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How the Fed Already Screwed You in 2016

Written By Geoffrey Pike

Posted December 7, 2015

2015fedAs everyone in the financial community guesses and anticipates the next move by the Federal Reserve, it is often just as important to look back as it is to look forward. The Fed is widely expected to raise its key interest rate in the coming weeks, but let’s look at how we got here and what it means going forward.

After the fall of 2008 (the word “fall” has a double meaning), the Fed embarked upon an unprecedented monetary policy. It lowered the federal funds rate (the rate banks charge for overnight lending) to between zero and one-quarter percent. In effect, the federal funds rate has been near zero for 7 years.

The Fed also had three rounds of quantitative easing, which is nothing more than the Fed printing money – digitally speaking. The money creation is really mostly entries on a computer screen. When all was said and done, the Fed had multiplied the adjusted monetary base from around $800 billion to around $4 trillion.

The quintupling of the monetary base over a 6-year period did not translate into massive price inflation, although some would argue there has been significant asset inflation in some areas. Much of the newly created money went into excess reserves at the banks.

In other words, most of the new money was not lent out. It did not multiply through the fractional reserve lending process. This really has kept a lid on consumer price inflation.

One other unique aspect of the Fed’s money creation, aside from its size, is that it didn’t just buy government debt as it has in the past. It also purchased mortgage-backed securities to take some of the bad debts off of the banks’ books. Its stated purposed was to lower mortgage rates, but more than anything it was a secret bank bailout.

Through all of this, we have seen a weak recovery. Unemployment rates have declined quite a bit, but it is hard to say how much of this is attributable to some people dropping out of the official workforce due to the lack of well-paying jobs.

Still, there is a sense of unease amongst the American people – particularly the middle class – that has not gone away from the last major recession.

The last round of monetary stimulus (QE3) came to an end around the end of October 2014. While that was over a year ago, that really brings us to where we are today.

2015: A Year of Nothing

To sum up the Federal Reserve’s policies for 2015, it was a year of a lot of talk and no action. It has been a year of the Fed doing essentially nothing.

We have heard continuous talk about the Fed raising its key interest rate. But so far, it has been just that – talk. Every time the market has been ready for a rate hike, the Fed has found an excuse to delay it. This talk of raising rates goes back to 2014.

Aside from press conferences and other forms of rhetoric, Fed officials have literally done virtually nothing. The monetary base has been in a narrow range – essentially flat. The Fed continues to roll over maturing debt, but is not adding to its holdings of debt.

Along with a stable money supply, the Fed’s key rate has stayed the same – just below one-quarter percent. But even this has required no effort by the Fed. Since the banks have massive excess reserves, they have little need for overnight borrowing to meet reserve requirements, thus keeping the federal funds rate low.

When we hear talk about the Fed raising rates, the only rate it can feasibly raise right now is the interest it pays to banks for their reserves. It won’t have anything to do with expanding or contracting the money supply as has been its tool in the past.

So overall, the Fed has done nothing over the last year, which is really probably the best case scenario.

The problem though is not the last year, but the 6 years that preceded it. The Fed would not allow the economy to fully correct in 2008 and after. Instead, the extremely loose money and low interest rates have only served to misallocate more resources.

This causes a distortion in where capital is invested and a distortion in savings. It leads to unsustainable bubbles and misleads entrepreneurs in their business investment.

When the stimulus is cut off, as it essentially has been in 2015, the misallocated resources eventually get exposed. Unless the Fed starts its monetary stimulus again at a rapid pace (which would prolong and worsen the inevitable), then we can expect some kind of a correction.

This is why looking at past policies is perhaps even more important than the future. The Fed has already done great damage over the last 7 years. But over the last year, the Fed has tightened, at least in the sense of not expanding its balance sheet.

This makes 2015 a very important year. Even though things seem calm right now, a coming economic downturn is becoming more likely. If the Fed follows through with its first rate hike in a very long time, then this will just help speed up the process by curtailing bank lending.

When we finally get the economic downturn we should currently expect, don’t blame the Fed’s policies of 2015. It is really the policies of 2008 through 2014 that set us up for what is still to come.

If the Fed’s monetary policies since 2008 had been similar to this past year, then we wouldn’t be in the mess we are in. The downturn would have seemed more painful going through 2009, but we would be in much better shape now.

2016 will be interesting, but 2015 has already told us what to expect. We should expect an economic downturn.