The Fed’s Magic Trick: Using Money It Doesn’t Have Yet

The Fed’s Magic Trick: Using Money It Doesn’t Have Yet

Why you should care

The Federal Reserve has a few new tricks up its sleeve, as it pulls back from years of flooding the economy with money.

We’ve all witnessed magic. Think of that huge, ugly Boeing 747 that leaps into the air after slow-walking the runway. Or that little 8 oz. device that holds a thousand novels.

Now imagine this trick: The government’s left hand (the U.S. Treasury) borrows $4.3 trillion from the public — enough in bonds to buy nearly a quarter of everything that Americans produce in a year. The public then sells the bonds back to the government’s right hand (the Federal Reserve). Where did the money go? Is the government magically creating money and borrowing from itself?

Actually, yes. It’s an amazing bit of money magic that could get even more interesting because this show’s about to end.

Of course, like the jumbo jet, the Federal Reserve’s latest trick isn’t really magic. It’s a sleight-of-hand maneuver known as QE. That’s not the name of an ocean liner, but it is something like a boat that’s floating all of us. It’s the Fed’s monthly buying spree called quantitative easing, which, by many accounts, has helped the economy lift off the bottom. Now it’s coming to an end. So what’s next?

Having climbed up this steep slope, how’s the Fed going to get down? The answer might surprise you: It’ll just sit there.

Obviously, it’s quantitative uneasing. It’s already started and produced one monetary-policy buzzword: tapering. After tapering, are you ready for the RRP? Read on.

A little history: Until the 2008 financial crisis, the Fed had only ever owned well under a trillion dollars of stuff (assets, financial instruments, bonds). When global financial markets started collapsing, it rushed quickly to buy bonds in order to put cash into the banks and save them. In short order, the world’s central bank — effectively what the Fed is — owned over 2 trillion dollars of stuff. But it wasn’t until about 18 months ago that the Fed just started buying bonds every month, on a regular and predictable monthly schedule of $85 billion, taking its treasure chest to the astounding sum of $4,303,143,000,000 and rising as of last Friday.

How can it afford this? It just prints the money, that’s how. Not literally. Money goes into the bank account of whoever sells the bonds, and the Fed hopes people or companies will pull it out and start spending in order to strengthen the economy. Extreme measures followed the financial crisis, when confidence evaporated. People and corporations didn’t want to spend cash they had, and banks have been stingy with lending.

Financial markets reacted well to the predictability of QE. While bond prices are lower than a year ago, and interest rates are higher, it’s been pretty much steady as she goes.

Now the question is: Having climbed up this steep slope, how’s the Fed going to get down? The answer might surprise you: It’ll just sit there.

Man slapping his forehead in middle of trading floor

A trader rubs his forehead on the floor of the New York Stock Exchange in New York, U.S., on Monday, April 7, 2008.

Source Jin Lee/Bloomberg/Getty

The Fed started tapering its bond buys late last year. The $85 billion per month is already down to $45 billion, on course to hit zero in October. What then? Probably nothing, most economists think. The bonds owned by the Fed will mature over a long period of time — 10 to 15 years — and gradually just disappear while it gets cash back from the Treasury and burns it. Again, not literally.

At the same time, the economy doesn’t usually stay Steady Eddie for long.

For that, the Fed needs a new magic trick: meet the RRP, reverse repurchase or reverse repo. Economists Joseph Gagnon of the Peterson Institute for International Economics and Brian Sack of D.E. Shaw Group have proposed that the relatively new RRP be used to control interest rates and inflation. Federal Reserve Bank of Atlanta President Dennis Lockhart said this week he expected this to become a key policy instrument in an age of abundant liquidity.

Technicalities aside, it works like this: Since the banks already have plenty of money left over from the Fed’s bond-buying program, the Fed won’t have to play its traditional role of supplying money to them. It’s the other way around. If consumer prices start to rise too much, or the economy gets overheated, then all it has to do is raise the interest rates it offers to the banks to hold their money. Hence, instead of lending money to you or me, banks will lend it to the Fed.

Gagnon isn’t worried about future inflation.

“Money does not turn into inflation in some hocus-pocus way,” says Gagnon. “You will see the spending, and when you do, the Fed needs to start raising interest rates.”

Could it go wrong? Possibly, if stock markets or housing prices get to crazy levels and people still aren’t spending money on goods and services.

Barring that, many forecasters think the economy will start to return to “normal” — and that Fed Chair Janet Yellen will start raising interest rates again — in the spring of 2015, although normal might not look like the past.

Gagnon, for example, expects slower growth in the future because of people saving for retirement and slow growth of the workforce, resulting in interest rates stabilizing at a lower rate than in the past. Some economists predict lower productivity growth in the future.

Others aren’t so sure. “We have a medium-term problem rather than long-term problem,” says Wesleyan University economist Richard Grossman. “We have a bump of people who have not made it into the labor force. But I don’t see convincing evidence of how productivity will be growing over the next 50 years.”

In truth, economists have a poor record of predicting the future. Grossman recalls Thomas Malthus’ famous 200-year-old forecast that “as soon as we’re better off we’ll all have sex and more kids and be poor again. I’m not as worried about a long-term slowdown.”

If Grossman’s right, the Fed operations of the future might look a lot like the past. After five years of a lousy economy, that’s a dream with real magic in it.

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