The Collected Essays of

Richard A. Stanford

Monetary Policy in an Open Economy World

Richard A. Stanford

Professor of Economics, Emeritus
Furman University
Greenville, SC 29613

CONTENTS

NOTE: You may click on the symbol <> at the end of any section to return to the CONTENTS.

Introduction

     1. The Relevant Money Supply in an Open Economy World
     2. Monetary Policy in an Open Economy World
     3. Central Bank Effectiveness in an Open Economy World

     4. Central Bank Independence
     5. The Fed's Independence

     6. Rules vs. Discretion in Monetary Policy
     7. Rules-Based Monetary Policy
     8. Targeting Price or QuTracking the Natural Rateantity for Monetary Policy
     9. Tracking the Natural Rate
     10. Hoarding and Monetary Policy
     11. Monetary Policy and Consumer Spending
     12. Calibrating Monetary Policy

     13. Lessons from American Banking History
     14. Deflation and Inflation, Historical Perspectives
     15. The Money Supply and Deflation
     16. The Money Supply and Inflation
     17. The Inflation Delusion

     18. The Discount Rate and Capital Scarcity
     19. Discount Rate Near Zero
     20. Distortions Due to Superlow Interest Rates

     21. The Federal Reserve and Deficit Finance
     22. Central Bank Purchases of Corporate Bonds and Equities
     23. Monetary Policy and Arbitrage
     24. Unwinding the Fed's Portfolio
     25. Growth and Monetary Stimulus
     26. Inflation and Unemployment
     27. Modern Monetary Theory
     28. Monetary Policy and Exchange Rates
     29. Monetary Policy and the Stock Market
     30. Monetary Policy and Rational Expectations
     31. Open Market Operations and the Federal Funds Rate
     32. Open Market Policy by Repo Transactions
     33. The Capital Scarcity Rate of Interest
     34. Monetary Policy in an Open-Economy World

     35. The Fed's Job is Done?
     36. About Inflation, November 2021
     37. Treasury Interest Rates and Economic Growth Rates
     38. Money Creation by Congress
     39. Inflation and Price Levels
     40. Threat to the Fed's Independence
     41. The Treasury and Monetary Policy

     42. A Final Word

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Introduction

The Federal Reserve is planning to cut rates at its policy meeting at the end of the month even though the United States economy, by most available evidence, is doing perfectly fine. .... it is a rare acknowledgment about the inherent uncertainties about the economy, in contrast to a tradition in which central bankers try to project an impression of being all-knowing. -- Neil Irwin, The New York Times, July 19, 2019

Do I believe in monetary policy? Is it an article of my economic faith? I was taught in both undergraduate and graduate-level money and banking courses that a central bank, the United States Federal Reserve in particular, can manipulate the price and the quantity of money in circulation to achieve economic stability characterized by moderate price inflation, satisfactory economic growth, and a low level of unemployment. But the experience of a career teaching economics courses and observing the functioning of central banks across the world has led me to both central bank and monetary policy agnosticism.

The thesis of this blog is that in an open-economy world characterized by imperfect human knowledge, complex transmission mechanisms, inadequate predictive models, imprecise policy calibration techniques, and that is populated by intelligent human operatives who can perceive and act to thwart the intentions of government officials, it is a delusion to think that central bankers can successfully implement monetary policy to achieve price stability, satisfactory economic growth, or low-enough rates of unemployment.

1. The Relevant Money Supply in Open Economy World

It is conventional to designate money supply definitions by the capital letter "M" plus a number ranging from 0 through 3 or 4, depending on the relative degree of liquidity of the items contained in the definition. The behavioral relevance of a money supply definition is what monetary items actually motivate spending by citizens and residents of the nation. On this consideration, perhaps the most widely accepted definition of a nation's money supply is M2 which includes coin, currency, checkable deposits, and small denomination savings and time deposits that are easily converted into any of the other monetary types included in M2. Most central banks include in the M2 statistics that they compile those items denominated only in units of their own currency, e.g., the "dollar" in the United States.

In an open-economy world it is possible that monetary balances denominated in several currency units will motivate spending by a nation's citizens and residents, irrespective of whether the balances are held domestically or abroad. A critical behavioral question is whether the relevant money supply of the nation should include monetary balances held abroad by citizens, and citizens' monetary balances denominated in currency units other than the nation's own money, irrespective of where they are held. For example, do American holdings of Turkish lira influence the spending habits of American consumers and businesses? The answer is perhaps not much because the Turkish lira is one of the world's minor currencies, and not a large quantity of them have escaped the Turkish economy to be held by Americans.

Let's put the question from the perspective of Turkish citizens: do Turkish holdings of American dollars in Turkey or elsewhere influence the spending habits of Turkish consumers and businesses? There may be more reason to respond in the affirmative to this question because the dollar is one of the world's international reserve currencies, and a very large volume of dollars has escaped the United States to be owned by people in other nations. If the answer is yes, then this implies that dollar holdings by Turks should be included in the Turkish money supply along with Turkish lira and other currencies which affect Turkish spending decisions. The relevant money supply for any nation, including both the U.S. and Turkey, is not purely its own domestic currency, but all of those things which can serve as media of exchange by its citizens anywhere in the open-economy world.

A large volume of dollars has escaped ownership by Americans in the post-WWII era due to the Marshall Plan, American tourism, imports of foreign merchandise and services, foreign direct and indirect investment by American firms, foreign aid disbursements, and continuing American military presence and spending in other nations. These foreign-owned dollar balances have become known as Eurodollars, Petrodollars, Asiadollars (or other regional specifications) depending upon the national identity of the holders. The quantities of such foreign dollar holdings have become far larger than the original quantities spent or transferred overseas by virtue of the fractional reserve nature of banking on a world-wide scale.

Although foreign bankers holding dollars are not subject to the Federal Reserve's reserve ratio requirements, they do choose to hold reserves against their dollar deposits as a matter of prudence. But their excess reserves of dollars yield no income, so they may issue dollar-denominated loans, just as American banks do, thereby creating additional dollar money. The successive rounds of redepositing and relending result in multiple credit creation, in this case of dollar money supplies held outside of the United States. So, while we can know with some precision the total of dollar deposits in American banks within the U.S. economy, it is not possible to know with any degree of precision at all how much dollar money there is in the whole world.

2. Monetary Policy in an Open Economy World

It is perhaps heroic to think that the Federal Reserve Board of Governors can effectively control the money supply that is relevant to spending behavior in the U.S. economy. It is also heroic to think that in an open-economy world any nation's central bank can neutralize the monetary effects of international trade and capital flows with any degree of precision in order to allow pursuit of domestic monetary growth targets. Dollar balances are functioning extensively as a third-party currency in facilitating both trade and financial transactions. By virtue of the large volume of dollars in use in the world, the dollar is has become a de facto world currency.

Americans may borrow Eurodollars, Petrodollars, or Asiadollars for spending and investment in the U.S. economy or anywhere else in the world. This means that the dollar-denominated domestic M2 money supply, which is the usual target of Federal Reserve monetary policy, is a fiction, or is at least an inadequate target. In order to effectively exercise monetary policy to stabilize the U.S. economy, the Fed should target not just the global M2 dollar money supply, but also aggregates of any and all currencies held by Americans and foreigners anywhere in the world which might be spent in the U.S. economy. Now we are talking about a truly heroic scale of monetary policy. And we are also talking about the exercise of monetary policy by one of the world's central banks on a scale that can affect economic conditions in other nations of the world.

There are several (but not so many) currencies in the world, the control of which by some central bank may be instrumental in economic stabilization. We can mention in addition to the U.S. dollar, the euro, the Chinese yuan, and the Japanese yen. When the central banks of any of these nations or regions set out to exercise monetary policy, even in respect only to their own currencies or only the quantities in their own economies, they may have important macroeconomic consequences for other economies of the world, and they may not achieve the intended effects in their own economies. This is why it is important to global economic stability for there to be coordination among the central banks. Indeed, the Group of Seven (G7) finance ministers have made a start in this direction, but they are not central bankers, and they have usually coordinated efforts to control exchange rates rather than monetary policy more broadly.

Leaving aside the question of whether central bank monetary manipulation may have unintended deleterious effects, would it be more efficient in an open world economy to have a single central bank which coherently administers monetary policy in the interest of world economic stability? Would this be a super-national central banking institution, or could it be simply one of the extant central banks which emerges to exercise de facto world-scope central banking prerogatives, whether recognized or accepted by other nations and central banks or not? I can think of only a couple of candidates in this regard: the U.S. Federal Reserve or possibly the European Central Bank. And what if the emergent de facto world central bank fails to recognize its world role, but mistakenly continues to exercise monetary policy in regard to its small but significant corner of the world?

3. Central Bank Effectiveness in an Open Economy World

In the environment of slow recovery and low growth of the world economy in the wake of the 2008 "Great Recession," central bankers have attempted to stimulate their respective economies by implementing looser monetary policies in the effort to accelerate growth. But monetary policy stimuli seem to have become ever less effective as discount rates have approached zero and "quantitative easing" has resulted in little additional commercial bank lending. Central bankers, among them the U.S. Federal Reserve Bank and the European Central Bank, recently have exhibited reticence, ambivalence, and uncertainty to further lower discount rates toward or below zero, or to engage in even more quantitative easing. This suggests the emerging impotence and irrelevance of central banking to their domestic or regional economies as well as to the world economy. Jon Hilsenrath, writing in The Wall Street Journal on August 25, 2016, put it this way:

In the 1990s, a period known in economics as the “Great Moderation,” it seemed the Fed could do no wrong. Policy makers and voters saw it as a machine, with buttons officials could push to heat or cool the economy as needed. Now, after more than a decade of economic disappointment, the central bank confronts hardened public skepticism and growing self-doubt about its own understanding of how the U.S. economy works.
(http://www.wsj.com/articles/years-of-fed-missteps-fueled-disillusion-with-the-economy-and-washington-1472136026?mod=djemalertNEWS)

The central bank role may be worse than simple lack of understanding of how the U.S. economy works. James Freeman, writing in The Wall Street Journal, says,

Historians may look back on this era and conclude that central bankers themselves were the primary disturbances buffeting the economy. George Gilder notes in his new book, “The Scandal of Money,” how much faster the economy grew in the postwar period before the Fed and other central banks employed such expansive tool kits.
(http://www.wsj.com/articles/the-5-000-year-government-debt-bubble-1472685194)

There are more than 160 national central banks in the world (http://centralbank.monnaie.me/). In a small nation with only a rudimentary local open market for its government securities, open market operations are unlikely to be effective. The central bank of such a nation may not be able to engage in effective open market operations to affect the reserves of its domestic commercial banks if government deficits have been financed for the most part by direct monetary expansion rather than public bond offerings. Even if the central bank should opt to purchase or sell bonds in other bond markets (e.g., the London, New York, or Tokyo bond markets), it would affect the reserves of commercial banks and the money supplies in other nations more so than in its own nation. In such cases, monetary policy must rely upon reserve ratio and discount rate adjustments.

In the case of a large nation with an open economy, monetary policy is likely to be even less effective. In an open economy, the reserves of commercial banks and the money supply can be affected both by trade flows and by international capital flows. For example, if the nation experiences a favorable balance in its trade accounts (e.g., it exports more than it imports), its businesses will be receiving payments either in its domestic currency or in foreign currencies which must be converted to its domestic currency, and the effect necessarily is to expand the domestic money supply, whether the central bank wants it to expand or not. Monetary contraction would necessarily follow from trade deficits. International capital flows motivated by international interest rate, inflation rate, and income change differentials would also be expected to affect the domestic money supply, irrespective of the wishes of the central bank.

In an open economy world, the chief occupation of the central bank may become off-setting or neutralizing the domestic monetary effects of trade and capital flows so that targets may be pursued with respect to some domestic monetary aggregate. However, if the central bank in fact does this, it renders inoperable the natural adjustment mechanisms which would correct trade and capital flow imbalances. The consequence is continuing depreciation or appreciation of the nation's exchange rate vis-a-vis the currencies of other nations. Exchange rate changes may buy time to allow the nation to correct fundamental imbalances by adjusting its domestic prices and incomes, but if the central bank is neutralizing the effects of trade and capital flows on the domestic money supply, these fundamental adjustments may never occur.

The central banks of some nations occasionally take their mission to be stabilization of the nation's exchange rate, usually to prevent further depreciation. The nation's exchange rate probably has been depreciating because the nation has been experiencing deficits in its trade balance. To prevent further depreciation, the central bank must purchase its own currency from the exchange rate markets by selling its holdings of other currencies (or gold). The side effect of this is to take money out of circulation, which results in contraction of income and output in the domestic economy (because money held by the central bank is not part of the money supply). This is the medicine which is necessary to correct the conditions that led to the currency depreciation pressures.

The U.S. Federal Reserve in conjunction with the U.S. Treasury Department is authorized to intervene in foreign exchange markets:

. . . while the Treasury, in consultation with the Federal Reserve System, has responsibility for setting U.S. exchange rate policy, the New York Fed is responsible for executing foreign exchange intervention. The U.S. monetary authorities—the Treasury and the Fed—may intervene in the foreign exchange market to counter disorderly market conditions, using funds that belong to the Federal Reserve and to the Exchange Stabilization Fund of the Treasury Department.
(https://www.newyorkfed.org/aboutthefed/fedpoint/fed27.html)

Upon occasion the Fed has participated with the Treasury Department in efforts to stabilize the dollar (provide "orderly conditions") on foreign exchange markets. There have also been instances when the effort has been directed toward forcing further depreciation of the dollar in order to relieve trade deficits, and other instances when the effort has been to support the value of the dollar by preventing further depreciation. In the former case, the Federal Reserve has been in the market to sell dollars (buy other currencies); in the latter case, it buys dollars (sells other currencies). Its ability to prevent further depreciation of the dollar is the extent of its holdings of other currencies and gold.

When a monetary authority enters foreign exchange markets to buy or sell its own or foreign currencies, it foregoes the ability to exert monetary policy in pursuit of domestic goals unless the domestic and foreign exchange goals happen to align. When they don't align and primacy is given to exchange rate goals, monetary policy cannot be directed toward domestic problems, and the "tail wags the dog," i.e., the interest of the domestic economy is made subsidiary to the perceived need to stabilize or manipulate the exchange rate.

When a central bank chooses the mission of exchange rate stabilization, the so-called "Gold Standard Rules of the Game" come into play. If the currency of the deficit nation is not allowed to depreciate, then its domestic economy must experience deflation of prices and contraction of its real income and output. In this case, domestic monetary policy must force domestic economic contraction of income and employment in order to keep the exchange rate from depreciating. Currency blocs typically do not survive for long because their governments reach the conclusion that it is better to suffer exchange rate depreciation than domestic income and output contraction.

4. Central Bank Independence

There has been a good bit of "buzz" recently in the financial press about how central bank independence has been overrated and may have outlived its usefulness. Supposedly, it's becoming a hindrance to averting deflation and promoting faster economic growth. Tom Fairless, writing in The Wall Street Journal, September 11, 2016, says that

Now, some economists argue that same independence could be hampering their ability to combat the current era's problem: inflation that's too low.

(http://www.wsj.com/articles/central-banks-prized-independence-may-be-a-hindrance-in-managing-inflation-1473612711)

This may be just a matter of flushing out the truth about the touted independence of central banks. Most are not so independent of the political process as we might imagine or hope.

Using a weighted average of central bank characteristics, N. Dincer and B. Eichengren have authored a definitive study of central bank independence which reveals that the U.S. Federal Reserve is not the most independent of the world's central banks (http://www.ijcb.org/journal/ijcb14q1a6.pdf). Dincer and Eichengren find that in 2010, Australia, India, Barbados, Singapore, and Saudi Arabia all had central banks that were more independent than the Fed.

What is it that impairs the Federal Reserve's independence from the political process, particularly from the executive branch of the U.S. government? The Treasury is a department of the executive branch of the government. The Federal Reserve is a creation of the legislative branch, the Congress, which jealously guards its oversight of the Fed. The Federal Reserve is required to "report" to Congress twice a year, and Treasury officials, including the Secretary, may be invited or subpoenaed to testify before Congressional committees at any time. Both the Secretary of the Treasury and the Chair of the Federal Reserve Board of Governors sit on the President's cabinet, and earlier Treasury secretaries and Fed chairs have been known to lunch together on a regular basis to talk over mutual concerns.

The first of what would become a central bank, the Bank of England, was established in 1694, but it was hardly a central bank at its founding. Since its purpose was to act as the government's banker and debt-manager, it was certainly not "independent" of the political process. It took another three centuries for the Bank of England to grow into a proper central bank in the modern sense.

The U.S. may have had rudimentary versions of what today is understood to be a central bank in the guises of the first and second Bank of the United States. The first bank was chartered by Congress in 1791 to operate for 20 years in assisting the newly established government to manage its Revolutionary War debts. Its charter expired in 1811 after the debts had been settled, but a second bank was chartered in 1816 to assist the government with its 1812 War debts. Neither of the first two banks chartered by Congress were independent of the political process, but both banks helped to keep the fledgling U.S. commercial banking system in check by periodically presenting state-chartered banks with quantities of their own notes for redemption in specie (gold or silver). Andrew Jackson is reputed to have had an aversion to all banks after his father suffered a bank loan foreclosure that took the family farm. Jackson vetoed the second bank recharter bill in 1836 on grounds that it was unconstitutional. With no further constraint upon hundreds of state-chartered banks that over-issued multiple denominations of their own notes, chaos ensued in the U.S. banking community until the Civil War when the Treasury Department began to function as a de facto central bank.

The Treasury issued paper money, "greenback" promises to pay, to finance the Union's expenses during the Civil War. After the war the Treasury helped to constrain the excesses of commercial banks by overseeing the establishment of a national banking system and forcing withdrawal of quantities of "greenback" money that had been issued to finance the Union war expenses. But while the Treasury could buy and sell bonds (what in modern terms is called "open market operations"), it did not do so systematically in a deliberate effort to avert a number of banking panics that occurred between the end of the Civil War and 1913. To quell the chaos, the Congress passed the Federal Reserve Act of 1913 to establish a centralized banking system that would operate apart from the Treasury. It took another three decades, the "roaring twenties," the Great Depression of the 1930s, and World War II and post-war inflation during the 1940s, for the Fed to develop central banking tools and actually learn how to be a central bank.

The concept of central bank independence from the political process did not emerge until the decade of the 1960s when the idea began to be discussed in academic and political circles in regard to the need to constrain inflation by isolating the Federal Reserve from the fiscal functions of government. The point is that the world did without a central bank until 1684 in England, and then most of the rest of the world did without central banks until the twentieth century. And a second point is that the idea of central bank independence is no more than about a half-century old. Current thought is that since central banks got along without political independence until the late-twentieth century, perhaps it is now time to review the usefulness of independence.

Joachim Fels, a managing director and global economic advisor who co-leads PIMCO's quarterly Cyclical Forum, has authored an influential essay in which he critiques the Fed's seeming inability to deal with twenty-first century deflation and debt overhangs:

Independence from government and the political process is obviously helpful when the main enemy is high inflation, as it enhances a central bank's credibility and helps monetary policymakers do tough things without political interference. But what happens when the main enemy is not inflation, but deflation, debt overhangs and financial crises – in other words, the world since 2008? Critics point out how the need or desire to defend their independence often hinders central banks from swiftly addressing these problems in the most direct and effective way (say, helicopter money or overt lender-of-last-resort action to underwrite troubled financial institutions or sovereigns). Instead, independent central banks have had to deploy second-best interventions such as quantitative easing (QE) or negative interest rate policy (NIRP), which distort financial markets and can have severe distributive consequences.
(https://www.pimco.com/insights/economic-and-market-commentary/macro-perspectives/the-downside-of-central-bank-independence)

Fels proposes that the Fed bypass the financial sector and directly implement fiscal stimulus, a policy that until now has been reserved for the exclusive authority of the Treasury:

. . . central banks could bypass the entire financial sector by endowing the government directly with freshly created money (e.g., crediting the Treasury's account at the Fed) that the government could then distribute to the public through tax-rebate checks or increased public spending – helicopter money. This could be a much more direct and effective way to overcome a demand deficiency and raise inflation expectations than using QE to remove financial assets that are in high demand (i.e., government bonds or high quality corporate bonds) or embarking on NIRP, which is an experiment with an uncertain outcome.

Nobel Economic Prize winner Christopher Sims asks,

Can fiscal deficit finance replace ineffective monetary policy in these conditions? Fiscal expansion can replace ineffective monetary policy at the zero lower bound, but fiscal expansion is not the same thing as deficit finance. It requires deficits aimed at, and conditioned on, generating inflation. The deficits must be seen as financed by future inflation, not future taxes or spending cuts. (https://www.kansascityfed.org/~/media/files/publicat/sympos/2016/econsymposium-sims-paper.pdf?la=en)

Given the long world history of trying to constrain inflation, it's ironic that we are now talking about the need for generating inflation during a short period when deflation threatens. Also, there may be a confusion over cause and effect. Inflation is an effect of excessive money supply issue when an economy is growing, not a cause of growth. In fact, in order to assess the amount of real economic growth measured in terms of GDP, the inflation component must be netted out. It is thus a misconception to construe an inflation target as a goal of monetary policy. Shifting monetary policy away from trying to constrain inflation and toward generating more of it may be like playing with matches.

Sims believes that the world has made a transition from inflation and rapid growth to deflation and slow growth:

The main problems today, and most likely also over our secular horizon, are continuing disinflationary or even deflationary global forces, public and private sector debt overhangs and the potential for new financial crises. Many observers ask whether central banks have exhausted the capacity of the ordinary and extraordinary policy tools they have deployed since the financial crisis.

Sims makes a case for a hybrid fiscal-monetary policy approach:

The fiscal theory of the price level does not, therefore, simply replace the notion that the quantity of money determines the price level with the idea that the quantity of government debt, or the sequence of nominal deficits, determines the price level. It implies that interest rate policy, tax policy, and expenditure policy, both now and as they are expected to evolve in the future, jointly determine the price level.

A realistic assessment leads to the conclusion that central banks in North America and Europe already have been doing what Fels and Sims advocate. The U.S. Federal Reserve has been indirectly accommodating the Treasury's need for additional liquidity since the 2008 Great Recession as the U.S. government has run tremendous deficits that have added to the U.S. public debt. Similar experiences have occurred in many European nations. The problem is that the additional liquidity has been used by governments mostly for social programs (redistribution, health, and welfare), and too little for stimulating investment, employment, and income generation.* There is little reason to believe that "helicopter money" provided to the Treasury by the Fed will be used any differently by the Congress than it has been used in recent experience.

Conferring fiscal authority upon the central bank may serve to alleviate short-run exigencies, but at the expense of long-run peril. It challenges credulity to think that the world now has made a permanent transition from inflation and rapid growth to deflation and slow growth, and that inflation will never again be a problem. World economic growth almost certainly will pick up again. The U.S. already is enjoying mild but steady growth and increasing employment, and growth in many "emerging market" countries is haltingly but surely alleviating poverty and improving overall well-being of their populations. Eventually, interest rates will return to capital-scarcity rate normals, and inflation will return in response to the huge amount of liquidity now "sloshing about" in the world's financial markets. But the treasury-central bank hybrid will by then be in full swing, and it may not be possible to break governments from demanding helicopter money any time they perceive that they "need" it.

Suppose that countries do enable a fusion of monetary and fiscal policies to deal with slow growth and actual or potential deflation. Will they have uncorked a monster Gini that cannot be put back into the bottle when inflation again "rears its ugly head?" And what then will be the need for central banks? Why not simply confer the money-creating authority directly upon the Treasury as during the Civil War era?

Why not? Because government officials throughout the world will find that they can expand their expenditures at will, financing them without the messy business of collecting taxes, simply by using the bookkeeping procedure of crediting their treasuries' accounts with any amounts of new money needed. How can anyone possibly believe that inflation is a phenomenon of the past, never to be experienced again?

With a central bank that is at least nominally independent of the political process and the fiscal function of government, there is some possibility and hope of restraining monetary growth and curbing the worst excesses of inflation. This of course depends entirely upon the knowledge, integrity, sense of public responsibility, and good will of those who are appointed to the governing board of the central bank.

5. The Fed's Independence

Kate Davidson, writing in The Wall Street Journal, February 1, 2017, says that

Last year, as the Senate prepared to vote on a bill to audit the Federal Reserve's interest-rate decisions, Janet Yellen picked up her phone and called Capitol Hill. Over two days, the Fed chairwoman spoke with five Republicans, some of whom she had never met privately since taking over at the central bank, according to her public calendar. She stuck to a script she had delivered many times, said a person familiar with the calls: The bill could allow politicians to interfere with Fed policy; academic studies show countries with independent central banks have lower inflation; the Fed is already audited. Ms. Yellen didn't persuade them. Though the Senate voted not to move forward with the bill—a relief for the Fed—only one of the chamber's 54 Republicans voted in the Fed's favor.
(https://www.wsj.com/articles/janet-yellens-uneasy-new-role-defending-the-fed-from-historic-political-pressure-1485966696)

Macroeconomists basically are of two opinions about the stability of a mixed market economy like that of the U.S.: either it contains within itself adequate automatic mechanisms for self-correction when shocked and needs no outside intervention, or it is fundamentally unstable and requires intervention by government to limit instability and sustain growth. As a legacy of Keynesian theory introduced in the 1930s, many (most?) macroeconomists today are persuaded of the need for intervention, and most governments have adopted the view that intervention is needed to stabilize their economies.

There are two branches of macropolicy, fiscal and monetary. In democratic polities, fiscal policy, government's activity with respect to taxation, spending, and budget control, has an inherent inflationary bias. Rather than implementing policy in the interest of macro stability, democratically elected governments, in financing the programs that they legislate, have a propensity to run chronic budgetary deficits.

This implies that the best hope for countering the fiscal inflationary bias is to have a wise monetary authority that will exercise prudence in control of the money supply to counter the fiscal profligacy. And lately, the government of the United States has abdicated the function of macroeconomic stabilization almost completely to its monetary authority, the Federal Reserve. Questions center about whether a "wise" person or group can be found to execute monetary policy in the interest of economic stability, whether such an authority should be elected or appointed, the extent of powers accorded to the monetary authority, and whether the public and their elected representatives can trust the wise authority.

In the U.S. we have opted for the President to appoint a group, the Federal Reserve Board of Governors, to exercise monetary authority in the interest of U.S. macroeconomic stability. The empowering legislation, the Federal Reserve Act of 1913, and subsequent convention have established a preference for the Federal Reserve to be as independent of the political process as possible. Most presidential administrations since 1913 have respected at least a facade of Fed independence. However, other central banks have been found to be more independent of the political processes in their respective nations than is the Fed in the U.S.

Davidson goes on to note that the nominal independence of the Fed now is being debated:

Once revered as the masterminds of the U.S. economy, Fed policy makers now face the most intense political scrutiny in a generation. The path of monetary policy, which is emerging from a decade of basement-level rates, is being debated in the political arena in a way not seen since the Paul Volcker era in the 1980s.

Davidson notes that Fed independence now may be under threat:

The new president thrust Ms. Yellen and the Fed onto the national political stage by criticizing them sharply during the campaign, and his election raised expectations that GOP bills to rein in the central bank could become law.

It is debatable (and currently debated) whether any of the recent Federal Reserve boards have functioned satisfactorily to moderate the instability of the U.S. economy. But the crucial aspect that militates in favor of preserving at least a modicum of independence of the Fed from the political process is the possibility of constraining the inherent inflationary tendency of the fiscal function of government to run budgetary deficits.

Between the so-called "Great Recession" of 2008 and 2014, in an effort to stimulate economic growth the Treasury Department of the U.S. government ran budgetary deficits that increased the U.S. public debt from just under $9 trillion to nearly $18 trillion (http://www.usgovernmentdebt.us/). During this same period, the Fed purchased from the open financial markets more than $4 trillion of Treasury bonds and mortgage-backed securities. These security purchases by the Fed effectively monetized a substantial portion of the increase of the government debt.

The Fed's willingness to accommodate Treasury debt financing suggests that the independence of the Fed from the political process has been severely compromised. If legislation were introduced to "clip the wings" of the Fed, there would be little to constrain the ability of an administration to finance any spending programs.

6. Rules vs. Discretion in Monetary Policy

The debate over rules vs. discretion in monetary policy has flared again. Minneapolis Federal Reserve Branch President Neel Kashkari, writing in The Wall Street Journal, December 18, 2016, says

After extraordinary actions by the Federal Reserve during and following the Great Recession, including quantitative easing programs and record low interest rates, some economists are calling for the Federal Open Market Committee to mechanically follow a simple rule in conducting monetary policy. As a regional Fed bank president and member of the FOMC, I believe this would unduly limit the Fed's policy tools and ultimately harm the economy and in turn employment. The idea is to effectively turn monetary policy over to a computer, rather than continue to let Fed policy makers use their best judgment to consider a wide range of data and economic trends. (http://www.wsj.com/articles/a-computer-cant-do-the-feds-job-1482098343)

Kashkari focuses his concern about such a rule on that proposed by John Taylor:

The classic example of such a rule is the one proposed by Stanford economist John Taylor more than 20 years ago. The “Taylor rule,” as it's widely known, calculates a desired level for the federal-funds rate based on measures of inflation and economic output.

Kashkari acknowledges the potential benefit of following a monetary rule:

In theory, stringently following simple rules has the potential to reduce policy uncertainty and unnecessary market volatility, increase the Federal Reserve's credibility in pursuing its dual mandate and reduce potential vulnerability to political pressure.

But he asserts the inability of such a rule to achieve economic stability in an environment of dynamic change:

Over the past 25 years the world has seen extraordinary technological innovations, the rise of China, the creation and strains of the eurozone, the financial crisis and U.S. inflation falling from around 4% to less than 2%. No simple algebraic formula can take into account such a dynamic global economy.

And Kashkari asserts the need for the exercise of human judgment in the application of monetary policy:

As part of its process to determine appropriate monetary policy, the FOMC consults rules such as the Taylor rule to see what they recommend. But ultimately we use judgment and historical precedence to decide if that guidance makes sense given other important economic trends that rules don't consider.

John Taylor has taken exception to Kashkari's position. Writing in The Wall Street Journal, December 20, 2016, he says:

. . . in a recent Journal op-ed, Neel Kashkari, president of the Minneapolis Fed and the newest member of the Federal Open Market Committee, joined the debate by arguing against rules-based reform. Those in favor of reform, he said, want the Fed to “mechanically follow a simple rule” and “effectively turn monetary policy over to a computer.” This is a false characterization of the reforms that I and many others support. In those reforms the Fed would choose and report on its strategy, which would neither be mechanical nor run by a computer.
(http://www.wsj.com/articles/the-case-for-a-rules-based-fed-1482276881)

Taylor also assets the flexibility of a rules-based policy like he proposes:

Mr. Kashkari . . . argues that a rules-based approach would shackle Fed policy makers, forcing them to “stick to” a rigid rule “regardless of economic conditions.” That too is false. The Fed could change or deviate from its strategy if circumstances changed, but the Fed would have to explain why. And he wrongly claims that rules cannot take account of changes in productivity growth.

Both positions seem to me to be problematic. As Taylor notes, the discretionary manipulation of interest rates and the quantity of money in circulation did not fare well during the so-called "Great Recession":

During the panic in the fall of 2008, the Fed did a good job in its lender of last resort capacity by providing liquidity and by cutting the fed-funds rate. But then the Fed moved sharply in an unconventional direction by purchasing large amounts of Treasury and mortgage backed securities, and by holding the fed-funds rates near zero for years after the recession was over. These policies were ineffective. Economic growth came in consistently below what the Fed forecast and much weaker than in earlier recoveries from deep recessions. Such policies discourage lending by squeezing margins, widen disparities in income distribution, adversely affect savers and increase the volatility of the dollar. Experienced market participants have expressed concerns about bubbles, imbalances and distortions.

But the rule-based specification of the desirable Federal Funds rate is unnecessary if all the Open Market Committee is trying to do is track the natural rate of interest as noted by Jason Douglas and Jon Sindreu, writing in The Wall Street Journal, December 11, 2016:

Central bankers respond that their policies are merely tracking changes in the so-called natural rate, an interest rate determined by powerful economic impulses.
(http://www.wsj.com/articles/central-bankers-zeal-for-the-natural-rate-draws-skeptics-1481476667)

The compulsion felt by central bankers to pursue the elusive natural rate betrays a Keynesian-like skepticism and mistrust of the financial markets to track the natural rate by themselves. Also, the FOMC often (usually?) delays changing the Federal Funds target rate until market pressures are already palpable. In this sense, then, the financial markets are in fact tracking the natural rate and the FOMC is only tracking market rates after an expected FOMC change of the Federal Funds rate target has been "priced in." The Fed follows the market rather than leads it.

The discussion of rule-based monetary policy has shifted from an annual percentage increase of the money supply as first proposed by Milton Friedman, to a proxy for it in the form of a desired level of the Federal Funds rate as proposed by Taylor. In Taylor's version, the desired target Federal Funds rate, even if adaptive to changing conditions, must be pursued by manipulating the money supply to nudge market interest rates toward the target. But the manipulation of the Federal Funds rate computed by an adaptive rule and the manipulation of the money supply to induce market rates to converged upon the desired rate can also accentuate cyclical behavior of the economy because of long and unpredictable response lags in the economy.

The logic of a monetary rule is based on the premise that a growing economy needs more money to facilitate the conduct of commerce. Monetary and banking history is replete with episodes of deflation when the money supply (global or local) has increased too slowly. In these episodes of deflation, commercial and industrial activity has been inhibited. Monetary and banking history has also shown that when money supplies increase too rapidly, inflation has been the result.

So, what is the "right" rate at which the money supply should increase? Milton Friedman postulated in 1960 (A Program for Monetary Stability, New York: Fordham University Press) what has become known as Friedman's k-percent rule. Friedman asserted that the money supply should be increased at a fixed rate, year-in and year-out, with no allowance for cyclical behavior of the economy. The fixed rate of monetary growth, or k-percent, should be equivalent to the sustainable rate of real growth of the economy as evidenced by historical experience.

The k-percent rule stipulated as the rate of real growth of the economy would exhibit countercyclical characteristics. When the economy starts to expand faster than the sustainable (and historical) average rate of real growth, the money supply would continue to increase at only the historical average rate of real growth, and thus dampen the excessive growth and not feed inflationary expectations. When the economy starts to expand more slowly than the sustainable historical average rate of real growth, the money supply would continue to grow at the historical average rate of real growth, and thus would stimulate the economic growth rate to return to the historical average rate of real growth.

The best argument for the exercise of human discretion in implementing monetary policy is that it may be needed to offset inconvenient changes in the "velocity of circulation" of the money supply (i.e., the rate at which the money supply is being spent). Although monetary data suggest that velocity is fairly stable, it may vary over the course of the business cycle, and it could possibly be instrumental in precipitating directions of change in the level of economic activity. Even if the money supply were to increase steadily at a k-percent rate per annum, improvement in the outlooks of investors and consumers may increase velocity and cause or accelerate an expansion. Likewise, emerging pessimism in the minds of investors and consumers may cause velocity to decrease, thereby precipitating or worsening an economic downturn.

With sufficient perception and understanding of how velocity may be changing, the FOMC might try to make off-setting changes in the Federal Funds rate target or in the rate of monetary expansion to counter variations in velocity. Militating against this argument is that changes of velocity may be identified only months or quarters after the fact of change. It may be difficult to make timely off-setting adjustments to the rate of monetary expansion that do not aggravate economic instability by impacting the economy after a direction of change has already occurred.

The money supply, its velocity of circulation, and the price of money should be virtually invisible elements (i.e., part of the economic landscape) of the economic system, not objects of manipulation by policy makers who must demonstrate that they are doing something when variations in the level of economic output occur. Assuming that velocity is sufficiently stable, rigidly adhering to a k-percent rate of growth would

relieve monetary policy makers of the responsibility to try to manage the money supply in the interest of economic stability;
prevent monetary authorities from engaging in excessive ("knee-jerk") responses in either direction of the sustainable and historical average rate of growth;
not feed the fires of hyper-inflation like that suffered in Germany after the First World War;
provide on-going but not excessive stimulus to the economy during downturns; and
ensure enough money in circulation to meet the needs of commerce and industry in a growing world economy, both to avert deflation and without fostering inflation.

And, the k-percent can be adjusted for a desired amount of inflation. For example, if the sustainable rate of growth of the economy is thought to be 3 percent per annum and a 2 percent rate of inflation is desired, the money supply should be increased by 5 percent per annum. But this assumes that the rate of spending of the money supply remains approximately constant.

It must be acknowledged that for either human discretion or a monetary rule to function satisfactorily, the economy should be operating in an environment of political stability where political authorities are tolerant of market mechanisms, regulation of economic activity is moderate, and political policies are predictable and enforcement is certain. It may be debated whether the U.S. economy in the early twenty-first century exhibits such characteristics. If not, the members of the FOMC will be sorely tempted to override any monetary rule that nominally is being followed. Kashkari acknowledges as much when he says that

If the FOMC were to make exceptions, even rarely and with good intentions, most of the benefits of mechanically following a rule would be lost. Uncertainty and volatility would return as soon as discretion re-entered the equation.

The rules vs. discretion debate has gotten side-tracked to a focus on specifying the price of money rather than the quantity of money in circulation. The debate should be redirected to the efficacy of human discretion vs. some form of a k-percent rule for increasing the money supply. To make a discretionary approach workable, the FOMC's wings need to be severely clipped. In the case of a k-percent rule, the FOMC should be disbanded. My sense of the issue is that a strict k-percent monetary rules approach likely would be superior to human discretion in providing stability to the economic system through predictable increases of the money supply and market determination of interest rates.

7. Rules-Based Monetary Policy

Donald Luskin, writing in The Wall Street Journal, February 16, 2017, notes that

During a January speech Ms. Yellen seemed to argue that rules-based monetary policy won't work. Yet the Fed's make-it-up-as-you-go approach clearly isn't successful, having neither supported satisfactory growth after the Great Recession nor achieved the central bank's inflation target. Yet for whatever reason, Ms. Yellen and other officials have been moving the Fed subtly over the past year toward what amounts to a policy rule.
(https://www.wsj.com/articles/yellen-gives-conservatives-something-to-cheer-1487290524)

Luskin describes how a Yellen rule might work:

. . . the new rule goes something like this: Interest rates should be set at the level that the market would produce by itself if the Fed didn't exist. . . . . It would, in the end, effectively reduce the Fed from an all-powerful economic meddler to a mere clearing house for banking-system reserves.

As "if the Fed didn't exist"? Does the Emperor not realize that he (or she) has no clothes? Why is it necessary for a monetary authority to "set" a rate that the market would reach by itself anyway? Why even have a monetary authority that only attempts to emulate what the financial markets would do if it did not exist? The delays entailed in recognition, action, and reaction time lags can render Fed policy actions disruptive of natural stabilizing forces resident in the economy. Indeed, policy actions may actually aggravate economic instability. Economic stability may well be served by restricting the Fed to being "a mere clearing house for banking-system reserves" and providing a money supply adequate to the needs of a growing economy.

Luskin relates the rule that Ms. Yellen may be moving the Fed toward to one espoused by a nineteenth century economist:

. . . Ms. Yellen's rule is a classic: Swedish economist Knut Wicksell, writing in the late 19th century before the Fed was founded, imagined an interest rate that would exist in a world without central banks, which he dubbed the “natural rate.”

It may be argued that Wicksell's natural rate corresponds to the "scarcity rate" in any region which is a measure of the scarcity of capital in the region relative to the demand for it. If allowed to vary freely, yield rates on long-term, essentially riskless bonds (e.g., 10-year U.S. government bonds) should approximate the scarcity rate which changes with the supply of real capital in the region relative to the demand for it.

Luskin describes how the natural rate might be discerned by a central bank,

. . . but how can the Fed know what the natural rate is, since the world is not really Fed-free? Wicksell's answer was simple: inflation. If the interest rate set by policy is below the natural rate, then too much credit will be created and it will show up as inflation. That's how to know that the Fed can raise rates a little.

and how Wicksell's rule might work during the Yellen era:

. . . if [the Fed follows this rule with gradual change], . . . the Fed won't kill the expansion by tightening. Seen in the context of the natural-rate rule, these gradual increases wouldn't be tightening at all. The Fed would merely be tracking the natural rate higher as the economy shifted to a faster-growth footing.

There is no point in the Fed tracking the natural rate if that's what financial institutions are doing anyway with their normal market transactions.

Luskin mentions John Taylor's monetary policy rule, but notes that contains a "fatal flaw":

There are other rules that could be considered. Stanford's John Taylor has introduced a much-discussed rule and argued persuasively on these pages that his formula would have kept the Fed from holding rates too low for too long in the mid-2000s, a policy that inflated the housing and mortgage bubble. But Mr. Taylor's idea has a fatal flaw common to most rules. The economic variables that go into it must be calibrated somehow, and then recalibrated somehow at intervals determined somehow as the world changes in unanticipated ways.

The concern about Taylor's rule is that it focuses on a proxy for the quantity of money, i.e., it would require manipulation of the money supply to pursue the interest rate that would avert excessive inflation or deflation. This amounts to an indirect "Rube Goldberg" type of control mechanism, e.g., tossing rocks to splash the water in hopes that ripples will move a boat in the desired direction. Why not just follow a money-supply rule?

Luskin omits reference to Friedman's k-percent rule that the money supply should approximately match the actual or desired rate of real growth of the economy (the "k-percent"). This rule, also discussed in the same 2016 comment, would have anti-cyclical (as well as anti-inflationary and anti-deflationary) properties, but it would not require recalibration for changing circumstances. Indeed, recalibration for changing circumstances would subvert its function to alleviate excessive contraction or expansion of the economy.

These considerations suggest that a revisiting of more fundamental questions about the nature, mission, powers, and tactics of a central bank might be needed.

David Harrison, writing in The Wall Street Journal, April 2, 2017, says that

The financial crisis and its aftermath shifted the consensus. Instead of high inflation, today's central banks are confronted with aging populations, lower long-term growth and higher saving rates. Those all hold down the real natural interest rate--the equilibrium interest rate, adjusted for inflation, that keeps borrowing, lending and the broader economy in balance.

A very low natural rate is a problem for central bankers, who manipulate short-term interest rates to manage their economies. When the economy heats up, they push rates higher to slow it down. When the economy slows down, they cut rates to speed it up.
(https://www.wsj.com/articles/rethinking-the-widely-held-2-inflation-target-1491138003)

We must take issue with both of these statements. It is the increasing supply of real capital relative to the demand for it in a region that holds the real natural rate (i.e., the "scarcity rate" of return) down, not population ageing, lower long-term growth, or higher saving rates. Growth and saving rates may respond to changes in short-term market interest rates, but it has not been shown definitively that central bank efforts to manipulate short-term market rates have succeeded in either speeding-up or slowing-down an economy's pace of real growth. Rather than causing short-term market rate changes, the Fed often changes its discount rate and target Federal Funds rate in response to changes in financial markets (whose traders already have "priced-in" expected rate changes), thereby following rather than leading the market.

8. Targeting Price or Quantity for Monetary Policy

In a game of billiards, a player may attempt to sink a ball in a side or corner pocket by hitting it with another ball that is poked by a pool cue in just the right direction and with just the right force. This is a difficult and lengthy "transmission mechanism" that often fails to achieve its goal.

On analogy, a central bank may attempt to achieve an economic growth or a price inflation goal by attempting to poke an interest rate target and hoping that in turn it will hit the economic growth rate or price inflation goal. This is also a lengthy and complex transmission mechanism that cannot be relied upon to achieve its goal. How can the central bank go about poking the interest rate target in just the right direction and with just the right force?

David Harrison, writing in The Wall Street Journal, April 2, 2017, says that

Central bankers, spooked by inflation spikes during the 1970s and early 1980s, had come to view targets as a core tenet of sound monetary policy. In the 1990s and 2000s, many picked a 2% target, seeing it as not so high that it would disrupt business decisions and wage negotiations, and not so low that it would make interest rates unmanageable.
(https://www.wsj.com/articles/rethinking-the-widely-held-2-inflation-target-1491138003)

One of the basic principles of Econ 101 demand-supply analysis is that a market participant may set the price at which he desires to sell his product, but then he must accept the quantity sold as a consequence. Alternately, he can choose to set a quantity (e.g., he can dump his entire production run onto the market), but he will then have to accept as consequence the market price. He might try to achieve either a price or a quantity goal by manipulating his quantity or price, but he can't control both price and quantity to his satisfaction apart from market realities. If he doesn't set his price just right, he will experience either inventory depletion or accumulation.

Does it work any better for a bureaucratic official to set either a market price or to determine the quantity that may be sold on a market? Historical experience has demonstrated time and again across many product markets under various political regimes that efforts to set prices by administrative fiat at levels above or below market-determined prices have caused persistent surpluses or shortages.

Does this principle also apply to central bank monetary policy? Federal Reserve officials don't advocate that any other office of government attempt to set product market prices, but they persist in the belief that administrative determination of short-term interest rates is the way to influence the level of economic activity or the rate of inflation. Short-term interest rates are market-determined prices; the Fed's discount rate and the Federal Funds target rate are administered prices.

As we have seen over the past several years, the Fed's announcement of a short-term interest rate target that differs from market rates is unlikely to draw market interest rates to the target without further action to manipulate the supply of money. This suggests that a more direct monetary policy "instrument" may be a quantity of money rather than the price of money.

As difficult as it might be to manipulate an instrument variable like a short-term interest rate, the lengthy and complex transmission mechanism makes it even more difficult to achieve a price or growth rate goal. In the eight years since the so-called "Great Recession" of 2008, the U.S. economy has continued to be sluggish with a real growth rate below 2 percent per annum. The U.S. CPI inflation rate has lingered below the Fed's announced goal of 2 percent per annum.

To induce the inflation rate to approach its announced goal, the Fed attempted to enable increased commercial bank lending by increasing bank reserves with three episodes of "quantitative easing" between 2008 and 2015. But in an environment of fear, anxiety, and pessimism, the Fed couldn't force bankers to lend or prospective borrowers to borrow. Most of the increased liquidity ended up in commercial bank excess reserves and business cash hoards rather than in circulation to stimulate spending.

In setting its target interest rates below market rates, the Fed also has attempted to manipulate the demand for money in order to stimulate borrowing for consumption or investment purposes. We've seen how well that has worked over the past eight years since the Great Recession.

9. Tracking the Natural Rate

Jason Douglas and Jon Sindreu, writing in The Wall Street Journal, December 11, 2016, say that

Central bankers respond that their policies are merely tracking changes in the so-called natural rate, an interest rate determined by powerful economic impulses. They contend this rate has fallen precipitously over the past 30 years as the result of tectonic shifts in the global economy, such as aging populations, a rising glut of savings and slowing productivity growth. This decline, they say, is the primary driver of collapsing borrowing costs across the advanced world.
. . . .
The idea of a natural rate was developed in the 19th century by Swedish economist Knut Wicksell, who described how capital investments—like machines or factories—produce a natural rate of inflation-adjusted returns. When banks offer loans below this rate, companies go on a borrowing binge and drive inflation up. If borrowing is costlier than this return on investment, businesses will slash outlays and unemployment will rise.

Central bankers today have adapted this thinking in pursuit of their goals. By shadowing their estimate of the natural rate, they hope to keep inflation stable and the economy growing at its full potential. Undershoot the rate and they aim to spur faster growth and inflation. Overshoot it and the economy and price rises should slow.
(http://www.wsj.com/articles/central-bankers-zeal-for-the-natural-rate-draws-skeptics-1481476667)

Wicksell's concept of the "natural rate" of interest corresponds to the "scarcity rate" of interest that is determined by the supply of real capital relative to the demand for it. If the natural rate has indeed come down over the past 30 years, it has not been due to what Douglas and Sindreu identify as "tectonic shifts in the global economy," but rather because the stocks of real capital in developed and financially mature countries have increased with positive net investment, resulting in diminishing returns to capital. Lower rates of economic growth are not causes of falling natural rates of interest, but rather consequences of the declining marginal productivity of capital stocks that have increased relative to labor supplies.*

In their principles of economics courses, economists describe the various self-adjusting and self-equilibrating mechanisms that are integral to a market economy. The Keynesian response to the so-called "Great Depression" of the 1930s decade cast suspicion upon the efficacy of these mechanisms to adjust to changing conditions. The very fact that "Central bankers today have adapted [Wicksell's] thinking in pursuit of their goals" by shadowing or tracking their estimate of the natural rate betrays a residual of the Keynesian suspicion that the automatic mechanisms built into the economy are not working, or don't work well or fast enough.

If central bankers are postulating their monetary policies on tracking or shadowing the natural rate of interest, then what's the point? One is led to wonder why they don't simply let market interest rates naturally adjust to the natural rate. This may happen anyway since central bankers often delay changing their administered-price lending rates (e.g., the Federal Reserve's "discount rate") until market rate pressures for a change are already palpable, i.e., they "price in" their expectations of a near-future rate change. When they do this, central bankers are simply following the market rather than leading the market or managing market interest rates.

In order to affirm their raison d'etre and credibility, central bankers must be seen by their publics and the governments of which they are a part as doing something in response to changing economic conditions. So, tracking or shadowing the natural rate of interest is perhaps the most innocuous thing that they can do to serve this need. If all central bankers are doing is tracking or shadowing what is happening naturally in their economies, they are at least not disrupting their economies. However, if in their quests to "manage" their economic processes they do induce market rates of interest to diverge significantly from the natural rates in their regions, there is a good chance the central banks themselves are sources of disturbance rather than promoters of economic stability and growth.
____________

*While natural rates of interest may be lower in more developed parts of the world that are capital-abundant, we should expect natural rates to be higher in lesser developed regions of the world that are capital-scarce relative to local demands for capital. The marginal productivities of new capital investments would be higher in such regions, inviting "offshore" investments in those regions by firms located other regions with more abundant capital and thus lower marginal productivities of capital.

10. Hoarding and Monetary Policy

Jon Sindreu, writing in The Wall Street Journal, March 6, 2017, says that

No number is more important for investors right now than inflation. . . . Yet investors are in a quandary: Theories used to forecast it just don't seem to work.
. . . .
. . . the last several years of extraordinary monetary policy have shaken a theory that had held sway for decades in financial markets: American economist Milton Friedman's view that inflation is ultimately a function of how much money a central bank prints.
(https://www.wsj.com/articles/everything-the-market-thinks-about-inflation-might-be-wrong-1488796206)

If the underlying theories no longer seem to work, then monetary policy based upon them is likely to be ineffective as well. Monetary policy should be targeted upon a monetary aggregate rather than an interest rate. A rate-based monetary policy focuses on a proxy for the quantity of money, i.e., achieving the interest rate that would avert excessive inflation or deflation would require manipulation of the money supply to pursue it.

Milton Friedman's explanation of inflation can be expressed by the so-called "equation of exchange" identity, M x V = P x Y, where M is the money supply, V is the velocity of circulation of money, P is the price level, and Y is the aggregate real output of the economy. The expression P x Y represents the value of aggregate output denominated at current market prices. A variation of the identity can be expressed as P = (M x V) / Y.

Delta (Δ) symbols may be inserted before each of the terms in these expressions to represent changes of the respective variables, e.g., ΔP = (ΔM x ΔV / ΔY. Supposing that velocity is approximately constant and the real output is at full employment (i.e., it cannot increase), it is obvious that the price level must vary with changes of the money supply, i.e., ΔP = f (ΔM), all else constant. Rather than an identity, this is an equation that implies causation.

Inflation (or deflation) occurs as P changes between two points in time, e.g., ΔP = (P₂ - P₁). The rate of inflation (or deflation) may be expressed as the percentage change of P between the two points in time, e.g., %ΔP = (P₂ - P₁) / P₁.

A further supposition, but one that is not explicit in the identity, is that increases of the money supply actually will be spent (rather than hoarded) due to the phenomenon of the diminishing marginal utility of money balances as they accumulate.

If Y is below full employment, an increase of either M (if not hoarded) or V might be expected to stimulate Y to increase toward full employment without causing P to rise until full employment is approached. P may begin to rise more rapidly and Y to increase less rapidly as full employment is approached. Empirical evidence indicates that V is relatively constant, so variation in M is thought to be the instigating factor in any change of Y or P. This is the basis for the presumption that M (rather than an interest rate) is the appropriate vehicle for implementing monetary policy.

Sindreu also notes that

. . . economists who study central-bank operations broadly believe that the amount of money created is a consequence of rising prices, not the cause. That is, if the price of apples goes from $1 to $2, the central bank will eventually need to issue more money to prevent money from getting scarce and interest rates from skyrocketing.

This suggests an alternate version of the identity: ΔM = (ΔP x ΔY) / ΔV. Again, if Y and V are approximately constant, the implication is that the money supply must change with the changing price level, and in the same direction. This won't be expressed as a functional relationship because the underlying causation is a matter of administrative fiat rather than market response.

Evidence in support of the functional relationship between the price level and the money supply can be found in numerous historical episodes of inflation that followed unprecedented increases of money supplies. The U.S. Civil War brought a nearly decade-long period of inflation as the Union Treasury Department issued copious amounts of "greenback" currency to finance the war. Perhaps the most notorious episode of inflation is the German hyperinflation following astronomical monetary increases during the 1920s. More recent episodes of inflation attributable to monetary expansion have occurred in Zimbabwe, Venezuela, Argentina, and Brazil. However, recently economists and central bankers have been looking for explanations of non-inflation rather than inflation.

There are recent episodes of deflation attributable to scarcity of money. A decade-long period of deflation ensued after President Andrew Jackson vetoed the Second Bank recharter bill in 1836 and had all government funds moved from commercial banks to the U.S. Treasury, thus taking money out of circulation. A twenty-year period of deflation began after the Civil War when the Treasury Department in 1870 implemented a process intended to restore convertibility of the dollar into gold by withdrawing much of the greenback currency that had been issued during the war.

Sindreu adds,

Yet, after the 2008 crisis hit, central banks in developed economies slashed interest rates and printed trillions of dollars, euros, pounds and yen. Many investors and policy makers believed inflation—and a selloff of government bonds—would soon follow.

But the expected inflation did not follow. The facts that inflation did not ensue and bond prices did not fall do not invalidate the equation of exchange identities, but they only reveal the effects of changes of things that were assumed constant but did not remain so. The two most critical factors in attempting to explain non-inflation appear to be the unexpected hoarding of cash by businesses and commercial banks, and the identities of the particular prices that have risen.

Why did the massive increases of the U.S. money supply brought about by the episodes of Quantitative Easing during 2009-2014 have so little impact on the U.S. consumer price level? The equation of exchange identity may be modified to indicate that M refers to the net amount of the money supply in circulation, i.e., that which is spent and not hoarded by businesses and commercial banks. Letting the amount of hoarded money be represented by the symbol H, the monetary identity may be expressed as P = ((M - H) x V) / Y. If V and Y are effectively constant, the functional relationship may be represented as ΔP = f (ΔM - ΔH). This implies that if ΔH = ΔM, then (ΔM - ΔH) = 0 so that any money supply increases will go into cash hoards and have no effect on the price level. This seems to be what the U.S. has been experiencing in the wake of the Great Recession. We should also note that if ΔH > ΔM, then (ΔM - ΔH) < 0, i.e., the net increase of the money supply will be negative and portend deflation even as ΔM is positive.

If not monetary expansion, then what does cause inflation? Sindreu notes a couple of old-favorite non-monetary explanations of inflation:

Before the 1980s, many economists described inflation as coming from a complex mix of sources. Companies nudged up prices when their input costs were higher—"cost-push" inflation—or when shelves were depleted by booming sales—"demand-pull" inflation.

Indeed, increasing demand may try to "pull" up prices, and increasing costs may try to "push" up prices, but neither force can have lasting effects on the price level or the rate of inflation if not accompanied and supported by a commensurate increase of the money supply (ΔM) or an increase in the rate at which the money supply is being spent (ΔV). The pull and push forces may provide the impetus to inflation, but they will not last long without supporting money supply expansion or acceleration that ratifies and makes effective the pull and push forces. Without a ratifying monetary expansion or acceleration, the incipient pull and push forces will dissipate and cause the economy to fall back into stagnation, or worse into unemployment and contraction.

What might restore the traditional functional relationship between the price level and the money supply, and hence the efficacy of monetary policy focused upon a monetary aggregate? The more-focused question is what might motivate banks and businesses to free-up their excess reserves and cash hoards to enable lending and investment? The most crucial factor seems to be the alleviation of the pessimism and uncertainty that has depressed real markets through much of the time since the Great Recession. The overhang of the QE monetary expansions between 2008 and 2015 stimulated output to increase slowly toward full employment during third longest period of expansion in the post-WWII era, and inflation approached the target preferred by the Federal Reserve.

11. Monetary Policy and Consumer Spending

A common presumption is that monetary policy executed by the Federal Reserve in the United States will have its primary effect on interest rates, and thus on interest sensitive transactions such as business investment spending, home mortgages, and motor vehicle purchases. But there is reason to suspect that changes of the money supply can have a more direct impact on consumer spending and hence on prices.

A central bank cannot directly control its nation's money supply. The money supply (i.e., the quantity of money in circulation) may be managed indirectly by a central bank when it chooses to purchase or sell financial instruments (e.g., government-issued bonds) in open financial markets, the side effects of which are, respectively, to increase or decrease privately-held bank deposits and/or the reserves of commercial banks, depending upon the identities of the sellers or buyers of the financial instruments.

An increase of commercial bank reserves enables the banks to increase lending, thereby increasing the quantity of money in circulation. However, there is no guarantee that an enabling increase of bank reserves will actually cause commercial banks to increase lending or prospective investors or consumers to increase borrowing. A decrease of commercial bank reserves may induce a decrease of lending and will force a decrease of lending if reserves drop below legal requirements, thereby causing a contraction of the money supply.

The phenomenon of the diminishing marginal utility of money balances may not always work as predicted. Distributions of pandemic relief funds during 2021 seem to have resulted in hoarding as some of the funds were held rather than being spent by consumers. A possible explanation is that pandemic distribution recipients suffered sufficient uncertainty about the future that they held back on spending the funds. When the pandemic appeared to be alleviated, the release of pandemic hoardings caused aggregate demand to increase faster than could be accommodated by supply increases, resulting in rising inflation in late 2021 and early 2022.

The marginal utility of money balances may also work in reverse. If the money supply decreases such that individual money balance holdings decrease, the marginal utility of the remaining money balances held will increase for normal, risk-averse money balance holders (neither misers nor gamblers), inducing them to decrease their spending. When the marginal utility of a dollar held rises to exceed the marginal utility of something that the dollar could buy, a rational consumer will suspend further spending. Hoarding behavior may be explained for people who experience increasing marginal utility as their money balances increase (e.g., misers).

It is important to remember that money held as assets of banking institutions is not in circulation. As the Fed begins to "unwind" its bond portfolio in 2022 by selling bonds, it will siphon money from the bank accounts of bond purchasers, thereby reducing the quantity of money in circulation. The expectation is that the majority of people are normal, rational, and risk-averse (neither misers nor gamblers) so that the marginal utilities of their held money balances will increase, thereby reducing consumer spending and curbing inflation.

12. Calibrating Monetary Policy

In their public statements, Federal Reserve officials attempt to speak with authority and precision about their policy mandates, the tools at their disposal, and their ability to manipulate the policy tools to hit their intended targets.

Eric Rosengren, president of the Federal Reserve Bank of Boston, in a New York Times interview by Binyamin Appelbaum on October 17, 2016, speaks with candor about the challenges facing monetary policy makers. Rosengren talks about the "calibration" of monetary policy by the Fed but acknowledges that it is difficult to hit a target exactly right:

The problem is the dynamics of how firms and individuals start thinking about the tightening process. Those dynamics make it very hard to calibrate the monetary policy process. People understand tightening. But convincing them of how much you're going to tighten and that you're going to hit it exactly right — particularly given that you haven't hit it exactly right in the past, it's pretty tough to convince people of that.
(http://www.nytimes.com/2016/10/18/upshot/q-and-a-with-eric-rosengren-the-danger-of-low-unemployment.html?em_pos=small&emc=edit_up_20161017&nl=upshot&nl_art=3&nlid=74240569&ref=headline&te=1)

Rosengren also alludes to the internal econometric model that the Fed uses, but notes that it does not handle all possible eventualities:

Our internal model does not have an election dummy in it. It's saying that we're not necessarily expecting that our long-term forecast is going to be affected by this election. That may be right or may be wrong.

And he speaks with seeming precision about being close to the Fed's dual mandates of 2 percent rate of inflation and 5 percent unemployment:

We're at 5 percent unemployment. By many people's estimates that's full employment. My own number is a little below that, so I would like to see the unemployment rate come down a little bit more. And if you look at the inflation rate, the core rate is 1.7 percent. . . . . So if you think you're near both elements of the dual mandate, and the policy rate [i.e., the discount rate, currently 1 percent for primary credit] is well below where you think it's going to be in the long run [around 3 percent], I think there is some justification for taking action on that basis.

But he also acknowledges the seeming inability of central banks to hit the 2 percent inflation target:

I think also the inability of so many central banks to hit their 2 percent inflation target has caused some people to say, “I want to actually see evidence that you can hit 2 percent, and since we've just seen the consequences of hitting the zero lower bound, I want to take out some insurance against hitting the zero lower bound more quickly.” I think both concerns are credible. My concern with those arguments would be that the very scenario that causes the next recession might be that we overshoot.

Rosengren notes the costs of making policy with imperfect information:

For a policy maker you actually have to make a determination with imperfect information about what the answers to those questions are. So an academic gets to work on exciting ideas and there's not much cost to being wrong. Anybody who's in a policy-making role knows there is cost and so that makes it more challenging.

One topic that Rosengren does not address is the impact on monetary policy of the fact that we now live in an open-economy world. An example of international sources of bond supply that may impact monetary policy is noted by Carolyn Cui, Ahmed Al Omran, and Christopher Whittall, writing in The Wall Street Journal, October 19, 2016:

Banks and investors flocked to buy Saudi Arabia's first global bonds, a milestone in the giant oil producer's efforts to diversify its economy and embrace global financial markets. . . . . Strong demand for the debt, sold primarily to U.S. investors in a private placement and to Asian institutions, allowed the Saudis to reduce the yields below initial marketing plans while reaching out to an expanding investor base. . . . . Buyers cited the appeal of above-average yields for a large, relatively rich country at a time of ultralow global interest rates and soft growth, as well as recent stability in the price of crude oil.
(http://www.wsj.com/articles/saudi-arabia-to-offer-international-investors-17-5-billion-in-bonds-1476876478?mod=djem10point)

Given the myriad of sources of increase and decrease of bonds coming onto global financial markets (not just within the financial markets of the United States itself), it is heroic (and perhaps delusional) to suppose that Federal Reserve officials can control the yield rates on bonds with any degree of precision or actually to cause yield rates to converge upon their announced discount rate target.

13. Lessons from American Banking History

A Fractional Reserve System

The American banking system is a fractional reserve banking system in the sense that commercial bankers desire to maintain reserves in the form of very liquid assets against their deposit liabilities. But they have learned with much experience that the reserves need to be only a very small proportion of the outstanding deposit liabilities--hence fractional reserves. It is also true that the Federal Reserve, the central bank of the American economy, requires commercial banks to maintain satisfactory amounts of reserves that are a fraction of deposit liabilities. But as a matter of prudence commercial bankers would do so anyway, and normally hold more reserves for safety than they are legally required to hold.

Most banking income is earned by acquiring assets in the form of customer loans or open market assets such as bonds. Deposit money is created as a by-product of extending loans to customers. A motive for commercial banks to hold excess reserves is that in 2008 the Fed began to pay interest on reserves deposited with the Fed. The Fed's payment of interest on reserve deposits to some extent has relieved the compulsion for commercial banks to minimize the holding of excess reserves in order to maximize their customer lending potential, so they now tend to hold more reserves than they are minimally-requied by the Fed to hold.

An Historical Outline of American Commercial and Central Banking

Banking during colonial times, banking is primitive at best; a few English-owned banking companies serve depository functions in the colonies; the only money in use is English or Spanish.

1776, American Revolution, after which a few gold or silver smiths begin to operate as depositories on their own authority (i.e., not chartered by any official agency).

1776-1781, Congress could not finance the Revolutionary war with large tax increases, as the memory of unjust taxation from the British stood fresh in the minds of the American public; the Continental Congress borrowed money from other nations, Benjamin Franklin securing loans of over $2 million from the French Government and President John Adams securing a loan from Dutch bankers and from domestic creditors; 1781, Congress establishes the U.S. Department of Finance.

1783, Revolutionary War ends; total debt reaches $43 million; Congress raises taxes.

1791, The ("First") Bank of United States is chartered by act of Congress to assist with finance of Revolutionary War debts; the 20 year charter expires in 1811, just before War of 1812.

1800, perhaps 300 or so private banks have been chartered by new state governments.

1812-1815, War of 1812 more than doubles nation’s debt from $45.2 million to $119.2 million; Treasury Department issues bonds to pay a portion of the debt.

1816, The ("Second") Bank of United States is chartered by Congress to assist government with financing of 1812 War debts, the 20 year charter to expire in 1836.

1820s and '30s, states charter new banks at rapid pace with no controls; eventually over 3000 banks chartered in the 13 states formed from the original colonies, each bank issuing as many as half dozen denominations of currency; "wildcat banking"; counterfeiting; no other federally chartered banks.

1829, Andrew Jackson elected President on promise of not renewing charter of Second Bank; Jackson feared and hated banking interests because a bank had foreclosed the mortgage on his father's farm.

1829-1836, Jackson regards the debt a “national curse;” blocks infrastructure projects and raises revenue by selling federally owned western lands; pays off the national debt after six years in office and divides a government surplus among indebted states.

1836, banking chaos ensues with termination of operations of second Bank of the United States; money, which has to be shifted from vaults of second bank to state banks, goes into transit along waterways, wagon-ways, and railroads, and is thus not available to facilitate commerce.

1837 to Civil War, "Free Banking" era, about half of the states allow anyone with a minimum amount of their own funds to open a bank; banking and economic instability ensues, but paper money issued by reputable state banks is generally convertible to gold at face value (par); paper money issued by distant or "unknown" ("wildcat") banks circulates at discount from par (economist Barry Eichengreen describes the ensuing chaos in a New York Times column, June 17, 2025, "This Bill Will Return Us to an Era of Economic Chaos," https://www.nytimes.com/2025/06/17/opinion/genius-act-stablecoin-crypto.html?campaign_id=39&emc=edit_ty_20250617&instance_id=156686&nl=opinion-today®i_id=74240569&segment_id=200089&user_id=86b0d837dd357b2a6e0e749321f6ed7f).

1860-1865, Civil War finance requires issue of paper money by governments on both sides; paper money is over-issued by state chartered banks and by both governments; excessive issue of Union (North) treasury notes, known as "greenbacks," eventually results in circulation at discounts from par; same occurs for Confederate (South) money, but even worse; at war's end Confederate issues of money become worthless, Federal greenbacks continue to circulate at discounts.

1869-1875, first American "Great Depression" follows from deliberate withdrawal of paper money by Congressional act to eliminate discount from par, with the objective to reestablish convertibility of currency to gold at par.

1873, collapse of Jay Cooke & Co., a major bank invested in railroading, causes the Panic of 1873; nearly a quarter of the country’s railroads go bankrupt, more than 18,000 businesses close, unemployment hits 14 percent; New York Stock Exchange suffers collapse; a period of deflation ensues and slow growth continues for 65 months; government collects less tax revenues and the national debt continues to grow.

1865-1913, in the absence of a central bank to exercise control over the banking system, the Treasury Department begins to learn and exercise some central banking functions; by the turn of the century there is widespread recognition of the inflationary potential of allowing the same governmental office responsible for financing government's expenditures to also be responsible for providing and controlling its money supply; demands for monetary reform become more outspoken.

1875-1890, era of Bimetalism; silver mining interests demand governmental support; Congress passes legislation to define sixteen ounces of silver as equal in value to an ounce of gold, and par values are determined between the dollar and both metals in the ratio of 16:1; but relative market values of gold and silver change; for a while gold is overvalued at the mint, and so is drained from circulation (mostly to Europe) and replaced by silver; later silver becomes overvalued and is drained from the economy to Europe (gold flows in from Europe); consequent economic instability ensues as gold flows into and out of the country, thereby affecting the domestic money supply; eventually bimetallism is ended and the U.S. government defines the value of the dollar exclusively in terms of gold, thereby committing to the international Gold Standard.

1880, beginning of charter of "National Banks" by federal government; state banks are prohibited from further issuance of bank notes; only National Banks chartered by the federal government are authorized to issue bank notes, but most banks choose to remain state banks in order to avoid control by the Treasury; money supply begins transition from mostly paper money to mostly demand deposits.

1880s until 1913, banking instability continues; money supply is inflexible in sense that much of the money is in bank vaults in the cities when it is needed in rural areas to facilitate planting, harvest; during off-seasons most money remains in rural areas when it is needed in the cities; banking panics precipitate numerous episodes of economic instability which worsen.

1912-1913, Congress debates the need for a central bank and the shape it is to take; the need for independence from the Treasury is a critical issue; Federal Reserve Act is passed by Congress in 1913.

1914-1932, Federal Reserve System (FRS) begins to operate, has to learn central banking functions; national banks lose authority to issue currency; this authority becomes the exclusive function of FRS in order to provide a uniform currency and a flexible money supply; number of state as well as national banks increase, state banks by much larger numbers because of FRS regulation of national banks; bulk of money supply is now demand deposits rather than currency.

1929-1932, after boom decade of 1920s, U.S. seconomy goes into depression with collapse of business confidence; output and employment contract by nearly 25 percent.

1930, Congress passes Smoot-Hawley Tariff Act, intended to protect American agriculture and business by raising import duties by approximately 20% on wide range of agricultural and industrial goods; Act contributes to worsening depression (a second "Great Depression") by stifling international trade and sparking retaliatory tariffs by other nations.

1932-1936, banking system collapses; FRS Board fails to comprehend its mission of being "lender of last resort" to the commercial banks, or that it is fundamentally different from commercial banks in that it cannot fail; FRS lets the money supply drop drastically as it mistakenly attempts to decrease its outstanding deposit liabilities in order to keep itself from failing; as FRS decreases its deposit liabilities (deposits of commercial banks), commercial banks cannot meet reserve requirements, call loans many of which are bad, become insolvent, fail; banking population drops from over 30,000 to less than half; the U.S. nationalizes all gold in the country and suspends gold payments to foreigners, thus goes off Gold Standard.

1936, with monetary stringency, interest rates rise in the U.S. relative to Europe, capital inflow increases, supplies American banks with excess reserves which FRS officials view with alarm as having great inflation potential; FRS does not realize that bankers wish to hold idle excess reserves for liquidity; FRS raises reserve requirements to "mop up" excess reserves, precipitates another banking crisis, monetary contraction, second downturn and depression trough.

late 1930s, gradual recovery as FRS officials begin to comprehend effects of their actions; FRS ceases decreasing reserves and the money supply.

early 1940s, beginning of WWII, FRS takes subsidiary role to Treasury, assists with war finance by keeping interest rates low, lets money supply increase, causing inflationary pressures; inflation is contained by price controls and rationing.

late 1940s, rationing and price controls are lifted at war end; pent-up inflationary pressures are released, causing a significant inflation; the U.S. participates in forming the Bretton Woods international monetary system by committing to fix the value of the U.S. dollar to gold so that other countries can fix the values of their currencies to the dollar (a pseudo Gold Standard).

post-WWII era, the U.S. runs chronic balance of payments deficits due to Marshall Plan, American tourism, American overseas investment, growing imports of foreign merchandise; the U.S. for a while maintains the value of the dollar to gold as its monetary gold stock depleats; confronted with continuing decline of the U.S. monetary gold stock, in 1971 President Nixon suspends domestic redemption of currency into gold; by 1973 Nixon suspends international gold payments by the U.S., thus ending the Bretton Woods international monetary system and initiating a flexible exchange rate system.

1951, William McChesney Martin, Jr., is appointed by President Eisenhower to chair the Federal Reserve Board of Governors; Martin negotiates an "accord" with the Treasury to regain its autonomy and independence; the Fed acts to raise interest rates and restrict the money supply to control inflation.

1952-1960, prices remain stable through rest of '50s; recession emerges in 1958 in second Eisenhower administration, the first on record with both rising unemployment and rising prices; "stagflation" is born.

early 1960s, Kennedy administration implements first "supply side" tax cut that stimulates growth; FRS pursues interest rate as monetary target due to Keynesian theoretical influence, lets money supply expand to keep interest rates under control; inflationary pressures worsen.

late 1960s, initiation of Viet Nam war requires increased military expenditures, adding to President Johnson's "Great Society" social welfare spending programs; increasing inflationary pressures; FRS targeting of interest rate control allows monetary aggregates to expand to keep interest rates low, fuels accelerating inflation.

1970, Nixon appoints personal friend Arthur F. Burns to succeed Martin as chair of Federal Reserve Board, leans on Burns to keep interest rates low; Burns acquiesces, but runaway price increases result in uncontrolled inflation.

early 1970s, Nixon administration tries wage-and-price guidelines, but is unsuccessful in containing inflation; Nixon resigns in 1974 Watergate scandal; Nixon is succeeded for two years by President Ford; President Carter is elected in 1976.

late 1970s, inflation psychology emerges with growing budget deficits, rising nominal interest rates; with crowding-out effect threatened, Fed acts to expand money supply to prevent further interest rate increases, but this only aggravates inflationary pressures.

1979, Paul Volker is appointed by President Carter to chair Federal Reserve Board, but Volker turns out to have monetarist rather than Keynesian leaning; Volker redirects FRS policy away from interest rate targeting and toward control of monetary aggregates so as to reduce the rate of growth of the money supply.

1981-1982, Volker's monetary stringency precipitates deep though brief recession; inflation psychology is broken and monetary and economic stability follow.

1983-1990, Reagan administration cuts taxes, pursues "supply side" policies which, coupled with careful control of monetary aggregates, initiates longest period of sustained U.S. expansion on record; FRS now indoctrinated in the need to pay more attention to monetary aggregates than to interest rates as target of monetary policy.

1980s and 1990s, failure of nearly a quarter of the more than 3200 savings and loan associations, requiring bailouts totaling nearly $90 billion; new home construction slows, contributing to early '90s recession.

late 1980s, President George H. W. Bush says "no new taxes" as a campaign promise, but confronted with rising Federal budget deficits, raises taxes after election; this brings about the end of the long expansion in 1990 and Bush's defeat in 1992.

1987, President Reagan appoints Alan Greenspan to succeed Volker as Fed chair; Greenspan is reappointed at successive four-year intervals until retiring early 2006; Greenspan's "easy-money" policy is likely cause of the "dot-com bubble" and the subprime mortgage crisis; Greenspan argued that the housing bubble was not a result of low-interest short-term rates but rather a global phenomenon caused by the progressive decline in long-term interest rates.

1989, enactment of FDIC Improvement Act requires all banking institutions receiving deposits to insure with the FDIC and all such institutions to come under the regulation of the Federal Reserve.

early 1990s, after Volker's retirement, the Greenspan FRS continues to give lip service to monetary aggregates and to targeting a range of growth for M2, but begins to give occasional attention to interest rates as Federal government runs ever larger budget deficits.

1992, Bill Clinton elected President, raises taxes in effort to control budget deficit, precipitates recession; interest rates at post-WWII lows as outside world purchases U.S. government bonds, thereby assisting the U.S. in financing its budget deficit without interest rate increases.

1993-1994, recovery occurs gradually with FRS leaning against monetary expansion; FRS raises discount rate five times during 1994, the latest being a 3/4 percent increase in mid-November 1994; long-term interest rates continue to rise, indicating that capital markets think that not enough yet has been done by the FRS to impose monetary stringency and avert inflation.

1999, Glass-Steagall Act repealed, removing separation between investment banks and depository institutions; this repeal is thought by many banking analysts to have contributed to financial crisis in 2007-2010.

late 1990s, early 2000s, wave of banking mergers among larger banks and acquisitions of smaller banks; many larger depository banks begin investment banking operations as enabled by repeal of Glass-Stegall Act.

2006, President George W. Bush appoints Ben Bernanke to succeed Greenspan as Fed Chair; Bernanke oversees the Fed's response to the 2008 "Great Recession" for which he is named the 2009 Time Person of the Year; Bernanke is awarded (jointly) the 2022 Nobel Memorial Prize in Economic Sciences for his analysis of the Great Depression; President Obama reappoints Bernanke as Fed chair in 2010; in a 2015 book Bernanke asserts that it was only the novel efforts of the Fed that prevented economic catastrophe greater than the Great Depression.

late 2000s, worst financial crisis and recession since the Great Depression of the 1930s; liquidity shortage in the banking system contributes to collapse of financial institutions and elicits bank bailouts by the government; stock market market suffers major decline; housing foreclosures contribute to construction decline and business failures in related fields; investor confidence collapses; government responds with massive fiscal stimulus which fails to have intended effect; unemployment increases toward 10 percent of the labor force; economic growth near zero.

2008, the Fed responds to the ensuing recession by lowering interest rates to near zero and initiates the process of "quantitative easing" in the effort to stem the so-called "Great Recession"; quantitative easing entails purchases of large quantities of bonds from commercial banks, paid for by crediting the reserves of commercial banks; most banks have large amounts of reserves in excess of legal requirements; the Federal Funds rate decreases toward zero, rendering it useless as a monetary policy tool.

2008, to put a floor under the Federal Funds rate and provide the Fed with some modicum of control, the Fed starts paying interest on commercial banks' reserve balances on deposit at the Fed; reserve balances interest rate changes expected to induce same-direction changes of the Federal Funds interest rate.

2008-2016, U.S. economy continues to be sluggish with real growth rate below 2 percent per annum; U.S. CPI inflation rate remains below the Fed's announced goal of 2 percent per annum; to induce the inflation rate to approach its announced goal, the Fed attempts to enable increased commercial bank lending by increasing bank reserves with four episodes of quantitative easing between 2008 and 2021; in an environment of fear, anxiety, and pessimism, the Fed is unable to force bankers to lend or prospective borrowers to borrow; most of the increased liquidity ends up in commercial bank excess reserves and business cash hoards rather than in circulation to stimulate spending.

2010, Congress temporarily increases deposit insurance limit to $250,000, passes Dodd-Frank Wall Street Reform and Consumer Protection Act to improve regulatory oversight of the banking system.

2010, emergence of privately-issued cyptocurrencies such as "bit coin."

2010-2011, financial crisis begins to ease, unemployment begins slow decline; economic growth increases toward 2 percent per annum; government budget deficit and accumulating public debt become central presidential campaign issues; Fed intends to keep interest rates low indefinitely.

2014, President Obama appoints Janet Yellen to succeed Bernanke as Fed chair; she is reappointed by President Trump in 2016; Yellen is succeeded by Jerome Powell in 2018 after Trump declines to renominate her for a second term; President Biden appoints Yelllen to serve a Secretary of Treasury, 2021-2025.

2015, long-time low rates are thought to cause financial instability and pose threat to the economy; Fed increases reserve balances interest rate for first time since 2006; reserve balances interest rate remains in low range of 1.25 percent to 1.5 percent, well below historical standards.

2017, Fed indicates that it intends to continue to implement systemwide "ample reserves," a policy that renders both the discount rate and the Federal Funds rate irrelevant as policy tools even if reserve balances interest rate changes elicit changes of the Federal Funds rate.

late 2017, President Trump declines to reappoint Democrat Janet Yellen, instead appoints Republican Jerome Powell to chair Fed Board; Powell reappointed by President Biden in 2021; Powell reduces quantitative easing (QE) and mortgage-backed security (MBS) purchases due to 2021–2023 inflation surge, with the consumer price index (CPI) in November 2021 reaching 6.8%.

2019-2023, Fed attempts to gain control of the inflation rate that exceeds its target of 2 percent per annum; supply-chain congestion and Covid pandemic cause market interest rates to fall; declining investment and other interest-sensitive spending precipitate a brief recession in 2020; U.S. inflation rate rises to 5 percent per annum by mid-2023 before beginning to decrease in late-2023.

2024-2025, Donald J. Trump elected to second presidential term, launches programs to trim size of government, eliminate DEI influences in government and American society, imposes off-and-on tariff increases above the historical 2% average rate on imports; elevated uncertainty in financial and business sectors begins to slow economic activity, accelerate inflation rate.

2024, Trump family issues "World Liberty" cybercoin, earns $57.35 million from sales of it in 2024.

April 2025, Trump presses Federal Reserve Board chairman Jerome Powell to fight impending recession by lowering interest rates; Powell, concerned about inflation potential, declines to comply; Trump indicates desire to terminate Powell's chairmanship; turmoil erupts in U.S. financial sector, sets in motion backlash; Trump backs away from intent to fire Powell.

June 2025, "Genius Bill" introduced in Congress; if passed into law it would authorize companies to issue a type of cryptocurrency called a stablecoin, the value of which would be tethered to a stable asset like the dollar; passage of the bill would authorize stablecoins to be issued by federally insured banks or by companies such as Walmart and Amazon; see the New York Times column by economist Barry Eichengreen, June 17, 2025, "This Bill Will Return Us to an Era of Economic Chaos," https://www.nytimes.com/2025/06/17/opinion/genius-act-stablecoin-crypto.html?campaign_id=39&emc=edit_ty_20250617&instance_id=156686&nl=opinion-today®i_id=74240569&segment_id=200089&user_id=86b0d837dd357b2a6e0e749321f6ed7f.

Lessons from U.S. Monetary and Banking History:

1. One society can use another society's money.

2. Banking innovation often occurs in response to the needs of war finance.

3. Free (or uncontrolled) commercial banking typically results in banking and currency chaos.

4. Gresham's Law: Bad money drives out good; cheap money drives out dear; debt money replaces commodity money; paper money replaces metallic money.

5. Disruptions to the banking system often are caused by misguided government policy.

6. No more than one monetary standard can be in effect at any one time.

7. If part of a nation's money supply becomes unavailable for circulation, its volume of commerce likely will contract.

8. Over-issue of the money medium results in the depreciation of its purchasing power.

9. The fiscal and monetary functions of government should be separate because of an inherent potential for inflation.

10. Central banking is fundamentally different from commercial banking; one is profit-oriented, the other is control-oriented.

11. Unlike a commercial bank, a central bank cannot fail.

12. A nation's money supply needs to be flexible and responsive to the needs of commerce and growth.

13. Commodity monies are strictly limited in quantity; debt monies can be expanded without limit (but with consequences).

14. Bankers may desire to hold reserves greater than they are required by law or authority to hold.

15. International capital flows can change a nation's commercial bank reserves and its money supply.

16. The central bank's commitment to a fixed exchange rate may deplete the nation's stocks of gold and foreign exchange.

17. A monetary policy of targeting interest rates is likely to cause monetary expansion and contribute to inflation.

18. A monetary policy of targeting the growth of a monetary aggregate (such as M2) can alleviate inflation, but with some undesirable side effects.

19. Price controls and rationing can only suppress inflationary pressures, not eliminate them.

20. If the monetary authority is subjugated to the fiscal authority, inflation is a likely consequence.

21. Efforts by the monetary authority to prevent crowding out of private investment usually results in monetary expansion and may contribute to inflation.

22. Supply-side fiscal policies may be able to stimulate an economy without causing inflation.

23. If the demand for bonds is increasing, it may be possible for government to finance its deficits without causing interest rates to rise.

24. A central bank can dictate only its own interest rate, but not market-determined interest rates.

25. Simply raising the central bank's interest rate may not achieve monetary restraint; the banking system's reserves must be decreased.

26. Simply lowering the central bank's interest rate may not achieve monetary stimulus; simply increasing the banking system's reserves may not achieve monetary stimulus.

27. Monetary expansion may produce price "bubbles" in areas other than measured by common price indexes, e.g., in financial, housing, and commodities markets.

28. Virtually any regulation imposed in the financial sector eventually will be circumvented by financial innovation.

29. Mixing depository and investment banking may have detrimental effects on the financial system.

30. Open market operations to provide banks with additional reserves (a.k.a. "quantitative easing") may not elicit additional bank lending if bankers see few viable lending opportunities.

31. In a democratic political system, electing an economically illiterate president with an anti-democratic (i.e., authoritarian) ideology has potential to co-opt the banking system for the executive's purposes; "stagflation" (simultaneous recession and inflation) is a possible consequence.

32. Implementing tariffs by legislative act or by executive order has potential to elicit tariff reciprocity by other nations with deleterious effects for banking systems and global economic stability.

14. Deflation and Inflation, Historical Perspectives

Deflation and inflation often have occurred over the phases of business cycles in Western market economies. Deflation or disinflation (slower inflation) typically accompanies slower growth or absolute contraction with some lag during the downswing phase, and inflation at a faster pace begins to manifest itself as recovery continues to ensue during the upswing. Cyclical deflation and inflation episodes typically are short-run phenomena lasting only a few quarters.

But there have been several longer-run episodes of inflation and deflation in the history of the U.S. economy, all of which eventually gave way to opposite-direction price level changes. A decade-long period of deflation ensued after Andrew Jackson vetoed the Second Bank recharter bill in 1836 and had all government funds moved from commercial banks to the U.S. Treasury. The Civil War brought a nearly decade-long period of inflation as the Union Treasury Department issued copious amounts of "greenback" currency to finance the war. A twenty-year period of deflation began after the Civil War in 1870 when the Treasury Department implemented a process intended to restore convertibility of the dollar into gold by withdrawing much of the greenback currency that had been issued during the war.

During the twentieth century, the "roaring twenties" decade was characterized by emerging real-estate and stock price bubbles. A long-term episode of deflation ensued after the 1929 stock market crash that ushered in a decade-long period of depression and halting recovery. World War II brought a half-decade long period of suppressed inflation which manifested itself in actual rising prices in the late-1940s after price controls were lifted at the end of the war. Many of these episodes of price level direction change have been precipitated by government actions, and the reversals of the direction of price-level change often have occurred without the intervention of monetary or fiscal authorities.

The post-World War II era in the United States has been characterized by faster or slower rates of inflation rather than periods of inflation alternating with episodes of actual deflation. Most of these price level variations have been shorter-term and have followed cyclical patterns. However, the recovery following the 2008 "Great Recession" has been slow with inflation well below the two percent per annum target preferred by Federal Reserve officials. As of mid-September 2016, the personal consumption expenditures price index, excluding food and energy, increased just 1.6 percent from September 2015. This has spawned monetary policy efforts to stimulate not only faster real growth, but also inflation at a fast enough pace to reach the Fed's target.

Some academic economists and macroeconomic policy makers recently seem to have become obsessed with the prospect of longer-term deflation, and to have dismissed the possibility of inflation in the foreseeable future. Nobel Economics Prize winner Christopher Sims believes that the world has made a transition from inflation and rapid growth to deflation and slow growth:

Is the phenomenon of inflation now an anachronism, unlikely to be experienced in the future? A brief and superficial overview of the earlier history of deflation and inflation in the West may serve to provide perspective on this question.

Trade in primitive (pre-money-using) societies was conducted by barter, i.e., by exchanging things for things. Because barter trade is inconvenient and inefficient, money was invented to facilitate trade. With the increasing use of money, markets emerged and commodities became priced in terms of so many common money units. Both barter and money-price trade occurred side-by-side in markets during the late Middle Ages. The world of the late Middle Ages was one of general economic stagnation characterized at times and in various places by falling commodity prices, i.e., by deflation.

Phillipp Bagus notes that beginning around the sixteenth century as both domestic and foreign trade were becoming more common, commercial interests advocated mercantilism to increase "the wealth of the nation" and avoid deflation.

Keeping their focus on monetary inflation, mercantilists are among the first to implicitly address the subject of deflation. According to mercantilist doctrine, a favorable balance of trade, i.e., an excess of exports over imports, would be beneficial for a country in terms of increasing its stock of precious metals. Mercantilists championed the accumulation of money as the best store of wealth and correspondingly feared the circumstances in which a country would be bereft of its money. Thus, they implicitly feared a monetary deflation.
(Phillipp Bagus, In Defense of Deflation, p.6. Springer International Publishing, Switzerland, 2015)

Deflation followed from the scarcity of enough precious metals to serve as money for conducting trade during the so-called "Age of Discovery," also beginning in the sixteenth century. European monarchs were motivated to commission voyages to the "New World" by adventurers in search of gold and silver, both to enhance their own wealth and to avert deflation. They also commissioned "privateers," essentially crown-sponsored pirates, to capture gold and silver from each other on the high seas. The influx of precious metals, largely through English, Spanish, and Portuguese seaports, funneled out into western Europe through trade, alleviating incipient deflation but eventually causing unprecedented inflation in western Europe. The influx of so much new money sparked growth processes and an industrial revolution that required ever more money to circulate in support of the growing volume of trade in order to prevent a return to deflationary conditions.

Fear of deflation due to the shortage of precious-metal money relative to the increasing needs of commerce elicited over the next three centuries a great monetary transformation from using costly precious metal money to using much cheaper "promise to pay" paper money. Gresham's Law came into its own: bad money drives out good money, and cheap money drives out dear money. By the late-twentieth century, bank account money was displacing paper money as the preferred mode of conducting trade. The monetary transformation was essentially complete as precious-metal money ceased to be used almost everywhere in the world.

During the commodity money era, fortuitous discoveries of precious metals led to gold or silver "rushes" that intermittently destabilized economies due to uncontrolled growth of the money supplies. The persistent shortage of enough precious metals to serve as money in a growing world economy was instrumental in precipitating a search for cheaper media to serve as money.

A momentous money transformation over the past three centuries has left very little commodity money still in use anywhere in the world. Now, virtually all modern monies are debt (or credit) monies in the forms of token coins, promise-to-pay paper currencies (which are liabilities of governments), and checkable deposits (which are liabilities of commercial banks). This transformation came about through a sequence of innovations in the emergence of commercial banking that include

depository operations of metal smiths,
written orders to pay,
bank notes as promises to redeem in gold or silver,
recognition that depositors typically withdraw only a small fraction of the valuables that they have on deposit,
the possibility of lending gold while it is on deposit, and
the possibility of lending multiple amounts of the deposited gold as long as borrowers make payments to parties who redeposit the borrowed gold back in the same bank.

Two other important innovations are warehouse receipts (e.g., gold and silver certificates) for the total values of the deposits and the possibility of multiple warehouse receipts in conventional denominations for the total value of any deposit. Eventually, warehouse receipts in the form of gold and silver certificates were demonetized in the United States, only to be replaced by pure "promise to pay" bank notes that are not redeemable in any amount of precious metal and not even backed by any amount of precious metal. This progression of innovations has served to transform money into ever more abstract forms.

During the precious-metal money-using era, the quantity of money in circulation was limited strictly by the amount of precious metals that could be found, extracted the ground and rivers, refined, and not used for non-monetary purposes (e.g., jewelry, flat and hollow tableware). After the great monetary transformation, there no longer has been a limit to the amount of paper and bank-account money that could be brought into circulation by the treasury departments of governments and by commercial and central banks.

The absence of such a limit has enabled the potential for inflation far beyond that precipitated in the sixteenth and seventh centuries by influxes of precious metals into western Europe, or in the nineteenth century by the over-issue of paper money. Christopher Sims' 2016 fear that the world has made a transition from inflation and rapid growth to deflation and slow growth now seems unfounded.

15. The Money Supply and Deflation

Jon Sindreu, writing in The Wall Street Journal, March 6, 2017, says that

What is the rationale for the suggestion that the process of inflation may lead the need for monetary expansion? The impetus to inflation may be provided by demand-pull and cost-push forces as the economy expands and approaches full employment, but these forces cannot last long without supporting money supply expansion or spending acceleration that ratifies and makes effective the pull and push forces. Without a ratifying monetary expansion or spending acceleration, the incipient pull and push forces will dissipate and cause the economy to fall back into stagnation, or worse into unemployment, output contraction, and deflation.

A scarcity of money portends deflation. Money might become scarce if the demand for it increases relative to supply of it (or the supply of it decreases relative to the demand for it), causing the "price" of each money unit (its purchasing power) to increase. The complementary phenomenon is that the prices of things that can be bought with a unit of "scarce" money will fall, i.e., deflation will ensue.

The contention that the central bank may need to issue more money to prevent money from becoming scarce as prices rise poses the contradiction that monetary expansion is needed during a period of inflation in order to avert deflation. This excuse for continuing monetary expansion during a period of inflation not only contradicts the presumption that slower monetary expansion, or actual monetary contraction, is the medicine needed to curb inflation; it also constitutes a recipe for accelerating inflation by continually feeding the demand pull and cost push forces.

With three episodes of "quantitative easing" that added over three trillion dollars of liquidity in the U.S. economy between 2008 and 2014, it hardly seems likely that money is becoming scarce. However, deflation would have been a real possibility if the cash hoards of businesses plus the excess reserves of banks had exceeded the QE monetary expansions. Although the possibility of deflation was a concern in the years following the Great Recession, it never actually materialized.

The phenomenon of money "getting scarce" actually occurred during the seventeenth century era of mercantilism, but not as a matter of inflation. Phillipp Bagus notes that beginning around the sixteenth century as both domestic and foreign trade were becoming more common, commercial interests advocated mercantilism to increase "the wealth of the nation" and avoid deflation.

Keeping their focus on monetary inflation, mercantilists are among the first to implicitly address the subject of deflation. According to mercantilist doctrine, a favorable balance of trade, i.e., an excess of exports over imports, would be beneficial for a nation in terms of increasing its stock of precious metals. Mercantilists championed the accumulation of money as the best store of wealth and correspondingly feared the circumstances in which a country would be bereft of its money. Thus, they implicitly feared a monetary deflation.
(Phillipp Bagus, In Defense of Deflation, p.6. Springer International Publishing, Switzerland, 2015)

Deflation followed from the scarcity of enough precious metals to serve as money for conducting trade during the so-called "Age of Discovery," also beginning in the sixteenth century. European monarchs were motivated to commission voyages to the "New World" by adventurers in search of gold and silver, both to enhance their own wealth and to avert deflation. They also commissioned "privateers," essentially crown-sponsored pirates, to capture gold and silver from each other on the high seas. The influx of precious metals, largely through English, Spanish, and Portuguese seaports, funneled out into western Europe through trade, alleviating incipient deflation but eventually causing unprecedented inflation in western Europe. The influx of so much new money sparked growth processes and an industrial revolution that required ever more money to circulate in support of the growing volume of trade in order to prevent a return to deflationary conditions.

A growing world economy needs commensurately more money to serve the needs of commerce, else deflation will ensue. Fear of deflation due to the shortage of precious-metal money relative to the increasing needs of commerce elicited the invention of ever cheaper substitutes for precious metals. A great monetary transformation from using costly precious metal money to using much cheaper "promise to pay" paper money ensued in the eighteenth through twentieth centuries. Gresham's Law came into its own: bad money drives out good money, and cheap money drives out dear money. By the late-twentieth century, bank account money was displacing paper money as the preferred mode of conducting trade. The monetary transformation was essentially complete as precious-metal money ceased to be used almost everywhere in the world. By the early twenty-first century, the bulk of the monies in circulation were "held" as accounting entries in digital form and could be transferred from one party to another by wire, internet, or digital devices.

Although the principal intent of the U.S. Federal Reserve in implementing quantitative easing programs between 2008 and 2015 was to stimulate real output growth to increase, a secondary goal was to elicit a rate of inflation in excess of 2 percent per annum. George Melloan, writing in The Wall Street Journal, March 10, 2017, says

But the Fed helped. Its three rounds of “quantitative easing”—effusions of newly created dollars—in roughly the same period (QE3 ended in October 2014) added a further $3.5 trillion in demand for Treasurys and for the troubled mortgage-backed securities issued by Fannie Mae and Freddie Mac. Cheap credit, and miserly yields on savings, pervaded the U.S. economy.
(https://www.wsj.com/articles/america-cant-escape-the-debt-vortex-1489099963)

The massive increase of the U.S. money supply brought about by three Quantitative Easing programs (2009-2014) neither stimulated significantly faster growth of real output nor caused inflation to reach 2 percent per annum in the eight years since the so-called "Great Recession" of 2008. Such low rates of inflation and real output growth are attributable to the fact that during this time of great uncertainty, the stimulative potential was impotent because much of the additional money was impounded in business cash hoards and commercial bank excess reserves. By definition, only money held as deposit liabilities of commercial banks (i.e., as assets of depositors) is in circulation; money held as reserves (i.e., as assets of commercial banks) is not in circulation. As Melloan puts it:

To avoid rampant inflation after putting all that new money into circulation, the Fed cleverly arranged for banks to lock up some $2 trillion in their reserve accounts at the central bank, paying them modest interest (now 0.5%) for their trouble. That has prevented the excess reserves from flooding into the economy in the form of cheap loans.

Even though they held substantial excess reserves, commercial banks were not extending loans which would have added money to their deposit liabilities (i.e., assets of the borrowers) and thereby would have entered into circulation.

But such massive increases of liquidity had to have an effect somewhere. Even though consumer price inflation has remained below 2 percent per annum during the years following the Great Recession, other prices in fact have risen more rapidly. Rather than holding idle cash in their vaults or excess reserves, businesses and commercial banks have precipitated financial market bubbles in buying stock shares and bonds, bidding their prices upward and yield rates downward.

During "normal times" stock prices and bond prices typically move in the opposite directions (i.e., stock prices and bond yield rates move in the same direction) as investors shift from holding one type of financial instrument to the other. Melloan explains why bond prices have continued to rise (and yields to fall) in tandem with share price increases:

Interest rates have also been held down by heavy global demand for U.S. dollar assets from big dollar earners like China and Japan. Foreign central banks boosted their holdings of Treasury bonds to $3 trillion in 2013, up from $1.2 trillion at the beginning of 2008, before leveling off in subsequent years. The rollover of those holdings has sustained steady foreign demand for Treasurys, keeping prices high and interest rates low.

Recently stock prices and bond prices have been moving in the same direction. Share indexes have continued to rise at the same time that bond prices rose. Bond prices continued to rise (and yield rates to fall) due to global uncertainties that increased the demands for the safety of American bonds, particularly those issued by the U.S. government.

16. The Money Supply and Inflation

How can an increase of the money supply cause inflation? The link between money supply increases and inflation is what economists refer to as the "diminishing marginal utility" of money balances. The sense of this is that additional dollars held by a rational and normally risk-averse person (i.e., neither a gambler nor a miser) mean ever less to him.*

When the utility (a.k.a. "satisfaction") of the last dollar added to a person's money holding drops below the utility of a dollar's worth of something that he could buy, it is rational to part with the dollar and buy the item. The vernacular of this is that "money burns a hole in the pocket."

If the supply of the item is not perfectly elastic with respect to its price, the additional purchase adds to the demand for it, causing its price to rise. When this occurs as a general phenomenon across all goods and services in response to an increase in the money supply, the increasing average of the prices constitutes inflation. Increases of the money supply precipitate inflation when the additional money is spent.

All money issued into circulation by a central bank will be held by some entities, whether individuals, businesses, or commercial banks. Why have the massive additions to the U.S. money supply brought about by the 2009-2014 phases of "Quantitative Easing" not caused inflation to rise above 2 percent per annum? With uncertainty and unease in the minds of spending and investment decision makers, the utility of holding money tends to increase, causing decision makers to delay or defer spending or investment decisions and hold more money. The additional money supplied won't cause inflation if it is not spent and is held in the cash hoards of businesses and individuals, or in the excess reserves of banks. And the additional money supplied may not precipitate inflation is there is sufficient slack in the economy (e.g., unemployment) so that the demands for more goods and services can be met without increasing costs of production.

As these conditions suggest, an increase of the money supply may not trigger inflation, but for inflation to have occurred, either the money supply has to have increased or the rate of spending the extant money supply (i.e., its "velocity") has to have increased. Although the velocity of money is normally quite stable, it might accelerate due to shortages following a natural disaster, or it could increase if output lags increasing demand as the pace of economic growth increases. Accelerating velocity could feed inflation even if the money supply is not increasing.

The best explanation for why inflation did not rise above 2 percent per annum during the recovery from the Great Recession is that the Quantitative Easing additions to the money supply were impounded in commercial bank excess reserves and business cash hoards due to uncertainty and unease in the minds of bankers and investment decision makers. Also, unemployment, having peaked around 10 percent of the labor force in 2009, provided substantial slack capacity in the economy, and only gradually came down toward 5 percent by early 2016.

As economic growth slowly increased and the economy approached full employment during 2016, the loosening of the pent-up liquidity held by banks and businesses has gradually caused inflation to approach the Fed's target of 2 percent per annum. With a sufficiently stimulative growth program, the swollen U.S. money supply could spark inflation well in excess of 2 percent per annum.
____________

*The marginal utility process also works in reverse: for a rational and normally risk-averse person, the marginal utility of money held increases as the person holds progressively less of it, for example as he spends it. When the marginal utility of the next dollar that might be spent is greater than the marginal utility of anything that it could be spent on, a rational person should stop spending and retain the remaining money that he holds. Although some people stop spending only when they stock out of money, rational people should stop spending before they stock out.

17. The Inflation Delusion

Ben Leubsdorf, writing in The Wall Street Journal, January 31, 2017, notes some modest good news about U.S. wages and benefits:

A broad gauge of U.S. wage and benefit costs, the employment-cost index, rose 2.2% during 2016, the Labor Department said Tuesday. The pace of compensation growth has stepped up modestly from its average annual growth of 2% in 2010 through 2014. (https://www.wsj.com/articles/measures-of-inflation-tick-up-around-the-globe-1485901927)

Leubsdorf also notes what is happening to the U.S. inflation rate:

The Fed's preferred measure of consumer-price inflation was up 1.6% in December from a year earlier, a level of growth last seen in September 2014, also thanks to energy prices rebounding.
. . . .
After years of fighting against deflation, the U.S., the eurozone and Japan show glimmerings of life in consumer prices and wages, evidence that an era of exceptionally low inflation is receding from the global economic landscape.

To "old-school" monetarists who understood that the principal responsibility of the Federal Reserve was to avert inflation, it must seem like anathema that central banks recently have perceived themselves to be fighting deflation and now seem to be pining for higher rates of inflation. But it is a delusion to believe that inflation by itself can be a driver of real economic growth, increasing employment, and higher real wages.*

Policy makers (and perhaps also some of the economists who advise them) seem to have forgotten about the effects of inflation on wage growth. Even though U.S. wages and benefits have increased at a nominal rate of 2.2% during 2016, the 1.6% rate of inflation over the same period means that the real wage-and-benefits gain was only 0.6%.

The inflation rate exceeded the rate of increase of average hourly earnings in early 2008 and in late 2011 and early 2012, causing the purchasing power of hourly earnings to decrease. Even though average hourly earnings increased only slightly more than 2% per annum during 2015, the real purchasing power of those earnings increased because the inflation rate hovered near zero during most of 2015. But as the inflation rate ticked upward relative to average hourly earnings during 2016, the purchasing power gain of average hourly earnings was gradually eroded by the rising inflation rate.

Inflation results when the money supply increases at a faster pace than the economy needs or can absorb. This almost certainly happened on a grand scale with three episodes of "Quantitative Easing" between 2009 and 2014. Quantitative easing was accomplished by the Fed's purchases of Treasury and agency mortgage bonds, the side effect of which was to increase the quantity of money in circulation. Michael S. Derby, writing in The Wall Street Journal, January 29, 2017, notes the magnitude of the Fed's portfolio increase between 2007 and 2014:

The Fed has boosted its portfolio of long-term bonds and other assets to $4.45 trillion from less than $1 trillion in 2007, just ahead of the financial crisis. Officials believe the large portfolio has helped to spur economic growth by holding down long-term interest rates.
(https://www.wsj.com/articles/fed-grapples-with-massive-portfolio-1485717712)

As we have seen over the last half-decade, holding interest rates to very low levels won't stimulate investment if an aura of uncertainty pervades the business sector.

The massive increase of the money supply brought about by the Quantitative Easing program caused inflation averaging no more than about 2% per annum in the eight years after the so-called "Great Recession" of 2008. Such low rates of inflation are attributable to the fact that during this time of great uncertainty, the stimulative potential was impotent because much of the additional money was impounded in commercial bank excess reserves and business cash hoards.

Derby acknowledges that drawing down the huge Fed portfolio by selling bonds could precipitate undesirable effects:

The balance sheet debate is still in its early stages, but it is on Ms. Yellen's mind. In a speech Jan. 19 at Stanford University, she noted the stimulative effects of the Fed's bondholdings are diminishing over time as the moment nears for the Fed to shrink them. Sheer anticipation of a drawdown of the bonds could push long-term rates higher, she said in a footnote to her comments. That's a reason to proceed cautiously.

But the undesirable effects may range far beyond simple anticipation of a portfolio drawdown. Derby notes concerns that the Fed's recent increases of its discount rate and the Federal Funds target rate range has caused dollar appreciation:

Some also worried that raising short-term rates was boosting the dollar, which curbed exports and weighed on inflation. Shrinking the balance sheet instead of raising short-term rates could be a way to tighten financial conditions without bearing the costs of a stronger currency.

The immediate effect of the Fed selling bonds on the open market to diminish its portfolio would be to withdraw money from circulation. But Derby's last statement doesn't follow. Selling bonds from the Fed's portfolio likely will depress bond prices, push up yield rates, and cause dollar appreciation as foreigners demand dollars to buy higher-yield American bonds.

The massive overhang of liquidity from the Quantitative Easing programs had the potential to cause inflation far in excess of 2% per annum. This may be the real reason that shrinking the Fed's portfolio was on Fed Chair Yellen's mind. Large scale bond sales to reduce the Fed's portfolio would cause commensurate money supply decreases that would limit the inflation potential, but they could also precipitate deflation and inhibit real growth of the economy. Indeed, a reason to proceed cautiously.
____________

*Nominal economic growth may occur when the market prices of the economy's output rise, thereby causing inflation. Real economic growth is enabled and encouraged by favorable conditions in the commercial and industrial environments. Such favorable conditions include open international trading relationships, supporting physical and financial infrastructures, tolerance of entrepreneurship, restrained regulation, a moderate tax policy, and an otherwise supportive polity. Gross Domestic Product (GDP) is a measure of the aggregate output of an economy compiled at current market prices. The real growth of an economy can be measured by changes of such an aggregate from which the inflation component has been removed by a statistical process called "deflation." Inflation is a component of nominal GDP growth, but it is not a cause of real economic growth and it should not be regarded as a tool for promoting real growth.

18. The Discount Rate and Capital Scarcity

The discount rate is the interest rate that commercial banks pay for the use of reserves borrowed from the Federal Reserve itself, but it is an administered price rather than a market-determined price. Although there seems to be a current presumption among monetary policy makers that the discount rate is the preeminent policy tool, it is not at all clear that discount rate changes also cause market-determined interest rates to change.

Economists conventionally identify four “factors of production,” land, labor, capital, and entrepreneurship, and the so-called returns to them, respectively, rent, wage, interest, and profit. Since interest is the return to real capital (real productive capacity, e.g., plant, equipment, housing), the "true" interest rate in any region is a measure of the scarcity of capital in the region relative to the demand for it. This true (or scarcity) interest rate is higher in regions where capital is scarce and lower in regions where capital is more abundant. The true interest rate should fall as capital becomes more abundant, e.g., with on-going economic development. It would rise if capital were to become scarcer, e.g., when equipment is destroyed by a natural disaster or war, or if gross investment in the region should become less than depreciation so that the capital stock actually shrinks.

The true or scarcity rate of interest has been referred to in economic literature as the "natural" rate of interest which may be approximated by the yields on long-term (10-year term) government bonds that are essentially riskless. James Mackintosh, writing in The Wall Street Journal, September 2, 2016, notes that

The new debate in central banking is over whether long-run interest rates are lower than in the past, thanks to permanently lower growth. Investors seem to share the view of many policy makers that they are: Long-dated bond yields have plummeted around the world. . . . . The president of the Federal Reserve Bank of San Francisco, John Williams, set the tone for the gathering of central bankers at Jackson Hole, Wyo., last month when he published a widely read letter suggesting the long-run "natural" rate of interest has come down drastically in the past 25 years.
(http://blogs.wsj.com/economics/2016/09/02/think-you-know-the-natural-rate-of-interest-think-again/)

We take issue with this assessment. The "natural" rate of interest corresponds to what we have called the scarcity rate of interest that is determined by the supply of real capital relative to the demand for it. If it has indeed come down over the past half century, it has not been due to "permanently lower growth," but rather because the stocks of real capital in the U.S., Canada, the U.K., and certain E.U. countries have increased with positive net investment (i.e., gross investment exceeding depreciation). Lower rates of economic growth are consequences of declining productivity of capital stocks that have increased relative to labor supplies, not causes of falling natural rates of interest. And, the lower rates of growth in these regions may be temporary responses to uncertainty about geopolitical conditions rather than a long-term or permanent phenomenon.

In a financial sense, interest may be defined as the price for the use of a dollar's (or other local currency unit's) worth of credit for a year. The issuance or sale of a financial instrument by a business firm or a government agency is an implicit demand for credit. The prices of financial instruments are determined by the interaction between forces of demand for and supply of them in the loanable funds market. Yield rates on financial instruments are understood to be their interest rates, computed from information about their market prices. Yield rates, which vary inversely with the market prices of financial instruments, also may vary by risk factors and terms to maturity.

When business firms increase their demands for loanable funds, they increase the supply of corporate bonds coming onto the market relative to the demand for bonds, putting downward pressure on bond prices. As bond prices fall, their yield rates rise, i.e., their bond interest rates rise. Bond interest rates can be expected to fall in response to a business sector decrease in the demand for loanable funds (evidenced by a decrease of the supply of bonds relative to the demand for bonds, causing bond prices to rise) or if the business sector retires more bonds at their maturities than are being issued.

The demand for loanable funds is a derived demand that is a function of the demand for the final goods and services that can be produced with the real capital financed by the loanable funds. The so-called "natural" rate of interest as measured by yield rates on long-term riskless financial instruments therefore cannot diverge significantly or for long from the true interest rate determined by the scarcity of real capital relative to the demand for it.

It may be a delusion to think that a central bank by changing its discount rate can cause market-determined interest rates to change very much from the scarcity rate of return on real capital. When a central bank changes its discount rate, it might precipitate changes of market interest rates in the same direction if banks and other lenders have been holding their lending rates constant in anticipation of a central bank rate change. But allowing for risk and term differences, market interest rates are determined ultimately by the scarcity of real capital relative to the demand for it.

As suggested by Mackintosh, the message for monetary policy is that "A declining natural rate of interest in major economies gives central banks less ammunition to stabilize the economy." This is because when the central bank causes its discount rate to follow the declining natural rate toward zero, it has less "room" to maneuver by further lowering the discount rate unless it is willing to take the discount rate into the negative range. Even then, there is no compelling reason to think that private sector investors will increase investment spending if they are obsessed with geopolitical uncertainty.

19. Discount Rate Near Zero

The U.S. Federal Reserve may be proactive in changing its discount rate (an administered price) with the intention of drawing (or dragging) market-determined interest rates along with it. For example, if Fed officials perceive the need to pursue a stimulative policy, it might lower the discount rate (unless it is already at or too close to zero), thereby reducing a positive spread or creating or widening a negative spread between the discount rate and the Federal Funds rate (a market-determined rate).

If commercial banks find it cheaper to borrow reserves from the Fed than from other commercial banks at the Federal Funds rate, they may both increase lending and offer lower lending rates to commercial borrowers. If commercial enterprises now borrow more from their banks and issue fewer bonds, the supply of bonds will decrease relative to bond demand, bond prices will rise and bond yield rates will fall. If this chain of events has occurred, the decrease of the discount rate has induced market-determined yield rates to fall, thereby stimulating economic activity.

Of course, as noted by John Maynard Keynes, "There are many a slip twixt the cup and the lip." If commercial banks already are holding excess reserves relative to reserve requirements, the lower discount rate may not induce them to borrow more reserves from the Fed. Or, if commercial bankers feel the need to hold even more in excess reserves, they may not increase lending. Or, if commercial enterprises see few opportunities for profitable investment, they may not increase borrowing, even if offered lower lending rates. Or, if the discount rate is already very low, there may not be room to further decrease it without taking it to zero or into the negative realm (where savers pay lenders to borrow from them).

James Freeman, writing in The Wall Street Journal, August 31, 2016, notes that central banks in a number of countries have indeed taken their discount rates into negative territory:

. . . it should count as news that politicians have lately been rewriting a rule in place since 3,000 B.C. This rule of history is that savers deserve to be compensated when they loan money. Not anymore. In much of the developed world lenders are the ones paying for the privilege of letting governments borrow their cash. Through the magic of modern central banking, countries in Europe and elsewhere have managed to drive their borrowing rates not just to historic lows but all the way into negative territory. As of Monday almost $16 trillion of government bonds world-wide were offering yields below zero.
(http://www.wsj.com/articles/the-5-000-year-government-debt-bubble-1472685194)

If any of these conditions obtain, a decrease of the discount rate will not have its intended effect on market-determined interest rates.

Upon occasion the Federal Reserve has changed the discount rate after the fact of changes in market-determined rates. This may happen when Fed officials perceive that the spread between the discount rate and the Federal Funds Rate has become too wide. When this happens, the Federal Reserve is following the market to get its administered-price interest rate in line with market realities rather than leading it and determining market interest rates.

When central bank monetary policy actions are unpredictable, markets for goods and services as well as for stocks and bonds may wait breathlessly to see whether the central bank is going to try to cause market interest rates to change, in what direction, or by what magnitude. Market traders who prognosticate the central bank's policy changes may take preemptive actions to offset what they think that the central bank might do. If their guesses are right, they may render the central bank's actions impotent. Wrong guesses by Fed prognosticators are likely to aggravate whatever problem the economy is experiencing. A surprise monetary policy action or a failure by a central bank to act when expected also can disrupt the stability of the economy.

If a central bank is unable to directly affect market interest rates by changing its discount rate (or if the discount rate is already so low that further decreases would take it to zero or into the negative range), it may try to use the third monetary policy tool, open market operations (a.k.a. "quantitative easing" or tightening). In this regard, the Federal Reserve of the United States has a luxury available only to a small number of central banks around the world. By virtue of the existence of a large volume of public debt (U.S. government treasury bonds) for which an extensive open market has developed, the Federal Reserve can trade in this market to buy and sell government securities. The side effect of such trading is to affect the reserves of commercial banks and either indirectly or directly the quantity of debt money in circulation in the economy.

20. Distortions Due to Superlow Interest Rates

In a Wall Street Journal column on November 10, 2016, Greg Ip says that

While Mr. Trump is no economist, he's articulating a view that's getting traction with economists and financiers: that even if superlow interest rates don't produce inflation, they can do more harm than good by distorting markets, redistributing wealth and fueling bubbles, and the Fed ought to abandon them.
(http://www.wsj.com/articles/does-donald-trump-spell-an-end-to-feds-low-rate-era-1478775604)

This is a simplistic view of the cause of inflation. Inflation is not caused by "superlow interest rates," but rather by excessive increases of the money supply. But inflation above 2 percent per annum did not occur because the excessive money supply issues brought about by the 2009-2014 episodes of "Quantitative Easing" were absorbed by banks in their excess reserves and by businesses hoarding cash. Banks and businesses don't actually hoard cash in their vaults; while they are waiting for potentially profitable investment opportunities, they purchase and hold yield-bearing securities. The increasing purchases of yield-bearing bonds relative to bond supply bids bond prices up and their yield rates (i.e., their interest rates) down to the "superlow" levels.

The so-called "natural rate of interest," usually measured by the yield rates on essentially riskless long-term (10-year maturity) bonds, cannot diverge for long or by much from the "true" rate of interest that reflects the scarcity or abundance of real capital in a region. Shorter-term, market-determined interest rates may be induced by monetary policy to diverge from the natural rate of interest, but it may be a delusion to think that a central bank by changing its discount rate can cause market-determined interest rates to change very much from the scarcity rate of return on real capital.

Allowing for risk and term differences, market interest rates are determined ultimately by the scarcity of real capital relative to the demand for it. When a central bank changes its discount rate, it might precipitate changes of market interest rates in the same direction if banks and other lenders have been holding their lending rates constant in anticipation of a central bank rate change, but the pressure for change already existed.

Artificially low market-determined interest rates distort financial markets because they imply that real capital is more abundant than it is in reality. The "superlow" interest rates (below the true scarcity rate of return to real capital) can induce businesses to undertake investments that may not pay for themselves when the products or services produced by them are sold at their market prices. That the "superlow" interest rates did not elicit the hoped-for increase of investment spending is attributable to geopolitical uncertainty. Once this uncertainty diminishes, distorted investment spending may ensue unless market-determined interest rates are allowed to rise toward the scarcity rate of return on real capital.

Ip also says in the same column that

. . . most economists and central bankers . . . believe interest rates are low because the economy can't tolerate higher rates. Raising them to reward savers or prevent bubbles would exact a price in too-low inflation or more unemployment, they say.

Well, not exactly. The concept of "too-low inflation" is suspect because an inflation target pertains only to the inflation component of a market-value denominated aggregate such as Gross Domestic Product (GDP). An inflation target, like the 2 percent presently preferred by the Federal Reserve, is irrelevant to real economic growth as measured by the real component of GDP. Faster real growth is caused by real factors, such as increasing productivity, improved transportation and communications infrastructure, lower business taxes, and less onerous regulation.

Market interest rates are low because the Fed has manipulated them downward to unrealistic levels. Superlow interest rates distort markets for real goods and services as well as financial markets. Economists recognize that incentives to spend and save are distorted by superlow interest rates. Rather than saving as much as they might have when offered interest rates that are more realistic to the true scarcity of capital, people are inclined to devote larger portions of their incomes to purchasing real things like consumer electronics. This distorts the consumer electronics markets by artificially increasing demands for those items relative to their supplies, bidding up their prices (e.g. cell phones priced at over $700 when the cost of producing them is less than $200 per unit) and inflating the profits of producers.

Allowing market interest rates to rise to more realistic levels may induce more saving and less spending on consumer goods, thereby alleviating a tendency for consumer goods prices to rise. The curb on consumer goods spending may result in greater unemployment in domestic consumer-goods producing industries.

But none of this may happen. One of the basic concepts of economics is that all bets are off if ceteris do not remain paribus, i.e., other things do not remain the same, as they almost certainly will not. Here is a non-exhaustive list of things that may not remain the same:

Savings available to domestic investors may be augmented by foreign purchases of U.S.-issued bonds which will also affect bond prices and yield rates in U.S. financial markets.
Foreigners, "spooked" by domestic U.S. political conditions or concerned about the direction of global U.S. leadership, might withdraw savings from the U.S. economy by unloading some of their holdings of U.S.-issued securities.
Geopolitical issues and uncertainty may cause exchange rates to change and influence international trading and off-shored investment decisions.
Trade agreements are likely to be abrogated or renegotiated, with consequent changes of export potential and import availability and delivered prices.
Policies in regard to corporate inversion activity and tax treatment of repatriated foreign-earned incomes are likely to change.
Trade and immigration policy changes may affect employment in domestic industries producing goods for export and import-competing goods.
Changes in corporate and personal income tax policies are likely to affect both personal saving and business investment decisions.
Although the Federal Reserve touts its nominal "independence" from the political process, contention between the Fed and the new administration may lead to Fed personnel changes with consequent policy reorientation.
A faster pace of economic growth may loosen pent-up liquidity held by banks, businesses, and individuals to cause inflation in excess of the 2 percent per annum target pursued by present Federal Reserve officials.

And many "other things" that can affect economic outcomes are likely to not be the same as they are now. All of which is to say that we need to reassess influences as circumstances change with the advent of the new presidential administration.

21. The Federal Reserve and Deficit Finance

Central banks have at their disposal three major monetary policy tools: commercial bank reserve ratio specification and adjustment, lending (or "discount") rate adjustment, and open market operations.* In executing open market operations, the U.S. Federal Reserve may purchase and hold only "used" bonds, i.e., bonds that had been issued previously by the U.S. Treasury and are being held by members of the public, business concerns, or commercial banks.

During and following World War II, Federal Reserve policy was deliberately accommodative of the Treasury's need to finance war expenditures by pegging long-term interest rates at 2.5 percent. An "accord" reached in 1951 between the Fed and the Treasury ended the accommodation and reasserted the independence of the Federal Reserve System from the U.S. Treasury (http://www.federalreservehistory.org/Events/DetailView/71). Since then the Fed has been prohibited from purchasing bonds newly issued by the Treasury or any other government agency due to the inherent potential for inflation (https://www.federalreserve.gov/faqs/how-does-the-federal-reserve-buying-and-selling-of-securities-relate-to-the-borrowing-decisions-of-the-federal-government.htm).

U.S. federal government deficits were typically less than half a trillion dollars per year prior to the "Great Recession" in 2008. Beginning in 2009 and continuing through 2012, federal deficits exceeded a trillion dollars per year, dropping back toward half a trillion dollars beginning in 2013. The deficit in FY 2015, the latest year for which complete data are available, was $563.57 billion (http://www.usgovernmentdebt.us/download_multi_year_2001_2016USb_15s2li101mcn_G0f).
The continuing annual government budget deficits that the U.S. Treasury has to finance by issuing government bonds has caused the public debt of the U.S. government to increase to over $18 trillion by the end of FY 2015, about the same size as the 2015 U.S. GDP) (http://www.statista.com/statistics/188105/annual-gdp-of-the-united-states-since-1990/)

Keynesian theory would suggest that the massive government spending that produced such large and continuing budget deficits after 2009 would of itself stimulate the economy to grow faster. But the U.S. growth rate has remained stubbornly low, less than 2 percent per annum since 2009. The great government spending may have averted absolute contraction and enabled a slow recovery to deliver the low-level of growth that the economy has experienced since 2009.

With the intent of alleviating the Great Recession of 2008 and accelerating the U.S. rate of economic growth, the Federal Reserve has progressively lowered its discount rate toward zero and engaged in "quantitative easing" (via open market purchases of government bonds) in the effort to put additional reserves into the hands of commercial bankers. Over the same period that the U.S. government was running deficits in excess of a trillion dollars per annum, the Federal Reserve executed two phases of quantitative easing. During QE1 (2009), Federal Reserve holdings of U.S. government securities more than doubled from under a trillion dollars to over 2 trillion dollars. Holdings increased to nearly 3 trillion dollars during QE2 (late 2010 to mid-2011). During a third phase, QE3 (late 2013 until October 2014), holdings increased to nearly 4.5 trillion dollars (http://www.nytimes.com/2014/10/30/upshot/quantitative-easing-is-about-to-end-heres-what-it-did-in-seven-charts.html?_r=0). Bankers have accumulated much of the additional liquidity as excess reserves that have done little to promote lending to businesses to undertake new investment.

The Fed's purchases of previously-issued Treasury bonds held by the public and commercial banks as the Treasury is selling new bonds at auction have the effect of indirectly accommodating the deficit finance process. The result is the second-hand monetization of debt which is no less accommodative of the Treasury's financing need than if the Fed purchased new bonds directly from the Treasury. The monetization of public debt occurs just the same, and it likely would precipitate inflation in more normal circumstances.

The issuance of new bonds by the U.S. Treasury to finance the government's deficits increases the supply of bonds coming onto the market. Given bond demand, this would be expected to lower bond prices and increase yield rates. The Fed's intent is to keep market-determined interest rates from rising or to induce them to fall toward a lowered discount rate. In the absence of other bond demand, it would have to purchase enough previously-issued Treasury bonds from the market to offset the increasing-yield effects of the newly-issued bonds.**

But the Fed is not the only demander of bonds. The U.S. is an open economy subject to foreign as well as domestic financial transactions. The demand for U.S. government bonds has been increasing not only because the Fed has been buying bonds, but also because both domestic and foreign interests are purchasing U.S. government bonds for their relative safety, and in spite of their low yields. This joint demand for bonds has been increasing as fast or faster than the supply of new bonds coming onto the market, causing bond prices to increase and their yield rates to fall. Foreign purchases of U.S. bonds have injected savings into the U.S. economy and assisted the U.S. Treasury to finance the government's deficits. And the falling bond yield rates have served the Fed's intent to lower interest rates toward the near-zero discount rate.

Since neither the U.S. nor many other U.S. trading partners are experiencing excessive inflation, it may be inferred that increases of the U.S. money supply as a result of indirect debt monetization and foreign purchases of U.S. bonds are being absorbed by increasing demand for money balances to hold or impounded by commercial banks as excess reserves.

Central bank purchases of government bonds will continue to be an ineffective growth stimulant as long as investment decision makers are uncertain or pessimistic about the future of demand for their products that could be produced with new capital investment. The continuing slow economic growth and low investment in the U.S. economy suggest that commercial bankers and corporate managers would rather "sit on" the additional liquidity as they wait for growth in the global economy to pick up.

The U.S. government is fortunate in that current conditions are not "normal." Slow economic growth, a discount rate near zero, and implicitly accommodative bond purchases by the Fed enable the continuing finance of annual government budget deficits that accumulate as public debt on which the debt service is minimal. Once the economy begins to grow faster and the Fed concludes that the discount rate can be raised, bond yield rates will rise. It will become much more costly for the government to continue to run budgetary deficits on the scale of recent years. And the overhang of commercial bank excess reserves will pose a much greater potential for inflation.
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*The discount rate is the interest rate that a central bank charges to its commercial banks when they borrow reserves from the central bank. It is a "discount" rate because a bank receives the proceeds of a loan by the Fed that is less than (discounted from) the face value of the loan, but the bank must repay the face value of the loan. Increasing the discount rate discourages commercial banks from borrowing reserves from the Fed to support additional lending; lowering it encourages additional borrowing and lending. Reserve ratio adjustments are commonly used by central banks of countries without well-developed open markets for debt instruments, but such adjustments are rarely implemented by central banks in countries with large and vibrant open markets. Increasing the required reserve ratio diminishes the lending ability of commercial banks by converting excess reserves into required reserves; decreasing it frees up reserves to support additional lending. Where such open markets function well enough, central banks may engage in open market operations by purchasing and selling bonds issued by their respective governments. Central bank purchases or sales of bonds have the effects of, respectively, adding to or reducing the reserves of commercial banks. Reserves in excess of those specified by the required reserve ratio may enable commercial bank lending to businesses and private citizens.

**The Federal Reserve cannot simply dictate changes of market-determined interest rates (e.g., yields on bonds) by changing its discount rate. When a discount rate change is announced, the Fed has to work behind the scenes by executing open market operations to change the demand or supply of bonds in the market, thereby causing bond prices to change and nudging yield rates toward the new discount rate. For example, if the Fed announces a discount rate decrease, in the absence of other sources of bond demand it needs to purchase bonds in the open market, adding to the demand for bonds relative to bond supply, pushing bond prices upward and yield rates downward toward the new lower discount rate. If there are no other sources of increasing bond demand, the trick is to purchase just enough bonds to induce bond yield rates to fall toward the new lower discount rate without under- or over-shooting.

22. Central Bank Purchases of Corporate Bonds and Equities

Central banks have at their disposal three monetary policy tools: commercial bank reserve ratio specification and adjustment, lending (or "discount") rate adjustment, and open market operations. In executing open market operations, the U.S. Federal Reserve is allowed to purchase and hold only "used" bonds, i.e., bonds that had been issued previously by the U.S. Treasury and are being held by members of the public, business concerns, or commercial banks. Except for a nominal amount for account settlement convenience, the Fed is prohibited from purchasing bonds newly issued by the Treasury (https://www.federalreserve.gov/faqs/how-does-the-federal-reserve-buying-and-selling-of-securities-relate-to-the-borrowing-decisions-of-the-federal-government.htm) due to the inherent potential for inflation. However, in 2008 the Fed began to purchase and hold mortgage-backed securities in order to try to provide additional stimulus to the economy and to stabilize the housing and financial markets (http://www.federalreserve.gov/newsevents/reform_mbs.htm). And by convention, the Fed does not purchase, hold, or sell any corporate bonds or stock shares (equities). But things may change in this regard.

In an effort to stimulate faster economic growth, the Fed implemented a looser monetary policy by lowering its discount rate toward zero and engaged in "quantitative easing" (a.k.a. open market purchases of government bonds) in the effort put more reserves in the hands of commercial bankers, and to induce market-determined interest rates to follow the discount rate. This policy effort had little impact on the amount of money in circulation because commercial banks were reluctant to borrow reserves and they impounded additional liquidity as excess reserves with little increase of lending to prospective commercial or industrial borrowers.

Faced with a shortage of bonds coming onto bond markets and unable to get enough additional money into circulation by buying government bonds from commercial banks to increase their reserves, central bankers in some countries are contemplating purchasing corporate bonds in addition to government bonds in hopes that the additional liquidity thereby injected into corporate bank accounts would motivate bank lending to businesses for investment spending.

It appears that equities are also gaining the attention of central bankers. Gerard Baker summarizes an item by Brian Blackstone and Tom Fairless in the September 5, 2016, issue of The Wall Street Journal:

Central banks have become some of the biggest investors in bond markets. Now some in the financial markets think stocks should benefit more from their largess. Some economists say the ECB, which meets Thursday [September 8, 2016] to decide if it should expand its current bond-buying program, should invest in equities. The reason: It is running out of bonds to buy. Other central banks already invest in equities. Switzerland's central bank has accumulated more than $100 billion worth of stocks, while another big stockholder is the Bank of Japan.
(http://www.wsj.com/articles/the-10-point-1473159296)

A central bank purchase of either corporate bonds or stock shares can elicit potential political favoritism or punishment problems because central bankers have to select which corporate bonds or which stock shares to purchase in the open market or directly from the corporate issuers. Corporate bonds selected for purchase by a central bank will experience increased demand relative to their supply, thereby bidding up those bond prices and depressing their yield rates. Likewise, when a central bank purchases corporate stock shares, it adds to the demand for them relative to their supply and bids up their prices on stock markets, likely sending inappropriate signals to investors and market traders.

The opposite political problem will emerge when central bankers find that they need to sell some of the corporate bonds or stock shares in their inventories. Selling the selected corporate bonds or stock shares will increase supply relative to their demand, depressing their market prices and, in the case of bonds, bidding up their yield rates.

A central bank purchase of corporate bonds and equities is likely to be no more effective than open market purchases of government bonds. It will be ineffective as long as investment decision makers are uncertain or pessimistic about the election outcome and the future of demand for their products that could be produced with new capital investment. The continuing slow economic growth and low investment in the U.S. economy suggest that corporate managers would rather "sit on" the additional liquidity as they wait for growth in the global economy to pick up.

Potentially even more disrupting (and disturbing) is the breaking of the convention by central banks not to purchase and hold corporate bonds and equities. This practice directly politicizes central bank open market operations due to favoritism or punishment of particular firms by selecting their bonds or equities for purchase or sale.

23. Monetary Policy and Arbitrage

In his newsletter of April 22, 2022, New York Times columnist Paul Krugman discusses how a recession might or might not happen. After considering the possibility that the Federal Reserve is moving too slowly with respect to the current inflation, Krugman says,

But there’s another possibility, which if you ask me isn’t getting enough attention. Namely, that the Fed will move, or maybe already has moved, too fast and that the economy will cool off much more than necessary. In that case ... we could have an unnecessary recession, one that could develop quite quickly.

Why worry about this possibility? After all, so far the Fed hasn’t done much in the way of concrete action: It has raised the interest rate it controls by only a quarter of a percentage point. But the longer-term interest rates that matter for the real economy, especially mortgage rates, have already soared based on the expectation that there will be many more rate hikes to come...

(https://messaging-custom-newsletters.nytimes.com/template/oakv2?campaign_id=116&emc=edit_pk_20220422&instance_id=59176&nl=paul-krugman&productCode=PK&regi_id=74240569&segment_id=89958&te=1&uri=nyt%3A%2F%2Fnewsletter%2Ffd12663f-83f4-5857-a70a-fa259675d556&user_id=86b0d837dd357b2a6e0e749321f6ed7f)

The interest rate that the Fed controls is its discount rate.* The implication is that the Fed's control of its discount rate extends to other interest rates across financial markets.

But the Federal Reserve cannot simply dictate changes of market-determined interest rates (e.g., bank lending rates, mortgage rates, yields on bonds) by changing its discount rate. The Fed may appear to dictate interest rate changes when financial interests anticipate a discount rate change but have been waiting for the Fed to announce the discount rate change to change their own rates.

As Krugman suggests, changes of market interest rates may lead an expected discount rate change so that the anticipated change has already been "priced in" by financial instrument traders. It is even possible that changing market interest rates may induce the Fed to change its discount rate to get in line with market realities, in which case the Fed would be following the financial markets rather than imposing its will on them.

In this essay, the word "bond" is used as a euphemism for all financial instruments that yield interest. It is important to recall that in financial markets, traders do not bid yield rates, whether explicitly or implicitly; they bid prices of financial instruments, and yield rates may be computed from the price information. It is important to remember that there are no special financial markets set aside for purchases and sales of government bonds or any other categories of bonds, including those of foreign origin; they are traded in the same financial markets with all other financial instruments. It is important to note that the Fed’s discount rate usually is a below-market interest rate at which only commercial banks that are members of the Federal Reserve System may borrow. The discount rate is not available to businesses, consumers, or home buyers.

Because there are other influences on financial market interest rates than the Fed, there is no guarantee when the Fed announces a discount rate change that market rates will follow. When a discount rate change is announced, the Fed may have to work behind the scenes by executing open market operations to change the demand or supply of bonds in the market, thereby causing bond prices to change and nudging yield rates toward the new discount rate.

For example, if the Fed announces a discount rate decrease, in the absence of other sources of increasing bond demand or decreasing bond supply, it needs to purchase bonds in the open market, adding to the demand for bonds relative to bond supply, pushing bond prices upward and yield rates downward toward the new lower discount rate. If there are no other sources of increasing bond demand or decreasing bond supply, the trick is to purchase just enough bonds to induce bond yield rates to fall toward the new lower discount rate without under- or over-shooting. This is an even trickier operation since there almost always are other sources of increasing bond demand or decreasing bond supply. Changing bond yield rates will elicit interest rate changes through the financial system by the process of arbitrage.

On the other hand, if the Fed announces a discount rate increase, in the absence of other sources of increasing bond supply or decreasing bond demand, it needs to sell bonds in the open market, adding to the supply of bonds relative to bond demand, pushing bond prices downward and yield rates upward toward the new higher discount rate. If there are no other sources of increasing bond supply or decreasing bond demand, the trick is to sell just enough bonds to induce bond yield rates to rise toward the new higher discount rate without under- or over-shooting. This is an even trickier operation since there almost always are other sources of increasing bond supply or decreasing bond demand. Changing bond yield rates will elicit interest rate changes through the financial system by the process of arbitrage.

Arbitrage, the simultaneous purchase and sale of financial instruments whose prices (and yield rates) are changing, works to transmit changing interest rates across financial markets to other financial instruments. It does this because profit-motivated financial instrument traders can be expected to sell financial instruments whose prices have risen (i.e., their yield rates have fallen) to capture profit and in order to use the sale proceeds to purchase other financial instruments, the prices of which have not risen or have fallen.

Assuming that there are no other sources of increased or decreased bond supply or demand, suppose that the Fed announces a discount rate increase with the intent to elicit interest rate increases across financial markets. It begins to sell bonds from its portfolio, causing the bond prices to fall and their yield rates to rise. Financial instrument traders will see profit opportunities in selling other financial instruments in their portfolios in order to buy the lower-priced bonds sold by the Fed. The sales of other financial instruments will lower their prices and raise their yield rates, thereby effecting transmission of the Fed’s intent to increase interest rates. The simultaneous sales and purchases of financial instruments will tend to bring about changes of interest rates across financial markets toward the Fed’s newly-announced increased discount rate.

Or, suppose that the Fed announces a discount rate decrease with the intent to elicit interest rate decreases across financial markets. It begins to buy bonds from the financial markets, causing the bond prices to rise and yield rates to fall. Financial instrument traders will see profit opportunities in selling financial instruments in their portfolios to the Fed in order to buy other financial instruments on the market. The purchases of other financial instruments will raise their prices and lower their yield rates, thereby effecting transmission of the Fed’s intent to decrease interest rates. The simultaneous sales and purchases of financial instruments will tend to bring about changes of interest rates across financial markets toward the Fed’s newly-announced decreased discount rate.

Concurrent increases or decreases of demand or supply of bonds from sources other than the Fed may disrupt or even frustrate the intent of the Fed to elicit market interest rate changes in its intended direction. Other sources of changing bond demand or supply may include federal and local governments, domestic businesses and bond market traders, and foreign governments, businesses, and bond traders.

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*The discount rate is an “administered price” rather than a market-determined rate. It is the interest rate that a central bank charges to its commercial banks when they borrow reserves from the central bank. It is a "discount" rate because a bank receives the proceeds of a loan by the Fed that is less than (discounted from) the face value of the loan, but the bank must repay the face value of the loan. Increasing the discount rate discourages commercial banks from borrowing reserves from the Fed to support additional lending; lowering it encourages additional borrowing and lending.

24. Unwinding the Fed's Portfolio

Nick Timiraos, writing in The Wall Street Journal, April 16, 2017, notes the implications of the Fed's acquisition of its $4+ trillion portfolio of mortgage and Treasury bonds during three episodes of "quantitative easing" between 2008 and 2015:

Before 2008, banks held relatively low levels of deposits--known as reserves--at the Fed. The central bank managed the federal funds rate by making small adjustments in the amount of these reserves through routine purchases and sales of Treasury securities. Now, with a large portfolio of securities, the Fed has left the banking system flush with trillions of dollars in reserves. It manages rates now by paying interest on these reserves.
(https://www.wsj.com/articles/fed-puts-together-plan-to-unwind-securities-portfolio-1492340401)

The Fed acquired most of the mortgage bonds from the mortgage guarantee agencies (Freddie Mac and Fannie Mae). The bulk of the Treasury bonds were acquired in the open financial markets, which had the effect of increasing commercial bank reserves. Although the Treasury was increasing the supply of bonds to the financial markets in order to finance the government's budget deficits during those years, the effect of the Fed's quantitative easing bond purchases was to increase the demand for Treasury bonds relative to the supply of them coming to the financial markets, bidding bond prices up and their yield rates down toward the Federal Funds target rate of 0.5%.

Timiraos describes the Fed's desire to "unwind" this huge portfolio:

The Fed wants to move toward a smaller portfolio for several reasons. The economy is on stronger footing, leaving less need for support from a large bond portfolio. The large holdings have become a political liability, unpopular in Congress. Moreover, getting started now could relieve pressure on possible new leadership in 2018, when Fed Chairwoman Janet Yellen's term ends. Finally, officials want room to ramp it back up in a crisis if needed.

Timiraos also describes the Fed's plan for unwinding its portfolio of mortgage and Treasury bonds:

Officials leaned at their March meeting toward reducing holdings of Treasuries and mortgage bonds simultaneously. They could reduce these holdings gradually by tapering the reinvestments of principal payments, or they could stop the reinvestments cold turkey, which would be easier to communicate to markets but could also create more market volatility. Significant shares of the Fed's Treasury holdings are scheduled to mature in 2018 and 2019.

All well and good for the Fed and its balance sheet, but what are the implications of this unwinding process for both the U.S. and the global economies?

A principle taught in the basic money-and-banking course is that the Fed "creates" money when it buys bonds from the public (individuals, businesses, commercial banks), and it "destroys" money when it sells bonds to the public. The means for creating and destroying money are bookkeeping entries that offset the bond transactions. The Fed creates money when it adds funds by bookkeeping entries to the bond sellers bank accounts. It destroys money when it subtracts funds form the bond buyer's bank accounts.*

As the securities held by the Fed mature, the Treasury redeems the bonds held by the Fed, the matured bonds are returned to the Treasury (i.e., they cease to exist as active financial instruments), and the Treasury pays "cash" to the Fed for them. On the Treasury's balance sheet, the bookkeeping entries to recognize this bond-maturation process decrease both its asset account "cash" and its liability account "bonds outstanding." On the Fed's balance sheet, the bookkeeping entries to recognize this swap of cash for matured bonds increase the Fed's asset account "cash" and decrease the Fed's asset account "bonds held." This transaction reduces the Fed's portfolio of interest-earning assets as it intends, but it leaves the Fed holding an increased cash balance (which it has implicitly destroyed in the bond-redemption process). It is important to remember that, by definition, money held as asset within the banking system and the Treasury is not in circulation and can have no effect on the economy.

Commercial banks acquired a tremendous amount of reserves in excess of legal requirements during the Fed's quantitative easing purchases of bonds from the public. A common presumption is that if the Fed's portfolio is decreased by letting bonds mature without replacing them, the lending potential of the commercial banking system would decrease, but this is not the case. The Fed originally bought the bonds from the public, paying cash for them in the form of deposits (and increased reserves) at commercial banks. Since the bond purchase transactions were between the Fed and members of the public, money was created. Reserves in excess of legal requirement could be reduced if the Fed were to sell non-maturing bonds to the public which pays for them, thereby reducing both their bank deposits and the reserves of commercial banks.

But in the Fed's portfolio-reduction bond redemption process, the maturing bonds are "sold" (i.e., returned) to the Treasury, not to the public. Since the redemption transactions are solely between the Fed and the Treasury, the reserve deposits of commercial banks are unaffected, and the excess-reserve lending potential of commercial banks remains intact. This lending potential may promote growth if business confidence continues to improve and induce businesses to increase borrowing from banks to finance capital investments. It also has potential to cause inflation if the demand for personal loans begins to increase when the economy is near full employment.

But there's more to this story. If the U.S. government were running budget surpluses, it could decrease the outstanding government debt by attrition as the various securities that the Fed holds mature simply by not replacing them (i.e., by not engaging in "refunding" operations). However, the U.S. government continues to run budget deficits that require financing ("funding"), so it needs to issue new bonds to finance the deficits and to roll over the maturing debt (i.e., to issue replacement bonds for the outstanding bonds that mature). Even as the "old" bonds go out of existence, the "new" bonds issued by the Treasury to replace them and to finance the deficits are auctioned to the financial markets because they are no longer being absorbed by the Fed in a quantitative easing process.

Since the Fed is no longer engaged in quantitative easing and is planning to "unwind" its portfolio, these new and replacement bonds increase the supply of bonds to the financial markets. Unless the demand for bonds is increasing at least as fast for other reasons, the increasing supply will depress bond prices and raise their yield rates. This may induce market rates to rise toward the Federal Funds target rate that the Fed intends to increase, but the rising interest rates may have a dampening effect on business and personal borrowing.

But this outcome is by no means certain. Given the fears and uncertainties currently afflicting the world, the safety and increasing yields of U.S. Treasury bonds make them attractive to foreigners, and this may cause the global demand for U.S. Treasury bonds to increase. If this demand were to increase even faster than the supply of new Treasury bonds to replace maturing bonds held by the Fed and to finance deficits, bond prices would increase, causing their yields to fall. This would be consistent with the Fed's intention to induce market interest rates to fall.

Foreigners (individuals, businesses, governments) may purchase some of the new and replacement bonds issued by the Treasury. To pay for the U.S. Treasury bonds that they purchase, foreigners would have to increase their demands for dollars from the foreign exchange markets relative to the supply of dollars. This would bid up foreign-currency prices of the dollar, causing the dollar to become even stronger.

Is there any reason to think that either the supply of bonds or the demand for dollars is increasing, or that interest rates may rise on global markets? Carolyn Cui, Ian Talley, and Ben Eisen, writing in The Wall Street Journal, April 23, 2017, note that

Emerging-market companies are binging on U.S. dollar debt and that could become a source of trouble in some parts of the world if growth slows, interest rates rise or the dollar resumes its ascent. Governments and companies in the developing world sold $179 billion in dollar-denominated debt in the first quarter, the most dollar debt ever raised in the first quarter and more than double the amount raised during the same period last year, according to data provider Dealogic.
(https://www.wsj.com/articles/flood-of-dollar-debt-could-come-back-to-haunt-emerging-economies-1492945204)

When foreign governments and companies "sell" dollar-denominated debt, they are actually issuing dollar-denominated bonds which are auctioned in international financial markets with payment required in U.S. dollars. Although these bonds are not issued by the U.S. Treasury, they none-the-less increase the supply of dollar-denominated bonds coming onto global bond markets. This also increases the demand for dollars from the forex markets to pay for the bonds. If bond demand and dollar supply do not increase commensurately, this phenomenon will depress bond prices and increase their yield rates at the same time that the foreign-currency prices of the dollar are rising. The rising yield rates may be counter to the Fed's policy intent, and the appreciating dollar may worsen the trade deficit.

Cui, Talley, and Eisen note repayment risk problems for emerging markets when the dollar appreciates:

Companies with dollar borrowings can be especially exposed. If the dollar rises, it makes the debt more expensive to pay off. Companies that don't earn dollar revenues, including some telecoms, property developers and retailers, can stumble. Repayment risk is especially high in countries with large external deficits and low levels of foreign-exchange reserves. If the dollar appreciates faster than expected, some corporate borrowers, especially those who derive their revenues largely in local currencies, could find themselves in a currency mismatch and be forced to ask the central bank for help--which not all central banks are positioned to do.

All of which is to note that the Fed's plans to wind down its $4+ trillion portfolio may have global repercussions far beyond the Fed's balance sheet, and outcomes are unlikely to be quite as expected.
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*On analogy, one can create a letter "m" on the computer screen by pressing the "m" key on the computer keyboard. Where does the letter "m" come from? It is simply "created" by the computer's logic. Where does the money that the Fed adds to the deposit balance of a bond seller come from? It is "created" by a bookkeeping entry. On analogy, a letter on the computer's screen can be destroyed by pressing the back-space key on the keyboard. Where does the letter go when it is destroyed? It simply ceases to exist. Where does the money go when a buyer pays the Fed for a bond? It too ceases to exist.

25. Growth and Monetary Stimulus

Jon Hilsenrath, writing in The Wall Street Journal, January 16, 2017, says that

An epoch of exceptional monetary stimulus is drawing to a close. Central banks have exhausted themselves in their efforts to spur economic growth with low—even negative—short-term interest rates and bond-purchase programs meant to drive financial-asset prices higher.
(http://www.wsj.com/articles/central-banks-drop-their-bazookas-1484560802)

In the wake of the Great Recession of 2008, governments in many countries have relied almost exclusively on central banks to foster recovery and stimulate growth. But it should be no surprise that the massive increases of money supplies (a.k.a. "quantitative easing") would be impounded in commercial bank excess reserves and business cash hoards. Nor should it have been surprising that driving interest rates toward zero would be an ineffective stimulant to investment in environments of uncertainty, anxiety, and pessimism. Hilsenrath goes on to note that

The low-rate epoch didn't deliver fast economic growth. In the advanced economies that championed the policies, economic output has expanded at a rate at or below 2% for six straight years and will do so again in 2017, estimates the International Monetary Fund.

The delayed recovery and slow growth is attributable to an aura of uncertainty, high tax rates on business income, excessive regulation of businesses, and government spending directed primarily to social net disbursements, all phenomena that low interest rates could not help. Growth enabling policies would have included tolerance and support of the business sector by the Administration, business tax rate reductions, elimination of the more onerous business regulation, and infrastructure spending.

Hilsenrath also points to the likelihood that the Federal Reserve, rather than acting proactively in changing interest rates, often follows the financial markets that have already perceived the need to change rates and have "priced in" expectations of future Fed rate changes:

If all goes according to plan, its benchmark interest rate will rest at 1.375% by year-end, a level not seen in the U.S. since before Lehman Brothers collapsed in September 2008. Anticipating the shift, investors have already pushed long-term interest rates higher. Yields on 10-year U.S. Treasury notes have jumped from 1.37% in July to near 2.5%.

The Federal Reserve, among other central banks, has taken upon itself a "dual mandate," i.e., to pursue both price stability and economic growth. A moral of the present story is that the "comparative advantage" of central banks lies not in stimulating economic growth, decreasing unemployment, or increasing incomes, but rather in providing an appropriate supply of money to avert both inflation and deflation.

Early in 2017, the U.S. economic growth rate was picking up, unemployment had fallen, and wages were increasing. The current improving economic conditions are attributable to the fact that non-monetary policy actions were under contemplation.

26. Inflation and Unemployment

Greg Ip, writing in The Wall Street Journal, October 30, 2016, says that . . .

economic circumstances and attitudes of policy makers have shifted in the past year in ways that suggest the likeliest path of inflation is up, not down. Data released Friday showed that core inflation, which excludes food and energy, reached a two-year high of 1.7% in the third quarter, according to the Fed's preferred measure. Other data found stirrings of wage acceleration. . . . The behavior of inflation-protected bonds suggests that in early July, investors expected U.S. inflation to average 1.4% over the coming decade. As of Friday, that had risen to 1.7%. (http://www.wsj.com/articles/inflation-long-quiescent-begins-to-stir-1477861130)

Ip reveals his theory of what causes inflation and deflation:

The best gauge of spare economic capacity is the unemployment rate. In the U.S., it has fallen to 5% from 10% seven years ago. Across the seven largest advanced economies, it has fallen from 8.4% in 2009 to 5.4% in July, back to where it stood in 2007, just before the global financial crisis, according to economists at Goldman Sachs. Typically, high unemployment nudges inflation down and low unemployment nudges it up. That inflation stayed low as unemployment declined led some economists to worry the relationship had broken down.

Does rising unemployment cause deflation (or disinflation, i.e., a slower rate of inflation)? Does decreasing unemployment cause inflation? These two quantities usually covary in opposite directions, but the link that connects the two lies with a couple of other variables, namely the money supply and the rate of economic growth.

A more plausible explanation of inflation is that the money supply has increased at a faster pace than the economy needs or can absorb. Deflation results when the pace of money supply increase is less than the needs of a growing economy. Nominal economic growth occurs when inflation raises the market prices of the economy's output. Real economic growth is enabled and encouraged by favorable conditions in the commercial and industrial environments: favorable international trading relationships, a supporting infrastructure, tolerance of entrepreneurship, restrained regulation, a moderate tax policy, and an otherwise supportive polity.

Gross Domestic Product (GDP) is a measure of the aggregate output of an economy compiled at current market prices. The real growth of an economy can be measured by changes of such an aggregate from which the inflation component has been removed (by a statistical process called "deflation"). Inflation is a component of nominal GDP growth, but it is not a cause of real economic growth and it should not be regarded as a tool for promoting real growth. It can serve as a policy target only for some measure of aggregate output compiled at current market prices (i.e., from which inflation has not been removed). In this sense, then, an inflation target is irrelevant if the goal is a faster pace of real growth.

It's hard to avoid the business cycle language of contraction, recovery, and expansion when discussing unemployment rates. Unemployment usually increases as the pace of economic growth slows during a contraction, and it decreases once the economy begins to grow faster during the recovery following a contraction. The U.S. unemployment rate reached a high at nearly 10 percent of the labor force at the trough of the so-called "Great Recession" beginning in 2008. The economy now has had nearly seven years of fairly steady growth averaging around 2 percent per annum in the recovery following the Great Recession. Unemployment has come down from nearly 10 percent of the labor force in 2009 to 5 percent at mid-2016, even as inflation has remained below 2 percent per annum.

So why has inflation remained low as unemployment has declined? One might think that the three Quantitative Easing phases implemented by the Federal Reserve in 2009-2014 should have increased the U.S. money supply by enough to cause substantial inflation, but the additions to the U.S. money supply have been absorbed in the excess reserves of banks and the increasing cash hoards of businesses. The business outlook remained sufficiently pessimistic that bankers saw few good lending possibilities and prospective borrowers declined to borrow.

Neither the decreasing unemployment rate nor the increasing money supply thus-far has caused the inflation rate to rise to a level that is satisfactory to Federal Reserve officials (around 2 percent per annum). But I would not count on low inflation at near-full employment to be a permanent feature of the U.S. economy. It would be a mistake to assume that the historic relationship between the money supply and the price level has broken down. And it is unlikely that the historic covariance relationship between the inflation rate and the unemployment rate no longer obtains. As noted by Ip, hints of accelerating inflation are now being observed. Eventually the mass of liquidity "sloshing about" in the global economy could precipitate inflation well above the Fed's target rate as the the unemployment rate drops below 5 percent of the U.S. labor force and the real economic growth rate increases above 2 percent per annum.

The rates of employment and unemployment are concomitants of the rate of real economic growth in an economy, but they are neither causes nor consequences of inflation.

The misconception that a falling unemployment rate may cause inflation is held at the highest policy-making levels. Kate Davidson, writing in The Wall Street Journal, November 2, 2016, says that

Some [Federal Reserve] officials argue for keeping rates low and letting the jobless rate, which was 5% in September, fall further in hopes of generating more jobs and economic gains for people who are only just starting to benefit from the expansion, including African-Americans and Hispanics. Others say the Fed should have raised rates already, warning that letting unemployment fall too low could lead to a surge in prices that forces the Fed to raise rates quickly, in turn causing a recession. These officials say this could hurt the very people their colleagues aim to help.

. . . .

Fed officials don't know exactly how low the jobless rate can go before inflation picks up too much. If they allow unemployment to fall to 4.5% and inflation doesn't start to pick up, they will have learned that they might be able to let it decline further without spurring inflation. (http://www.wsj.com/articles/fed-doesnt-aim-to-push-inflation-beyond-2-1478036513)

The potential for "a surge in prices" and "spurring inflation" lies not in decreasing unemployment, but it the massive increases of the money supply brought about by the three phases of Quantitative Easing by the Fed during 2009-2014.

Gerard Baker, writing in The Wall Street Journal, November 18, 2016, says that

The U.S. dollar steamed to a level not seen since 2003 and yields on the 10-year Treasury note reached a high for the year Thursday, as Federal Reserve Chairwoman Janet Yellen confirmed investors' view that the U.S. economy is strong enough to withstand an interest-rate rise soon. Ms. Yellen told lawmakers in testimony Thursday that the Fed could move “relatively soon,” after the government released a grab bag of economic data all pointing to a stronger economy: an improving housing market, rising consumer prices and a more robust labor market. The number of Americans filing new claims for unemployment insurance fell last week to its lowest level since 1973, the Labor Department reported Thursday.
(http://www.wsj.com/articles/the-10-point-1479470176)

27. Modern Monetary Theory

Stephanie Kelton, a professor of economics and public policy at Stony Brook University, has become a leading proponent of a fringe idea known as Modern Monetary Theory, or MMT. She argues that the government should pay for programs requiring big spending, such as the Green New Deal, by simply printing more money.

In his September 1, 2021, NYT opinion piece, Peter Coy noted that Representative John Yarmouth (Kentucky's 3rd Congressional District), who chairs the House Budget Committee for the 117th Congress, gave a "full-throated defense" of Modern Monetary Theory on the June 17 edition of C-SPAN's "Washington Journal."

Coy, Katia Dmitrieva, and Matthew Boesler, writing in Bloomsberg Business Week on Marcy 21, 2019, offer a beginner's guide to MMT that traces its thought lineage (https://www.bloomberg.com/news/features/2019-03-21/modern-monetary-theory-beginner-s-guide). The tenets of MMT include:

The fundamental Keynesian premise: a monetary-based capitalist economy inevitably experiences departures from full employment and price stability; in the absence of effective self-correction, the macroeconomy needs to be managed by government authority to achieve and maintain stability.
Money in the twenty-first century is almost exclusively fiat money issued by governments of nation states; it is no longer (if it ever was) a human innovation to avert quid pro quo problems associated with barter.
A nation-state's government is the only supplier of fiat money that may be used in its economy; the principal means of issuing fiat money is government spending or the repurchase or redemption of the government's debt obligations.
A tax obligation is necessary to assure the demand for fiat money which is declared by the state to be legal tender for paying tax obligations and satisfying all debt obligations, public or private; this means that a lender's only recourse for satisfaction of outstanding loans is acceptance of the fiat currency.
A nation that prints its own currency may be unconcerned about debt accumulation because it can always print (or create by accounting means) more money to redeem the debt and pay interest on it; however, there may be inflationary consequences of issuing ever more money.
Government can spend whatever it needs to spend to meet social needs (e.g., infrastructure, education, health care) or to alleviate unemployment up to the point that the rate of inflation becomes higher than desired by government authority.*
A government program to guarantee employment may serve as an automatic stabilizer to provide employment to meet social needs; when private sector employment and incomes decrease during a recession, government employment and wage payment can increases to take up the slack; when private sector employment recovers, people can be expected to leave government employment for better-paying jobs in the private sector; government may create as much money as necessary to pay the government-employment wage bill.
The only constraint on spending (public, private) is inflation which occurs when too much money enters into circulation; an increase of the rate of inflation signals that too much money is in circulation relative to available goods and services and the potential to provide more.
Monetary policy centered on manipulating interest rates is largely impotent due to long, complex, and uncertain transmission mechanisms; monetary and fiscal authorities should be merged or required to work in concert to keep interest rates as low as possible, preferably zero.
Fiscal policy (i.e., government spending, tax collection, debt issue, debt redemption) should be the principal means by which the macroeconomy is managed to diminish unemployment and avoid excessive inflation.
The government fiscal authority taxes and issues debt (i.e., floats bonds), not to finance its expenditures, but rather to absorb excess money in circulation; government may increase the amount of money in circulation by increasing spending, reducing tax rates, and repurchasing or redeeming outstanding bonds.

Some Quibbles

The MMT approach largely ignores the real constraints of production capacity by assuming that supply chains always work smoothly* and supply always can accommodate to changes of demand by simple reallocation of undifferentiated resources from former uses to newly perceived social needs.

MMT also seems to presume that the labor force is comprised of homogenous units of labor that have no occupational or place preferences and can be employed (assigned) to social needs when private sector employment falls. Also, if wage rates in a guaranteed government employment program are set too high, people may choose to remain in government employment rather than return to private employment when the economy recovers.

MMT devotes no apparent attention to the on-going process of technological disemployment (i.e., robotization). The proposed government guaranteed employment program has the potential to become a universal basic income program as workers are displaced by robotization.

MMT appears to ignore the possibility that businesses and households may thwart a fiscal authority's effort to stimulate a recessed economy by increasing the amount of money in circulation with bond purchases. If they impound and hold cash hordes rather than spend them, the additional money won't have the desired effect. Or, if businesses and households are holding little excess cash during an expansion, they may not be in the market to purchase bonds when the fiscal authority attempts to quell inflation by issuing new bonds to siphon purchasing power out of the economy. Or, they may have more profitable investment opportunities or more desirable spending opportunities than buying government bonds.

Interest rates are the "prices" for the use of a scarce resource, capital. Keeping interest rates "as low as possible, preferably zero" by authoritarian means implies the abundance of capital, which simply is not a reality of the world in which we live.

Bond yield rates, which vary inversely to bond prices, are the effective interest rates on bonds. The supply of bonds to financial markets is a reflection of the scarcity of real capital because the proceeds of bond sales can be used to acquire real capital (plant, equipment, etc.). Bond prices rise/fall (and yield rates fall/rise) when the supply of bonds to financial markets increases/decreases relative to the demand for bonds. Changes in bond interest rates are transmitted to other financial markets via arbitrage (i.e., the simultaneous purchase and sale of financial instruments across markets).

As a reflection of the scarcity of real capital, market interest rates may vary significantly from a target interest rate set by a fiscal authority (or a monetary authority that is subservient to the fiscal authority), especially if the target rate is set very low or zero. A fiscal authority determined to force market interest rates down to a very low target interest rate must be prepared to purchase bonds from financial markets virtually without limit (or until it has bought up all outstanding bonds), thereby increasing the amount of money in circulation and precipitating inflation. Of course, it can simultaneously try to sell new bonds to absorb excess money as it repurchases old bonds if there is any longer a market for its bonds.

In an open-economy world, bond prices and yield rates vary with both domestic and international demand for and supply of bonds. Depreciation of the nation's currency may be a result of chronic trade deficits, or it may signal that the global supply of the nation's bonds exceed the global demand for them. The nation's exchange rates with other nations' currencies may be managed by issuing more bonds or purchasing or redeeming outstanding bonds. However, if the government devotes fiscal policy to managing exchange rates, it gives up the ability to use fiscal policy to address domestic needs unless the fiscal policy to address domestic needs coincides with that required to manage exchange rates.

The Main Problem

The MMT advocacy of delivering management of a macroeconomy into the hands of a fiscal authority is laughable on its face. Twenty-first century partisan politics alone in the United States demonstrates Congressional gridlock and the inability of a democratically-elected legislative assembly to make timely fiscal changes that would be requisite to achieving and maintaining macroeconomic stability. But there are other serious problems for fiscal policy.

A fiscal authority that is empowered to adjust tax rates and approve or curb expenditures upon perceived need can create uncertainty in both the business and household sectors. Such uncertainty may disrupt domestic and international supply chains and adversely affect employment and production planning processes. It may foster a cottage industry that attempts to predict the timing and magnitude of such changes, and it may induce efforts to offset or counter expected fiscal changes. If expectations of future fiscal changes are accurate, they may contribute to a stabilization process by "pricing in" the expected changes, but if expectations are wrong, they are likely to disrupt production processes and aggravate macroeconomic instability.

Given our present state of macroeconomic knowledge, it is heroic to think that fiscal policy decision makers can accurately specify the magnitudes of needed tax rate adjustments or expenditure changes with any degree of accuracy, especially since the response to any such fiscal policy changes may have amplified effects via spending multiplier processes that are uncertain. If the fiscal policy decision maker implements a policy change that is too small to counter an undesirable macroeconomic condition, the condition will persist. If the fiscal policy decision maker implements a policy change that is too large, it is likely to aggravate the condition rather than ameliorate it.

Economists refer to the time between when a macroeconomic change occurs and when it is recognized by government officials as the recognition lag. They refer to the time between recognition of such a change and the taking of some action to offset it as the response lag. Needless to say, these lags are both variable in duration and themselves unpredictable. The response lag for monetary policy may be a matter of days or weeks, while that for fiscal policy may be months or quarters. In democratic polities, fiscal policy actions must be proposed, debated, and legislated, processes that may span years.

There is yet another lag that may eclipse the first two in duration. It is the so-called reaction lag, the period between when an action is taken and the effects of the action fully work through the economy. The reaction lag usually involves a multiplier process of consecutive rounds of respending. Experience in the U.S. economy suggests that the multiplier effect of a fiscal policy action may be completed in as little as a year, but it may not be fully worked out in more than two years. The duration of the reaction lag is therefore even less predictable than are the recognition and response lags. The three lags together may span a period of as little as a year, or as much as three or more years. These lags taken together put the government in the position of needing to implement a compensating policy even before some event shocks the economy.

Given these lags, another serious problem is that the natural adjustment mechanisms of the economy may have reversed the direction of change of the economy by the time that the policy designed to deal with the original problem finally has its effect. For example, in a contracting economy, an expansionary fiscal policy is called for. But by the time the contraction can be confirmed, expansionary policy implemented, and the multiplier process completed, the economy of its own volition likely will have begun its recovery. So the expansionary monetary policy impacts an already-expanding economy. A similar, but reversed, scenario can be depicted for an economy entering a period of expansion. Because of variable and unpredictable time lags in the implementation of macropolicy, government's well-intentioned efforts to stabilize the economy often end up destabilizing it--"booming the boom," or "depressing the depression."

Experience with these efforts has convinced some economists that deliberate policy activism often involves policy overreactions due to time lags in recognizing changing conditions, initiating policy actions, and the completion of adjustments. Today, some economists are not so sure that deliberate manipulation of the government's budget in efforts to diminish macroeconomic instability doesn't inject more instability into the economy than would be present if the government simply left the macroeconomy to manage itself.

When unemployment or inflation have "reared their ugly heads," bureaucrats usually have felt compelled to follow the admonition, "Don't just sit there, do something!" Because discretionary policy overreactions may tend to destabilize a macroeconomy rather than stabilize it, many macroeconomists have become leery of policy activism. But bureaucrats have difficulty following the reverse admonition: "Don't just do something, sit there!" The ability to wait patiently simply is not in the genes of political animals. Political inaction may be worse for a bureaucrat's career than policy overreaction.

And finally, there is an ultimate "deal-breaker" for fiscal policy as the vehicle for managing a macroeconomy. Domestic macroeconomic stabilization may not be the highest priority of the government, or at least not until the economy becomes seriously destabilized by excessive inflation or unemployment or both. Under more normal circumstances, particularly in democratic polities, the government's agenda may require it to become oriented mainly to program needs rather than economic stability. Program needs may include social, educational, military, and infrastructure projects.

A democratic government may enact such programs almost irrespective of their financing requirements. The dominant fiscal motivation of a democratically elected government may be financing the program expenditures to which it has become committed, irrespective of the fiscal requirements of economic stability. But here is where MMT comes into its own. Advocates of MMT argue that "government can spend whatever it needs to spend to meet social needs (e.g., infrastructure, education, health care) or to alleviate unemployment up to the point that the rate of inflation becomes higher than desired by government authority." (This "not-news" was well understood by twentieth-century monetarists.) The rate of inflation is the canary in the government spending mine.

Most governments' budgets tend to be in chronic deficit, irrespective of whether their economies are contracting or expanding, and irrespective of whether they are democratic or autocratic. When the needs of program finance dominate public policy, the government loses its capacity to manipulate its budget in the pursuit of economic stability. In MMT, program needs may be of higher priority than is macroeconomic stability. Even so, according to MMT advocates the government fiscal authority should be able to use its spending, tax collection, debt issue, and debt redemption abilities to ensure macroeconomic stability (i.e., diminishing unemployment and avoiding excessive inflation).

An Authoritarian Advocacy

Given the difficulties of managing a mixed market (capitalist) macroeconomy with a democratic polity, the MMT prescription that macroeconomic stabilization should be implemented with fiscal policy would require a strong central fiscal authority that is imbued with sufficient knowledge and wisdom, and that is committed to the general welfare of its society, a veritable "philosopher king." Even a deliberative body along the lines of the Board of Governors of the Federal Reserve System may not be able to act expeditiously in response to macroeconomic change, much less to devise preemptive policy actions to head off predicted adverse changes. Ideally, the ability to vary tax rates, expenditures, and bond market activity in timely fashion to achieve and maintain macroeconomic stabilization would require the authority and power bordering that of a commissar or a fascist dictator. Modern Monetary Theory implicitly is a call for an authoritarian solution that may not be compatible with democratic polity or market economy.
------------

*On October 15, 2021, the Editorial Board of The Washington Post wrote:

As inflation has picked up over the past year, Federal Reserve officials have assured the public that the fast pace of price increases is “transitory,” the result of temporary supply chain kinks due to covid-19. Once Malaysian microchip factories, Chinese ports and Mexican auto assembly lines get rolling again, the supply of suddenly expensive goods such as cars will catch up with demand, and prices will level off. Another factor, the massive fiscal support Congress passed in the form of covid-19 aid, will run out over the course of this and next year.

In August, inflation appeared to decelerate. But the Bureau of Labor Statistics reported Wednesday that it picked up again in September — increasing 0.4 percent from the previous month and 5.4 percent from a year earlier — bringing fresh anxiety about how long Americans would have to struggle with rapidly rising prices. This comes on top of months of growing or steady inflation before August. (https://www.washingtonpost.com/opinions/2021/10/15/inflation-is-rising-democrats-must-avoid-making-it-worse/?utm_campaign=wp_todays_headlines&utm_medium=email&utm_source=newsletter&wpisrc=nl_headlines&carta-url=https%3A%2F%2Fs2.washingtonpost.com%2Fcar-ln-tr%2F34ff384%2F616aa2e29d2fda9d41124dba%2F596c29ff9bbc0f208654282b%2F42%2F67%2F616aa2e29d2fda9d41124dba)

28. Monetary Policy and Exchange Rates

In the wake of the U.K. Brexit vote in June of 2016, the U.S. dollar appreciated for a short time relative to the U.K. pound (i.e., the pound depreciated with respect to the dollar) but the pound recovered in a few weeks. Since the beginning of 2016, the U.S. dollar has depreciated a net of 13.7 percent against the U.K. pound. This dollar depreciation benefits U.S. domestic producers of goods for export to U.K. by making U.S. goods appear less expensive to British buyers, but at the same time it curbs U.S. imports from U.K. by making British goods appear more costly to Americans.

Because of uncertainty surrounding the Brexit vote, the depreciation of the dollar relative to the pound may be a special case. Between early January and mid-July of 2016, the U.S. dollar appreciated 6.1 percent against the Canadian dollar, 2.5 percent against the euro, 15.2 percent against the Japanese yen, 5.4 percent against the Australian dollar, and 5.2 percent against the New Zealand dollar. The U.S. dollar appreciation manifests itself as depreciations of those currencies vis-a-vis the U.S. dollar. These currency depreciations should be expected to stimulate exports to the U.S. and thus improve their trade balances and rates of economic growth.

But in recent weeks, these currencies have appreciated against the U.S. dollar in spite of their respective central banks' efforts to implement looser monetary policies in hopes of precipitating depreciation of their currencies. Other things remaining the same, if a looser monetary policy increases a country's money supply, the increased amount of money in circulation would be expected to increase the demand for foreign currencies relative to their supplies on foreign exchange markets, bidding up their prices in terms of their respective domestic currencies, i.e., causing their domestic currencies to depreciate. Since this has not been happening recently, we may infer that "other things" have not remained the same. One possibility is that the supplies of foreign exchange have increased at a faster rate than has the demand for foreign exchange.

Another possibility for explaining the failure of a looser monetary policy to precipitate currency depreciation has been demonstrated recently in the U.S. economy by the Federal Reserve. In an effort to stimulate faster economic growth, the Fed has been implementing a looser monetary policy by lowering the discount rate toward zero and engaging in "quantitative easing" (a.k.a. open market purchases of government bonds). This policy effort has had little impact on the amount of money in circulation because commercial banks have been reluctant to borrow reserves and they have been impounding additional liquidity as excess reserves with little increase of lending to prospective commercial or industrial borrowers. An old adage is that one can lead a horse to water, but cannot force it to drink. On analogy, a central bank can provide additional reserves to commercial banks, but it can't force commercial bankers to lend, and it can't force prospective borrowers to borrow.

In spite of a looser monetary policy, instead of depreciating, the U.S. dollar has appreciated against many of its trading partner currencies since the first of 2016. This episode of dollar appreciation may be attributable to something else that did not remain the same, i.e., increasing uncertainty in global markets that stimulates foreign demand for U.S. dollars to buy relatively safe U.S. government bonds. The increasing foreign demand for U.S. dollars has overwhelmed any effects of a looser monetary policy that might have precipitated dollar depreciation. The dollar appreciation of course has dampened exports and prevented improvement of the U.S. trade balance.

These considerations suggest not only that monetary policy may be ineffective in a general sense, but that it may be a mistake for a central bank to attempt to manipulate monetary policy in pursuit of exchange rate goals. If the exchange rate goal (e.g., depreciation of the domestic currency) does not align with domestic macroeconomic needs (e.g., inflation aversion), then giving primacy to the exchange rate goal renders monetary policy unavailable for addressing the macroeconomic need. Occasionally, exchange rate and domestic macroeconomic needs may align, as for example when the domestic economy needs stimulus to grow faster and the alleviation of a trade deficit would benefit from depreciation of the domestic currency relative to foreign currencies. Otherwise, monetary policy should be addressed toward domestic macroeconomic needs, leaving the exchange rate to change in regard to foreign exchange market conditions.

Kevin Warsh is a former member of the Federal Reserve board and now is a distinguished visiting fellow in economics at Stanford University's Hoover Institution. Writing in The Wall Street Journal, August 24, 2016, he says:

The Fed seeks to fix interest rates and control foreign-exchange rates simultaneously—an impossible task with the free flow of capital. Its “forward guidance,” promising low interest rates well into the future, offers ambiguity in the name of clarity. It licenses a cacophony of communications in the name of transparency. And it expresses grave concern about income inequality while refusing to acknowledge that its policies unfairly increased asset inequality. (http://www.wsj.com/articles/the-federal-reserve-needs-new-thinking-1472076212)

29. Monetary Policy and the Stock Market

James Mackintosh, writing in The Wall Street Journal on August 23, 2016, clearly reveals the implicit expectation on the parts of stock market investors and traders that central bankers will direct monetary policy to their benefit, at least when "disaster strikes":

Faith in how far central banks will protect against losses comes and goes, though. In market-speak, the Yellen put is less out of the money if a smaller price fall pushes the Fed to act. At the moment, investors seem to think the put is barely out of the money at all.

The danger, then, is not so much complacency about markets, but complacency about central banks. The lesson of the past seven years is that policy makers will step in every time disaster strikes. But investors tempted to rely on the central banks should note that disasters did still strike, and markets had big falls before help arrived. (http://www.wsj.com/articles/its-getting-scarily-quiet-in-the-stock-market-1471889703)

Adam Shell, writing in the USA Today section of The Greenville News, September 10, 2016, describes a single-day event that confirms the expectation of stock market investors that central bank monetary policy will support their interests:

At the market close [on Friday, September 9, 2016], the Dow Jones industrial average was down 394.46 points at 18,085.45 — its worst one-day drop since the 610-point slide on June 24 after the United Kingdom voted to leave the European Union — as investors fretted over the prospect of getting less support from the world's central banks.
(http://greenvillenewssc.sc.newsmemory.com/?token=8d29e797bd2b94d8c5a652a605b4b95e&cnum=2433627&fod=1111111STD&selDate=20160910&licenseType=none&)

Parallel to the concern that a central bank might implement its monetary policy to manipulate or moderate changes in exchange rates, when a central bank uses its monetary policy tools to serve the interests of stock markets, these tools are unavailable to pursue domestic macroeconomic needs unless these needs happen to align with the interests of stock market investors and traders.

Kevin Warsh, a former member of the Federal Reserve board, writes in The Wall Street Journal, August 24, 2016:

The Fed often treats financial markets as a beast to be tamed, a cub to be coddled, or a market to be manipulated. It appears in thrall to financial markets, and financial markets are in thrall to the Fed, but only one will get the last word.
(http://www.wsj.com/articles/the-federal-reserve-needs-new-thinking-1472076212)

The original and fundamental remit of any central bank is to pursue price stability and promote general macroeconomic well-being and growth. To the extent that a central bank places its policy primacy on stock market conditions, it's another case of the tail wagging the dog, i.e., the interests of the stock market are served even if the larger macroeconomic needs of the global economy are ignored. Rather than being the objects of monetary policy, both the stock and exchange markets should be left to react to monetary policy actions which are taken to address income, employment, and price level issues.

30. Monetary Policy and Rational Expectations

Intelligent, knowledgeable, and rational economic decision makers have the ability to thwart policy intentions of government officials, including those at the Federal Reserve.

In order to make rational decisions, the manager of a microeconomic decision unit (a business firm or a household) must be able to predict not only what is likely to happen in the economy, but also what government officials are likely to try to do about any economic problem that emerges. The first predictive problem is difficult enough; the second adds a further dimension of uncertainty. The second dimension might not be so serious except that the actions of monetary and fiscal authorities often are not very predictable. And there are good reasons for their lack of predictability, i.e., their propensity to implement policy surprises.

Two economic theories shed light on the lack of predictability of public policy makers. In the first, the so-called "adaptive expectations hypothesis," intelligent decision makers are presumed to learn from historical experience which they then extrapolate to expectations of future states. For example, suppose that the economy is at its normal operating capacity that is growing at a steady rate enabled by population growth, technological advance, and net positive capital investment. Perhaps at the behest of politicians, the Fed decides to try to increase the real output of the economy above the normal operating capacity or to increase the economy's growth rate by decreasing interest rates or by increasing the money supply or the rate at which it is increasing. It implements the expansionary monetary policy as a surprise, i.e., without making any public announcement.

This unexpected (surprise) action stimulates liquidity-sensitive purchases and increases demand for the output of the economy. The demand stimulus may induce an increase of output above the normal operating capacity, but it also sets in motion a process of "demand-pull" inflation. It doesn't take long for consumers to realize that prices are higher today than they were yesterday, and they were higher yesterday than the day before. It therefore appears reasonable to expect prices to be higher tomorrow than today, and even higher the day after tomorrow. Thus, it would be wise to go ahead and make anticipated purchases today rather than wait for the higher future prices, even if the items are not needed until a future date.

The current purchases add to today's demand for those items and virtually insure rising prices tomorrow. But when decision makers are surprised by the realization that prices are higher than they had counted on when they made their employment and output decisions, they may adjust their employment and output plans to lower levels so that output falls back toward the normal operating capacity of the economy. This results in further inflation, but of the "cost-push" variety, until the economy adjusts back to its normal operating capacity.

The second theory is the "rational expectations hypothesis." In this theory, knowledgeable decision makers are presumed to reason and analyze as well as extrapolate. Decision makers have the presence of mind to take into account what government policy makers might do in regard to any emerging situation or to the intent of politicians, and thus to modify their behavior in response both to the situation and what the policy makers might do in response to it.

Again, suppose that the economy is near its normal operating capacity. Instead of surprising the economy with a demand stimulus, the Federal Reserve makes public announcement that it is implementing an expansionary monetary policy (e.g., to decrease its discount rate) with the intention of increasing the output of the economy or causing it to grow faster. Rational decision makers deduce that an inflationary process may ensue, but they will be skeptical that the policy can sustain output above the normal operating capacity or growth rate for long. Thus, when they make their employment and production decisions for future months, they adjust their list prices and wage increases in anticipation of the ensuing inflation without ever increasing real output. The real output of the economy or its growth rate does not change, even temporarily, when a Fed policy is publicly announced or correctly predicted. It is only when a Fed policy action surprises the economy or is not predictable that real output changes, however temporarily.

To the extent that the rational expectations theory is correct in its premise that rational decision makers analyze as well as extrapolate, then it is only by surprising the economy, or behaving unpredictably, that Fed policy changes can have any real impact on the economy, and then only temporarily. And it is for this reason that government officials tend to take unexpected policy actions and thereby interject an additional degree of instability into their economies.

The 2011 Nobel Prize in Economics was awarded to economists Thomas Sargent and Christopher Sims for their work during the 1970s and '80s in analyzing and modeling rational responses of society to macroeconomic changes, particularly interest rates.

The stability of a macroeconomy depends critically upon the expectations of decision makers concerning future macroeconomic conditions and political decisions. The economy can remain stable only as long as decision makers' expectations match actual conditions fairly closely, i.e., when there are no surprises. Real output may rise temporarily above the normal operating capacity of an economy when the actual rate of price inflation exceeds the price expectations of decision makers, i.e., when decision makers are surprised by the price inflation. Real output may fall below the normal operating capacity of an economy when the actual rate of inflation is below decision makers' price expectations, i.e., when they are surprised by less inflation than expected. This may occur when there is a decrease of the output of the economy below the normal operating capacity.

A more general conclusion is that any ensuing period of expansion or contraction must be attributable to something unexpected that results in wrong guesses by decision makers about future conditions. Politicians count on such wrong guesses.

31. Open Market Operations and the Federal Funds Rate

The Federal Open Market Committee often agonizes over whether and when to raise or lower its Federal Funds rate by changing the interest rate that the Fed pays to commercial banks on their excess reserves. The Federal Funds rate is the interest rate that commercial banks charge each other to borrow their excess reserves overnight. Kate Davidson, writing in The Wall Street Journal, October 13, 2016, says,

Some Fed officials warned the central bank was risking a dangerous inflation surge and could undermine its own credibility by further delaying rate increases. Several others, however,said that with little evidence of emerging inflationary pressures and signs of remaining slack in the labor market, there was no hurry to act. The division led to a rare triple dissent, with three regional Fed presidents voting against the committee's decision to hold rates steady at a range of 0.25% to 0.50% in September. Even among those who wanted to wait, several said the decision was “a close call,” according to the minutes.
(http://www.wsj.com/articles/wsj-survey-economists-expect-next-fed-rate-increase-in-december-1476367202)

The Fed can of course change its own interest rate (an administered price), but how does that feed through the economy to changes of market-determined interest rates? The Federal Reserve cannot simply dictate changes of market-determined interest rates (e.g., yield rates on bonds) by announcing a change of the rate of interest paid on commercial banks' excess reserves. In some instances the Fed may appear to have dictated market interest rate changes if lenders were ready for a rate change and expected one but had been delaying their own lending rate changes while waiting for the official announcement of a rate change.

When the excess reserves rate is changed with intent to cause the Federal Funds rate to change, the Fed has to work behind the scenes by executing open market operations to change the demand for or supply of bonds in the market, thereby causing bond prices to change and nudging yield rates toward the new Federal Funds target rate. Interest rate changes become transmitted through the financial markets via interest rate arbitrage (i.e., the simultaneous purchase and sale of bonds to take advantage of bond price differentials, and thus their corresponding yield rate differentials).

For example, if the Fed engineers a Federal Funds rate increase, in the absence of other sources of bond supply it needs to sell bonds in the open market, adding to the supply of bonds relative to bond demand, pushing bond prices downward and yield rates upward toward the new higher Federal Funds rate. If there are no other sources of increasing bond supply, the trick is to sell just enough bonds to induce bond yield rates to rise toward the new higher Federal Funds rate without under- or over-shooting.

In an open-economy world there are other sources of bond supply as foreigners offer bonds for sale in U.S. financial markets. With an influx of foreign bonds, the Fed may not need to sell as many bonds as it would if the U.S. were a closed economy. If an influx of foreign bonds is so great that bond prices fall far enough to cause yield rates to rise above the increased Federal Funds rate, the Fed may end up having to buy bonds to bring yield rates down to the new Federal Funds rate. An example of other sources of bond supply is noted by Carolyn Cui, Ahmed Al Omran, and Christopher Whittall, writing in The Wall Street Journal, October 19, 2016:

The Fed is empowered to purchase or sell U.S. Treasury securities directly from and to commercial banks or security dealers holding deposits in commercial banks in the U.S. in order to make lasting changes to the volume of reserves in the U.S. commercial banking system. The Fed bought U.S. Treasury securities outright, mostly through securities dealers, in the three big episodes of "quantitative easing" between 2009 and 2014.

Other major central banks likewise engage in open market operations if their financial markets are deep enough, and they too may try to lower market-determined interest rates in order to stimulate faster economic growth. To do so they buy bonds issued by their own and other governments, thereby increasing the demand for bonds relative to supply in order to push bond prices up and their corresponding yield rates down. Todd Buell and Paul Hannon, writing in The Wall Street Journal, October 16, 2016, indicate the intent of the European Central Bank:

European Central Bank President Mario Draghi Thursday signaled that policy makers may extend their program of bond purchases beyond its scheduled expiration in March, but without offering a clear commitment to do so. Mr. Draghi was speaking at a news conference after the central bank's decision to leave its key rate unchanged at a record-low of 0%, where it has been since March. The ECB also left its deposit rate at minus 0.4%, meaning that banks pay to leave excess cash at the central bank overnight.

(http://www.wsj.com/articles/european-central-bank-leaves-rates-on-hold-1476964265?mod=djemalertEuropenews)

The implementation of monetary policy becomes more complicated when central banks pursue policies that cause bond prices to diverge between domestic and foreign financial markets. For example, when foreign central banks implement policies that cause bond prices to rise (and their corresponding yield rates to fall) in their national financial markets while the Fed is implementing a policy to cause bond prices to fall (and their corresponding yield rates to rise) in the U.S. financial markets, foreign investors have incentive to buy bonds in the U.S. financial markets at lower prices to get higher returns, and U.S. bond issuers have incentive to sell bonds at higher prices in foreign financial markets to collect larger sale proceeds and pay lower interest rates. Both actions will tend to cause bond prices and corresponding yield rates to reverse direction in their respective financial markets and converge internationally, possibly thwarting the intentions of their respective central banks.

It should be noted that central banks usually engage in open market operations only in their own national financial markets; buying or selling bonds in foreign financial markets will affect the reserves of banks in those markets but will not affect the reserves of banks in their own national markets. Yet, some of those other central banks have found that they are running out of government-issued bonds to buy in local financial markets, so they are beginning to buy corporate securities. Nina Trentman, writing in The Wall Street Journal, September 26, 2016, says that

The European Central Bank has been gobbling up corporate and government bonds for months and plans to buy assets valued at €80 billion, or about $90 billion, a month until March 2017. Between June 8 and last Friday, it bought €27.9 billion of corporate debt. The Bank of England, trying to prevent a slowdown in the wake of the U.K.'s vote to leave the European Union, is set to start its program Tuesday, and aims to buy £10 billion ($13 billion) in company debt over the next 18 months.
(http://www.wsj.com/articles/corporate-bond-buying-attracts-doubts-as-growth-tool-for-europe-1474930008)

By virtue of the huge U.S. public debt (as of October 20, 2016, $19.756 trillion, excluding U.S. government agency debt and state and local debt, http://www.usgovernmentdebt.us/), the quantity of U.S. treasury securities ("bonds") outstanding is large enough and U.S. financial markets are deep enough that the Fed has yet to run out of U.S. Treasury bonds to buy outright, and it holds a substantial quantity of such bonds in its own portfolio (as of October 12, 2016, $2.463 trillion of U.S. Treasury securities plus $1.736 trillion of mortgage-backed securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1) that could be sold. However, rather than engaging in outright security transactions, the Fed now executes open market operations by borrowing from or lending funds to primary securities dealers via auctions, with U.S. Treasury securities serving as collateral for the loans. The side effect of such open market auction transactions is temporarily to increase or decrease commercial bank reserves.

32. Open Market Policy by Repo Transactions

A commercial bank suffering a deficiency of reserves relative to the legal requirement has a number of options to address the deficiency. If time permits, it may simply wait while issuing no new loans and hope that outstanding loan attrition occurs, i.e., that enough of its outstanding loans are paid down or paid off by borrowers so that its reserves meet the legal requirement. If time does not allow the loan attrition possibility, it may:

borrow reserves at the Fed's "discount window," receiving an amount less than the face value of the loan (the discount) but repaying the face value of the loan;

borrow so-called "Federal Funds" from other commercial banks that have excess reserves to lend;

sell some of the securities that it owns on the open market;

sell some of the securities that it owns to security dealers who can offer interest rate bids to borrow funds from the Fed by implicitly selling securities to the Fed to be repurchased the next day.

Open market auctions are conducted by the Federal Reserve Bank of New York (FRBNY) on behalf of the Federal Reserve System. The FRBNY website describes the intent as follows:

To implement monetary policy, short-term repurchase and reverse repurchase agreements are used to temporarily affect the size of the Federal Reserve System's portfolio and influence day-to-day trading in the Federal Funds market.
(https://apps.newyorkfed.org/markets/autorates/fed%20funds)

Open market operations may be implemented by the Fed in the process of "unwinding" its huge portfolio acquired in three episodes of "quantitative easing" between 2008 and 2014. The Federal Reserve Bank of New York (FRBNY) website currently identifies the only other open market operations as repurchase and reverse repurchase operations. In a repo auction, security dealers bid on borrowing money from the Fed, offering U.S. Treasury securities as collateral. They implicitly "sell" the securities to the Fed on the day of agreement, and then repurchase them the next day. In a reverse repo auction, dealers offer interest rates at which they would lend money to the Fed. They implicitly "buy" securities from the Fed on the day of agreement, and the Fed repurchases them the next day. Repurchase agreements are made at the initiative of the trading desk at FRBNY which implements monetary policy at the behest of the Federal Open Market Committee (FOMC).

Security dealers' deposits with commercial banks vary with the needs of commercial banks to increase or decrease their reserves. A commercial bank finding itself temporarily deficient of required reserves can sell U.S. Treasury securities in its portfolio to a securities dealer. The process of clearing the transaction adds to the bank's reserves as the securities dealer pays for the securities. A commercial bank with excess reserves (which are not supporting lending that would earn interest income) may buy U.S. Treasury securities from a securities dealer to earn interest while the securities are held in its inventory. The purchase of securities reduces the bank's reserves as the bank pays the dealer for the securities. In turn, securities dealers with more or less securities in their portfolios than they wish to hold may participate in the FRBNY's repo or reverse repo auctions.

Security dealers may choose whether to participate in a FRBNY auction. If no or few dealers choose to participate in a repo auction by the FRBNY to temporarily borrow funds from the Fed, the implication is that the dealers either do not need to borrow funds, or they think that the rate offered by the Fed is too high to pay to borrow funds. In a reverse repo offering, if the FRBNY chooses not to accept any of the interest rates offered by the securities dealers to lend money to the Fed, the implication is that the rates offered by the securities dealers are too high.

Since reverse repo transactions are loans by security dealers to the Fed for settlement the next day, they temporarily drain reserves from the commercial banking system, reducing its potential to issue loans to banking customers during the day. The self-reversing nature of these overnight reverse repo transactions return the loaned funds to the securities dealers the next day with interest, and in the process add reserves back to the banking system. The only difference in system reserves before and after a reverse repo transaction is the amount of interest income received by the dealers which is added to the dealers' deposits in commercial banks.

The typical term of repo operations is overnight, but the FRBNY can conduct these operations with terms out to 65 business days. Since repo and reverse repo transactions are short-term and self-reversing, they have no significant lasting effect on the total of reserves in the banking system, but they may influence the effective Federal Funds rate and market-determined interest rates.

Chart 11 shows the Fed's overnight repo and reverse repurchase agreements between 2019 and 2024. In the upper panel of Chart 11, the Fed began accepting repo agreements to lend money to security dealers in late 2019 during the Covid-19 pandemic by temporarily (overnight) purchasing securities from them in modest amounts up to $100 billion per day. The securities were repurchased by the dealers the next day per the repo agreements. The repo agreements had the effect of temporarily supplying reserves to the banking system. The Fed ceased accepting repo agreements by mid-2020 as recovery from the pandemic ensued.

As shown in the lower panel of Chart 11, the Fed accepted modest amounts of reverse repurchase agreements to borrow money from securities dealers until early 2018 after which the volume of accepted agreements rarely departed from zero until early-2021. The Fed began accepting reverse repo agreements by temporarily selling securities to dealers in mid-2021 as inflation heated up during the recovery from the Covid-19 pandemic. The reverse repo agreements had the effect of temporarily (overnight) draining reserves from the banking system. The Fed continued to accept reverse repo agreements through early 2024. The reverse repo agreement amounts gradually increased toward $2.4 trillion per day in late-2022 through mid-2023. Acceptance of reverse repo agreements declined thereafter as inflation begain to subside in late-2023.

The Fed's ostensible intent in using repo operations may be to affect the size of the Federal Reserve's portfolio of securities, but another important result is to nudge the effective Federal Funds interest rate and market-determined interest rates toward the Fed's main policy tool, the interest rate that it pays to commercial banks on their reserve balances.

Chart 12 shows the Fed's interest rates from mid-2015 to early 2024. The top panel of Chart 12 shows that the Fed gradually increased its interest rate paid on reserve balances to early-2019 when it began to decrease it to zero in early-2020 during the Covid-19 pandemic. The Fed began increasing the interest rate on reserve balances in mid-2020 as the economy began recovery from the pandemic and the rate of inflation increased. The Fed plateaued this interest rate by late-2023 when it appeared that inflation was abating. The rate on reserve balances is an administered interest rate.

The middle panel of Chart 12 shows that the Fed lets the rates paid on accepted overnight reverse repurchase agreements track the interest rate on reserve balances. The rate on accepted overnight reverse repurchase agreements is a market-determined interest rate.

The bottom panel of Chart 12 confirms that the effective Federal Funds rate adjusted to the interest rate on reserve balances and the rate on accepted overnight reverse repurchase agreements as these were changed by the Fed. The effective Federal Funds rate is a market-determined interest rate.

If the Fed recently has lowered the interest rate that it pays to commercial banks on their excess reserves and the effective Federal Funds rate still is above it, the FRBNY may decrease the repo bid rates that it accepts from security dealers to borrow money from the Fed. Or, if the Fed has recently raised the interest rate that it pays to commercial banks on their excess reserves and the effective Federal Funds rate still is below it, the FRBNY may increase the repo bid rates that it accepts from security dealers to lend money to the Fed. The acceptance of dealer bid rates may nudge the effective Federal Funds rate and market interest rates toward the excess reserves interest rate.

The FRBNY relies on overnight self-reversing repo transactions that only temporarily change commercial bank reserve balances but make no lasting impacts on bank reserves. But the repo and reverse repo auctions serve as the instruments for nudging the effective Federal Funds rate to settle on the excess reserves interest rate set by the Fed and to align market-determined interest rates with the effective Federal Funds rate.

33. The Capital Scarcity Rate of Interest

Introduction

Many commentators and textbooks that purport to explain interest rates treat them only as returns to financial instruments. Little if any attention is given to the underlying real basis of interest rates. The natural rate of interest, described by Knut Wicksell in 1898, is no longer a "hot topic" in economics or finance literature, but it may be mentioned in passing on the way to describing interest rates as purely financial phenomena. My intent in this work is to describe a variation on the natural rate concept and argue that it is fundamental to understanding both the real and the financial aspects of interest rates. Charts provided by the Federal Reserve Bank of St. Louis (Federal Reserve Economic Data, FRED) have been downloaded to illustrate most relationships.

Economists conventionally identify four “factors of production,” land, labor, capital, and entrepreneurship, and the so-called returns to them, respectively: rent, wage, interest, and profit. Since interest is specified as the return to real capital (physical productive capacity, e.g., plant, equipment, housing), the "true" interest rate in any region is a measure of the scarcity of capital in the region relative to the demand for it. This true interest rate is referred to in this essay as the "capital scarcity rate of interest," or simply as the "scarcity interest rate." Rates of return can be computed for any of the factors of production, so the term "scarcity interest rate" will be taken to refer to the rate of return to the region's stock of capital rather than to any of the region's other resource endowments.

The Natural Rate of Interest

The scarcity rate of interest corresponds loosely to the concept of the "natural rate" of interest introduced by Knut Wicksell in 1898 (Geldzins und Güterpreise; English translation, "Interest and Prices," 1936). Wicksell defined the natural rate as "a certain rate of interest on loans which is neutral in respect to commodity prices and tends neither to raise nor to lower them" (https://en.wikipedia.org/wiki/Neutral_rate_of_interest#:~:text=The%20neutral%20rate%20of%20interest%2C%20previously%20called%20the,keeping%20inflation%20constant.%20It%20cannot%20be%20observed%20directly). In modern parlance, this rate is described as a "neutral rate" of interest,

The neutral rate of interest (also called the long-run equilibrium interest rate, the natural rate and, to insiders, r-star or r*) is the short-term interest rate that would prevail when the economy is at full employment and stable inflation: the rate at which monetary policy is neither contractionary nor expansionary. It is a function of the economy’s underlying characteristics and is not set by the Federal Reserve. (Sam Boocker, Michael Ng, and David Wessel, https://www.brookings.edu/articles/the-hutchins-center-explains-the-neutral-rate-of-interest/).

The neutral rate of interest might be understood as the interest rate that would obtain in equilibrium at full employment in a non-money-using economy, i.e., a pure barter economy. Even in a barter economy, investment in productive capacity, e.g., building a fence around a chicken coop, would be expected to yield real returns in the forms of more eggs and consumable chickens that are protected from predators. And those real returns can be expressed as a greater or lesser percentage rate of return in comparing results before and after construction of the fence. In a money-using economy, money serves as a denominator of value rather than the real value itself. The monetization of the values of real things with a common currency results in prices that enable comparisons of values and computation of financial interest rates.

The Capital Scarcity Rate of Interest

Interest is a real phenomenon attributable to the ability of real (rather than financial) capital to increase human productivity. Interest would be paid "in kind" in a barter economy. Interest is the return to scarce real capital in the same sense that the wage is the return to scarce labor. Both returns are positive as long as the respective factors of production are scarce and they are productive. In this sense, the capital scarcity interest rate can never become zero or negative unless the quantity of real capital becomes superabundant.

In a money-using economy, the fundamental reason that interest is paid for the use of money over some period of time is that money can be used to claim (i.e., acquire) real capital goods which increase productive capacity. The only two reasons to demand loanable funds are to use them to purchase real capital equipment and to purchase consumer goods. The reason that interest is paid on consumer loans is that loanable funds have to be bid away from purchasing real capital goods. Consumer loan interest rates often are higher than commercial loan rates simply because consumers have to out-bid commercial borrowers to capture some of the loanable funds.

The capital scarcity interest rate is region specific. Due to the effect of diminishing returns, the scarcity rate of interest is higher in regions where capital is scarce and lower in regions where capital is more abundant. The scarcity interest rate would be expected to fall as capital becomes more abundant with on-going economic development. It would rise if capital were to become scarcer, e.g., when equipment is destroyed by a natural disaster or war, or if gross investment in the region should become less than depreciation so that the nominal capital stock shrinks.

Scarcity rates of interest may be lower in more developed parts of the world that are capital-abundant; we should expect scarcity rates to be higher in lesser developed regions of the world that are capital-scarce relative to local demands for capital. The marginal productivities of new capital investments would be higher in capital-scarce regions, inviting "offshore" investments in those regions by firms located in other regions with more abundant capital and thus lower marginal productivities of capital. Growth rates in capital-scarce regions may slow as their capital stocks increase with ensuing development.

Economic activities that affect and are affected by the capital scarcity interest rate:

Economic Growth and Development
Interregional Trade
Industrial Policy
Protectionist Policy
Financial Markets
Monetary Policy

The Scarcity Rate and the Neutral Rate

The concept of the scarcity rate of interest is not as restricted as that of the natural or neutral interest rate. The scarcity interest rate accommodates monetary transactions and policy, and it enables consideration of disequilibria in both real and financial markets as they are linked to each other. The scarcity rate concept is posited relative to the real capital stock in a region. The neutral interest rate concept takes no explicit account of the capital stock or of regional differences of installed capital.

If all the conditions specified for the neutral rate were met, the scarcity rate in a region would converge upon the neutral rate in that region. It is in this sense that, with due consideration to disequilibrium conditions, the neutral rate in a region might serve as a proxy for the scarcity rate in that region. Neither the neutral interest rate nor the scarcity interest rate is observable or trackable, but inferences may be drawn about the value of a regional scarcity interest rate by observing what is happening in regional markets.

Although the neutral or natural rate of interest is not directly observable, yields on longer-term government bonds that are essentially riskless have served as proxies for the natural rate of interest. James Mackintosh, writing in The Wall Street Journal September 2, 2016, notes that

The new debate in central banking is over whether long-run interest rates are lower than in the past, thanks to permanently lower growth. Investors seem to share the view of many policy makers that they are: Long-dated bond yields have plummeted around the world. . . . . The president of the Federal Reserve Bank of San Francisco, John Williams, set the tone for the gathering of central bankers at Jackson Hole, Wyo., last month when he published a widely read letter suggesting the long-run "natural" rate of interest has come down drastically in the past 25 years. (http://blogs.wsj.com/economics/2016/09/02/think-you-know-the-natural-rate-of-interest-think-again/)

As shown in Chart 1, yield rates on 20- and 30-year term U.S. Treasury Securities indeed have come down over the period between 1982 and 2020. The mystery of the "permanently lower growth" posited by Mackintosh may be explained by the diminishing returns to the increasing stocks of real capital in developed countries such as the U.S., Canada, the U.K., and certain E.U. countries.

Chart 1a shows the Holston-Laubach-Williams estimates of R-star, the natural rate of interest for the U.S. from 1985 to 2022. A comparison of Charts 1 and 1a shows that the Holston-Laubach-Williams estimates have fallen along with the 20- and 30-year bond yield rate since 2000.

Yield rates on long-term bonds often are taken as proxies for the natural rate of interest. However, as specified for the natural rate of interest, the economy is rarely in equilibrium at full employment with stable inflation and no involvement by a central bank. It would be more appropriate to construe the yields on long-term bonds as proxies for the capital scarcity interest rate for which non-equilibrium states are not precluded.

Long-term U.S. Treasury security yields shadow the capital scarcity interest rate only imperfectly. Long-term bond issuance has been interrupted on two occasions: issuance of the 20-year bond was suspended between 1987 and 1993, and the 30-year bond was not issued between 2002 and 2006. Beginning in 2020 the declining paths of the yields on U.S. Treasury long-term securities were disturbed by the Federal Reserve’s effort to address inflation by increasing the interest rate paid to banks on their deposited reserves. The fact that the 20- and 30-year bond yield rate paths depicted in Chart 1 are not smooth but rather exhibit up/down changes from quarter to quarter implies disequilibrium states and market adjustments to the changing capital scarcity interest rate.

Has the U.S. recently experienced “permanently lower growth” as contended by Mackintosh? The top panel of Chart 2 shows the path of real GDP from 1955 to 2023. The mild upward concavity of the path suggests that the GDP growth rate may have increased slightly over the period. The middle panel of Chart 2 shows real GDP on a per capita basis. With decreasing indigenous birth rates offset by immigration, the near linear up-sloping path of per capita real GDP also belies the contention that growth has become permanently lower. The annual percent changes of real GDP from previous periods shown in the bottom panel of Chart 2 may exhibit a very slight downward trend that implies only a slight diminishing of the real GDP rate of growth.

The Capital Stock and the Capital Scarcity Interest Rate

As shown in the top panel of Chart 3, real (adjusted for inflation) gross private domestic investment in the U.S. has increased during the second half of the twentieth century and into the twenty-first century, with brief downturns only during recessions. The middle panel in Chart 3 shows net (after allowing for depreciation) private domestic investment from 1960 to 2024. Except for when it was negative in 2009, net investment increased the stock of real capital in the U.S. as shown in the bottom panel of Chart 3.

The effect of diminishing returns to the increasing capital stock suggests that the real GDP growth rate should be declining and that the capital scarcity interest rate should be decreasing. Two phenomena that have offset the effect of diminishing returns to capital are technological advance that increases the productivity of the increasing capital stock, and net positive immigration. Immigration has offset the declining indigenous birth rate in the U.S. to enable continuing growth of the U.S. labor force that complements the increasing stock of capital. And technological advance has promoted investment and served as a recession recovery vehicle. With the ever-increasing U.S. capital stock, we might expect the capital scarcity interest rate to decline, but technological advance and positive net immigration may have prevented the capital scarcity interest rate from declining.

The productivity of any resource, human or physical, can be measured as the ratio of a produced amount ("output") to the quantity of the resource used in producing the output. While labor productivity can be measured as the ratio of output per man-hour (assumed homogeneous) used in the production of the output, real capital is so diverse that it is impossible to measure the region-wide productivity of capital per se. However, a region's overall ("total factor") productivity can be measured. It increases when more output is produced by all of the resources employed in producing the output.

The upper panel of Chart 13 shows an index (2017=100) of U.S. non-farm business labor productivity during the second half of the twentieth century and in the early 21st century. The lower panel of Chart 13 shows U.S. total factor productivity over the same period and on the same scale. While both productivity index paths increase and reach 100 in 2017, the fact that the index values of total factor productivity in most years prior to 2017 were higher than the index values of labor productivity in the same years implies that the productivity of capital was increasing as well.

The productivity of a nation's capital stock may increase with investment in more efficient equipment and advancing technology, or by using more labor to complement existing equipment. Even with a declining indigenous birth rate, immigration has enabled the U.S. population (and its labor force) to grow as fast or faster than the capital stock to increase the nation’s total factor productivity as shown in the lower panel of Chart 13.

Increasing total factor productivity may have enabled the U.S. capital scarcity interest rate to remain higher than implied by the falling long-term security yield rates shown in Chart 1. The U.S. capital scarcity interest rate apparently has remained higher than capital scarcity interest rates in many developed countries by enough to attract foreign direct investment to the U.S. The upper panel of Chart 14 shows the increasing rest-of-world foreign direct investment in the U.S. The lower panel of Chart 14 shows U.S. direct investment abroad, implying that U.S. businesses have found even higher capital scarcity interest rates in countries with lesser capital stocks that warrant off-shore direct investment.

Regional capital scarcity rates in the U.S. appear to have diverged. Diminishing returns to historic real capital accumulation in what now are called “rust-belt” states likely have caused their capital scarcity interest rates to decrease. Capital scarcity interest rates in the so-called “sun-belt” states have been higher by enough to attract capital inflows, not only from other regions within the U.S., but also from Europe and Asia. The U.S. state of South Carolina is an example of an internal region that has received substantial foreign direct investment since the middle of the twentieth century.

Financial Markets and Monetary Policy

The capital scarcity interest rate is described as a real return on a real stock of capital without regard to money. But in a money-using economy almost everything is valued in money prices, and yields are computed on financial instruments that are valued in money terms. How do rates of return on financial instruments relate to the capital scarcity interest rate?

Financial markets are comprised of the many individual and institutional traders who buy and sell financial instruments such as the bonds issued by businesses and governments. Their knowledge and expectations are exhibited in the demands for and supplies of bonds. The bond prices from which the yield rates are calculated change to reflect increasing or decreasing demands for the bonds relative to the supplies of such bonds. Increasing bond prices (and falling yield rates) indicate that the demand for bonds recently has increased relative to supply (or that supply has decreased). Decreasing bond prices (and increasing yield rates) indicate that demand for such bonds recently has decreased relative to supply (or that supply has increased). Changes of the average yields represent the collective understandings and expectations of bond traders about economic and financial conditions, and they may induce market adjustments relative to the scarcity rate of interest in the region.

Natural adjustment processes in a region tend to cause financial interest rates to gravitate toward the region's scarcity rate. But monetary policy may induce market interest rates to diverge significantly from the scarcity rate in their region. Monetary policy that induces market rates to fall below the scarcity rate will stimulate spending in the economy and may cause inflation. Monetary policy that causes market rates to rise above the scarcity rate will have depressive effects on the region to diminish the rate of inflation (or possibly even to cause deflation).

The Federal Reserve's reserve balances interest rate is its "go-to" monetary policy tool in the twenty-first century. Reserve balances are commercial banks' excess reserves that they place on deposit with the Federal Reserve. The Fed executes monetary policy by adjusting the interest rate that it pays on these excess reserve deposits in order to change the Federal Funds rate (the rate that commercial banks charge each other to lend their reserves). The reserve balances interest rate is an administered price rather than a market-determined price. Although the Fed relies on manipulation of this interest rate as its main policy tool, it may be a delusion to think that a central bank changing an administered rate can cause market-determined interest rates to change very much from the scarcity rate of return on real capital. Allowing for risk and term differences, market interest rates are determined ultimately by the scarcity of real capital relative to the demand for it.

Market forces that cause market interest rates to gravitate toward the scarcity rate of interest may frustrate central bank intent. If the central bank intends to promote long-term growth or short-term recovery from a recent downturn, it might try to stimulate investment and other interest-sensitive spending by inducing the Federal Funds rate to decrease below the scarcity interest rate. The lower Federal Funds rate will percolate through the financial markets by arbitrage to stimulate bank borrowing. The increased bank borrowing transforms more of banks' excess reserves to become required reserves. If excess reserves diminish far enough, banks with insufficient reserves to cover their loans may be forced to borrow reserves on the Federal Funds market (or from the Fed itself), thereby bidding the Federal Funds rate back up toward the scarcity rate.

If the economy is overheating with inflation higher than tolerable, the central bank may attempt to curb investment and other interest-sensitive spending by inducing the Federal Funds rate to increase above the scarcity rate. It may raise the interest rate paid on reserve balances which acts as a floor for the Federal Funds rate. The higher Federal Funds rate will percolate through the financial markets by arbitrage to dampen bank borrowing. The decreased bank borrowing releases more of banks' required reserves to become excess reserves. The increasing excess reserves will decrease borrowing on the Federal Funds market, thereby bidding the Federal Funds rate back down toward the scarcity rate.

The Loanable Funds Market

In a financial sense, interest is the price for the use of a dollar's (or other local currency unit's) worth of credit for a year. The issuance or sale of a financial instrument by a business firm or a government agency is an implicit demand for credit. The prices of financial instruments are determined by the interaction between forces of demand for and supply of them in loanable funds markets (i.e., bank lending and bond markets). Yield rates on financial instruments are understood to be their market-determined interest rates (as distinguished from the capital scarcity interest rate determined by resource endowments in the region). Yield rates, which vary inversely with the market prices of financial instruments, also may vary by risk factors and terms to maturity.

U.S. Treasury bill prices are market-determined prices because they are "closing market bid quotations on the most recently auctioned Treasury bills in the over-the-counter market as obtained by the Federal Reserve Bank of New York at approximately 3:30 PM each business day" (https://home.treasury.gov/policy-issues/financing-the-government/interest-rate-statistics). Parties other than the Treasury may engage in the market in which Treasury bills are traded. Banks and other financial interests, both domestic and foreign, may enter the bond market to purchase and sell Treasury and corporate securities by bidding and offering bond prices (not yield rates). If they can get better price deals than offered by the Treasury, market participants will trade with each other rather than with the Treasury. Market yield rates by terms to maturity are calculated from the average prices of bond trades each day. Market yield rates may differ from administered rates set by the Fed's Open Market Committee at its most recent meeting. They may also differ from the region's scarcity rate of interest.

Commentators, pundits, and even financial professionals often personify markets, speaking as if they are persons who behave and know things about the economy and financial markets. Is there reason to think that market bond prices and the yield rates calculated from them contain any special information apart from the interest rates set by monetary authorities? The bond market is comprised of the many individual and institutional traders who buy and sell bonds. Their knowledge and expectations are exhibited in the demands for and supplies of bonds by term categories. The bond prices from which the yield rates are calculated change to reflect increasing or decreasing demands for the bonds relative to the supplies of such bonds. Increasing bond prices (and falling yield rates) indicate that the demand for bonds in that term category recently has increased relative to supply (or that supply has decreased). Decreasing bond prices (and increasing yield rates) indicate that demand for such bonds recently has decreased relative to supply (or that supply has increased). So, yes, recent changes of the average yields by terms to maturity represent the collective understandings and expectations of bond traders about economic and financial conditions, and they may reflect market adjustments relative to the scarcity rate of interest in the region.

The demand for loanable funds is a derived demand that is a function of the demand for the final goods and services that can be produced with the real capital, investment in which was financed by the loanable funds. Market forces cause yield rates on long-term financial instruments to gravitate toward the scarcity interest rate in the region. Market yield rates that exceed the region's scarcity interest rate can be expected to dampen investment spending, decreasing the supply of bonds coming onto financial markets relative to bond demand, raising their prices and lowering their yield rates toward the scarcity rate in the region. Market yield rates below the region's scarcity interest rate can be expected to stimulate investment spending so that the demand for additional loanable funds increases, increasing the supply of bonds coming onto financial markets relative to bond demand, decreasing bond market prices and raising their yield rates toward the region's scarcity rate of interest. These outcomes will be different if bond market demands or supplies change in the same directions as supplies or demands change or at different rates of change.

Normal and Inverted Yield Curves

Longer-term bonds typically earn higher yield rates than shorter-term bonds to reflect the temporal remoteness of their proceeds at maturity. The higher yield rate rewards the long-term bond holder for the opportunity cost of doing without the funds spent in acquiring the bond for a longer period of time until the bond matures. A "normal" term relationship is illustrated in the upper panel of Chart 4 by the blue path for 1/2/2018. But the yield relationship occasionally may become "inverted" when yields on longer-term bonds are below those on shorter-term bonds as illustrated in Chart 4 by the red path of 8/13/2019. On this date, yield rates on 5-year bonds were lower than those on 3-month and 2-year bonds.

As depicted in the lower panel of Chart 4, yield rate inversions often have been followed by recessions within a few months. The 8/13/2019 yield rate inversion shown in the upper panel of Chart 4 was followed by a brief recession in early-2020 attributed to 2019 holiday season supply chain congestion and the Covid19 pandemic. This recession may have dampened investment plans, decreasing the supply of bonds relative to the demand for bonds, raising their prices and lowering their yield rates relative to the scarcity rate of interest. The fact that a longer and deeper recession expected by prognosticators had not happened by early 2024 suggested that a "soft landing" from the supply chain and pandemic disruption had occurred as long-term yield rates again approached the scarcity rate of interest.

Yield rates may invert when supplies of longer-term bonds decrease (or demands increase) to cause longer-term bond prices to rise and their yield rates to fall relative to those for shorter-term bonds. Or, yield rates may invert when supplies of shorter-term bonds increase (or demands decrease) to cause shorter-term bond prices to fall and their yield rates to rise relative to those for longer-term bonds. Yield rate inversion may involve a combination of these conditions.

A scenario for a yield rate inversion might occur when expectation of an economic downturn leads business firms to cut back on investment spending financed by supplying longer-term corporate bonds to the market. As the supplies of longer-term bonds decrease relative to the demands for them, their prices rise and their yield rates fall relative to yield rates on shorter-term bonds. The decreasing longer-term yield rates may even fall below the scarcity rate of interest.

If longer-term interest rates remain lower than shorter-term interest rates along an inverted yield curve, eventually business firms will have incentive to shift their demands for loanable funds to finance new investment spending. They may do so by increasing the supply of longer-term corporate bonds with higher prices and lower yield rates relative to the demands for such bonds while decreasing the supply of shorter-term corporate bonds. This will put downward pressure on the longer-term bond prices and upward pressure on the shorter-term bond prices. The yield rate inversion will be alleviated by the rise of longer-term yield rates and the fall of shorter-term yield rates. If longer-term yield rates had fallen below the scarcity rate of interest, they may increase back toward the scarcity rate in the adjustment process.

The Emergence of Federal Reserve Monetary Policy Tools

Classical textbook explanations of the Federal Reserve's monetary policy tools have described the discount rate, open market operations, and the required reserve ratio. But the Federal Reserve's monetary policy "tool box" has changed over time.

By mid-twentieth century the Federal Reserve's monetary policy tools included the discount rate, open market operations, and the required reserve ratio. Having found during the Great Depression that changes to the required reserve ratio may have drastic and undesirable effects on the banking system, the Fed abandoned the required reserve ratio as a policy tool except for use in extreme circumstances or to make policy corrections.

During the latter half of the twentieth century, the main policy tools became the discount rate and open market operations (purchases and sales of bonds issued by the Treasury and government agencies). The discount rate is the interest rate that commercial banks pay to borrow reserves from the Federal Reserve when they suffer a deficiency of required reserves. It is a "discount rate" in the sense that a bank negotiates a stipulated loan amount from the Fed and receives a lesser amount (the difference being the discount) but pays back to the Fed the full stipulated amount of the loan. For example, if a bank negotiates a $1 million loan from the Fed and receives proceeds of $950,000, it must pay back the full $1 million for a discount rate of 5 percent.

With the emergence of the so-called "Federal Funds" market that enabled commercial banks to borrow reserves from each other, commercial bank borrowing from the Fed diminished, rendering the discount rate an ineffective policy tool. Federal Funds are banks' excess reserves that may be loaned overnight to other banks. The rate that the borrowing bank pays to the lending bank is negotiated between the two banks. The effective Federal Funds rate is the weighted average rate for all of these negotiations.

A new tool was introduced in 2008 as the Fed initiated the process of "quantitative easing" in the effort to stem the "Great Recession." Quantitative easing entailed purchases of large quantities of bonds from commercial banks. The Fed paid for the bonds by crediting the reserves of commercial banks. Since most banks then had large amounts of excess reserves (in excess of legal requirements), the Federal Funds rate decreased toward zero, rendering it useless as a monetary policy tool. To put a floor under the Federal Funds rate and provide the Fed with some modicum of control, the Fed started paying interest on commercial banks' reserves on deposit at the Fed. As noted by Edmund L. Andrews and Michael M. Grynbaum in a New York Times column on October 7, 2008, "Paying interest on reserves allows the central bank to set a floor on interest rates and retain at least some control over monetary policy." The Federal Funds rate can be expected to settle at this floor because banks would be unwilling to lend their excess reserves to other banks at a lower rate than they can earn on excess reserves deposited at the Fed. In 2017 the Fed announced that it would continue the policy of "ample reserves."

After 2008 the Fed's main policy tool became the interest rate that it pays to commercial banks on their reserve balances on deposit at the Fed. Changing this interest rate induces the effective Federal Funds rate to follow it, with the presumption that market-determined interest rates will follow the Federal Funds rate. The Fed uses repurchase and reverse repurchase operations to bring this about.

The upper panel of Chart 5 shows Federal Funds rates from 1955 to 2024. During 2008 to 2013, the Federal Funds rate was nearly zero as the Fed set the target Federal Funds rate at zero in an effort to promote recovery from the 2007-2008 financial crisis.

The lower panel of Chart 5 shows yield rates on 10-year constant maturity Treasury securities to enable comparison to the Federal Funds rate. The 10-year Treasury Bill, the U.S. security that is most liquid and most widely traded in the world, serves as a benchmark for setting home mortgage rates in the U.S. Casual observation suggests that the 10-year Treasury Bill rate moves nearly in lockstep with the Federal Funds rate, but it is not clear whether changes of either lead changes in the other. Regressions on data for these two variables do not reveal significant dependent variable lag or lead relationships or for month-to-month differences of both variables with dependent variable lags or leads.

The media (print, audio, video) foster the notion that the Fed dictates interest rates and causes them to change as the vehicle for implementing monetary policy. This is of course a fiction, although a convenient one for reporting the actions of the Fed and assessing its monetary policy intent. If the Fed wished to implement a “tight” monetary policy to dampen inflationary pressures, it would make public announcement that it was raising the Federal Funds rate by some percent (usually expressed as a number of basis points, e.g., 50 for a half-percent change). What it was in fact doing was announcing a new rate target. Once a target rate change was announced the Fed would act behind the scenes to reset its reserves balance interest rate and cause market-determined rates to approach the newly announced target. The Open Market Committee would become a bond market trader, entering the market to purchase bonds to induce bond prices to rise (yield rates to fall), or to sell bonds to induce bond prices to fall (yield rates to rise).

Changing financial market conditions precipitate the need or opportunity for lenders to change interest rates. However, market-determined interest rates may become “sticky” if lenders are conditioned by periodic Fed announcements of interest rate target changes. If the Fed is widely predicted or expected to announce a rate change in the near future, lenders may wait for the announcement as the excuse or trigger for changing their lending rates. If this happens, it indeed gives the appearance that the Fed has been able to dictate a change of interest rates. But if the Fed has been waiting on market pressures for a rate change to build, it has followed the market rather than led the market to cause rates to change.

Aftermath of the Great Recession

In the eight years following the so-called "Great Recession" of 2008, the U.S. economy continued to be sluggish with a real growth rate below 2 percent per annum. The U.S. CPI inflation rate lingered below the Fed's announced goal of 2 percent per annum. To induce the inflation rate to approach its announced goal, the Fed attempted to enable increased commercial bank lending by increasing bank reserves with four episodes of "quantitative easing" between 2008 and 2021 as depicted in Chart 6. But in an environment of fear, anxiety, and pessimism, the Fed couldn't force bankers to lend or prospective borrowers to borrow. Most of the increased liquidity ended up in commercial bank excess reserves and business cash hoards rather than in circulation to stimulate spending.

The quantitative easing between 2008 and 2015 provided the U.S. banking system with what in Fed terminology is called "ample reserves." In 2017 the Fed indicated that it intends to continue to implement a policy of systemwide ample reserves. This would appear to render both the discount rate and the Federal Funds rate irrelevant as policy tools even if changes of the reserve balances interest rate can elicit changes of the Federal Funds rate. However, even with ample reserves systemwide, there usually are a few commercial banks whose loan officers have approved a sufficient amount of new loans during a day so as to put the banks in deficient reserve positions at the end of the day. Banks suffering a deficiency of reserves would need to borrow Federal Funds overnight to cover their deficiencies.

Changes of the Federal Funds rate prompted by changes in the Fed's reserve balances interest rate will percolate through the financial markets by arbitrage. Also, some banks (how many?) await announcement of changes in the Committee's target Federal Funds rate or in the Fed's reserve balances interest rate as signals to change their own lending rates. To the extent that some banks must borrow Federal Funds and other banks adjust their loan rates on the Fed's changing rate signals, changes of the reserve balances interest rate may confer "at least some control over monetary policy" as suggested by Andrews and Grynbaum. But this control is likely to be modest and tenuous at best, especially if the Federal Funds rate is induced to diverge too far from the scarcity rate of interest.

The Reserve Balances Interest Rate

Both the pre-2008 and post-2008 monetary policy transmission mechanisms are lengthy, complex, uncertain, and fraught with the potential for failure. Other than open market operations, the reserve balances interest rate is the only monetary policy tool now actively employed by the Fed. Recently, open market operations have been devoted to "unwinding" the Fed's huge portfolio of bonds acquired in the three episodes of quantitative between 2008 and 2015. This increase of the supply of bonds coming onto the market is likely to depress bond prices and increase yield rates unless offset by other Fed policy actions.

The Fed's reserve balances interest rate has become its "go-to" monetary policy tool in the twenty-first century. The Fed now executes monetary policy by adjusting the interest rate that it pays on commercial banks' reserves in order to change the Federal Funds rate. The reserve balances interest rate is an administered price rather than a market-determined price. Although the Fed now relies on manipulation of this interest rate as its main policy tool, it may be a delusion to think that a central bank changing an administered rate can cause market-determined interest rates to change very much from the scarcity rate of return on real capital. Allowing for risk and term differences, market interest rates are determined ultimately by the scarcity of real capital relative to the demand for it.

Market forces may cause market interest rates to gravitate toward the scarcity rate of interest, and these forces may frustrate central bank intent. If the central bank intends to promote long-term growth or short-term recovery from a recent downturn, it might try to stimulate investment and other interest-sensitive spending by inducing the Federal Funds rate to decrease below the scarcity interest rate. The lower Federal Funds rate will percolate through the financial markets by arbitrage to stimulate bank borrowing. The increased bank borrowing transforms more of banks' excess reserves to become required reserves. If excess reserves diminish far enough, banks with insufficient reserves to cover their loans may be forced to borrow reserves on the Federal Funds market (or from the Fed itself), thereby bidding the Federal Funds rate back up toward the scarcity rate.

A similar analysis can describe a situation when the economy is overheating with inflation higher than tolerable. If the central bank intends to curb investment and other interest-sensitive spending by inducing the Federal Funds rate to increase above the scarcity rate, it may raise the interest rate paid on reserve balances which serves as a floor for the Federal Funds rate. The higher Federal Funds rate will percolate through the financial markets by arbitrage to dampen bank borrowing. The decreased bank borrowing releases more of banks' required reserves to become excess reserves. The increasing excess reserves will decrease borrowing on the Federal Funds market, thereby bidding the Federal Funds rate back down toward the scarcity rate.

In a New York Times transcripton of columnist Matthew Rose's conversation with economists Oren Cass, Jason Furman, and Rebecca Patterson on May 6, 2025, Furman said,

Coming into this year [2025], the unemployment rate was exactly where the Fed wanted it to be [4.1%], while core inflation, which is a good predictor of future inflation, was 2.8 percent, uncomfortably above the Fed’s 2 percent target. So we hadn’t quite achieved the soft landing. That plus the huge inflation experience we went through means the Fed needs to be especially vigilant about the inflation side of its mandate. (https://www.nytimes.com/2025/05/06/opinion/trump-economy-federal-reserve.html?campaign_id=39&emc=edit_ty_20250506&instance_id=153973&nl=opinion-today&regi_id=74240569&segment_id=197395&user_id=86b0d837dd357b2a6e0e749321f6ed7f)

Recent Policy Experience

The Fed's recent concern has been to gain control of the rate of inflation that exceeded its target 2 percent per annum in 2021. Supply-chain congestion and the Covid pandemic of 2019-2020 likely caused market-determined interest rates to fall below the scarcity rate. The result was declining investment and other interest-sensitive spending that precipitated a brief recession in 2020. The U.S. inflation rate as measured by the Trimmed Mean PCE is depicted in Chart 7. By this measure, inflation rose to 5 percent per annum by mid-2023 before beginning to decrease in late 2023.

The Trimmed Mean PCE inflation rate produced by the Federal Reserve Bank of Dallas is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). The data series is calculated by the Dallas Fed, using data from the Bureau of Economic Analysis (BEA). Calculating the trimmed mean PCE inflation rate for a given month involves looking at the price changes for each of the individual components of personal consumption expenditures. The individual price changes are sorted in ascending order from “fell the most” to “rose the most,” and a certain fraction of the most extreme observations at both ends of the spectrum are thrown out or trimmed. The inflation rate is then calculated as a weighted average of the remaining components. The trimmed mean inflation rate is a proxy for true core PCE inflation rate. The resulting inflation measure has been shown to outperform the more conventional “excluding food and energy” measure as a gauge of core inflation. (https://fred.stlouisfed.org/series/PCETRIM12M159SFRBDAL)

Fed officials became concerned that a low reserve balances interest rate and low Federal Funds interest rates (1/2 percent per annum) enabled little monetary control. They began stair-stepping the rates upward in early 2017 and continued to do so until mid-2019 when the economy showed signs weakening during the emerging Covid pandemic that dampened consumer spending. Coincidentally, supply-chain chokes emerged in the run up to the 2019 Christmas season to further dampen consumer spending.

The top and middle panels of Chart 8 show stepwise increments of the excess reserves interest rate and the interest rate paid on reserve balances from 2016 to 2024. The bottom panel confirms that the effective Federal Funds rate moved in lockstep with the reserve balances rate.

Market Rates and the Scarcity Rate

As suggested by James Mackintosh in a The Wall Street Journal column on September 2, 2016, a message for monetary policy is that "A declining natural rate of interest in major economies gives central banks less ammunition to stabilize the economy." (http://blogs.wsj.com/economics/2016/09/02/think-you-know-the-natural-rate-of-interest-think-again/) If the effective Federal Funds rate follows a decrease of the central bank's reserve balances interest rate, the Fed has less "room" to maneuver by further lowering the Federal Funds rate. Once the Federal Funds rate reaches zero, the Fed may be able to do so only if it is willing to decrease the interest rate paid on reserve balances far enough to take the Federal Funds rate into the negative range. Even then, there is no compelling reason to think that a decrease of the interest rate paid on reserve balances will induce private sector investors to increase investment spending if they are obsessed with geopolitical uncertainty.

Jason Douglas and Jon Sindreu, writing in The Wall Street Journal, December 11, 2016, say that

Central bankers respond that their policies are merely tracking changes in the so-called natural rate, an interest rate determined by powerful economic impulses.
. . . .
By shadowing their estimate of the natural rate, they hope to keep inflation stable and the economy growing at its full potential. Undershoot the rate and they aim to spur faster growth and inflation. Overshoot it and the economy and price rises should slow.
(http://www.wsj.com/articles/central-bankers-zeal-for-the-natural-rate-draws-skeptics-1481476667)

As noted above, if all the conditions specified for the natural rate were met, the capital scarcity interest rate would converge upon the natural rate. Since natural rate equilibrium conditions rarely obtain in the real world, we will assume that Douglas and Sindreu's comment applies to the capital scarcity rate of interest rather than to the natural rate of interest.

If central bankers are postulating their monetary policies on tracking or shadowing the scarcity rate of interest, then one is led to wonder why don't they simply let market interest rates naturally adjust to the scarcity rate. This may happen anyway since central bankers often delay changing their administered-price rates (the reserve balances interest rate or the Federal Funds target rate) until market rate pressures for a change are already palpable, i.e., market participants "price in" their expectations of a near-future rate change. When they do this, central bankers are simply following the market rather than leading the market or managing market interest rates.

A problem is that the scarcity interest rate is not an observable rate that can be tracked, but it might be approximated by the yield rates on long-term bonds. If investment increases following a decrease of the Federal Funds rate due to the central bank lowering the reserve balances interest rate, the implication may be that market rates were below the scarcity rate. The increasing investment may increase the supply of corporate bonds relative to bond demand, causing their prices to fall and their yield rates to rise back toward the scarcity rate. If investment decreases following an increase of the Federal Funds rate due to the central bank increasing the reserve balances rate, the implication may be that market rates were above the scarcity rate. The decreasing investment may decrease the supply of corporate bonds relative to bond demand, causing their prices to rise and their yield rates to fall back toward the scarcity rate.

Donald Luskin, writing in The Wall Street Journal, February 16, 2017, described how a market interest rate rule might work:

One might wonder why it would be necessary for a monetary authority to set a rate that the market would reach by itself anyway. Why even have a monetary authority that only attempts to emulate what the financial markets would do if it did not exist? The delays entailed in recognition, action, and reaction time lags can render Fed policy actions disruptive of natural stabilizing forces resident in the economy. Indeed, policy actions may actually aggravate economic instability. Economic stability may well be served by restricting the Fed to being "a mere clearing house for banking-system reserves" and providing a money supply adequate to the needs of a growing economy.

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Take-Aways From This Essay:

The Fed attempts to manipulate market yield rates by influencing the Federal Funds rate.

Prior to 2008 the Fed influenced the Federal Funds rate with open market operations.

Since 2008, the Fed has dominated the Federal Funds rate by setting the interest rate paid to banks on their reserves on deposit at the Fed.

The Fed's reserve balances interest rate policy to influence the Federal Funds rate appears to have been successful in alleviating inflation and sustaining employment to bring about a "soft landing" in early 2024.

The soft landing may have resulted because as the economy recovered from the Covid pandemic and supply-chain congestion, market yield rates moved back toward the natural rate of interest, irrespective of the Federal Funds rate.

The characteristics of an open-economy world may render the Fed's monetary policy tools of modest capability.

The efficacy of central bank monetary policy is a delusion in a globally open-economy world in which economic and financial interests adjust their activities in pursuit of the capital scarcity rates of interest in their respective regions.

Diminishing Marginal Utility of Money

The link between money supply increases and consumer spending is what economists refer to as the "diminishing marginal utility" of money balances. The sense of this is that when the money supply increases, the additional dollars held by a rational and normally risk-averse person (i.e., neither a gambler nor a miser) mean ever less to him. When the utility (a.k.a. "satisfaction") of the last dollar added to a person's money holding drops below the utility of a dollar's worth of something that he could buy, it becomes rational to part with the dollar and buy the item. The vernacular of this is that "money burns a hole in the pocket." If the additional spending adds to the demand for items relative to their supplies, prices may be bid up. When this happens across the spectrum of the goods that are consumed, inflation occurs.

The phenomenon of the diminishing marginal utility of money balances may not always work as predicted. Distributions of pandemic relief funds during 2021 seem to have resulted in hoarding as some of the funds were held rather than being spent by consumers. A possible explanation is that pandemic distribution recipients suffered sufficient uncertainty about the future that they held back on spending the funds. When the pandemic appeared to be alleviated, the release of pandemic hoardings caused aggregate demand to increase faster than could be accommodated by supply increases, resulting in rising inflation in late 2021 and early 2022.

The marginal utility of money balances may also work in reverse. If the money supply decreases such that individual money balance holdings decrease, the marginal utility of the remaining money balances held will increase for normal, risk-averse money balance holders (neither misers nor gamblers), inducing them to decrease their spending. When the marginal utility of a dollar held rises to exceed the marginal utility of something that the dollar could buy, a rational consumer will suspend further spending. Hoarding behavior may be explained for people who experience increasing marginal utility as their money balances increase (e.g., misers).

It is important to remember that money held as assets of banking institutions is not in circulation. As the Fed begins to "unwind" its bond portfolio in 2022 by selling bonds, it will siphon money from the bank accounts of bond purchasers, thereby reducing the quantity of money in circulation. The expectation is that the majority of people are normal, rational, and risk-averse (neither misers nor gamblers) so that the marginal utilities of their held money balances will increase, thereby reducing consumer spending and curbing inflation.

Arbitrage

Changes in the prices of bonds (and thus their yield rates) become transmitted to the prices (and yields) of other types of financial instruments via the process of arbitrage, i.e., the simultaneous purchase and sale of different types of financial instruments. Arbitrageurs are successful if they are able to operate by the criterion of “buy low, sell high.” Buying will tend to increase price in the lower-price market; selling will tend to lower price in the higher-price market. If they are successful, they will both capture profits and precipitate convergence of prices (and yields) across the markets. Unsuccessful arbitrageurs will suffer losses and tend to destabilize markets, and they may cause interest rates on different types of financial instruments to diverge.

Diminishing Returns

Diminishing returns is the physical phenomenon underlying the capital scarcity rate of interest. Most real world production processes exhibit the phenomenon of diminishing returns, i.e., beyond some point, output begins to increase at a decreasing rate. A graphic model of a diminishing returns production process is illustrated in Chart 9. The back walls of a 3-dimension (3rd order) production surface are illustrated in quadrant I as outlined by the path 0ABC0 in which product output (Q) is on the vertical axis, and amounts of labor (L) and capital (K) are on the right and left floor axes, respectively. The total product function label Q = f ( L , K | . . . ) may be read, "output is a function of the amounts of labor and capital, given fixed amount of all other inputs."

In quadrant III, a slice through the 3-D surface illustrates increasing the amount of labor used in an installed capital stock (plant and equipment) of K₂. The total product function label Q = f ( L | K₂ , . . . ) may be read, "output is a function of the amount of labor, given the K₂ plant and fixed amounts of all other inputs." As the amount of labor is increased in this plant, output at first increases at an increasing rate from K₂ to point E. Using more labor beyond the L₁ amount causes output to increase at a decreasing rate along the path from E to F, G, H, and J. This is depicted by the downward concavity of the total product slice beyond the L₁ amount of labor. The downward concavity of the total product slice beyond the L₁ amount of labor illustrates the phenomenon of diminishing returns to labor when the amount of capital is fixed.

Marginal Products of Labor and Capital

The figure in quadrant V of Chart 10 depicts for the K₂ amount of capital the average product curve, AP_L = (Q / L), and the marginal product curve, MP_L = (?Q / ?L) for the smallest possible ?Q. Marginal product measures the rate of change of total product, i.e., the slope of the Q function along the K₂ slice from E to F, G, H, and J. AP_L at first is greater than MP_L but turns down and passes through the peak of MP_L at the L₂ amount of labor. Beyond the L₂ amount of labor, MP_L decreases (slopes downward) until it reaches zero on the labor axis at L₅, corresponding to the maximum amount of product that can be produced, given the K₂ installed plant. The downward sloping range of the MP_L cuve illustrates the phenomenon of diminishing returns to labor, given the K₂ amount of capital.

Capital often is thought of as a fixed input to which labor is the variable input that is added. But in some production processes the amount of labor is fixed (e.g., members of the family on a family farm) while the amount of capital can be varied by acquiring more or disposing of some equipment. Quadrant VI of Chart 10 illustrates diminishing returns to capital, given a fixed amount of labor, L₂. The previous paragraph could be repeated with L and K swapped to reveal the phenomenon of diminishing returns to capital illustrated by the downward concavity of the Q = f ( K | L₂ , . . . ) function beyond the K₁ amount of capital and the downward slope of the MP_K curve beyond the K₂ amount of capital. It is this phenomenon that underlies the capital scarcity rate of interest.

The figures in quadrants VII and VIII of Chart 10 show that every point along a Q slice of the production function for a fixed amount of one factor is also on a Q slice for a fixed amount of the other factor. In the quadrant VII diagram, as the amount of labor is increased in a fixed plant K₂, the slope of the Q function path decreases but the slopes of the cross-cutting K slices increase. Another way to describe this is that with an increasing amount of L, given the K₂ plant, the marginal product of L decreases while the marginal product of K increases. And this also would be true in quadrant VIII as the amount of capital is increased for use by a fixed amount of labor L₂. Increasing the amount of capital, given a fixed amount of labor, will increase the marginal product of labor even as the marginal product of capital decreases.

Technological advance that improves the efficiency of both of the factors of production would shift the 3-D surface 0ABC0 upward and outward along both of their axes to forestall the effects of diminishing returns to both factors. The marginal product curves of both factors also would shift upward and outward to forestall the effects of diminishing returns. Technological advance that improves the efficiency of only one of the productive factors will skew the surface upward and outward only along the axis of that factor. Such technological advance would forestall diminishing returns to that factor and increase the productivity of the other factor.

Yield Rates Vary Inversely with Market Prices

A simple example illustrates that yield rates vary inversely with market prices. A zero-coupon bond (one that promises no interest payment) would sell in the bond market only at a price lower than face (or par) value. The formula for computing the nominal yield rate on a zero-coupon bond is (face value - market price) / face value. For example, if a 1-year term bond with face value of $1000 can be purchased for $950, its nominal yield rate would be [ (1000 - 950) / 1000 ] = .05 or 5 percent. If a purchaser is willing to pay a higher price of $960 for this bond, the nominal yield rate would be lower: [ (1000 - 960) / 1000 ] = .04 or 4 percent.

Bond Demand and Supply

The yield rates or rates of return on bonds vary inversely with the prices of those bonds. The bond yield rates are implicitly the interest rates on the bonds.

In the bond market, demand and supply are presumed to be normally sloped relative to the prices of the bonds as illustrated in Figures 1 and 2. Since financial instruments exhibit a wide range of denominations, the "quantity of bonds" on the horizontal axis should be understood not in terms of a number of such financial instruments, but rather as an amount of financing demanded or supplied by such instruments. For purpose of exposition, a standard bond of fixed denomination, e.g., $1 million, might be assumed so that the horizontal axis units can be understood as the number of such bonds. An increase in the demand for bonds from D₁ to D₂ in Figure 1, other things unchanged relative to the supply of bonds, results in an increase in the price of bonds from P₁ to P₂, and a corresponding fall in their yield rate. If the demand for bonds should decrease from D₁ to D₃, the price of bonds would fall to P₃ and the yield rate would rise.

Bonds are supplied to the market by corporations seeking funds to finance investments and by governments needing to finance budgetary deficits. In Figure 2 an increase in the supply of bonds from S₁ to S₂, other things unchanged for bond demand, results in a decrease in the price of bonds from P₁ to P₂, with corresponding rise in the yield rate. A decrease in the supply of bonds to S₃ would elicit an increase in the price of bonds to P₃ and a fall in their yield rate.

When private parties have more money than they want to hold in their bank accounts (or under their mattresses), they can purchase goods and services, or they can purchase financial instruments in the bond market. When they do the latter, the demand for bonds increases as in Figure 1, pushing bond prices higher and yield rates lower. When private parties want to hold more money than they have, they can cut back on their purchases of goods and services relative to their continuing income flows, or they can sell some of their financial instruments in the bond markets. To the extent that they do the latter, the supply of bonds increases as in Figure 2, pushing bond prices lower and yield rates higher.

The supply of bonds may be affected by the intents of businesses to finance capital investments, the needs of governments to finance deficits or dispose of surpluses, and the intent of the central bank to execute monetary policy. Changing interest rate differentials between domestic and foreign locales may also induce bond demand or supply shifts. It is the market forces of demand and supply in the bond market that cause bond prices to change and their yield rates to change in the opposite direction.

Changes in the prices of bonds (and thus their yield rates) become transmitted to the prices (and yields) of other types of financial instruments via the process of arbitrage, i.e., the simultaneous purchase and sale of different types of financial instruments or financial instruments in different local markets. Arbitrageurs are successful if they are able to operate by the criterion of “buy low, sell high.” If they are successful, they will both capture profits and precipitate convergence of prices (and yields) across the markets. Unsuccessful arbitrageurs will suffer losses and tend to destabilize markets, and they may cause interest rates on different types of financial instruments to diverge.

Monetary Policy Transmission Mechanism

A monetary policy transition mechanism consists of the steps in the linkage between an action taken by a monetary authority and the ultimate goal that is expected (or hoped) to be impacted. On analogy, it is a bit like the transmission in an automobile that conducts power from the engine to the drive wheels. This analogy is imperfect because, unless the auto transmission is worn or damaged, the power conducted to the drive wheels is certain (although with some loss of power, the longer and the more steps in the linkage).

A better analogy might be the transmission mechanism entailed in the effort by a classic 8-ball billiards game player to cause one of his balls to drop into a pocket. Upon "breaking" the racked set of balls,

the player lines up his cue stick on the cue ball and
pokes it with sufficient force and proper direction
to roll toward one of his balls (striped or solid) and
hit it at just the right angle and with enough force to cause it to roll toward a pocket and drop into it.

This process is fraught with uncertainty and the potential for failure at every linkage because the player may not have perfectly aimed the cue stick, it may not have tapped the cue ball with enough force, the direction of roll of the cue ball may not be true to the player's intent, the force with which cue ball hits the player's ball may not be sufficient to cause the player's ball to roll far enough toward a pocket, and the direction of roll of the player's ball may cause it to ricochet off the side of the table instead of dropping into the pocket. If the player is successful, he can continue to try to drop more of his balls into pockets until one of his tapped balls fails to drop into a pocket or the game is won. If he is not successful, play reverts to his opponent.

And like the 8-ball billiards game, the monetary policy transmission mechanism is complex and has many linkages, each of which may fail the monetary authority's intent. The steps in the Fed's pre-2008 policy linkage was

first to announce a change in the Federal Funds target rate,
then engage in open market operations
to alter the excess reserves positions of commercial banks which would
induce desired changes in the demand or supply of loanable funds (bank lending and bond market activity)
so that financial instrument (bond) prices would change to cause
the market-determined Federal Funds rate to move toward the announced Federal Funds target rate and
yield rates on financial instruments to move toward the announced Federal Funds target rate
with expectation (or hope) that just enough force had been applied to cause spending in the economy to change in the direction intended by the Federal Funds target rate announcement
without precipitating (further) recession or inflation.

Beginning in 2008 with three episodes of "quantitative easing," the Fed's new "ample reserves" policy linkage became

first to announce a change in the interest rate paid to commercial banks on their reserve balances on deposit at the Fed
so as to impose a floor below the nominal market-determined Federal Funds rate,
rendering it a de facto administered rate under the indirect control of the Fed which would
pull market-determined interest rates toward the Federal Funds rate
to induce desired changes in the demand or supply of loanable funds (bank borrowing and bond market activity)
so that market-determined financial instrument prices would change to cause
yield rates on financial instruments to move toward the announced reserve deposits interest rate
with expectation (or hope) that just enough force had been applied to cause spending in the economy to change in the direction intended by the reserve deposits rate announcement
without precipitating (further) recession or inflation.

To emphasize, these monetary policy transmission mechanisms are lengthy, complex, and fraught with uncertainty. The Fed "pokes" at a policy rate (Federal Funds or reserve balances) with hope that a desired outcome occurs eight or more links following. In either case (pre-2008 or 2008 onward), the effects of the process diminish beyond any link at which the outcome is less than expected. The process will come to an early end at any link that fails or where the expected outcome is the opposite of what is required for desired outcome.

Possible monetary policy process obstruction may occur if market participants key their decisions on their perceptions of the scarcity rate of interest that is different from the announced policy rate. In an open-economy world, policy process obstruction may be brought about by unexpected trade and capital flows that affect the relevant money supply, financial instrument prices, and yield rates. Monetary policy interruption may be caused by unexpected spending changes as occurred in 2019-2022 due to the Covid pandemic and supply chain congestion, in 2022-2024 by unexpected military hostilities, by natural disasters, and by ensuing climate change.

Repurchase and Reverse Repurchase Operations

Open market operations may be implemented by the Fed in the process of "unwinding" its huge portfolio acquired in three episodes of "quantitative easing" between 2008 and 2014. The Federal Reserve Bank of New York (FRBNY) website currently identifies the only other open market operations as repurchase and reverse repurchase operations. In a repo auction, security dealers bid on borrowing money from the Fed, offering U.S. Treasury securities as collateral. They implicitly "sell" the securities to the Fed on the day of agreement, and then repurchase them the next day. In a reverse repo auction, dealers offer interest rates at which they would lend money to the Fed. They implicitly "buy" securities from the Fed on the day of agreement, and the Fed repurchases them the next day. Repurchase agreements are made at the initiative of the trading desk at FRBNY which implements monetary policy at the behest of the Federal Open Market Committee (FOMC).

Economic Growth and Development

Due to the effect of diminishing returns, the scarcity rate of interest is higher in regions where capital is scarce and lower in regions where capital is more abundant. Regional differences in scarcity rates invite interregional capital flows. The high capital scarcity interest rate should entice investment spending both by locals and by foreigners contemplating off-shore investments. The capital scarcity interest rate would be expected to fall as capital becomes more abundant with on-going economic development.

Economists distinguish between economic growth and economic development. "Growth," taken to be an improvement in the material well-being of humans, is usually measured as the rate of increase of per capita real income or output of a society. "Real" means that adjustments have been made to eliminate the effects of inflation so that the real component of nominal income increase can be examined. "Per capita" means that some measure of the total output of a society, typically its Gross Domestic Product (GDP), has been divided by the population of the society to get a measure of income on a per-person basis.

"Development" is understood to mean change in the structure of society. The various dimensions of social structure include economic, social, political, moral, religious, and environmental. Development is both a requisite of growth and a consequence of growth--they are inseparable.

A serious problem is that development is typically disruptive of social structures, and thus entails costs. While by definition growth yields only benefits, development seems to involve mostly costs. A rational judgment of whether a process of development cum growth is desirable should be based on the relationship between the benefits of growth against the costs of development, i.e., B_g/C_d. If the value of the ratio of B_g/C_d is greater than 1, the growth-development process is desirable. It is undesirable if the value of the B_g/C_d ratio is less than 1.

Economists make the case that the most effective poverty alleviating vehicle over the past couple of centuries has been economic growth that has been enabled by economic development, and that market economies are more favorable to development than are authoritarian economies.

The suffering of the poor may be less amenable to relief by sharing the existing wealth than by a process of economic development that increases the society's stock of capital (which is part of its physical wealth) due to its high scarcity rate of return to capital. The poor are helped via the "spill-over effects" of employment and income generation, and in terms of a growing volume of lower-priced consumables that are more affordable to the poor.

Interregional Trade and Comparative Advantage

Trading relationships among nations exhibit variations in scarcity interest rates that correspond to their resource endowments. Since the pure theory of trade abstracts completely from references to nation states, it is necessary to shift from the language of "international trade" to that of "interregional trade." Different regions of the world have different endowments of natural, human, and capital resources. Different regions within nation states also may exhibit divergent scarcity interest rates.

Due to the principle of diminishing returns, regions that are richly endowed with capital resources can be expected to exhibit lower capital scarcity rates of interest than trading partner regions that are deficient of capital resources but well endowed with natural and human resources. Economists have enunciated the so-called principle of comparative advantage to explain regional specialization in the production of goods and services.

It is a fact of physical nature that resources are unequally distributed across the earth's geographic space. Some resources approach ubiquity (found everywhere); others are concentrated by regions. Resources that are found in only one or two places on earth may be referred to as geographic uniquities. Examples include rare elements or precious gems or metals, agricultural commodities that grow only under very special conditions, and natural tourist attractions. Populations of regions possessing such uniquities are fortunate in having access to such resources which they are able to exploit; populations elsewhere are correspondingly unfortunate. Populations of regions devoid of such uniquities may acquire them (or things produced using them) by engaging in interregional trade or military aggression to capture them.

There are few perfect ubiquities or uniquities among productive resources. Most resources are found in many places across the globe, although in greater or lesser geographic concentrations. Goods and services requiring those resources as inputs may be produced more cheaply in regions where they are found in abundance than in other regions where they are scarce.

Economists have developed the principle of comparative advantage to explain regional specialization in the production of goods and services. According to this principle, people in each region should specialize in producing those goods and services that can be produced most efficiently in their region compared to other regions. "Most efficiently" means at least opportunity cost (in terms of other goods and services foregone) compared to the other regions. Since the production of goods becomes geographically specialized, people in different regions must trade their specialties for the specialties of people in other regions.

Generalization in consumption is enabled everywhere through trade even though there is regional specialization in production. It can be shown with theoretical exercises as well as empirical information that those who specialize their production according to the principle of comparative advantage and trade with one another enjoy higher welfare than they would under conditions of autarky.

It is sometimes suggested that there are regions of the world that are essentially devoid of productive advantages, whereas other regions seem to possess all of the advantages (veritable "Gardens of Eden"). This problem can be resolved by further refining the definition of comparative advantage. A region's absolute advantages include all of those things that it can produce at lower opportunity costs than can be achieved in other regions. A region's absolute disadvantage is anything that can be produced elsewhere at lower costs in terms of other goods and services which must be foregone.

It may well be that opportunity costs of most things are lower in one region relative to all others, but this does not mean that the region should generalize in production. Its comparative advantages lie in producing those things for which it has greatest absolute advantage(s), while the comparative advantages of other regions lie in producing the things for which they have least absolute disadvantages. They should still specialize in production, but the one in its greatest absolute advantage and all the rest in their least absolute disadvantages. It follows logically from this definition of comparative advantage that it is not possible for a region to have no comparative advantage(s). Furthermore, it can be shown that all of the regions of the world, the sparsely-endowed as well as the abundantly endowed, will enjoy higher welfare with specialization according to the principle of comparative advantage and trade with one another unencumbered by politically imposed constraints.

Modern elaborations of the theory of comparative advantage recognize at least five bases for regional comparative advantages: capital and other resource endowments, cultural preferences, known technologies, scale economies, and company-specific knowledge. The first three are endogenous to locale; the last two technically are independent of geography but may become location specific at the discretion of production decision makers.

It would be highly unlikely in any of these cases that perfect specialization (i.e., only product X is produced in region A and only product Y is produced in region B) would result. Both goods would continue to be produced in both regions, but in each region more of the comparative advantaged good would be produced and less of the comparative disadvantaged good(s). Also, the real world is composed of many regions, some of which are similar to others in respect to resource endowments, preferences, or technologies, and different from the other regions in various respects. The basis for comparative advantage of each may lie in one of these areas or a combination of them. Empirical evidence indicates that a larger volume of the world's trade is conducted among regions that are similar in income levels and preferences than among regions that are widely divergent in any of these areas.

Unless offset by regional decrease of capital in non-comparative-advantaged industries (e.g., by non-replacement of worn equipment, natural disaster, or war), the process of investing in capital to increase regional specialization in comparative-advantaged industries should be expected to decrease the marginal productivity of the region's capital stock and cause its capital scarcity rate of interest to decrease.

Industrial Policy

As trading relationships become more open and free with on-going globalization, specialization of production toward each nation's real comparative advantages ensues. Regions with abundant natural and human resources but meager stocks of capital will experience increasing specialization in producing products that employ intensively their abundant resources. But the government of a region with a meager stock of physical capital may wish to promote industrial investment in production activities for which the region does not have comparative advantages.

As industrial investment increases specialization in the non-comparative advantaged production processes, the formerly comparative advantaged processes become despecialized. Jobs will be threatened and businesses in comparative advantage production will suffer declining sales and profits attributable to the ensuing process of comparative advantage despecialization. Those who feel threatened can be expected to appeal to their congressional or parliamentary representatives to provide protection for the domestic industry in the form of tariffs or non-tariff barriers to trade.

Industrial policy has been described as government picking winners and identifying losers among the resident industries within the nation, and then acting to encourage and support the chosen winners. The most likely reason for an industrial policy to fail is that bureaucratic choices of national-champion industries may not correspond to the nation's natural or acquired comparative advantages. If an administration chooses to support non-comparative-advantaged domestic industries, production costs will be higher than in potential trading-partner nations that do possess the respective comparative advantages. Consumers of the nation will pay higher product prices for domestically-produced goods and enjoy lower levels of welfare than they might have enjoyed if they had consumed comparable imports from regions possessing the respective comparative advantages.

Various U.S. states have practiced forms of industrial policy in their efforts to attract industry or particular firms to locate plants within their borders. The principle underlying state-level industrial policy is the contention that since capital is generally more mobile geographically than is labor, capital should move to sites where it can employ capable and well-trained labor. States vie with one another to demonstrate that their labor forces are capable and well-trained, and that they possess the physical and financial infrastructure to support the sought-after industry. State-level industrial policy may cause market interest rates to diverge from the region’s scarcity rate.

A variant of industrial policy, import-substitution industrialization (ISI), was adopted as development vehicle in several capital-scarce nations during the second half of the twentieth century. The idea was to try to "birth" and protect from global competition non-comparative-advantaged "infant" domestic industries until they could "grow up" and somehow attain comparative advantages on world markets. In the meanwhile, domestic consumers would pay the price of protection in the form of higher prices of domestically-produced goods compared to the lower prices of imports. But the ISI strategy has been discredited in favor of export-oriented development (EOD), i.e., identifying and pursuing development of nations' actual comparative advantages in producing both industrial goods and primary products that can be exported to pay for lower-priced imports.

Industrial policy may cause market-determined interest rates to diverge from the region’s scarcity rate. Industrial policy that only shifts investment from comparative-advantaged production to non-comparative-advantaged production may cause little change in the gross capital stock of the region and thus leaves the capital scarcity interest rate of the region unchanged. Industrial policy that increases the region's capital stock by stimulating investment in non-comparative-advantaged production as capital investment in comparative-advantaged production continues may cause the scarcity interest rate of the region to increase as the marginal productivity of capital in the region declines. This phenomenon may have occurred with South Carolina's industrial policy that stimulated investment in the automobile, tire, aircraft, and other "tech" industries as investment continued to sustain capital engaged in South Carolina's agriculture.

Protectionist Policy

Governments often resort to various forms of protectionist policy when domestic industries are threatened by foreign competition. The most common forms of protection of a domestic industry are tariffs imposed on imports, non-tariff barriers to restrict the inflow of imports, and subsidies that promote domestic industries which compete with imports. If the region has been capital abundant with a low capital scarcity interest rate, these protection measures will tend to increase the capital scarcity interest rate of the region. In a capital scarce region with a high capital scarcity interest rate, the imposition of protectionist measures will tend to lower the capital scarcity interest rate.

A tariff is a tax on an imported good that is paid, not by the exporter, but by the consumers in the nation whose government imposes the tariff. The effect of the imposition of a tariff by the government is to raise the price of the imported product to domestic consumers, which, if the domestic demand for the import is sufficiently elastic with respect to price, will reduce the volume of the import, thereby providing a modicum of protection to the domestic industry. With the tariff in place, domestic producers will be able to sell their product at the higher imported price, although a smaller quantity. The increased price of the import has the effect of worsening the nation's terms of trade; since the foreign-made product now costs more to domestic consumers, each unit of a domestically produced export can buy only a smaller quantity of the import. However, if the domestic demand for the import is sufficiently inelastic, the tariff may not greatly decrease the amount of the product imported.

Once a tariff is imposed, the domestic market price of the product rises. Domestic producers are all too happy to accept the higher price although it may still not be as high as the pre-trade domestic price. Domestic production increases. At the higher market price, domestic consumption falls and the quantity of the product imported decreases. These effects will be relatively small if the world supply is fairly inelastic with respect to price, but the effects will become larger if world supply increases and becomes more elastic.

Non-tariff barriers (NTBs) include quotas on imports, health and safety restrictions on imports, import packaging and labeling requirements, discriminatory performance standards for imports, etc., that are intended to curb imports or raise their delivered prices. Both tariffs and NTBs may cause market-determined interest rates to diverge from the region’s scarcity rate.

Protectionist measures that only shift investment from comparative-advantaged production to non-comparative-advantaged production may cause little change in the gross capital stock of the region and thus leave the capital scarcity interest rate of the region unchanged. Protectionist measures that increase the region's capital stock by stimulating investment in non-comparative-advantaged production as capital investment in comparative-advantaged production continues may cause the scarcity interest rate of the region to increase as the marginal productivity of capital in the region declines.

Lags in the Adjustment Process

Economists refer to the time between when a macroeconomic change occurs and when it is recognized by government officials as the recognition lag, and the time between recognition of such a change and the taking of some action to offset it as the response lag. Needless to say, the lags are both variable in duration and themselves unpredictable. The response lag for monetary policy may be a matter of days or weeks, while that for fiscal policy may be months or quarters. In democratic societies, fiscal policy actions must be proposed, debated, and legislated, processes that often are very time consuming.

There is yet another lag which may eclipse the first two in duration. It is the so-called reaction lag, the period between when an action is taken and the effects of the action fully work through the economy. The reaction lag usually involves a multiplier process of consecutive rounds of respending. Experience in the U.S. economy suggests that the multiplier effect of a fiscal policy action may be completed in as little as a year, but may not be fully worked out in more than two years. The duration of the reaction lag is therefore even less predictable than are the recognition and response lags. The three lags together may span a period of as little as a year, or as much as three or more years. These lags taken together put the government in the position of having to implement a compensating policy even before some event shocks the economy.

This brings us to the most serious problem of implementing any government policy in the interest of stabilizing the economy. It is that the natural adjustment mechanisms of the economy will likely have reversed the direction of change of the economy by the time that the policy designed to deal with the original problem finally has its effect. For example, in a contracting economy, expansionary fiscal and monetary policies are called for. But by the time the contraction can be confirmed, expansionary policy implemented, and the multiplier process completed, the economy of its own volition will likely have begun its recovery. So the expansionary monetary policy impacts an already-expanding economy. A similar, but reversed, scenario can be depicted for an economy entering a period of expansion. Because of variable and unpredictable time lags in the implementation of macropolicy, government's well-intentioned efforts to stabilize the economy often end up destabilizing it--"booming the boom," or "depressing the depression."

Macroeconomic Adjustment to International Disturbances

As the world economy becomes progressively more open and economically integrated, the vehicles for macroeconomic adjustment to internationally-sourced disturbances attain ever greater significance. Basically, there are only three macroeconomic adjustment vehicles: exchange rates, domestic prices (including interest rates), and domestic employment (and incomes). A progression of "if statements" identifies the relevant adjustment possibilities:

1. If exchange rates are allowed sufficient flexibility, they may serve as "shock absorbers" for the domestic economy against internationally-sourced disturbances.

2. If exchange rates are fixed by government authorities, domestic prices assume the burden of adjustment.

3. If domestic prices are insufficiently flexible, the adjustment process must descend upon domestic employment and incomes.

4. If government authorities employ macropolicy to stabilize domestic prices, employment, and incomes, exchange rate flexibility must serve as the adjustment vehicle.

5. If government authorities attempt both to stabilize domestic prices and employment and to fix exchange rates, there is no effective vehicle of macroeconomic adjustment to international disturbances. In the absence of an effective adjustment vehicle, payments imbalances will persist.

An important conclusion emerges from these considerations: the degree of domestic macroeconomic stability of a nation may depend upon the degree of flexibility that its government accords to rates of exchange between its currency and other currencies. As a general rule, we may expect domestic macroeconomic conditions in any economy to be more volatile in response to international disturbances the less flexible are its exchange rates. Fixing or stabilizing exchange rates forces the adjustment to international disturbances upon domestic macroeconomic conditions of prices and employment.

How does U.S. macropolicy mesh with these adjustment vehicles? The top and middle panels of Chart 11 have been brought forward to Chart 12 to be compared to the U.S. dollar-to-euro spot exchange rate in the bottom panel. The exchange rate path shown in this panel demonstrates that U.S. exchange rates are not fixed; their flexibility provides a modicum of shock absorption to both domestic- and internationally-sourced disturbances.

The Federal Reserve does practice macropolicy in its pursuit of price stability, but the interest rate targets that it sets may cause market-determined interest rates to diverge from regional capital scarcity interest rates. It cannot be said that any U.S. authority implements fiscal policy with consistency. The Congress typically legislates spending bills with respect to politically-perceived program needs and only occasionally with regard to employment and income deficiencies. The Treasury Department of the executive branch of the U.S. government is tasked with implementing Congressional legislation to finance federal government expenditures, including regular annual deficits. The sporadic nature of these hodge-podge fiscal actions are not oriented primarily toward achieving macroeconomic stability of employment and incomes. The incoherence of U.S. macropolicy may be a source of the price, employment, and income instability that has been experienced.

Exchange Rates During the Great Recession

The 2008 “Great Recession” was an internal disturbance to the U.S. economy that had international repercussions. The bottom panel of Chart 12 shows that the dollar appreciated as the dollar price of the euro fell from $1.58 in June 2008 to $1.27 in November 2008 (i.e., the euro price of the dollar increased from 0.63 euro to 0.79 euro).

In the effort to alleviate emerging recessions since 2008, the Fed engaged in four rounds of quantitative easing (QE1, November 2008; QE2, November 2010; QE3, September 2012; QE4, March 2020) by increasing the reserves of depository institutions. Following QE1, the dollar depreciated as the price of the euro rose from $1.27 in February 2009 to $1.49 in November 2009 (i.e., the euro price of the dollar decreased from 0.79 euro to 0.68 euro).

Quantitative easing in the U.S. is implemented by the Federal Reserve when it purchases bonds from depository institutions, paying for the bonds by increasing their reserves. The increased reserves enable lending that increases the quantity of money in circulation to stimulate business investment and consumer spending in the economy. The increasing quantity of money in circulation may cause market-determined interest rates to diverge from the capital scarcity interest rate and set in motion adjustment processes. The increasing quantity of money in circulation won’t change the capital scarcity interest rate unless it induces investment that causes a change in the capital stock of the region.

As the Fed buys bonds during a quantitative easing action, bond supplies decrease on U.S. financial markets relative to bond demands, bidding up bond prices and decreasing bond yield rates. The proceeds from selling bonds at higher bond prices motivate businesses and governments to issue new bonds to finance investment and spending plans. Some of the new bond issuers are foreign businesses and governments who receive payment in dollars that must be converted to their own currencies for repatriation. The repatriation of these funds shows up in the middle panel of Chart 12 in a capital account deficit. The U.S. capital account, roughly in balance in 2008, had a deficit of nearly $5.88 billion in 2009. A deficit in the capital account implies that money is flowing out of the country and suggests that the nation is increasing its possession of foreign assets (e.g., bonds).

The increasing supply of dollars on foreign exchange (FX) markets during 2009 depressed the euro price of the dollar from 0.79 euro to 0.68 euro. Deficits in the capital account (middle panel of Chart 12) weakened the dollar (bottom panel of Chart 12) when dollar proceeds of bond sales by foreigners were converted to foreign currencies on FX markets for repatriation. Subsequently, the weakened dollar stimulated exports of U.S. products and services, increasing the demand for dollars on FX markets to purchase U.S. goods and services (top panel of Chart 12) and reversing the dollar appreciation attributed to the quantitative easing. In 2010 the dollar price of the euro fell from $1.49 in November 2009 to $1.22 in June 2010 (i.e., the euro price of a dollar rose from 0.67 euro to 0.82 euro). Even with this dollar depreciation, the U.S. trade balance deficit increased from $379.7 million in 2009 to $432.0 million in 2010 as American imports continued to exceed its exports.

Similar patterns may be discerned in each of the subsequent episodes of quantitative easing. Following the brief 2020 recession, the pattern for QE4 differed from the earlier quantitative easing episodes in that the disturbance was externally sourced by the Covid19 pandemic and the clogging of west-coast supply chains.

Regressions on monthly data, July 1954 through October 2024, for Federal Funds and 10-Year Treasury Bills, with dependent variable lags and leads.

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    2 10YrTB         PERIODS LAGGED: 0
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  1 FF

COEF OF MULTIPLE CORRELATION (R):      0.9051     CORRECTED R:           0.9051
COEF OF MULTIPLE DETERMINATION (R^2)   0.8192     CORRECTED R^2:         0.8192
STANDARD ERROR OF THE ESTIMATE:        1.2317     MEAN SQUARED ERROR:    1.5172

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        7067.2774         843
  REMOVED BY REGRESSION:        5789.7906           1        F-VALUE: 3816.0894
  RESIDUAL:                     1277.4868         842            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FF         0.9051      0.7337    0.0119   61.7745     0.0000
CONSTANT (A)             2.2223
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    2 10YrTB         PERIODS LAGGED: 1
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  1 FF

COEF OF MULTIPLE CORRELATION (R):      0.9049     CORRECTED R:           0.9049
COEF OF MULTIPLE DETERMINATION (R^2)   0.8188     CORRECTED R^2:         0.8188
STANDARD ERROR OF THE ESTIMATE:        1.2332     MEAN SQUARED ERROR:    1.5207

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        7056.3455         842
  REMOVED BY REGRESSION:        5777.4456           1        F-VALUE: 3799.2273
  RESIDUAL:                     1278.9000         841            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FF         0.9049      0.7329    0.0119   61.6379     0.0000
CONSTANT (A)             2.2300
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    2 10YrTB         PERIODS LAGGED: 2
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  1 FF

COEF OF MULTIPLE CORRELATION (R):      0.9037     CORRECTED R:           0.9037
COEF OF MULTIPLE DETERMINATION (R^2)   0.8166     CORRECTED R^2:         0.8166
STANDARD ERROR OF THE ESTIMATE:        1.2402     MEAN SQUARED ERROR:    1.5381

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        7045.7816         841
  REMOVED BY REGRESSION:        5753.7859           1        F-VALUE: 3740.8640
  RESIDUAL:                     1291.9957         840            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FF         0.9037      0.7314    0.0120   61.1626     0.0000
CONSTANT (A)             2.2412
SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
________________________________________

DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    2 10YrTB         PERIODS LAGGED: 3
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  1 FF

COEF OF MULTIPLE CORRELATION (R):      0.9023     CORRECTED R:           0.9023
COEF OF MULTIPLE DETERMINATION (R^2)   0.8142     CORRECTED R^2:         0.8142
STANDARD ERROR OF THE ESTIMATE:        1.2481     MEAN SQUARED ERROR:    1.5578

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        7035.3224         840
  REMOVED BY REGRESSION:        5728.3293           1        F-VALUE: 3677.1947
  RESIDUAL:                     1306.9931         839            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FF         0.9023      0.7298    0.0120   60.6399     0.0000
CONSTANT (A)             2.2531
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    2 10YrTB         PERIODS LAGGED: 5
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  1 FF

COEF OF MULTIPLE CORRELATION (R):      0.8989     CORRECTED R:           0.8989
COEF OF MULTIPLE DETERMINATION (R^2)   0.8081     CORRECTED R^2:         0.8081
STANDARD ERROR OF THE ESTIMATE:        1.2684     MEAN SQUARED ERROR:    1.6088

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        7015.2898         838
  REMOVED BY REGRESSION:        5668.7352           1        F-VALUE: 3523.6086
  RESIDUAL:                     1346.5546         837            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FF         0.8989      0.7261    0.0122   59.3600     0.0000
CONSTANT (A)             2.2792
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    2 10YrTB         PERIODS LAGGED: 10
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  1 FF

COEF OF MULTIPLE CORRELATION (R):      0.8922     CORRECTED R:           0.8922
COEF OF MULTIPLE DETERMINATION (R^2)   0.7960     CORRECTED R^2:         0.7960
STANDARD ERROR OF THE ESTIMATE:        1.3073     MEAN SQUARED ERROR:    1.7090

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        6970.4841         833
  REMOVED BY REGRESSION:        5548.5860           1        F-VALUE: 3246.6627
  RESIDUAL:                     1421.8981         832            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FF         0.8922      0.7184    0.0126   56.9795     0.0000
CONSTANT (A)             2.3355
________________________________________

Conclusion: 10YrTB data are highly correlated to simultaneous FF data beginning at row 1 (July 1954), but there is no significant lag of 10YrTB after FF.?

  
SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    1 FF             PERIODS LAGGED: 0
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  2 10YrTB

COEF OF MULTIPLE CORRELATION (R):      0.9051     CORRECTED R:           0.9051
COEF OF MULTIPLE DETERMINATION (R^2)   0.8192     CORRECTED R^2:         0.8192
STANDARD ERROR OF THE ESTIMATE:        1.5195     MEAN SQUARED ERROR:    2.3089

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                       10754.8987         843
  REMOVED BY REGRESSION:        8810.8345           1        F-VALUE: 3816.0894
  RESIDUAL:                     1944.0642         842            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTB     0.9051      1.1166    0.0181   61.7745     0.0000
CONSTANT (A)            -1.6482
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    1 FF             PERIODS LAGGED: 1
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  2 10YrTB

COEF OF MULTIPLE CORRELATION (R):      0.9013     CORRECTED R:           0.9013
COEF OF MULTIPLE DETERMINATION (R^2)   0.8124     CORRECTED R^2:         0.8124
STANDARD ERROR OF THE ESTIMATE:        1.5478     MEAN SQUARED ERROR:    2.3958

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                       10740.3694         842
  REMOVED BY REGRESSION:        8725.5372           1        F-VALUE: 3642.0784
  RESIDUAL:                     2014.8322         841            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTB     0.9013      1.1113    0.0184   60.3496     0.0000
CONSTANT (A)            -1.6163
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    1 FF             PERIODS LAGGED: 2
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  2 10YrTB

COEF OF MULTIPLE CORRELATION (R):      0.8930     CORRECTED R:           0.8930
COEF OF MULTIPLE DETERMINATION (R^2)   0.7975     CORRECTED R^2:         0.7975
STANDARD ERROR OF THE ESTIMATE:        1.6081     MEAN SQUARED ERROR:    2.5861

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                       10728.8366         841
  REMOVED BY REGRESSION:        8556.4992           1        F-VALUE: 3308.6294
  RESIDUAL:                     2172.3374         840            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTB     0.8930      1.1008    0.0191   57.5207     0.0000
CONSTANT (A)            -1.5556
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    1 FF             PERIODS LAGGED: 3
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  2 10YrTB

COEF OF MULTIPLE CORRELATION (R):      0.8829     CORRECTED R:           0.8829
COEF OF MULTIPLE DETERMINATION (R^2)   0.7795     CORRECTED R^2:         0.7795
STANDARD ERROR OF THE ESTIMATE:        1.6782     MEAN SQUARED ERROR:    2.8164

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                       10716.2332         840
  REMOVED BY REGRESSION:        8353.3155           1        F-VALUE: 2966.0076
  RESIDUAL:                     2362.9177         839            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTB     0.8829      1.0879    0.0200   54.4611     0.0000
CONSTANT (A)            -1.4812
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    1 FF             PERIODS LAGGED: 5
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  2 10YrTB

COEF OF MULTIPLE CORRELATION (R):      0.8628     CORRECTED R:           0.8628
COEF OF MULTIPLE DETERMINATION (R^2)   0.7444     CORRECTED R^2:         0.7444
STANDARD ERROR OF THE ESTIMATE:        1.8067     MEAN SQUARED ERROR:    3.2640

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                       10687.5542         838
  REMOVED BY REGRESSION:        7955.5572           1        F-VALUE: 2437.3384
  RESIDUAL:                     2731.9970         837            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTB     0.8628      1.0619    0.0215   49.3694     0.0000
CONSTANT (A)            -1.3300
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    1 FF             PERIODS LAGGED: 10
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  2 10YrTB

COEF OF MULTIPLE CORRELATION (R):      0.8183     CORRECTED R:           0.8183
COEF OF MULTIPLE DETERMINATION (R^2)   0.6697     CORRECTED R^2:         0.6697
STANDARD ERROR OF THE ESTIMATE:        2.0547     MEAN SQUARED ERROR:    4.2219

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                       10633.3159         833
  REMOVED BY REGRESSION:        7120.7142           1        F-VALUE: 1686.6228
  RESIDUAL:                     3512.6017         832            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTB     0.8183      1.0053    0.0245   41.0685     0.0000
CONSTANT (A)            -1.0003
________________________________________

Conclusion: FF data are highly correlated to simultaneous 10YrTB data beginning at row 1 (July 1954), but there is no significant lag of FF after 10YrTB (i.e., lead of 10YrTB ahead of FF).

Regressions on monthly difference data, July 1954 through October 2024, for Federal Funds and 10-Year Treasury Bills, with dependent variable lags and leads.

  
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    4 10YrTBDIF      PERIODS LAGGED: 0
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  3 FFDIF

COEF OF MULTIPLE CORRELATION (R):      0.3288     CORRECTED R:           0.3288
COEF OF MULTIPLE DETERMINATION (R^2)   0.1081     CORRECTED R^2:         0.1081
STANDARD ERROR OF THE ESTIMATE:        0.2515     MEAN SQUARED ERROR:    0.0633

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                          59.5722         841
  REMOVED BY REGRESSION:           6.4413           1        F-VALUE:  101.8376
  RESIDUAL:                       53.1309         840            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FFDIF      0.3288      0.1805    0.0179   10.0915     0.0000
CONSTANT (A)             0.0013
________________________________________

DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    4 10YrTBDIF      PERIODS LAGGED: 1
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  3 FFDIF

COEF OF MULTIPLE CORRELATION (R):      0.0782     CORRECTED R:           0.0782
COEF OF MULTIPLE DETERMINATION (R^2)   0.0061     CORRECTED R^2:         0.0061
STANDARD ERROR OF THE ESTIMATE:        0.2656     MEAN SQUARED ERROR:    0.0706

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                          59.5719         840
  REMOVED BY REGRESSION:           0.3646           1        F-VALUE:    5.1664
  RESIDUAL:                       59.2073         839            SIG:    0.0219

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FFDIF      0.0782      0.0429    0.0189    2.2730     0.0219
CONSTANT (A)             0.0018
________________________________________

DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    4 10YrTBDIF      PERIODS LAGGED: 2
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  3 FFDIF

COEF OF MULTIPLE CORRELATION (R):      0.0158     CORRECTED R:           0.0158
COEF OF MULTIPLE DETERMINATION (R^2)   0.0002     CORRECTED R^2:         0.0002
STANDARD ERROR OF THE ESTIMATE:        0.2666     MEAN SQUARED ERROR:    0.0711

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                          59.5696         839
  REMOVED BY REGRESSION:           0.0148           1        F-VALUE:    0.2080
  RESIDUAL:                       59.5548         838            SIG:    0.6534

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FFDIF      0.0158      0.0086    0.0190    0.4561     0.6534
CONSTANT (A)             0.0019
________________________________________

?
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    4 10YrTBDIF      PERIODS LAGGED: 3
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  3 FFDIF

COEF OF MULTIPLE CORRELATION (R):      0.0052     CORRECTED R:           0.0052
COEF OF MULTIPLE DETERMINATION (R^2)   0.0000     CORRECTED R^2:         0.0000
STANDARD ERROR OF THE ESTIMATE:        0.2668     MEAN SQUARED ERROR:    0.0712

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                          59.5673         838
  REMOVED BY REGRESSION:           0.0016           1        F-VALUE:    0.0224
  RESIDUAL:                       59.5657         837            SIG:    0.8759

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FFDIF     -0.0052     -0.0028    0.0190   -0.1496     0.8759
CONSTANT (A)             0.0019
________________________________________

Conclusion: 10YrTBDIF monthly difference data are moderately correlated to simultaneous FFDIF monthly difference data beginning at row 3 (September 1954), but there is no significant lag of 10YrTBDIF after FFDIF.

DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    3 FFDIF          PERIODS LAGGED: 0
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  4 10YrTBDIF

COEF OF MULTIPLE CORRELATION (R):      0.3288     CORRECTED R:           0.3288
COEF OF MULTIPLE DETERMINATION (R^2)   0.1081     CORRECTED R^2:         0.1081
STANDARD ERROR OF THE ESTIMATE:        0.4582     MEAN SQUARED ERROR:    0.2099

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                         197.7342         841
  REMOVED BY REGRESSION:          21.3803           1        F-VALUE:  101.8376
  RESIDUAL:                      176.3539         840            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTBDIF  0.3288      0.5991    0.0594   10.0915     0.0000
CONSTANT (A)             0.0030
________________________________________

DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    3 FFDIF          PERIODS LAGGED: 1
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  4 10YrTBDIF

COEF OF MULTIPLE CORRELATION (R):      0.3717     CORRECTED R:           0.3717
COEF OF MULTIPLE DETERMINATION (R^2)   0.1382     CORRECTED R^2:         0.1382
STANDARD ERROR OF THE ESTIMATE:        0.4506     MEAN SQUARED ERROR:    0.2031

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                         197.7104         840
  REMOVED BY REGRESSION:          27.3223           1        F-VALUE:  134.5367
  RESIDUAL:                      170.3880         839            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTBDIF  0.3717      0.6780    0.0585   11.5990     0.0000
CONSTANT (A)             0.0034
________________________________________
?
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    3 FFDIF          PERIODS LAGGED: 2
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  4 10YrTBDIF

COEF OF MULTIPLE CORRELATION (R):      0.1437     CORRECTED R:           0.1437
COEF OF MULTIPLE DETERMINATION (R^2)   0.0206     CORRECTED R^2:         0.0206
STANDARD ERROR OF THE ESTIMATE:        0.4806     MEAN SQUARED ERROR:    0.2310

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                         197.6599         839
  REMOVED BY REGRESSION:           4.0802           1        F-VALUE:   17.6633
  RESIDUAL:                      193.5797         838            SIG:    0.0001

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTBDIF  0.1437      0.2621    0.0624    4.2028     0.0001
CONSTANT (A)             0.0043
________________________________________

DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    3 FFDIF          PERIODS LAGGED: 3
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  4 10YrTBDIF

COEF OF MULTIPLE CORRELATION (R):      0.0142     CORRECTED R:           0.0142
COEF OF MULTIPLE DETERMINATION (R^2)   0.0002     CORRECTED R^2:         0.0002
STANDARD ERROR OF THE ESTIMATE:        0.4859     MEAN SQUARED ERROR:    0.2361

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                         197.6593         838
  REMOVED BY REGRESSION:           0.0400           1        F-VALUE:    0.1693
  RESIDUAL:                      197.6194         837            SIG:    0.6841

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTBDIF -0.0142     -0.0260    0.0631   -0.4115     0.6841
CONSTANT (A)             0.0048
________________________________________

Conclusion: FFDIF monthly difference data are moderately correlated to simultaneous 10YrTBDIF monthly difference data beginning at row 3 (September 1954), but there is no significant lag of FFDIF after 10YrTBDIF (i.e., lead of 10YrTBDIF ahead of FFDIF).

Regressions on monthly data, July 1954 through October 2024, for Federal Funds and 10-Year Treasury Bills, with dependent variable lags and leads, beginning row 326 (July 1981).

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    2 10YrTB         PERIODS LAGGED: 0
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  1 FF

COEF OF MULTIPLE CORRELATION (R):      0.9251     CORRECTED R:           0.9251
COEF OF MULTIPLE DETERMINATION (R^2)   0.8558     CORRECTED R^2:         0.8558
STANDARD ERROR OF THE ESTIMATE:        1.1907     MEAN SQUARED ERROR:    1.4178

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        5081.9878         518
  REMOVED BY REGRESSION:        4348.9776           1        F-VALUE: 3067.3808
  RESIDUAL:                      733.0102         517            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FF         0.9251      0.8468    0.0153   55.3839     0.0000
CONSTANT (A)             2.0025
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    2 10YrTB         PERIODS LAGGED: 1
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  1 FF

COEF OF MULTIPLE CORRELATION (R):      0.9226     CORRECTED R:           0.9226
COEF OF MULTIPLE DETERMINATION (R^2)   0.8512     CORRECTED R^2:         0.8512
STANDARD ERROR OF THE ESTIMATE:        1.1999     MEAN SQUARED ERROR:    1.4398

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        4991.2761         517
  REMOVED BY REGRESSION:        4248.3519           1        F-VALUE: 2950.7042
  RESIDUAL:                      742.9242         516            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FF         0.9226      0.8370    0.0154   54.3204     0.0000
CONSTANT (A)             2.0251
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    2 10YrTB         PERIODS LAGGED: 2
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  1 FF

COEF OF MULTIPLE CORRELATION (R):      0.9191     CORRECTED R:           0.9191
COEF OF MULTIPLE DETERMINATION (R^2)   0.8447     CORRECTED R^2:         0.8447
STANDARD ERROR OF THE ESTIMATE:        1.2148     MEAN SQUARED ERROR:    1.4756

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        4892.8094         516
  REMOVED BY REGRESSION:        4132.8635           1        F-VALUE: 2800.7580
  RESIDUAL:                      759.9459         515            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FF         0.9191      0.8256    0.0156   52.9222     0.0000
CONSTANT (A)             2.0536
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    2 10YrTB         PERIODS LAGGED: 3
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  1 FF

COEF OF MULTIPLE CORRELATION (R):      0.9145     CORRECTED R:           0.9145
COEF OF MULTIPLE DETERMINATION (R^2)   0.8364     CORRECTED R^2:         0.8364
STANDARD ERROR OF THE ESTIMATE:        1.2358     MEAN SQUARED ERROR:    1.5273

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        4797.3158         515
  REMOVED BY REGRESSION:        4012.2816           1        F-VALUE: 2627.0355
  RESIDUAL:                      785.0342         514            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FF         0.9145      0.8136    0.0159   51.2546     0.0000
CONSTANT (A)             2.0853
________________________________________

Conclusion: 10YrTB data are highly correlated to simultaneous FF data beginning at row 326 (July 1981), but there is no significant lag of 10YrTB after FF (i.e., lead of FF ahead of 10YrTB).

?
SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    1 FF             PERIODS LAGGED: 0
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  2 10YrTB

COEF OF MULTIPLE CORRELATION (R):      0.9251     CORRECTED R:           0.9251
COEF OF MULTIPLE DETERMINATION (R^2)   0.8558     CORRECTED R^2:         0.8558
STANDARD ERROR OF THE ESTIMATE:        1.3008     MEAN SQUARED ERROR:    1.6922

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        6065.3423         518
  REMOVED BY REGRESSION:        5190.4961           1        F-VALUE: 3067.3808
  RESIDUAL:                      874.8462         517            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTB     0.9251      1.0106    0.0182   55.3839     0.0000
CONSTANT (A)            -1.4408
________________________________________


SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    1 FF             PERIODS LAGGED: 1
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  2 10YrTB

COEF OF MULTIPLE CORRELATION (R):      0.9247     CORRECTED R:           0.9247
COEF OF MULTIPLE DETERMINATION (R^2)   0.8551     CORRECTED R^2:         0.8551
STANDARD ERROR OF THE ESTIMATE:        1.2844     MEAN SQUARED ERROR:    1.6497

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        5875.1341         517
  REMOVED BY REGRESSION:        5023.8841           1        F-VALUE: 3045.3145
  RESIDUAL:                      851.2501         516            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTB     0.9247      0.9944    0.0180   55.1844     0.0000
CONSTANT (A)            -1.3822
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    1 FF             PERIODS LAGGED: 2
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  2 10YrTB

COEF OF MULTIPLE CORRELATION (R):      0.9217     CORRECTED R:           0.9217
COEF OF MULTIPLE DETERMINATION (R^2)   0.8495     CORRECTED R^2:         0.8495
STANDARD ERROR OF THE ESTIMATE:        1.2946     MEAN SQUARED ERROR:    1.6760

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        5734.3236         516
  REMOVED BY REGRESSION:        4871.2047           1        F-VALUE: 2906.5180
  RESIDUAL:                      863.1189         515            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTB     0.9217      0.9795    0.0182   53.9121     0.0000
CONSTANT (A)            -1.3272
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    1 FF             PERIODS LAGGED: 3
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  2 10YrTB

COEF OF MULTIPLE CORRELATION (R):      0.9175     CORRECTED R:           0.9175
COEF OF MULTIPLE DETERMINATION (R^2)   0.8418     CORRECTED R^2:         0.8418
STANDARD ERROR OF THE ESTIMATE:        1.3143     MEAN SQUARED ERROR:    1.7274

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                        5611.1453         515
  REMOVED BY REGRESSION:        4723.2866           1        F-VALUE: 2734.4096
  RESIDUAL:                      887.8587         514            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTB     0.9175      0.9647    0.0184   52.2916     0.0000
CONSTANT (A)            -1.2715
________________________________________

Conclusion: FF data are highly correlated to simultaneous 10YrTB data beginning at row 326 (July 1981), but there is no significant lag of FF after 10YrTB (i.e., lead of 10YrTB ahead of FF).

Regressions on monthly difference data, July 1954 through October 2024, for Federal Funds and 10-Year Treasury Bills, with dependent variable lags and leads.

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    4 10YrTBDIF      PERIODS LAGGED: 0
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  3 FFDIF

COEF OF MULTIPLE CORRELATION (R):      0.3019     CORRECTED R:           0.3019
COEF OF MULTIPLE DETERMINATION (R^2)   0.0911     CORRECTED R^2:         0.0911
STANDARD ERROR OF THE ESTIMATE:        0.2628     MEAN SQUARED ERROR:    0.0691

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                          39.2869         518
  REMOVED BY REGRESSION:           3.5807           1        F-VALUE:   51.8458
  RESIDUAL:                       35.7062         517            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FFDIF      0.3019      0.2780    0.0386    7.2004     0.0000
CONSTANT (A)            -0.0120
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    4 10YrTBDIF      PERIODS LAGGED: 1
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  3 FFDIF

COEF OF MULTIPLE CORRELATION (R):      0.1014     CORRECTED R:           0.1014
COEF OF MULTIPLE DETERMINATION (R^2)   0.0103     CORRECTED R^2:         0.0103
STANDARD ERROR OF THE ESTIMATE:        0.2729     MEAN SQUARED ERROR:    0.0745

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                          38.8242         517
  REMOVED BY REGRESSION:           0.3995           1        F-VALUE:    5.3642
  RESIDUAL:                       38.4247         516            SIG:    0.0197

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FFDIF      0.1014      0.0929    0.0401    2.3161     0.0197
CONSTANT (A)            -0.0184
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    4 10YrTBDIF      PERIODS LAGGED: 2
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  3 FFDIF

COEF OF MULTIPLE CORRELATION (R):      0.1597     CORRECTED R:           0.1597
COEF OF MULTIPLE DETERMINATION (R^2)   0.0255     CORRECTED R^2:         0.0255
STANDARD ERROR OF THE ESTIMATE:        0.2705     MEAN SQUARED ERROR:    0.0732

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                          38.6631         516
  REMOVED BY REGRESSION:           0.9865           1        F-VALUE:   13.4851
  RESIDUAL:                       37.6766         515            SIG:    0.0005

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FFDIF      0.1597      0.1461    0.0398    3.6722     0.0005
CONSTANT (A)            -0.0178
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    4 10YrTBDIF      PERIODS LAGGED: 3
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  3 FFDIF

COEF OF MULTIPLE CORRELATION (R):      0.0670     CORRECTED R:           0.0670
COEF OF MULTIPLE DETERMINATION (R^2)   0.0045     CORRECTED R^2:         0.0045
STANDARD ERROR OF THE ESTIMATE:        0.2736     MEAN SQUARED ERROR:    0.0748

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                          38.6411         515
  REMOVED BY REGRESSION:           0.1734           1        F-VALUE:    2.3176
  RESIDUAL:                       38.4676         514            SIG:    0.1244

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 FFDIF      0.0670      0.0612    0.0402    1.5224     0.1244
CONSTANT (A)            -0.0198
________________________________________

Conclusion: 10YrTBDIF monthly difference data are moderately correlated to simultaneous FFDIF monthly difference data beginning at row 326 (July 1981), but there is no significant lag of 10YrTBDIF after FFDIF.

?
SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    3 FFDIF          PERIODS LAGGED: 0
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  4 10YrTBDIF

COEF OF MULTIPLE CORRELATION (R):      0.3019     CORRECTED R:           0.3019
COEF OF MULTIPLE DETERMINATION (R^2)   0.0911     CORRECTED R^2:         0.0911
STANDARD ERROR OF THE ESTIMATE:        0.2854     MEAN SQUARED ERROR:    0.0815

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                          46.3480         518
  REMOVED BY REGRESSION:           4.2243           1        F-VALUE:   51.8458
  RESIDUAL:                       42.1238         517            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTBDIF  0.3019      0.3279    0.0455    7.2004     0.0000
CONSTANT (A)            -0.0209
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    3 FFDIF          PERIODS LAGGED: 1
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  4 10YrTBDIF

COEF OF MULTIPLE CORRELATION (R):      0.2908     CORRECTED R:           0.2908
COEF OF MULTIPLE DETERMINATION (R^2)   0.0846     CORRECTED R^2:         0.0846
STANDARD ERROR OF THE ESTIMATE:        0.2823     MEAN SQUARED ERROR:    0.0797

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                          44.9229         517
  REMOVED BY REGRESSION:           3.8000           1        F-VALUE:   47.6818
  RESIDUAL:                       41.1229         516            SIG:    0.0000

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTBDIF  0.2908      0.3116    0.0451    6.9052     0.0000
CONSTANT (A)            -0.0187
________________________________________

SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    3 FFDIF          PERIODS LAGGED: 2
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  4 10YrTBDIF

COEF OF MULTIPLE CORRELATION (R):      0.1294     CORRECTED R:           0.1294
COEF OF MULTIPLE DETERMINATION (R^2)   0.0167     CORRECTED R^2:         0.0167
STANDARD ERROR OF THE ESTIMATE:        0.2805     MEAN SQUARED ERROR:    0.0787

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                          41.2105         516
  REMOVED BY REGRESSION:           0.6896           1        F-VALUE:    8.7642
  RESIDUAL:                       40.5209         515            SIG:    0.0036

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTBDIF  0.1294      0.1328    0.0449    2.9604     0.0036
CONSTANT (A)            -0.0187
________________________________________
?
SIMPLE LINEAR REGRESSION:       Y = A + B(1)*X
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN:    3 FFDIF          PERIODS LAGGED: 3
INDEPENDENT VARIABLE (X) IS MATRIX COLUMN:  4 10YrTBDIF

COEF OF MULTIPLE CORRELATION (R):      0.0929     CORRECTED R:           0.0929
COEF OF MULTIPLE DETERMINATION (R^2)   0.0086     CORRECTED R^2:         0.0086
STANDARD ERROR OF THE ESTIMATE:        0.2799     MEAN SQUARED ERROR:    0.0783

ANALYSIS OF VARIANCE:     SUMS OF SQUARES   DEGREES OF FREEDOM
  TOTAL:                          40.6185         515
  REMOVED BY REGRESSION:           0.3506           1        F-VALUE:    4.4751
  RESIDUAL:                       40.2679         514            SIG:    0.0327

INDEP VAR  SIMPLE R    COEF (B)  S.E. COEF  T-VALUE  SIGNIFICANCE
1 10YrTBDIF  0.0929      0.0948    0.0448    2.1154     0.0327
CONSTANT (A)            -0.0180
________________________________________

Conclusion: FFDIF monthly difference data are moderately correlated to simultaneous 10YrTBDIF monthly difference data beginning at row 326 (July 1981), but there is no significant lag of FFDIF after 10YrTBDIF (i.e., lead of 10YrTBDIF ahead of FFDIF).

34. Monetary Policy in an Open-Economy World

It is difficult to implement monetary policy as a means of offsetting private-sector changes of spending because the linkages between money-supply changes and spending are only indirect and imprecise. The monetary policy transmission mechanism works either through influencing market interest rates that affect interest-sensitive purchases, or through the diminishing marginal utility of money balances which induces consumer spending changes. At this stage of our understanding, it is not possible with any degree of precision to effect the right monetary policy action to elicit just the appropriate offsetting change of spending.

Even more troubling than these minor difficulties is the fact that it is never possible to perfectly predict changes of aggregate spending, and it may not be possible to predict such changes at all. More often than not, the first evidence of a change of aggregate spending occurs some number of months or quarters after the fact. This puts the Fed in the position of reacting to such changes rather than concurrently offsetting them.

And then there is the proverbial "elephant in the room." We live and operate in an open-economy world. In an open economy, the reserves of commercial banks and the money supply are affected both by trade flows and by international capital flows. For example, if the nation experiences a favorable balance in its trade accounts (e.g., it is in surplus when it exports more than it imports), its domestic businesses will be receiving payments either in its domestic currency or in foreign currencies which must be converted to its domestic currency, and the effect necessarily is to expand the domestic money supply and commercial bank reserves, whether or not the central bank wants them to expand. Monetary contraction would necessarily follow from trade deficits that decrease the domestic money supply. The upper panel of Chart 11 shows the variability of the U.S. trade balance, continually in deficit, between 1999 and 2024.

International capital flows motivated by international interest rate, inflation rate, and income change differentials will affect the domestic economy, irrespective of the intent of the central bank. The lower panel of Chart 11 shows the variability of the U.S. capital account between 1999 and 2023, often in deficit, near balance in 2005, 2008, and 2012, in surplus only in 2001 and 2017. In many of these years, deficits in both the trade and capital accounts have decreased the quantity of money in circulation as payments were made to foreigners to import goods and services and to invest abroad.

In an open-economy world, the central bank may attempt to offset or neutralize the monetary effects of trade and capital flows so that domestic monetary targets may be pursued. However, if the central bank does this, it renders inoperable any natural adjustment mechanisms that would correct trade and capital flow imbalances. The consequence would be continuing depreciation or appreciation of the nation's exchange rate vis-a-vis the currencies of other nations. Exchange rate changes may buy time to allow the nation to correct fundamental imbalances by adjusting its domestic prices and incomes, but if the central bank is neutralizing the effects of trade and capital flows on the domestic economy, these fundamental adjustments may never occur.

It is perhaps heroic to think that the Federal Reserve Board of Governors can effectively exert global control over interest rates or the money supply that is relevant to spending behavior in the U.S. economy. Dollar balances held by Americans and foreigners in other countries can facilitate both trade and financial transactions in the domestic economy. By virtue of the large volume of dollars in use in the world, the dollar has become a de facto world currency. Americans may borrow Eurodollars, Petrodollars, or Asiadollars for spending and investment in the U.S. economy or anywhere else in the world. This means that the dollar-denominated domestic money supply is a fiction or at least an irrelevant target. In order to effectively exercise monetary policy in efforts to stabilize the U.S. economy, the Fed would have to target not just the global dollar money supply, but also aggregates of any and all currencies held by Americans and foreigners anywhere in the world that might be converted to dollars and spent in the U.S. economy.

The loanable funds market now is global in scope because American citizens can buy and sell U.S. Treasury bonds, foreign government-issued securities, and domestic and foreign corporate securities anywhere in the world where markets have emerged to enable such trading. And foreigners (non-citizens of the United States) may negotiate loans from U.S. banks and trade securities in U.S. bond markets which in reality have become global markets.

The international trading of securities tends to eliminate bond price differences globally, and thus to equalize yield rates globally on same-term securities. As soon as international bond price differences are detected, securities traders will engage in international arbitrage to capture profits and eliminate the price and yield rate differences. Buying low and selling high will cause lower prices to rise and higher prices to fall until prices converge. But the international arbitrage that eliminates international price and yield rate differences may cause bond yield rates to become higher or lower than region-specific scarcity interest rates. These differences may induce local decreases or increases of investment spending.

There are only a few nations whose central banks might be able to implement monetary policy on global scale: the U.S., the U.K., the E.U., Japan, and China. When the central banks of any of these nations or regions set out to execute monetary policy, even in respect only to their own currencies or only the amounts in circulation in their own economies, they may have important macroeconomic consequences for other economies of the world, and they may not achieve the intended effects in their own economies.

35. The Fed's Job is Done?

Neil Irwin, writing in The New York Times, March 15, 2017, says that Fed Chair Janet Yellen, at her first new conference of 2017, conveyed the message that after nearly eight years of trying to nurse the economy back to health, the Fed's work was nearly done.

She also displayed little of the fear of setback that has been pervasive at the Fed for years. The central bank has spent the last eight years trying to help the recovery along with a series of monetary interventions; more than any other institution in Washington, it owns the recovery.
(https://www.nytimes.com/2017/03/15/upshot/yellens-message-my-work-here-is-mostly-done.html?ref=economy&_r=0)

This statement is fairly typical of the commercial and financial press which seems to be in thrall of the Federal Reserve. But a view from "outside the Beltway" and away from Wall Street is that the Fed's interventions in "trying to help the recovery along" did little more than "ride herd" on an economy that had been moseying along at its own pace. It appears that the Fed's policy inventions (massive monetary expansions, lowering the rate that it pays to commercial banks on their excess reserves and the Federal Funds rate toward zero, verbal guidance in its public pronouncements) accomplished very little in stimulating faster economic growth or causing inflation to rise to the Fed's own announced target of 2 percent per annum.

Rather than the Fed "owning the recovery," the slow growth of the economy and the flat inflation rate were owned by the Obama administration due to its ever more strident regulation and general unfriendliness toward the business sector. The massive increases of the money supply brought about by three episodes of "quantitative easing" between 2008 and 2014 were for the most part locked up in business cash hoards and excess reserves of commercial banks. Businesses were reticent about investing and banks were reluctant to issue new loans because of fear of failure and loss, and a general aura of pessimism about economic prospects.

The economy finally began to grow at a slightly faster pace due to an emerging perception of business optimism, and the inflation rate began to gradually creep upward toward the Fed's 2 percent target rate. As the aura of pessimism evaporated, businesses became more willing to spend their cash hoards on capital investments. And businesses were beginning to submit more viable loan applications to bankers who were becoming more willing to use their excess reserves to support increased lending.

There appears to be no way to ascertain definitively whether it was the actions of the Federal Reserve or those of the Obama administration that had the greatest influence over the U.S. economy after 2008. Fed officials remained unchallenged in their belief that it was their actions that facilitated the slow growth that brought the U.S. economy to near-full employment by early 2017. The Obama administration, which was accorded credit for averting an even worse economic calamity, escaped the appearance of responsibility for the economy's sluggish growth.

36. About Inflation, November 2021

Recently there has been much hand wringing in the media about inflation, and even some economists who speak on the national stage appear to be mystified by what is causing inflation and what to do about it. They seem to have forgotten their Econ 101 Demand-Supply lessons. Virtually all aspects of the late-2021 inflation episode can be explained with basic demand-supply analysis, early elaborations of which date from the writings of 18th and 19th century Classical Economists (Locke, Smith, Marshall).

Inflation is a rise in the general price level measured as a weighted average index of the prices of a collection of goods and services typically purchased by consumers. The weights are calculated as the percentage of expenditures on the item in the collection of included goods and services. The general price level increases because the prices of many of the component items have risen even though the prices of other component items may have fallen.

If no other prices change, an increase of the price of a single item will increase the average of prices of all items included to compute an index of the price level. Prices of components rise/fall when demands for them increase/decrease relative to the supplies of them available in markets. Prices may also rise/fall when supplies decrease/increase relative to their respective market demands. The time frame for such a rise in the general price level is not specified, but it may be presumed that inflation is a persistent phenomenon lasting more than a couple of months and manifested across a wide array of products.

The enabling cause of a period of inflation is more money in circulation than consumers and businesses want to hold. The Austrian School of economic thought provides a cogent explanation of the spending behavior of rational people who experience diminishing marginal utility (usefulness, satisfaction, pleasure) as they consume successive units of a good. The presumption is that money is a normal good subject to diminishing marginal utility. The marginal (additional) utility of additions to money holdings tends to fall until it is below the utility of some item that the money can buy, so it becomes rational to part with the money and acquire the item ("money burns a hole in the pocket"). Or, when money balances are spent off, the marginal utility of the remaining units held tends to rise until it eclipses the utility of another unit of an item that could be purchased. When this happens, spending (parting with units of money) should stop.

Quantitative easing (QE) bond purchases by the Federal Reserve (the U.S. central bank) to alleviate the 2008 recession added to the U.S. money supply and thus was expected to stimulate additional spending. The economy did in fact begin recovery, but more slowly than expected because a good bit of the additional money went into consumer and business cash hordes. Uncertainty seemed to have outweighed or suspended the diminishing marginal utility of money as people and businesses built up cash balances. These cash hordes constituted something of a monetary overhang that was supplemented by Trump's and Biden's Pandemic relief payments that put even more money into circulation, but they stimulated less spending than hoped.

These monetary accumulations may have left an excess of money in circulation in the U.S. economy, enough to sustain and feed a generalized and prolonged period of inflation. But the most recent inflation episodes may be due to more short-term causes.

The late-2021 price increases thus-far are short-term phenomena (they have been labeled "transitory") manifested in markets for certain (but not all) items. These price increases may be attributable to an unfortunate convergence of market conditions. Consumer spending decreased during the 2020-2021 COVID-19 Pandemic with buildup of cash balances as two stages of pandemic relief payments were received. Businesses reduced production rates, cut back on inventory purchases, and laid off workers. The pandemic relief payments enabled the labor force participation rate (LFPR) to decrease, and resignations by workers disaffected with their jobs further reduced the labor supply.

As the Pandemic moderated during 2021, the pent-up demand was released, spending increased, inventories fell, and businesses tried to hire more workers. But with more jobs available than job seekers, workers demanded higher wages, encouraging an increase of union militancy. The situation was aggravated when supply chains choked during the run up to 2021 holiday season.***

Eventually, as the COVID-19 pandemic moderated in the run up to the end-of-year holiday season, spending accelerated, implying that the marginal utilities of holding the additional money balances diminished. The increased spending added to the demands for goods and services relative to their supplies, thus bidding up prices of fuel and many holiday season items to give the appearance of a general inflation. When the holiday spending binge finishes, the increasing marginal utility of remaining cash balances should curb spending, slow the rate of inflation, and possibly even bring down many prices.

The annual inflation rate indicated by the Consumer Price Index (CPI) in the U.S. had remained below 2% for the past couple of years. It increased from 1.4% in January, 2021, to 5.4% in June where it remained until October when it jumped to 6.2% (https://tradingeconomics.com/united-states/inflation-cpi), precipitating much discussion and alarm in the media. It should be noted that the rates 1.4%, 5.4%, and 6.2% are annual rates of increase, not the increase of the price level in each of the respective months.

Item price increases during a few months suggest short-term demand increases or supply decreases rather than a general or protracted process of inflation. Supply chains are not significantly different in November 2021 from their more normal pre-Pandemic states. As supply chains normalize after the holiday rush, prices are likely to stabilize, and many can be expected to come down. Gasoline prices already have moderated and can be expected to fall as we get past the holiday travel season. However, prices often come back down more slowly than they rose. Prices that are "sticky" in the downward direction may have ratchetted upward without coming back down.

There are yet other factors that have increased the U.S. money supply and contributed to inflation pressures. During the post-2008 recession era, the federal government continually ran annual budgetary deficits. The deficits have required that the U.S. Treasury Department issue new bonds to finance the on-going federal deficits. The Federal Reserve is prohibited by law from buying newly-issued bonds directly from the Treasury, a process that would be highly inflationary. But at the same time that the Treasury issued new bonds that added to the bond supply, the Fed offset the increased supply with monthly purchases of "old bonds" (issued earlier) in order to lower nominal interest rates in an effort to encourage investment and stimulate growth.

An analogy would be a bond bathtub for which the Treasury controls the spigot at one end and the Fed controls the drain at the other end. The level of bonds in the tub (and their yield rates) would remain constant as long as the Fed drains "old bonds" at the same pace that the Treasury pours in "new bonds." If the Fed's drain pace is slower/faster than the Treasury's pour pace, the amount of bonds in the tub will increase/decrease, their prices can be expected to fall/rise, and their yield rates to rise/fall.

During the post 2008 recession era, the Fed paid for the "old bonds" that it purchased with new money, thereby monetizing the debt. This "new money" was not printed, but rather was added by accounting entries to the reserves of commercial banks as they sold bonds to the Fed, thereby increasing their lending capacities. As new loans were issued, the debt monetization process added to the money supply, inducing more spending (due to the diminishing marginal utility of money). This of course contributed to the increase of market prices of goods and services during the second half of 2021 and the run-up to the 2021 holiday season.

The Fed can determine its own lending rate (the "discount rate" available to commercial banks) and the rate that it pays commercial banks on their excess reserves. The Federal Funds rate usually moves with changes of the excess reserves interest rate. But the Fed cannot dictate changes in market-determined interest rates or yield rates on bonds. In order to cause market interest rates to change, the Fed must enter the bond market to buy or sell bonds (called "open market operations"). The Fed's discount rate was 2.25% in February, 2020. In March 2020, in order to stimulate growth in the economy the Fed lowered the discount rate to 0.25% where it has remained through 2021 (https://fred.stlouisfed.org/series/INTDSRUSM193N). After lowering the discount rate, the Fed purchased bonds to bid their prices up and their yields rates down. Market interest rates represented by long-term (10-year) bond yields were 1.76% in January, 2020. They dropped to 0.62% in July 2020 but rebounded to 1.58% by October 2021 (https://fred.stlouisfed.org/series/IRLTLT01USM156N). The Fed's bond purchases achieved only temporary success in bringing market rates down toward its lowered discount rate, but the bond purchases had the side effect of further increasing the supply of money in circulation which contributed to the inflationary pressures.

As more item prices increased during 2021 to give the appearance of longer-term inflation, computed real interest rates (nominal rates minus the rate of inflation) have gone negative (1.58% - 5.4% = -3.82%), and the faster the pace of inflation the more negative real interest rates became (1.58% - 6.2% = -4.62%). Negative real interest rates have enabled a housing bubble and encouraged highly-leveraged stock purchases to drive up stock market averages.

As of the end of 2020, the Fed held $5.1 trillion of federal bonds, or 23.9% of the total federal debt outstanding (https://fred.stlouisfed.org/series/FDHBFRBN). Fed officials have discussed the need to reduce its swollen portfolio of bond holdings, and it has begun a graded reduction in its monthly bond purchases.** If the Fed does start selling off some of the bonds that it holds, the bank balances of bond purchasers will decrease. The marginal utility of their remaining balances can be expected to rise to dampen consumer and investment spending, also adding to recession pressures. This should alleviate the inflationary pressure, but it might also "spook" the financial markets and cause a "crash" that could metastasize to both domestic and international markets for goods, services, and labor.

Yield rates on bonds vary inversely with their prices. There are numerous formulae for computing yield rates, but the "nominal yield" formula illustrates most simply the inverse relationship between the price of a zero-coupon bond and its yield rate:

nominal yield = (face value at maturity - current price) / current price

For a bond that has a $1000 face value, provides no coupon interest payments, and is sold and traded at a market price that is discounted from face value, e.g., $982.7, the effective yield would be ($1000 - $982.7) / $982.7, or approximately 1.76 percent. If the market price should rise to $993.8, the effective yield, ($1000 - $993.8) / $993.8, would fall to approximately 0.62 percent.

If the Fed sells off some of its bond holdings, the increasing supply of bonds relative to bond demand will cause bond prices to fall and yield rates to rise. The increasing bond yield rates will spread through financial markets by arbitrage and have a dampening effect on market transactions that are interest rate sensitive, e.g., business investment and house and car purchases.

Market interest rates have remained low despite the Fed's reduction of its bond purchases. This may be due to the fact that the market for U.S. government-issued bonds is not limited to U.S. market participants. In an open-economy world with global financial markets and near-instant communications, the global demand for U.S. government-issued bonds may keep pace with or increase even faster than the supply that increases with U.S. deficit financing. Foreigners have incentive to buy U.S. government-issued bonds even at low yield rates because they are regarded as some of the safest investments available. Global bond demand increasing fast enough to absorb the increasing supply of U.S. government-issued bonds may enable interest rates to decrease and remain low even as the government runs ever larger budgetary deficits.

As of the end of 2020, the federal debt of the United States was $26.9 trillion, of which $21.6 trillion was held publicly (the rest was held by the Fed and other government agencies). Of the publicly held federal debt, 33% were foreign holdings (https://sgp.fas.org/crs/misc/RS22331.pdf), down from 48% in 2008. This decrease is attributable to the increase of federal debt that had to be financed by selling bonds rather than to decreased holdings of U.S. debt by foreigners. Japan and China held the largest amounts in 2020, each more than $1 trillion.

Foreign purchasers of U.S. government-issued bonds must acquire dollars on foreign exchange (FX) markets in order to buy them. Unless the supply of dollars to the FX markets also increases, an increasing foreign demand for dollars can be expected to cause the dollar to appreciate relative to the buyers' currencies, thereby dampening the foreign demand for U.S. exports and contributing to recession pressures.

Americans supply dollars to the FX markets in order to purchase bonds and imports of goods and services. The volume of imports is especially large in the run up to the end-of-year holidays. The increasing supply of dollars to the FX markets would be expected to decrease the domestic money supply and portend dollar depreciation vis-a-vis other currencies. The dollar has been gradually depreciating with respect to the euro since late-May, 2021 (https://ycharts.com/indicators/euro_to_us_dollar_exchange_rate), and the U.S. trade balance has worsened over the same period (https://tradingeconomics.com/united-states/balance-of-trade). This indicates that Americans have increased the supply of dollars to the FX markets faster than the foreign demand for dollars has increased. The increasing supply of dollars to the FX markets should reduce the domestic money supply and may help to relieve inflationary pressure after the holidays.

Advocates of Modern Monetary Theory (MMT) have argued that governments can deficit finance infrastructure and social spending virtually without limit until inflation "becomes uncomfortable." If the current price increases become regarded as inflation that accelerates fast enough, monetary and fiscal policy decision makers may begin to feel uncomfortable. The inflation rate is the canary in the bond market mine.

It may be too early (mid-November, 2021) to call the recent item price increases "inflation" because some of the proximate causes of recent price increases will clear up after the holidays. The natural slump in economic activity that usually occurs in the winter months following the end-of-year holidays may also help to bring prices back down. However, there may still be an excess of money in circulation in the U.S. economy, enough to sustain and feed a generalized and prolonged period of inflation. We will just have to wait and see. But if the Fed acts precipitously to contract the money supply by reducing its bond portfolio too rapidly, it will risk incurring a recession deeper and longer than the post-holiday slump. Tolerating a faster rate of inflation may be the "price" of avoiding a recession.*

__________

*Writing in The New York Times, November 23, 2021, economist and opinion columnist Paul Krugman says,

But for a long time economists assumed that those Depression-era conditions would never come back, that the Fed could always engineer an economic recovery when it wanted to. As it turns out, however, interest rates can indeed hit the “zero lower bound” in the 21st century; in fact, that has been the norm since 2007. This in turn means that while everyone is talking about inflation risks right now, the Fed is also concerned about the risks of overreacting to inflation. If it raises interest rates and that pushes the economy into a recession, it might not be able to cut rates enough to get us out again. (https://www.nytimes.com/2021/11/23/opinion/fed-powell-unemployment.html?campaign_id=39&emc=edit_ty_20211124&instance_id=46167&nl=opinion-today&regi_id=74240569&segment_id=75218&te=1&user_id=86b0d837dd357b2a6e0e749321f6ed7f)

**Nick Timiraos, writing in The Wall Street Journal on December 3, 2021, says,

Another decline in the unemployment rate in November keeps the Federal Reserve on track to quicken the wind-down of its stimulus programs at its meeting later this month, paving the way to raise interest rates in the first half of next year to curb inflation. The Fed closed a chapter on its aggressive pandemic policy response when it approved plans at its meeting last month to shrink, or taper, its $120 billion monthly asset-purchase program by $15 billion in each of November and December. At that pace, the asset purchases would end next June. The Fed wants to end the asset purchases before it lifts interest rates, which it held near zero. (https://www.wsj.com/articles/fed-jobs-report-wages-unemployment-interest-rates-11638541375)

***Glenn Hubbard, writing in The New York Times on December 13, 2021, says

This time last year, few forecasters predicted inflation of almost 7 percent. Yet when consumers want to buy more than the economy is producing — the macroeconomic story of the year — it is a classic harbinger of rising prices. The Covid pandemic delivered supply shocks in the form of disrupted workforces and supply chains. This, in turn, exerted upward pressure on prices. Very low interest rates and generous government Covid relief programs, designed to cushion a fall in demand in response to the pandemic, added to demand and price pressures. . . . .

Policymakers injected three rounds of fiscal stimulus into the pandemic-afflicted economy. The most recent round sat atop stored-up household savings of at least $2 trillion, according to recent estimates. Those savings were accrued from earlier rounds of stimulus, as well as an improving labor market.
. . . .

As supply chains normalize, inflation will almost surely moderate. But by this time next year, inflation as measured by the Consumer Price Index, the weighted average of a basket of goods commonly purchased by households, could still be as high as 4.5 percent; the core inflation the Fed emphasizes, which excludes food and energy prices, could be 3 percent.

(https://www.nytimes.com/2021/12/13/opinion/inflation-biden-powell-economy-federal-reserve.html?campaign_id=39&emc=edit_ty_20211214&instance_id=47750&nl=opinion-today&regi_id=74240569&segment_id=76924&te=1&user_id=86b0d837dd357b2a6e0e749321f6ed7f

Steven Rattner, writing in The New York Times on April 14, 2022, says that

The debate over whether the recent surge in inflation is transitory or permanent has been settled. Now the question is whether the Federal Reserve can tame increasing inflationary turbulence and bring the economy to a soft touchdown.

Mounting evidence suggests a hard landing — in other words, a recession. We need our economic policymakers to move quickly before the likely damage, already in progress, escalates.

(https://www.nytimes.com/2022/04/14/opinion/interest-rates-inflation-federal-reserve.html?campaign_id=39&emc=edit_ty_20220414&instance_id=58478&nl=opinion-today&regi_id=74240569&segment_id=89214&te=1&user_id=86b0d837dd357b2a6e0e749321f6ed7f)

37. Treasury Interest Rates and Economic Growth Rates

In the January 12, 2022, issue of The New York Times, Peter Coy reported his takes on presentations by economic and finance specialists at the online 2022 annual meeting of the Allied Social Science Associations, which includes the American Economic Association and the American Finance Association. Here are a few of my takes on what Coy reported.

Coy says that

The puzzle all of them are trying to solve is why interest rates on Treasury securities are so low (currently less than 1.8 percent for 10-year notes, below the expected 10-year inflation rate of 2.5 percent), given the huge and persistent deficits the government is running.

I suspect that the difference between the (less than) 1.8 percent Treasury interest rates for 10-year notes and the expected 10-year inflation rate of 2.5 percent is due to the fact that the demand for U.S. Treasury bonds is greater than that in the U.S. market alone. None of what Coy reports from the Association meeting appears to take into account global markets for U.S. Treasury notes.

If the global demand for Treasury notes were increasing faster than the global supply, the prices of U.S. Treasury notes would rise and cause their yield rates to fall below what might be expected in the U.S. market alone. If nothing else affected the FX markets, an increasing foreign demand for dollars to buy U.S. bonds would precipitate dollar depreciation relative to other currencies and serve as evidence that the global demand for Treasury notes is increasing faster than the global supply.

But dollars are supplied to the FX markets for reasons other than bond transactions. The dollar has been gradually depreciating with respect to the euro and other currencies since late-May, 2021 (https://ycharts.com/indicators/euro_to_us_dollar_exchange_rate), and the U.S. trade balance has worsened over the same period (https://tradingeconomics.com/united-states/balance-of-trade). The increasing demand for imported goods in the run up to the end-of-year holiday season has eclipsed their supplies due to chokes in the import supply chain at U.S. ports of entry. The American increase of the supply of dollars to the FX markets for imported goods has overpowered any foreign increase of the demand for U.S. Treasury securities relative to the supply of them.

Coy reports that another panelist, Amir Sufi of the University of Chicago’s Booth School of Business, estimated that the United States still had some fiscal space [in which to borrow to finance deficit spending] in late 2019 because the pandemic caused people to spend less, leaving abundant savings for the bond market. Amir noted that in the longer term, increased inequality increases savings rates because rich people save more than poor people, thus allowing the government to borrow more without satiating lenders. Unsaid is the possibility that the global demand for U.S. Treasury notes also provides fiscal space beyond the U.S. bond market for the U.S. government to borrow.

Coy reports that at the same online meeting, Ricardo Reis of the London School of Economics said, “there’s a lot more fiscal space out there than might have been appreciated before.” A "lot more fiscal space out there" lies in the larger global market for U.S. Treasury notes.

Coy quotes Atif Mian of Princeton, a proponent of Modern Monetary Theory, "the federal government of the United States never has to worry about paying what it owes because it can always print more money." Mian goes on to say that

The only concern of adherents of the theory is that too much government spending (or too little taxation) could overheat the economy, causing inflation. ... to retain the faith of investors that increasing debt is sustainable, the government might have to cut spending or raise taxes. The scary though relatively unlikely scenario, Mian said, is that a dysfunctional government in the future would fail to do those things.

Really? I suspect that under a future Trump administration it would be highly likely that government would become dysfunctional and fail to cut spending or raise taxes when needed, thereby contributing to a faster rate of inflation.

The attendees at the 2022 annual Allied Social Sciences online meeting appeared to focus almost exclusively on government spending relative to taxation as the cause of inflation. Not mentioned was the overhang of excess money in circulation from the post-2008 purchases of U.S. Treasury notes by the Federal Reserve, and the 2020 and 2021 pandemic recovery disbursements to households under the Trump and Biden administrations.

Inflation can be expected to moderate as the Fed slows its purchases of U.S. Treasury obligations, and even more so if the Fed acts to "unwind" its huge portfolio of U.S. bonds purchased between 2008 and the present. But if the Fed raises its bank interest rate (the "discount rate") and actually begins to offload some of its accumulated portfolio of Treasury bonds, it risks precipitating a recession in 2022-2023.

38. Money Creation by Congress

In a New York Times opinion piece dated July 19, 2023, Peter Coy offers an incomplete explanation of how banks create money (https://www.nytimes.com/2023/07/19/opinion/money-paul-sheard-mmt.html?campaign_id=39&emc=edit_ty_20230720&instance_id=97993&nl=opinion-today&regi_id=74240569&segment_id=139810&te=1&user_id=86b0d837dd357b2a6e0e749321f6ed7f).

It is incomplete because he neglects to mention that the money-creating ability of a bank is enabled, but also constrained, by its reserve position. He then goes on to assert that both Congress and the Federal Reserve create money.

Bankers aren’t the only creators of money. Congress creates money from thin air by deficit spending and the Federal Reserve creates it by buying bonds.

The Federal Reserve does indeed enable the creation of new money when it buys "old" (previously-issued) bonds. The clearing process adds to commercial bank reserves and thus enables banks to increase the amount of money in circulation through the lending process.

But deficit spending requires the sale of newly-issued bonds. Both selling and buying bonds can't create money.

In the United States, Congress is not empowered to create money. It can authorize spending only funds that are collected in taxes or are borrowed by issuing bonds. Deficit spending by Congress doesn't create new money; it simply shifts money currently in circulation from the bank accounts of bond buyers to that of the government. Deficit spending is accomplished when newly-issued bonds are purchased which in the clearing process reduces the bond buyers' bank account balances and the reserves of their commercial banks. The clearing process takes previously-issued money temporarily out of circulation until the government puts it back into circulation by spending it.

No new money is created by deficit spending unless there emerges an imbalance between the amount of money taken out of circulation when new bonds are sold and the amount of money reinjected into circulation by government spending. The clearing process simply shifts old money from bond sellers bank accounts (and their banks' reserves) to that of the government. Assuming that all of the bond-sale proceeds are spent by the government, the money goes back into circulation and commercial bank reserves are restored to their state ex ante the bond-issuance process. Since the amount of money in circulation is unchanged by deficit spending, the deficit spending process per se is unlikely to contribute to inflationary pressure.

This conclusion follows only in a "closed economy,” i.e., only if Congress, the Treasury, the bond buyers and sellers, the commercial banks, and bank borrowers all are in the same country and there are no external market participants. But there may be complicating factors.

If bonds that are newly-issued by deficit spending are purchased by foreigners, money balances previously held abroad may add to the domestic money supply and thus may stimulate spending and contribute to inflation in the domestic economy. The process may contribute to deflation in foreign economies from which money is shifted when the newly-issued bonds are purchased by foreigners.

Whether the issuance of new bonds will have domestic inflationary or deflationary effects depends on the response by the central bank. If inflation has been an on-going process, it may suit the central bank to let the issuance of new bonds cause interest rates to rise in expectation that the higher interest rates may dampen economic activity and slow inflation. The risk is that the rising interest rates may dampen economic activity so sharply as to precipitate a recession.

Domestic and foreign purchases of bonds may cause bond demand to increase faster than bond supply is increasing to finance a deficit. This would cause domestic bond prices to rise and put downward pressure on interest rates. This might stimulate the economy and put upward pressure on prices.

Financing a deficit by issuing bonds may increase the domestic supply of bonds relative to domestic bond demand. This may cause bond prices to fall and their yield rates to rise. Increasing yield rates are likely to be transmitted to the structure of interest rates by the process of arbitrage and thereby to dampen economic activity.

If the central bank wants to avert interest rate increases as new bonds are sold, it may purchase old bonds to offset the downward trend of bond prices and upward pressure on interest rates. But old bond purchases by the central bank will increase the amount of money in circulation and add to the reserves of commercial banks to enhance their lending capacities. The additional money in circulation may stimulate economic activity and contribute to inflationary pressure.

A couple of conclusions follow. First, when Congressional spending causes a deficit that requires the issuance of new bonds, no new money is created (injected into circulation) by this process alone. Second, new money may enter into circulation depending on the rates at which domestic and foreign bond demand is increasing relative to domestic bond supply, and the intent of the central bank with respect to interest rate changes, the rate of inflation, and the level of economic activity.

<>

39. Inflation and Price Levels

Paul Krugman notes in a recent newsletter (December 5, 2023) that the rate of inflation now is approaching the Fed's goal:

Over the past six months, the personal consumption expenditure deflator excluding food and energy ... has risen at an annual rate of only 2.5 percent, down from 5.7 percent in March 2022. The Fed’s inflation target is 2 percent, so we’re not quite there yet. (https://messaging-custom-newsletters.nytimes.com/dynamic/render?campaign_id=116&emc=edit_pk_20231205&first_send=0&instance_id=109377&nl=paul-krugman&paid_regi=1&productCode=PK&regi_id=74240569&segment_id=151785&te=1&uri=nyt%3A%2F%2Fnewsletter%2F71ffa2ad-6dfc-5bd1-aac3-63d1f40f3126&user_id=86b0d837dd357b2a6e0e749321f6ed7f)

Krugman also notes that journalists are deflected from saying anything positive about the slowing rate of inflation, and some Americans still insist that inflation is running wild. This opinion of course contributes to a public perception that the Biden administration has managed inflation poorly.

There has been much speculation among pundits as to why the decreasing inflation has not been recognized by the general public as a positive phenomenon. I think that a contributing factor is that people are conditioned to think in terms of comparative levels rather than rates of change between levels.

The current price of an article is an amount that is spent on it. The current price can be compared to the amount that was spent on the same (or similar) article at an earlier time. Both the current price and the previous price are levels. But inflation is a rate of change between two points in time, i.e., between levels.

While the inflation rate has been slowing, people shopping in grocery stores and buying at gas pumps make comparisons of current prices relative to earlier prices which were not as high and judge that inflation is still a problem, even though prices are rising more slowly (a decreasing rate of increase).

But if they are hoping for prices to come back down to previous levels, that would require deflation, i.e., a negative rate of change of prices. Deflation would portend another set of problems that likely would include economic contraction with rising unemployment and falling wage rates.

Unfortunately, the general public's obsession with temporal comparisons of prices rather than rates of change of prices, seem to militate against the Biden administration.

<>

40. Threat to the Fed's Independence

President Donald J. Trump appointed Jerome H. ("Jay") Powell to chair the Federal Reserve Board of Governors during Mr. Trump's first presidential term (45). But Mr. Trump "fell out" with Mr. Powell during that term and has talked about replacing him through President Biden's term (46) and on into Mr. Trump's second term (47).

In his quest to achieve political power and authority over the Fed, in early April 2025 Mr. Trump insisted that Mr. Powell reduce interest rates to alleviate an impending recession that Mr. Trump himself spawned by raising tariffs on merchandise, parts, and equipment imported from U.S. trading partners. Finding himself faced with a dilemma of whether to loosen monetary policy to avert a recession or tighten monetary policy to prevent faster inflation, Mr. Powell deferred response to Mr. Trump's demand in order to see how U.S. and global financial markets respond to the tariff increases.

This deferral has angered Mr. Trump who has said that termination of Mr. Powell's term as Fed chair "cannot come fast enough." Mr. Trump does not have the authority to fire the director of an independent agency of the U.S. government that was created by Congress, and Mr. Powell has refused to resign.* The professional economics community, especially those concerned with monetary matters, is "up in arms" over Mr. Trump's implicit threat to the independence of the U.S. central bank.**

Does any of this matter?

My response is a tentative "No" with respect to interest rate control, and a resounding "Yes!" in regard to the rest of the Fed's remit.

In another essay I have argued that the Federal Reserve really can't control interest rates apart from the so-called "natural rate of interest," a variation on which I have labeled the "capital scarcity rate of interest." (https://dickstanfordlegacy.blogspot.com/2024/09/the-scarcity-rate-of-interest.html) Here is a summary of that argument:

Interest is not just a financial rate; it is the return to scarce real capital in the same sense that wage is the return to scarce real labor.
As the capital stock of a region increases with net new investment, diminishing returns causes its capital scarcity rate of interest to decrease; capital abundant regions have lower capital scarcity interest rates than do capital scarce regions.
Natural adjustment processes in a region cause financial interest rates to gravitate toward the region's capital scarcity interest rate.
Monetary policy that induces financial interest rates to fall below the capital scarcity interest rate stimulates spending and may accelerate the rate of inflation; monetary policy that causes financial interest rates to rise above the capital scarcity interest rate depresses spending and may slow the rate of inflation (or cause deflation).
In 2008 the Fed's main policy tool became the interest rate that it pays to commercial banks on their reserve balances on deposit at the Fed; the reserve balances interest rate is an administered price.
The Federal Funds rate, the average of daily over-night rates that commercial banks charge each other to borrow excess reserves, is a market-determined interest rate.
Changing the reserve balances interest rate induces the effective Federal Funds rate to follow it; market-determined financial interest rates usually follow the Federal Funds rate.
Market-determined financial interest rates may become “sticky” if lenders are conditioned by periodic Fed announcements of interest rate target changes to wait for an announcement as the trigger for changing their lending rates, thus giving the appearance that the Fed has been able to dictate a change of interest rates.
If the Fed waits for market pressures to build for a change of its reserve balances interest rate, it is passively following the market rather than actively executing monetary policy to induce financial interest rates to change.
Market participants who "price in" expectations of future rate changes implicitly are adjusting their lending rates to the capital scarcity interest rate.
A central bank that tracks or shadows the scarcity rate of interest should let market-determined interest rates naturally adjust to the scarcity rate.

If this argument is valid, then any effort to exert control over market interest rates may not matter as much as either Mr. Trump or Mr. Powell may think. Mr. Trump's chaotic tariff decisions are likely to cause market interest rates to rise, slowing investment and growth of the U.S. economy. If he wants lower market interest rates, Mr. Trump should be working to get capital scarcity interest rates in the U.S. to decrease by stimulating investment and growth so that market-determined interest rates will adjust downward to them. I suspect that Mr. Powell is well aware of the reality of capital scarcity interest rates even as he indulges the public delusion that the Fed is in control of market rates.

In a New York Times transcripton of columnist Matthew Rose's conversation with economists Oren Cass, Jason Furman, and Rebecca Patterson on May 6, 2025, Furman said,

In early April 2025, the 10-year Treasury yield was around 4.2%. The fact that the Fed had been unable to get the early-2025 core inflation rate down to the its 2 percent target rate implies that spending may have been excessive if market interest rates were below the capital scarcity interest rate. By mid-April 2025, President Trump was urging Federal Reserve Board chair Jerome Powell to lower market interest rates even further to prevent recession brought on by Trump's imposition of tariffs. But to avert accelerating inflation due to Trump's tariffs, the Fed would need to increase market interest rates above the capital scarcity interest rate to dampen spending.

Mr. Trump may be right about one thing. Mr. Powell's Fed often has been slow to act and late relative to the perceived need to act because it often waits to see what the markets are doing before announcing a change of the reserve balances interest rate. And if the markets actually are adjusting to capital scarcity interest rates, it is counter-productive for the Fed to try to muscle interest rates away from them.

Interest rate control may be only a very public veil obscuring the Fed's more powerful behind-the-scene tools, particularly its oversight of banking and financial institutions and its ability to manage its own asset portfolio by entering financial markets as a trader. The Fed is prohibited from purchasing and holding more than a small amount of bonds newly-issued by the U.S. government, but it can and does enter financial markets at will to purchase or sell "old" bonds that have previously been issued.

The side effect of a Fed purchase of old bonds is to "pay for" them with money added to the bond sellers' bank accounts. When those transactions have cleared, the reserves of banks also are increased, and so are their capacities to issue new loans up to the limits of reserve requirements determined by the Fed as authorized by Congress. The side effect of a Fed sale of bonds from its portfolio is to withdraw money from the buyers' bank accounts. When those transactions have cleared, the reserves of banks have been decreased, and so have been their capacities to issue new loans. The Fed's ability manage its portfolio by purchasing and selling financial instruments is a more effective monetary policy tool than are its efforts to control interest rates.

The Fed exercised its market-trader capability following the 2008 recession by engaging in several episodes of "quantitative easing" during which it acquired large tranches of bonds from financial institutions. The intent was to alleviate recession conditions by increasing their lending capacities. The most recent episode of quantitative easing occurred following the 2019 Covid Pandemic.

While successful in stimulating the economy, the quantitative easing episodes caused the Fed's portfolio to baloon, and they may have been responsible for inflation in excess of the Fed's targets during the ensuing recovery. During the Pandemic recovery, the Fed has been unable to bring the U.S. inflation rate down to its 2 percent target while trying to "unwind" its excessive bond portfolio. The anti-inflation struggle will continue as the Trump tariffs of 2025 cause the inflation rate to increase.

The Federal Reserve System was established by Congress in 1913 (https://en.wikipedia.org/wiki/History_of_the_Federal_Reserve_System) to be an agency of the U.S. government that is independent of political processes. The Fed answers to Congress in twice-yearly reports, and the chair of the Fed can be subpoenaed at any time to testify before Congress. But the Fed is not under the control of either the legislative or the executive branches of the U.S. government.

The Fed is charged by Congress to provide and control a stable money supply for the U.S. economy. It has served this goal during the 20th century (although not without difficulties and criticism) through depression, war, and bouts of inflation and recession. While its remit does not include the entire world, it has great influence over global monetary matters due to the dollar serving as an international reserve currency, the perceived stability and safety of its bonds, and the sheer size of the U.S. economy.

The issue of interest rate control aside, the nation and the world need for the Federal Reserve to remain in place and functional as an independent agency of the U.S. government. The Fed needs to be able to exercise its powers conferred by Congress as "backstop" to avert economic and financial crises. The Fed's presence and independence ensure the stability of the U.S. dollar, the reliability of U.S. public debt, and the safety of the global financial system. Mr. Trump's attacks on Fed Chairman Jerome Powell also are attacks on the independence of the Federal Reserve and implicitly on that of every other central bank.

It is well documented that nations with independent central banks enjoy lower rates of inflation than nations whose central banks are under executive or authoritarian control. If an authoritarian government should gain complete control of its central bank, it could force the central bank to create money without limit to finance current government expenditures and retire accumulated debt. Accelerating inflation would be the likely consequence. Mr. Trump may already have perceived of this possibility.

The best hope for preserving the independence of the Federal Reserve and central banks around the world is for Mr. Powell to continue to stand firm against Mr. Trump's demands and attacks.

April 23, 2025
__________

*As of April 23, 2025, Mr. Trump appears to have backed off of his desire to fire Fed Chairman Powell, but Trump's back-and-forth chaos on this issue has left financial market participants with greater uncertainty about the Trump administration's policy with respect to the central bank.

Alice Wright, on the Dailymail.Com website, June 19, 2025, writes that

Trump has said he will soon name the next head of the Federal Reserve chief in a move that could rattle financial markets. Such a move would be highly controversial since there is nearly a year left in current chairman Jerome Powell's term. The independence of the Fed — which sets benchmark interest rates that influence everything from mortgage costs to stock prices — is seen by Wall Street as vital for market stability. .... Markets respond not just to official Fed decisions, but also to hints about future moves — meaning mixed signals could cause turmoil. 'You're going to have two people trying to steer the ship: One that's actually steering it, and one that's the backseat driver,' Ryan Sweet, chief US economist at Oxford Economics told Reuters. .... A new Fed chair seen as under Trump's influence would also concern Wall Street. 'Whomever is appointed, the key thing to monitor is whether they are perceived as being a political appointee,' Eric Winograd, chief U.S. economist at AllianceBernstein told Reuters. (https://www.dailymail.co.uk/yourmoney/article-14824955/donald-trump-economic-decision-wall-street.html)

**Mr. Trump's efforts to get Mr. Powell to resign may involve something more sinister as reported by Sarah K. Burris on the Raw Story website, June 24, 2025:

MSNBC's Nicolle Wallace asked [Charlie] Sykes about Trump's "obsession" with Powell and his ongoing desperation to fire Powell until he sees the stock market "recoil." "There's two things that are going on here," Sykes said. "Number one, Trump wants to bully the Fed and the bullying is not working. Powell is not caving in as so many other institutions have. But beyond the bullying, I think it's important to understand what Trump is doing here. Trump is obviously very, very anxious about what's going to happen with the economy." He noted that [Justin] Wolfers and other economists pointing out the massive impact Trump's tariffs have had on the economy sent the president scrambling. "Donald Trump wants someone else to blame. This is, I think, an underappreciated point. He is setting Jerome Powell up to be the scapegoat so that if things go south, Trump can say, It wasn't me. The buck does not stop with me or my policies. The blame should go to the Fed," said Sykes. "And so this is one of the reasons why he is obsessively calling out Jerome Powell, because he wants somebody that he can point the finger at if, as obviously he worries, the economy that he inherited actually goes into the tank."

41. The Treasury and Monetary Policy

The Issue

There has been discussion recently [2024-2025] in the financial media and among some economists specializing in monetary matters that the U.S. Treasury has begun to engage in monetary policy operations that previously have been the preserve of the Federal Reserve. But from 1846 forward, the newly established "Independent Treasury" discovered, learned, and implemented what in modern parlance would be called "monetary policy."

A July 2024 study by Hudson Bay Capital contends that selection by the U.S. Treasury of term categories for bond auctions has had monetary policy implications paralleling the Federal Reserve's Quantitative Easing (QE) bond transactions:

By adjusting the maturity profile of its debt issuance, Treasury is dynamically managing financial conditions and through them, the economy, usurping core functions of the Federal Reserve. We dub this novel tool “activist Treasury issuance,” or ATI. By manipulating the amount of interest rate risk owned by investors, ATI works through the same channels as the Fed’s quantitative easing programs. (https://www.hudsonbaycapital.com/documents/FG/hudsonbay/research/635102_Activist_Treasury_Issuance_-_Hudson_Bay_Capital_Research.pdf)

Stephen Miran, a former senior advisor to the US Treasury Department, is a senior strategist at Hudson Bay Capital and a fellow at the Manhattan Institute. In the transcription of an interview on September 2, 2024, by David Beckworth, Miran says that

There's a wide variety of things that have converged to allow growth and inflation and markets to be so strong in the face of such aggressive Fed tightening. Deficits play a role. Geopolitics plays a role. AI plays a role, all of this stuff. But are there other policy levers that people haven't studied and thought about? And we started looking at the Treasury's issuance patterns, and it seemed that Treasury had started to deviate from historic norms.... (https://www.mercatus.org/macro-musings/stephen-miran-activist-treasury-issuance-and-monetary-policy-implications-second)

In the same interview, Miran reports that Hudson Bay Capital

... found a range of estimates on term premium that would indicate that the 10-year yield was reduced by 14 to 40 basis points with a central guess at 25 basis points, so a quarter of a percentage point, right? That quarter of a percentage point is equivalent, in terms of the amount of economic stimulus delivered, by a one-point cut to the fed funds rate, to the Fed's primary policy tool, the overnight rate.

The History

Prior to 1846 Congress had chartered two "Bank of the United States," the first in 1791 to assist with financing Revolutionary War debts, and the second in 1816 to assist with financing 1812 War debts, both with 20-year charters. But neither served as treasurys to the U.S. government, and neither developed tools of monetary policy beyond disciplining state banks by accumulating state bank notes and presenting them to the issuers to be redeemed in gold or silver.

Implementation of monetary policy by the U.S. Department of Treasury is not a new phenomenon. The Treasury Department has a long history of engaging in actions that today might be regarded as monetary policy. It began in 1837 when President Martin Van Buren proposed the establishment of an independent U.S. treasury to deal with a financial crisis during which banks with inadequate gold and silver reserves refused to convert paper money into gold or silver. The Panic of 1837 spawned a 5-year depression. Presidential politics between Whigs and Democrats killed the Independent Treasury Act of 1840, but President James K. Polk pushed a revived treasury bill through Congress, signing the Independent Treasury Act on August 6, 1846.

From 1846 to 1913 the Independent Treasury managed the money supply of the federal government independently of the national banking and financial systems. American interests observed central banking institutions in Europe and began to envy them. In the absence of an American central bank to exercise control over the banking system, the Treasury Department began to learn and exercise central banking functions.

From 1860 to 1865, Civil War finance resulted in the issue of paper money by governments on both sides. Paper money was over-issued by state chartered banks and by both governments. Excessive issue of Union (North) treasury notes, known as "greenbacks," eventually resulted in circulation at discounts from par. The same occurred for Confederate (South) money, but even worse. At war's end, Confederate issues of money became worthless; Federal greenbacks continued to circulate at discounts from face values.

Between 1869 and 1875, the first American "Great Depression" followed from the Treasury's deliberate withdrawal of paper money by Congressional act to eliminate discount from par, with the objective to reestablish convertibility of currency to gold at par. In 1880 state banks were prohibited from further issuance of bank notes, and the federal government began chartering "National Banks" that were authorized to issue bank notes backed by gold reserves under the supervision of the Treasury. Most banks choose to remain state banks in order to avoid control by the Treasury.

In 1875, at the behest of silver mining interests, Congress passed legislation defining sixteen ounces of silver as equal in value to an ounce of gold, with par values between the dollar and the two metals in the ratio of 16:1. But with changing relative market values, gold became overvalued at the mint. It drained from circulation, mostly to Europe, and was replaced by silver. Later, silver became overvalued and drained from the economy to Europe; gold flowed in from Europe. Economic instability ensued as gold flowed into and out of the country, thereby whiplashing the domestic money supply. Eventually Congress defined the value of the dollar exclusively in terms of gold, thereby committing to the international Gold Standard.

Banking instability continued as the money supply was geographically inflexible in the sense that much of the money supply was in the Treasury's vaults in the cities when it was needed in rural areas to facilitate planting and harvest. During the off-seasons most of the money supply remained in rural areas when it was needed in the cities. Banking panics precipitated numerous episodes of economic instability which continued to worsen. In 1912-1913, Congress debated the need for a central bank and the shape it would take. In recognition of the need for independence from the Treasury, the Federal Reserve Act was passed by Congress in 1913, implicitly reserving the implementation of monetary policy to the Federal Reserve.

But the transition of monetary control from the Treasury to the Federal Reserve was not instantaneous or without difficulty. With the onset of depression in 1932, the Federal Reserve Board (FRB) failed to comprehend its mission of being a "lender of last resort" to the commercial banks, or that it was fundamentally different from commercial banks in that it could not fail. The FRB let the money supply drop drastically as it mistakenly attempted to decrease its outstanding deposit liabilities in order to keep itself from failing.

As the FRB decreased its deposit liabilities (i.e., the deposits of commercial banks), commercial banks could not meet their reserve requirements. Banks called loans, many of which were bad; banks became insolvent and failed. The banking population dropped from over 30,000 to less than half by the end of the decade. The U.S. nationalized all gold in the country and suspended gold payments to foreigners, thus going off the Gold Standard. Meanwhile, budget deficits increased with depression spending which the Treasury handled by issuing bonds that added to the public debt.

By 1936, the increasing bond supply relative to bond demand caused bond prices to fall and yield rates to rise in the U.S. relative to Europe. This precipitated a capital inflow, supplying American banks with excess reserves which FRB officials viewed with alarm as having great inflation potential. The FRB did not realize that bankers wished to hold idle excess reserves for liquidity. The FRB raised reserve requirements to "mop up" excess reserves, precipitating another banking crisis, monetary contraction, and a second downturn and depression trough. Only in the late 1930s with gradual recovery did FRB officials begin to comprehend the effects of their actions. The FRB ceased decreasing reserves and the money supply.

Increasing bond sales at the onset of WWII depressed bond prices and increased yield rates. However, the FRB took a subsidiary role to Treasury to assist with war finance by keeping interest rates low. Even as it held the line on interst rates, the FRB let the money supply increase during the war, causing inflationary pressures that were contained by price controls and rationing. At the end of the war, price controls and rationing ended, causing a spurt of price inflation in the late-1940s. In 1951, the FRB negotiated an "accord" with the Treasury to regain its autonomy and independence. This enabled the Fed to raise interest rates and restrict the money supply to control inflation.

In another essay (https://dickstanfordlegacy.blogspot.com/2024/02/economic-issues.html#S48) I described the emergence of the Treasury's procedure for refunding the national debt that has resulted in the cumulative increase of the national debt to more than $33 trillion by early 2025. The refunding procedure recently has been used by Treasury to shift the term structure of outstanding debt from higher-yield longer-term debt to lower-yield shorter-term debt in order to lessen the burden of debt service. This Treasury procedure is reminiscent of the way in which the Federal Reserve has used "Operation Twist" in its effort to "flatten" the yield curve.

This brief excursion through the history of the Treasury Department should have revealed numerous Treasury actions and procedures that have had monetary effects on the U.S. economy. The recent study by Hudson Bay Capital really brings up nothing new, but it does point out the possibility of equivalence between the effects of Treasury actions and Federal Reserve actions. So, we are down to examining the motivations of Treasury decision makers compared to those of Federal Reserve decision makers.

The Resolution

Scott Fullwiler dismisses the contention that the Treasury is usurping the core functions of the Federal Reserve. He argues that the identity of the policy actor should be irrelevant:

I find it completely counterproductive to have a theory of macroeconomics in which we define fiscal policy and monetary policy based on who is acting. If the US Congress and Treasury choose to send $1 trillion to households without raising taxes, it’s called fiscal policy. But if the Fed does the exact same thing, it’s apparently called monetary policy. .... It seems much clearer to simply say that (a) the act of creating a deficit—raising the net financial wealth of the non-government sector—is fiscal policy, and (b) the act of announcing and then supporting an interest rate target with security sales (or purchases, or interest on reserves)—which has no effect on the net financial wealth of the non-government sector—is monetary policy. (https://www.levyinstitute.org/blog/fed-fiscal-policy-treasury-monetary-policy/)

I agree with Fullwiler's objection to defining fiscal policy and monetary policy based on who is acting. Fullwiler focuses on the interest rate target to identify monetary policy actions implemented by the Treasury. An alternate approach would be to examine the effects of Treasury security sales on changes in the money supply that work on the economy via the diminishing marginal utility of held money balances. Treasury bond sales take money out of circulation. A decrease of Treasury bond sales increases the amount of money remaining in circulation. Money balances in excess of what consumers and businesses wish to hold get spent to stimulate the economy. An increase of Treasury bond sales decreases the amount of money in circulation. To alleviate the perception of a deficiency of money balances being held, consumers and businesses cut back on purchases to depress economic activity. In this view, interest rate changes are consequences of changes of the money supply relative to the demand for money to hold, but they too impact the economy by inducing changes of lending rates on home mortgages, auto loans, and consumer loans.

Whether a Treasury action in regard to the interest rate or the money supply constitutes monetary policy depends on the intent of the Treasury decision maker. One's true intention (what is in one's "head and heart") cannot be known with certainty unless confidence can be placed in oral or written statements of intent. If the announced intent of a Treasury action is only to fund a deficit, refund maturing debt, or adjust the term profile of the outstanding debt, the action is fiscal in nature, and any monetary effects are incidental. If the intent is to stimulate or dampen economic activity or to avert inflation or deflation, the action is an implementation of monetary policy, and any fiscal effects are incidental. Likewise, if the intent of a Federal Reserve action is to adjust the term profile of the outstanding debt, the action is fiscal in nature, and any monetary effects are incidental. If the intent of a Federal Reserve action is to stimulate or dampen economic activity or to avert inflation or deflation, the action is an implementation of monetary policy, and any fiscal effects are incidental. Both agencies have the ability to implement either type of policy.

"Operation Twist" sounds like it might be a purely fiscal action taken by the Federal Reserve, but Adam Hays, writing July 13, 2022, on the Investopedia website describes operation twist as a monetary policy action implemented by the Federal Reserve:

Operation Twist is a Federal Reserve (Fed) monetary policy initiative used in the past to lower long-term interest rates to further stimulate the U.S. economy when traditional monetary tools were lacking via the timed purchase and sale of U.S. Treasuries of different maturities. The term gets its name from the simultaneous buying of long-term bonds and selling short-term bonds, suggests a "twisting" of the yield curve and creating less curvature in the rates term structure. (https://www.investopedia.com/terms/o/operation-twist.asp#:~:text=Operation%20Twist%20is%20a%20Federal%20Reserve%20(Fed))

It is important to note the origin and authority of the two agencies. The Treasury was established by Congress in 1846 to be a department of the executive branch of government. It originally implemented both fiscal and monetary functions, but after the establishment of the Federal Reserve System in 1913 its remit entailed only fiscal functions. Implicitly it no longer has any monetary policy responsibility. The Federal Reserve was established by Congress to be an agency of government that is independent of either the executive or the legislative branch of government. Its remit is to implement monetary policy in the interest of the stability of the U.S. economy, but it is not prohibited from implementing fiscal actions.*

Something more ominous may be going on here. At mid-2025, President Trump appears to be "going for broke" in attempting to gain maximum authhoritarian control over the U.S. economy. If indeed the Treasury Department now is implementing monetary policy, it may well fit into Mr. Trump's scheme since the Treasury is a department of the executive branch of the U.S. government, and thus is under direct control of the president. Mr. Trump has been urging Federal Reserve Board Chair Jerome Powell to lower interest rates in order to avert recession that may ensue from his tariff policy, but Mr. Powell continues to resist doing so in concern that interest rates may need to increase to avert inflation pressures.

If Mr. Powell won't comply with Mr. Trump's request to lower interest rates, Mr. Trump may side-step the Federal Reserve and get the Treasury to do his bidding. Mr. Powell can influence market interest rates by changing the interest rate that the Fed pays to commercial banks on their excess reserves deposited with the Fed. The Secretary of the Treasury doesn't have a similar tool to influence market interest rates. But at Mr. Trump's behest the Secretary might attempt to manipulate market interest rates by directing the Treasury to sell longer-term bonds and purchase shorter-term bonds, implementing a version of operation twist. This would have the effect of increasing shorter-term bond prices (e.g., 10-year Treasuries) that serve as benchmarks for lenders to set their lending rates. The yields on shorter-term bonds would fall as their prices rise, which is what Mr Trump has been prompting Mr. Powell to do. Once Mr. Trump discovers that the Treasury can execute monetary policy, it might spell the end of the Federal Reserve's monetary policy preserve.**

All of this may be moot. In June 2025, a so-called "Genius Bill" was introduced in Congress. If passed into law, it would authorize companies to issue a type of cryptocurrency called a stablecoin, the value of which would be tethered to a stable asset like the dollar; passage of the bill would authorize stablecoins to be issued by federally insured banks or by companies such as Walmart and Amazon. A possibly flawed underlying assumption is that the dollar will remain stable (it is losing value at mid-2025 due to Mr. Trump's tariff policy and rising global concerns about the ability of the Treasury to continue to redeem all maturing Treasury obligations as the U.S. national debt exceeds $36 trillion). Authorizing the issue stablecoin by banks and companies is likely to end the effective implementation of monetary policy by either the Federal Reserve or the Treasury. Economist Barry Eichengreen expects the law to return the U.S. financial sector to a state of chaos such as that which ensued from 1837 to the Civil War. (New York Times, June 17, 2025, "This Bill Will Return Us to an Era of Economic Chaos," https://www.nytimes.com/2025/06/17/opinion/genius-act-stablecoin-crypto.html?campaign_id=39&emc=edit_ty_20250617&instance_id=156686&nl=opinion-today®i_id=74240569&segment_id=200089&user_id=86b0d837dd357b2a6e0e749321f6ed7f)

There is an even-bigger question. In another essay I have argued that forces of adjustment in a market economy act to cause market-determined interest rates to converge upon the region's capital scarcity interest rate. (https://dickstanfordlegacy.blogspot.com/2020/08/essays-on-monetary-policy.html#S33) This rate is determined by the region's endowment of capital relative to other productive inputs. A corollary of this premise is that any activist implementation of policy to cause market-determined interest rates to divege from the region's capital scarcity interest rate will be reversed by the adjustment forces inherent in the market economy.

What follows is that there is no valid role for either monetary or fiscal policy in a market economy apart from altering the region's comparative advantages. Neither the Treasury Department nor the Federal Reserve should exercise policy activism in attempts to force or induce market-determined interest rates to diverge from the region's capital scarcity interest rate. The Federal Reserve should allow market-determined interest rates to track the region's capital scarcity interest rate. This contention has been explored in another essay with respect to fiscal policy activism, but it may just as well apply to monetary policy activism. (https://dickstanfordlegacy.blogspot.com/2024/02/economic-implications-essays.html#S31)
__________

*There is an interesting relationship between the chair of the Federal Reserve Board during the early part (2014-2018) of President Trump's first term and the Secretary of the Treasury during President Biden's presidential term (2021-2025): the same person, economist Janet Yellen, served in both positions. This leads one to wonder whether Yellen may have brought her monetary policy predilections from her term as Chair of the Federal Reserve Board of Governors to her term as Secretary of Treasury.

**In an essay on The Hill website, June 22, 2025, Sylvan Lane describes how Mr. Trump is attempting to subvert the Fed's so-called "dual mandate" and shift the mandate to the fiscal function of funding deficits and refunding maturing debt:

During World War I and II, the Fed yielded to pressure from presidential administrations to keep interest rates low and ease the burden of the rising debt.

While that practice extended for nearly a decade after the bombing of Pearl Harbor, the Fed and Treasury eventually reached an agreement in 1951, setting the stage for the next seven decades of economic management.

“The purpose of the ‘accord’ was to make Treasury manage its debt, rather than expecting the Fed to ‘monetize’ it. In turn, the Fed asserted its control of monetary policy via the setting of interest rates to meet congressional mandates for price stability and maximizing employment,” said Sarah Binder, political science professor at George Washington University and co-author of “The Myth of Independence: How Congress Governs the Federal Reserve.”

The Fed has since avoided anything that could be considered financing the federal debt while sticking to its “dual mandate” of balancing unemployment and inflation. And while several presidents have verbally pressured the Fed to keep rates low since 1951, none has made a formal move to limit its legal authority over monetary policy.

“Based on most concepts of ‘independent’ monetary policy, the central bank shouldn’t be monetizing the debt. That is, it shouldn’t be taking the administration’s financing needs into account when it aims to meet its mandates,” Binder said. “Those mandates are price stability and strong labor markets,” she added. “Congress has not given the Fed an additional mandate to make it easier for the Treasury to finance its debt.”

But Trump could be laying the groundwork for a shift toward a “fiscal dominance” regime, [David] Beckworth [research fellow and monetary policy director at the Mercatus Center] warned, in which the Fed would be forced to clean up the government’s fiscal mess and abandon the bank’s legal obligation to keep prices stable and unemployment low.

(https://www.msn.com/en-us/money/markets/trump-ropes-fed-into-debt-fight-as-gop-faces-fiscal-mess/ar-AA1Hczca?ocid=msedgdhp&pc=U531&cvid=c940f90e206c49389affd941dc0e0c8d&ei=243)

42. A Final Word

The commentaries included in this essay collection have revealed the difficulties of implementing monetary policy. The final word is a reprise of a statement made in the Introduction. Today we live in an open-economy world characterized by imperfect human knowledge, complex transmission mechanisms, inadequate predictive models, and imprecise policy calibration techniques. Intelligent human operatives can perceive, rationalize, and act to thwart the intentions of government officials. It is a delusion to think that central bankers can successfully implement monetary policy to achieve price stability, satisfactory economic growth, or low-enough rates of unemployment. Such conditions, if they occur, are more likely to come about by the normal functioning of the economy, and perhaps in spite of central bank interventions to manipulate the economy.

If the world were populated exclusively by intelligent and knowledgeable rational expectations decision makers, then no action by any politician or public policy decision maker would have any permanent effect. Monetary policy would be ineffective and pointless.

But monetary policy actions by central bank officials occasionally appear to work. Why? There are enough people in any population who are of lesser intelligence, who pay little attention to what is happening around them, who do not systematically extrapolate past experience to future expectations, and who do not think rationally that politicians and public policy makers can implement surprise policy actions that fool or manipulate them. So, I profess agnosticism about monetary policy. Despite my formal economic training, I no longer have faith in the ability of central bank officials to implement monetary policy with good effect. Sometimes it works; more often it doesn't. The world may be better off letting nature take its course without policy interventions to alter its direction or force. Que sera, sera!

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Dick Stanford's Essays

EssaysVolume4

The Collected Essays of

Richard A. Stanford

Monetary Policy in an Open Economy World

Richard A. Stanford

3. Central Bank Effectiveness in an Open Economy World

10. Hoarding and Monetary Policy

11. Monetary Policy and Consumer Spending

13. Lessons from American Banking History

27. Modern Monetary Theory

28. Monetary Policy and Exchange Rates

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StanfordCollectedEssays

EssaysVolume12

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EssaysVolume4

The Collected Essays of Richard A. Stanford

Monetary Policy in an Open Economy World

Richard A. Stanford

3. Central Bank Effectiveness in an Open Economy World

10. Hoarding and Monetary Policy

11. Monetary Policy and Consumer Spending

13. Lessons from American Banking History

27. Modern Monetary Theory

28. Monetary Policy and Exchange Rates

Comments

Post a Comment

Popular posts from this blog

StanfordCollectedEssays

EssaysVolume12

EsssaysVolume10

The Collected Essays of

Richard A. Stanford