What to Look for in a FED Exit
Pundits are already lining up to call the recent action by the Federal Reserve its big exit strategy. However, facts are damning things. A Federal Reserve exit from the markets won’t be in the form of interest rate policy, it’ll come when the Fed starts to dump its MBS and Treasury holdings.
Why the Fed is Lost
Rate hikes may ease fears that the Federal Reserve isn’t doing a good job at protecting the domestic economy, however, the rate hike is largely ineffective as a means of controlling monetary policy. The Federal Funds rate, the rate at which banks borrow from each other to cover reserve requirements means very little when banks have more capital than at any time in American history. There is simply very little or no need to borrow from other banks in today’s climate, mostly because member banks already have trillions sitting unused.
How the Fed CAN Affect Monetary Policy
The best way for the Federal Reserve to call back its record capital expansion is to sell the products it purchased during the credit easing, mostly MBS and treasuries, all of which the Fed still retains. By allowing banks to trade in Agency paper and treasuries for newly created reserves, the Federal Reserve created more than $800 billion in new money, none of which can be called back by higher rates. The Federal Reserve absolutely HAS to sell these products to call the money back, interest rate policy means nothing.
There is Still Time
The Federal Reserve is in an uncomfortable position, but in its favor is the simple fact that American’s still aren’t buying and are actually paying down debt. This greatly restricts the money multiplier as well as inflation, due to the fact that the money supply is shrinking month after month as consumers avoid credit. At some point, however, spending will come back and it is at that time that the Federal Reserve will be on the hook to sell at least some of its aggressive holdings.
