Mises Wire |
- The Fed's Policies since the 2020 Coronavirus Panic
- Entrepreneurs Are Motivated by Profit, Not Risk
- More Evidence the American Economic "Recovery" Will Disappoint
- There's No Conflict between Profit and "Social Responsibility"
| The Fed's Policies since the 2020 Coronavirus Panic Posted: 02 Jun 2021 12:00 PM PDT [This article is part of the Understanding Money Mechanics series, by Robert P. Murphy. The series will be published as a book in 2021.] In chapter 7 we summarized some of the major changes in how central banks have operated since the 2008 financial crisis. In the present chapter, we detail some of the even more recent changes in Federal Reserve operations since the onset of the coronavirus panic in March 2020. Size of the Fed's Balance SheetThe most obvious change in Fed policy has been the dramatic expansion of its balance sheet since March 2020. Figure 1: Total Assets Held by the Federal Reserve  As figure 1 indicates, the explosion in Fed asset purchases since March 2020 dwarfs even the three rounds of QE (quantitative easing) following the 2008 financial crisis. Indeed, from March 4, 2020, through March 3, 2021, the Fed increased its assets from $4.2 trillion to $7.6 trillion, an incredible one-year jump of $3.3 trillion (or 78 percent). Furthermore, as the graph reveals, the upward trajectory continues as of this writing. Composition of the Fed's Balance SheetBesides the quantitative change in the Fed's asset purchases, there has been a qualitative change in the type of asset. In particular, the Fed is now buying large amounts of private sector corporate bonds (both individually and exchange-traded funds); as of the mid-May 2021 balance sheet report, the Fed's "Corporate Credit Facilities LLC" held almost $26 billion in assets.1 This change in policy would have been extremely controversial (if only for the potential corruption) prior to the financial crisis, but it is now a seemingly natural outgrowth of the expansion of Fed discretionary power that began in the fall of 2008. The Fed announced the creation of the Primary and Secondary Corporate Credit Facilities LLC in March 2020 (though it did not begin aggressively buying corporate debt—which had to have been rated "investment grade" before the pandemic hit—until June 20202). At the same time, the Fed announced expansions of preexisting asset purchase programs, as well as the creation of a "Term Asset-Backed Securities Loan Facility (TALF), to support the flow of credit to consumers and businesses," which would "enable the issuance of asset-backed securities (ABS) backed by student loans, auto loans, credit card loans, loans guaranteed by the Small Business Administration (SBA), and certain other assets."3 At this point, the Federal Reserve now has the capability of influencing the credit markets not just for commercial banks, but for commercial and residential real estate, corporate bonds, commercial paper, cars, student loans, and even personal credit cards. Abolition of Reserve Requirements for US BanksIn an emergency statement issued in the evening on Sunday, March 15, 2020, the Fed announced a host of new policies in light of the then emerging alarm over the coronavirus.4 In addition to cutting the target for the federal funds rate back down to 0 percent (with a range of up to 0.25 percent) and pledging to increase the scale of its asset purchases, the Federal Open Market Committee (FOMC) statement concluded with this tantalizing paragraph:
The final word, "website," contained a hyperlink to the Fed's main website. Yet if one looked at the compilation of press releases, there was an additional item posted on March 15, 2020, titled "Federal Reserve Actions to Support the Flow of Credit to Households and Businesses," which was alluded to in the official FOMC statement.5 For our purposes, we will highlight the last measure listed in this supplemental statement:
Since the Fed's actions following the financial crisis of 2008, the US banking system as a whole has been awash with excess reserves (see the second chart in chapter 14). This is because following the Fed's injections of new reserves under the various rounds of quantitative easing, the commercial banks did not create new loans for their own customers to the maximum amount legally allowed. Therefore, the immediate impact of the Fed's 2020 decision to abolish reserve requirements should be minimal, since the original reserve requirements were not binding at the time of the change. However, even though the US banking system had more than enough reserves to cover its requirements, it is still the case that the level of required reserves rose dramatically—quintupling from about $40 billion to more than $200 billion—since the financial crisis, as the following chart reveals: Figure 2: Required Reserves of US Depository Institutions  (In the chart, the Required Reserves line falls vertically to zero at the end, because the Fed's policy change abolished reserve requirements.) To avoid confusion, the reader should remember that in addition to the Fed's direct actions that caused the monetary base to soar, money "held by the public" (which we can summarize by the monetary aggregate M1) also dramatically increased following the 2008 crisis. Later in this chapter we will explain the redefinition of M1 in 2020, but the graph of M1 we present in chapter 14 shows the measure in its old definition; the reader can see that it rose steadily after 2008, and jumped sharply in 2020. To the extent that much of this increase in money held by the public took the form not of actual physical currency, but of checking account balances at commercial banks, the statutorily required reserves rose correspondingly—as reflected in the chart above. Some analysts argue that the Fed's abolition of reserve requirements merely reflects the new realities of modern banking. With the 1994 introduction of retail "sweep accounts"6 and especially in the post-2008 era of large central bank balance sheets, some have argued that reserve requirements are anachronistic and no longer influence commercial bank lending decisions, except to necessitate cumbersome maneuvers.7 Although the situation is no doubt nuanced, some of the more glib defenses of the new Fed policy prove too much. For example, the Fed's own explanation (quoted above) says, "This action eliminates reserve requirements for thousands of depository institutions and will help to support lending to households and businesses." If it were indeed the case that the reserve requirements did not constrain bank lending—as claimed by some of those dismissing the announcement as a bit of trivia—then abolishing the requirements wouldn't support lending to households and businesses. To put it simply, if the abolition of reserve requirements really have no effect, then one wonders why the Fed decided to implement the move along with the other emergency measures activated at the onset of the coronavirus crisis. At the very least, abolishing the requirements will give the commercial banks freer rein to make loans down the road, if conditions return to a scenario where the original rules would have provided a check on additional bank credit inflation. Redefinition of M1On February 23, 2021, the Fed announced:
In other words, in late April of 2020, the Fed removed some of the limits on savings deposits in a way that made them equivalent to checking account deposits. As such, savings deposits from May 2020 forward are now included in M1, whereas before they had been excluded from it. Yet either way, savings deposits were always included in M2. Consequently, we can look at the Fed's graphs of both M1 and M2 to isolate the impact of the reclassification: Figure 3: M1 and M2 Money Stock, Showing Effect of May 2020 Redefinition As the figure indicates, there was a massive spike in the official M1 measure in May 2020, largely (though not entirely) reflecting the reclassification of savings deposits as part of M1. However, note that M2 also rose sharply at exactly this time, reflecting a genuine increase in money held by the public because of the coronavirus panic and Fed policy. (Also remember that the M1 chart shown in chapter 14 was made based on the original M1 numbers, before the retroactive reclassification occurred. The chart in chapter 14 shows that M1, even according to the old definition, truly did spike in the spring of 2020.) Given the change in Regulation D, the reclassification of M1 made perfect sense. Some economists have speculated that the motivation for the Fed's decision to discontinue publication of certain monetary measures—which occurred at the same time as the retroactive M1 reclassification—may have been to obscure the large increase in US Treasury and foreign bank deposits with the Fed, as such data might fuel concerns that the Fed is acting to monetize US government spending.9 Switch to Average Inflation TargetingOn August 27, 2020, the Fed posted its "2020 Statement on Longer-Run Goals and Monetary Policy Strategy," which amended the original statement adopted back in 2012. The following excerpt highlights the major change in the 2020 amendment:
Before the August 2020 change, the Fed had adopted a constant (price) inflation target, which reset anew each period. For example, if the Fed wanted inflation (in the Personal Consumption Expenditure index) to average 2 percent in 2020, but in actuality the desired inflation measure came in at only 1 percent, then under the old system, the Fed in 2021 would try again to hit 2 percent. But under the new system, the Fed might shoot for inflation of 2.5 percent for both 2021 and 2022 to make up for the initial undershooting of the target back in 2020. (We are ignoring the complications of exponential growth to keep the arithmetic simple.) This is what the Fed authors mean by saying they are switching to an average inflation target: in our example, if the Fed undershoots the target in 2020, the average over the three-year period can only hit the target if the Fed overshoots in 2021 and 2022. At the Jackson Hole monetary conference held in late August 2020, Fed chair Jay Powell gave the opening remarks. He first summarized some of the major changes in the global economy and central bank practice since 2012, and then explained the new Fed policy by saying:
Specifically, Powell argued that the fall in real interest rates, as well as muted (price) inflationary expectations, made the "zero lower bound" a much more potent threat in 2020 than it had been a decade earlier. When short-term nominal interest rates hit 0 percent, it is difficult for the central bank to cut further; why would people lend out their money at a negative interest rate when they could just hold cash and earn 0 percent? According to some economists, at the zero lower bound conventional monetary policy loses traction and other measures are needed. In theory, the switch to average inflation targeting can help alleviate the problem posed by the zero lower bound. Investors know that if the Fed runs into trouble during a sluggish year and inflation falls short of the target, then the Fed is required to let the economy "run hot" for a while in order to make up for the lost ground. Even if nominal interest rates stay at 0 percent, the increase in expectations of future inflation lower real interest rates and have the same impact as if the Fed had more room to cut nominal interest rates in the present. In contrast to this optimistic interpretation of the Fed's new regime, a more cynical take is that Federal Reserve officials knew that their massive monetary expansion in 2020 would lead to higher price inflation, and they wanted to provide themselves with a framework to justify their failure to stay within their own guidelines.
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| Entrepreneurs Are Motivated by Profit, Not Risk Posted: 02 Jun 2021 09:00 AM PDT According to modern portfolio theory (MPT), financial asset prices fully reflect all available and relevant information, and any adjustment to new information is virtually instantaneous. For instance, if the central bank raises interest rates by 0.5 percent, and if market participants anticipated this action, asset prices will reflect this expected increase prior to the central bank raising interest rates. Note that once the central bank lifts the interest rate by 0.5 percent, this increase will have no effect on asset prices, since it is already embedded in asset prices. Should, however, the central bank raise interest rates by 1 percent, rather than the 0.5 percent expected by market participants, then the prices of financial assets will react to this additional increase. According to the MPT, the individual investor cannot outsmart the market by trading based on the available information, since the available information is already contained in asset prices. Changes in asset prices occur because of news, which cannot be predicted in any systematic manner. This means that methods which attempt to extract information from historical data, such as fundamental analysis or technical analysis, are of little help, for whatever an analyst uncovers in the data is already known to the market and hence will not assist in "making money." The proponents of the MPT argue that if past data contains no information for the prediction of future prices, then it follows that there is no point in paying attention to fundamental analysis. According to one of the pioneers of MPT, Burton G. Malkiel, in his book A Random Walk Down Wall Street,
Does the MPT Framework Make Sense?Is it valid to argue that past information is completely embedded in prices and therefore of no consequence? It is questionable whether market participants can discount the duration and the strength of various phenomena. For instance, a market-anticipated lowering of interest rates by the central bank, while being regarded as old news, which is therefore not supposed to have real effects, will in fact set in motion the the boom-bust cycle. Obviously, these changes in the real incomes of individuals will lead to changes in the relative prices of assets. To suggest, then, that somehow the market will quickly incorporate all the future effects of various present occurrences without telling us how it is done is questionable. Even if we were to accept that modern technology enables all market participants to have equal access to news, there is still the issue of news interpretation. It has to be realized that markets are comprised of individual investors who require time to understand the implications of various causes and their implications for the prices of financial assets. Even if a particular cause was anticipated by the market, that does not mean it was understood and therefore discounted. If this were so, it would mean that market participants could immediately assess future consumers' responses and counterresponses to a given cause. This, of course, must mean that market participants not only must know consumers' preferences but also how these preferences are going to change. Consumer preferences, however, cannot be revealed before consumers have acted. MPT Implies Diversification Reduces Investment RiskThe basic idea of MPT is that compiling a portfolio of volatile stocks, i.e., risky stocks, will lead to a reduction in overall risk. The guiding principle for combining stocks in this way is that each stock represents activities that are affected by given factors differently. Once combined, these differences will cancel each other out, thereby reducing the total risk. The theory indicates that risk can be broken into two parts. The first part is associated with the tendency of returns on a stock to move in the same direction as the general market. The other part of the risk results from factors peculiar to a particular company. The first part of the risk is labelled systematic risk, the second part, unsystematic. According to MPT, through diversification only unsystematic risk is eliminated. Systematic risk cannot be removed through diversification. It is held that return on any stock or portfolio is positively related to the systematic risk, i.e., the higher the systematic risk, the higher the return. The systematic risk of stocks captures the reaction of individual stocks to general market movements. Some stocks tend to be more sensitive to market movements while other stocks display less sensitivity. The relative sensitivity to market movements is estimated by means of statistical methods and is known as beta. (Beta is the numerical description of systematic risk). If a stock has a beta of 2, it means that on average it swings twice as much as the market. If the market goes up 10 percent, the stock tends to rise 20 percent. If however, the stock has a beta of 0.5, then it tends to be more stable than the market. Are Profits Reward for Risk Taking?Is it true that profit is a reward for risk taking? No. In the words of Ludwig von Mises,
Mises then suggests,
Mises then adds,
An investor who is preoccupied with risk rather than identifying profit opportunities is likely to undermine himself. On this Mises wrote,
Again, for a businessman the ultimate criteria for investing his capital is to employ it in those activities which will produce goods and services that are on the highest priority list of consumers. It is this striving to satisfy the most urgent needs of consumers that produces profits. The size of an entrepreneur's return on his investment is determined not by how much risk he assumes, but rather by whether he complies with consumers' wishes. In an attempt to minimize risk, practitioners of MPT tend to institute a high degree of diversification. However, having a large number of stocks in a portfolio might leave little time to analyze the stocks and understand their fundamentals. This could raise the likelihood of putting too much money in bad investments. This way of conducting business would not be an entrepreneurial investment but rather gambling. John Maynard Keynes also had misgivings about diversification to reduce risk. On August 15, 1934, Keynes wrote to Francis Scott, the Provincial Insurance chairman,
ConclusionModern portfolio theory (MPT) gives the impression that there is a difference between investing in the stock market and investing in a business. The success or failure of investing in stocks depends ultimately on the same factors that determine the success or failure of any business. Proponents of the MPT argue that diversification is the key to the creation of the best possible consistent returns. The key should be the profitability of the various investments and not the diversification as such. In addition, following the MPT, if one wants to secure higher profit, one needs to take a greater risk. In fact, the size of an entrepreneur's return on his investment is determined not by how much risk he assumes, but rather by whether he complies with consumers' wishes.
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| More Evidence the American Economic "Recovery" Will Disappoint Posted: 02 Jun 2021 08:45 AM PDT Two things should concern us. First, the weakness of the recovery in the middle of the largest fiscal and monetary stimulus seen in decades, and second, the short and diminishing effect of these programs. Original Article: "More Evidence the American Economic "Recovery" Will Disappoint" This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.  |
| There's No Conflict between Profit and "Social Responsibility" Posted: 02 Jun 2021 08:45 AM PDT The "People over Profits" mantra is once again is being heard in Washington. But this time we're hearing about it from business lobbyists themselves who are now parroting leftwing slogans about "social responsibility." Original Article: "There's No Conflict Between Profit and 'Social Responsibility'" This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.  |
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