Balance Sheet Normalization, Or Not

By: C.Jay Engel
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Politicians, bureaucrats, and media talking heads specialize in saying one thing but meaning something else. In Fed world, something referred to as “balance sheet normalization” would be thought to be a return of balance sheet levels to pre-crisis numbers (roughly $850 billion). But common sense does not prevail. Instead, as it turns, normalization doesn’t mean a return to normal. CNBC:

Interviews with Fed officials, and public statements they’ve made suggest the Fed’s new normalized balance sheet could end up being three times as large as it was before the financial crisis. And it could be bigger than that.

Of course, this was the almost inevitable, given the Fed’s irrational fear of monetary deflation and their unwillingness to do anything that might make Wall Street think the punch bowl of easy money was being whisked away. Not to mention the political motivations of remitting profits back to the Treasury and artificially suppressing the US Government’s cost of borrowing.

The CNBC article states:

A bigger Fed balance sheet on a more permanent basis is potentially good news for long-term interest rates. It means the Fed will have fewer bonds to unload, and so exert less upward pressure on interest rates. But if the Fed’s calculations are wrong, it could mean higher inflation and higher rates.

“Good news for interest rates” does not, of course, mean good news for the economy as a whole. The economic role that interest rates play is to coordinate the use of scarce resources across time in accordance with the time preferences of human beings. So an interest rate that is kept lower due to central bank policies interferes with the market process. Resources are consumed in a way that varies with the desires of people acting in the free economy.

The article sums up opponents of a large balance sheet as follows:

Opponents of a large balance sheet say the Fed should reduce it as much as possible so it doesn’t become a victim of politics, where Congress or the executive branch could mandate that the balance sheet be used to buy certain types of securities to solve fiscal problems. They also worry that such a large balance sheet is potentially inflationary.

Contrary to the mainstream press and what has become of “orthodox” economics, “inflation” (by which they mean rising consumer prices) is not the primary threat of suppressed interest rates. Economic depressions themselves are caused by the malinvestment that takes place during the era of too low interest rates. The healing process of liquidating these malinvestments is the pain of higher interest rates and the falling of asset prices. This healing process is what the Fed actively works to prevent by refusing to actually normalize the balance sheet.

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