Disinflation good, Fed bad

The Bureau of Economic Analysis announced the Personal Consumption Expenditures Price Index (PCEPI) rose 0.2 percent during June. Headline inflation over the past year was 3.0 percent. It was 4.1 percent with food and energy excluded. Encouragingly, the continuously compounded annual rate of change was under 2.0 percent last month, which suggests the Federal Reserve is back on target.

The June data largely reinforces what we learned from the May release: Disinflation is likely to continue, even if core inflation remains higher than we’d like. The Federal Reserve probably didn’t need to raise its interest rate target last week. The new target range is 5.25 to 5.0 percent. Hence the inflation-adjusted policy rate is somewhere between 3.31 and 3.56 percent. For comparison, economists’ estimated “neutral” interest rate is between 0.58 percent and 1.14 percent. Monetary policy is now restrictive.

We get the same picture from the monetary aggregates. The Fed’s balance sheet is holding steady at $8.2 trillion. The money supply, as measured by M2, is falling at 3.6 percent per year. Liquidity-weighted measures of the money supply are not as worrisome: They’re falling somewhere between 1.98 and 2.55 percent per year. Overall, the data tell us monetary policy is somewhere between appropriately and excessively tight.

But what about the Fed’s gargantuan balance sheet? Total assets are holding steady at roughly $8.2 trillion. That’s roughly double its pre-pandemic level. However, we can’t infer easy money from a big balance sheet.

Remember, the Fed is operating in a floor system: It adjusts interest rates not through open market operations, but by paying banks interest on reserves. The fed funds rate has to track this rate. If it were more profitable to keep money in Fed bank accounts than to lend in the overnight market, no bank would choose the latter.

Essentially, the Fed is borrowing back all the liquidity it created. It can dampen inflationary pressures by disincentivizing financial intermediation. This isn’t a free lunch, of course. Fed payments make its profits, and hence remittances to the Treasury, lower than they otherwise would be. Eventually that will make the politicians cranky. Expect even more political pressure on the Fed.

Of course, the Fed paying banks not to lend gets more costly when interest rates go up. Something unusual has happened: The Fed is currently realizing losses. Earlier this month, its net assets were negative $3.27 billion. Treasury remittances have stopped. It’s using accounting gimmicks (adding “deferred assets” to its balance sheet), which highlights just how strange the situation is.

But that’s not the worst part. The floor system also gives the Fed enormous power to allocate credit. That means financial resources are directed according to bureaucratic and political considerations, rather than economic considerations. There’s no way for non-market actors to direct credit more reliably than market actors. The discipline of profit and loss is essential. There are significant social costs to government-directed capital—but these are often unseen, and hence rarely incur popular opposition.

If the Fed looks good now, it’s only because their previous failures lowered the bar. They deserve limited credit for cleaning up a mess they made in the first place. They deserve even less for retaining a flawed operating system that detracts from the competitiveness and efficiency of the U.S. financial sector. I’m hopeful we’ll get tolerable monetary policy in the next few months. But good monetary policy isn’t an option without major institutional reforms.

Related Articles – Central Banking, Inflation, Monetary Policy, Sound Money Project