The Fed's Game Plan: Growth Today, Inflation Tomorrow

With QE2 running its course and QE3 in discussion, the Fed is facing many problems, especially with all the stimulus still in the system which will result in higher inflation. The Fed's reserve balance has more then tripled making it so there is growth now and inflation later.

Warren Hatch
Catalpa Capital Advisors
Jul. 13, 2011, 9:07 AM
BUSINESS INSIDER

During four years of history-making monetary policy, the Fed used just about every tool in the box. First they slashed interest rates to zero. Then they launched an unprecedented quantitative easing.

After QE1 ran its course, they launched another round with QE2, which itself just ended. Barring QE3, the Fed’s massive easing policy has finally ended.

But it hasn’t gone away. If it takes as long to get policy back to normal, all the stimulus that is still sloshing around the system could threaten dramatically higher inflation pressures, presenting the Fed with a fresh set of problems.

To deal with the financial crisis, the Fed had to improvise brand new approaches. In the summer of 2007, they started by cutting the federal funds rate, their customary policy tool. The Fed requires the major banks to keep a portion of their assets on reserve at the Fed against their liabilities, a balance that is monitored by the Fed each day. Banks that find themselves short can borrow from other banks that have excess reserves at the federal funds rate.

If the Fed wants to lower the rate, they can add to the excess reserves and make it cheaper for banks to borrow; the banks, in turn, can then lend out to their customers at lower rates as the Fed’s easing policy radiates through the economy. By late 2008, the federal funds rate on excess reserves was already as low as it could go, so the Fed took the radical step of increasing the size of the reserve balance itself.

Quantitative easing had its roots in early 2008 when the Fed started shifting out of Treasuries (the blue shading in the chart) and into other assets that were weighing down the banking system (the red shading). By the time Lehman collapsed and the Fed formally embarked on QE1, the share of Treasuries had shrunk from its long-term average of around 90% at the start of the year to just 50%. After debasing the quality of the reserve balance, the Fed then doubled it in order to provide liquidity directly to commercial banks (such as the TARP program), to overseas central banks (through currency swaps), and eventually to the mortgage market itself (by purchasing toxic mortgage-backed securities). By the time QE1 expired in early 2010, the share of Treasuries was 34% of the reserve balance.

A few months later, QE2 began to take shape when policymakers voiced concerns about the health of the recovery and the risk of a Japan-style deflationary spiral. The Fed increased the reserves yet again, this time by aggressively expanding the purchase of US Treasuries. Where QE1 was effectively a financial rescue mission, QE2 was pure debt monetization: while it was in force, the Fed bought some 85% of all the net issuance by the federal government and ended up holding more Treasuries than the entire commercial banking system.

The Fed’s reserve balance has more than tripled to nearly $3 trillion, priming the pump for growth now and inflation later. The stimulative effects of easy monetary policy helped lift stocks, commodities, as well as the economy’s GDP. Employment and housing remain sluggish, but given the dire predictions about a plunge into another depression that surrounded the launch of quantitative easing, the Fed has done its job reasonably well. Moreover, the threat of a deflationary spiral is no longer on the radar. In fact, the greater risk now is a surge in inflation before Fed officials are able to remove the easy money overhang. The decisive upturn in core inflation could be an early harbinger of much higher price pressures to come.

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