The Fed Couldn't Hike Even If It Wanted To
A growing contingent of financial professionals and members of the media have called for the Federal Reserve to withdraw the liquidity it has injected into capital markets to prevent inflation and asset bubbles. Such discourse brings up a key question: does the Fed have the ability to remove the excess liquidity it has added to the markets? As alarming as it may seem, the answer may be "no".
First, a brief primer on interest rates and monetary policy: the 0.25% interest rate quoted by the Fed is known as the federal funds rate; this is the interest rate established by the Federal Open market Committee at which depository institutions, such as banks, lend balances to each other overnight. The fed funds rate is a key data point which drives monetary policy and the cost of credit in the United States and the world.
The Fed's primary means of implementing monetary policy and affecting the fed funds rate is through open market operations in which the Fed buys treasuries (to add money into capital markets thereby lowering interest rates) or sells treasuries (to drain capital markets of money thereby raising interest rates). The importance of treasuries in implementing monetary policy was highlighted in Alan Greenspan's book, The Age of Turbulence, when he discussed the possibility that the national debt could be paid down as a result of forecasted surpluses in January of 2001: "of course, shedding the debt burden would be a happy development for our country, but it would nevertheless pose a big dilemma for the Fed. Our primary lever of monetary policy was buying and selling treasury securities. But as the debt was paid down, those securities would grow scarce, leaving the Fed in need of a new set of assets to effect monetary policy. For nearly a year, senior Fed economists and traders had been exploring the issue of what other assets we might buy and sell."
Another important and oft quoted interest rate is the discount rate, which is the rate at which the Fed lends directly to depository institutions. The Fed could change this rate directly, however, and typically the discount rate closely tracks the fed funds rate and is of secondary importance. The third key tool by which the Fed could impact interest rates is by changing reserve requirements, which is the amount of funds that a depository institution such as a bank must hold in reserve against specified deposit liabilities. However, the Fed is loathe to change reserve requirements due to the potential liquidity problems it could create for some banks and the difficulty in forecasting how a change would impact the multiplier effect on the money supply. In that sense, the buying and selling of Treasuries serves as the Fed's method of choice for conducting open market operations, and as such, the amount of Treasuries held on the Fed's balance sheet relative to bank reserves and money supply are important in determining the Fed's ability to enact monetary policy.
Each week, the Federal Reserve publishes its balance sheet, typically on Thursday afternoon at 4:30 pm. As of November 11, 2009, The Fed's total assets stood at $2.1 trillion composed of an assortment of securities. Approximately $777 billion is U.S. Treasuries of various maturities which, if the Fed decided it wanted to raise rates, would be the primary ammunition with which to impact monetary policy. Given that the M2 money supply stood at $8.3 trillion as of September 2009 and excess bank reserves held on deposit by banks at the Fed surpassed $1 trillion on November 4, 2009, even if the Fed sold every treasury in its vaults (a highly unlikely scenario), it would only represent 9% of the money supply and still leave banks with approximately $672 billion of excess reserves.
To give you a point of reference, excess bank reserves were as low $267 billion in October 2008 (thus they've increased by a factor of four in the span of a year) and the M2 money supply was about $1 trillion lower in January 2008 ($7.4 trillion to be precise). All this liquidity came from the Fed of course, but the key problem is that the Fed may not be able to take back what it has so generously given. The reason is that the liquidity was used to buy over $1 trillion of ‘assets' which the Fed holds on its balance sheet as a result of bailouts, which includes but is not limited to: $150 billion of agency debt (Freddie Mac, Fannie Mae, etc), $776 billion of mortgage backed securities, $200 billion of term credit and loans extended to banks, and roughly $65 billion of assets held in Maiden Lane LLC's which were the vehicles formed to facilitate the Bearn Stearns bankruptcy and AIG bailout.
The liquidity of the aforementioned securities is likely very low and their value as listed on the Fed's balance sheet is likely a far cry from what an arm's length sale would yield in today's markets. Furthermore, if the Fed were to dump its MBS or agency debt into the market, it would likely cause real estate values to plummet again. These two features of these ‘assets' eliminate them as securities which the Fed could use to conduct open market operations and impact interest rates. As such, the Fed really only has the capacity to sop up $777 billion of liquidity through the sale of its securities, which still leaves substantial excess reserves in bank coffers and only decreases the level of M2 money supply to levels last seen in October 2008.
In conclusion, it is very possible that the Fed does not have the securities to impact interest rates in a meaningful way and as such, is presently forced to maintain its stance that it will not increase rates (because it really cannot) despite the specter of looming inflation and asset bubbles. Although the Fed may point to readings of misleading gauges such as the CPI and core inflation as proof that monetary expansion has not caused inflationary pressures, the market seems to believe otherwise as all time-highs reached in gold prices, the debasement of the dollar relative to other currencies, and strong crude oil pricing despite weak crude oil fundamentals all point to the dramatic oversupply of dollars.
