Fed flirts with stimulus

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As expected, the Federal Reserve signaled its commitment to fighting inflation by holding interest rates steady at this week’s Federal Open Market Committee meeting. It also announced a worrying move that will get much less attention. It is slowing down the rollback of its balance sheet, which could be a prelude to inflation-causing stimulus.

The Fed is risking failing its inflation expectations stress test even without cutting interest rates.

The Fed’s balance sheet is its most powerful tool for adjusting the money supply, far more powerful than interest rates. And as bears repeating, the money supply is the most important part of inflation.

The Fed’s balance sheet consists mostly of government bonds. If the Fed wants to grow the money supply and raise inflation, it buys bonds. If it wants to shrink the money supply and lower inflation, it sells bonds. This technique is called open market operations, because the Fed buys and sells bonds in the open market.

Unlike interest rate policy or bank reserve requirements, open market operations directly affect the money supply with no middle men. As I wrote several times during the pandemic, inflation observers should pay more attention to open market operations than to interest rates.

This works because unlike private buyers, when the Fed buys bonds, it can do so with money it creates out of thin air. Those brand-new dollars then circulate throughout the economy. This process takes time, which is why Fed policy has lag times which range from six months to a year and a half.

How powerful is the Fed’s balance sheet policy? It caused the majority of the great COVID inflation. When COVID-19 first hit, Fed officials panicked and bought up about $5 trillion of bonds. This more than doubled its balance sheet, which grew from around $4.2 trillion to just under $9 trillion. That grew the money supply by about 40 percent over two years. The result was inflation topping out at 9.2 percent. Both of these figures are about quadruple their usual rates.

This spike lines up perfectly with the lag times one would expect from Fed policy. So does inflation’s slow decline after the Fed stopped growing its balance sheet and began raising interest rates.

Some of this panicked stimulus was the Fed’s own decision. It began ramping up its balance sheet within weeks of the pandemic reaching the US to compensate for slower economic activity during lockdowns. Some of frenzy was also due to the Fed’s unwritten obligation to help the political branches finance trillions of dollars of new deficit spending.

Economists have differing opinions on whether fiscal or monetary policy is steering the inflationary ship. Regardless of who is giving the orders, open market operations were the mechanism that caused most of the great COVID inflation.

That pandemic history shows why this week’s balance sheet news is important. The Fed’s balance sheet is currently about $7.4 trillion, down from a peak of just under $9 trillion. The Fed hasn’t been actively selling off bonds to reduce the money supply. Instead, it has been taking a passive approach of letting bonds mature, collecting the proceeds, and retiring those dollars from circulation.

It has been doing that at a steady rate of about $75 billion per month for almost two years, minus a brief spike in early 2023. This week’s policy change is slowing that rollback by two thirds. The balance sheet will still shrink, just at a slower rate of $25 billion per month instead of $75 billion. This means that the Fed will continue to retire matured bonds, but will be supplementing that by buying some bonds as well to slow down the net decline in assets.

This is almost certainly a reaction to last week’s anemic GDP news, and the fact that the labor market will eventually cool down. Given the Fed’s lag times, its window for stimulating the economy in time for the November 2024 elections runs from about now until its next meeting in six weeks. Fed Chair Jerome Powell has so far stood up to political pressure to stimulate, but that era could now be over.

This week’s meeting may be an important inflection point. We’ll learn more at its next meeting in six weeks, and interest rates are no longer the only concern.

Is this week’s balance sheet policy change a hidden first step in going back to COVID-era stimulus, and the higher inflation that goes with it? Or is it a minor one-time adjustment?

Inflation expectations are the main holdup in getting rid of the last percentage point of extra inflation. And those expectations hinge on the Fed’s credibility as an inflation fighter. Most of the headlines will be positive news about staying firm on interest rates. But the balance sheet change is worrying. The Fed is doing itself no favors.

For ways Congress can help the Fed stay focused on fighting inflation, see my inflation chapter in CEI’s Agenda for Congress.