When the Fed Encountered Gold Kryptonite

Paul Volcker is the demigod of the Federal Reserve, long ago ascended to Mount Olympus, or Valhalla, or wherever banker gods go when they leave us. Those who believe the Fed can cause or cure inflation yearn for current Fed leaders to exercise the power by which Volcker, as they believe, crushed the great inflation ignited by Nixon in 1972 when he took the dollar off gold.

What no one seems to have told the idolators is that about 15 years ago, the Fed was exposed to gold Kryptonite, which, as all Superman fans know, permanently deprives bankers of their powers. The graphs below tell the story.

The first is a graph of the total reserves of all depository institutions as far back as the Fed keeps that series, starting with 1959.  Ignore, for a moment, the last 15 years or so. We will get to that. Focus instead on the long apparently flat line from 1959-2008.

It’s not actually flat. It looks flat only because on this graph the y-axis reaches into the trillions in order to include the years after 2008. Before that time, total depository reserves never reached $100 billion.

Graph No. 1 Total Reserves of Depository Institutions 1959-2022

Now look at graph No. 2, which includes the years when the Volcker legend was forged but stops in 1988. The scale is in billions making things a bit clearer.

In those days, it was widely believed that the Fed should halt inflation by curbing credit and causing a recession so Americans would be poor and not buy things. The Fed’s main tool to curb credit was buying or selling Treasury debt. Buying Treasuries would add to the reserves of member banks, selling them would subtract. When their reserves contracted, the banks would have to contract their loan portfolios, perhaps causing the recession the Powell Fed devoutly wishes. Alternatively, the Fed could raise or lower reserve requirements, though this was considered more disruptive and was less often the chosen course.

As the graph shows, from January 1980 when reserves peaked at $45.2 billion to March 1984 when they bottomed at $36.2 billion the line has a distinct downward slope. That downward slope is the Volcker strategy.

Graph No. 2 Total Reserves of Depository Institutions 1972-1988

As graph No. 3 shows, The Volcker strategy did correlate with a dramatic reduction in inflation, at least as measured by the CPI, and not one but two recessions, which must make the Powell people very jealous.

Graph No. 3: CPI 1975 to 1988

Post hoc, propter hoc? Possibly.

We will never know for sure because there are contrary bits of evidence and at least two alternative explanations.

One bit of contrary evidence is back in graph 2. After bottoming in 1984, bank reserves started booming again, at a far steeper rate than in the 1970s and reaching some $62 billion by 1988. Yet as Graph No. 3 shows, inflation continued downward. In the out-years not shown on the graph, inflation continued to recede, with modest ups and down until 2021.

The two alternative explanations are:

1. The Fed was not necessary to the recessions, inflation did that all by itself. Protracted double-digit inflation demands double-digit interest rates, though there is typically a lag as expectations adjust. And double-digit interest rates can hardly avoid causing a recession. That this was not noticed at the time is testimony to the sway the Phillips Curve held over U.S. economists and the media.  Bizarrely, maintaining that inflation and unemployment should be inversely correlated, it was only Phillips Curve dogmatism that made “stagflation” a surprise and apparent paradox.
2. The other alternative explanation is Ronald Reagan. The Reagan tax cuts along with the preceding reduction of the long-term capital gains tax rate dramatically increased the after-tax returns on financial investments. Pre-Reagan, the after-tax, inflation-adjusted return on the S&P had actually sunk into negative territory. Rembrandt and Renoir paid better than RCA, Raytheon, or Republic Steel. By making productive investment attractive again, Reagan boosted demand for dollars, starting a trend that would run for almost 40 years.

We will refrain from dogmatizing as to the actual inflation killer, but it seems clear that the Volcker legend has some leaks

Which reminds us that we have not yet gotten to the point of this column. Here it is: Even if the Volcker legend is true, what Volcker did can’t be repeated, because the Fed ceded its control of bank reserves 15 years ago.

In 2008, Congress allowed the Fed to pay interest on reserves it held from member banks. In part, this was to persuade systemically important banks to accept the hundreds of billions of dollars the Fed was throwing at them despite a shortage of legitimate lending opportunities. In 2010, the Fed took Congress up on the offer and began paying interest on those swelling reserves.

The result shows up in graph No. 4. Starting in 2008, reserves begin to climb to levels an order of magnitude higher than ever before.

Graph No. 4: Total Reserves of Depository Institutions 2000-2022

Here is the crucial point. Nearly all that growth was in excess reserves, i.e., funds voluntarily held by banks over and above Federal Reserve requirements. According to the Cleveland Fed, excess reserves grew from $1.9 billion in August 2008 to $2.6 trillion by January 2015. They hover around $3 trillion today.

With excess reserves 1,000 times required reserves, the Fed’s once most treasured tool becomes irrelevant.

No correlation is discernible between these voluntarily held reserves and either the CPI or the health of the economy, except that reserves do appear to increase when banks become unwilling to lend to the real economy as they did in 2020.   They appear to decrease when market interest rates go up, or when competing lending opportunities abound, but this has little to do with the Fed. It is an effect of rising rates more than a cause. In any event we have very little history of reserves of this magnitude, blurring clarity on cause and effect

Our friend and super-financial genius, hedge-fund founder, and now banker, Andy Redleaf remarks that with the Fed paying banks to keep money on ice, “buying or selling Treasuries has about as much impact on the real economy as me shifting my wallet from my right-hand pocket to my left.”

The one Fed tool that might possibly have contributed to the defeat of inflation from 1979 through 1982 no longer exists.

Today, the only purpose the Fed serves is to excuse the Biden Administration for the ravages it has wrought on the real economy, from the lockdowns to green goo from the climate cranks and emergency Marxists to the FTC crippling capital flows to innovators by discovering monopolies under every bed. The myth of the Fed’s power is doing more to entrench emergency socialism than Dr. Fauci in his most hallucinogenic dreams.

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