The latest decline in stock prices and narrowing of yield spreads are signs associated with a recession and even a developing financial crisis. The Fed’s current policies have all the signs of a policy mistake similar the one that produced a financial crisis.
In 2008 the Federal Reserve failed in its primary mission. That mission is to make sure there is sufficient money in the economy to prevent a decline in business activity.
Monetary policy was once straightforward. The Fed would buy securities to make money more available and it would sell securities to make money less available. This straightforward approach ended in 2008 when the Fed changed its operating procedures.
In 2008, as the economy entered a recession, the Fed sold $300 billion in securities. In retrospect, it should be clear that continuing to sell securities amid an economic downturn was a terrible mistake.
The Fed belatedly did the right thing in the first half of 2009. It purchased back the $300 billion in securities it had sold. Almost immediately, the stock market began to recover and by mid-year the economic began to recover.
The Fed spent the next five years purchasing an additional $3 trillion in securities. This was three times the amount it had purchased since its founding in 1913. The purchases were so excessive that banks left $2 trillion of these funds on deposit with the Fed.
No one knows how such massive purchases of securities have impacted the monetary system. Nor is apparent how the $2 trillion banks have on deposit with the Fed will impact the amount of money in the economy.
This year, as in 2008, the Fed has again sold $300 billion in securities. One difference this year from 2008 is that banks have shifted $472 billion of their deposits with the Fed into the economy.
What isn’t known is whether the Fed’s sales of securities are powerful enough to overwhelm any stimulus from banks’ shifting of funds into the economy. It’s conceivable that, as in 2008, the restraint from Fed sales of securities is the dominant force driving monetary policy.
The Fed’s ongoing experiments with monetary operations have created challenges in interpreting the impact of it monetary actions. Given the unknowns surrounding monetary policy, the Fed’s most prudent course of action is to stop selling securities and pause with any further increase in interest rates.
If the Fed pauses in its moves toward monetary restraint, it will reduce the odds of a recession and send stock prices sharply higher.
Blog with Dr. G
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