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A recent Mish post discussing the question of whether the Fed "pumps" money into the economy contains some provocative wisdom on interest rate-setting from Minyanville "professor" Reamer:
I had realized that the Fed's "targetting" of interest rates by literally setting them directly -- money supply be damned -- was incredibly bad. It is simply fiat policy at its extreme; almost as bad as FDR setting the price of gold for international buyers arbitrarily in the Depression. It is the antithesis of free markets, contrary to the pervasive free market rhetoric of people like Greenspan. But I hadn't realized the full ramifications of just how incredibly broken this rate-maintenance system is: until the Fed makes a rate change, the forcing of a constant funds rate actually exacerbates both expansionary speculation and deflationary collapse (depending on whether the policy rate is above or below equilibrium). Way to go, Fed.
This is not how the Fed system has always worked. In the Volcker era, money supply was targetted. The Fed attempted to reach a desired interest rate indirectly by adjusting the money supply -- and the result was naturally imperfect, as the interest rate emerged from a combination of money supply and money demand. It wasn't until Mr. Bubble took over in '87 that the money supply method was abandoned and today's "direct fiat rate" was implemented. You can see this quite clearly on the funds rate charts, where the graph transforms abruptly from organic and jagged to mechanically-stepwise:
This may have looked like quite a miracle brought forth by Greenspan. But all that has happened is that the imperfections inherent in reaching an interest rate through real-world money supply and demand have been replaced with accelerating fluctuations in money supply. All those pre-1987 jagged events, where a funds rate target met rapidly-shifting real-world demand conditions, now surface instead in harder-to-see deflationary and asset-inflationary shocks.
To extend the puzzle and provide a bit more detail, take a look at the following chart of the effective daily Federal Funds rate, gleaned from Economagic:
What is interesting about this chart is that we see some level of daily fluctuations remained -- even under Greenspan -- until about 2000. Then almost all of the fluctuations disappeared. I am not quite sure what happened here to effect this, but it appears significant. And given the above points, the elimination of this volatility means the spillover into credit instability must be even worse than it used to be.
This all goes a long way to explaining the finance world's tunnel vision on what the Fed does. Until the Fed makes a rate change, they are causing spiralling deflation or asset inflation, depending on whether the funds rate is above or below equilibrium.
In effect, the Fed under Greenspan implemented a dynamically unstable monetary system, outright (it's unstable in other ways I've discussed before as well). In this system, when the Fed isn't adjusting the interest rate, they're destabilizing the economy. It is essentially impossible under this system for there to be any sort of stability: it is a mathematical certainty that chaos will be produced. The only saving grace for the Fed is that this chaos is not glaringly obvious at the surface. Or at least, it isn't obviously attributable to them.
So Greenspan's "genius" was actually to subvert some of the core problems in the monetary system -- in the process, unfortunately, making them worse.
A parting question for iTulip readers: Is anyone else bothered by the fact that dramatic changes in what the Fed does seem to take place with alarming frequency without them publicly telling anyone -- in advance, if at all? Or better yet: asking. Asking would be nice.
Oops -- guess I forgot that the Federal Reserve isn't actually Federal (nevermind the point that it doesn't "reserve" much of anything), and that its clients are the major banks, not the public. Silly me...
This article was originally posted on autoDogmatic.
There is another operational element here that very few folks appreciate and it is this: In setting the fed funds target rate and defending it, the Fed's open market operations take the form of either pumping liquidity into or out of the banking system (via Fed Funds) in an effort to keep the target rate at (for now) 5.25%.
Let's say that economic activity is heating up; there is more manufacturing activity, more employment, more lending by banks and as a result of all of those, more demand for short term monies by commercial banks. Bank lending activity goes up and their demand for short term money (the cost of which is set by the Fed) increases commensurate with their need to keep capital/coverage ratios at whatever bare minimum regulations demand they be. So, net/net greater economic activity implies more money demand by commercial banks. If money demand by commercial banks increased, in the absence of the Fed, we would see the 'cost' of the money (the interest rate) do what?
Like all goods, when the demand for something goes up, the price increases in the short run. So in the case of short term (Fed) funds, increased economic activity generates greater demand for short term funds by commercial banks and that increases the cost of those monies -- increases the interest rate of these monies. But the rate -- cost -- of Fed Funds is 5.25% and the good boys at the NY Fed have pledged that it will defend the FOMC's Fed Funds target -- neither letting it rise nor fall. But if increased economic activity is driving up the Fed Funds rate, then the Fed must increase the supply of credit in an attempt to keep the rate at 5.25%. This is of course a basic law of economics: in the face of increased demand, prices rise. The only thing that can keep prices the SAME would be an immediate increase in supply. And that is what the NY Fed does when economic activity increases -- they increase the supply of monies in the system (via repos and other means) in order to defend that Fed Funds target.
More interesting than that is what happens when economic decreases. The opposite situation arrives: when economic activity decreases the demand from commercial banks for short term funds decreases and thus the price (rate) falls. In order to maintain and defend that fed funds target in a scenario where economic activity is decreasing and lending activity is slowing, the Fed has to decrease the supply of monies available to the system. Thus, the Fed will be taking money from the system once economic activity decreases unless and until they change the Fed Funds rate target.
That period of time between a slowdown in economic activity and an eventual decrease in the Fed Funds rate can take months or quarters. If the size and severity of the misallocation of investments in the economy are significant, that period where the NY Fed open market desk is defending the FOMC's rate by decreasing monies in the system, need not be lengthy at all to create the kind of tightening of monies that is so anathema to a credit-driven, asset-based economy. A few months of taking money out of the system in order to defend a Fed funds target is all that is theoretically needed to create the type of tail event that we believe it highly probable in the credit and stock markets, not to mention the real economy.
The conditions of decreasing economic activity are present; the malinvestments are both huge and pervasive; the Fed could easily start to take money out of the system to keep the Fed Funds rate at 5.25%; and commercial bank lending declined last week more than it has at any time since February 1960. Those are the conditions -- sufficient but perhaps necessary -- for a credit-based contagion event. And few times in history have markets been implying the odds of this are so low.
I had realized that the Fed's "targetting" of interest rates by literally setting them directly -- money supply be damned -- was incredibly bad. It is simply fiat policy at its extreme; almost as bad as FDR setting the price of gold for international buyers arbitrarily in the Depression. It is the antithesis of free markets, contrary to the pervasive free market rhetoric of people like Greenspan. But I hadn't realized the full ramifications of just how incredibly broken this rate-maintenance system is: until the Fed makes a rate change, the forcing of a constant funds rate actually exacerbates both expansionary speculation and deflationary collapse (depending on whether the policy rate is above or below equilibrium). Way to go, Fed.
This is not how the Fed system has always worked. In the Volcker era, money supply was targetted. The Fed attempted to reach a desired interest rate indirectly by adjusting the money supply -- and the result was naturally imperfect, as the interest rate emerged from a combination of money supply and money demand. It wasn't until Mr. Bubble took over in '87 that the money supply method was abandoned and today's "direct fiat rate" was implemented. You can see this quite clearly on the funds rate charts, where the graph transforms abruptly from organic and jagged to mechanically-stepwise:
This may have looked like quite a miracle brought forth by Greenspan. But all that has happened is that the imperfections inherent in reaching an interest rate through real-world money supply and demand have been replaced with accelerating fluctuations in money supply. All those pre-1987 jagged events, where a funds rate target met rapidly-shifting real-world demand conditions, now surface instead in harder-to-see deflationary and asset-inflationary shocks.
To extend the puzzle and provide a bit more detail, take a look at the following chart of the effective daily Federal Funds rate, gleaned from Economagic:
What is interesting about this chart is that we see some level of daily fluctuations remained -- even under Greenspan -- until about 2000. Then almost all of the fluctuations disappeared. I am not quite sure what happened here to effect this, but it appears significant. And given the above points, the elimination of this volatility means the spillover into credit instability must be even worse than it used to be.
This all goes a long way to explaining the finance world's tunnel vision on what the Fed does. Until the Fed makes a rate change, they are causing spiralling deflation or asset inflation, depending on whether the funds rate is above or below equilibrium.
In effect, the Fed under Greenspan implemented a dynamically unstable monetary system, outright (it's unstable in other ways I've discussed before as well). In this system, when the Fed isn't adjusting the interest rate, they're destabilizing the economy. It is essentially impossible under this system for there to be any sort of stability: it is a mathematical certainty that chaos will be produced. The only saving grace for the Fed is that this chaos is not glaringly obvious at the surface. Or at least, it isn't obviously attributable to them.
So Greenspan's "genius" was actually to subvert some of the core problems in the monetary system -- in the process, unfortunately, making them worse.
A parting question for iTulip readers: Is anyone else bothered by the fact that dramatic changes in what the Fed does seem to take place with alarming frequency without them publicly telling anyone -- in advance, if at all? Or better yet: asking. Asking would be nice.
Oops -- guess I forgot that the Federal Reserve isn't actually Federal (nevermind the point that it doesn't "reserve" much of anything), and that its clients are the major banks, not the public. Silly me...
This article was originally posted on autoDogmatic.
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