FMQ Update

There is another more solid reason, and that is the US banking system has undergone an overall transition from a money-multiplier basis of regulation to a new regime reflecting international Basel III capital and liquidity requirements. The Fed still requires a 10% reserve on bank deposit and checking accounts whose terms are less than seven days, net of cash balances in bank tills and vaults. But this now comprises a minority activity on bank balance sheets, which is where Basel III comes in. Therefore, excess reserves at the Fed are a handy means of retaining risk-free liquidity to comply with international banking regulations.

There is also a developing problem with the Fed trying to reduce its balance sheet at a time when the US budget deficit is running over the trillion-dollar level. The banks know from Fed tightening plans that they will have to collectively absorb roughly $150bn of Fed sales of Treasury bonds every quarter. After allowing for an additional quarterly supply in the bond market of a further $300bn from the US Treasury at a time when foreign buyers are losing their investment appetite, there is every reason for a far-sighted banker to preserve liquidity.

In other words, a combination of regulatory reasons and bankers’ far-sighted caution appears to be limiting bank credit expansion. The prospect of a flood of new US Treasury stock issued to finance the deficit and sales of existing bonds by the Fed is already crowding out private sector lending by contributing to banking caution. And this is why the Fed should be reviewing its monetary policy.

The future course of FMQ

Far from FMQ signaling there is ample room for depository institutions to draw down their excess reserves and gear them up into extra bank credit, we can see regulatory reasons why this cannot happen, and why systemically important banks might want to keep their powder dry to purchase US Treasuries in future. Meanwhile, the productive economy appears to be running into a brick wall.

At this stage, the Fed can only guess whether the productive sector of the US economy is just pausing for breath before resuming its upward trajectory. However, the coincidence of the mature phase of the credit cycle with the Trump fiscal stimulus had been an underlying concern since Powell was appointed chairman, which was why the Fed implemented plans to prepare its balance sheet for another credit crisis sooner rather than later.

The wild-card which has tipped this sensible strategy over the edge was the additional factor of Trump’s trade protectionism. It has acted as a catalyst to impel both the American and the global economy into a sudden halt. To be fair, Trump’s trade protectionism has not been the only factor. The EU has moved towards banning diesel and all petrol cars before 2040, wrongfooting swathes of European industry based on the internal combustion engine. When the Fed began its tightening, China had embarked on a policy of purging shadow banking and other unorthodox means of credit generation with predictable results. The result of these diverse factors has been to stall global trade at the peak of the credit cycle.

The Fed will also be watching out for the consequences of trade protectionism on foreign capital inflows. For several decades, dollars earned through import surpluses have been routinely reinvested in US Treasuries, effectively financing America’s persistent budget deficits. This transmission mechanism between the twin deficits is now under threat, evidenced by these flows beginning to reverse. According to Treasury TIC data, there were net capital outflows of $91.4bn in December.[vi] 

Furthermore, in an echo of Smoot-Hawley, American corporations are being badly hit by reciprocal trade protectionism, not just in direct export trade, but by the determination of major governments, notably the Chinese, to replace US sources with home-grown technology. These are markets that are being lost to US chip manufacturers and other high-tech industries forever.

For the Fed, the prognosis is not encouraging. History, as I have pointed out in several recent articles, has not been kind either.[vii] In particular, the coincidence of Smoot-Hawley tariffs and the peak of the credit cycle in 1929 is an important and worrying precedent. We can be reasonably certain the senior economists at the Fed are unaware of the potential disruption from this coincidence (they need to have a grasp of Austrian cycle theory – which we can be sure they don’t), so a deepening slump will be an additional and unpleasant surprise to them.

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