In The Throes of a Dilemma
Before launching into the dilemma, a brief bit of history and structure of the US banking system.
Most people are aware of something called the Federal Reserve System.
It was created in 1913 when Congress passed The Federal Reserve Act. The law sets up 12 Federal Reserve Banks operating within geographic areas, or districts, covering the United States. There is an overall Federal Reserve Board which can veto action(s) taken by the Federal Open Market Committee (FOMC) – consisting of twelve members–the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents. The FOMC oversees open market operations and the setting of interest rates. Open market operations are those whereby the Federal Reserve buys and sells US treasuries and other debt securities, i.e. mortgages.
Since 1951 the Federal Reserve system has operated independently of the US Treasury Dept.
So, what does this central bank called the Federal Reserve do? Answer: it sets the monetary policy of the country. It controls the money supply by increasing the amount of currency in circulation or shrinking it. It does so by buying and selling short-term treasuries (and other securities) on the open market and by setting interest rates.
The problem currently faced by the Federal Reserve starts back in 2008. With the national debt then sitting at $5T, Congress appropriated nearly $1 trillion to bail out the big banks from their own mistakes in what was a bubble in the housing market. Banks had made tons of unsecured loans to many people who bought houses but couldn’t afford them, because Fannie Mae, Freddie Mac and Hud were buying many of those mortgages. The money from Congress covered the bad loans made.
During the subsequent period the economy went into recession.
During the recession, to deal with the commensurate increased spending by Congress, the Federal Reserve needed to create more money to accommodate the expenditures. Congress had just increased the national debt by a large chunk so the Treasury Dept. had to sell more bonds which would normally increase the interest rate needed to entice those buying treasuries on the open market.
But Ben Bernanke, then Fed Chair, came up with the solution called “quantitative easing” (QE). It was a theory developed by a German in 1995. In our case what happened was the Fed not only increased the number of treasuries it bought, but it also purchased a major portion of the debt being sold by the Treasury Dept and kept it off the open market. What that did was increase the liquidity of the banks – aka, create money to offset a recession – while keeping interest rates at near zero. Remember, interest rates normally would be rising as more debt is incurred and sold. This activity continued throughout the Obama presidency as the national debt increased by some $15T to over $20T trillion during those 8 years. A weak economy, the explosion of spending and the debt, and purchase thereof by the Fed, the normal pressure of inflation due to the huge increase in the money supply was delayed. Between 2008 and 2015, the Fed’s balance sheet, its total assets, ballooned from $900 billion to $4.5 trillion. Interest rates remained artificially low because much of the national debt was kept off the open market with Fed purchases thereof.
As a new administration took office in 2021 the economy was well on its way to recovery to pre-COVID days. But it wasn’t long before two things happened. One, the US production of oil was stymied meaning oil prices shot up – affecting the price of everything. Two, additional appropriations by Congress continued to add trillions to the debt. So more treasuries needed to be sold. In addition, taxes were raised, especially for business corporations.
But the Fed already had all these debt securities on its books – treasuries bought under QE – and its balance sheet looked like a financial nightmare. It couldn’t continue to buy treasuries and keep them off the open market.
By the end of 2022 the debt totaled over $31T and the increase in the money supply and the price of oil had inflation raging.
Such a huge increase in prices and the continuing rise in debt relative to our GDP finally caught up to the artificial activities (QE) employed by the Fed to hide it.
Because interest rates were artificially kept low and a commensurate demand for loans did not increase during COVID, most banks bought treasuries from the FED at “the discount rate” – meaning they bought them from the Fed at less than their market value. While returns to banks were low with treasuries, it was the best they could do with their reserves at the time.
The Fed had two options at that point: address inflation by raising the interest rates or address a slowing economy by lowering the rates. But rates were already low and there was little room to address the slowing economy. Ergo, the dilemma. It chose to address inflation by raising the rates.
That choice had and will have consequences.
Raising interest rates in an economy that’s already stalling will negatively affect the economy even more. But the raising of interest rates results in decreases in treasury bill value.
And with banks holding so much in treasuries, the value of their respective reserves decreased. Several major banks recently folded when their reserves were less than the total loans they had outstanding.
The last time the Fed increased interest rates during a recession was 1929. What followed was the Great Depression.
You’ve seen this from me before – namely the Fed is between a rock and a hard place. It now can do little in one direction without negatively affecting everything else.
Meanwhile, our current federal administration and most members of Congress appear to be unaware of what’s happening because of what they did. The Biden administration is touting the new programs funded, unconscious to the fact the additional trillions appropriated intensified inflation.
The political conflict now is about raising the debt ceiling. The discussion should be about lowering it.
The Fed is trying to pick up the pieces of very bad monetary policy – and we’re paying the price. Just look at your grocery and gas bills – and the value of your pension/IRA funds.
The piper will be paid.
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Have a great and prosperous week.
Hug somebody.
References:
https://www.bankrate.com/banking/federal-reserve/what-is-quantitative-easing/
https://www.foxnews.com/opinion/6-trillion-problem-threatens-push-inflation-even-higher
https://en.wikipedia.org/wiki/Federal_Open_Market_Committee
SPIDER Bites
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