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The Fed’s “Own Goal”

As we wait to see whether the Fed slants its statement ever-so-slightly to the hawkish side or ever-so-slightly to the dovish side (not to mention whether Chairman Yellen repeats her blunt performance in the presser), it is probably worth a few moments to think about what the Fed ought to do.

Yesterday’s inflation figures, viewed in isolation, might be perceived as a one-off bad figure. I pointed out yesterday some reasons that this would be an unfortunate error. Keep in mind that anything the Fed does to address monetary policy will take some time to impact an economic process with momentum. That is to say that even if the Fed tightened today, core inflation over 3% is probably still going to happen. The real question is how high inflation goes, and how long it stays there. There is no longer any question about whether inflation is rising. (This has actually been true for a while, but people who were focused on core rather than median and didn’t look at the particulars of inflation, as well as those who focus on the “output gap” as preventing any possibility of inflation, have been able to ignore the signs for a while).

As an aside, the “output gap” crowd – who expected deflation in 2009-10, and didn’t get it, and now expect disinflation, but aren’t getting it – aren’t defeated yet. They’ll simply re-define the gap to fit the data, I am sure. When you get to choose your own observations and change the model to fit the observations, science is easy.

What concerns me about the Fed’s next steps here, and the state of the debate, is that the Federal Reserve seems overly focused on the level of interest rates, and how to adjust them, and not on the level of reserves or controlling the transactional money supply. For example, recently the IMF published a paper arguing that central banks should raise the long-term inflation target from 2% to 4% because with a 2% target it is too easy to get deflation and have interest rates pinned at zero, leaving the central bank powerless to stop deflation. It seems not to matter to the author that Japan only recently proved that it is money, and not interest rates, that matter when they were able to get out of deflation with an aggressive QE. And, after all, “Helicopter” Ben made the point years ago that deflation is easy to prevent if only the Fed prints money.

So the cult of interest rate manipulation concerns me. Another, and more influential, example (because after all, no one really believes the central bank will start targeting 4% inflation) is in the publication recently of “Monetary Policy with Abundant Liquidity: A New Operating Framework for the Federal Reserve,” co-authored by Brian Sack and Joseph Gagnon. Dr. Sack used to be head of the Fed’s Open Markets Desk, so his opinions have some weight in the institution. In this policy brief, he and his co-author suggest ways that the Fed could raise rates even without reducing the amount of excess reserves in the system. Their approach would, indeed, succeed in moving interest rates. But the proposal, in the authors’ words, “appropriately ignores the quantity of money.”

Considering that it is the quantity of money, not its price, that impacts inflation – as hundreds of years of monetary history have proven beyond any educated doubt – this is a frightening view. We are always looking for where the next policy error will come from; this is certainly a strong candidate.

There is a crucial misunderstanding here, and it is unfortunately a fundamental tenet of the interest rate cult. Interest rates are not the cause of money supply changes, but the result of them. The way the Fed operates tends to cause this confusion, because the Fed seems to adjust interest rates. But that is not in fact what happens. The Desk actually adjusts the level of reserves in the system, and reads the interest rate as an indication of whether reserves are at the right level (or at least, this was the way it used to be done, before the “environment of abundant liquidity”). The confusion has gradually developed, and the institution has contributed to the confusion by gradually altering its policy statements to obfuscate what is actually going on. The domestic policy directive of February 1989 said in part:

“In the implementation of policy for the immediate future, the Committee seeks to maintain the existing degree of pressure on reserve positions…somewhat greater reserve restraint would, or slightly lesser reserve restraint might, be acceptable in the intermeeting period. The contemplated reserve conditions are expected to be consistent with growth of M2 and M3 over the period from December through March at annual rates of about 2 and 3½ percent, respectively.”

Notice that the main focus here is how pressure on reserves leads to money supply growth. By 1994, the Fed was drawing the line to interest rates more explicitly. The press release following the February 4th, 1994 meeting said in part:

“Chairman Alan Greenspan announced today that the Federal Open Market Committee decided to increase slightly the degree of pressure on reserve positions. The action is expected to be associated with a small increase in short-term money market interest rates.”

The Federal Reserve eventually stopped talking about “reserve positions,” although that continued to be how interest rates were managed in fact. Here is what the Fed was saying in January 2007:

“The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.”

Now, of course, the Fed not only sets the current level of interest rates but also gives us an expected path.

But again, even when the Fed was talking about the interest rate target, the Fed actually managed interest rates by managing reserves. By doing large system repos or matched sales, the supply of reserves was managed with respect to what the Fed thought the demand for reserves (which is unobservable in real time) was. If the resulting interest rate was too low or too high, then they added or subtracted to the supply reserves. And thus we get to the point that is crucial for understanding how monetary policy is conducted: the interest rate is a measurement of the pressure on reserves.

Interest rates, in other words, are like a thermometer that measures the temperature in the body. The doctor plies his trade on a feverish patient with an eye on the thermometer. He can’t see the microbes and antibodies, but the thermometer tells him (her) if he (she) is winning. In exactly the same way, the level of short-term interest rates tells the Fed if they have too many reserves or too few. But suppose the doctor lost sight of the real purpose of treatment? Suppose the doctor said “wow, this would be so much easier if I just put a little dial on the thermometer so that I could control the reading directly! Then I could just set it to the right temperature and I would be done.” We would all recognize that doctor as a quack, and the patient would probably die.

This approach, though, is what the Sack/Gagnon paper proposes. We want to control the temperature, so let’s introduce a thermometer that allows us to control the temperature! But this is wrong, because it is the reserve position that is critical to control; it is that which is out of control at the moment due to the presence of copious excess reserves; and the fact that the Fed can simply set the interest rate is irrelevant. (Why do we need a Fed? Why not have Congress set the legal interest rate at the “appropriate level” so that the Fed doesn’t even need to do open market operations?)

The Sack/Gagnon plan will clearly permit the movement of interest rates to wherever the Fed wants them to be. But it will not solve the root problem, which is that the level of required reserves is essentially out of the Fed’s control – which means the size of the money supply is out of its control as well. Excess reserves will continue to leak into transactional money, and inflation will continue to rise. Here is your error. The Fed is about to score an “own goal.”

  1. Spencer Hall
    June 21, 2014 at 1:25 pm

    Paul Meek described the FRB-NY’s operating procedure in his 1974 booklet on “Open Market Operations”. The fed’s current monetary transmission mechanism was changed by William McChesney Martin Jr. in c. 1965. Between 1951 and 1965, net changes in Reserve Bank credit were determined by monetary policy (i.e., after the Treasury-Federal Reserve Accord in 1951, and not by the public sector’s demand for loan-funds, & not by accommodating the commercial banker’s need for reserves).

    The FOMC’s net free, or net borrowed, reserve targeting approach changed in response to the CBs buying their liquidity (as opposed to the old fashioned practice of storing their liquidity) beginning in c. 1965 (coinciding with the rise in chronic monetary inflation & in anticipated inflation). E.g., M1 grew at less than a 2 percent rate in the decade ending in 1964 and in the nine subsequent years money supply grew at a rate in excess of 6.5 percent…

    The problem stemmed from using the wrong criteria (interest rates, rather than member bank legal reserves) in formulating & executing monetary policy. The effect of tying open market policy to a fed funds bracket was to supply additional (& excessive) legal reserves to the banking system when loan demand accelerated (& vice versa). I.e., Keynes’s liquidity preference curve (demand for money) is a false doctrine (confuses money with liquid assets).

    This change was encouraged by the 5 successive raises in the Board’s Reg. Q policy for the CBs exclusively beginning in 1957 (i.e., by allowing the CBs to pay for the deposits they already owned). I.e., the operations of the FRB-NY’s “trading desk” began to be dictated by the Fed Funds “bracket racket”. Though, as Paul Meek described, the repo rate on gov’ts is the actual transmission mechanism (not the FFR), or essentially, the one-day return on all government securities, while the daily volume of fed funds transactions are trivial in comparison.

    The money stock can never be managed by any attempt to control the cost of credit. The only tool in a free capitalistic society thru which the volume of money can be controlled is legal reserves (i.e., monetarism). But monetarism has never been tried (i.e., Paul Volcker targeted non-borrowed reserves – not total reserves).

    The “unified theory” is that the NBs are the customers of the CBs. Thus all demand drafts originating from the NBs clear thru the payment system (commercial banking system). And bank reserves are driven by payments (bank debits). Legal reserves are a surrogate for monetary flows (bank debits or total spending). 95 percent of all demand drafts clear thru demand deposits (see G.6 release). Caution, roc’s in RRs cannot be retrofitted.

    The scientific evidence is irrefutable. The trajectory for the 24 month rate-of-change (roc), in monetary flows (the scientific method), projects a top in the inflation indices during May 2014. Then, the 10 month roc (proxy for real-output), mirrors the seasonal economic inflection points (scientific proof). Both lags have been mathematical constants for the last 100 years.

    Monetary flows represent our means-of-payment money times its transactions rate-of-turnover (MVt). Required (legal) reserves (RRs), reflect transaction type deposit classifications 30 days prior. I.e., RRs serve as the policy metric for our primary money stock (means-of-payment money).

    The 10 month roc in money flows (RRs) peaks in July. The problem is that there is a 15 percentage point deceleration in MVt by October (proxy for real-output).

    This drop (projection), is somewhat diminished by not discounting future monetary expansion, not discounting any increase in Vt (e.g., non-bank lending/investing), & the annual decline in seasonal factors. But then there is a 62 percent drop in the proxy for the inflation indices by December. I.e., roc’s in MVt foreshadow subpar economic growth.

  2. Spencer Hall
    June 22, 2014 at 3:54 pm

    Our monetary mismanagement has been the assumption that the money supply can be managed through interest rates. Since c. 1965, the operation of the “trading desk” has been dictated by a series of interest rate pegs.

    The technicians in charge of the hour-to-hour administration of open market operations apparently believe that there is, at any given time, a federal funds rate that is consonant with a proper rate of change in the money supply. They have in fact plugged this concept into a computer model. (a policy rule or a “Taylor” like rule).

    What they have actually “plugged in” is an open ended device through which the commercial banks can decide whether or not there should be an expansion in the legal lending capacity of the banking system – the capacity to create credit (money) and to acquire additional earning assets.

    This has assured the bankers that no matter what lines of credit they extend, they can always honor them – since the Fed assures the banks access to costless legal reserves whenever the banks need to cover their expanding loans – deposits

  1. October 8, 2015 at 7:41 am

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