In case you were wondering . . . Part 6 - $4.5 Trillion, 2% and a Theory of Relativity

The Federal Reserve Bank was formed in 1913 to establish and manage a currency and regulate the banking industry. Today, the Federal Reserve System consists of the Board of Governors, Federal Open Market Committee (FOMC), and 12 Reserve Banks, of which commercial banks are Members.

The FOMC is mandated to set Monetary Policy to promote maximum employment, stable prices and moderate long-term interest rates. The Board of Governors implements the policy using the currency in circulation; Member Bank liquidity and reserves; and short-term interest rates.

Until the Recession of 2008, the Fed kept to the mandate. After that, the Central Banks of the major economic powers began to work in cooperation. Experimental economic theory was invoked and the Fed adopted a more active role in the economy.* The Federal Reserve Balance Sheets (below) illustrate the result.

(dollars in trillions) 12/31/2016 12/31/2007 $ Chge %Chge

Total Assets $ 4.45 $ 0.92 $ 3.53 384%

U.S. Treasuries $ 2.75 $ 0.75 $ 1.82 243%

U.S. Backed Mortg $ 1.80 $ - $ 1.80 n/a

Total Liabilities $ 4.41 $ 0.88 $ 3.53 401%

$’s in Circulation $ 1.46 $ 0.79 $ 0.67 85%

Member Bk Dep $ 2.22 $ 0.03 $ 2.19 7300%

Reverse Repo’s $ 0.80 $ - $ 0.80 n/a

The changes in Significant Assets and $’s in Circulation show the volume of money created to inject liquidity into the Member Banks. Not all stayed in the marketplace. Note the substantial increase in Member Bank Deposits. As an aside, this may have been a control on the inflation inherent in Quantitative Easing. The Reverse Repo Agreements (RRA) are short-term investments in Treasuries or backed by Treasuries. The type of investment is nothing new and is an effective way to employ idle cash. That the Fed would compete with commercial banks is new.

Chairman Yellen recommends unwinding the Fed Balance Sheet to the pre-2008 standard. But, excepting the RRA program, any significant contraction other than allowing bonds to mature will reduce funds available to the broad economy and $ in Circulation. These are powerful anti-inflationary actions and will strengthen the value of the dollar.

“Evidence suggests that the population roughly expects inflation in the vicinity of 2%. We’re focused on making sure that inflation expectations and actual inflation stay very well anchored.”

Federal Reserve Chairman Janet Yellen 4/11/2017

But expectation is driven by condition – low GDP growth and high underemployment. Both must change. Also, 2% inflation is a baseline – that expected in a static economy. Why protect stasis in a dynamic environment? I believe the Chairman’s comment is a defense of the scheduled increases in short-term interest rates. But, why hobble the economy now?

When my attention is directed too strongly one way, I look another. The Balance Sheet and the 2% Inflation goal lead me to exchange rates.

Japan and the EU are highly regulated and unhealthy economies. Japan suffers from significant underemployment and a declining GDP. Europe has dangerous unemployment and low GDP growth. The Quantitative Easing program we discontinued in Oct of 2014 continues in both at significant levels and with increasing ineffectiveness. Both economies are employing negative Interest Rates and Bond Yields to encourage investment.

China remains on a knife edge. While its trading partners are pinching pennies, it must maintain a significant positive foreign trade balance to employ a huge population. Years of communism left a legacy of inadequate financial and physical infrastructure. The Chinese people hunger for prosperity, security and a future.

In contrast, the United States’ economy might be bloodied, but it’s not bowed. The dollar remains the safe-haven currency.

Currency valuations are the ‘theory of relativity”. Recently, Mr. Trump stated the dollar was trading too high. But to whom was he speaking? To our Fed or to the Central Banks of our trading partners? Is the Dollar too high or are the Euro, Yen, and Renminbi too low?

Currency values are a major element of trade policy. A strong currency can be a barrier to trade by penalizing exports and discounting imports. The Balance Sheets of the Central Banks of our trading partners went through the same transformation as ours. If they are not unwound, allowing economies and currencies to strengthen, unfavorable trading conditions will result.

*WSJ 12/12/12 Inside the Risky Bets of Central Banks; Ben S. Bernanke 9/2/2016 Should the Fed Keep its Balance Sheet Large?