FOMC moves in the right direction

In a few weeks, according to the report following today's FOMC meeting, the Fed will have "tapered" its purchases of bonds by about one-third (from $85 billion per month in December to $55 billion a month). And lo and behold, the sky has not fallen, nor is it about to. Nevertheless, the market continues to fret that tapering is a form of tightening, since, as the theory goes, the economy has managed to grow only thanks to Fed "stimulus," and that without it, economic activity will grind to a halt.

Never in my many years of Fed watching has there been so much confusion about how Fed policy operates.

The myth persists that QE bond purchases are "stimulative" because it involves the printing of massive amounts of money and the artificial depressing of yields. But this is simply not the case. As the chart above shows, 10-yr yields today are actually higher than they were when the Fed launched its first QE bond purchases. Bond prices have actually fallen despite $3 trillion of bond purchases by the Fed. The chart also makes it clear that yields have actually risen during each episode of QE bond-buying. Operation Twist (OT) was ineffective as well, since 10-yr yields were essentially unchanged during the period in which the Fed was buying 10-yr bonds and selling short-term bonds. The main determinant of yields is not the marginal purchases by the Fed, but the market's willingness to hold the entire stock of bonds (Treasuries, MBS, corporate bonds, etc., totaling many tens of trillions of dollars), since all bonds are priced off of Treasuries. That willingness, in turn, is a function of the market's expectations for inflation and economic growth.

As I've explained before, the Fed is not "printing money" when it buys bonds. When the Fed buys bonds it must buy them from banks. The Fed pays for the bonds by crediting banks' reserve account at the Fed. Bank reserves are not money that can be spent anywhere. They only exist on the Fed's balance sheet. Banks use their reserves to collateralize their deposits and to increase their lending, but to date the growth of the money supply has not been unusually rapid, as the chart above shows—only slightly more than 6% per year for the past 20 years. This is not to say that all will be A-OK forever, since the $2 trillion of excess reserves currently in the system would allow banks to expand their lending—and the money supply—by several orders of magnitude if they so desired.

When the Fed buys bonds, they become part of the Fed's assets. The Fed incurs a corresponding liability in the form of bank reserves. In effect, the Fed buys bonds from banks by borrowing the money from the banks to buy the bonds. The Fed pays the banks interest on their reserves of 0.25%, so from the banks' perspective, they are lending money to the Fed for a modest rate of interest which is actually better than they could get by buying T-bills, which currently yield only 0.05%.

As the chart above shows, the Fed's purchases of $3 trillion of notes and bonds (assets) have been offset by an approximately equal increase in currency (about $0.4 trillion) and bank reserves (about $2.6 trillion).

In addition to saying they will continue to taper their bond purchases, the FOMC decided to drop its 6.5% unemployment rate threshold. They will now consider a range of economic variables when deciding to taper and when and by how much to raise short-term interest rates. It's unfortunate that they have backed off of a rules-based policy and now have more discretion—which creates uncertainty—but at the same time this could give them more flexibility to act more or less aggressively if conditions warrant. Meanwhile, continuing to taper is definitely a step in the right direction since, as I've noted in recent posts, there are signs that the demand for bank reserves is declining and banks' willingness to lend is increasing.