The Fed's Failed Policies.

• Author: Todd, Walker F.

Once upon a time, there were monetary velocity and a money multiplier. Since 2008, there has been neither monetary velocity nor a money multiplier, at least not at levels comparable to the status quo ante. Nevertheless, for all the exotic measures attempted by the Federal Reserve after 2008, none delivered expansion of bank credit, M-1, M-2, or GDP; restructuring of household or small firm balance sheets; or aggregate demand leading to greater consumption or investment, at least not on the scale reasonably expected from the quantity of new reserves created. Government spending, however, has done quite nicely. Is this scenario sustainable? If not, then why has the Fed persisted in its pursuit (quantitative easing, unnecessarily high guaranteed returns on reverse repurchase agreement transactions, etc.)? Even if the Fed finally stops creating new monetary reserves (hopefully, for a generation or so), why do other central banks take up where we left off? Have we in fact stopped creating new monetary reserves, and, if so, what should we do next (exit strategy)? Possible paths out of the wilderness are described.

Hint: None involves quantitative easing (QE) or helicopter money. And one should be skeptical about interest rate increases until we see growth in some other major economy, any other major economy.

The Breakdown of the Monetary Transmission Mechanism

In a fractional reserve hanking system, whenever a bank funds a loan, it essentially is creating new money in an amount equal to the reciprocal of the reserve requirement, currently 10 percent for demand liabilities. The rate of expansion of the aggregate banking system's reserves toward the multiplier of 10 is affected by the public's desire to hold some of the proceeds of loan disbursements (viewed by the public as new cash) instead of spending all the proceeds. The more the proportion of such new deposits retained, the slower the economic expansion that the creation of new bank reserves theoretically should cause.

On its face, greater than expected retention of loan proceeds and other cash apparently is what happened after 2008. With the exception of QE1 (2Q2009 to 2Q2010), during which monetary velocity (the ratio of GDP to the money stock, M2 in this case) grew slightly, from 1.711 to 1.746, velocity has fallen ever since and reached a nearly 60-year low of 1.437 in 3Q2016. This begs the question of why QE continued to be pursued once it was clear that it was not working--that is, did not have the desired effects.

Payment of interest on banks' reserve balances at the Federal Reserve Banks (in the aggregate, the Fed) began in October 2008. Excess reserves (a reflection of the public's desire to hold a greater amount of cash or its equivalent) began to emerge above historical average levels after August 2008 (Todd 2013: 5).

Unfortunately, once the Fed started paying interest on reserves, it made no distinction between required and excess reserves. All banks maintaining reserves, whether required or excess, received the same interest rate: 0.25 percent per annum from December 2008 to December 2015, which was the ceiling rate in the Fed's target range for the federal funds rate of 0-0.25 percent. That rate increased to 0.50 percent in December 2015, still the top of the Fed's target range of 0.25-0.50 percent. From November 2015 to November 2016, most fed funds trading was greatly diminished in volume and occurred in a trading range well below the Fed's rate ceiling, roughly 0.32 to 0.41 percent. (1)

The fed funds ceiling rate is comparatively generous on a safe asset for banks holding excess reserves in a zero-rate and negative-rate environment globally. (2) When I was in Switzerland and Austria in November 2015 for an academic conference attended by several current and former representatives of the Swiss National Bank, I was asked repeatedly, "Why is the Fed paying interest on excess reserves?" Indeed, and at the ceiling rate, not the floor rate, besides. I had no good answer for the Swiss. Anyway, paying interest on banks' balances at the Fed is the third of four tools identified by former Board of Governors Chairman Ben Bemanke in a July 21, 2009, article, "The Fed's Exit Strategy" (reprinted in Mankiw 2015: 338-39). At the time, Bemanke did not distinguish between required and excess reserves or suggest dual-rate payments. But he should have done so.

With no monetary velocity and no money multiplier, how is it exactly that monetary policy is to be transmitted to the general economy? And with zero or negative interest rates, how is interest rate targeting supposed to affect the real economy? The monetary transmission mechanism broke down and even now, eight years after the crisis, still shows no sign of working properly again.

The Fed's Failure to Stimulate the Real Economy

For all the exotic measures attempted by the Federal Reserve after 2008, none delivered expansion of bank credit, M-l, M-2, or GDP; restructuring of household or small firm balance sheets; or aggregate demand leading to greater consumption or investment, at least not on the scale reasonably expected from the quantity of new reserves created.

The Board's release, "Assets and Liabilities of Commercial Banks in the United States (Weekly)--H.8," shows that bank credit barely grew during the QE era (2009-14): 1.6, 4.1, and 1.3 percent, 2011-13, for example. Loans and leases in bank credit also barely grew then: 1.5, 2.9, and 2.3 percent, 2011-13. Commercial and industrial (C&I) loans grew at what normally would have been an acceptable rate (9.9 percent on average, 2011-15), but more rapid growth was restrained by mostly negative growth in household and consumer lending during the same period. Residential mortgage lending (other than home equity lines of credit or HELOCs) was negative until 2014 and did not grow normally until 2016. HELOCs have remained a negative factor for at least eight years, but perhaps that is a good thing.

All of this restrained lending activity occurred in the face of a fivefold increase (499 percent) in the size of the Fed's balance sheet from August 6, 2008 ($901.7 billion, the last balance sheet of normal size) until year-end 2014 (QE3 ended in mid-year 2014). The Fed's balance sheet continued to expand slightly, exceeding $4.5 trillion in late 2014 and continuing at about that level until the present ($4,499 trillion as of November 2, 2016). (3)

Government Spending Is a Different Story

The main vehicle for the expansion of the Fed's balance sheet was the funding of large Treasury deficits in the postcrisis era. The Treasury sold securities to fund its deficits, the Fed purchased some of them at Treasury auctions, and then over time the Fed met demand for liquidity in financial markets by purchasing Treasury securities from primary dealers and other recognized holders, like foreign central banks.

The Fed also rendered the Treasury an enormous favor by funding nonbank financial entities, through securities purchases and otherwise, that the Treasury would have been called upon to fund in the absence of Fed action. For example, starting from zero just before the crisis, the Fed now holds $1,736...