Monetary Policy in an Open Economy World
Monetary Policy in an Open Economy World
Richard A. Stanford
Furman University
Greenville, SC 29613
Copyright 2026 by Richard A. Stanford
All rights reserved. No part of this book may be reproduced, stored, or transmitted by any means—whether auditory, graphic, mechanical, or electronic—without written permission of the author, except in the case of brief excerpts used in critical articles and reviews.
CONTENTS
NOTE: You may click on the symbol <> at the end of any section to return to the CONTENTS.
1. The Emergence of Federal Reserve Monetary Policy Tools
2. The Relevant Money Supply in an Open Economy World
3. Monetary Policy in an Open Economy World
4. Central Bank Effectiveness in an Open Economy World
5. Central Bank Independence
6. The Fed's Independence
7. Rules vs. Discretion in Monetary Policy
8. Rules-Based Monetary Policy
9. Targeting Price or Quantity for Monetary Policy
10. Tracking the Natural Rate
11. Hoarding and Monetary Policy
12. Monetary Policy and Consumer Spending
13. Calibrating Monetary Policy
14. Discount Rate Near Zero
15. Deflation and Inflation, Historical Perspectives
16. The Money Supply and Deflation
17. The Money Supply and Inflation
18. The Inflation Delusion
19. Inflation and Price Levels
20. The Fed's 2 percent Inflation Goal
21. Threat to the Fed's Independence
22. Moral Hazard in the Banking System
23. Monetary Policy in an Open-Economy World
24. The U.S. Economy at Mid-2026
25. A Final Word
Appendix. Lessons from American Banking History
<Blog Post Essays>
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 book 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.
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 of the 1930s 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. 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.
During 2008 to 2013, the the Fed set the target Federal Funds rate at zero in an effort to promote recovery from the 2007-2008 financial crisis. 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.
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 induce market-determined rates to approach the newly announced target. The Open Market Committee could 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.
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 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. Much of the increased liquidity ended up in commercial bank excess reserves and business cash hoards rather than in circulation to stimulate spending.
The functioning of bond markets is predicated on the assumptions that there will always be bonds for sale in the markets and that there will always be buyers for bonds that are for sale in bond markets, but that may not always be the case. The Editorial Board of The Washington Post, July 4, 2025, describes the situation in March 2020 that led to the quantitative easing episode now designated as QE4:
To express this in bond demand and supply terms, the increased supply of Treasury bonds coming onto bond markets in March 2020 exceeded dealer banks' demand for Treasury bonds on that date, causing their prices to fall and their yield rates to rise. In the effort prevent Treasury bond prices from collapsing and to curb the escalation of yield rates, the Federal Reserve added to the demand for Treasury bonds by purchasing billions of dollars of them. The Fed's intent may have been to avert collapse of bond markets, but the side effect was to increase commercial bank reserves which enabled increased lending that would stimulate economic activity and promote inflation. Fiscal actions are not in the Federal Reserve's dual mandate (to achieve price stability and maintain maximum employment), but QE4 was a fiscal operation with incidental monetary side effects.
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 intended to continue to implement a policy of systemwide ample reserves. That 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 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 some control over monetary policy. 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 capital scarcity rate of interest.
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. The 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 capital 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 capital 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 capital 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 capital scarcity interest 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 capital scarcity interest rate.
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.
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 that 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.
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?
In the environment of slow recovery and low growth of the world economy in the wake of the 2008 "Great Recession," central bankers attempted to stimulate their respective economies by implementing looser monetary policies in the effort to accelerate growth. But monetary policy stimuli seemed to have become ever less effective as discount rates approached zero and "quantitative easing" resulted in little additional commercial bank lending. Central bankers, among them the U.S. Federal Reserve Bank and the European Central Bank, 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:
(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,
(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.
When continuing deficits in a nation's trade balance cause its exchange rate to depreciate, its central bank may take its mission to be stabilization of the exchange rate. To prevent further depreciation, the central bank must purchase its own currency from exchange markets by selling its holdings of other currencies or gold. The side effect of this is to take money out of domestic circulation because money held by the central bank is not part of the domestic money supply. Contraction of income and output in the domestic economy may follow, but this is medicine that 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 enters 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.
The independence of a nation's central bank from its political processes has been touted as a foundation of economic stability and the ability to avert inflation. But there has been commentary 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 promoting faster economic growth and dealing with governmental budget issues. 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 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. The idea of central bank independence is no more than about a half-century old. 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, authored an influential essay in which he critiqued the Fed's seeming inability to deal with twenty-first century deflation and debt overhangs:
(https://www.pimco.com/insights/economic-and-market-commentary/macro-perspectives/the-downside-of-central-bank-independence)
Fels proposed 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)
There may be confusion here
over cause and effect. Inflation is an effect of excessive money supply
issue when an economy is growing, not a cause of growth. In order
to assess the amount of real economic growth measured in terms of GDP, the
inflation component must be netted out.
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 [post 2008].
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.
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 military adventures, 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 would 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 budget exigencies, but at the expense of long-run peril.
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 their budget problems. 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.
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 depends upon the knowledge, integrity,
sense of public responsibility, and good will of those who are appointed to
the governing board of the central bank.
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 [Trump, 2016] 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 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.
Minneapolis Federal Reserve Branch President Neel Kashkari, writing in The Wall Street Journal, December 18, 2016, describes the debate over rules vs. discretion in monetary policy:
Kashkari focuses his concern about such a rule on that proposed by John Taylor:>
Kashkari acknowledges the potential benefit of following a monetary rule:
But he asserts the inability of such a rule to achieve economic stability in an environment of dynamic change:
And Kashkari asserts the need for the exercise of human judgment in the application of monetary policy:
John Taylor has taken exception to Kashkari's position. Writing in The Wall Street Journal, December 20, 2016, he says:
(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:
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":
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:
(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.
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
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. 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.
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)
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 capital 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.
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.
Jason Douglas and Jon Sindreu, writing in The Wall Street Journal, December 11, 2016, say that
. . . .
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.
11. 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.
12. 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 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 expected. 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.
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:
(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:
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:
But he also acknowledges the seeming inability of central banks to hit the 2 percent inflation target:
Rosengren notes the costs of making policy with imperfect information:
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:
(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.
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).
(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.
In a Wall Street Journal column on November 10, 2016, Greg Ip says that
(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
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.
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:
(https://www.kansascityfed.org/~/media/files/publicat/sympos/2016/econsymposium-sims-paper.pdf?la=en)
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.
(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.
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.
Jon Sindreu, writing in The Wall Street Journal, March 6, 2017, says 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.
(https://www.wsj.com/articles/everything-the-market-thinks-about-inflation-might-be-wrong-1488796206)
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)
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)
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.
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.
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.
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 in 2016 perceived themselves to be fighting deflation
and seemed 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.
19. Inflation and Price Levels
Paul Krugman notes in a newsletter dated December 5, 2023, that the rate of inflation 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®i_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. 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.
<>
20. The Fed's 2 Percent Inflation Goal
In 2012, following decades of debate among Fed governors serving on the Federal Open Market Committee (FOMC), the Federal Reserve established a 2 percent inflation goal for achieving price stability. The goal was specified in a "consensus statement," known more formally as the "Statement on Longer-Run Goals and Monetary Policy Strategy." It was authored by a subcommittee of the FOMC chaired by then-governor Janet Yellen:
Essays in this collection have confirmed that the Fed possesses tools that enable it to push market-determined interest rates toward an announced target, so why hasn't it been able to achieve its 2 percent inflation goal? Actually, two questions need to be addressed: Can the Fed with confidence cause market interest rates to change in an intended direction? If so, can the intended market interest rate changes actually affect the rate of inflation?
1. In regard to the first question, retail lenders tend to adjust their market interest rates downward to decreases in the Federal Funds interest rate target and the reserves deposit interest rate, but this is only a first-stage adjustment. As described in Essay 46, even though the Fed can push market interest rates toward an announced target, a second-stage adjustment may offset the first stage rate change. In a second stage adjustment, mortgage, autoloan, and other retail lenders enjoy increasing loan demand at the lower market rates. Financial institutions can increase their lending capacities by selling Treasury Bills and other short-term bonds that they have been holding. An increasing supply of bonds coming onto the bond market relative to bond demand would depress bond prices and increase their yield rates. A cut in the Federal Funds rate target thus could induce a rise in market interest rates, offsetting a first-stage decrease of market interest rates. Whether market interest rates ultimately increase or decrease in response to a change of the Federal Funds rate target depends on the relative magnitudes of changes of bond demand and supply.
2. The Federal Funds rate targets set to pursue it may be rather arbitrary relative to the capital scarcity interest rate in the region. While interest rates are determined in bond markets, they tend to gravitate toward the capital scarcity interest rate that reflects bond traders' awareness of capital availability relative to the demand for it. When market rates are below the capital scarcity interest rate, borrowing costs are less than rates of return on capital. This encourages borrowing to finance investment spending, and it may precipitate faster inflation if the economy is near full employment as it has been in 2025 and 2026.
When market interest rates are below the capital scarcity interest rate, net positive investment spending (gross investment greater than depreciation) adds to the stock of capital in the region. If this relationship persists long enough (e.g., during the Covid19 recovery period from 2020 to 2025), it can reduce the capital scarcity interest rate due to the phenomenon of diminishing returns to the increasing capital stock. If the capital scarcity interest rate falls below market interest rates (or if market interest rates rise above the capital scarcity interest rate), the higher borrowing costs will discourage bond issuance to finance new investment.
The recent increase of the inflation rate (4.2 percent on June 10, 2026) suggests that the the capital scarcity interest rate (which reflects return on capital investment) has dropped below bond yields against which market interest rates are adjusted. The 10-year Treasury Bill rate trended around 4 percent per annum over the past decade, but the recent increase to 4.59 percent at mid-May 2026 may portend future recession if it now exceeds the capital scarcity interest rate.
Monetary policy authorities may be unaware of the capital scarcity interest rate, whether their target rate is above or below it, and whether their policy actions cause market-determined rates to rise above or fall below it. The inability of the Fed's monetary policy to achieve its goal of reducing the rate of inflation to 2 percent per annum may have been due to market interest rates rising above the capital scarcity interest rate or the capital scarcity interest rate falling below market interest rates.
3. Monetary policy transmission mechanisms are lengthy, complex, and fraught with uncertainty. The Fed "pokes" at a policy rate (the Federal Funds rate or the reserves balance rate) with hope that a desired inflation abatement or growth outcome occurs through numerous links. 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 the desired outcome.
4. In an open economy, the reserves of commercial banks and the money supply are affected both by trade flows and by international capital flows. When a nation experiences a favorable balance of trade, 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.
5. 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. By early June 2026, the U.S. inflation rate had reached 4.2 percent due to political realities (e.g., war in Iran) that have caused the inflation rate to diverge even farther from the Fed's 2 percent inflation rate goal
These (and perhaps other) factors that undermine the Fed's attempt to address the inflation rate by manipulating its administered prices have rendered monetary policy essentially impotent. This is implied by the Fed's lack of success in achieving the 2 percent inflation goal since it was enunciated in 2012.
__________
Megan Leonhardt, writing on the MSN website, July 18, 2026, says that
The fact that the U.S. inflation rate has remained above the Fed's target 2 percent rate for 63 months indicates that the Fed's implementation of monetary policy over this period via the Federal Funds target rate has failed to achieve its goal.
"Markets pricing in an interest rate hike this year" indicates that bond buyers are demanding higher yield rates, i.e., buying bonds only at lower prices, to compensate for purchasing power loss due to an expected higher rate of inflation. This means that markets have already raised interest rates, whether the Fed chooses to acknowledge the fact by increasing its Federal Funds target rate.
What is yet unknown is whether the priced-in market interest rates are above or below the capital scarcity interest rate. A recession or a slowdown in the rate of growth of the economy in late 2026 or early 2027 would imply that market rates have eclipsed the capital scarcity interest rate and have dampened investment spending. Continuing economic growth may indicate that market rates are at or below the capital scarcity interest rate. Or, investment in the ongoing AI boom may avert a recession or slower growth, implying that AI investment returns are higher than the capital scarcity interest rate.
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