Misunderstanding the Fed Balance Sheet — A Costly Mistake
At "A Dash" our principal mission is identifying the real experts on various topics.
There are so many sources of information and analysis. The business models for financial media depend upon ratings, so popularity rules. The easiest way to connect with readers or viewers is via the anecdote, the dramatic chart, and analysis that can be explained in "pop economics" terms.
The Fed balance sheet provides a good example. The bearish element of the punditry has highlighted the dramatic increase in the monetary base and the various Fed programs as a sign of incipient disaster. At first, many suggested that we were about to have another Great Depression. Some still maintain this position despite the improving economic indicators. Arguing in the alternative, these same people argue that we have merely delayed the real consequences. In particular, we have already sowed the seeds for a new inflationary bubble
We have recommended a more compelling viewpoint. It is not popularly accepted, partly because it is difficult to understand. It is not Pop Economics.
Briefly put, the Fed has stepped in to provide lending in markets where the private market has dried up. This was necessary to limit the impact of the recession. Fed Chair Bernanke has explained the plan for an exit strategy, to be implemented when normal and sensible lending resumes.
We see this as wise and sensible public policy. We understand that many disagree, and that is what makes a market. In particular, we have highlighted the thoughtful and market-oriented analysis of Bob McTeer, former Dallas Fed President and analyst at a free market think tank. His credentials and expertise are impeccable. We strongly urge readers to consider his analysis of Fed policy. Here are some highlights.
McTeer criticizes those who use a compressed time horizon to show the increase in the monetary base. He thinks this is deceptive, and points out that the analysts have no clear causal reasoning for the prediction of an inflationary explosion. He is modest in his analysis, accepting that there is room for some inflation protection.
His key point is that the Fed is filling in for a failure of private markets to do normal lending. This is a process that started with the failure of Lehman and the temporary cessation in commercial paper. There will be an end and an exit strategy. He notes that the monetary base expansion occurred eight months ago and has leveled off. He writes as follows:
Meanwhile, the time to shrink is not close. The velocity of money
obviously declined dramatically as money growth accelerated months ago.
Under those conditions, rapid money growth is needed to prevent
deflation. Anticipating velocity changes may be hard, but seeing them
after the fact is rather easy. Just divide GDP (P x Q in the equation
of exchange) by M (whichever definition of money you fancy) and you get
the income velocity of that measure of money. Having GDP growing slower
(negative lately) than M is growing tells you that V is declining.
Put another way: Money doesn't cause inflation; spending money may
cause inflation. Money is not being spent at a sufficient rate lately
to cause inflation.
The decline of nonbank credit leaves a large hole to be filled by bank
credit until things return to normal. That's what Chairman Bernanke is
doing as he purchases debt (assets) other than treasury debt-commercial
paper, mortgage-backed securities, packaged student loans, auto credit,
etc. Focusing on these purchases and not realizing the hole he is
trying to fill would lead you to believe, falsely in my opinion, that
seeds of future inflation are being sowed.
…(T)he inflationary impact of fiscal deficits depend almost entirely on
how they are financed, i.e., whether new money is created in the
process. Growing deficits without comparable monetary expansion will
push interest rates up sufficiently to get the debt purchased. Higher
interest rates are likely to crowd out private investment as the
government commands more and more of the financial resources. This is
not a good outcome, but it's not inflation.
There is a time and place for various policies. An ideological perspective that nothing will work is a losing investment strategy, as we have seen in the last several months. Readers would be well advised to read the entire McTeer analysis.
There is a lot of buzz about what will be the "New Normal." We expect this to be a return to sensible lending practices, relying on private markets. The Fed will withdraw as this takes place.