On Being An FOMC Member

[thenews]

It's easy to criticise the Fed for its failures, because its successes have been only one in number: kicking the can down the road.

But we should spare a thought for the difficulties policy-makers now face. So what would you do if you were on the Open Market Committee?

Repeatedly kicking that can has so far succeeded, but economic conditions are changing all the time, throwing up new challenges. The next chart dramatically exposes the one issue that historically would have determined interest rate policy in advance, but is being widely ignored, even by the FOMC.

Simply subtracting M2 money from M1 money gives a running indication of bank lending. And as the chart shows, it has been growing above trend since mid-January, followed by a sudden spurt timed from early July. This requires, on the face of it, an immediate normalisation of interest rates to bring the expansion of bank credit back towards its established trend.

The source of this increase in bank lending can be attributed in some measure to a draw-down of bank reserves held at the Fed. Controlling the release of excess reserves was always seen as the eventual challenge for the Fed, when it expanded its balance sheet in the wake of the Lehman crisis, and that moment seems to have arrived. Since March, total reserve balances have declined just $150bn, which when geared up through a modest fractional reserve multiplier, easily accounts for the spurt in bank credit. It requires an increase in the Fed Funds Rate to slow down the outflow.

The question then arises, who is borrowing this money? If other information available to the FOMC reveals a developing appetite from the non-financial sector, and which can also be taken to indicate an improvement in business conditions, then the Fed Funds Rate should be increased without delay. Credit being applied to the non-financial economy is bound to lead to higher prices, meaning that the CPI target could be exceeded much sooner than anyone thinks is likely.

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