Wise use, prudence, and respect for markets require a steady hand.
Recent turmoil in the banking sector has focused attention on the role of central banks, both in economies and in bank supervision and control. This will discuss central banks, like the U.S. Federal Reserve, and some of the tools they use to implement their policies, which can be opaque to the average person.
First, let’s differentiate fiscal policy, which, in the United States, is controlled by the Congress and the president through the federal budget, and monetary policy, which is the province of the Federal Reserve.
Fiscal policy relates to spending, deficits, government revenues, and taxation. It is a reflection of elected officials’ desires and objectives for the economy and should reflect the well-being of the people. You’re able to deduct the interest on a home mortgage from your income taxes, for example, because elected officials believe home ownership is a desirous outcome for the economy. The reasoning goes that home ownership helps builds stable communities amd stimulates investment in consumer durables, like furntiture, refrigerators, and dishwashers.
Monetary policy, on the other hand, controls the money supply and interest rates and is supposedly free of political considerations, although there is plenty of evidence politics comes into play in making Federal Reserve policy.
But Congress has tasked the Fed with two principal mandates.
The first mandate is to ensure price stability, so that prices neither increase nor decrease significantly. Since 1996, the Fed has defined “price stability” as a 2 percent per-annum rate of inflation. The 2 percent inflation is sort of a “fudge factor”—a tripwire to prevent deflation, or a decline in prices. It is intended to avoid the economy falling into a deflationary spiral, what economists call a “liquidity trap.”
In a liquidity trap, people anticipate declining prices, so they delay spending, which causes demand to fall and prices to decline further. The Fed can lower rates and inject cash into the economy in such circumstances, but nothing will stimulate spending, even at what economists call the “zero bound,” when interest rates are zero. The economy falls into a deep and, theoretically, insurmountable depression. (Countering a liquidity trap at the zero bound is one of the main reasons banks around the world are experimenting with central bank digital currencies, or CBDCs. As I wrote earlier, CBDCs allow central banks to stimulate spending at or below the zero bound in a “use it or lose it” scenario.)
The second mandate Congress gave the Fed is to pursue full employment, which had long been encouraged, but that was made an explicit mandate by the Full Employment and Balanced Growth Act of 1978.
“Full employment” is generally considered to be an unemployment rate of 4 percent or less, which is people leaving jobs, coming into the workforce, etc. But the full-employment mandate implicitly supports a low interest rate, so it’s difficult to balance in an inflationary environment where interest rates are rising. Indeed, countering inflation has only rarely been achieved without slowing the economy and increasing unemployment. When it does happen, it is colloquially called a “soft landing.” (The Phillips curve holds that unemployment and inflation are inversely related, but has been mostly disproven as a rule by “stagflation,” the portmanteau of economic stagnation and inflation that plagued the Ford and Carter administrations in the 1970s. But there is still an intuitive sense in the marketplace that inflation adversely affects employment and slows hiring and encourages firings.)
The Fed’s Toolbox
The Fed has various means to expand, contract, and otherwise control the money supply. These tools were never explicitly granted to the Fed by the laws that created it, but have emerged, holistically, at the Fed’s own initiative from a general grant of authority that were then acknowledged by regulations.
The Basic Tools
There are three “plain-vanilla” tools the policy-making Federal Open Market Committee (FOMC) uses to control the money supply.
The first is the discount rate, the rate of interest the Fed charges member banks to borrow money at the Fed’s discount window. While banks can borrow from the Fed, most make other borrowing arrangements, so the discount rate—as set—tends to be more influential than operative. If the Fed raises or lowers its discount rate, other lenders follow suit immediately.
The second tool is the Fed’s reserve requirement, whereby the Fed dictates the amount of deposits member banks must retain to meet withdrawal demands. A high reserve requirement tends to decrease the money supply, whereas a low or nil requirement will stimulate the economy as more money is being lent out.
The most well-known, and most common, tool the Fed uses to control the money supply is open market operations that are voted by the FOMC. The FOMC sells securities to reduce the money supply so as to slow inflation and buys securities to grow the money supply to stimulate growth.
The Fed’s More Esoteric Tools
The Fed requires member banks to maintain a certain minimum balance on reserve at the Federal Reserve and it pays interest on those deposits. Since 2008, though, the Fed has paid interest on the deposits exceeding those minimum balances, known as “excess reserves.” Originally, a law change had anticipated the Fed would pay interest on excess deposits in 2011; however, that was advanced by new laws adopted to address the financial crisis of 2008–09. The liquidity that existed in the market in those days had put downward pressure on the Fed’s overnight rate, so interest was paid on excess deposits to absorb the excess cash. The Fed continues to pay interest on excess deposits because it is a useful means of setting the baseline rate for the market, because no banker will lend money at a rate lower than the Fed pays on its excess deposits.
The Fed also engages is repurchase agreements. These, too, are intended to affect short-term (mostly overnight) interest rates. In a “repo,” the Fed buys securities held by banks and makes a corresponding commitment to sell them back at a later date. The repos put cash into the economy to boost the money suppy.
Since 2014, the Fed has used overnight reverse repurchase agreements to further “fine tune” the money supply. These act as the mirror image of repos, where the Fed sells securities and repurchases them the next day. The overnight reverse repurchase agreements are intended to set the overnight floor on interest.
How the Tools Are Used
Fed policy usually is implemented after the Fed votes changes in rates at one of the regularly schedule meetings of the FOMC. It is at these meetings where the Fed tends to use what I call their basic tools, such as if the FOMC votes for a policy change to lower or raise rates. But things can get kind of dicey from time t0 time, and between meetings, principally because liquidity dries up.
Generally, liquidity is the ease by which one can convert assets to cash. When there is a mismatch between what a buyer will pay and a seller will accept for an asset, it is difficult to convert assets to cash. Banks may also reduce or even eliminate lending altogether if economic circumstances require it. In 2008, for example, the collapse of the housing market caused long-term mortgage lending to dry up because the deposits that financed those mortgages were demand deposits payable immediately. Banks had to cover depositors demands so preserved cash.
The recent turmoil at Silicon Valley Bank (SVB), for example, was a consequence of SVB’s relatively small number of uninsured depositors with large balances demanding their deposits that had been invested in notes that had a 10-year duration.
How the Fed addresses these intermittent crises are addressed can vary. In September 2019, for example, cash demands for federal income tax payments caused a radical spike in secured overnight financing (SOFR) rates. On Sept. 17, SOFR rates spike by three percentage points above the Fed target range, causing a liquidity crisis. To address it, the Fed stepped in and offered up to $75 billion of repos to inject additional cash using Treasury debt and “agency debt,” meaning securities of the Federal National Mortgage Agency (“Fannie Mae”), the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and their associated mortgage-backed securities as collateral. Within days, rates stabilized and the liquidity was restored.
The latest banking crisis with Silicon Valley Bank seems to have become more stable for now, despite what I believe was a badly botched response from the Treasury Department and Secretary Janet Yellen. First Citizens has reportedly agreed to buy SVB, and the run on regional banks—triggered largely by Yellen’s vacillations—seems to have largely subsided. But the stability has come at a cost: the Fed has had to reverse course and expand its balance sheet as the Fed created a credit facility to allow banks to borrow for up to one year using Treasury and agency debt, but treating their collateral value as what their value will be at maturity, that is, at “par.” (So, e.g., a Treasury bond with a $1,000 value at maturity, but a current market value of $800, will be treated as though it is currently worth $1,000 and banks can borrow against that full value as collateral.)
Central banks play a critical role in the functioning of markets. Irrespective of whether you agree with their policies (and I am one who disputes the policies often), they fulfill a critical function in national and international economies. Were they not to exist, their role would very likely be filled by private financiers, such as J.P. Morgan (the individual, not the bank), who stepped in to lend money to provide liquidity in the Panic of 1907.
Still, it is important to remember that the Fed’s ability to control the money supply and rates is dependent on the market for U.S. government securities. As China, Japan, and other countries back away from the U.S. dollar over concerns about our debt and other issues, our government securities become less desirable and the spread between the bid and the ask—liquidity—in our financial markets can become more tenuous. There will come a time, I fear, that our failure to address our massive debt burden will cause the Fed to lose control over rates and the money supply. When that happens, the United States will have lost a significant element of its sovereignty. And Americans will have lost a great deal of the their freedom.