The Fed "disappoints" and that is good

Seems there were a lot of people hoping that the FOMC might decide to "do something" about the persistently weak recovery. Instead, while yesterday they acknowledged that economic growth has "decelerated somewhat over the first half of this year," they added merely that they will "closely monitor incoming information ... and provide additional accommodation as needed." That's hardly a clarion call for more aggressive monetary ease, and that's a good thing, because there's not much more they can or should do at this point.

Thanks to two Quantitative Easing programs, the Fed has already created an astounding $1.6 trillion of bank reserves—17 times the amount that existed prior—of which $1.5 trillion remain on deposit at the Fed in the form of Excess Reserves. In order to support the current level of bank deposits, banks only need about $100 billion of "required" reserves, leaving $1.5 trillion available to make new loans and otherwise expand the money supply. If banks are content to hold $1.5 trillion of excess reserves today, would they be much less willing to hold the same amount of reserves if the Fed cut the Interest on Reserves to 15 bps (from the current 25) as many have suggested they should? It's hard to believe that a 10 bps reduction in the yield on excess reserves would make a significant difference. (Going to zero might make a small difference, but it would also drive money market funds out of business or force them to pay negative interest rates.) If the banking system prefers to earn almost nothing on a mountain of excess reserves instead of making loans at a rate that is many multiples of that, then that can only mean that banks are too risk-averse to make more loans today, and/or borrowers in aggregate are too risk-averse to take on more debt.

In other words, the problem of weak growth cannot be traced to any shortage of money or lack of sufficient reserves, or to the level of short-term interest rates. Risk aversion and a lack of confidence are the most likely culprits, and it's hard to see how a Fed that repeatedly acknowledges that it is very concerned about the outlook for growth is making any positive contribution to the problem.

Should the Fed attempt to force-feed the financial markets with new lending? Argentina is trying to do this, by ordering banks to increase their lending between now and year end, and to do so by making loans with interest rates lower than the current level of inflation. Last time I checked, that move hasn't made a whit of difference to the Argentine economy, but it has helped push down the value of the peso on the black market, where pesos now trade at a 32% discount to the official exchange rate.

Should the Fed adopt negative interest rates? That's just another way of force-feeding money into the economy: encourage more borrowing by ensuring that borrowing costs will be lower than inflation and lower than nominal GDP. Borrowers are almost sure to win, but lenders are almost sure to lose. That's a zero-sum game that can't result in any positive contribution to growth. Money gets pumped into real estate and commodities (i.e., into real assets that will likely benefit from higher inflation) and into speculative (e.g., leveraged) activities, but not necessarily into productive (i.e., job-creating) activities. Indeed, the transparently inflationary nature of policies such as this can only induce greater risk-aversion. That's why Argentina's economy is sinking rather than picking up, precisely because the government is so transparently trying to goose lending.

Can the Fed do anything to reduce risk aversion and boost confidence, and thus address the real underlying problems? Well, yes: they could refrain from pumping yet more reserves into an already-over-stuffed banking system, and they could refrain from reducing already-very-low short-term interest rates to zero. And that's exactly what they did with their statement yesterday. They have reduced risk aversion because they have reduced the chances of a catastrophic error of monetary policy, in which they are slow to reverse their accommodation, thus creating a huge excess supply of money which could be very inflationary. That helps explain why the dollar today is trading at close to a two-year high against other major currencies, and why gold is down 16% from last year's high.

What the Fed has yet to do is explain in greater detail why monetary policy cannot provide a magical solution to the world's problems at this point—that fiscal policy holds the key to future progress. On that score we are still waiting to see credible attempts to rein in the size and scope of government and to minimize tax and regulatory burdens in most of the world's major economies. Draghi can't come up with a ECB program that will fix that overnight; the ECB, like the Fed, can only do so much.