personal views of a former fed trader

Follow The Money

The recent fiscal actions taken by the U.S. are not just remarkable in scale, but also in form. A sizable chunk of the historic $5t in spending actually ended up in the hands of the general public via various types of transfer payments and grants. That money was essentially created out of thin air by the Fed and then spent into the economy by the Treasury. Observing the Fed’s growing balance sheet offers a glimpse as to the scale of the printing, but it does not reveal where the money ends up. Generally speaking, the created money ends up as a deposit liability in the banking system. Banks must file detailed regulatory reports on their deposit liabilities, so it is possible have an idea of the type of depositors who ultimately benefited from the government’s largess. In this post we first review the GFC era policy response, show how the distribution of money this time is now more favorable towards retail, and suggest that this change is contributing to inflation.

The U.S. fiscal response has been extreme

Last Time Was Different

During the GFC the stock market and real estate market crashed and would not recover for a few years. One way to look at a market crash is as a sudden surge in the demand for money. A typical person’s asset holdings include real estate, stocks, bonds, and cash. Real estate, stocks, and bonds all fluctuate in value but $1 in cash is always $1. When sentiment shifts, people sell their volatile assets for assets that are not volatile. However, the amount of cash in the system is relatively fixed in the short-term while valuations of other assets can assets soar. This mismatch means that when there is a surge in the demand for money, a large crowd of paper wealth is competing for a limited amount of cash. This requires investors to rapidly lower their selling price to obtain the cash. Thus asset prices crater.

Deposits can be directly created via bank credit creation, or indirectly via Fed actions

In this context, the official sector’s response was to add money into the system. Most money is created by commercial banks when they make loans, but at that time the banking sector was on life support and could not create money. The Fed stepped in with QE and bought a significant amount of Agency MBS, and later Treasuries. QE adds reserve assets (money for banks) and deposit liabilities (money for non-banks) to the banking system. This allowed bank deposits to grow even as banks were not able to extend credit. The Treasury also issued trillions in Treasury securities, which are a form of money in the financial system. These actions helped meet the public’s demand for money. Note that while there was more money in the financial system, the net worth of most people was still lower due declines in their financial assets. Growth and inflation during this period was unremarkable.

$1.5 Trillion in Helicopter Money For Retail

This time around massive stimulus is proceeding even though the banks are in good shape and household net worth is at all time highs. In addition, this time the government offered substantial payments to the general public. The demand for money was acute in March 2020, but it quickly faded while the policy response continued. The different context and distribution of money suggests that a lot the new money will be spent on goods and services.

The marginal propensity to consume varies by wealth, where the wealthy tend to save more of their income and the less wealthy consume more of their income. Airdropping trillions of dollars to retail suggests increased spending on goods and services, while airdropping trillions to the institutional community suggests increased spending on financial assets. Bank regulatory filings break out deposits by account size, making it possible to roughly estimate how much of the newly created deposits ended up in the hands of retail (assumed to have less than $250k in their bank account). Some of the increases shown here will be due to bank credit creation, but bulk will be the result of government action.

Almost all money created from the GFC policy response ended up in large accounts
This time retail received lots of free money

The post GFC round of deposit creation went almost exclusively to the institutional community, with the level of retail deposits little changed. It should not be surprising that economic growth was subdued at the time, as the public did not actually have more money to spend. This time around the institutional community continued to be the dominant recipient of the newly created money, but deposits held by retail also increased by $1.5t ($1.2t in banks and savings associations, and $300b in credit unions that are not in the graph). The trillions of free money in part filtered to the American public.

The economic impact was predictable. Annualized consumer spending reached all time highs, housing prices increased 15%, and the stock market (especially retail favorites) soared to record highs. The public’s purchasing power increased significantly in a short period of time, and will remain at an elevated level until prices adjust higher.

Inflation is a Political Choice

The Fed cannot directly create inflation because it does not have spending powers, but the fiscal authorities have the power and motivation to spend. They easily pushed CPI to 13 year highs by spending trillions on goods, services, and transfer payments. This can continue because sovereigns in a fiat system have no budget constraints (only political constraints) – the central bank can always finance their spending. (Note that this also gives the Fed less control over inflation, as fiscal spending is indifferent to interest rate hikes.)

A view that inflation is transitory is fundamentally a political view that the free money will stop flowing. Yet, the Administration has been unambiguous in its desire for trillions more in spending. Free money is what the public desires, and a winning political platform. A cultural shift has occurred where the deficit hawks that were once a fixture on the political landscape have all gone extinct. The flow of the most recent fiscal stimulus is ebbing, but the authorities are already discussing the next stimulus program. History suggests that the spending will not just continue, but accelerate.

19 Comments

  1. LR

    Great write-up as always! Any thoughts on how Modern Monetary Theory plays into all of this?
    The concept sounds very similar to your last paragraph.

    • Fed Guy

      I think of MMT as a generally accurate description of how our financial system works. But note that a developing country would not be able to operate in an MMT fashion – large deficits will immediately be greeted by capital flight. Our system works in an MMT fashion because there is a lot of confidence in it built up over generations. If we lose that confidence then deficits will matter.

      • Poe

        Would you agree that MMT been in operation since the Fed adopted inflation targeting as their framework in the 1980’s, while the merits of MMT as policy is still be debated in the political realm?

  2. Antony Mek

    Do you have a general opinion of Lacy Hunt’s view or holes in his arguments?

    • Fed Guy

      Lacy is great, I always want to hear what he is saying. One difference is that I think public debt is not deflationary because it never has to be paid back. In fact, permanent QE is the same as public debt cancellation (see here).

      • Antony Mek

        This is very informative, so its clear you know more than I do so I shall defer to you, but I am a huge fan of Lacy Hunt.

        I think your point in that article would be to say the Treasury and the Fed have to act in Unison, but the fed cannot act alone and since the fed is willing to, it is really up to the treasury alone, and defacto congress to spend.

        So lets say if Biden thinks a real boom is happening (ex-stimulus) and cuts of lifeline unemployment and republicans are willing to have a fair amount of suffering ensue to gain re-election in the midterms and stifle any kind of spending. The real world and deflation beckons, No?

        Also just out of curiosity is there any way you can show me via an article you have written how the purchasing of MBS by the Fed lights a housing bubble. Thanks.

        Thank you for joining the Fintwit community you have been a huge asset and it is appreciated by a huge swath of silent consumers of your work.

        • Fed Guy

          I think that inflation is largely a political choice, so if the Congress decides to stop spending we could see inflation move lower.

          There’s a lot of things moving house prices higher – internal migration to suburbs, higher commodity prices, many free money programs from Gov, and low mortgage rates. Fed MBS purchases puts downward pressure on mortgage rates (specifically, the spread between mortgage rates and Treasury yields). I wouldn’t say that is a big piece of the puzzle, but I think it is putting some upward pressure on house prices.

          • Antony Mek

            Thanks for your input sir.
            Have a great week!

          • Clifford Sondock

            Another major exogenous variable to Housing Prices is Zoning Regulation and infrastructure. Housing production is greatly influenced by Zoning and utilities. Zoning continues to become more restrictive, constraining Supply thereby increasing Prices. Lower mortgage rates compound the problem. But Housing is mostly influenced by Zoning.

  3. Georgios

    Many thanks for the thoughts,

    The Fed’s quasi-abandonment of FAIT and the increased sensitivity to inflation will now be a limitation to more fiscal spending? I.e. more fiscal spending will now cause earlier hikes, which then 1. will slow the economy 2. increase the fiscal cost (the Fed pays floating on reserves, but receives fixed on its QE bonds) and 3. result in lower equity valuations?

    Of course the mid-term elections are the second risk to continuous fiscal expansion.

    • Fed Guy

      I don’t get the sense that Fed actions or fiscal costs are a limit to fiscal spending, which seem much more about the need to win elections. But large fiscal spending could spur earlier hikes. Risk markets won’t like that, but I think there are structural constraints as to how high rates can go given the size and role of the Treasury market, see here.

  4. RB

    Thank you for these consistently great pieces you post here. This piece , along with the “Zombie Concepts: The Money Multiplier” piece, seem to point to a radical change in money-creation – i.e., Fed reserves are inert, only Treasury creates money now . Could you comment on whether you think that Banks will ever regain their position as primary money creators, or will they just sputter along for the foreseeable future? You explain that “inflation is a political choice” in that cyclical management is now up to the Treasury. Surely this is not what officials and regulators (should) have in mind?

    • Fed Guy

      Very good point – it seems money creation has moved to the public sector. There hasn’t been much private credit creation this past year. Looking through history, governments always want more power. It may not be good policy, but it seems inevitable that government will play an even bigger role in money creation.

      • RB

        thank you for your reply – I suppose USC Article I, Section 8 has returned with a vengeance. But I just wonder whether the heavy-handed Basel treatment of Banks’ off-balance sheet credit creation has left us with a perpetual funding gap, especially when it comes to trade finance and correspondent banking – a state of permanent under-risking. or something like that…

      • Anonymous

        If Fed wanted money creation, should’ve pursued counter-cyclical policy w/ banks as the regulator, e.g. instead of punishing banks last spring w/ even MORE difficult stress tests and limits on capital (duh). There was already trust in the banks, and multiples of capital rel to GFC. Inadvertently acting pro-cyclically. Banks paid dues via capital build from 2009-2015 thru B3 et al keeping a lid on inflation. This time should’ve been and be different than the last one.

    • WRC

      “Surely this is not what officials and regulators (should) have in mind?”

      The optimist in me would say that the Fed might not be completely oblivious. Powell did mention in the last FOMC presser that their projections assume decline in fiscal spending, perhaps to its more normal levels. But of course, Fed having less control over inflation is a whole different ball game from reduced fiscal spending exerting less inflationary pressure.

      Only time will tell I suppose.

  5. HJ

    feeling lucky that i found this blog today, thanks for the insights. Although the bond markets are currently acting in favor of FED transitionary opinion, it seems that the inflation will not only be persistent, but also to be completely diverging from whatever the future interest rates to become.

    • WRC

      Which begs the question. Should the Fed even try to tighten monetary policy just because there’s higher inflation if it doesn’t do much. I don’t mean to say that they shouldn’t do anything, but this would alter the calculation a lot. Perhaps they should tighten their policy stance a lot less than inflation alone would indicate. Of course, if it becomes too extreme, and there’s a raging inflationary fire going on, they won’t have a choice; but barring such events, their reaction function might have changed. The next question is this. Are they aware of the possibility of this?

  6. Qun Wang

    Very nice article
    With the amount of debt the government is holding, I could not see another way other than inflation for the government to hold the bubble. I totally agree with you that “Inflation is a Political Choice”.

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