(American Institute for Economic Research) The recent move by the Federal Reserve to increase support for the overnight lending market further informs our understanding of monetary manipulation that has characterized the last decade. Although the putative reason for the recent intervention is to support the overnight lending market, political motivation appears to have played a significant role in the decision. The operation provides increased support by the Fed to the market for U.S. Treasuries while hiding the effects of the intervention.
The Federal Reserve has provided support for the repo market. But the support, which has caused an uptick in the Fed’s balance sheet of nearly $200 billion, has not only occurred through an abnormal increase in repurchase-agreement holdings (repos) of the Federal Reserve. The Federal Reserve has also increased its holdings of Treasuries by purchasing from primary dealers who are also active in the overnight lending market.
The saga of hidden intervention continues. In recent weeks, the Federal Reserve has also acquired repurchase agreements. Reverse repurchase agreements affect only the discrepancy between the quantity of base money and the size of the Fed’s balance sheet, whereas repurchase agreements add to the balance sheet as the Federal Reserve has purchased the instruments with newly created money. In the first case, the Federal Reserve borrows from the market; in the second, it provides short-term loans to the market.
If you expect that this would also lead to an increase of the quantity of base money, if not the quantity of base money in circulation, you are mistaken. Since the announcement of increased support for the overnight lending market, we have also seen a substantial increase in deposits of the Treasury at the Federal Reserve. So long as funds provided by recent purchases by the Federal Reserve are sterilized by a change of similar magnitude in the size of the Treasury’s general account at the Fed, there will be neither an increase in the quantity of base money in circulation nor an increase in the total quantity of base money.
Monetary Policy Is Political
What is the purpose of the Federal Reserve’s purchases? Yes, interest rates in the overnight lending market had risen. And, yes, the provision of liquidity appears to have stabilized rates in that market. We never entered crisis mode. Not even close. But that does not explain why the Federal Reserve chose this path to stabilize the overnight lending market. After all, it could have solely increased holdings of repurchase agreements or decreased holdings of reverse repurchase agreements without increasing holdings of Treasuries. This would have accomplished the same goal without the additional economic distortions in the Treasury market generated by the chosen intervention.
One must wonder if Jerome Powell was seizing the opportunity to ease pressure from the current administration. As George Selgin has pointed out, the problem of Federal Reserve officials reducing the size of the balance sheet is a political one. The large balance sheet is not necessary to promote macroeconomic stability. It is necessary to keep interest rates low in sectors favored by Fed policy.
The Federal Reserve is subsidizing the Treasury. The apparent trouble in overnight markets appears to have provided an excuse to quietly reengage in the now decade-old program of support. In the process, Powell has — for the first time during his tenure — increased the size of the Federal Reserve’s balance sheet.
As long as the Federal Reserve continues this practice of purchasing Treasuries and hiding the results of monetary expansion by sterilizing the resultant monetary expansion, it will enable excessive federal spending while leaving the public with little recourse. In turn, the federal government can avoid facing the consequences of fiscal irresponsibility.