Why this article?

This is the 3^rd article in the “The Buylyst Fed Papers” series. So far, I’ve covered:

1. Why did it all start? Why have a Fed at all?
2. How did the Fed evolve, crisis after crisis? What did it learn?

This article is about the Fed as it stands today – with more than 100 years of institutional memory. It’s not a perfect system (and we’ll get to why that is at the end) but it’s pretty effective. Let’s just say that if you’re nervous about your purchasing power significantly decreasing because of a depreciation in the currency, you’re in a small minority. Most of us are reasonably confident about the purchasing power of our dollar looking forward 6 months or a year. A big reason – which we don’t think about – is that the Fed is doing its job.

Together, by the end of this article, we’ll have a much better understanding about what the Fed is supposed to do, what it does, and how it does it. I’ll stick my neck out there and say that you’ll have a better understanding of how the Fed (and our economy) works compared to 90% of professional investors out there.

First, the Fed is not about Government Control.

I often hear many libertarian-types go on about how the Fed is like a puppeteer, exercising an unconscionable level of control over the US economy. It’s true that the Fed has massive influence over the economy, but it’s not true that it’s a puppeteer. It exists to ensure stability in the banking system, which is the bedrock of the laissez-faire, capitalistic system libertarians love. I love it too.

Hint: Capitalism has the word “capital” in it. Where does the capital come from? In large part, it comes from banks. Of course, most of the media headlines these days are dominated by Venture Capitalists. But a bulk of the capital to small businesses – the bulk of our economy in the US – is supplied by banks. Why? They have a steady supply of cash that people deposit with them, which they loan out because that’s how they make money. Banks are “spread businesses” – they borrow at a lower rate and lend at a higher rate. They’re essential to the economic machinery.

So, the Fed’s supposed to regulate banking? Yes, but that’s just a part of it. Their objective is to make sure there is stability in the banking system – meaning availability of capital and no bank runs – to facilitate the Fed’s real mandate. Sure, one can argue that the Fed can easily overstep. But it’s ludicrous to think that a bunch of economists convene to discuss world domination. So, what is the Fed’s real mandate anyway? As per their language:

The objectives as mandated by the Congress in the Federal Reserve Act are promoting (1) maximum employment, which means all Americans that want to work are gainfully employed, and (2) stable prices for the goods and services we all purchase. In this way, the Fed’s monetary policy decisions truly affect the financial lives of all Americans—not just the spending decisions we make as consumers, but also the spending decisions of businesses—about what they produce, how many workers they employ, and what investments they make in their operations.

In short, the Fed’s mandate is to promote:

1. Maximum Employment and…
2. Price Stability.

“Promote” is a key word. The Fed cannot ensure these outcomes. But it can do its best – within its powers – to “promote” an environment in which they happen. They do this via the banking system, because in a capitalistic society like ours, banking is what greases the wheels of the economy. In a word, our economy runs on credit.

How does the Fed promote Maximum Employment and Price Stability? 2 words: Inflation Targeting.

It’s all about Inflation Targeting.

It sounds awfully reductive, but this is the result of over 100 years of experience, which included a few failed experiments. Mind you, the Fed and the modern monetary system is still an experiment. But it’s miles better than it was even 30 years ago. As I discussed in the last WTF article, the Fed learnt from the Great Depression that persistent Deflation is a great threat to the economy, and, in the 70s, it learnt that persistent Inflation is a great threat. But it turns out that some inflation is supposed to be good. More on that later.

And as I also pointed out in WTF 2, as the Fed was working overtime to restore normalcy in the banking sector through The Great Recession of 2008-09, it drew on lessons of Deflation from the Great Depression. In 2008-09, soon after the Fed launched its major Quantitative Easing program to prevent a Deflation contagion, it realized that it needed to be mindful of Inflation as well. Why? Firstly, for obvious reasons like persistent inflation crippling the US Economy. But, secondly, for a more intangible reason: It needed to hang on to the hard-fought CREDIBILITY that Paul Volcker had built up for the Fed in the 1980s. Credibility is what makes the economy work. If producers and consumers don’t have any confidence in their currency by losing faith in the Fed, economic activity ceases. That leads to mass layoffs, and the problem of Deflation compounds. We’ve seen this movie play out in the Great Depression.

As the Fed launched a major, unconventional asset-buying operation – called Quantitative Easing – during 2008-09 to stave off DEFLATION, it needed to be very clear to the economy, the banking sector and the financial markets that it will not let INFLATION spiral out of control. In fact, it was as recent as 2012 when the Federal Open Market Committee (FOMC) uttered the words “Inflation Targeting” in the public arena. And it wasn’t until 2016, that the Fed officially clarified that their policy target is a long-term Inflation rate of 2%. But it’s also true that the Fed had an “implicit” Inflation Target even during the Greenspan era of the 1990s.

Even so, all this is recent stuff – a sum-total of all the failures and all the experience from each major economic crisis in the last 100-120 years. Today, the Fed conducts Monetary Policy with the 2% Inflation Target as their true north. You may be thinking: OK, it seems logical to do that as a way to achieve its mandate #2: Promoting Price Stability. But what does that have to do with its mandate #1: Promoting Full Employment?

First: Ensure stability in the Banking sector.

Before we get into how Inflation Targeting (IT) helps the Fed promote Full Employment, we need to answer a simple question that comes up often: Why should the Fed tolerate any Inflation at all? Wouldn’t it be nice if prices never went up? Yes. But that would be a symptom of the economy not growing at all. Why? We need to go back to what I discussed in WTF 1 – how commercial/retail banks are the ones who “create money”. That’s because MONEY SUPPLY – the amount of money sloshing around in the economy – is the key to Inflation. If there is more money supply relative the demand for money, inflation builds up. Money supply-and-demand dynamics take place in the Banking industry. More on this in the next section, but first, we need to be on the same page on how banks operate. Some of this will be repetitive from WTF 1, so feel free to skip to the next section.

Banks loan money at higher rates and borrow at lower rates. That’s their business. Most of what they lend out is borrowed money. These borrowings can be in the form of deposits, like your savings account, or they can be borrowed from other banks or from the public markets (by issuing stocks and bonds). The money they lend out – to businesses, to people – shows up on the Assets side of their balance sheet. The borrowings – deposits, bonds, loans from other banks – are Liabilities. The difference between their Assets and Liabilities at any given point in time equals Equity. In other words, the difference is their Net Worth. How does the Net Worth build up over time? Net Interest Income. This is the spread in interest rates that bank pockets – this is the difference in the higher interest rate at which they lend and the lower interest rate at which they borrow.

There is a counterintuitive point about Banking that I should highlight. Most of us think that the bank must have cash deposits on hand to fund their assets (the money they lend out). That doesn’t need to be the case at all. They can lend out money they’ve borrowed. Bear in mind that your deposit in your bank is borrowed money for your bank. Your bank pays you a (probably paltry) interest rate for this borrowing. This brings us back to WTF 1, in which I discussed how they do this: The Fractional Reserve Banking System. Banks are required to hold just 10% of their reserves with the Fed – reserves meaning cash reserves to fund withdrawals or other immediate cash needs if the bank exhausts all other sources of (borrowed cash). Each bank in the Fed system (now all US banks) has 10% of their reserves with the Fed. This means they can lend out the other 90%. That creates a virtuous snowball effect, up to a point.

I’ll quickly illustrate an example of this snowball effect once more (also did in WTF1; pardon the redundancy). A bank finds a lending opportunity. It borrows $1,000 from another bank or from investors (by issuing bonds). Out of this $1,000 Liability, it lends $900 because it’s required to park $100 (10%) with the Fed. That $900 is somebody’s loan, which (let’s assume) she deposits in another bank. That other bank can lend out $810 (90% of $900) to someone else – because it is also required to keep 10% as reserves with the Fed. This cycle goes on and on, until $9,000 of loans are made in the economy based on that initial $1,000 loan.

Here is a key point: Overall in the economy, all loans are matched by all borrowings. Thus, we have the popular saying: Loans create Deposits. One bank’s asset – loans made – is another bank’s liability – deposits. As for the initial $900, which the original bank lent, was also funded by borrowed money – it may not have been deposits on day 1, but it could also be “matched” by future deposits.

Down the line, the bank is expected to recover the initial $900, presumably because of its excellent credit due-diligence. If the borrower of that $900 returns the money, with interest, fantastic! Then Assets outstrip Liabilities – because of Interest earned – and the bank adds to its own Net Worth (Equity). On the other end of the spectrum, if the borrower defaults, then the bank writes down the Asset Side of its Balance Sheet to $0. At the end of this dire scenario, money wasn’t created. The bank can foreclose property or equipment to recover part of that loan. In this particular loan case, Assets fall behind Liabilities. Obviously, the bank will be out of business if many borrowers default.

Money is created because money is just electronic entries in an account. Even in the good old days of cash-only, coming up with cash would only be relevant when depositors would come to the bank and withdraw cash. That’s Treasury’s headache – to print pieces of paper to back up money that’s been created in the banking system. But bank runs can happen, and there can be a shortage of actual paper-cash at times.

That’s why the Fed – since the early days of its existence – imposed a Fractional Reserve Banking system. It forces banks to keep some cash for emergency withdrawals. When that happens, the bank facing this sort of crisis can borrow from other banks in some other part of the country. The balancing act for the Fed is to keep just a fraction of a bank’s reserves in order to avoid systemic bank-runs, and at the same time not cause the bank to miss out on lending opportunities. That would impede economic growth. Banks make money by lending. And that’s how the economy runs smoothly – because businesses and people have access to the “pooled savings” of society via banks. Banks play the role of “watch guards” when lending out this “pooled” pile of savings. They do the due-diligence so you don’t have to; whether they do a good job or not is another debate.

The key lesson – as it relates to BANKING STABILITY – is that the Fed’s required reserves also function as a clearinghouse for the banks themselves. Banks often borrow from each other to fund their daily needs or to fund withdrawals from depositors in case it exceeds their cash-on-hand. So, when banks borrow from each other – a key operation in their daily functioning – it is in the “Outside Money” world (as I discussed in WTF 1). This keeps banks solvent, since there is a clearinghouse that makes sure that banks with extra reserves can lend to banks who need extra reserves.

Outside Money is meant to ensure that there is adequate supply of Inside Money – the amount of money actually sloshing around in the real economy. The Fed has more control over Outside Money – the bank reserves. It has very little control over Inside Money. That’s the purview of the free market: how much MONEY DEMAND there is, and how much MONEY SUPPLY there is to meet that demand is determined by people and businesses making investment decisions and the banks that supply them with credit. The Fed’s job is to “promote” an environment that supply and demand of money are roughly matched at all times. It can’t control money demand, so it exerts influence over money supply.

How much money supply? Enough to maintain a long-term Inflation Target of 2%.

Second: Target Inflation.

If the banking sector is stable, the second step is to target Inflation. Why Inflation? This is the crux of The Buylyst Fed Papers.

Inflation happens when demand exceeds supply. It’s the same with money. Demand for money comes from people and businesses wanting to spend more. Supply of Money comes from banks willing to lend them more. The Fed sees Inflation as the key marker for this supply-demand matching in Money.

The Fed likes to maintain an environment where the long-term inflation rate of the US Dollar hovers around 2%. Why 2% you ask? Good question. We’ll tackle that soon. But first, we should understand why Inflation is a good catch-all number for the Fed to target.

First, the Fed doesn’t want Deflation. The Great Depression taught us that Deflation causes economic activity to cease. If prices keep falling, demand falls because people and businesses postpone consumption. That’s terrible for the economy. Layoffs happen. Demand falls even more, firms go out of business, more layoffs…you get the picture. Too much Inflation is bad for obvious reasons – purchasing power of people decreases. The non-obvious reason is that inflation starts eating into firms’ profit margins. Now we’re getting warmer. This is where the inflation becomes an “ears on the ground” measure for the Fed.

My core competency is analyzing businesses as investment opportunities. In the process, I dig into financial statements all the time. So, let me use that to explain how Inflation is the link between Macro and Micro-economic policy.

Firms make a profit when their revenue exceeds costs. That’s obvious. Revenues = Price X Volume. Costs, however, come in many flavors. Broadly speaking, every business in the world has these layers of costs:

1. Input costs.
2. Labor Costs.
3. Financing Costs.

Recall that in WTF 2, I had mentioned that back in the 70s and 80s, when Paul Volcker was hell-bent on fighting Inflation, the Fed had realized that it’s important to distinguish Cost-Push Inflation vs. Demand-Pull Inflation. Both are important. But in the 70s, the problem was predominantly cost-push inflation.

Cost-push inflation can lead to something called Stagflation, which happened in the 70s. This is an unpleasant mix of Unemployment and Inflation. When input costs go up, profit margins get squeezed. A business has 2 ways to tackle this:

1. Raise product prices.
2. Reduce wages and layoff people.

In the 70s, firms did BOTH in the hopes of keeping their profit margins intact. That was Stagflation. But firms did this because they had no hope of inflation slowing down. This was a credibility problem. They didn’t believe that the Fed would bring inflation back down. Volcker changed that, but not without pain. More in WTF 2 on that.

Demand Pull inflation is a sign that there’s too much money chasing too few goods. This happens when the economy is booming. So, it’s tempting to keep this party going. But if this overstretches, firms and people tend to drink too much from the proverbial punchbowl and borrow too much. Chasing high prices and great prospects, firms borrow too much to produce more, and hire more people, and may even pay them more to join the party. They can do this when credit is cheap compared to their profit forecasts. At some point this goes overboard. It happens time and time again. They borrow too much, hire more people at high wages, and flood the economy with more products. At some point, competitive forces ensure that prices come back crashing down because of too much supply or too many new entrants or both. Then the firms are stuck with lot of capital invested in new factories and new hires. Suddenly, both the Price and Volume variables that make up Revenue start falling. Suddenly, the firm doesn’t generate enough profit to meet its borrowing/financing costs. Suddenly, the firm needs to find ways to raise cash. Guess what? Layoffs.

Either way, high inflation is a self-perpetuating thing that eventually leads to mass layoffs, which causes all sorts of problems. One can argue that such booms and busts are fair in a free market economy. That’s a philosophical debate.  But, in reality, most people and businesses don’t like booms and busts. They like to plan ahead, whether in life or in spending decisions. If there is no confidence in their currency, economic activity slows down because of uncertainty. One thing businesses hate when they’re making long-term decisions is uncertainty. If that uncertainty is reduced, they tend to hire people with confidence.

There are 2 important points here:

1. Inflation is an important variable for businesses.
2. Inflation expectations may be even more important when firms make hiring decisions.

To remove uncertainty, the Fed – since 2012 – has made it explicitly clear that its major policy target is 2% Inflation. This is the level at which it regards the economy as neither too hot nor too cold. This is the level at which the Fed believes that people who want to work will get work because business will invest without thinking about extraneous things – such as the value of their dollar.

Why 2% Inflation?

This is a great question. And I’ll be upfront – I don’t know the answer. Obviously, the Fed has done some number-crunching with fancy statistical models. But here’s my attempt at a logical, qualitative explanation:

I’m a research analyst who spends his days staring at balance sheets and income statements. In my line of work, there aren’t many laws upon which I can rely. But there is one grand equation that always holds true:

Assets – Liability = Equity.

I’ve touched on this equation earlier when I was talking about banking. If we zoom out, we can superimpose this equation on the whole economy. Whether its consumers or businesses, everybody produces, makes money, invests and also loses money. A majority of people in the US borrow to consume or invest. Everyone has the same balance sheet equation. People and businesses have assets, and they have liabilities. The difference is their net worth. Add them all up and the same holds true of the economy. On average, every year, the assets generate some income (the income statement). This is extra money created in the economy. This is money that’s created as a result of the effort of the people in a given country. You can call it GDP or some version of it.

In the US, when the economy functions at a healthy rate – with full employment – GDP growth is roughly 3-4%. So, we should expect that money is created within the system. And this is extra money supply that wasn’t there before. If the demand for money – already at a healthy rate – remains stable, this extra money supply should cause some inflation. It’s the sign of a healthy economy.

Money was borrowed. Money was invested in productive assets. The assets generated revenue. The revenue exceeded borrowing costs, labor costs and input costs. Extra money was generated.

The Fed deems it safe to anchor this extra money supply at 2%. And the Fed goes to work every day trying to ensure that inflation remains at around 2% over the long-term.

What’s in the Fed’s toolbox?

We’ve been talking about money supply and money demand for a while. Here’s something you may already know, at least intuitively. The price of money is the INTEREST RATE. This is the variable over which the Fed has partial influence. It influences money supply to match up with money demand via interest rates – all of it aimed at keeping Inflation at roughly 2%. If it succeeds at that, it believes that it takes care of the Full Employment mandate as well.

The Fed has 4 main tools in its toolbox:

1. Fed Funds Rate
2. Open Market Transactions
3. Discount Window
4. Reserve Requirement Ratio

Using these tools, the Fed tries to influence money supply in the economy to target 2% inflation.

If you recall, there’s Outside Money and Inside Money. Outside Money is the pile of reserves that the banks hold with the Fed. Inside Money is money within the banking system – tethered to the real economy where people and business produce and consume. The banking system relies on credit – liabilities to fuel its lending opportunities. Banks borrow amongst each other to fill their funding needs. This is called the Interbank market. It’s big and it's important. The Fed has power to influence this interest rate – the rate at which banks lend to each other. This rate in the US is called the Fed Funds Rate (FFR).

The Fed doesn’t just set a rate, however. It “targets” an FFR every 6 weeks. It does this via Open Market Transactions (OMT). When the Fed sees signs of the economy overheating or cooling down (signs of potential inflation or deflation), it engages in either “expansionary” or “contractionary” monetary policy via OMT.

OMT usually involves buying or selling US Treasury Bonds to a bunch of big banks in the US. When the Fed buys Bonds, it increases the level of money supply, thereby influencing the FFR to decrease. It does this when it sees signs of money supply not keeping up with money demand. The opposite is also true. The Fed sells bonds to these banks when it sees signs that money supply is outpacing money demand. Ultimately, the FFR hovers close to the Fed’s target.

The Discount Window is a facility in which the banks can borrow directly from the Fed. In the earlier case, the Fed was just influencing the FFR so that banks can lend and borrow freely amongst each other as per the economy’s demands for credit. But sometimes, the interbank market isn’t enough. Sometimes, banks need to borrow directly from the Fed. This happens from time to time. Usually, the Discount Rate exceeds the FFR. That’s because the Fed prefers to just deal with the FFR.

The Required Reserve Ratio is roughly 10%. I don’t think this has changed in a while. Why 10% and not 8%? I don’t know. Round number?

The fifth tool that I didn’t mention came to light during the 2008-09 crisis. The Fed engaged in a massive Quantitative Easing program. This meant that the Fed was buying all sorts of securities as part of its Open Market Transactions – not just Treasury Bonds. They bought mortgage-backed securities, troubled assets and other exotic securities in order to keep rates low – mortgage rates and medium-term rates low. They were stretching way beyond their zone of expertise. Usually, the Fed just targets short-term rates – literally – overnight rates. This was highly unconventional at the time, but the Fed deemed it necessary at the time to keep the banking sector stable and the credit market flowing. Why? Because it didn’t want a Great Depression situation in which lack of credit and Deflation exacerbated each other to cause an unemployment rate of 25%. As I mentioned before, soon after it launched this massive program, it had to focus its attention on Inflation. So far, so good.

With these 5 tools, the Fed’s main objective is to keep Inflation at roughly 2%. It’s a tough job. And it’s not a science. They’ve kept inflation under control since the Volcker Disinflation of the 1980s. But they can and will make some mistakes. And sometimes its policies will fall flat because of bad Fiscal Policy, which is outside the Fed’s purview. Case in point: The current Trade War.

This is the best bad system we have.

The Fed has made many mistakes in the past. The way it stands today is a result of those mistakes. Inflation Targeting seems to be working at the moment – many experts thought that the Fed’s Quantitative Easing program would lead to high inflation. In 2012, the Fed felt compelled to confirm what many other knew all along – that its main focus is on Inflation Targeting, at 2%.

While we can feel safer about our $$s, it’s clearly not a perfect system. In my view, here are the potential flaws:

1. The 2% target seems rather rigid and definitive. What if the economy consistently grows at a much higher rate in the future because of, say, technological progress? Can the Fed change this number?
2. The Fed’s structure seems too much like a “politburo”. The President nominates the Chairman for the Federal Reserve Board. Of course, the nomination must get approval of the Congress. And then there is an FOMC (and Open Market Committee). It all sounds a bit Stalinist.
3. And precisely because of #2, the Fed can get political. As I write this, Fed Chairman Powell and President Trump are in a war of words. But if Mr. Powell bows down to the President’s wishes to lower rates and ignore Inflation, the Fed could lose its credibility. It hasn’t happened yet. But it can.
4. There still seems to be inefficient layers between the real economy and the Fed’s attempts to keep prices and employment stable. Fed policies take months, even a year, to make an impact on price stability and employment. A lot can happen in a year. I get the impression that the world is moving too fast for its policies to make a big impact.
5. As income inequality increases in the US, does it impact the effectiveness of a one-size-fits-all monetary policy? Does it need to be more decentralized?
6. Ultimately, the Fed relies on imperfect data and imperfect economic models (there are no perfect economic models). This leaves huge room for mistakes.
7. There is a shadow banking system that’s outside the purview of the Fed. Banks may not be the primary source of credit in a few years. It’s a possibility. What is the relevance of the Fed then?

These are questions that keep ringing in my mind. And I’m not alone. In fact, some people are convinced that the Fed is harmful. There are people on both sides of the political spectrum – liberal or conservative – who call for alternatives to the Fed. The Left doesn’t like the Fed’s rather laissez-faire approach. And the Right doesn’t like the “politburo” model. It makes sense – the Fed as it stands today is the product of a big consensus between two schools of economic thought – Keynesians and Monetarists. Extremists on both sides will not like it.

While I have those questions in my mind, I believe this is the best bad system we have. At the end of the day, I’m fairly confident that my dollars will hold on to their purchasing power. And I’m in the majority.