Monetary Mayhem Clouds Crystal Ball

You can’t read or watch financial news these days without a heavy dose of speculation about what the Fed is going to do with short-term interest rates, when it’s going to do it, and how long it’s going to do it for.

There’s nothing wrong with paying some attention to this news, but what investors need to realize is that this is not your father’s (or mother’s) monetary policy and they need to focus on the money supply. (Yes, we know we’ve written about this before, but this issue is so important it warrants multiple repetitions. Expect another reminder again sometime in the next few months.)

Prior to the Financial Crisis of 2008-09, the Fed implemented monetary policy by either (a) buying Treasury securities from banks to add reserves to the banking system or (b) selling Treasury securities to banks to drain reserves from the banking system. Adding reserves would loosen monetary policy, draining reserves would tighten monetary policy.

Why would the Fed add or drain reserves? Because banks would actively trade reserves among each other on an overnight basis to meet the reserve requirements. The Fed, by adding or draining reserves, could influence the interest rate banks would charge each other to acquire those reserves and that rate was highly sensitive to Fed decisions. This was a “scarce reserve” model for monetary policy. When it was implemented carefully, it delivered persistently low inflation for multiple decades.

Then along came the Financial Crisis and that scarce reserve model was abandoned and replaced with a model based on “abundant reserves.” The Fed, through multiple rounds of Quantitative Easing, flooded the banking system with more reserves than the banks would ever need. In turn, the Fed made those reserves valuable by paying the banks an interest rate to hold them. No longer would banks scramble to acquire reserves to meet legal requirements based on the amount of deposits they held; now banks would want them only if and when the Fed paid them enough interest on those reserves, like now, when the Fed is paying banks 4.65% per annum and that figure is likely heading higher during the next few months.