The Fed called a mulligan

by Rebecca

Ex post, it is obvious that the Fed was way too tight in the second half of 2008. To be sure, the FOMC was actively engaged in its standard easing policies; however, the Fed got the Treasury to aid in its sterilization efforts, and later the Fed fast-tracked the interest on reserves (IOR) program (originally set for an October 1, 2011 start). The Fed was misguided in its sterilization efforts, as aggregate demand was already collapsing.

Something was afoot well before the collapse of Lehman Brothers. David Beckworth at Macro and Other Market Musings backs up Scott Sumner’s (TheMoneyIllusion blog) theories with an intuitive analysis using the equation of exchange (MV = PY):

Below is a table with the results in annualized values (Click to enlarge):

This table confirms what we saw in the levels: a sharp decline in velocity appears to be the main contributor to the collapse in nominal spending in late 2008 and early 2009 as changes in the monetary base and the money multiplier largely offset each other.

… (And a little later)

Unfortunately, though, it appears the Fed was so focused on preventing its credit easing program from destabilizing the money supply that it overlooked, or least underestimated, developments with real money demand (i.e. velocity). As a consequence, nominal spending crashed.

This line research essentially posits that the Fed got it terribly wrong in the second half of 2008. As David shows in the table above, the velocity of money was dropping with households clinging to cash under heightened economic uncertainty.

If this theory is true, then one could view the $300 billion Treasury buyback program (see the NY Fed’s Q&A here) as the Fed’s equivalent of “calling a mulligan” in an attempt to take back its sterilization efforts in 2008.

The $300 billion buyback of Treasuries will restock about 75% of the Fed’s Treasury holdings (focused in notes and bonds rather than bills, but there is a contemporaneous objective to pull long rates down) that dwindled previous to the onset of the SFP account. Unfortunately, though, it was already too late.

(The Treasury issued short-term notes and deposited the proceeds with the Fed in order to aid in the Fed’s sterilization efforts – see an old post of mine for a more thorough explanation of the SFP, or the Supplementary Financing Program.)

Another event recently occurred that would support the view that the FOMC is backpedaling: the Treasury’s Supplementary Financing Program (SFP) is going bye bye.

The Treasury started this week to unwind its account with the Fed (the SFP listed on the liabilities side of the Fed balance sheet). This is almost surely going to end up as excess reserve balances in the banking institution, as the Fed is unlikely to sterilize these flows. (Note that one could see if the Fed was sterilizing the flows if its Treasury holdings started to fall again.)

I guess that the real question is: where would we be now if the Fed had pushed harder on the money supply in 2008? I imagine that Angry Bear readers have many thoughts on this.

Rebecca Wilder

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