-Source-American Thinker-
Despite a large tax cut and seven-and-a-quarter-point increases in the fed funds rate, inflation continues to be an elusive target, lingering at around 2%. The only interest rates that seem to be reacting to the Federal Open Market Committee's promptings are those of Treasury-issued debt, residential mortgages, and lending. The Phillips Curve has lost its relevance as a predictor of inflation, as full employment is no longer a trigger, at least for now. Meanwhile, the FOMC continues to exclude the energy and food components from its calculation of inflation, which is troubling for two reasons: (1) oil is where the action is today, and (2) groceries have been on the rise for some time – just ask my wife.
Inflation's elusiveness may be at least partially explained by the systemic changes to banking that have occurred because of the 2007 crisis and the Fed's reaction to it – namely, collapse of the fed funds market, redefinition of the fed funds rate, and creation of trillions of dollars of excess reserves as a substitute form of bank liquidity.
The 2007 crisis collapsed the fed funds market when credit quality became an issue and liquidity in the market dried up. Prior to that time, it had operated successfully as an unsecured overnight market for cash balances held by banks at the Fed, which fulfilled their needs for daily liquidity. Back then, there were many more lenders than borrowers, with the smaller banks tending to be lenders and the larger banks borrowers. The crisis changed all of this.
Although former Fed chairman Ben Bernanke's unconventional monetary policy failed to stimulate economic growth as was intended, it did ensure the continued demise of the fed funds market by using interest on excess reserves to set the upper bound of the fed funds rate and interest on reverse repos to set the lower bound. This replaced the FMOC's traditional practice of buying and selling short-term Treasury securities to tease the fed funds rate up or down in order to control the price of overnight liquidity to banks, which then affected other interest rates accordingly. Read more
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