A Brave New World

#103: A look, backwards and forwards, at modern monetary policy.

The 2008 banking crisis was a threshold moment that prompted an overhaul of monetary policy that continues to this day. In simplistic terms, prior to 2008, the banking system and monetary framework operated under a “scarce reserves” framework. The Federal Reserve made small daily transactions in the Federal Funds market in order to achieve their interest rate targets. Banks did not earn any return on their cash balances, and therefore were incentivized to hold as little liquidity as possible. The regulatory environment was quite permissive.

The benefit of this paradigm was that broad money supply could expand via bank leverage with relatively little base money expansion¹. From the early 1980s through 2008 the Fed printed few actual dollars compared to the growth in money supply.

The downside of relying on bank leverage for money supply growth is that banks became quite levered — 32:1 on a cash basis — and therefore exposed to both solvency and liquidity risks.

When the mortgage bubble went bust, the Federal Reserve had two choices to de-risk the banking sector and reset bank leverage to a prudent level. It could either force a dramatic unwind of leverage in banks with depression-level implications for the economy, or the Fed could recapitalize the banks with freshly printed dollars which would allow the money supply to remain unchanged. Unsurprisingly, from September 2008 to January 2009, the Fed embarked on its first large-scale asset purchase, buying loans from banks with newly printed money. Monetary policy entered a new era.

This crisis action doubled the Fed’s balance sheet and increased bank liquidity threefold, reducing bank leverage to a much reasonable level. But there was little impact on the overall money supply or bank deposits. The original Quantitative Easing (QE) was indeed an asset swap between the commercial banks and the central bank. The cash infusion also came with tougher regulations which would prevent leverage buildup again. Banks received more cash but they would need to hold onto it.

Another major change was the introduction of interest on reserve balances (IORB)². The Federal Reserve would begin paying banks interest on the cash reserves they held at the Fed. This adjustment was meant both to help ensure the Federal Funds target rate in the new “ample reserves” regime, while also incentivizing banks to maintain larger cash balances. While IORB had a minimal impact in the ZIRP regime, the implications have grown larger today as we will discuss later.

Monetary policy continued to evolve in the 2010s. Large-scale asset purchases transformed from a crisis tool to recapitalize banks into a standing feature of monetary policy for stimulative purposes. The Reverse Repo facility (RRP) was introduced in 2013 ironically to soak up excess cash introduced via QE in the years prior and help maintain the Federal Funds target. Finally, the central bank began to shrink its balance sheet as a restrictive policy tool via Quantitative tightening (QT) for the first time in 2017, before abruptly reversing the policy due to money market stress in September 2019.

The COVID crisis brought new wholesale changes. The Federal Reserve once again embarked on a massive asset purchase (money printing), doubling the monetary base yet again. But unlike 2008, the main purpose of COVID QE was to fund massive fiscal stimulus. While this did reduce bank leverage again, it did so by adding new cash and deposits into the bank sector via fiscal spending. Money supply expanded in-line with the increase in the Fed’s balance sheet.

A plethora of other facilities were also born in 2020 to help extend the Federal Reserve’s backstop beyond commercial banks and into other systemically important areas of the financial system including corporate bonds, money market funds and broker-dealers, and foreign central banks. Many of these facilities have since expired but others like the Standing Repo Facility (SRF), established in 2021 remain today.

The subsequent surge in inflation — exacerbated by the Fed’s funding of fiscal expansion — prompted a dramatic tightening in policy. The combination of higher rates, QT, and the RRP facility led to major bank failures in early 2023, and further changes to policy. Notably, the Fed temporarily created the Bank Term Funding Program (BTFP), and established a new precedent for depositor backstopping beyond traditional FDIC limits.

The point of this sermon is that modern monetary policy is a new invention. Most of the mechanisms that we will discuss in this article have been conjured in recent years, and have worked together in-concert for even less time. It’s a brave new monetary world.

There simply isn’t precedent from which to draw concrete and academically tested answers about the impacts on the economy. Some of these new levers are active (QE, QT, Rates), others are passive (IORB, RRP). All influence the bank reserves, non-bank financial activity, money supply, inflation, fiscal policy, and economic activity, often in contradictory ways.

The challenge for policymakers and prognosticators is to layer an understanding of these new financial concepts on top of the traditional interest rate-focused monetary framework. This is a process that, in my opinion, requires some degree of curiosity and humility. It also leads to some interesting questions.

For example…

• Should the Fed’s taper QT while holding interest rates steady?

• Do higher rates actually exacerbate inflation?

• Is Fiscal Dominance the new monetary policy?

Let’s dig in.