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The Fed's Plumbing is Fine: The Definition of Money is Not

October 1, 2019 | Commentary

  • The Federal Open Market Committee recently lowered the target Fed Funds rate by 25 basis points and is expected to cut at least once more by the end of the year.  This came on the heels of open market purchases to inject cash into the short-term lending market that had seen an unexpected jump in the demand for cash.  In both instances the Fed properly used long-standing tools from their policy kit.
  • Much of the Fed’s behavior over the last decade has been misanalyzed.  Quantitative easing and zero Fed Funds rates for many years were expected to create inflation that never materialized.  Many macroeconomic analysts erred in focusing on the base money definition that includes excess reserves.  Effective money supply, that is, money that has an impact on real economic activity, should not have included these isolated reserves.
  • In a little noticed or commented-on move, the FOMC cut the interest rate paid on excess reserves by five basis points more the Fed Funds rate.  This was the first time they did not change the two rates in lock step.  If this signals a trend it means banks will have additional incentives to reduce their excess reserves held at the Fed and put those assets to work in the economy.
  • The rate cuts and the change in excess reserve payments are both designed to expand the effective money supply and create liquidity in the economy.  This kind of liquidity has historically supported both real economic activity and asset values for investors.

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