Banks are the instrument through which the Federal Reserve enacts its monetary policy.  It doesn’t matter whether we want to play that role or not.  The Federal Reserve’s FOMC (Federal Open Market Committee) sets monetary policy, and those in the banking industry must follow.  Banks are the instrument, but Fed decisions affect every aspect of the economy.

For instance, if the FOMC decides to drive interest rates up, banks must try to follow or get crushed by market forces.  Shortly after rate increases, the consumer feels two things: income on checking accounts gets better, but the cost of loans goes up, eventually.

There is always a lag between FOMC policy decisions and the effect of those decisions.  However, banks, consumers, and the market will be forced to react to those monetary decisions.  I may not agree with what the Fed does, but never bet against it.  It will drive markets.

Increased interest rates depress the market because the cost of borrowing gets higher.  That is the Fed’s intent under current monetary policy.  It is a blunt, powerful tool that bludgeons the private marketplace into recession.

Further, the rate at which the Fed increases interest has a powerful, and in this case destructive, effect on the private market.  Remember the lag time between Fed rate increases and bank implementation thereof?  Well, banks have obligations to depositors and borrower (time deposits and loan agreements) that we must honor.  Rapid rate increases crush bank margins during the adjustment period.  Banks will adjust, but the process is painful.  

We should ask if rate increases are appropriate and if they address the cause of inflation.  The Fed thinks so, but a lot of us in the private sector don’t.  To answer this question, we need to go a little deeper into monetary policy implementation.  

So we just talked about one of the tools the Federal Reserve has: interest rates.  There is another tool at its disposal.  It is a bit more difficult to understand, but it is extremely powerful at shaping entire economies.

That second tool is the supply of money — what bankers and economists call liquidity.  As its name implies, it is like the flow of water.  Riverbanks control the flow of water nicely, when the increase is gradual.  But when the Fed increases the supply of money tenfold, the river becomes a raging torrent and inundates its banks.  Seeing the metaphor?  We bankers again implement monetary policy and try to contain the flow of money, but when the Fed opens the floodgates, we all get inundated.

Money supply is a subtle but powerful tool.  In 2008, the Federal Reserve implemented a strange policy called Quantitative Easing (Q.E.).  Basically, it printed money.  It increased the supply of money in the economy tenfold.  And once again, the magnitude was astonishing.  When it was all done, the Fed had printed over $8 trillion.  That’s not a river; it’s a tidal wave.  To see what excess liquidity can do to a bank, look at the failure of SVB.

We don’t see the money supply increase in our daily lives, but we are certainty feeling its effect.  For instance, the prices of fuel, groceries, services have gone up tremendously.  We call it inflation.  This coin, inflation, has two sides.  The other is devaluation.  They are the same, but they only appear to be different depending on our perspective.

Devaluation of the buying power of our dollar is caused by the Fed printing too much money.  Think Q.E.  Every dollar printed in excess of the amount required to provide liquidity to our economy devalues every other dollar in circulation.  Devaluation of buying power is the cause of inflation.  You are required to spend more dollars today to purchase goods.

Then why is the Fed using interest rates to quell inflation?  Clearly, rates are not the cause.  The massive supply of money the Fed printed a decade ago is.  The Fed will argue that it reduced the money supply by a trillion dollars.  Commendable.  But it has another $7 trillion to go before we have any hope of controlling inflation.  At this rate, we have at least another seven years.  Can the economy stand another seven years?

My intent is not to get down on the FOMC’s case.  They all mean well.  But perhaps they need to re-adjust their thinking.  The two schools of economic thought are stark and divergent.

The first school suggests that more federal involvement is better.  Its adherents believe that the government can serve the needs of the many and provide stability, safety.  Our entire nation has been in this mode steadily for 100 years, since Woodrow Wilson was president.  

How are we doing now?  Government is in control, but everything else is out of control.  Increasing interest rates, as the preferred method of controlling inflation, ignores the cause of and the solution to our depressed economy and price inflation.

This brings us to the other method of economic thinking.

The counterpoint to a government-centric nation is an individual-centric nation.  The solution to inflation requires a reduction in government spending.  The mechanics of reduced spending are complex, requiring both the legislative and administrative branches along with Fed policy.  

That means fiscal and monetary policy aligned to reduce debt by reducing spending.  A significant reduction in government spending would allow the Federal Reserve to more aggressively address inflation (which is devaluation of the buying power of the dollar) by reducing the supply of money.  That act would reduce the amount of debt with which our nation and all citizens are burdened.  

This is the individual-centric economic policy.

Jay Davidson is founder and CEO of a commercial bank.  He is a student of the Austrian School of Economics and a dedicated capitalist.  He believes there is a direct connection joining individual right and responsibility, our Constitution, capitalism, and the intent of our Creator.

Image via Picryl.