Fed Policy Hurts Price Discovery!

With every economic crisis, US Federal Reserve policy has run further away from the dictates of Milton Friedman. After cutting rates to near zero and increasing its holdings of assets by over 70% last year, Chairman Powell said this month that policy would remain “very supportive” of the economy.

By contrast, Friedman, co-author with Anna Jacobson Schwartz of the authoritative “A Monetary History of the United States, 1867 - 1960,” proposed that money supply should grow at a set pace every year equivalent to the rate of growth of the real economy. His prescription was a result of his finding with Schwartz that monetary policy acted on the economy with a long and variable lag. Consequently, if the Fed were to accelerate money growth to combat a recession, its full impact may not be felt until several quarters later when the economy was facing inflationary pressures.

The big push into unknown territory began with the global financial crisis when the then Fed Chair, Ben Bernanke, decided that it was not sufficient to lower interest rates to near zero. As I have discussed elsewhere, Bernanke and his colleagues on the Federal Reserve Board decided by the end of 2008 that they would purchase bonds putting new money into the system. With little theoretical backing, Bernanke claimed that the new policy, dubbed Quantitative Easing or QE, was functionally equivalent to a reduction in rates.

In contrast to the Friedman dictum, post-2008 policy was highly discretionary. And it suffered in spades the result that the late Nobel Laureate had anticipated — the Federal Reserve’s repeated predictions of a pickup in inflation have yet to come true despite the central bank’s assets rising to nine times their level 11 years ago.

Another important consequence of the Fed policy shift was to distort what is known as “price discovery.” This is the process whereby transactions of securities occur by having demand and supply come together. The process is important because it is the bedrock of the free market economy. It describes the way sellers and buyers freely make estimations of future returns and risk in holding a security.

By contrast, QE — described at its introduction as “temporary” by the then Fed Chairman — became the most important force in the bond market over the past decade in setting yields. It is not surprising that the central bank did not keep its promise that the massive increase of its balance sheet would be temporary — it is always politically easy to provide stimulus than to withdraw it.

Distortions to the price discovery process accelerated last year with the Fed’s decision to respond to covid by buying high-yield bond ETFs and “fallen angels” (securities that had previously been investment grade). Before investors could estimate risk and buy some high-yielding securities, the central bank had already sent their prices skyward. Who wants to fight the Fed?! And will the Fed purchase a basket of US equities the next time there is a significant correction in equities?

All of this is relevant just in case yet another act of market distortion is being contemplated. With Treasury yields surging since the beginning of 2021, potentially hurting economic growth, could the Fed further impair price discovery by deciding to purchase long-dated bonds? Known as Yield Curve Control, it would be QE’s cousin — in YCC, the central bank buys or sells bonds to set the level of the yield rather than the quantity.

You may not like money supply being allowed to grow at a constant rate — even a computer could do it! But introduction of human discretion only makes it worse.

Komal S. Sri-Kumar

President, Sri-Kumar Global Strategies, Inc.

February 21, 2021

Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities.  Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.

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