Guest Post by Lee Adler (The Wall Street Examiner)
Barry Ritholtz called attention this morning to a Monetary Policy Transmission flow chart by Bloomberg’s Joe Bruesuelas this morning that purports to show the reason behind “ZIRP’s more modest impact on the broader economy than the outsized impact we see on risk assets.” I don’t mean to single out Mr. Brusuelas here. He’s a great guy, and from the things I’ve seen of him, he’s usually right on target with his economic analyses. But like all other economists who are puzzled by the reason the Fed’s policies have not had much apparent impact on the economy as they have had on the markets, he misses the most important and critical access of the route through which Fed policy reaches the economy. Here’s his flow chart.
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What this chart illustrates is not so much the blockages to monetary policy transmission as the failure of mainstream economists and pundits to grasp the simplest and most important fact of how monetary policy is transmitted.
Fed Monetary policy actions are transmitted to the economy via the trading accounts of the Primary Dealers and the markets. That’s how money begins its path to reaching bank reserves and economic activity. The dealers are the transmission mechanism. The markets are the transmission mechanism from the dealers to the economy. The Primary Dealers get the cash first. They are the only deciders of how to distribute it. The only exception to this rule is when the Fed uses unconventional policy actions to lend directly to the end users, as it did with its alphabet soup programs beginning with the TAF in 2007 and 2008.
We saw how well that went when the Fed deliberately circumvented the usual Primary Dealer transmission pipeline. Things only turned up when the Fed began QE, a large scale program to pump reserves into the system via the traditional means- purchases of securities from the Primary Dealers.
When the Fed purchases Treasuries or MBS from the Primary Dealers, it credits the dealers’ accounts at the Fed for the purchase. Therefore, the first response to any Fed direct policy action is the decisions the dealers make about what to do with the cash via the markets. The cash comes in through their trading accounts and it leaves the same way. It’s their money. They can use it to buy Treasuries, and they do. They can use it to buy other bonds, and they do that sometimes.
They also make markets in everything else. They are the worldwide big dogs in every kind of market. They are the house. They can buy stocks; they can buy commodities; and they do, and they can finance their hedge fund customers, and they do that. Everything that happens in terms of monetary policy transmission is a derivative of those first trades the dealers make once the Fed has made the purchases from them. The Primary Dealers are the the first pipe through which all conventional monetary actions flow. That is why the markets respond first and foremost. The explanation is that simple. The money enters the economy via the financial markets. There’s no other reason for it.
This chart leaves that most fundamental fact out. It should be THE first and most important pipe in any flow chart showing how monetary actions flow into the economy. Leaving that out means that there’s no possibility of understanding why the system works the way it does.