Inflation: The Elusive Target

Despite a large tax cut and seven increases of one quarter of a point in the fed funds rate, inflation continues to be an elusive target, lingering at around 2%.  The only interest rates that seem to be reacting to the Federal Open Market Committee's promptings are those of Treasury-issued debt, residential mortgages, and lending.  The Phillips Curve has lost its relevance as a predictor of inflation, as full employment is no longer a trigger, at least for now.  Meanwhile, the FOMC continues to exclude the energy and food components from its calculation of inflation, which is troubling for two reasons: (1) oil is where the action is today, and (2) groceries have been on the rise for some time – just ask my wife.

Inflation's elusiveness may be at least partially explained by the systemic changes to banking that have occurred because of the 2007 crisis and the Fed's reaction to it – namely, collapse of the fed funds market, redefinition of the fed funds rate, and creation of trillions of dollars of excess reserves as a substitute form of bank liquidity.

The 2007 crisis collapsed the fed funds market when credit quality became an issue and liquidity in the market dried up.  Prior to that time, it had operated successfully as an unsecured overnight market for cash balances held by banks at the Fed, which fulfilled their needs for daily liquidity.  Back then, there were many more lenders than borrowers, with the smaller banks tending to be lenders and the larger banks borrowers.  The crisis changed all of this.

Although former Fed chairman Ben Bernanke's unconventional monetary policy failed to stimulate economic growth as was intended, it did ensure the continued demise of the fed funds market by using interest on excess reserves to set the upper bound of the fed funds rate and interest on reverse repos to set the lower bound.  This replaced the FMOC's traditional practice of buying and selling short-term Treasury securities to tease the fed funds rate up or down in order to control the price of overnight liquidity to banks, which then affected other interest rates accordingly.

As a consequence, what once was a viable consortium in which buyers and sellers predominated in free-market competition to determine price no longer exists.  The fed funds market has since shrunk from a daily volume of over $300 billion before the crisis to $60 billion today.  Currently, the only sellers of funds in this market are those financial organizations not eligible to hold reserves, and banks that purchase such funds for arbitrage in their reserve accounts.

Thus, the fed funds rate, the rate paid to banks on their excess reserves, is no longer a market-derived rate pushing up other rates and reverberating through the economy.  One need only review the average C.D. yields as reported by Bankrate.com to conclude the Fed's base rate is not functioning as it did.  For example, 6-month CD yields are at 0.31%; 1-year C.D.'s are at 0.59%; 2.5-year are at 0.78%; and 5-year are at 1.24%.  All are well below the overnight rate of 2% being paid on excess reserves.

The Fed has painted itself into a corner.  On the one hand, its new monetary tools provide a more powerful and efficient means of controlling the base rate, enabling changes to be implemented instantaneously.  But such changes are no longer cascading through the economy as they did when Paul Volcker increased the fed funds rate to double digits to combat inflation that had reached 13.5% by 1980, and the nation's interest rates followed suit, rising into the stratosphere while taming inflation to 1.9% by 1986.

Moreover, these new tools have made the marginal cost of changes in the fed funds rate expensive.  For example, in July of last year, the Fed announced its plans to shrink the amount of excess reserves on its balance sheet to between $400 billion and $1 trillion, which means it will cost between $4 billion and $10 billion per year for every 1% increase in the fed funds rate.  Therefore, given the Fed's anticipated new neutral rate for the base rate of around 3.0%, the annual cost will be somewhere between $12 billion and $30 billion.  The Fed will pay for this with the earnings from a security portfolio that originally was $4.3 trillion in size and produced $100 billion in annual earning transfers to Treasury but is now in the process of being downsized to $2.7 trillion and will produce about $60 billion annually – sufficient to cover these costs but resulting in far less earning transfers to Treasury.

The FOMC's elimination of the daily requirement for banks to buy or sell liquidity in the fed funds market, as was necessary prior to the crisis concurrently, has disadvantaged all other financial organizations not eligible to hold reserves that were participants in the market and, in the process, changed the fundamental character of it as well as the substance of the fed funds rate.  These changes are economically and operationally beneficial for banks and make the FOMC's control of the base rate much easier – but are at the expense of non-bank financial organizations, the Treasury (taxpayers), and have added complexity to the search for the elusive inflation that most would agree, in moderation, is an essential ingredient for economic growth and prosperity.

Despite a large tax cut and seven increases of one quarter of a point in the fed funds rate, inflation continues to be an elusive target, lingering at around 2%.  The only interest rates that seem to be reacting to the Federal Open Market Committee's promptings are those of Treasury-issued debt, residential mortgages, and lending.  The Phillips Curve has lost its relevance as a predictor of inflation, as full employment is no longer a trigger, at least for now.  Meanwhile, the FOMC continues to exclude the energy and food components from its calculation of inflation, which is troubling for two reasons: (1) oil is where the action is today, and (2) groceries have been on the rise for some time – just ask my wife.

Inflation's elusiveness may be at least partially explained by the systemic changes to banking that have occurred because of the 2007 crisis and the Fed's reaction to it – namely, collapse of the fed funds market, redefinition of the fed funds rate, and creation of trillions of dollars of excess reserves as a substitute form of bank liquidity.

The 2007 crisis collapsed the fed funds market when credit quality became an issue and liquidity in the market dried up.  Prior to that time, it had operated successfully as an unsecured overnight market for cash balances held by banks at the Fed, which fulfilled their needs for daily liquidity.  Back then, there were many more lenders than borrowers, with the smaller banks tending to be lenders and the larger banks borrowers.  The crisis changed all of this.

Although former Fed chairman Ben Bernanke's unconventional monetary policy failed to stimulate economic growth as was intended, it did ensure the continued demise of the fed funds market by using interest on excess reserves to set the upper bound of the fed funds rate and interest on reverse repos to set the lower bound.  This replaced the FMOC's traditional practice of buying and selling short-term Treasury securities to tease the fed funds rate up or down in order to control the price of overnight liquidity to banks, which then affected other interest rates accordingly.

As a consequence, what once was a viable consortium in which buyers and sellers predominated in free-market competition to determine price no longer exists.  The fed funds market has since shrunk from a daily volume of over $300 billion before the crisis to $60 billion today.  Currently, the only sellers of funds in this market are those financial organizations not eligible to hold reserves, and banks that purchase such funds for arbitrage in their reserve accounts.

Thus, the fed funds rate, the rate paid to banks on their excess reserves, is no longer a market-derived rate pushing up other rates and reverberating through the economy.  One need only review the average C.D. yields as reported by Bankrate.com to conclude the Fed's base rate is not functioning as it did.  For example, 6-month CD yields are at 0.31%; 1-year C.D.'s are at 0.59%; 2.5-year are at 0.78%; and 5-year are at 1.24%.  All are well below the overnight rate of 2% being paid on excess reserves.

The Fed has painted itself into a corner.  On the one hand, its new monetary tools provide a more powerful and efficient means of controlling the base rate, enabling changes to be implemented instantaneously.  But such changes are no longer cascading through the economy as they did when Paul Volcker increased the fed funds rate to double digits to combat inflation that had reached 13.5% by 1980, and the nation's interest rates followed suit, rising into the stratosphere while taming inflation to 1.9% by 1986.

Moreover, these new tools have made the marginal cost of changes in the fed funds rate expensive.  For example, in July of last year, the Fed announced its plans to shrink the amount of excess reserves on its balance sheet to between $400 billion and $1 trillion, which means it will cost between $4 billion and $10 billion per year for every 1% increase in the fed funds rate.  Therefore, given the Fed's anticipated new neutral rate for the base rate of around 3.0%, the annual cost will be somewhere between $12 billion and $30 billion.  The Fed will pay for this with the earnings from a security portfolio that originally was $4.3 trillion in size and produced $100 billion in annual earning transfers to Treasury but is now in the process of being downsized to $2.7 trillion and will produce about $60 billion annually – sufficient to cover these costs but resulting in far less earning transfers to Treasury.

The FOMC's elimination of the daily requirement for banks to buy or sell liquidity in the fed funds market, as was necessary prior to the crisis concurrently, has disadvantaged all other financial organizations not eligible to hold reserves that were participants in the market and, in the process, changed the fundamental character of it as well as the substance of the fed funds rate.  These changes are economically and operationally beneficial for banks and make the FOMC's control of the base rate much easier – but are at the expense of non-bank financial organizations, the Treasury (taxpayers), and have added complexity to the search for the elusive inflation that most would agree, in moderation, is an essential ingredient for economic growth and prosperity.