The Fed is A Proxy for Government

Well, that was fun! The GOP's attempt to reform healthcare hit a brick wall of politics. Conservative Republicans wanted to completely "repeal" Obamacare, while moderates and leaders were willing to keep much of it as long as it cost less. Moving one way or the other lost too many votes. Democrats refused to participate. So, the bill died.

The stock market rose when it looked like Speaker Ryan's bill would pass, and fell when prospects faded. But US stocks remain undervalued. Nothing, other than politics, has changed and we expect equity values to continue to rise

There is a huge debate in America these days about the role of government in the economy. This debate reached a fever pitch following the Economic Panic of 2008.

Republicans pushed TARP, which basically said "free markets cause problems and government must be used to fix them." President Obama used that shift in philosophy to suggest government should run healthcare.

At the same time, the Federal Reserve cut interest rates to zero and massively increased the size of its balance sheet. The key question is whether this is a permanent increase in the size and scope of government or can it be rolled back? Will the Fed shrink its balance sheet?

The Fed's balance sheet grew from $800 billion before 2008 to $4.4 trillion today. From 6% to 24% of GDP. It's a bigger share of GDP today than it was during the Great Depression.

Quantitative Easing and the size of the Fed's balance sheet has completely changed the way monetary policy is managed. It used to be that the Fed changed the size of its balance sheet to move interest rates. If it wanted rates to fall, it would buy bonds (increase the size of its balance sheet) by printing new money. That money would boost bank reserves and force the federal funds rate lower. If it wanted rates to rise, it would sell bonds, shrinking the amount of reserves, driving up rates as banks competed for a smaller pool.

These days, with over $2 trillion of "excess reserves," the Fed manages monetary policy by changing the rate that it will pay banks to sit on those excess reserves. The idea being that if the Fed pays enough then banks won't lend them out. In other words, the Fed thinks it can control the money supply by encouraging or punishing banks. This is the same idea behind the negative interest rate experiments in Europe and Japan.