FOMC: No Longer “Patient”, But Dovish As Ever

How to Blunt the Absence of a Sentence

Wall Street’s Kremlinologists were not baffled for long. Shortly after the FOMC statement was released, the US dollar tanked and everything that wasn’t nailed down soared in price. Essentially the FOMC has repeated the exercise it first engaged in when it removed the phrase “considerable time” from its statement to replace it with the word “patient”, only in a slightly more wordy manner this time. Essentially, the monetary policy statement was as dovish as it could possibly be in light of the corner Fed board members have talked themselves into with their vaunted communication policy.

The differences between the January and the March statements can be seen at the WSJ’s statement tracker. Apart from an outright assurance that there won’t be a rate hike in April, it was mentioned that the timing of a possible hike thereafter remains uncertain. The remainder of the statement reads a bit like a long lament over the economy’s refusal to obey. Somehow, all the pumping that has occurred thus far hasn’t had much of an effect. Obviously, there was no indication that any of the board members realize that money printing is actually undermining the economy.

Photo credit: Andrew Harrer / Bloomberg / Getty Images



Along with the statement, the estimates of board members regarding future growth and the future level of the FF rate were released as well, and both were downgraded rather considerably. This has given the bubble another lease of life, at least – so far – for another day. Meanwhile, money supply growth keeps re-accelerating, but hasn’t yet left its recent range:


1-TMS-2, y-y-growthTMS 2: the year-on-year growth rate has accelerated to 8.35% as of the end of January – click to enlarge.


An Important Consideration

The most important paragraph that keeps recurring in statement after statement is probably this one:


“The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.”


In other words, the Fed’s balance sheet size will remain at an extremely elevated level. There has been a tiny decline in assets on the balance sheet in recent months, but in terms of its potential effect on the money supply, it has been more than outweighed by the resumption in inflationary bank credit growth.


2-Fed assetsAssets held by the Federal Reserve – click to enlarge.


We have a strong suspicion that there will never again be a sizable decline in the Fed’s balance sheet, unless perhaps if bank credit growth really goes bonkers and the money supply grows accordingly. Readers may wonder how it is even possible to talk about rate hikes while a huge amount of assets and bank reserves can be found on the Fed’s balance sheet. After all, normally the Federal Funds rate target is achieved by the open market desk providing reserves by buying securities from banks (either as repos or the form of coupon passes) if credit demand is so strong that the rate target is in danger of being exceeded, and selling securities if the rate target threatens to be undercut because too many reserves are offered in the interbank market.

Obviously one would have to assume that before a first rate hike can even be considered, reserves would have to be reduced considerably. However, the same modus operandi that ensures that deposit money in the system grows in parallel with bank reserves in “QE” operations would then have the opposite effect (balanced to some degree by whatever growth in fiduciary media occurs due to new bank lending). The money supply would not only stop growing, it would very likely begin to shrink. There would be genuine deflation in other words. The likelihood of the central bank allowing that to happen must be estimated to be somewhere between zilch and nada.

However, this problem has been solved a long time ago already, at the very beginning of the “QE” policy. Readers will probably suspect already what that solution consists of – it is the introduction of interest payments on bank reserves. This creates some beer money for the banks, but the more important aspect of it is that it prevents that the interbank market from being flooded with reserves in the event of a rate hike. All the Fed needs to do is to raise the interest rate it pays on reserves in parallel with the Federal Funds rate. It is worth noting though that although the FF rate corridor is currently between 0 to 25 basis points and the deposit rate is fixed at 25 basis points, the effective FF rate has been oscillating between 6 and 12 basis points since May of 2013. Presumably, there is very little demand for reserves given the high level of excess reserves. Moreover, almost no reserves are actually required to support extant deposits in spite of official reserve requirements. This is due to sweeps, which allow banks to let demand deposits masquerade as savings deposits (“money market deposit accounts”) overnight.


Geared Toward Inflation

One could say that the entire system has been geared toward maximum monetary and credit inflation for quite some time (sweeps were introduced in the mid 90s and a vast credit and asset boom promptly ensued). It is thinkable that Fed assets and bank reserves will be allowed to decline at a slow pace as long as bank lending remains brisk, but we doubt that the Fed will ever do something similar to the what the BoJ did in 2006, when it reduced the monetary base by 25% in one fell swoop (the reason why the BoJ could do this without impacting Japan’s money supply much is that it apparently buys securities mainly from banks, and hence creates comparatively little deposit money directly when engaging in QE).

Anyway, there is absolutely no “danger” that the engine of inflation will abandon its well-worn ways. Why would it suddenly stop, after robbing the dollar of an estimated 96-97% of its purchasing power over the past century? Our forecast in this respect would be that the printing presses will only be impeded if consumer price inflation suddenly takes off. Of course, “price inflation” is whatever the government says it is. We have often mentioned the theoretical impossibility of calculating a “general price level” (this would only work if the laws of supply and demand didn’t apply to money as well, and even then the calculation would be logically dubious), but obviously it is possible to at least show trends in prices. However, the calculation has been altered many times, and always in the direction of showing less and less price inflation (not a single reform of the calculation of CPI has resulted in it becoming higher than previously).

Below is a chart comparing TMS-2 with total bank credit outstanding (all loans and leases at commercial banks). As can be seen, both remain on a growth trajectory. Consumer credit growth is a bit more subdued than the growth in corporate lending, as many households continue to lick their post real estate bubble wounds. Companies will probably be next. While their cash reserves have grown in the aggregate, their debts have grown even faster. Moreover, the aggregate data are hiding a lot of important details, such as the fact that the biggest cash holders are quite concentrated and consist of a fairly small number of companies; in addition, the firms with the biggest debts are definitely not identical with those holding the most cash.


3-TMS-2 and bank credit-a
TMS-2 and bank credit. Inflationary bank credit expansion has been in reverse until 2010 and has resumed to grow ever since, if at a slightly slower pace than before the crisis. The main point here is actually only this: economy-wide, there has been no deleveraging whatsoever (neither “beautiful” nor otherwise).



Apparently, the FOMC continues to be haunted by the much dreaded “ghost of 1937”, which we last discussed in mid 2013. It is a Keynesian shibboleth that the Fed became “too tight” in 1937 on account of a few small baby step rate hikes and a tiny increase in reserve requirements and hence “caused” the decline in asset prices and economic activity that followed. The reality of the matter was that the artificial pumping that preceded 1937 created another unsustainable mini-boom and that the Fed was suddenly faced with an unexpected outbreak of “price inflation”. Had it continued to pump, the malinvestments of the boomlet may well only have been revealed at a later stage, but it would have risked immolating the currency along the way.

One must suspect that the modern-day Fed has learned precisely the wrong lesson from the event. By the time this becomes crystal-clear, it will however be far too late to do anything about it. The mistake of launching another credit and asset boom cannot be “unmade” painlessly.


4-DXYPost FOMC roller-coaster ride in the dollar – click to enlarge.

Charts by: St. Louis Federal Reserve Research, BarCharts