The Fed’s Missing Toolbox

Ahead of the Federal Reserve’s annual migration to Jackson Hole, the press is focused on what breadcrumbs the central bank might, or might not, drop on its plans in respect of interest rates. Then there’s the question of how the Fed intends to normalize its swollen balance sheet — north of $7 trillion — at a time when investors are increasingly “nervous,” as the FT’s Gillian Tett says, about the monetary “distortions” caused by the Fed and other central banks.Feature the recent turbulence in global markets, which amounted to, as Ms. Tett tells it, an “aftershock from the unwinding of that extraordinary monetary policy experiment known as quantitative easing and zero interest rates.” The Fed led the way down this primrose path under its chairman, Ben Bernanke, following the meltdown in 2008. Other central banks followed. Reversing course has proven harder than they hoped — and suggested.The trouble, as Ms. Tett sees it, is that “investors have normalized cheap money in recent years,” after the Fed held interest rates artificially low while racking up trillions in assets in a bid to stimulate the economy. Investors were oblivious to “the distortions this has caused,” as Ms. Tett tells it, but are beginning, “belatedly,” to realize “how odd it was.” She writes that “free(ish) money,” which was “fuelling asset inflation,” is now “coming to an end.”Hence the market gyrations earlier this month, after a weak jobs report in America and the fallout from the collapse of the so-called “carry trade,” in which investors capitalized on Japan’s own Quantitative Easing program to borrow in the cheaper yen that resulted and snap up American assets. There are now “fears,” Ms. Tett notes, that other “long-ignored QE distortions” could wreak havoc. Is the Fed going to offer reassurances at Jackson Hole?Whatever Chairman Powell deigns to say on the matter, his remarks are likely to be overshadowed by the hubris of his Nobel prize-winning predecessor, Mr. Bernanke. At Jackson Hole in 2010, Mr. Bernanke crowed that his Quantitative Easing program had “made an important contribution to the economic stabilization and recovery that began in the spring of 2009.” This despite warnings that it might, could, would, or should induce a wave of inflation.At the time, the Fed’s balance sheet stood around $2.4 trillion — more than double its historic level of less than $1 trillion. It turned out that the central bank was just warming up. The problem, it seems, was that it was much easier to add assets than to part with them. When the central bank tried to scale back its balance sheet in 2013, it sparked a so-called “taper tantrum,” and the Fed had to reverse course. As 2020 began the Fed had some $4 trillion in assets.Then, during the Covid pandemic, the Fed launched another round of Quantitative Easing, and the balance sheet soared to some $9 trillion. The dollars were created with a few strokes of the keyboard, James Grant has observed, summoned “into existence as a sorcerer might summon the spirits.” The balance sheet is now at some $7.2 trillion, and one former Fed governor, Kevin Warsh, is among those seeing it as a cause of today’s stubborn price inflation. It’s a far cry from Mr. Bernanke’s victory lap at Jackson Hole in 2010. He dismissed a “concern” about more Quantitative Easing — “that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time.” This is the same Mr. Bernanke who had waved off the inflation threat, averring “we could raise interest rates in 15 minutes, if we have to.”Fear not, though, the chairman assured his listeners. “To mitigate this concern,” he crooned, the Fed “has expended considerable effort in developing a suite of tools to ensure that the exit” from Quantitative Easing “can be smoothly accomplished when appropriate.” Fourteen summers later, the world is still waiting for that long-promised “exit.” The Fed, meanwhile, eschews the most effective tool of all for combating inflation: honest money.

The Fed’s Missing Toolbox

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