A Federal Case

The US Federal Reserve Bank has had to inject massive amounts of funds into the banking system recently as shortages have caused overnight interbank lending (repo) rates to spike over 7% whereas normally these rates hover around 1.9% ... see: CNBC Story. Many economists are scratching their heads as to why this drying up of liquidity has occurred. I have a thought ... bear with me.

Now, I’m not an economist nor do I play one on this blog ... but I think I might have an idea what is going wrong. Over the last many months the Fed had reduced its balance sheet by over $600 billion (see chart) ... that had been bloated during the repeated “quantitative easings” employed during the Obama administration to hold our economy’s head above water.

The then-Fed chairman, Ben Bernanke expanded the Fed’s balance sheet by $3.6 trillion to $4.5 trillion (again see chart) by buying government bonds and mortgages ... see: Investopedia Entry This basically means that this same amount of readily-available money (M1) had been injected into the banking system ... resulting in pushing up asset prices and slightly stimulating the economy.

Enter stage right in 2017 President Trump ... and, as a reward, the Fed began to “burn off” its balance sheet, see: guerillastocktrading and the above chart. And the Fed also increased interest rates by 2 percentage points ... while Trump was reducing taxes and regulations. These are countervailing forces ... yet our economy started to grow much faster than had been the case. However, these Fed actions, combined with Trump’s trade war with China, has started slowing our economy down somewhat ... which would suggest a lower need for liquidity injections from the Fed.

So what is going on? My conclusion: Once any banking system gets used to a certain money supply, it cannot easily adjust to a markedly lower one ... no matter what Professor Bernanke had assured us. This may be due to inherent sluggishness in how the velocity of money changes?