Fed can’t reach ‘normal’

September 28, 2017
Pat Heller

At the conclusion of their latest meeting Sept. 20, the Federal Open Market Committee (FOMC) added an extra sentence toward the end of their statement. It said, “In October, the Committee will initiate the balance sheet normalization program described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.”

In an attachment to this announcement was a news release of the Implementation Note for the FOMC’s decisions at the meeting. For the Normalization Program it stated, “Effective in October 2017, the Committee directs the [Open Market] Desk [at the Federal Reserve Bank of New York] to roll over at auction the amount of principal payments from the Federal Reserve’s holdings of Treasury securities maturing during each calendar month that exceeds $6 billion, and to reinvest in agency mortgage-backed securities the amount of principal payments from the Federal Reserve’s holdings of agency debt and agency mortgage-backed securities received during each calendar month that exceeds $4 billion.”

Translated into plain English, that long instruction means that the Fed will reduce its holdings of U.S. Treasury debt and mortgaged-backed obligations of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) by $10 billion per month.

Until the Great Recession that started a decade ago, the total assets of the Federal Reserve were about $900 billion. As part of the government bailouts, the Fed acquired more Treasury debt, which quickly soared to more than $2 trillion. It then kept right on growing, reaching $4.5 trillion by the end of 2014. It has since steadied about that level.

All along, the official position of the Federal Reserve was that it would not shrink assets to decade-ago levels until there was a normalization of the federal funds interest rate from its then close-to-zero-percent rate. The raising of this interest rate itself would not be done until there were signs that the American economy had recovered sufficiently from the Great Recession to absorb the negative impact of such rate hikes.

In 2013, the Federal Reserve had discussed scaling back its third round of quantitative easing (inflation of the money supply). The mere mention that this was under discussion resulted in a spike in bond interest rates, which threatened to derail the alleged economic recovery.

The Fed waited until December 2015 before it increased the federal funds interest rate for the first time in six years. Today that interest rate is barely 1 percent, compared to more than 4 percent at the beginning of 2008. Clearly the Fed does not regard the U.S. economy as having fully recovered from the Great Recession.

Despite the lack of confidence in the recovery of the U.S. economy, as demonstrated by the current extremely low federal funds interest rates, the Fed wants to pretend a recovery is really under way. One way to signal economic confidence would be to announce the start of reducing the Fed’s balance sheet.

This time around, the Fed is trying to avoid shocking financial markets by taking extremely small steps. At $10 billion per month, it would take 30 years to shrink the Federal Reserve’s assets from $4.5 trillion to $900 billion!

In financial markets, 30 years is forever. Effectively, the Fed is posturing that it is trying to reduce is balance sheet as a sign of confidence in the U.S. economy while contradicting that posture by not actually doing so. In other words, the Fed is relying on words to deceive the public because its announced actions do not back up the headlines that resulted from last Wednesday’s FOMC announcement.

Even though the underlying details were that the Fed is doing almost nothing to change its policies from the past decade, it still left itself some wiggle room by stating that this program could be changed if future circumstances warrant.

So, what does this posturing by the Federal Reserve indicate for the future value of the U.S. dollar and for precious metals?

As I write this Sept. 25, the U.S. Dollar Index is down almost exactly 10 percent since the end of last year. Consistent with recent statements by President Trump and Treasury Secretary Mnuchin, this decline will not be reversed. If anything, look for the dollar to fall even further against other currencies (though this will not be as dramatic going forward, as other nations will also be trying to devalue their currencies).

As the value of the U.S. dollar declines along with other currencies, that will tend to support higher gold and silver prices. Year-to-date, the price of gold is up about 12 percent versus the U.S. dollar, and silver has appreciated around 6 percent. Look for them to do much better from now into the future.