The reuse of securities and collateral has forced banks to hold more liquidity for two reasons: to maintain customer confidence that bank commitments could always be honored with more complex and interrelated claims; and because new regulations have imposed it (the Liquidity Coverage Ratio). This demand for liquidity required accommodation from the Fed – otherwise rates would rise and / or market tensions would return.
Each episode of volatility was followed by monetary easing and a rally in stocks and house prices, while the leveraged stocks of private equity managers significantly outperformed the dynamic stock market. The Fed has always “had its back on the market”.
These pre-COVID-19 QE policies mainly involved dealing with banks, investment financial institutions and official brokers in the bond market.
Banks can’t get rid of the Fed’s nominal liabilities, but they can do so in real terms through higher prices – by lending to households and businesses at zero interest rates and creating nominal demand. But there’s never been a whole lot of income gain in there, with rates close to zero and new capital rules to think about.
The chosen path of reducing bank balance sheet risks and supporting greater risk-taking in the shadow banking sector has created a new demand for liquidity. At the same time, this meant that little was going to affect nominal demand and inflation.
These policies have led to greater social division. Even as the jobs of workers with little or no education began to shrink and their labor contracts and wages were compromised in the face of the penetration of Chinese imports and new technologies, they saw unprecedented increases in wealth for the elites. .
The chart shows the major components of the Fed’s balance sheet and the share of the richest 10 percent of households in US wealth. In early 2009, the richest 10 percent of American households controlled 58 percent of the country’s wealth (roughly where they had been sitting since 1989). During the period of monetary easing since 2009, this group’s share of wealth has increased to 65%. The middle classes were the biggest losers, and the poorest 50 percent never had much to start with.
The previous decade of inflating the “air mattress” (and abandoning tapering) had not led to any inflation. So why this time?
Have money, will spend
The reason is that the expansion of COVID-19 was not just about the interbank market and the needy financial system. Fiscal policy led to an interaction with the Fed’s balance sheet which ultimately pumped money into the hands of ordinary citizens who would spend it.
Government monetary funding (as would happen if the Treasury borrowed directly from the Fed to write its COVID-19 checks) is taboo in modern central banking. However, the Treasury can borrow on the open market (mainly from institutions via primary dealers) and deposit the proceeds in the general treasury account at the Fed. This is shown by the yellow area in the graph.
Since its peak of US $ 1.8 trillion in August 2020, the decline in those deposits as the Treasury sent checks to households was over US $ 1.6 trillion. Essentially, this had the effect of transferring institutional liquidity to the transaction accounts of ordinary citizens.
The bankers of these ordinary citizens are getting increased claims on the Fed, and bank reserves would normally have increased more if this had not been offset by political action. This has been duly implemented, as shown in the orange area of the graph. Bank reserves were held where the Fed wanted them, while the household sector got $ 1.6 trillion.
The difference between dealing in the interbank market and putting money directly into the hands of households is obvious to everyone. Household funds have been spent and growing demand under circumstances of supply chain disruption and tightening labor markets (the ‘big resignation’ as American workers quit to find better paying jobs) is causing the ‘inflation.
The financial transfer in cash to households is transitional, but other fiscal measures to support demand are in preparation. It should also be remembered that bringing key supply chains home and reducing the influence of dictatorships on Western economies still has a long way to go.
Thus, the risk of inflation is real and will continue if wage and price increases feed off each other. The only reasonable way to go is Fed tightening.
Having been allowed to run for the wrong reasons, any easy money unwinding will affect the pyramid of financial complexity and leverage that has been supported by monetary policy for so long.
It must be a bumpy ride for the Fed and the richest 10 percent of US households.
But it is long overdue. And Australia will not be spared.