense of individual liberty; it encourages the state’s aggressiveness and fuels its war machine.

Tragically, however, people consider falsely the Fed as their “knight in shining armor” coming to their rescue in times of trouble rather than what the institution really is: the very source of economic and societal grievance. People do not blame the Fed for the trouble it causes, but instead welcome Fed action for overcoming the damage it has caused in the first place. That is why many people keep their fingers crossed that the Fed’s latest “exit plan” will succeed.

The Fed’s Exit Plan

In the course of the financial and economic crisis of 2008–2009, the Fed lowered interest rates to basically zero. It also increased its balance sheet from $879.4 billion at the end of 2007 to $4.5 trillion in September 2017. It did this by purchasing US Treasuries and agency mortgage-backed securities (MBS) in the amount of $2.4 trillion and $1.7 trillion, respectively, thereby having injected additional ‘base money’ into the US banking system.

Recently, the Fed has changed course. It has raised its target interest rate from near-zero to a still-tiny rate slightly above 1 percent. What is more, the Fed has decided to start shrinking its balance sheet beginning in October 2017 by gradually reducing the reinvestment of principal payments from its security holdings. Specifically, it will reinvest each month’s principal payments only to the extent that such payments exceed gradually rising caps.

The cap will be set at $10 billion per month in October 2017 and stepped up each quarter, reaching a maximum of $50 billion per month a year later. This will bring the Fed’s balance sheet of US dollars down by an estimated $1.7 trillion to $2.8 trillion at the end of 2020 — which would still be $1.9 trillion above its pre-crisis level seen at the end of 2007.

The Fed’s exit plan has spooked some investors.

It is feared that the Fed’s draining of liquidity from the banking sector could result in an overly restrictive effect on credit markets. This, in turn, could push borrowing costs upward, sending the economy — and financial markets in particular — down, even potentially paving the way toward a new full-blown crisis. So what is to be made of the Fed’s plan to unwind its balance sheet in the years to come?

Reducing the Money Supply Could Lead to a Bust

The Fed’s envisaged reduction in reinvesting maturing bonds in its portfolio will affect the quantity of credit and money.

The Fed, however, is proceeding with extreme caution, afraid that any sizable change would cause the interbank interest rate to spike and bring down the entire economy and financial system.

In practice, the Fed will thus have to keep sitting on a significant part of its bond holdings and buy new bonds once they mature. A true and final exit from the Fed’s active role in the credit market — and thus an end to long-term interest rate manipulation — is therefore nowhere in the near future.

Whether or not the Fed’s plan will actually result in a contraction in the quantity of money will depend on two conditions: The banking sector’s willingness and ability to expand its balance sheet and investor appetite for agency MBS (or other credit products).

The Safety Net

To make the unwinding of (part of ) its securities holdings run smoothly, it should be clear that the Fed has to continue to cater to the needs of banks and fixed income investors. Perhaps most importantly, the Fed will have to hold up its ‘safety net’ — a tacit promise that operates already in the shadows: to stand ready at any time to prop up the economy and financial markets from collapsing.

This is, in fact, exactly what investors have learned from the last crisis: the Fed, in its determination to keep the fiat money regime going, has made all too clear that it is willing, and has the capacity, to take recourse to manipulative policies (in the form of suppressing interest rates) and raising inflation (that is expanding the quantity of money through credit expansion) to keep the economy afloat and prop up financial market prices.

If and when investors remain confident that the Fed’s safety net remains in place whatever comes, the (partial) winding down of the Fed’s bloated balance sheet is unlikely to cause disruptions in the smooth functioning of financial markets and the continuation of the monetary policy induced expansion of the economy. The truly critical factor in all this is, however, the level of market interest rates.

The Great Distortion

For the latest economic recovery has been, first and foremost, fueled by artificially low interest rates. Exceptionally low borrowing costs have encouraged firms to invest more, private households to consume more, and the public sector to spend more — and so growth seems to have returned. If interest rates rise, however, the monetary policy induced economic upswing (“boom”) will come to a shrieking halt, most likely to fall back into recession (“bust”).

But not only is the continuation of the Fed’s low interest rate policy required to keep the current boom going. By no means less important is the corollary of the Fed’s safety net. For it has created among investors the illusion of stability, encouraging investors to lose sight of unavoidable uncertainties and vagaries of real life; it has put to rest investor default concern, thereby artificially reducing credit premia and lowering borrowing costs.

It is fair to say that the economy and financial markets in particular have become, more than ever before, dependent on the Fed’s monetary machination: By having distorted interest rates and prices on the grandest scale, the Fed has actually established a “hall of mirrors”: a mirage of returning economic and financial prosperity. Nor will the Fed’s destructive policy be ended by the planned unwinding of its balance sheet.

Rather than look to the Fed for the solutions, a more practical and honest approach is to demystify the Fed’s damaging effect on the economy sooner rather than later.

The material liberation has liberated our spirits and has allowed us to live more fulfilling lives than before. So, I don’t want to hear the “money can’t give you happiness” thing. If this doesn’t make you happy — that people are free to do these things and pursue things they love — then there ain’t no satisfying you.

Thorsten Polleit is chief economist of Degussa and macro-economic advisor to the P&R REAL VALUE fund. He is honorary professor at the University of Bayreuth a nd an Associated Scholar of the Mises Institute.

Source: The Fed’s Great Unwind: Will It Sink Us? | Mises Institute