Cheap Fed Liquidity Forestalls Deleveraging & Entices Debt

Over the past few months I revisited nearly everything I thought I knew about money and banking, and in particular, central banks. There are lots of strong opinions with respect to how and why they impact the investment markets and economy. As a macro-minded investor, these are crucial issues. As an Integrating Investor, there was only one way to get my arms around it—to dig in. I found that the Federal Reserve’s (Fed) impact is more indirect than I previously believed. Surprisingly, both Austrian and Keynesian perspectives support this.

In Part 1 of this series I presented an Austrian-inspired view of banking. I described lending decisions as occurring on a micro-level. Hence, a top-down approach to monetary policy is significantly, informationally disadvantaged and impossibly doomed. In Part 2, I incorporated Hyman Minsky’s and L. Randall Wray’s—post-Keynesians—work into that perspective. I found that the Fed doesn’t create money; only private banks can. I also re-conceptualized banking as a carry trade.

Despite conflicting in many ways, both economic schools of thought acknowledge that a central monetary authority is irrelevant with respect to money creation. Combining them shows that profit motives and risk tolerances of private bankers interacting with businessmen, entrepreneurs, and citizens drive the economy and money supply.

This begs the questions: If the Fed doesn’t print money, what on earth does it do? What’s the connection to higher leverage levels? And most importantly, should I even care as an investor?

Piecing it all together, I found a link between the Fed, fiat currency, and elevated leverage. While it’s far from a proof, there is a logical thread: Cheap liquidity.

The Fed Provides Liquidity To Banks Only

The Fed doesn’t create money; confusing I know. In fact, it doesn’t even print currency (the U.S. Treasury does)! The Fed is a “banker’s bank.” It interacts with private banks via the reserve accounts they hold with it. These commercial bank reserves are the only touchpoint between the Fed and the rest of the economy.

The Fed’s mandate is to promote certain political and economic goals. Realistically, it can only try to influencedecisions made by private banks by adding and subtracting reserves to accounts that are held with it. This is accomplished by targeting the Federal Funds Rate (FFR), setting the interest it pays on excess reserves (IOER), and purchasing and selling U.S. Treasuries (UST) and mortgage backed securities (MBS) in its System Open Market Account (SOMA) which is more commonly called Quantitative Easing (QE).