Many believe in the power of the Fed. Unfortunately, this is based upon a misunderstanding of what is taking place and what the economy really is.
Most are aware of the "levers" the Fed tries to pull. Their ace in the hole is always interest rates. This is what they seek to control. Through direct intervention, i.e. raising or lowering the Fed Funds Rate, the central bank feels it can move the economy.
Sadly, it is total nonsense. If it were the case, there would be no need to keep coming up with other programs to indirectly influence the economy.
One such example is QE and QT. Through the buying or selling of assets, the Fed seeks to alter the liquidity that is available. The problem here is they are not using US dollars in the transactions. Ultimately, this becomes nothing more than a propaganda scheme to influence behavior.
The reality is we are not dealing with broad economy money (legal tender). Instead, these are bank instruments put on the balance sheets of member banks in hopes of stimulating lending. That is QE with the opposite being QT.
That said, this is not the main reason Fed Policy fails.
In this article we will discuss it.
We often see people espousing the idea of lowering interest rates as a way to kickstart the economy. The problem with this is the viewpoint of the economy as a buyer.
Lower interest rates and buyers will purchase.
Unfortunately, this is nothing more than perspective. It is a one-sided question. The other side is not considered. The situation is even worse due to the fact that the other side is more important.
Fractional reserve banking means that the digital money supply is commercial bank money. Since bank notes (center bank money) have basically been eliminated for the overwhelming majority of transactions, the legal tender is controlled by the banks.
Hence, the actions of the commercial banks is crucial. Yet, everyone wants to focus upon the borrowers.
Here is the twist that changes everything: the economy is a lender, not a buyer.
When economies are large and thriving, the ability to lend is strong. Banks are willing to expand the money supply, helping to grow the economy. Returns are garnered for all involved, further stimulating investment.
This is known as the upswing in the business cycle.
It is easy to be on board with economic expansion. Things get hairy when the reverse happens. Inflation turns to deflation, something that most think is a positive, until they lose their jobs and their 401K balances crash.
Reversals are where people start calling for the Fed to inject itself. Often, this is a push for lower interest rates.
This is a problem of mindset.
It is mythology to believe that people will spend more as interest decline. While some industries are affected, the overall is based upon more than a single rate.
For example, a 50 or 100 basis point reduction in interest rates means nothing if one lost his or her job. In business, CFOs tend not to allow more debt to be taken on when the economy is crashing. Instead, they start to strengthen the balance sheet by reducing the debt exposure.
Here is one of the reasons why Fed policy fails. There might be a few who run out and buy new cars. this does not offset the number of CEOs-CFOs who reject $50 million mortgages on new plants. Those plans get shelved until things turn around.
There is, however, an even more important component to this.
Banks all think like the CFOs. The reason why lending dried up during recessions is the banks are simply unwilling to lend. In fact, in many instances they are prohibited.
The Fed is only one regulator of the commercial banks in the United States. There are others such as the OCC. Things such as bad debts are monitored. Unfortunately, one thing that is constant in every economic slowdown is the rise in defaults. This means the bank's capital requirements are closely looked at.
Even if the regulators are on the sideline, the firms own VAR (value at risk) models often prohibit the expansion of loans. When that safe zone there is exceed, banks have to use balance sheet capacity to hedge the situation, moving the numbers back.
It is a situation that is shown by the idea of going to the bank when a company is in trouble. That is the worst time to get a loan as the bank will quickly reject the application. Banks are not in the business of lending on weakness.
This holds true for a business or the economy in general.
Since the money supply is controlled by the lenders, it is crucial to view the economy based upon its ability to lend. During the downside of the business cycle, defaults rise and lending tightens.
It is that simple. Lower or higher interest rates will have no impact upon the desire to lend if repayment is in question. Banks are not in the business of giving out loans just to write them off as losses (if they can avoid it).
