Bond Market Demand and Supply
Bond Market Demand and Supply
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.
20. The Fed, the Treasury, and Bond Markets
21. The Treasury and Monetary Policy
22. Central Bank Purchases of Corporate Bonds and Equities
23. Monetary Policy and Arbitrage
24. Unwinding the Fed's Portfolio
25. Growth and Monetary Stimulus
26. Inflation and Unemployment
27. Modern Monetary Theory
28. Monetary Policy and Exchange Rates
29. Monetary Policy and the Stock Market
30. Monetary Policy and Rational Expectations
31. Open Market Operations and the Federal Funds Rate
32. Open Market Policy by Repo Transactions
33. Interventions after the Great Recession
34. Inflation, Demand, and Supply
35. Treasury Interest Rates and Foreign Exchange Markets
36. Money Creation by Congress
39. The Capital Scarcity Rate of Interest
40. Interest Rate Determination: A Grand Delusion
41. Interest Rate Policy and the Rate of Price Change
42. Monetary Policy by Committee
43. Leading or Following the Market?
44. Shorter- and Longer-term Bond Yield Rates
46. The U.S. Economy at Mid-2026
47. 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.
Central banks have at their disposal three major monetary policy tools: commercial bank reserve ratio specification and adjustment, lending (or "discount") rate adjustment, and open market operations.* In executing open market operations, the U.S. Federal Reserve may purchase and hold only "used" bonds, i.e., bonds that had been issued previously by the U.S. Treasury and are being held by members of the public, business concerns, or commercial banks.
During and following World War II, Federal Reserve policy was deliberately accommodative of the Treasury's need to finance war expenditures by pegging long-term interest rates at 2.5 percent. An "accord" reached in 1951 between the Fed and the Treasury ended the accommodation and reasserted the independence of the Federal Reserve System from the U.S. Treasury (http://www.federalreservehistory.org/Events/DetailView/71). Since then the Fed has been prohibited from purchasing bonds newly issued by the Treasury or any other government agency due to the inherent potential for inflation (https://www.federalreserve.gov/faqs/how-does-the-federal-reserve-buying-and-selling-of-securities-relate-to-the-borrowing-decisions-of-the-federal-government.htm).
U.S. federal government deficits were typically less than half a trillion dollars per year prior to the "Great Recession" in 2008. Beginning in 2009 and continuing through 2012, federal deficits exceeded a trillion dollars per year, dropping back toward half a trillion dollars beginning in 2013. The deficit in FY 2015 was $563.57 billion (http://www.usgovernmentdebt.us/download_multi_year_2001_2016USb_15s2li101mcn_G0f).
The continuing annual government budget deficits that the U.S. Treasury had to finance by issuing government bonds caused the public debt of the U.S. government to increase to over $18 trillion by the end of FY 2015, about the same size as the 2015 U.S. GDP) (http://www.statista.com/statistics/188105/annual-gdp-of-the-united-states-since-1990/)
Keynesian theory would suggest that the massive government spending that produced such large and continuing budget deficits after 2009 would of itself stimulate the economy to grow faster. But the U.S. growth rate remained stubbornly low, less than 2 percent per annum. The great government spending may have averted absolute contraction and enabled a slow recovery to deliver the low-level of growth that the economy experienced since 2009.
With the intent of alleviating the Great Recession of 2008 and accelerating the U.S. rate of economic growth, the Federal Reserve progressively lowered its discount rate toward zero and engaged in "quantitative easing" (via open market purchases of government bonds) in the effort to put additional reserves into the hands of commercial bankers. Over the same period that the U.S. government ran deficits in excess of a trillion dollars per annum, the Federal Reserve executed two phases of quantitative easing. During QE1 (2009), Federal Reserve holdings of U.S. government securities more than doubled from under a trillion dollars to over 2 trillion dollars. Holdings increased to nearly 3 trillion dollars during QE2 (late 2010 to mid-2011). During a third phase, QE3 (late 2013 until October 2014), holdings increased to nearly 4.5 trillion dollars (http://www.nytimes.com/2014/10/30/upshot/quantitative-easing-is-about-to-end-heres-what-it-did-in-seven-charts.html?_r=0). Bankers accumulated much of the additional liquidity as excess reserves that did little to promote lending to businesses to undertake new investment.
The Fed's purchases of previously-issued Treasury bonds held by the public and commercial banks as the Treasury sold new bonds at auction had the effect of indirectly accommodating the deficit finance process. The result was the second-hand monetization of debt which was no less accommodative of the Treasury's financing need than if the Fed purchased new bonds directly from the Treasury. The monetization of public debt occurred just the same.
The issuance of new bonds by the U.S. Treasury to finance the government's deficits increased the supply of bonds coming onto the market. Given bond demand, bond prices fell and yield rates rose. The Fed's intent was to keep market-determined interest rates from rising or to induce them to fall toward the lowered discount rate. In the absence of other bond demand, it had to purchase enough previously-issued Treasury bonds from the market to offset the increasing-yield effects of the newly-issued bonds.
Monthly open market auctions are conducted by the Treasury Department to finance budget deficits or to "refund" (i.e., replace) maturing bonds. In an open market auction, security dealers are invited to submit bids for amounts of bond issues offered by the Treasury at stipulated prices in various term categories. On analogy, the Treasury acts as "manufacturer" of a product called "bonds." Security dealers function as "wholesale distributors" who buy bond products from the manufacturer and then "retail" them to domestic and foreign commercial and central banks who are in the market to buy bonds.
Commercial banks maintain inventories of bonds that vary with their needs to increase or decrease their reserves. A commercial bank finding itself temporarily deficient of required reserves can sell Treasury securities in its portfolio to a securities dealer. The process of clearing the transaction adds to the bank's reserves as the securities dealer pays for the securities. A commercial bank with excess reserves (which are not supporting lending that would earn interest income) may buy Treasury securities from a securities dealer to earn interest while the securities are held in its inventory. The purchase of securities reduces the bank's reserves as the bank pays the dealer for the securities. In turn, securities dealers with more or less securities in their portfolios than they wish to hold may participate in repo or reverse repo auctions conducted by the FRBNY.
If no or few dealers choose to participate in a repo auction by the FRBNY to temporarily borrow funds from the Fed, the implication is that the dealers either do not need to borrow funds, or they think that the prices are too low (i.e., the yield rates offered by the Fed are too high) to pay to borrow funds. In a reverse repo offering, if the FRBNY chooses not to accept any of the bond prices (and yield rates) offered by the securities dealers to lend money to the Fed, the implication is that the prices are too low, or the rates offered by the securities dealers are too high.
In an effort to "unwind" its inventory of bonds acquired in episodes of "quantitative easing" following the Great Recession of 2008, the Treasury may retire maturing bonds without replacing them, or it may enter the bond market to sell non-maturing bonds. Treasury purchases or sales of bonds have the effects of, respectively, adding to or reducing the reserves of commercial banks. Reserves in excess of those specified by the required reserve ratio may enable commercial bank lending to businesses and private citizens.
Jason Ma, writing on the Fortune website, July 20, 2026, reported that U.S. debt at mid-2026 is $39 trillion; the projected 2026 U.S. budget deficit is $2 trillion; interest costs on U.S. debt are $1 trillion a year, i.e., half of the budget deficit; the Treasury Department relies heavily on short-term securities that have lower yields; about 85% of debt issuance over the past few years has been Treasury bills that mature in a year or sooner; and 20% of outstanding federal debt will come due in the next four months [by November 2026].
Martin Baccardax,writing on the Barrons website, August 13, 2026:
Karishma Vanjani, writing on the MSN website, August 11, 2026:
The Wall Street Journal Markets Today column noted on August 12, 2026, that
Domestic securities dealers are not the only demanders of bonds. The U.S. is an open economy subject to foreign as well as domestic financial transactions. The demand for U.S. government bonds has been increasing not only because securities dealers buy bonds, but also because both domestic and foreign interests purchase U.S. government bonds for their relative safety, and in spite of their low yields. When the joint demand for bonds increases as fast or faster than the supply of new bonds coming onto the market from governments and corporations, bond prices increase and their yield rates fall. Foreign purchases of U.S. bonds have injected savings into the U.S. economy, assisted the U.S. Treasury to finance the government's deficits, and increased the U.S. money supply. In 2017 the falling bond yield rates served the Fed's intent to lower interest rates toward the near-zero discount rate.
Since neither the U.S. nor many other U.S. trading partners were experiencing excessive inflation following the 2008 Great Recession, it may be inferred that increases of the U.S. money supply as a result of indirect debt monetization and foreign purchases of U.S. bonds were being absorbed by increasing demand for money balances to hold or impounded by commercial banks as excess reserves.
Central bank purchases of government bonds continue to be an ineffective growth stimulant as long as investment decision makers are uncertain or pessimistic about the future of demand for products that could be produced with new capital investment. The slow economic growth and low investment in the U.S. economy following the Great Recession suggest that commercial bankers and corporate managers preferred to "sit on" the additional liquidity as they waited for growth in the global economy to pick up.
The U.S. government is fortunate in that conditions in 2016 were not "normal." Slow economic growth, a discount rate near zero, and implicitly accommodative bond purchases by the Fed enabled the continuing finance of annual government budget deficits that accumulated as public debt on which the debt service was minimal. Once the economy began to grow faster and the Fed concluded that the discount rate could be raised, bond yield rates began to rise. Higher yield rates made it much more costly for the government to continue to run budgetary deficits on the scale of recent years, and the overhang of commercial bank excess reserves posed a much greater potential for inflation.
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*The discount rate is the interest rate that a central bank charges to its commercial banks when they borrow reserves from the central bank. It is a "discount" rate because a bank receives the proceeds of a loan by the Fed that is less than (discounted from) the face value of the loan, but the bank must repay the face value of the loan. Increasing the discount rate discourages commercial banks from borrowing reserves from the Fed to support additional lending; lowering it encourages additional borrowing and lending. Reserve ratio adjustments are commonly used by central banks of countries without well-developed open markets for debt instruments, but such adjustments are rarely implemented by central banks in countries with large and vibrant open markets. Increasing the required reserve ratio diminishes the lending ability of commercial banks by converting excess reserves into required reserves; decreasing it frees up reserves to support additional lending. Where such open markets function well enough, central banks may engage in open market operations by purchasing and selling bonds issued by their respective governments. Central bank purchases or sales of bonds have the effects of, respectively, adding to or reducing the reserves of commercial banks. Reserves in excess of those specified by the required reserve ratio may enable commercial bank lending to businesses and private citizens.
The Federal Reserve cannot simply dictate changes of market-determined interest rates (e.g., yields on bonds) by changing its discount rate. When a discount rate change is announced, the Fed has to work behind the scenes by changing the interest rate that it pays to commercial banks on their excess reserves on deposit at the Fed, or by executing open market operations to change the demand or supply of bonds in the market, thereby causing bond prices to change and nudging yield rates toward the new discount rate. For example, if the Fed announces a discount rate decrease, it will also decrease the reserves deposit interest rate. In the absence of other sources of bond demand it may need to purchase bonds in the open market, adding to the demand for bonds relative to bond supply, pushing bond prices upward and yield rates downward toward the new lower discount rate. If there are no other sources of increasing bond demand, the trick is to purchase just enough bonds to induce bond yield rates to fall toward the new lower discount rate without under- or over-shooting.
The Issue
There has been discussion recently [2024-2025] in the financial media and among some economists specializing in monetary matters that the U.S. Treasury has begun to engage in monetary policy operations that previously have been the preserve of the Federal Reserve. But from 1846 forward, the newly established "Independent Treasury" discovered, learned, and implemented what in modern parlance would be called "monetary policy."
A July 2024 study by Hudson Bay Capital contends that selection by the U.S. Treasury of term categories for bond auctions has had monetary policy implications paralleling the Federal Reserve's Quantitative Easing (QE) bond transactions:
By adjusting the maturity profile of its debt issuance, Treasury is dynamically managing financial conditions and through them, the economy, usurping core functions of the Federal Reserve. We dub this novel tool “activist Treasury issuance,” or ATI. By manipulating the amount of interest rate risk owned by investors, ATI works through the same channels as the Fed’s quantitative easing programs. (https://www.hudsonbaycapital.com/documents/FG/hudsonbay/research/635102_Activist_Treasury_Issuance_-_Hudson_Bay_Capital_Research.pdf)
Stephen Miran, a former senior advisor to the US Treasury Department, is a senior strategist at Hudson Bay Capital and a fellow at the Manhattan Institute. In the transcription of an interview on September 2, 2024, by David Beckworth, Miran says that
There's a wide variety of things that have converged to allow growth and inflation and markets to be so strong in the face of such aggressive Fed tightening. Deficits play a role. Geopolitics plays a role. AI plays a role, all of this stuff. But are there other policy levers that people haven't studied and thought about? And we started looking at the Treasury's issuance patterns, and it seemed that Treasury had started to deviate from historic norms.... (https://www.mercatus.org/macro-musings/stephen-miran-activist-treasury-issuance-and-monetary-policy-implications-second)
In the same interview, Miran reports that Hudson Bay Capital
... found a range of estimates on term premium that would indicate that the 10-year yield was reduced by 14 to 40 basis points with a central guess at 25 basis points, so a quarter of a percentage point, right? That quarter of a percentage point is equivalent, in terms of the amount of economic stimulus delivered, by a one-point cut to the fed funds rate, to the Fed's primary policy tool, the overnight rate.
The History
Implementation of monetary policy by the U.S. Department of Treasury is not a new phenomenon. The Treasury Department has a long history of engaging in actions that today might be regarded as monetary policy. It began in 1837 when President Martin Van Buren proposed the establishment of an independent U.S. treasury to deal with a financial crisis during which banks with inadequate gold and silver reserves refused to convert paper money into gold or silver. The Panic of 1837 spawned a 5-year depression. Presidential politics between Whigs and Democrats killed the Independent Treasury Act of 1840, but President James K. Polk pushed a revived treasury bill through Congress, signing the Independent Treasury Act on August 6, 1846.
From 1846 to 1913 the Independent Treasury managed the money supply of the federal government independently of the national banking and financial systems. American interests observed central banking institutions in Europe and began to envy them. In the absence of an American central bank to exercise control over the banking system, the Treasury Department began to learn and exercise central banking functions.
From 1860 to 1865, Civil War finance resulted in the issue of paper money by governments on both sides. Paper money was over-issued by state chartered banks and by both governments. Excessive issue of Union (North) treasury notes, known as "greenbacks," eventually resulted in circulation at discounts from par. The same occurred for Confederate (South) money, but even worse. At war's end, Confederate issues of money became worthless; Federal greenbacks continued to circulate at discounts from face values.
Between 1869 and 1875, the first American "Great Depression" followed from the Treasury's deliberate withdrawal of paper money by Congressional act to eliminate discount from par, with the objective to reestablish convertibility of currency to gold at par. In 1880 state banks were prohibited from further issuance of bank notes, and the federal government began chartering "National Banks" that were authorized to issue bank notes backed by gold reserves under the supervision of the Treasury. Most banks choose to remain state banks in order to avoid control by the Treasury.
In 1875, at the behest of silver mining interests, Congress passed legislation defining sixteen ounces of silver as equal in value to an ounce of gold, with par values between the dollar and the two metals in the ratio of 16:1. But with changing relative market values, gold became overvalued at the mint. It drained from circulation, mostly to Europe, and was replaced by silver. Later, silver became overvalued and drained from the economy to Europe; gold flowed in from Europe. Economic instability ensued as gold flowed into and out of the country, thereby whiplashing the domestic money supply. Eventually Congress defined the value of the dollar exclusively in terms of gold, thereby committing to the international Gold Standard.
Banking instability continued as the money supply was geographically inflexible in the sense that much of the money supply was in the Treasury's vaults in the cities when it was needed in rural areas to facilitate planting and harvest. During the off-seasons most of the money supply remained in rural areas when it was needed in the cities. Banking panics precipitated numerous episodes of economic instability which continued to worsen. In 1912-1913, Congress debated the need for a central bank and the shape it would take. In recognition of the need for independence from the Treasury, the Federal Reserve Act was passed by Congress in 1913, implicitly reserving the implementation of monetary policy to the Federal Reserve.
But the transition of monetary control from the Treasury to the Federal Reserve was not instantaneous or without difficulty. With the onset of depression in 1932, the Federal Reserve Board (FRB) failed to comprehend its mission of being a "lender of last resort" to the commercial banks, or that it was fundamentally different from commercial banks in that it could not fail. The FRB let the money supply drop drastically as it mistakenly attempted to decrease its outstanding deposit liabilities in order to keep itself from failing.
As the FRB decreased its deposit liabilities (i.e., the deposits of commercial banks), commercial banks could not meet their reserve requirements. Banks called loans, many of which were bad; banks became insolvent and failed. The banking population dropped from over 30,000 to less than half by the end of the decade. The U.S. nationalized all gold in the country and suspended gold payments to foreigners, thus going off the Gold Standard. Meanwhile, budget deficits increased with depression spending which the Treasury handled by issuing bonds that added to the public debt.
By 1936, the increasing bond supply relative to bond demand caused bond prices to fall and yield rates to rise in the U.S. relative to Europe. This precipitated a capital inflow, supplying American banks with excess reserves which FRB officials viewed with alarm as having great inflation potential. The FRB did not realize that bankers wished to hold idle excess reserves for liquidity. The FRB raised reserve requirements to "mop up" excess reserves, precipitating another banking crisis, monetary contraction, and a second downturn and depression trough. Only in the late 1930s with gradual recovery did FRB officials begin to comprehend the effects of their actions. The FRB ceased decreasing reserves and the money supply.
Increasing bond sales at the onset of WWII depressed bond prices and increased yield rates. However, the FRB took a subsidiary role to Treasury to assist with war finance by keeping interest rates low. Even as it held the line on interst rates, the FRB let the money supply increase during the war, causing inflationary pressures that were contained by price controls and rationing. At the end of the war, price controls and rationing ended, causing a spurt of price inflation in the late-1940s. In 1951, the FRB negotiated an "accord" with the Treasury to regain its autonomy and independence. This enabled the Fed to raise interest rates and restrict the money supply to control inflation.
The emergence of the Treasury's procedure for refunding the national debt has resulted in the cumulative increase of the national debt to more than $33 trillion by early 2025. The refunding procedure recently has been used by Treasury to shift the term structure of outstanding debt from higher-yield longer-term debt to lower-yield shorter-term debt in order to lessen the burden of debt service. This Treasury procedure is reminiscent of the way in which the Federal Reserve has used "Operation Twist" in its effort to "flatten" the yield curve.
This brief excursion through the history of the Treasury Department should have revealed numerous Treasury actions and procedures that have had monetary effects on the U.S. economy. The recent study by Hudson Bay Capital really brings up nothing new, but it does point out the possibility of equivalence between the effects of Treasury actions and Federal Reserve actions. So, we are down to examining the motivations of Treasury decision makers compared to those of Federal Reserve decision makers.
The Resolution
I find it completely counterproductive to have a theory of macroeconomics in which we define fiscal policy and monetary policy based on who is acting. If the US Congress and Treasury choose to send $1 trillion to households without raising taxes, it’s called fiscal policy. But if the Fed does the exact same thing, it’s apparently called monetary policy. .... It seems much clearer to simply say that (a) the act of creating a deficit—raising the net financial wealth of the non-government sector—is fiscal policy, and (b) the act of announcing and then supporting an interest rate target with security sales (or purchases, or interest on reserves)—which has no effect on the net financial wealth of the non-government sector—is monetary policy. (https://www.levyinstitute.org/blog/fed-fiscal-policy-treasury-monetary-policy/)
Fullwiler focuses on the interest rate target to identify monetary policy actions implemented by the Treasury. An alternate approach would be to examine the effects of Treasury security sales on changes in the money supply that work on the economy via the diminishing marginal utility of held money balances. Treasury bond sales take money out of circulation. A decrease of Treasury bond sales increases the amount of money remaining in circulation. Money balances in excess of what consumers and businesses wish to hold get spent to stimulate the economy. An increase of Treasury bond sales decreases the amount of money in circulation. To alleviate the perception of a deficiency of money balances being held, consumers and businesses cut back on purchases to depress economic activity. In this view, interest rate changes are consequences of changes of the money supply relative to the demand for money to hold, but they too impact the economy by inducing changes of lending rates on home mortgages, auto loans, and consumer loans.
Whether a Treasury action in regard to the interest rate or the money supply constitutes monetary policy depends on the intent of the Treasury decision maker. One's true intention (what is in one's "head and heart") cannot be known with certainty unless confidence can be placed in oral or written statements of intent. If the announced intent of a Treasury action is only to fund a deficit, refund maturing debt, or adjust the term profile of the outstanding debt, the action is fiscal in nature, and any monetary effects are incidental. If the intent is to stimulate or dampen economic activity or to avert inflation or deflation, the action is an implementation of monetary policy, and any fiscal effects are incidental. Likewise, if the intent of a Federal Reserve action is to adjust the term profile of the outstanding debt, the action is fiscal in nature, and any monetary effects are incidental. If the intent of a Federal Reserve action is to stimulate or dampen economic activity or to avert inflation or deflation, the action is an implementation of monetary policy, and any fiscal effects are incidental. Both agencies have the ability to implement either type of policy.
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 security dealers' 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 (see the essay at https://dickstanfordlegacy.blogspot.com/2025/07/essaysvolume4.html#S41).
"Operation Twist" sounds like it might be a purely fiscal action taken by the Federal Reserve, but Adam Hays, writing July 13, 2022, on the Investopedia website describes operation twist as a monetary policy action implemented by the Federal Reserve:
Operation Twist is a Federal Reserve (Fed) monetary policy initiative used in the past to lower long-term interest rates to further stimulate the U.S. economy when traditional monetary tools were lacking via the timed purchase and sale of U.S. Treasuries of different maturities. The term gets its name from the simultaneous buying of long-term bonds and selling short-term bonds, suggests a "twisting" of the yield curve and creating less curvature in the rates term structure. (https://www.investopedia.com/terms/o/operation-twist.asp#:~:text=Operation%20Twist%20is%20a%20Federal%20Reserve%20(Fed))
It is important to note the origin and authority of the two agencies. The Treasury was established by Congress in 1846 to be a department of the executive branch of government. It originally implemented both fiscal and monetary functions, but after the establishment of the Federal Reserve System in 1913 the Treasury's remit entailed only fiscal functions. Implicitly it no longer has any monetary policy responsibility. The Federal Reserve was established by Congress to be an agency of government that is independent of either the executive or the legislative branch of government. Its remit is to implement monetary policy in the interest of the stability of the U.S. economy, but it is not prohibited from implementing fiscal actions.*
Something more ominous may be going on here. At mid-2025, President Trump appears to be "going for broke" in attempting to gain maximum authoritarian control over the U.S. economy. If indeed the Treasury Department now is implementing monetary policy, it may well fit into Mr. Trump's scheme since the Treasury is a department of the executive branch of the U.S. government, and thus is under direct control of the president. Mr. Trump has been urging Federal Reserve Board Chair Jerome Powell to lower interest rates in order to avert recession that may ensue from his tariff policy, but Mr. Powell continues to resist doing so in concern that interest rates may need to increase to avert inflation pressures.
If Mr. Powell won't comply with Mr. Trump's request to lower interest rates, Mr. Trump may side-step the Federal Reserve and get the Treasury to do his bidding. Mr. Powell can influence market interest rates by changing the interest rate that the Fed pays to commercial banks on their excess reserves deposited with the Fed. The Secretary of the Treasury doesn't have a similar tool to influence market interest rates. But at Mr. Trump's behest the Secretary might attempt to manipulate market interest rates by directing the Treasury to sell longer-term bonds and purchase shorter-term bonds, implementing a version of operation twist. This would have the effect of increasing shorter-term bond prices that serve as benchmarks for lenders to set their lending rates. The yields on shorter-term bonds would fall as their prices rise, which is what Mr Trump has been prompting Mr. Powell to do. Once Mr. Trump discovers that the Treasury can execute monetary policy, it might spell the end of the Federal Reserve's monetary policy preserve.**
All of this may be moot. In June 2025, a so-called "Genius Bill" was introduced in Congress. If passed into law, it would authorize companies to issue a type of cryptocurrency called a stablecoin, the value of which would be tethered to a stable asset like the dollar; passage of the bill would authorize stablecoins to be issued by federally insured banks or by companies such as Walmart and Amazon. A possibly flawed underlying assumption is that the dollar will remain stable (it is losing value at mid-2025 due to Mr. Trump's tariff policy and rising global concerns about the ability of the Treasury to continue to redeem all maturing Treasury obligations as the U.S. national debt exceeds $36 trillion). Authorizing the issue stablecoin by banks and companies is likely to end the effective implementation of monetary policy by either the Federal Reserve or the Treasury. Economist Barry Eichengreen expects the law to return the U.S. financial sector to a state of chaos such as that which ensued from 1837 to the Civil War. (New York Times, June 17, 2025, "This Bill Will Return Us to an Era of Economic Chaos," https://www.nytimes.com/2025/06/17/opinion/genius-act-stablecoin-crypto.html?campaign_id=39&emc=edit_ty_20250617&instance_id=156686&nl=opinion-today®i_id=74240569&segment_id=200089&user_id=86b0d837dd357b2a6e0e749321f6ed7f)
There is an even-bigger question. In another essay I have argued that forces of adjustment in a market economy act to cause market-determined interest rates to converge upon the region's capital scarcity interest rate. This rate is determined by the region's endowment of capital relative to other productive inputs. A corollary of this premise is that any activist implementation of policy to cause market-determined interest rates to divege from the region's capital scarcity interest rate will be reversed by the adjustment forces inherent in the market economy.
What follows is that there is no valid role for either monetary or fiscal policy in a market economy apart from altering the region's comparative advantages. Neither the Treasury Department nor the Federal Reserve should exercise policy activism in attempts to force or induce market-determined interest rates to diverge from the region's capital scarcity interest rate. The Federal Reserve should allow market-determined interest rates to track the region's capital scarcity interest rate. This contention with respect to fiscal policy activism may just as well apply to monetary policy activism.
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*There is an interesting relationship between the chair of the Federal Reserve Board during the early part (2014-2018) of President Trump's first term and the Secretary of the Treasury during President Biden's presidential term (2021-2025): the same person, economist Janet Yellen, served in both positions. This leads to a question of whether Yellen may have brought her monetary policy predilections from her term as Chair of the Federal Reserve Board of Governors to her term as Secretary of Treasury.
**In an essay on The Hill website, June 22, 2025, Sylvan Lane describes how Mr. Trump is attempting to subvert the Fed's so-called "dual mandate" and shift the mandate to the fiscal function of funding deficits and refunding maturing debt:
During World War I and II, the Fed yielded to pressure from presidential administrations to keep interest rates low and ease the burden of the rising debt.
While that practice extended for nearly a decade after the bombing of Pearl Harbor, the Fed and Treasury eventually reached an agreement in 1951, setting the stage for the next seven decades of economic management.
“The purpose of the ‘accord’ was to make Treasury manage its debt, rather than expecting the Fed to ‘monetize’ it. In turn, the Fed asserted its control of monetary policy via the setting of interest rates to meet congressional mandates for price stability and maximizing employment,” said Sarah Binder, political science professor at George Washington University and co-author of “The Myth of Independence: How Congress Governs the Federal Reserve.”
The Fed has since avoided anything that could be considered financing the federal debt while sticking to its “dual mandate” of balancing unemployment and inflation. And while several presidents have verbally pressured the Fed to keep rates low since 1951, none has made a formal move to limit its legal authority over monetary policy.
“Based on most concepts of ‘independent’ monetary policy, the central bank shouldn’t be monetizing the debt. That is, it shouldn’t be taking the administration’s financing needs into account when it aims to meet its mandates,” Binder said.
“Those mandates are price stability and strong labor markets,” she added. “Congress has not given the Fed an additional mandate to make it easier for the Treasury to finance its debt.”
But Trump could be laying the groundwork for a shift toward a “fiscal dominance” regime, [David] Beckworth [research fellow and monetary policy director at the Mercatus Center] warned, in which the Fed would be forced to clean up the government’s fiscal mess and abandon the bank’s legal obligation to keep prices stable and unemployment low.
(https://www.msn.com/en-us/money/markets/trump-ropes-fed-into-debt-fight-as-gop-faces-fiscal-mess/ar-AA1Hczca?ocid=msedgdhp&pc=U531&cvid=c940f90e206c49389affd941dc0e0c8d&ei=243)
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A central bank purchase of either corporate bonds or stock shares
can elicit potential political favoritism or punishment problems because central
bankers have to select which corporate bonds or which stock shares to purchase
in the open market or directly from the corporate issuers. Corporate bonds
selected for purchase by a central bank will experience increased demand
relative to their supply, thereby bidding up those bond prices and depressing
their yield rates. Likewise, when a central bank purchases corporate stock
shares, it adds to the demand for them relative to their supply and bids
up their prices on stock markets, likely sending inappropriate signals to
investors and market traders.
Central banks have at their disposal three monetary policy tools:
commercial bank reserve ratio specification and adjustment, lending (or
"discount") rate adjustment, and open market operations. In executing
open market operations, the U.S. Federal Reserve is allowed to purchase
and hold only "used" bonds, i.e., bonds that had been issued previously
by the U.S. Treasury and are being held by members of the public, business
concerns, or commercial banks. Except for a nominal amount for account settlement
convenience, the Fed is prohibited from purchasing bonds newly issued by
the Treasury (https://www.federalreserve.gov/faqs/how-does-the-federal-reserve-buying-and-selling-of-securities-relate-to-the-borrowing-decisions-of-the-federal-government.htm)
due to the inherent potential for inflation. However,
in 2008 the Fed began to purchase and hold mortgage-backed securities in
order to try to provide additional stimulus to the economy and to stabilize
the housing and financial markets (http://www.federalreserve.gov/newsevents/reform_mbs.htm).
And by convention, the Fed does not purchase, hold, or sell any corporate
bonds or stock shares (equities). But things may change in this regard.
In an effort to stimulate faster economic growth, the Fed implemented a looser monetary policy by lowering its discount
rate toward zero and engaged in "quantitative easing" (a.k.a. open market
purchases of government bonds) in the effort put more reserves in the hands
of commercial bankers, and to induce market-determined interest rates to
follow the discount rate. This policy effort had little impact on the
amount of money in circulation because commercial banks were reluctant
to borrow reserves and they impounded additional liquidity as
excess reserves with little increase of lending to prospective commercial
or industrial borrowers.
Faced with a shortage of bonds coming onto bond markets and unable to
get enough additional money into circulation by buying government bonds
from commercial banks to increase their reserves, central bankers in some
countries are contemplating purchasing corporate bonds in addition to government
bonds in hopes that the additional liquidity thereby injected into corporate
bank accounts would motivate bank lending to businesses for investment spending.
It appears that equities are also gaining the attention of central
bankers. Gerard Baker summarizes an item by Brian Blackstone and Tom
Fairless in the September 5, 2016, issue of The Wall Street Journal:
(http://www.wsj.com/articles/the-10-point-1473159296)
The opposite political problem will emerge when central bankers find that
they need to sell some of the corporate bonds or stock shares in their inventories.
Selling the selected corporate bonds or stock shares will increase supply
relative to their demand, depressing their market prices and, in the case
of bonds, bidding up their yield rates.
A central bank purchase of corporate bonds and equities is likely to be
no more effective than open market purchases of government bonds. It will
be ineffective as long as investment decision makers are uncertain or pessimistic
about the election outcome and the future of demand for their products that
could be produced with new capital investment. The continuing slow economic
growth and low investment in the U.S. economy suggest that corporate managers
would rather "sit on" the additional liquidity as they wait for growth in
the global economy to pick up.
Potentially even more disrupting (and disturbing) is the breaking of the
convention by central banks not to purchase and hold corporate bonds and
equities. This practice directly politicizes central bank open market operations
due to favoritism or punishment of particular firms by selecting their bonds
or equities for purchase or sale.
23. Monetary Policy and Arbitrage
In his
newsletter of April 22, 2022, New York Times columnist Paul Krugman
discusses how a recession might or might not happen. After considering the
possibility that the Federal Reserve is moving too slowly with respect to the
current inflation, Krugman says,
But there’s another
possibility, which if you ask me isn’t getting enough attention. Namely, that the
Fed will move, or maybe already has moved, too fast and that the economy will
cool off much more than necessary. In that case ... we could have an unnecessary recession, one that
could develop quite quickly.
Why worry about this
possibility? After all, so far the Fed hasn’t done much in the way of concrete
action: It has raised the interest rate it controls by only a quarter of a
percentage point. But the longer-term interest rates that matter for the real
economy, especially mortgage rates, have already soared based on the
expectation that there will be many more rate hikes to come...
The interest rate that the Fed controls is
its discount rate.* The implication is that the Fed's control of its discount
rate extends to other interest rates across financial markets.
But the Federal Reserve cannot simply dictate changes of market-determined interest rates (e.g., bank lending rates, mortgage rates, yields on bonds) by changing its discount rate. The Fed may appear to dictate interest rate changes when financial interests anticipate a discount rate change but have been waiting for the Fed to announce the discount rate change to change their own rates.
As Krugman suggests, changes of
market interest rates may lead an expected discount rate change so that the
anticipated change has already been "priced in" by financial
instrument traders. It is even possible that changing market interest rates may
induce the Fed to change its discount rate to get in line with market realities,
in which case the Fed would be following the financial markets rather than
imposing its will on them.
In this essay, the word "bond" is used as a euphemism for all financial instruments that yield interest. It is important to recall that in financial markets, traders do not bid yield rates, whether explicitly or implicitly; they bid prices of financial instruments, and yield rates may be computed from the price information. It is important to remember that there are no special financial markets set aside for purchases and sales of government bonds or any other categories of bonds, including those of foreign origin; they are traded in the same financial markets with all other financial instruments. It is important to note that the Fed’s discount rate usually is a below-market interest rate at which only commercial banks that are members of the Federal Reserve System may borrow. The discount rate is not available to businesses, consumers, or home buyers.
Because there are other influences on financial market interest rates than the Fed, there
is no guarantee when the Fed announces a discount rate change that market rates
will follow. When a discount rate change is announced, the Fed may have to work
behind the scenes by executing open market operations to change the demand or
supply of bonds in the market, thereby causing bond prices to change and
nudging yield rates toward the new discount rate.
For example, if the Fed announces a discount rate decrease, in the absence of other sources of increasing bond demand or decreasing bond supply, it may need to purchase bonds in the open market, adding to the demand for bonds relative to bond supply, pushing bond prices upward and yield rates downward toward the new lower discount rate. If there are no other sources of increasing bond demand or decreasing bond supply, the trick is to purchase just enough bonds to induce bond yield rates to fall toward the new lower discount rate without under- or over-shooting. This is an even trickier operation since there almost always are other sources of increasing bond demand or decreasing bond supply. Changing bond yield rates will elicit interest rate changes through the financial system by the process of arbitrage.
On the other hand, if the Fed announces a discount rate increase, in the absence of other sources of increasing bond supply or decreasing bond demand, it may need to sell bonds in the open market, adding to the supply of bonds relative to bond demand, pushing bond prices downward and yield rates upward toward the new higher discount rate. If there are no other sources of increasing bond supply or decreasing bond demand, the trick is to sell just enough bonds to induce bond yield rates to rise toward the new higher discount rate without under- or over-shooting. This is an even trickier operation since there almost always are other sources of increasing bond supply or decreasing bond demand. Changing bond yield rates will elicit interest rate changes through the financial system by the process of arbitrage.
Arbitrage, the simultaneous purchase and sale of financial instruments whose prices (and yield rates) are changing, works to transmit changing interest rates across financial markets to other financial instruments. It does this because profit-motivated financial instrument traders can be expected to sell financial instruments whose prices have risen (i.e., their yield rates have fallen) to capture profit and in order to use the sale proceeds to purchase other financial instruments, the prices of which have not risen or have fallen.
Assuming that there are no other sources of increased or decreased bond supply or demand, suppose that the Fed announces a discount rate increase with the intent to elicit interest rate increases across financial markets. It begins to sell bonds from its portfolio, causing the bond prices to fall and their yield rates to rise. Financial instrument traders will see profit opportunities in selling other financial instruments in their portfolios in order to buy the lower-priced bonds sold by the Fed. The sales of other financial instruments will lower their prices and raise their yield rates, thereby effecting transmission of the Fed’s intent to increase interest rates. The simultaneous sales and purchases of financial instruments will tend to bring about changes of interest rates across financial markets toward the Fed’s newly-announced increased discount rate.
Or, suppose that the Fed announces a discount rate decrease with the intent to elicit interest rate decreases across financial markets. It begins to buy bonds from the financial markets, causing the bond prices to rise and yield rates to fall. Financial instrument traders will see profit opportunities in selling financial instruments in their portfolios to the Fed in order to buy other financial instruments on the market. The purchases of other financial instruments will raise their prices and lower their yield rates, thereby effecting transmission of the Fed’s intent to decrease interest rates. The simultaneous sales and purchases of financial instruments will tend to bring about changes of interest rates across financial markets toward the Fed’s newly-announced decreased discount rate.
Concurrent increases or decreases of
demand or supply of bonds from sources other than the Fed may disrupt or even
frustrate the intent of the Fed to elicit market interest rate changes in its intended
direction. Other sources of changing bond demand or supply may include federal
and local governments, domestic businesses and bond market traders, and foreign
governments, businesses, and bond traders.
_________
The discount rate is an “administered price” rather than a
market-determined rate. It is the interest rate that a central bank charges to
its commercial banks when they borrow reserves from the central bank. It
is a "discount" rate because a bank receives the proceeds of a loan
by the Fed that is less than (discounted from) the face value of the loan, but
the bank must repay the face value of the loan. Increasing the discount rate
discourages commercial banks from borrowing reserves from the Fed to support
additional lending; lowering it encourages additional borrowing and lending.
Nick Timiraos, writing in The Wall Street Journal, April 16,
2017, notes the implications of the Fed's acquisition of its $4+
trillion portfolio of mortgage and Treasury bonds during three episodes
of "quantitative easing" between 2008 and 2015:
Before 2008, banks held relatively low levels of deposits--known as
reserves--at the Fed. The central bank managed the federal funds rate by
making small adjustments in the amount of these reserves through
routine purchases and sales of Treasury securities. Now, with a large
portfolio of securities, the Fed has left the banking system flush with
trillions of dollars in reserves. It manages rates now by paying
interest on these reserves.
(https://www.wsj.com/articles/fed-puts-together-plan-to-unwind-securities-portfolio-1492340401)
The Fed acquired most of the mortgage bonds from the mortgage guarantee
agencies (Freddie Mac and Fannie Mae). The bulk of the Treasury bonds
were acquired in the open financial markets, which had the effect of
increasing commercial bank reserves. Although the Treasury was
increasing the supply of bonds to the financial markets in order to
finance the government's budget deficits during those years, the effect
of the Fed's quantitative easing bond purchases was to increase the
demand for Treasury bonds relative to the supply of them coming to the
financial markets, bidding bond prices up and their yield rates down
toward the Federal Funds target rate of 0.5%.
Timiraos describes the Fed's desire to "unwind" this huge portfolio:
The Fed wants to move toward a smaller portfolio for several reasons. The economy is on stronger footing, leaving less need for support from a large bond portfolio. The large holdings have become a political liability, unpopular in Congress. Moreover, getting started now could relieve pressure on possible new leadership in 2018, when Fed Chairwoman Janet Yellen's term ends. Finally, officials want room to ramp it back up in a crisis if needed.
Timiraos also describes the Fed's plan for unwinding its portfolio of mortgage and Treasury bonds:
Officials leaned at their March meeting toward reducing holdings of Treasuries and mortgage bonds simultaneously. They could reduce these holdings gradually by tapering the reinvestments of principal payments, or they could stop the reinvestments cold turkey, which would be easier to communicate to markets but could also create more market volatility. Significant shares of the Fed's Treasury holdings are scheduled to mature in 2018 and 2019.
All well and good for the Fed and its balance sheet, but what are the
implications of this unwinding process for both the U.S. and the global
economies?
A principle taught in the basic money-and-banking course is that the Fed
"creates" money when it buys bonds from the public (individuals,
businesses, commercial banks), and it "destroys" money when it sells
bonds to the public. The means for creating and destroying money are
bookkeeping entries that offset the bond transactions. The Fed creates
money when it adds funds by bookkeeping entries to the bond sellers bank
accounts. It destroys money when it subtracts funds form the bond
buyer's bank accounts.*
As the securities held by the Fed mature, the Treasury redeems the bonds
held by the Fed, the matured bonds are returned to the Treasury (i.e.,
they cease to exist as active financial instruments), and the Treasury
pays "cash" to the Fed for them. On the Treasury's balance sheet, the
bookkeeping entries to recognize this bond-maturation process decrease
both its asset account "cash" and its liability account "bonds
outstanding." On the Fed's balance sheet, the bookkeeping entries to
recognize this swap of cash for matured bonds increase the Fed's asset
account "cash" and decrease the Fed's asset account "bonds held." This
transaction reduces the Fed's portfolio of interest-earning assets as it
intends, but it leaves the Fed holding an increased cash balance (which
it has implicitly destroyed in the bond-redemption process). It is
important to remember that, by definition, money held as asset within
the banking system and the Treasury is not in circulation and can have
no effect on the economy.
Commercial banks acquired a tremendous amount of reserves in excess of
legal requirements during the Fed's quantitative easing purchases of
bonds from the public. A common presumption is that if the Fed's
portfolio is decreased by letting bonds mature without replacing them,
the lending potential of the commercial banking system would decrease,
but this is not the case. The Fed originally bought the bonds from the
public, paying cash for them in the form of deposits (and increased
reserves) at commercial banks. Since the bond purchase transactions were
between the Fed and members of the public, money was created. Reserves
in excess of legal requirement could be reduced if the Fed were to sell
non-maturing bonds to the public which pays for them, thereby reducing
both their bank deposits and the reserves of commercial banks.
But in the Fed's portfolio-reduction bond redemption process, the
maturing bonds are "sold" (i.e., returned) to the Treasury, not to the
public. Since the redemption transactions are solely between the Fed and
the Treasury, the reserve deposits of commercial banks are unaffected,
and the excess-reserve lending potential of commercial banks remains
intact. This lending potential may promote growth if business confidence
continues to improve and induce businesses to increase borrowing from
banks to finance capital investments. It also has potential to cause
inflation if the demand for personal loans begins to increase when the
economy is near full employment.
But there's more to this story. If the U.S. government were running
budget surpluses, it could decrease the outstanding government debt by
attrition as the various securities that the Fed holds mature simply by
not replacing them (i.e., by not engaging in "refunding" operations).
However, the U.S. government continues to run budget deficits that
require financing ("funding"), so it needs to issue new bonds to finance
the deficits and to roll over the maturing debt (i.e., to issue
replacement bonds for the outstanding bonds that mature). Even as the
"old" bonds go out of existence, the "new" bonds issued by the Treasury
to replace them and to finance the deficits are auctioned to the
financial markets because they are no longer being absorbed by the Fed
in a quantitative easing process.
Since the Fed is no longer engaged in quantitative easing and is planning to "unwind" its portfolio, these new and
replacement bonds increase the supply of bonds to the financial
markets. Unless the demand for bonds is increasing at least as fast for
other reasons, the increasing supply will depress bond prices and raise
their yield rates. This may induce market rates to rise toward the
Federal Funds target rate that the Fed intends to increase, but the rising interest
rates may have a dampening effect on business and personal borrowing.
But this outcome is by no means certain. Given the fears and
uncertainties currently afflicting the world, the safety and increasing
yields of U.S. Treasury bonds make them attractive to foreigners, and
this may cause the global demand for U.S. Treasury bonds to increase. If
this demand were to increase even faster than the supply of new
Treasury bonds to replace maturing bonds held by the Fed and to finance
deficits, bond prices would increase, causing their yields to fall. This
would be consistent with the Fed's intention to induce market interest rates to
fall.
Foreigners (individuals, businesses, governments) may purchase some of
the new and replacement bonds issued by the Treasury. To pay for the
U.S. Treasury bonds that they purchase, foreigners would have to
increase their demands for dollars from the foreign exchange markets
relative to the supply of dollars. This would bid up foreign-currency
prices of the dollar, causing the dollar to become even stronger.
Is there any reason to think that either the supply of bonds or the
demand for dollars is increasing, or that interest rates may rise on
global markets? Carolyn Cui, Ian Talley, and Ben Eisen, writing in The Wall Street Journal, April 23, 2017, note that
Emerging-market companies are binging on U.S. dollar debt and that could
become a source of trouble in some parts of the world if growth slows,
interest rates rise or the dollar resumes its ascent. Governments and
companies in the developing world sold $179 billion in
dollar-denominated debt in the first quarter, the most dollar debt ever
raised in the first quarter and more than double the amount raised
during the same period last year, according to data provider Dealogic.
(https://www.wsj.com/articles/flood-of-dollar-debt-could-come-back-to-haunt-emerging-economies-1492945204)
When foreign governments and companies "sell" dollar-denominated debt,
they are actually issuing dollar-denominated bonds which are auctioned
in international financial markets with payment required in U.S.
dollars. Although these bonds are not issued by the U.S. Treasury, they
none-the-less increase the supply of dollar-denominated bonds coming
onto global bond markets. This also increases the demand for dollars
from the forex markets to pay for the bonds. If bond demand and dollar
supply do not increase commensurately, this phenomenon will depress bond
prices and increase their yield rates at the same time that the
foreign-currency prices of the dollar are rising. The rising yield rates
may be counter to the Fed's policy intent, and the appreciating dollar may
worsen the trade deficit.
Cui, Talley, and Eisen note repayment risk problems for emerging markets when the dollar appreciates:
Companies with dollar borrowings can be especially exposed. If the dollar rises, it makes the debt more expensive to pay off. Companies that don't earn dollar revenues, including some telecoms, property developers and retailers, can stumble. Repayment risk is especially high in countries with large external deficits and low levels of foreign-exchange reserves. If the dollar appreciates faster than expected, some corporate borrowers, especially those who derive their revenues largely in local currencies, could find themselves in a currency mismatch and be forced to ask the central bank for help--which not all central banks are positioned to do.
All of which is to note that the Fed's plans to wind down its $4+
trillion portfolio may have global repercussions far beyond the Fed's
balance sheet, and outcomes are unlikely to be quite as expected.
____________
Sean Williams, writing on the MSN website, August 8, 2026, notes that Federal Reserve Board Chair Kevin Warsh has introduced two non-traditional means of executing monetary policy.
One is that the Fed can raise interest rates without adjusting the Federal Funds target rate by removal of forward guidance from FOMC meeting statements. "With inflation running hot at the moment (a three-year high of 4.2% in May and 3.5% in June), bond traders have been pushing up yields at the long end of the Treasury yield curve. The 30-year Treasury yield reached a 19-year high, while the 10-year yield isn't too far from accomplishing the same feat" as hiking the federal funds rate by a quarter point (https://www.msn.com/en-us/money/economy/forget-rate-hikes-fed-chair-kevin-warsh-can-raise-interest-rates-using-2-nontraditional-methods/ar-AA29PsDM?ocid=msedgdhp&pc=DCTS&cvid=6a7b12af742e412fa91060c5ec19470e&ei=51). But this is a one-off policy move that can't be repeated.
Another way that the Fed can influence interest rates without adjusting the Federal Funds target rate is through "deleveraging" the Fed's balance sheet. As of Aug. 5, 2026, the Fed held $6.75 trillion in assets, primarily long-term Treasury bonds and mortgage-backed securities that were acquired by "quantitative easing" after the 2008 Great Recession. Selling trillions of dollars of U.S. Treasury bonds would push up long-term bond yields and market interest rates that are adjusted with respect to the long-term yield rates. That would make borrowing to finance investment and interest-sensitive consumer spending costlier as if the Federal Funds target rate had been hiked. This strategy can be repeated until the Fed's portfolio has been exhausted or deleveraged to an adequate level.
The deleveraging strategy can also be put into reverse as needed by purchasing more bonds. The three post-2008 quantitative easing bond purchases increased leverage of the Fed's portfolio by adding to commercial bank reserves that could support increased lending. The leveraging/deleveraging strategy may have unintended effects with respect to fiscal policy that normally is implemented by the Treasury Department.
___________
*On analogy, one can create a letter "m" on the computer screen by
pressing the "m" key on the computer keyboard. Where does the letter "m"
come from? It is simply "created" by the computer's logic. Where does
the money that the Fed adds to the deposit balance of a bond seller come
from? It is "created" by a bookkeeping entry. On analogy, a letter on
the computer's screen can be destroyed by pressing the back-space key on
the keyboard. Where does the letter go when it is destroyed? It simply
ceases to exist. Where does the money go when a buyer pays the Fed for a
bond? It too ceases to exist.
<>
In the wake of the Great Recession of 2008, governments in many countries have relied almost exclusively on central banks to foster recovery and stimulate growth. But it should be no surprise that the massive increases of money supplies (a.k.a. "quantitative easing") would be impounded in commercial bank excess reserves and business cash hoards. Nor should it have been surprising that driving interest rates toward zero would be an ineffective stimulant to investment in environments of uncertainty, anxiety, and pessimism. Jon Hilsenrath, writing in The Wall Street Journal, January 16, 2017, says that
The delayed recovery and slow growth is attributable to an aura of uncertainty, high tax rates on business income, excessive regulation of businesses, and government spending directed primarily to social net disbursements, all phenomena that low interest rates could not help. Growth enabling policies would have included tolerance and support of the business sector by the Administration, business tax rate reductions, elimination of the more onerous business regulation, and infrastructure spending.
Hilsenrath also points to the likelihood that the Federal Reserve, rather than acting proactively in changing interest rates, often follows the financial markets that have already perceived the need to change rates and have "priced in" expectations of future Fed rate changes:
The Federal Reserve, among other central banks, has taken upon itself a "dual mandate," i.e., to pursue both price stability and economic growth. A moral of the present story is that the "comparative advantage" of central banks lies not in stimulating economic growth, decreasing unemployment, or increasing incomes, but rather in providing an appropriate supply of money to avert both inflation and deflation.
Early in 2017, the U.S. economic growth rate was picking up, unemployment had fallen, and wages were increasing. The improving economic conditions were attributable to the fact that non-monetary policy actions were under contemplation.
Gross Domestic Product (GDP) is a measure of the aggregate output of an economy compiled at current market prices. The real growth of an economy can be measured by changes of such an aggregate from which the inflation component has been removed (by a statistical process called "deflation"). Inflation is a component of nominal GDP growth, but it is not a cause of real economic growth and it should not be regarded as a tool for promoting real growth. It can serve as a policy target only for some measure of aggregate output compiled at current market prices (i.e., from which inflation has not been removed). In this sense, then, an inflation target is irrelevant if the goal is a faster pace of real growth.
It's hard to avoid the business cycle language of contraction, recovery, and expansion when discussing unemployment rates. Unemployment usually increases as the pace of economic growth slows during a contraction, and it decreases once the economy begins to grow faster during the recovery following a contraction. The U.S. unemployment rate reached a high at nearly 10 percent of the labor force at the trough of the so-called "Great Recession" beginning in 2008. The economy had nearly seven years of fairly steady growth averaging around 2 percent per annum in the recovery following the Great Recession. Unemployment came down from nearly 10 percent of the labor force in 2009 to 5 percent at mid-2016, even as inflation remained below 2 percent per annum.
So why did inflation remain low as unemployment declined? One might think that the three Quantitative Easing phases implemented by the Federal Reserve in 2009-2014 should have increased the U.S. money supply by enough to cause substantial inflation, but the additions to the U.S. money supply have been absorbed in the excess reserves of banks and the increasing cash hoards of businesses. The business outlook remained sufficiently pessimistic that bankers saw few good lending possibilities and prospective borrowers declined to borrow.
Prior to 2020, neither the decreasing unemployment rate nor the increasing money supply caused the inflation rate to rise to the Fed's preferred target (around 2 percent per annum). But low inflation at near-full employment cannot be counted on to be a permanent feature of the U.S. economy. It would be a mistake to assume that the historic relationship between the money supply and the price level has broken down. And it is unlikely that the historic covariance relationship between the inflation rate and the unemployment rate no longer obtains. As noted by Ip, hints of accelerating inflation were being observed. Eventually the mass of liquidity "sloshing about" in the global economy could precipitate inflation well above the Fed's target rate as the the unemployment rate drops below 5 percent of the U.S. labor force and the real economic growth rate increases above 2 percent per annum.
The rates of employment and unemployment are concomitants of the rate of real economic growth in an economy, but they are neither causes nor consequences of inflation.
The misconception that a falling unemployment rate may cause inflation has been held at the highest policy-making levels. Kate Davidson, writing in The Wall Street Journal, November 2, 2016, says that
The potential for "a surge in prices" and "spurring inflation" lies not in decreasing unemployment, but it the massive increases of the money supply brought about by the three phases of Quantitative Easing by the Fed during 2009-2014.
At its July FOMC meeting, the recent inflation rate decrease led nine of the twelve FOMC members to vote to hold the benchmark short-term interest rate steady at a range of 3.5% to 3.75% rather than hike it by a quarter percent or more to dampen the inflation pressures.
The Bureau of Labor Statistics' July 2026 employment report indicated that 23,000 jobs were lost in July compared to an expected gain of 80,000. The June employment gain was adjusted downward from 57,000 to 20,000. But the July unemployment rate decreased from 4.2 percent to 4.1 percent because the labor force participation rate fell from 61.5 percent to 61.4 percent, its lowest in more than five years, as 264,000 people left the labor force (they no longer had jobs or were seeking jobs). A decreasing labor-force participation rate is an implicit increase of unemployment even as the measured unemployment rate decreased. The decreasing labor-force participation rate appeared to alleviate the inflation problem.
The Fed had been focused on the inflation side of its dual mandate. Increases of the Federal Funds target rate range were contemplated to induce market interest rates to rise and dampen investment and interest-sensitive consumer purchases. The Fed could shift its attention to the employment side by decreasing the target rate range in an effort to avert recession and stimulate growth and employment. That might please the President and the Treasury Secretary by decreasing the Treasury's interest expense. But it could also accelerate the rate of inflation by decreasing market interest rates that would stimulate investment spending and interest-sensitive purchases.
The Fed seems disposed to use only one of its monetary policy tools, the Federal Funds target rate range, to address both inflation and employment matters, but that could require changing the rate range in opposite directions. The Fed can't do both when confronted simultaneously by inflation and unemployment. The Fed might try using another of the tools at its disposal to address unemployment, e.g., quantitative easing/unwinding or repurchse/resale transactions, but these too might prove contradictory.
A possibility would be to leave employment problems to be addressed by fiscal policy that is implemented by the Treasury, but the Treasury may be constrained by refunding outstanding debt as it matures or by the need to issue more bonds to finance a deficit. There appear to be no viable solutions to the simultaneous occurrence of inflation and unemployment. Essay 20 explores fiscal implications of monetary policy, and Essay 21 treats montary implications of the Treasury's fiscal policy.
27. Modern Monetary Theory
Stephanie Kelton, a professor of economics and public policy at Stony Brook University, has become a leading proponent of a fringe idea known as Modern Monetary Theory, or MMT. She argues that the government should pay for programs requiring big spending, such as the Green New Deal, by simply printing more money.
Coy, Katia Dmitrieva, and Matthew Boesler, writing in Bloomsberg Business Week on Marcy 21, 2019, offer a beginner's guide to MMT that traces its thought lineage (https://www.bloomberg.com/news/features/2019-03-21/modern-monetary-theory-beginner-s-guide). The tenets of MMT include:
- The fundamental Keynesian premise: a monetary-based capitalist economy inevitably experiences departures from full employment and price stability; in the absence of effective self-correction, the macroeconomy needs to be managed by government authority to achieve and maintain stability.
- Money in the twenty-first century is almost exclusively fiat money issued by governments of nation states; it is no longer (if it ever was) a human innovation to avert quid pro quo problems associated with barter.
- A nation-state's government is the only supplier of fiat money that may be used in its economy; the principal means of issuing fiat money is government spending or the repurchase or redemption of the government's debt obligations.
- A tax obligation is necessary to assure the demand for fiat money which is declared by the state to be legal tender for paying tax obligations and satisfying all debt obligations, public or private; this means that a lender's only recourse for satisfaction of outstanding loans is acceptance of the fiat currency.
- A nation that prints its own currency may be unconcerned about debt accumulation because it can always print (or create by accounting means) more money to redeem the debt and pay interest on it; however, there may be inflationary consequences of issuing ever more money.
- Government can spend whatever it needs to spend to meet social needs (e.g., infrastructure, education, health care) or to alleviate unemployment up to the point that the rate of inflation becomes higher than desired by government authority.*
- A government program to guarantee employment may serve as an automatic stabilizer to provide employment to meet social needs; when private sector employment and incomes decrease during a recession, government employment and wage payment can increases to take up the slack; when private sector employment recovers, people can be expected to leave government employment for better-paying jobs in the private sector; government may create as much money as necessary to pay the government-employment wage bill.
- The only constraint on spending (public, private) is inflation which occurs when too much money enters into circulation; an increase of the rate of inflation signals that too much money is in circulation relative to available goods and services and the potential to provide more.
- Monetary policy centered on manipulating interest rates is largely impotent due to long, complex, and uncertain transmission mechanisms; monetary and fiscal authorities should be merged or required to work in concert to keep interest rates as low as possible, preferably zero.
- Fiscal policy (i.e., government spending, tax collection, debt issue, debt redemption) should be the principal means by which the macroeconomy is managed to diminish unemployment and avoid excessive inflation.
- The government fiscal authority taxes and issues debt (i.e., floats bonds), not to finance its expenditures, but rather to absorb excess money in circulation; government may increase the amount of money in circulation by increasing spending, reducing tax rates, and repurchasing or redeeming outstanding bonds.
Some Quibbles
MMT also seems to presume that the labor force is comprised of homogenous units of labor that have no occupational or place preferences and can be employed (assigned) to social needs when private sector employment falls. Also, if wage rates in a guaranteed government employment program are set too high, people may choose to remain in government employment rather than return to private employment when the economy recovers.
MMT devotes no apparent attention to the on-going process of technological disemployment (i.e., robotization). The proposed government guaranteed employment program has the potential to become a universal basic income program as workers are displaced by robotization.
MMT appears to ignore the possibility that businesses and households may thwart a fiscal authority's effort to stimulate a recessed economy by increasing the amount of money in circulation with bond purchases. If they impound and hold cash hordes rather than spend them, the additional money won't have the desired effect. Or, if businesses and households are holding little excess cash during an expansion, they may not be in the market to purchase bonds when the fiscal authority attempts to quell inflation by issuing new bonds to siphon purchasing power out of the economy. Or, they may have more profitable investment opportunities or more desirable spending opportunities than buying government bonds.
The Main Problem
The MMT advocacy of delivering management of a macroeconomy into the hands of a fiscal authority is laughable on its face. Twenty-first century partisan politics alone in the United States demonstrates Congressional gridlock and the inability of a democratically-elected legislative assembly to make timely fiscal changes that would be requisite to achieving and maintaining macroeconomic stability. But there are other serious problems for fiscal policy.
A fiscal authority that is empowered to adjust tax rates and approve or curb expenditures upon perceived need can create uncertainty in both the business and household sectors. Such uncertainty may disrupt domestic and international supply chains and adversely affect employment and production planning processes. It may foster a cottage industry that attempts to predict the timing and magnitude of such changes, and it may induce efforts to offset or counter expected fiscal changes. If expectations of future fiscal changes are accurate, they may contribute to a stabilization process by "pricing in" the expected changes, but if expectations are wrong, they are likely to disrupt production processes and aggravate macroeconomic instability.
Given our present state of macroeconomic knowledge, it is heroic to think that fiscal policy decision makers can accurately specify the magnitudes of needed tax rate adjustments or expenditure changes with any degree of accuracy, especially since the response to any such fiscal policy changes may have amplified effects via spending multiplier processes that are uncertain. If the fiscal policy decision maker implements a policy change that is too small to counter an undesirable macroeconomic condition, the condition will persist. If the fiscal policy decision maker implements a policy change that is too large, it is likely to aggravate the condition rather than ameliorate it.
Economists refer to the time between when a macroeconomic change occurs and when it is recognized by government officials as the recognition lag. They refer to the time between recognition of such a change and the taking of some action to offset it as the response lag. Needless to say, these lags are both variable in duration and themselves unpredictable. The response lag for monetary policy may be a matter of days or weeks, while that for fiscal policy may be months or quarters. In democratic polities, fiscal policy actions must be proposed, debated, and legislated, processes that may span years.
There is yet another lag that may eclipse the first two in duration. It is the so-called reaction lag, the period between when an action is taken and the effects of the action fully work through the economy. The reaction lag usually involves a multiplier process of consecutive rounds of respending. Experience in the U.S. economy suggests that the multiplier effect of a fiscal policy action may be completed in as little as a year, but it may not be fully worked out in more than two years. The duration of the reaction lag is therefore even less predictable than are the recognition and response lags. The three lags together may span a period of as little as a year, or as much as three or more years. These lags taken together put the government in the position of needing to implement a compensating policy even before some event shocks the economy.
Given these lags, another serious problem is that the natural adjustment mechanisms of the economy may have reversed the direction of change of the economy by the time that the policy designed to deal with the original problem finally has its effect. For example, in a contracting economy, an expansionary fiscal policy is called for. But by the time the contraction can be confirmed, expansionary policy implemented, and the multiplier process completed, the economy of its own volition likely will have begun its recovery. So the expansionary monetary policy impacts an already-expanding economy. A similar, but reversed, scenario can be depicted for an economy entering a period of expansion. Because of variable and unpredictable time lags in the implementation of macropolicy, government's well-intentioned efforts to stabilize the economy often end up destabilizing it--"booming the boom," or "depressing the depression."
Experience with these efforts has convinced some economists that deliberate policy activism often involves policy overreactions due to time lags in recognizing changing conditions, initiating policy actions, and the completion of adjustments. Today, some economists are not so sure that deliberate manipulation of the government's budget in efforts to diminish macroeconomic instability doesn't inject more instability into the economy than would be present if the government simply left the macroeconomy to manage itself.
And finally, there is an ultimate "deal-breaker" for fiscal policy as the vehicle for managing a macroeconomy. Domestic macroeconomic stabilization may not be the highest priority of the government, or at least not until the economy becomes seriously destabilized by excessive inflation or unemployment or both. Under more normal circumstances, particularly in democratic polities, the government's agenda may require it to become oriented mainly to program needs rather than economic stability. Program needs may include social, educational, military, and infrastructure projects.
An Authoritarian Advocacy
Given the difficulties of managing a mixed market (capitalist) macroeconomy with a democratic polity, the MMT prescription that macroeconomic stabilization should be implemented with fiscal policy would require a strong central fiscal authority that is imbued with sufficient knowledge and wisdom, and that is committed to the general welfare of its society, a veritable "philosopher king." Even a deliberative body along the lines of the Board of Governors of the Federal Reserve System may not be able to act expeditiously in response to macroeconomic change, much less to devise preemptive policy actions to head off predicted adverse changes. Ideally, the ability to vary tax rates, expenditures, and bond market activity in timely fashion to achieve and maintain macroeconomic stabilization would require the authority and power bordering that of a commissar or a fascist dictator. Modern Monetary Theory implicitly is a call for an authoritarian solution that may not be compatible with democratic polity or market economy.
___________
*On October 15, 2021, the Editorial Board of The Washington Post wrote:
In August, inflation appeared to decelerate. But the Bureau of Labor Statistics reported Wednesday that it picked up again in September — increasing 0.4 percent from the previous month and 5.4 percent from a year earlier — bringing fresh anxiety about how long Americans would have to struggle with rapidly rising prices. This comes on top of months of growing or steady inflation before August. (https://www.washingtonpost.com/opinions/2021/10/15/inflation-is-rising-democrats-must-avoid-making-it-worse/?utm_campaign=wp_todays_headlines&utm_large=email&utm_source=newsletter&wpisrc=nl_headlines&carta-url=https%3A%2F%2Fs2.washingtonpost.com%2Fcar-ln-tr%2F34ff384%2F616aa2e29d2fda9d41124dba%2F596c29ff9bbc0f208654282b%2F42%2F67%2F616aa2e29d2fda9d41124dba)
In the wake of the U.K. Brexit vote in June of 2016, the U.S. dollar appreciated for a short time relative to the U.K. pound (i.e., the pound depreciated with respect to the dollar) but the pound recovered in a few weeks. Since the beginning of 2016, the U.S. dollar has depreciated a net of 13.7 percent against the U.K. pound. This dollar depreciation benefits U.S. domestic producers of goods for export to U.K. by making U.S. goods appear less expensive to British buyers, but at the same time it curbs U.S. imports from U.K. by making British goods appear more costly to Americans.
Because of uncertainty surrounding the Brexit vote, the depreciation of the dollar relative to the pound may be a special case. Between early January and mid-July of 2016, the U.S. dollar appreciated 6.1 percent against the Canadian dollar, 2.5 percent against the euro, 15.2 percent against the Japanese yen, 5.4 percent against the Australian dollar, and 5.2 percent against the New Zealand dollar. The U.S. dollar appreciation manifests itself as depreciations of those currencies vis-a-vis the U.S. dollar. These currency depreciations should be expected to stimulate exports to the U.S. and thus improve their trade balances and rates of economic growth.
But in recent weeks, these currencies have appreciated against the U.S. dollar in spite of their respective central banks' efforts to implement looser monetary policies in hopes of precipitating depreciation of their currencies. Other things remaining the same, if a looser monetary policy increases a country's money supply, the increased amount of money in circulation would be expected to increase the demand for foreign currencies relative to their supplies on foreign exchange markets, bidding up their prices in terms of their respective domestic currencies, i.e., causing their domestic currencies to depreciate. Since this has not been happening recently, we may infer that "other things" have not remained the same. One possibility is that the supplies of foreign exchange have increased at a faster rate than has the demand for foreign exchange.
Another possibility for explaining the failure of a looser monetary policy to precipitate currency depreciation has been demonstrated recently in the U.S. economy by the Federal Reserve. In an effort to stimulate faster economic growth, the Fed has been implementing a looser monetary policy by lowering the discount rate toward zero and engaging in "quantitative easing" (a.k.a. open market purchases of government bonds). This policy effort has had little impact on the amount of money in circulation because commercial banks have been reluctant to borrow reserves and they have been impounding additional liquidity as excess reserves with little increase of lending to prospective commercial or industrial borrowers. An old adage is that one can lead a horse to water, but cannot force it to drink. On analogy, a central bank can provide additional reserves to commercial banks, but it can't force commercial bankers to lend, and it can't force prospective borrowers to borrow.
In spite of a looser monetary policy, instead of depreciating, the U.S. dollar has appreciated against many of its trading partner currencies since the first of 2016. This episode of dollar appreciation may be attributable to something else that did not remain the same, i.e., increasing uncertainty in global markets that stimulates foreign demand for U.S. dollars to buy relatively safe U.S. government bonds. The increasing foreign demand for U.S. dollars has overwhelmed any effects of a looser monetary policy that might have precipitated dollar depreciation. The dollar appreciation of course has dampened exports and prevented improvement of the U.S. trade balance.
These considerations suggest not only that monetary policy may be ineffective in a general sense, but that it may be a mistake for a central bank to attempt to manipulate monetary policy in pursuit of exchange rate goals. If the exchange rate goal (e.g., depreciation of the domestic currency) does not align with domestic macroeconomic needs (e.g., inflation aversion), then giving primacy to the exchange rate goal renders monetary policy unavailable for addressing the macroeconomic need. Occasionally, exchange rate and domestic macroeconomic needs may align, as for example when the domestic economy needs stimulus to grow faster and the alleviation of a trade deficit would benefit from depreciation of the domestic currency relative to foreign currencies. Otherwise, monetary policy should be addressed toward domestic macroeconomic needs, leaving the exchange rate to change in regard to foreign exchange market conditions.
Kevin Warsh, a distinguished visiting fellow in economics at Stanford University's Hoover Institution, writing in The Wall Street Journal, August 24, 2016, says:
James Mackintosh, writing in The Wall Street Journal on August 23, 2016, clearly reveals the implicit expectation on the parts of stock market investors and traders that central bankers will direct monetary policy to their benefit, at least when "disaster strikes":
(http://greenvillenewssc.sc.newsmemory.com/?token=8d29e797bd2b94d8c5a652a605b4b95e&cnum=2433627&fod=1111111STD&selDate=20160910&licenseType=none&)
Parallel to the concern that a central bank might implement its monetary policy to manipulate or moderate changes in exchange rates, when a central bank uses its monetary policy tools to serve the interests of stock markets, these tools are unavailable to pursue domestic macroeconomic needs unless these needs happen to align with the interests of stock market investors and traders.
Kevin Warsh, a former member of the Federal Reserve board, writes in The Wall Street Journal, August 24, 2016:
(http://www.wsj.com/articles/the-federal-reserve-needs-new-thinking-1472076212)
The original and fundamental remit of any central bank is to pursue price stability and promote general macroeconomic well-being and growth. To the extent that a central bank places its policy primacy on stock market conditions, it's another case of the tail wagging the dog, i.e., the interests of the stock market are served even if the larger macroeconomic needs of the global economy are ignored. Rather than being the objects of monetary policy, both the stock and exchange markets should be left to react to monetary policy actions which are taken to address income, employment, and price level issues.
Intelligent, knowledgeable, and rational economic decision makers have the ability to thwart policy intentions of government officials, including those at the Federal Reserve.
In order to make rational decisions, the manager of a microeconomic decision unit (a business firm or a household) must be able to predict not only what is likely to happen in the economy, but also what government officials are likely to try to do about any economic problem that emerges. The first predictive problem is difficult enough; the second adds a further dimension of uncertainty. The second dimension might not be so serious except that the actions of monetary and fiscal authorities often are not very predictable. And there are good reasons for their lack of predictability, i.e., their propensity to implement policy surprises.
Two economic theories shed light on the lack of predictability of public policy makers. In the first, the so-called "adaptive expectations hypothesis," intelligent decision makers are presumed to learn from historical experience which they then extrapolate to expectations of future states. For example, suppose that the economy is at its normal operating capacity that is growing at a steady rate enabled by population growth, technological advance, and net positive capital investment. Perhaps at the behest of politicians, the Fed decides to try to increase the real output of the economy above the normal operating capacity or to increase the economy's growth rate by decreasing interest rates or by increasing the money supply or the rate at which it is increasing. It implements the expansionary monetary policy as a surprise, i.e., without making any public announcement.
This unexpected (surprise) action stimulates liquidity-sensitive purchases and increases demand for the output of the economy. The demand stimulus may induce an increase of output above the normal operating capacity, but it also sets in motion a process of "demand-pull" inflation. It doesn't take long for consumers to realize that prices are higher today than they were yesterday, and they were higher yesterday than the day before. It therefore appears reasonable to expect prices to be higher tomorrow than today, and even higher the day after tomorrow. Thus, it would be wise to go ahead and make anticipated purchases today rather than wait for the higher future prices, even if the items are not needed until a future date.
The current purchases add to today's demand for those items and virtually insure rising prices tomorrow. But when decision makers are surprised by the realization that prices are higher than they had counted on when they made their employment and output decisions, they may adjust their employment and output plans to lower levels so that output falls back toward the normal operating capacity of the economy. This results in further inflation, but of the "cost-push" variety, until the economy adjusts back to its normal operating capacity.
The second theory is the "rational expectations hypothesis." In this theory, knowledgeable decision makers are presumed to reason and analyze as well as extrapolate. Decision makers have the presence of mind to take into account what government policy makers might do in regard to any emerging situation or to the intent of politicians, and thus to modify their behavior in response both to the situation and what the policy makers might do in response to it.
Again, suppose that the economy is near its normal operating capacity. Instead of surprising the economy with a demand stimulus, the Federal Reserve makes public announcement that it is implementing an expansionary monetary policy (e.g., to decrease its discount rate) with the intention of increasing the output of the economy or causing it to grow faster. Rational decision makers deduce that an inflationary process may ensue, but they will be skeptical that the policy can sustain output above the normal operating capacity or growth rate for long. Thus, when they make their employment and production decisions for future months, they adjust their list prices and wage increases in anticipation of the ensuing inflation without ever increasing real output. The real output of the economy or its growth rate does not change, even temporarily, when a Fed policy is publicly announced or correctly predicted. It is only when a Fed policy action surprises the economy or is not predictable that real output changes, however temporarily.
To the extent that the rational expectations theory is correct in its premise that rational decision makers analyze as well as extrapolate, then it is only by surprising the economy, or behaving unpredictably, that Fed policy changes can have any real impact on the economy, and then only temporarily. And it is for this reason that government officials tend to take unexpected policy actions and thereby interject an additional degree of instability into their economies.
The 2011 Nobel Prize in Economics was awarded to economists Thomas Sargent and Christopher Sims for their work during the 1970s and '80s in analyzing and modeling rational responses of society to macroeconomic changes, particularly interest rates.
The stability of a macroeconomy depends critically upon the expectations of decision makers concerning future macroeconomic conditions and political decisions. The economy can remain stable only as long as decision makers' expectations match actual conditions fairly closely, i.e., when there are no surprises. Real output may rise temporarily above the normal operating capacity of an economy when the actual rate of price inflation exceeds the price expectations of decision makers, i.e., when decision makers are surprised by the price inflation. Real output may fall below the normal operating capacity of an economy when the actual rate of inflation is below decision makers' price expectations, i.e., when they are surprised by less inflation than expected. This may occur when there is a decrease of the output of the economy below the normal operating capacity.
A more general conclusion is that any ensuing period of expansion or contraction must be attributable to something unexpected that results in wrong guesses by decision makers about future conditions. Politicians count on such wrong guesses.
The Federal Open Market Committee often agonizes over whether and when to raise or lower its Federal Funds rate by changing the interest rate that the Fed pays to commercial banks on their excess reserves. The Federal Funds rate is the interest rate that commercial banks charge each other to borrow their excess reserves overnight. Kate Davidson, writing in The Wall Street Journal, October 13, 2016, says,
(http://www.wsj.com/articles/wsj-survey-economists-expect-next-fed-rate-increase-in-december-1476367202)
The Fed can of course change its own interest rate (an administered price), but how does that feed through the economy to changes of market-determined interest rates? The Federal Reserve cannot simply dictate changes of market-determined interest rates (e.g., yield rates on bonds) by announcing a change of the rate of interest paid on commercial banks' excess reserves. In some instances the Fed may appear to have dictated market interest rate changes if lenders were ready for a rate change and expected one but had been delaying their own lending rate changes while waiting for the official announcement of a rate change.
When the excess reserves rate is changed with intent to cause the Federal Funds rate to change, the Fed has to work behind the scenes by executing open market operations to change the demand for or supply of bonds in the market, thereby causing bond prices to change and nudging yield rates toward the new Federal Funds target rate. Interest rate changes become transmitted through the financial markets via interest rate arbitrage (i.e., the simultaneous purchase and sale of bonds to take advantage of bond price differentials, and thus their corresponding yield rate differentials).
For example, if the Fed engineers a Federal Funds rate increase, in the absence of other sources of bond supply it needs to sell bonds in the open market, adding to the supply of bonds relative to bond demand, pushing bond prices downward and yield rates upward toward the new higher Federal Funds rate. If there are no other sources of increasing bond supply, the trick is to sell just enough bonds to induce bond yield rates to rise toward the new higher Federal Funds rate without under- or over-shooting.
In an open-economy world there are other sources of bond supply as foreigners offer bonds for sale in U.S. financial markets. With an influx of foreign bonds, the Fed may not need to sell as many bonds as it would if the U.S. were a closed economy. If an influx of foreign bonds is so great that bond prices fall far enough to cause yield rates to rise above the increased Federal Funds rate, the Fed may end up having to buy bonds to bring yield rates down to the new Federal Funds rate. An example of other sources of bond supply is noted by Carolyn Cui, Ahmed Al Omran, and Christopher Whittall, writing in The Wall Street Journal, October 19, 2016:
(http://www.wsj.com/articles/saudi-arabia-to-offer-international-investors-17-5-billion-in-bonds-1476876478?mod=djem10point)
The Fed is empowered to purchase or sell U.S. Treasury securities directly
from and to commercial banks or security dealers holding deposits in commercial
banks in the U.S. in order to make lasting changes to the volume of reserves
in the U.S. commercial banking system. The Fed bought U.S. Treasury
securities outright, mostly through securities dealers, in the
three big episodes of "quantitative easing" between 2009 and 2014.
Other major central banks likewise engage in open market operations if
their financial markets are deep enough, and they too may try to lower market-determined interest rates in order to stimulate faster
economic growth. To do so they buy bonds issued by their own and other
governments, thereby increasing the demand for bonds relative to supply in
order to push bond prices up and their corresponding yield rates down. Todd Buell and Paul Hannon, writing in The Wall Street Journal, October 16, 2016, indicate the intent of the European Central Bank:
The implementation of monetary policy becomes more complicated when central banks pursue policies that cause bond prices to diverge between domestic and foreign financial markets. When foreign central banks implement policies that cause bond prices to rise (and their corresponding yield rates to fall) in their national financial markets while the Fed is implementing a policy to cause bond prices to fall (and their corresponding yield rates to rise) in the U.S. financial markets, foreign investors have incentive to buy bonds in the U.S. financial markets at lower prices to get higher returns, and U.S. bond issuers have incentive to sell bonds at higher prices in foreign financial markets to collect larger sale proceeds and pay lower interest rates. Both actions will tend to cause bond prices and corresponding yield rates to reverse direction in their respective financial markets and converge internationally, possibly thwarting the intentions of their respective central banks.
It should be noted that central banks usually engage in open market operations only in their own national financial markets; buying or selling bonds in foreign financial markets will affect the reserves of banks in those markets but will not affect the reserves of banks in their own national markets. Yet, some of those other central banks have found that they are running out of government-issued bonds to buy in local financial markets, so they are beginning to buy corporate securities. Nina Trentman, writing in The Wall Street Journal, September 26, 2016, says that
The European Central Bank has been gobbling
up corporate and government bonds for months and plans to buy assets valued
at €80 billion, or about $90 billion, a month until March 2017. Between
June 8 and last Friday, it bought €27.9 billion of corporate debt. The Bank
of England, trying to prevent a slowdown in the wake of the U.K.'s vote
to leave the European Union, is set to start its program Tuesday, and aims
to buy £10 billion ($13 billion) in company debt over the next 18 months.
(http://www.wsj.com/articles/corporate-bond-buying-attracts-doubts-as-growth-tool-for-europe-1474930008)
A commercial bank suffering a deficiency of reserves relative to the legal requirement has a number of options to address the deficiency. If time permits, it may simply wait while issuing no new loans and hope that outstanding loan attrition occurs, i.e., that enough of its outstanding loans are paid down or paid off by borrowers so that its reserves meet the legal requirement. If time does not allow the loan attrition possibility, it may:
- borrow reserves at the Fed's "discount window," receiving an amount less than the face value of the loan (the discount) but repaying the face value of the loan;
- borrow so-called "Federal Funds" from other commercial banks that have excess reserves to lend;
- sell some of the securities that it owns on the open market;
- sell some of the securities that it owns to security dealers who can offer interest rate bids to borrow funds from the Fed by implicitly selling securities to the Fed to be repurchased the next day.
(https://apps.newyorkfed.org/markets/autorates/fed%20funds)
Open market operations may be implemented by the Fed in the process of "unwinding" its huge portfolio acquired in three episodes of "quantitative easing" between 2008 and 2014. The Federal Reserve Bank of New York (FRBNY) website currently identifies the only other open market operations as repurchase and reverse repurchase operations. In a repo auction, security dealers bid on borrowing money from the Fed, offering U.S. Treasury securities as collateral. They implicitly "sell" the securities to the Fed on the day of agreement, and then repurchase them the next day. In a reverse repo auction, dealers offer interest rates at which they would lend money to the Fed. They implicitly "buy" securities from the Fed on the day of agreement, and the Fed repurchases them the next day. Repurchase agreements are made at the initiative of the trading desk at FRBNY which implements monetary policy at the behest of the Federal Open Market Committee (FOMC). The prices and yield rates of bonds are not affected by repo and reverse repo transactions because they are temporary and settled the next day.
Security dealers' deposits with commercial banks vary with the needs of commercial banks to increase or decrease their reserves. A commercial bank finding itself temporarily deficient of required reserves can sell U.S. Treasury securities in its portfolio to a securities dealer. The process of clearing the transaction adds to the bank's reserves as the securities dealer pays for the securities. A commercial bank with excess reserves (which are not supporting lending that would earn interest income) may buy U.S. Treasury securities from a securities dealer to earn interest while the securities are held in its inventory. The purchase of securities reduces the bank's reserves as the bank pays the dealer for the securities. In turn, securities dealers with more or less securities in their portfolios than they wish to hold may participate in the FRBNY's repo or reverse repo auctions.
Security dealers may choose whether to participate in a FRBNY auction. If no or few dealers choose to participate in a repo auction by the FRBNY to temporarily borrow funds from the Fed, the implication is that the dealers either do not need to borrow funds, or they think that the rate offered by the Fed is too high to pay to borrow funds. In a reverse repo offering, if the FRBNY chooses not to accept any of the interest rates offered by the securities dealers to lend money to the Fed, the implication is that the rates offered by the securities dealers are too high.
Since reverse repo transactions are loans by security dealers to the Fed for settlement the next day, they temporarily drain reserves from the commercial banking system, reducing its potential to issue loans to banking customers during the day. The self-reversing nature of these overnight reverse repo transactions return the loaned funds to the securities dealers the next day with interest, and in the process add reserves back to the banking system. The only difference in system reserves before and after a reverse repo transaction is the amount of interest income received by the dealers which is added to the dealers' deposits in commercial banks.
The typical term of repo operations is overnight, but the FRBNY can conduct these operations with terms out to 65 business days. Since repo and reverse repo transactions are short-term and self-reversing, they have no significant lasting effect on the total of reserves in the banking system except for the interest income that is added to dealers' deposits at commercial banks. The prices and yield rates of bonds are not affected by repo and reverse repo transactions because they are temporary and settled the next day.
Chart 11 shows the Fed's overnight repo and reverse repurchase agreements between 2019 and 2024. In the upper panel of Chart 11, the Fed began accepting repo agreements to lend money to security dealers in late 2019 during the Covid-19 pandemic by temporarily (overnight) purchasing securities from them in modest amounts up to $100 billion per day. The securities were repurchased by the dealers the next day per the repo agreements. The repo agreements had the effect of temporarily supplying reserves to the banking system. The Fed ceased accepting repo agreements by mid-2020 as recovery from the pandemic ensued.
The Fed's ostensible intent in using repo operations may be to affect the size of the Federal Reserve's portfolio of securities, but another important result is to nudge the effective Federal Funds interest rate and market-determined interest rates toward the Fed's main policy tool, the interest rate that it pays to commercial banks on their reserve balances.
Chart 12 shows the Fed's interest rates from mid-2015 to early 2024. The top panel of Chart 12 shows that the Fed gradually increased its interest rate paid on reserve balances to early-2019 when it began to decrease it to zero in early-2020 during the Covid-19 pandemic. The Fed began increasing the interest rate on reserve balances in mid-2020 as the economy began recovery from the pandemic and the rate of inflation increased. The Fed plateaued this interest rate by late-2023 when it appeared that inflation was abating. The rate on reserve balances is an administered interest rate.
The bottom panel of Chart 12 confirms that the effective Federal Funds rate adjusted to the interest rate on reserve balances and the rate on accepted overnight reverse repurchase agreements as these were changed by the Fed. The effective Federal Funds rate is a market-determined interest rate.
If the Fed recently has lowered the interest rate that it pays to commercial banks on their excess reserves and the effective Federal Funds rate still is above it, the FRBNY may decrease the repo bid rates that it accepts from security dealers to borrow money from the Fed. Or, if the Fed has recently raised the interest rate that it pays to commercial banks on their excess reserves and the effective Federal Funds rate still is below it, the FRBNY may increase the repo bid rates that it accepts from security dealers to lend money to the Fed. The acceptance of dealer bid rates may nudge the effective Federal Funds rate and market interest rates toward the excess reserves interest rate.
The FRBNY relies on overnight self-reversing repo transactions that only temporarily change commercial bank reserve balances but make no lasting impacts on bank reserves. But the repo and reverse repo auctions serve as the instruments for nudging the effective Federal Funds rate to settle on the excess reserves interest rate set by the Fed and to align market-determined interest rates with the effective Federal Funds rate.
__________
By mid-2026 the Japanese yen had been depreciating for several months. Matt Peterson, writing for CNBC on the MSN website, August 3, 2026, described Treasury Secretary Scott Bessent's request for Japan to use a Fed borrowing facility called the Foreign and International Monetary Authorities, or FIMA, Repo Facility. The FIMA facility allows a foreign central bank to lend (implicitly, "sell") some of its holdings of U.S. Treasury bonds and repurchase them the next day. It then can use the proceeds to support its own currency by buying it on the FX market. Temporarily selling and repurchasing the Treasury bonds avoids falling Treasury prices and rising Treasury yields. The FIMA repo facility has a limit of $60 billion a day for each foreign central bank.
Japan held approximately $1.1 trillion of U.S. Treasury bonds as of May 2026. Yen depreciation was occurring as the yen price of the dollar increased from 157 toward 160 per dollar. Bessent's FIMA intervention to prevent further yen depreciation was in the neighborhood of $60 billion. Compared to outright sales and repurchases of bonds on bond markets, the wider use of the FIMA repo facility might lessen the volatility of Treasury bond prices and yield rates. The use of the FIMA facility for currency interventions may have broad political and economic appeal. It isn't within the Fed's remit, so use of it by the Treasury requires Fed acquiescence. (https://www.msn.com/en-us/money/economy/analysis-federal-reserve-may-be-pulled-into-bessent-s-effort-to-support-japan-s-yen/ar-AA29kuHX?ocid=msedgntp&pc=DCTS&cvid=6a708df7f29b41cea281e813f50d9ad7&cvpid=0d9e21c71fef478487b7a0ae357b7bdc&ei=24).
The Editorial Board of The Guardian has characterized Bessent's FIMA yen transaction less as a rescue of the yen than as an attempt to enable a cash flow that benefits the U.S. Treasury. The FIMA facility has enabled Japan’s weak currency to become a global funding utility that avoids bond market price and yield rate volatility (https://www.theguardian.com/commentisfree/2026/aug/12/the-guardian-view-on-japans-yen-trump-wants-to-keep-the-easy-money-machine-running).
In the yen "carry trade," bankers temporarily "borrow" yen from the U.S. Treasury in FIMA transactions, sell them for dollars, use the dollar proceeds to buy higher-yielding U.S. assets, and then sell the assets for dollars to enable repurchasing enough yen to settle their Treasury accounts. Carry trade transactions are profitable when the dollar asset sale proceeds exceed the amounts necessary to settle the Treasury yen accounts. The addition of profits to deposits in U.S. commercial banks increases the U.S. money supply that can stimulate growth or cause inflation if the economy is near full employment.
The commercial and financial press
seems to be in thrall of the Federal Reserve. But a view from
"outside the Beltway" and away from Wall Street is that the Fed's
interventions in "trying to help the recovery along" after the 2008 "Great Recession" did little
more than "ride herd" on an economy that had been moseying along at its
own pace. It appears that the Fed's policy inventions (massive monetary
expansions, lowering the rate that it pays to commercial banks on their excess reserves and the Federal Funds rate toward zero, verbal guidance in its public pronouncements) accomplished very little in stimulating faster economic growth or causing inflation to rise to the Fed's own announced target of 2 percent per annum.
Rather than the Fed "owning the recovery," the slow growth of the
economy and the flat inflation rate were owned by the Obama
administration due to its ever more strident regulation and general
unfriendliness toward the business sector. The massive increases of the
money supply brought about by three episodes of "quantitative easing"
between 2008 and 2014 were for the most part locked up in business cash
hoards and excess reserves of commercial banks. Businesses were reticent
about investing and banks were reluctant to issue new loans because of
fear of failure and loss, and a general aura of pessimism about economic
prospects.
The economy finally began to grow at a slightly faster pace due to
an emerging perception of business optimism, and the inflation rate began to gradually creep upward toward the Fed's 2 percent target rate.
As the aura of pessimism evaporated, businesses became more willing to spend their cash hoards on capital investments. And businesses were beginning to submit more viable loan applications to bankers who were becoming more willing
to use their excess reserves to support increased lending.
There appears to be no way to ascertain definitively whether
it was the actions of the Federal Reserve or those of the Obama administration that had the greatest influence over the U.S. economy after 2008. Fed officials remained unchallenged in their belief that it was their actions that
facilitated the slow growth that brought the U.S. economy to near-full
employment by early 2017. The Obama administration, which was accorded credit for averting an even worse economic calamity, escaped the appearance of responsibility for the economy's sluggish growth.
The Fed's discount rate was 2.25% in February, 2020. In March 2020, in order to stimulate growth in the economy the Fed lowered the discount rate to 0.25% where it has remained through 2021 (https://fred.stlouisfed.org/series/INTDSRUSM193N). After lowering the discount rate, the Fed purchased bonds to bid their prices up and their yields rates down. Market interest rates represented by long-term (10-year) bond yields were 1.76% in January, 2020. They dropped to 0.62% in July 2020 but rebounded to 1.58% by October 2021 (https://fred.stlouisfed.org/series/IRLTLT01USM156N). The Fed's bond purchases achieved only temporary success in bringing market rates down toward its lowered discount rate, but the bond purchases had the side effect of further increasing the supply of money in circulation which contributed to the inflationary pressures.
But for a long time economists assumed that those Depression-era conditions would never come back, that the Fed could always engineer an economic recovery when it wanted to. As it turns out, however, interest rates can indeed hit the “zero lower bound” in the 21st century; in fact, that has been the norm since 2007. This in turn means that while everyone is talking about inflation risks right now, the Fed is also concerned about the risks of overreacting to inflation. If it raises interest rates and that pushes the economy into a recession, it might not be able to cut rates enough to get us out again. (https://www.nytimes.com/2021/11/23/opinion/fed-powell-unemployment.html?campaign_id=39&emc=edit_ty_20211124&instance_id=46167&nl=opinion-today®i_id=74240569&segment_id=75218&te=1&user_id=86b0d837dd357b2a6e0e749321f6ed7f)
Another decline in the unemployment rate in November [2021] keeps the Federal Reserve on track to quicken the wind-down of its stimulus programs at its meeting later this month, paving the way to raise interest rates in the first half of next year to curb inflation. The Fed closed a chapter on its aggressive pandemic policy response when it approved plans at its meeting last month to shrink, or taper, its $120 billion monthly asset-purchase program by $15 billion in each of November and December. At that pace, the asset purchases would end next June. The Fed wants to end the asset purchases before it lifts interest rates, which it held near zero. (https://www.wsj.com/articles/fed-jobs-report-wages-unemployment-interest-rates-11638541375)
***Glenn Hubbard, writing in The New York Times on December 13, 2021, says
This time last year [2020], few forecasters predicted inflation of almost 7
percent. Yet when consumers want to buy more than the economy is
producing — the macroeconomic story of the year — it
is a classic harbinger of rising prices. The Covid pandemic delivered
supply shocks in the form of disrupted workforces and supply chains.
This, in turn, exerted upward pressure on prices. Very low interest
rates and generous government Covid relief programs, designed to cushion
a fall in demand in response to the pandemic, added to demand and price
pressures.
. . . .
Policymakers injected three rounds of fiscal stimulus into the pandemic-afflicted economy. The most recent round sat atop stored-up household savings of at least $2 trillion, according to recent estimates. Those savings were accrued from earlier rounds of stimulus, as well as an improving labor market.
. . . .
As supply chains normalize, inflation will almost surely moderate. But
by this time next year, inflation as measured by the Consumer Price
Index, the weighted average of a basket of goods commonly purchased by
households, could still be as high as 4.5 percent; the core inflation
the Fed emphasizes, which excludes food and energy prices, could be 3
percent.
(https://www.nytimes.com/2021/12/13/opinion/inflation-biden-powell-economy-federal-reserve.html?campaign_id=39&emc=edit_ty_20211214&instance_id=47750&nl=opinion-today®i_id=74240569&segment_id=76924&te=1&user_id=86b0d837dd357b2a6e0e749321f6ed7f
Steven Rattner, writing in The New York Times on April 14, 2022, says that
The debate over whether the recent surge in inflation is
transitory or permanent has been settled. Now the question is whether the
Federal Reserve can tame increasing inflationary turbulence and bring
the economy to a soft touchdown.
Mounting evidence suggests a hard landing — in other words, a
recession. We need our economic policymakers to move quickly before the likely
damage, already in progress, escalates.
35. Treasury Interest Rates and Foreign Exchange Markets
In January 2022, yields on 10-year Treasury notes were less than 1.8 percent. Peter Coy, writing in the January 12, 2022, issue of The New York Times, asks why interest rates on Treasury securities are so low, given the huge and persistent deficits the government is running.
Interest rates for 10-year Treasury notes may have been so low due to the fact that the global demand for U.S. Treasury bonds is greater than that in the U.S. market alone. If the global demand for Treasury notes were increasing faster than the global supply, the prices of U.S. Treasury notes would rise and cause their yield rates to fall below what might be expected in the U.S. market alone. If nothing else affected the foreign exchange (FX) markets, an increasing foreign demand for dollars to buy U.S. bonds would precipitate dollar depreciation relative to other currencies and serve as evidence that the global demand for Treasury notes is increasing faster than the global supply.
Dollars are supplied to the FX markets for reasons other than bond transactions. The dollar had been gradually depreciating with respect to the euro and other currencies since late-May, 2021, and the U.S. trade balance worsened over the same period (https://tradingeconomics.com/united-states/balance-of-trade). The increasing demand for imported goods in the run up to the end-of-year holiday season eclipsed their supplies due to chokes in the import supply chain at U.S. ports of entry. The American increase of the supply of dollars to the FX markets for imported goods overpowered any foreign increase of the demand for U.S. Treasury securities relative to the supply of them.
The global demand for U.S. Treasury notes provided "fiscal space" beyond the U.S. bond market for the U.S. government to borrow to finance deficit spending because the pandemic caused people to spend less, leaving abundant savings for the bond market. In the longer term, increasing inequality would increase saving rates because rich people save more than poor people, thus allowing the government to borrow more without satiating lenders.
Coy quotes Atif Mian of Princeton, a proponent of Modern Monetary Theory, "the federal government of the United States never has to worry about paying what it owes because it can always print more money." Mian goes on to say that
The only concern of adherents of the theory is that too much government spending (or too little taxation) could overheat the economy, causing inflation. ... to retain the faith of investors that increasing debt is sustainable, the government might have to cut spending or raise taxes. The scary though relatively unlikely scenario, Mian said, is that a dysfunctional government in the future would fail to do those things.
It may be less unlikely than Mian imagined that government could become dysfunctional and fail to cut spending or raise taxes when needed, thereby contributing to a faster rate of inflation.
Other factors contributing to iniflation in 2021-2022 were the overhang of excess money in circulation from the post-2008 purchases of U.S. Treasury notes by the Federal Reserve and the 2020 and 2021 pandemic recovery disbursements to households under the Biden and first Trump administrations.
The Federal Reserve enables the creation of new money when it buys "old" (previously-issued) bonds. The clearing process adds to commercial bank reserves and thus enables banks to increase the amount of money in circulation through the lending process.
But deficit spending requires the sale of newly-issued bonds. Both selling and buying bonds can't create money.
In the United States, Congress is not empowered to create money. It can authorize spending only funds that are collected in taxes or are borrowed by issuing bonds. Deficit spending by Congress doesn't create new money; it simply shifts money currently in circulation from the bank accounts of bond buyers to that of the government. Deficit spending is accomplished when newly-issued bonds are purchased which in the clearing process reduces the bond buyers' bank account balances and the reserves of their commercial banks. The clearing process takes previously-issued money temporarily out of circulation until the government puts it back into circulation by spending it.
No new money is created by deficit spending unless there emerges an imbalance between the amount of money taken out of circulation when new bonds are sold and the amount of money reinjected into circulation by government spending. The clearing process simply shifts old money from bond sellers bank accounts (and their banks' reserves) to that of the government. Assuming that all of the bond-sale proceeds are spent by the government, the money goes back into circulation and commercial bank reserves are restored to their state ex ante the bond-issuance process. Since the amount of money in circulation is unchanged by deficit spending, the deficit spending process per se is unlikely to contribute to inflationary pressure.
This conclusion follows only in a "closed economy,” i.e., only if Congress, the Treasury, the bond buyers and sellers, the commercial banks, and bank borrowers all are in the same country and there are no external market participants. But there may be complicating factors.
If bonds that are newly-issued by deficit spending are purchased by foreigners, money balances previously held abroad may add to the domestic money supply and thus may stimulate spending and contribute to inflation in the domestic economy. The process may contribute to deflation in foreign economies from which money is shifted when the newly-issued bonds are purchased by foreigners.
Whether the issuance of new bonds will have domestic inflationary or deflationary effects depends on the response by the central bank. If inflation has been an on-going process, it may suit the central bank to let the issuance of new bonds cause interest rates to rise in expectation that the higher interest rates may dampen economic activity and slow inflation. The risk is that the rising interest rates may dampen economic activity so sharply as to precipitate a recession.
Domestic and foreign purchases of bonds may cause bond demand to increase faster than bond supply is increasing to finance a deficit. This would cause domestic bond prices to rise and put downward pressure on interest rates. This might stimulate the economy and put upward pressure on prices.
Financing a deficit by issuing bonds may increase the domestic supply of bonds relative to domestic bond demand. This may cause bond prices to fall and their yield rates to rise. Increasing yield rates are likely to be transmitted to the structure of interest rates by the process of arbitrage and thereby to dampen economic activity.
If the central bank wants to avert interest rate increases as new bonds are sold, it may purchase old bonds to offset the downward trend of bond prices and upward pressure on interest rates. But old bond purchases by the central bank will increase the amount of money in circulation and add to the reserves of commercial banks to enhance their lending capacities. The additional money in circulation may stimulate economic activity and contribute to inflationary pressure.
A couple of conclusions follow. First, when Congressional spending causes a deficit that requires the issuance of new bonds, no new money is created (injected into circulation) by this process alone. Second, new money may enter into circulation depending on the rates at which domestic and foreign bond demand is increasing relative to domestic bond supply, and the intent of the central bank with respect to interest rate changes, the rate of inflation, and the level of economic activity.
<>
39. The Capital Scarcity Rate of Interest
Introduction
Many commentators and textbooks that purport to explain interest rates treat them only as returns to financial instruments. Little if any attention is given to the underlying real basis of interest rates. The natural rate of interest, described by Knut Wicksell in 1898, is no longer a "hot topic" in economics or finance literature, but it may be mentioned in passing on the way to describing interest rates as purely financial phenomena. My intent in this work is to describe a variation on the natural rate concept and argue that it is fundamental to understanding both the real and the financial aspects of interest rates. Charts provided by the Federal Reserve Bank of St. Louis (Federal Reserve Economic Data, FRED) have been downloaded to illustrate most relationships.
Economists conventionally identify four “factors of production,” land, labor, capital, and entrepreneurship, and the so-called returns to them, respectively: rent, wage, interest, and profit. Since interest is specified as the return to real capital (physical productive capacity, e.g., plant, equipment, housing), the "true" interest rate in any region is a measure of the scarcity of capital in the region relative to the demand for it. This true interest rate is referred to in this essay as the "capital scarcity rate of interest," or simply as the "scarcity interest rate." Rates of return can be computed for any of the factors of production, so the term "scarcity interest rate" will be taken to refer to the rate of return to the region's stock of capital rather than to any of the region's other resource endowments.
The Natural Rate of Interest
The scarcity rate of interest corresponds loosely to the concept of the "natural rate" of interest introduced by Knut Wicksell in 1898 (Geldzins und Güterpreise; English translation, "Interest and Prices," 1936). Wicksell defined the natural rate as "a certain rate of interest on loans which is neutral in respect to commodity prices and tends neither to raise nor to lower them" (https://en.wikipedia.org/wiki/Neutral_rate_of_interest#:~:text=The%20neutral%20rate%20of%20interest%2C%20previously%20called%20the,keeping%20inflation%20constant.%20It%20cannot%20be%20observed%20directly). In modern parlance, this rate is described as a "neutral rate" of interest,
In a money-using economy, the fundamental reason that interest is paid for the use of money over some period of time is that money can be used to claim (i.e., acquire) real capital goods which increase productive capacity. The only two reasons to demand loanable funds are to use them to purchase real capital equipment and to purchase consumer goods. The reason that interest is paid on consumer loans is that loanable funds have to be bid away from purchasing real capital goods. Consumer loan interest rates often are higher than commercial loan rates simply because consumers have to out-bid commercial borrowers to capture some of the loanable funds.
The capital scarcity interest rate is region specific. Due to the effect of diminishing returns, the scarcity rate of interest is higher in regions where capital is scarce and lower in regions where capital is more abundant. The scarcity interest rate would be expected to fall as capital becomes more abundant with on-going economic development. It would rise if capital were to become scarcer, e.g., when equipment is destroyed by a natural disaster or war, or if gross investment in the region should become less than depreciation so that the nominal capital stock shrinks.
Scarcity rates of interest may be lower in more developed parts of the world that are capital-abundant; we should expect scarcity rates to be higher in lesser developed regions of the world that are capital-scarce relative to local demands for capital. The marginal productivities of new capital investments would be higher in capital-scarce regions, inviting "offshore" investments in those regions by firms located in other regions with more abundant capital and thus lower marginal productivities of capital. Growth rates in capital-scarce regions may slow as their capital stocks increase with ensuing development.
Economic activities that affect and are affected by the capital scarcity interest rate:
The concept of the scarcity rate of interest is not as restricted as that of the natural or neutral interest rate. The scarcity interest rate accommodates monetary transactions and policy, and it enables consideration of disequilibria in both real and financial markets as they are linked to each other. The scarcity rate concept is posited relative to the real capital stock in a region. The neutral interest rate concept takes no explicit account of the capital stock or of regional differences of installed capital.
If all the conditions specified for the neutral rate were met, the scarcity rate in a region would converge upon the neutral rate in that region. It is in this sense that, with due consideration to disequilibrium conditions, the neutral rate in a region might serve as a proxy for the scarcity rate in that region. Neither the neutral interest rate nor the scarcity interest rate is observable or trackable, but inferences may be drawn about the value of a regional scarcity interest rate by observing what is happening in regional markets.
Although the neutral or natural rate of interest is not directly observable, yields on longer-term government bonds that are essentially riskless have served as proxies for the natural rate of interest. James Mackintosh, writing in The Wall Street Journal September 2, 2016, notes that
The new debate in central banking is over whether long-run interest rates are lower than in the past, thanks to permanently lower growth. Investors seem to share the view of many policy makers that they are: Long-dated bond yields have plummeted around the world. . . . . The president of the Federal Reserve Bank of San Francisco, John Williams, set the tone for the gathering of central bankers at Jackson Hole, Wyo., last month when he published a widely read letter suggesting the long-run "natural" rate of interest has come down drastically in the past 25 years.
(http://blogs.wsj.com/economics/2016/09/02/think-you-know-the-natural-rate-of-interest-think-again/)
Yield rates on long-term bonds often are taken as proxies for the natural rate of interest. However, as specified for the natural rate of interest, the economy is rarely in equilibrium at full employment with stable inflation and no involvement by a central bank. It would be more appropriate to construe the yields on long-term bonds as proxies for the capital scarcity interest rate for which non-equilibrium states are not precluded.
Long-term U.S. Treasury security yields shadow the capital scarcity interest rate only imperfectly. Long-term bond issuance has been interrupted on two occasions: issuance of the 20-year bond was suspended between 1987 and 1993, and the 30-year bond was not issued between 2002 and 2006. Beginning in 2020 the declining paths of the yields on U.S. Treasury long-term securities were disturbed by the Federal Reserve’s effort to address inflation by increasing the interest rate paid to banks on their deposited reserves. The fact that the 20- and 30-year bond yield rate paths depicted in Chart 1 are not smooth but rather exhibit up/down changes from quarter to quarter implies disequilibrium states and market adjustments to the changing capital scarcity interest rate.
Has the U.S. recently experienced “permanently lower growth” as contended by Mackintosh? The top panel of Chart 2 shows the path of real GDP from 1955 to 2023. The mild upward concavity of the path suggests that the GDP growth rate may have increased slightly over the period. The middle panel of Chart 2 shows real GDP on a per capita basis. With decreasing indigenous birth rates offset by immigration, the near linear up-sloping path of per capita real GDP also belies the contention that growth has become permanently lower. The annual percent changes of real GDP from previous periods shown in the bottom panel of Chart 2 may exhibit a very slight downward trend that implies only a slight diminishing of the real GDP rate of growth.
As shown in the top panel of Chart 3, real (adjusted for inflation) gross private domestic investment in the U.S. has increased during the second half of the twentieth century and into the twenty-first century, with brief downturns only during recessions. The middle panel in Chart 3 shows net (after allowing for depreciation) private domestic investment from 1960 to 2024. Except for when it was negative in 2009, net investment increased the stock of real capital in the U.S. as shown in the bottom panel of Chart 3.
The effect of diminishing returns to the increasing capital stock suggests that the real GDP growth rate should be declining and that the capital scarcity interest rate should be decreasing. Two phenomena that have offset the effect of diminishing returns to capital are technological advance that increases the productivity of the increasing capital stock, and net positive immigration. Immigration has offset the declining indigenous birth rate in the U.S. to enable continuing growth of the U.S. labor force that complements the increasing stock of capital. And technological advance has promoted investment and served as a recession recovery vehicle. With the ever-increasing U.S. capital stock, we might expect the capital scarcity interest rate to decline, but technological advance and positive net immigration may have prevented the capital scarcity interest rate from declining.
The productivity of any resource, human or physical, can be measured as the ratio of a produced amount ("output") to the quantity of the resource used in producing the output. While labor productivity can be measured as the ratio of output per man-hour (assumed homogeneous) used in the production of the output, real capital is so diverse that it is impossible to measure the region-wide productivity of capital per se. However, a region's overall ("total factor") productivity can be measured. It increases when more output is produced by all of the resources employed in producing the output.
The upper panel of Chart 13 shows an index (2017=100) of U.S. non-farm business labor productivity during the second half of the twentieth century and in the early 21st century. The lower panel of Chart 13 shows U.S. total factor productivity over the same period and on the same scale. While both productivity index paths increase and reach 100 in 2017, the fact that the index values of total factor productivity in most years prior to 2017 were higher than the index values of labor productivity in the same years implies that the productivity of capital was increasing as well.
The productivity of a nation's capital stock may increase with investment in more efficient equipment and advancing technology, or by using more labor to complement existing equipment. Even with a declining indigenous birth rate, immigration has enabled the U.S. population (and its labor force) to grow as fast or faster than the capital stock to increase the nation’s total factor productivity as shown in the lower panel of Chart 13.
Increasing total factor productivity may have enabled the U.S. capital scarcity interest rate to remain higher than implied by the falling long-term security yield rates shown in Chart 1. The U.S. capital scarcity interest rate apparently has remained higher than capital scarcity interest rates in many developed countries by enough to attract foreign direct investment to the U.S. The upper panel of Chart 14 shows the increasing rest-of-world foreign direct investment in the U.S. The lower panel of Chart 14 shows U.S. direct investment abroad, implying that U.S. businesses have found even higher capital scarcity interest rates in countries with lesser capital stocks that warrant off-shore direct investment.
Regional capital scarcity rates in the U.S. appear to have diverged. Diminishing returns to historic real capital accumulation in what now are called “rust-belt” states likely have caused their capital scarcity interest rates to decrease. Capital scarcity interest rates in the so-called “sun-belt” states have been higher by enough to attract capital inflows, not only from other regions within the U.S., but also from Europe and Asia. The U.S. state of South Carolina is an example of an internal region that has received substantial foreign direct investment since the middle of the twentieth century.
Financial Markets and Monetary Policy
The capital scarcity interest rate is described as a real return on a real stock of capital without regard to money. But in a money-using economy almost everything is valued in money prices, and yields are computed on financial instruments that are valued in money terms. How do rates of return on financial instruments relate to the capital scarcity interest rate?
Financial markets are comprised of the many individual and institutional traders who buy and sell financial instruments such as the bonds issued by businesses and governments. Their knowledge and expectations are exhibited in the demands for and supplies of bonds. The bond prices from which the yield rates are calculated change to reflect increasing or decreasing demands for the bonds relative to the supplies of such bonds. Increasing bond prices (and falling yield rates) indicate that the demand for bonds recently has increased relative to supply (or that supply has decreased). Decreasing bond prices (and increasing yield rates) indicate that demand for such bonds recently has decreased relative to supply (or that supply has increased). Changes of the average yields represent the collective understandings and expectations of bond traders about economic and financial conditions, and they may induce market adjustments relative to the scarcity rate of interest in the region.
Natural adjustment processes in a region tend to cause financial interest rates to gravitate toward the region's scarcity rate. But monetary policy may induce market interest rates to diverge significantly from the scarcity rate in their region. Monetary policy that induces market rates to fall below the scarcity rate will stimulate spending in the economy and may cause inflation. Monetary policy that causes market rates to rise above the scarcity rate will have depressive effects on the region to diminish the rate of inflation (or possibly even to cause deflation).
The Federal Reserve's reserve balances interest rate is its "go-to" monetary policy tool in the twenty-first century. Reserve balances are commercial banks' excess reserves that they place on deposit with the Federal Reserve. The Fed executes monetary policy by adjusting the interest rate that it pays on these excess reserve deposits in order to change the Federal Funds rate (the rate that commercial banks charge each other to lend their reserves). The reserve balances interest rate is an administered price rather than a market-determined price. Although the Fed relies on manipulation of this interest rate as its main policy tool, it may be a delusion to think that a central bank changing an administered rate can cause market-determined interest rates to change very much from the scarcity rate of return on real capital. Allowing for risk and term differences, market interest rates are determined ultimately by the scarcity of real capital relative to the demand for it.
Market forces that cause market interest rates to gravitate toward the scarcity rate of interest may frustrate central bank intent. If the central bank intends to promote long-term growth or short-term recovery from a recent downturn, it might try to stimulate investment and other interest-sensitive spending by inducing the Federal Funds rate to decrease below the scarcity interest rate. The lower Federal Funds rate will percolate through the financial markets by arbitrage to stimulate bank borrowing. The increased bank borrowing transforms more of banks' excess reserves to become required reserves. If excess reserves diminish far enough, banks with insufficient reserves to cover their loans may be forced to borrow reserves on the Federal Funds market (or from the Fed itself), thereby bidding the Federal Funds rate back up toward the scarcity rate.
If the economy is overheating with inflation higher than tolerable, the central bank may attempt to curb investment and other interest-sensitive spending by inducing the Federal Funds rate to increase above the scarcity rate. It may raise the interest rate paid on reserve balances which acts as a floor for the Federal Funds rate. The higher Federal Funds rate will percolate through the financial markets by arbitrage to dampen bank borrowing. The decreased bank borrowing releases more of banks' required reserves to become excess reserves. The increasing excess reserves will decrease borrowing on the Federal Funds market, thereby bidding the Federal Funds rate back down toward the scarcity rate.
In a financial sense, interest is the price for the use of a dollar's (or other local currency unit's) worth of credit for a year. The issuance or sale of a financial instrument by a business firm or a government agency is an implicit demand for credit. The prices of financial instruments are determined by the interaction between forces of demand for and supply of them in loanable funds markets (i.e., bank lending and bond markets). Yield rates on financial instruments are understood to be their market-determined interest rates (as distinguished from the capital scarcity interest rate determined by resource endowments in the region). Yield rates, which vary inversely with the market prices of financial instruments, also may vary by risk factors and terms to maturity.
U.S. Treasury bill prices are market-determined prices because they are "closing market bid quotations on the most recently auctioned Treasury bills in the over-the-counter market as obtained by the Federal Reserve Bank of New York at approximately 3:30 PM each business day" (https://home.treasury.gov/policy-issues/financing-the-government/interest-rate-statistics). Parties other than the Treasury may engage in the market in which Treasury bills are traded. Banks and other financial interests, both domestic and foreign, may enter the bond market to purchase and sell Treasury and corporate securities by bidding and offering bond prices (not yield rates). If they can get better price deals than offered by the Treasury, market participants will trade with each other rather than with the Treasury. Market yield rates by terms to maturity are calculated from the average prices of bond trades each day. Market yield rates may differ from administered rates set by the Fed's Open Market Committee at its most recent meeting. They may also differ from the region's scarcity rate of interest.
Commentators, pundits, and even financial professionals often personify markets, speaking as if they are persons who behave and know things about the economy and financial markets. Is there reason to think that market bond prices and the yield rates calculated from them contain any special information apart from the interest rates set by monetary authorities? The bond market is comprised of the many individual and institutional traders who buy and sell bonds. Their knowledge and expectations are exhibited in the demands for and supplies of bonds by term categories. The bond prices from which the yield rates are calculated change to reflect increasing or decreasing demands for the bonds relative to the supplies of such bonds. Increasing bond prices (and falling yield rates) indicate that the demand for bonds in that term category recently has increased relative to supply (or that supply has decreased). Decreasing bond prices (and increasing yield rates) indicate that demand for such bonds recently has decreased relative to supply (or that supply has increased). So, yes, recent changes of the average yields by terms to maturity represent the collective understandings and expectations of bond traders about economic and financial conditions, and they may reflect market adjustments relative to the scarcity rate of interest in the region.
The demand for loanable funds is a derived demand that is a function of the demand for the final goods and services that can be produced with the real capital, investment in which was financed by the loanable funds. Market forces cause yield rates on long-term financial instruments to gravitate toward the scarcity interest rate in the region. Market yield rates that exceed the region's scarcity interest rate can be expected to dampen investment spending, decreasing the supply of bonds coming onto financial markets relative to bond demand, raising their prices and lowering their yield rates toward the scarcity rate in the region. Market yield rates below the region's scarcity interest rate can be expected to stimulate investment spending so that the demand for additional loanable funds increases, increasing the supply of bonds coming onto financial markets relative to bond demand, decreasing bond market prices and raising their yield rates toward the region's scarcity rate of interest. These outcomes will be different if bond market demands or supplies change in the same directions as supplies or demands change or at different rates of change.
As depicted in the lower panel of Chart 4, yield rate inversions often have been followed by recessions within a few months. The 8/13/2019 yield rate inversion shown in the upper panel of Chart 4 was followed by a brief recession in early-2020 attributed to 2019 holiday season supply chain congestion and the Covid19 pandemic. This recession may have dampened investment plans, decreasing the supply of bonds relative to the demand for bonds, raising their prices and lowering their yield rates relative to the scarcity rate of interest. The fact that a longer and deeper recession expected by prognosticators had not happened by early 2024 suggested that a "soft landing" from the supply chain and pandemic disruption had occurred as long-term yield rates again approached the scarcity rate of interest.
Yield rates may invert when supplies of longer-term bonds decrease (or demands increase) to cause longer-term bond prices to rise and their yield rates to fall relative to those for shorter-term bonds. Or, yield rates may invert when supplies of shorter-term bonds increase (or demands decrease) to cause shorter-term bond prices to fall and their yield rates to rise relative to those for longer-term bonds. Yield rate inversion may involve a combination of these conditions.
A scenario for a yield rate inversion might occur when expectation of an economic downturn leads business firms to cut back on investment spending financed by supplying longer-term corporate bonds to the market. As the supplies of longer-term bonds decrease relative to the demands for them, their prices rise and their yield rates fall relative to yield rates on shorter-term bonds. The decreasing longer-term yield rates may even fall below the scarcity rate of interest.
If longer-term interest rates remain lower than shorter-term interest rates along an inverted yield curve, eventually business firms will have incentive to shift their demands for loanable funds to finance new investment spending. They may do so by increasing the supply of longer-term corporate bonds with higher prices and lower yield rates relative to the demands for such bonds while decreasing the supply of shorter-term corporate bonds. This will put downward pressure on the longer-term bond prices and upward pressure on the shorter-term bond prices. The yield rate inversion will be alleviated by the rise of longer-term yield rates and the fall of shorter-term yield rates. If longer-term yield rates had fallen below the scarcity rate of interest, they may increase back toward the scarcity rate in the adjustment process.
The Emergence of Federal Reserve Monetary Policy Tools
Classical textbook explanations of the Federal Reserve's monetary policy tools have described the discount rate, open market operations, and the required reserve ratio. But the Federal Reserve's monetary policy "tool box" has changed over time.
By mid-twentieth century the Federal Reserve's monetary policy tools included the discount rate, open market operations, and the required reserve ratio. Having found during the Great Depression that changes to the required reserve ratio may have drastic and undesirable effects on the banking system, the Fed abandoned the required reserve ratio as a policy tool except for use in extreme circumstances or to make policy corrections.
During the latter half of the twentieth century, the main policy tools became the discount rate and open market operations (purchases and sales of bonds issued by the Treasury and government agencies). The discount rate is the interest rate that commercial banks pay to borrow reserves from the Federal Reserve when they suffer a deficiency of required reserves. It is a "discount rate" in the sense that a bank negotiates a stipulated loan amount from the Fed and receives a lesser amount (the difference being the discount) but pays back to the Fed the full stipulated amount of the loan. For example, if a bank negotiates a $1 million loan from the Fed and receives proceeds of $950,000, it must pay back the full $1 million for a discount rate of 5 percent.
With the emergence of the so-called "Federal Funds" market that enabled commercial banks to borrow reserves from each other, commercial bank borrowing from the Fed diminished, rendering the discount rate an ineffective policy tool. Federal Funds are banks' excess reserves that may be loaned overnight to other banks. The rate that the borrowing bank pays to the lending bank is negotiated between the two banks. The effective Federal Funds rate is the weighted average rate for all of these negotiations.
A new tool was introduced in 2008 as the Fed initiated the process of "quantitative easing" in the effort to stem the "Great Recession." Quantitative easing entailed purchases of large quantities of bonds from commercial banks. The Fed paid for the bonds by crediting the reserves of commercial banks. Since most banks then had large amounts of excess reserves (in excess of legal requirements), the Federal Funds rate decreased toward zero, rendering it useless as a monetary policy tool. To put a floor under the Federal Funds rate and provide the Fed with some modicum of control, the Fed started paying interest on commercial banks' reserves on deposit at the Fed. As noted by Edmund L. Andrews and Michael M. Grynbaum in a New York Times column on October 7, 2008, "Paying interest on reserves allows the central bank to set a floor on interest rates and retain at least some control over monetary policy." The Federal Funds rate can be expected to settle at this floor because banks would be unwilling to lend their excess reserves to other banks at a lower rate than they can earn on excess reserves deposited at the Fed. In 2017 the Fed announced that it would continue the policy of "ample reserves."
After 2008 the Fed's main policy tool became the interest rate that it pays to commercial banks on their reserve balances on deposit at the Fed. Changing this interest rate induces the effective Federal Funds rate to follow it, with the presumption that market-determined interest rates will follow the Federal Funds rate. The Fed uses repurchase and reverse repurchase operations to bring this about.
The upper panel of Chart 5 shows Federal Funds rates from 1955 to 2024. During 2008 to 2013, the Federal Funds rate was nearly zero as the Fed set the target Federal Funds rate at zero in an effort to promote recovery from the 2007-2008 financial crisis.
The lower panel of Chart 5 shows yield rates on 10-year constant maturity Treasury securities to enable comparison to the Federal Funds rate. The 10-year Treasury Bill, the U.S. security that is most liquid and most widely traded in the world, serves as a benchmark for setting home mortgage rates in the U.S. Casual observation suggests that the 10-year Treasury Bill rate moves nearly in lockstep with the Federal Funds rate, but it is not clear whether changes of either lead changes in the other. Regressions on data for these two variables do not reveal significant dependent variable lag or lead relationships or for month-to-month differences of both variables with dependent variable lags.
__________
Changing financial market conditions precipitate the need or opportunity for lenders to change interest rates. However, market-determined interest rates may become “sticky” if lenders are conditioned by periodic Fed announcements of interest rate target changes. If the Fed is widely predicted or expected to announce a rate change in the near future, lenders may wait for the announcement as the excuse or trigger for changing their lending rates. If this happens, it indeed gives the appearance that the Fed has been able to dictate a change of interest rates. But if the Fed has been waiting on market pressures for a rate change to build, it has followed the market rather than led the market to cause rates to change.
Aftermath of the Great Recession
In the eight years following the so-called "Great Recession" of 2008, the U.S. economy continued to be sluggish with a real growth rate below 2 percent per annum. The U.S. CPI inflation rate lingered below the Fed's announced goal of 2 percent per annum. To induce the inflation rate to approach its announced goal, the Fed attempted to enable increased commercial bank lending by increasing bank reserves with three episodes of "quantitative easing" between 2008 and 2015 as depicted in Chart 6. But in an environment of fear, anxiety, and pessimism, the Fed couldn't force bankers to lend or prospective borrowers to borrow. Most of the increased liquidity ended up in commercial bank excess reserves and business cash hoards rather than in circulation to stimulate spending.
The 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 (see the essay at https://dickstanfordlegacy.blogspot.com/2025/07/essaysvolume4.html#S41).
The quantitative easing between 2008 and 2015 provided the U.S. banking system with what in Fed terminology is called "ample reserves." In 2017 the Fed indicated that it intends to continue to implement a policy of systemwide ample reserves. This would appear to render both the discount rate and the Federal Funds rate irrelevant as policy tools even if changes of the reserve balances interest rate can elicit changes of the Federal Funds rate. However, even with ample reserves systemwide, there usually are a few commercial banks whose loan officers have approved a sufficient amount of new loans during a day so as to put the banks in deficient reserve positions at the end of the day. Banks suffering a deficiency of reserves would need to borrow Federal Funds overnight to cover their deficiencies.
Changes of the Federal Funds rate prompted by changes in the Fed's reserve balances interest rate will percolate through the financial markets by arbitrage. Also, some banks (how many?) await announcement of changes in the Committee's target Federal Funds rate or in the Fed's reserve balances interest rate as signals to change their own lending rates. To the extent that some banks must borrow Federal Funds and other banks adjust their loan rates on the Fed's changing rate signals, changes of the reserve balances interest rate may confer "at least some control over monetary policy" as suggested by Andrews and Grynbaum. But this control is likely to be modest and tenuous at best, especially if the Federal Funds rate is induced to diverge too far from the scarcity rate of interest.
The Reserve Balances Interest Rate
Both the pre-2008 and post-2008 monetary policy transmission mechanisms are lengthy, complex, uncertain, and fraught with the potential for failure. Other than open market operations, the reserve balances interest rate is the only monetary policy tool now actively employed by the Fed. Recently, open market operations have been devoted to "unwinding" the Fed's huge portfolio of bonds acquired in the three episodes of quantitative between 2008 and 2015. This increase of the supply of bonds coming onto the market is likely to depress bond prices and increase yield rates unless offset by other Fed policy actions.
The Fed's reserve balances interest rate has become its "go-to" monetary policy tool in the twenty-first century. The Fed now executes monetary policy by adjusting the interest rate that it pays on commercial banks' reserves in order to change the Federal Funds rate. The reserve balances interest rate is an administered price rather than a market-determined price. Although the Fed now relies on manipulation of this interest rate as its main policy tool, it may be a delusion to think that a central bank changing an administered rate can cause market-determined interest rates to change very much from the scarcity rate of return on real capital. Allowing for risk and term differences, market interest rates are determined ultimately by the scarcity of real capital relative to the demand for it.
Market forces may cause market interest rates to gravitate toward the scarcity rate of interest, and these forces may frustrate central bank intent. If the central bank intends to promote long-term growth or short-term recovery from a recent downturn, it might try to stimulate investment and other interest-sensitive spending by inducing the Federal Funds rate to decrease below the scarcity interest rate. The lower Federal Funds rate will percolate through the financial markets by arbitrage to stimulate bank borrowing. The increased bank borrowing transforms more of banks' excess reserves to become required reserves. If excess reserves diminish far enough, banks with insufficient reserves to cover their loans may be forced to borrow reserves on the Federal Funds market (or from the Fed itself), thereby bidding the Federal Funds rate back up toward the scarcity rate.
A similar analysis can describe a situation when the economy is overheating with inflation higher than tolerable. If the central bank intends to curb investment and other interest-sensitive spending by inducing the Federal Funds rate to increase above the scarcity rate, it may raise the interest rate paid on reserve balances which serves as a floor for the Federal Funds rate. The higher Federal Funds rate will percolate through the financial markets by arbitrage to dampen bank borrowing. The decreased bank borrowing releases more of banks' required reserves to become excess reserves. The increasing excess reserves will decrease borrowing on the Federal Funds market, thereby bidding the Federal Funds rate back down toward the scarcity rate.
In a New York Times transcripton of columnist Matthew Rose's conversation with economists Oren Cass, Jason Furman, and Rebecca Patterson on May 6, 2025, Furman said,
In early April 2025, the 10-year Treasury yield was around 4.2%. The fact that the Fed had been unable to get the early-2025 core inflation rate down to the its 2 percent target rate implies that spending may have been excessive if market interest rates were below the capital scarcity interest rate. By mid-April 2025, President Trump was urging Federal Reserve Board chair Jerome Powell to lower market interest rates even further to prevent recession brought on by Trump's imposition of tariffs. But to avert accelerating inflation due to Trump's tariffs, the Fed would need to increase market interest rates above the capital scarcity interest rate to dampen spending.
The Trimmed Mean PCE inflation rate produced by the Federal Reserve Bank of Dallas is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). The data series is calculated by the Dallas Fed, using data from the Bureau of Economic Analysis (BEA). Calculating the trimmed mean PCE inflation rate for a given month involves looking at the price changes for each of the individual components of personal consumption expenditures. The individual price changes are sorted in ascending order from “fell the most” to “rose the most,” and a certain fraction of the most extreme observations at both ends of the spectrum are thrown out or trimmed. The inflation rate is then calculated as a weighted average of the remaining components. The trimmed mean inflation rate is a proxy for true core PCE inflation rate. The resulting inflation measure has been shown to outperform the more conventional “excluding food and energy” measure as a gauge of core inflation. (https://fred.stlouisfed.org/series/PCETRIM12M159SFRBDAL)
Fed officials became concerned that a low reserve balances interest rate and low Federal Funds interest rates (1/2 percent per annum) enabled little monetary control. They began stair-stepping the rates upward in early 2017 and continued to do so until mid-2019 when the economy showed signs weakening during the emerging Covid pandemic that dampened consumer spending. Coincidentally, supply-chain chokes emerged in the run up to the 2019 Christmas season to further dampen consumer spending.
The top and middle panels of Chart 8 show stepwise increments of the excess reserves interest rate and the interest rate paid on reserve balances from 2016 to 2024. The bottom panel confirms that the effective Federal Funds rate moved in lockstep with the reserve balances rate.
Sean Williams, writing on the MSN website, August 8, 2026, noted that recently-appointed Federal Reserve Board Chair Kevin Warsh introduced two non-traditional means of executing monetary policy.
One is that with removal of "forward guidance" from FOMC meeting statements, the Fed can induce interest rates to increase without adjusting the Federal Funds target rate.
But this is a one-time policy move that can't be repeated unless forward guidance is restored.
Another way that the Fed can influence market nterest rates without adjusting the Federal Funds target rate is through "deleveraging" the Fed's balance sheet. As of Aug. 5, 2026, the Fed held $6.75 trillion in assets, primarily long-term Treasury bonds and mortgage-backed securities that were acquired by "quantitative easing" after the 2008 Great Recession. Selling trillions of dollars of U.S. Treasury bonds would push up long-term bond yields and market interest rates that are adjusted with respect to long-term yield rates. That would make borrowing to finance investment and interest-sensitive consumer spending costlier as if the Federal Funds rate target had been hiked. This strategy can be repeated until the Fed's portfolio has been exhausted or deleveraged to an adequate level.
The deleveraging strategy also can be put into reverse as needed by purchasing more bonds. The three post-2008 quantitative easing bond purchases increased leverage of the Fed's portfolio by adding to commercial bank reserves that could support increased lending. The leveraging/deleveraging strategy may have unintended effects with respect to fiscal policy that traditionally is implemented by the Treasury Department.
Jason Douglas and Jon Sindreu, writing in The Wall Street Journal, December 11, 2016, say that
. . . .
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)
If all the conditions specified for the natural rate were met, the capital scarcity interest rate would converge upon the natural rate. Since natural rate equilibrium conditions rarely obtain in the real world, we will assume that Douglas and Sindreu's comment applies to the capital scarcity rate of interest rather than to the natural rate of interest.
If central bankers are postulating their monetary policies on tracking or shadowing the scarcity rate of interest, then one is led to wonder why don't they simply let market interest rates naturally adjust to the scarcity rate. This may happen anyway since central bankers often delay changing their administered-price rates (the reserve balances interest rate or the Federal Funds target rate) until market rate pressures for a change are already palpable, i.e., market participants "price in" their expectations of a near-future rate change. When they do this, central bankers are simply following the market rather than leading the market or managing market interest rates.
Donald Luskin, writing in The Wall Street Journal, February 16, 2017, described how a market interest rate 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. (https://www.wsj.com/articles/yellen-gives-conservatives-something-to-cheer-1487290524)
One might wonder why it would be necessary for a monetary authority to set a rate that the market would reach by
itself anyway. Why even have a monetary authority that only attempts to
emulate what the financial markets would do if it did not exist? The delays
entailed in recognition, action, and reaction time lags can render Fed policy actions disruptive of natural stabilizing forces resident in the economy.
Indeed, policy actions may actually aggravate economic instability. Economic
stability may well be served by restricting the Fed to being "a mere clearing
house for banking-system reserves" and providing a money supply adequate
to the needs of a growing economy.
<>
Summary:
- The Fed attempts to manipulate market yield rates by influencing the Federal Funds rate.
- Prior to 2008 the Fed influenced the Federal Funds rate with open market operations.
- Since 2008, the Fed has dominated the Federal Funds rate by setting the interest rate paid to banks on their reserves on deposit at the Fed.
- The Fed's reserve balances interest rate policy to influence the Federal Funds rate appears to have been successful in alleviating inflation and sustaining employment to bring about a "soft landing" in early 2024.
- The soft landing may have resulted because as the economy recovered from the Covid pandemic and supply-chain congestion, market yield rates moved back toward the natural rate of interest, irrespective of the Federal Funds rate.
- The characteristics of an open-economy world may render the Fed's monetary policy tools of modest capability.
- The efficacy of central bank monetary policy is a delusion in a globally open-economy world in which economic and financial interests adjust their activities in pursuit of the capital scarcity rates of interest in their respective regions.
40. Interest Rate Determination: A Grand Delusion
In a Washington Post column dated May 20, 2026, Andrew Ackerman and Frederica Cocco provide two explanations of what determines and changes interest rates. (https://www.washingtonpost.com/business/2026/05/20/rising-bond-yields-mean-higher-mortgages-car-loans-americans/?utm_campaign=wp_todays_headlines&utm_large=email&utm_source=newsletter&carta-url=https%3A%2F%2Fs2.washingtonpost.com%2Fcar-ln-tr%2F474259a%2F6a0d862758a5db17fbc0785f%2F596c29ff9bbc0f208654282b%2F23%2F65%2F6a0d862758a5db17fbc0785f)
They begin by observing that on May 19, yields on 30-year Treassury bonds increased to settle at 5.18 percent. They note that the 10-year Treasury note, "which serves as a benchmark that influences mortgage rates, auto loans and credit card borrowing costs," increased to 4.68 percent, the nighest since January 2025. They go on to say that "When bond yields rise, interest rates on consumer loans tend to follow — because banks and lenders use Treasury yields as a baseline for setting the rates they charge borrowers."
The rising bond yield rates occurred because bond traders sold off large amounts of bonds relative to bond demands, increasing the supply of bonds relative to demand on bond markets, causing bond prices to fall and yield rates to rise. They then say that "The recent bond sell-off reflects a range of concerns, including fears that inflation — stoked by oil prices stuck above $100 a barrel amid the war in Iran — could force the Federal Reserve to raise interest rates."
So, which is it? Are interest rates detertmined in bond markets, or does the Federal Reserve set and change interest rates?
In shifting the explanation of interest rate changes from bond markets to the Federal Reserve, Ackerman and Cocoo reflect the conventional wisdom that the U.S. central bank determines and changes interest rates. But is this conventional wisdom actually a wispread delusion?
The conventional wisdom is displayed in several New York Times columns appearing in early 2026 in regard to whether Federal Reserve Chair nominee Kevin Warsh will act independently or attempt to implement President Trump's demand to lower interest rates. In the following, the bold-faced emphasis has been added:
In a conversation column dated January 31 including Oren Cass, Jason Furman, and Natasha Sarin, Furman says that "On independence and most everything else about how Warsh handles the job, it is important to remember that, if confirmed, Warsh would be one vote out of 12. If he comes into a rate-setting meeting and argues, 'We have to cut rates because Donald Trump wants us to,' he will probably be outvoted 11 to 1." (https://www.nytimes.com/2026/01/31/opinion/kevin-warsh-jerome-powell-trump-fed-chair.html)
Catherine Rampell, in a column dated February 1, 2026, says that "The real litmus test, of course, is whether Mr. Warsh will do the president’s bidding. Mr. Trump has been clear that he expects his next Fed chair to slash interest rates and stimulate the economy." (https://www.nytimes.com/2026/02/01/opinion/trump-fed-chair-kevin-warsh.html)
In a column dated April 21, David Wessel says that "Both as a Fed governor and in the 15 years since, Mr. Warsh has emphasized the importance of maintaining the Fed’s ability to set interest rates free from interference from elected politicians." (https://www.nytimes.com/2026/04/21/opinion/jerome-powell-fed-kevin-warsh-hearings.html)
Jared Bernstein and Janet L. Yellen say in a column on May 12 that "If this reasoning [increasing productivity will slow inflation] sounds familiar, it could be because Kevin Warsh, President Trump’s nominee to be the Federal Reserve chair, uses it to justify the idea of cutting interest rates, even though inflation is still clocking in above the Fed’s 2 percent target." (https://www.nytimes.com/2026/05/12/opinion/kevin-warsh-fed-ai.html)
The notion that the Fed dictates interest rates and causes them to change as the vehicle for implementing monetary policy is a fiction, although a convenient one for reporting the actions of the Fed and assessing its monetary policy intent. The process is more complicated than media statements suggest. Once the Fed announces a new Federal Funds target rate, the Fed resets its reserves balance interest rate to influence commercial bank lending and induce market-determined rates to approach the newly announced target. The Federal Reserve Bank of New York, acting on behalf of the Open Market Committee, may engage in repurchase transactions as needed to purchase bonds, inducing bond prices to rise (yield rates to fall), or to sell bonds, inducing bond prices to fall (yield rates to rise).
The Fed may be able to push market-determined interest rates toward an announced target, but in another essay (#41) I have explored the possibility that market interest rates tend to gravitate toward what I have called the "capital scarcity interest rate" that reflects bond traders' awareness of capital availability relative to the demand for it.
Interest is a real phenomenon attributable to the ability of real (rather than financial) capital to increase human productivity. Interest is paid in monetary terms in modern money-using economies, but it would be paid "in kind" in a barter economy. Interest is the return to scarce real capital in the same sense that the wage is the return to scarce labor. Both returns are positive as long as the respective factors of production are scarce and they are productive. In this sense, the capital scarcity interest rate can never become zero or negative unless the quantity of real capital becomes superabundant.
The capital scarcity rate of interest corresponds loosely to the concept of the "natural rate of interest" introduced by Knut Wicksell in 1898. In modern parlance, this rate is described as a "neutral rate of interest" that would obtain in equilibrium at full employment in a non-money-using economy, i.e., a pure barter economy. Although neither the natural rate of interest nor the capital scarcity rate of interest is directly observable, yields on longer-term government bonds that are essentially riskless have ben treated as proxies.
The capital scarcity interest rate is region specific. Due to the effect of diminishing returns, we would expect the capital scarcity rate of interest to be higher in regions where capital is scarce and lower in regions where capital is more abundant. The Fed stipulates a "one-size-fits-all" Federal Funds rate target for the entire U.S. economy. The Federal Funds rate target could be above the capital scarcity interest rate in a region with abundant capital, or it might be below the capital scarcity interest rate in a region with a smaller capital endowment. Relationships between the regional capital scarcity interest rates and a common Federal Funds rate target may cause investment rate differentials among regions within the nation.
Market-determined interest rates tend to converge on the capital scarcity interest rate in each region. When market rates are below the capital scarcity interest rate, business interests can be expected to increase borrowing to finance new investments. The increased borrowing adds to the supply of bonds coming onto bond markets relative to bond demand, bidding bond prices down and yield rates up. This process will continue until the increasing yield rates approach the capital scarcity interest rate. When market rates are above the capital scarcity interest rate, business interests can be expected to decrease borrowing, reducing the supply of bonds coming onto bond markets relative to bond demand, bidding bond prices up and yield rates down toward the capital scarcity interest rate.
The Fed can push market-determined interest rates toward an announced target, but its pushing may be short-lived as the market-determined rates adjust to align with the capital scarcity interest rate.
41. Interest Rate Policy and the Rate of Price Change
Media writers and some professional economists who comment on monetary matters seem to regard interest rates as purely financial phenomena, not tethered to anything real in the world. Many of them appear to have forgotten (or never grasped) their Econ 101 instruction in demand-supply analysis as it pertains to financial markets. In another essay (#41) I introduced the concept of the "capital scarcity rate of interest" to link the determination of market interest rates to the stock of real capital and to show that demand-supply analysis can shed light on most interest rate determination matters.
Interest is a real phenomenon attributable to the ability of real (rather than financial) capital to increase human productivity. Interest is paid in monetary terms in modern money-using economies, but it would be paid "in kind" in a barter economy. Interest is the return to scarce real capital in the same sense that the wage is the return to scarce labor. Both returns are positive as long as the respective factors of production are scarce and they are productive. In this sense, the capital scarcity interest rate can never become zero or negative unless the quantity of real capital becomes superabundant.
The Scarcity Rate and the Natural Rate
The capital scarcity rate of interest corresponds loosely to the concept of the "natural rate" of interest introduced by Knut Wicksell in 1898 (Geldzins und Güterpreise; English translation, "Interest and Prices," 1936). Wicksell defined the natural rate as "a certain rate of interest on loans which is neutral in respect to commodity prices and tends neither to raise nor to lower them" (https://en.wikipedia.org/wiki/Neutral_rate_of_interest#:~:text=The%20neutral%20rate%20of%20interest%2C%20previously%20called%20the,keeping%20inflation%20constant.%20It%20cannot%20be%20observed%20directly). In modern parlance, this rate is described as a "neutral rate" of interest that would obtain in equilibrium at full employment in a non-money-using economy, i.e., a pure barter economy. Although the neutral or natural rate of interest is not directly observable, yields on longer-term government bonds that are essentially riskless have served as proxies for the natural rate of interest.
If all the conditions specified for the natural rate were met, the capital scarcity interest rate would converge upon the natural rate. Neither the neutral interest rate nor the scarcity interest rate is observable or trackable, but inferences may be drawn about the value of a regional scarcity interest rate by observing whether investment spending is increasing or decreasing in regional markets.
The Fed's 2 Percent Goal
The immediate matter that has attracted my attention is how the Federal Reserve expects its manipulation of interest rates to reduce a rate of price inflation that exceeds its goal of 2 percent per annum. 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:
The Fed's Monetary Policy "ToolBox"
The more important question is whether the Fed now possesses tools to affect the rate of price inflation by manipulation of interest rates. Through much of the twentieth century, the Federal Reserve's monetary policy tools included the discount rate, open market operations, and the required reserve ratio. With the post-WWII emergence of the so-called "Federal Funds" market that enabled commercial banks to borrow reserves from each other, the Federal Funds interest rate became the Fed's principal monetary target.
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.
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 Federal Funds rate to follow it because banks with excess reserves to lend need not accept rates lower than that paid by the Fed. The presumption is that market-determined interest rates will follow the Federal Funds rate.
The media (print, audio, video) foster the notion that the Fed dictates market interest rates and causes them to change as the vehicle for implementing monetary policy. This is a fiction, although a convenient one for reporting the actions of the Fed and assessing its monetary policy intent. What the Fed in fact does is to announce a new Federal Funds rate target (actually, a target range). Once a target rate change is announced the Fed resets its reserves balance interest rate to induce market-determined rates to approach the newly announced target. The Federal Reserve Bank of New York, acting on behalf of the Open Market Committee, then becomes a bond market trader, entering the market as needed 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). The FRBNY employs temporary repurchase transactions to implement such purchases and sales (essay #32).
The 10-year Treasury Bill is the most liquid and most widely traded in the world. It serves as a benchmark for setting home mortgage and other interest rates in the U.S. The 10-year Treasury Bill rate moves nearly in lockstep with the Federal Funds rate, but lead/lag regression analyses are unable to discern which might lead the other. Changes of the Treasury Bill rate percolate through financial markets by arbitrage to other interest rates. The 10-year Treasury Bill rate trended around 4 percent per annum over the past decade, but it increased to 4.59 percent at mid-May 2026 (https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value=2026).
So, the Fed may possesses tools that enable it to push market-determined interest rates toward an announced target, but this is only a first-stage of adjustment. As described in Essay 46, a second-stage adjustment may offset the market interest rate change in the first-stage adjustment. 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. This is a possible explanation of why the Fed has yet to achieve bringing the PCE inflation rate down to its preferred 2 percent goal.
This analysis suggests that an inflation rate goal and the Federal Funds rate targets set to pursue it may be rather arbitrary relative to the capital scarcity interest rate in the region. And, political realities (e.g., war in Iran) have caused the PCE inflation rate to diverge even farther from the 2 percent inflation rate goal. By early June 2026, it had reached 4.2 percent.
A Tale of Two Rates
Can the FOMC's manipulation of market-determined interest rates affect the real economy and the rate of price inflation? 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. Borrowing costs are less than rates of return on capital when market rates are below the capital scarcity interest rate. This encourages borrowing to finance investment spending, and it may precipitate faster inflation if the economy is near full employment. Borrowing costs are greater than rates of return on capital when market rates are above the capital scarcity interest rate. This can be expected to curb borrowing to finance investment spending, and it may have depressive effects on the region, diminishing the rate of inflation or possibly even causing deflation.
Market-determined interest rates tend to converge on the capital scarcity interest rate in each region. When market rates are below the capital scarcity interest rate, business interests can be expected to increase borrowing to finance new investments. The increased borrowing adds to the supply of bonds coming onto bond markets relative to bond demand, bidding bond prices down and yield rates up. This process will continue until the increasing yield rates reach the capital scarcity interest rate. When market rates are above the capital scarcity interest rate, business interests can be expected to decrease borrowing to finance new investments. The decreased borrowing reduces the supply of bonds coming onto bond markets relative to bond demand, bidding bond prices up and yield rates down. This process will continue until the decreasing yield rates reach the capital scarcity interest rate.
The divergence of market interest rates from the capital scarcity interest rate in a region also may affect the capital scarcity interest rate if the divergence persists long enough to cause significant change to the stock of capital in the region. When market interest rates are below the capital scarcity interest rate, net positive investment spending (gross investment greater than depreciation) increases the stock of capital in the region and reduces the capital scarcity interest rate due to the phenomenon of diminishing returns to capital. Net negative investment in a region will decrease the stock of capital and increase the capital scarcity interest rate.
Monetary policy intended to pursue an inflation rate goal may induce market interest rates to diverge from the capital scarcity interest rate in a region. Monetary policy that induces market rates to fall below the capital scarcity interest rate will reduce borrowing costs relative to rates of return on capital and stimulate investment spending that accelerates the rate of economic growth in the region, and it may cause faster inflation. Monetary policy that causes market rates to rise above the scarcity rate will increase borrowing costs relative to rates of return on capital and have depressive effects on the region's economy. It may diminish the rate of inflation, or possibly even cause deflation.
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 still below the capital scarcity interest rate. The recent increase of the inflation rate (4.2 percent on June 10, 2026) suggests that market interest rates may have become higher than the U.S. capital scarcity interest rate, a possible explanation of the recent slowdown in the economy's rate of growth.
The capital scarcity interest rate is region specific. Due to the effect of diminishing returns, the capital scarcity rate of interest is expected to be higher in regions with small stocks of capital and lower in regions where capital is more abundant. The Fed stipulates a "one-size-fits-all" Federal Funds rate target for the entire U.S. economy. The rate target could be above the capital scarcity interest rate in a region with abundant capital, or it could be below the capital scarcity interest rate in a region with a smaller capital endowment. Relationships between the regional capital scarcity interest rates and a common Federal Funds rate target may explain investment rate differentials among regions within a nation.
Transmission and Obstruction
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. Beginning in 2008 following three episodes of quantitative easing, the Fed's policy linkage became
- first announce a change in the Federal Funds target rate,
- then reset the interest rate paid to commercial banks on their reserve balances on deposit at the Fed to impose a floor below the Federal Funds rate,
- rendering it a de facto administered rate under the indirect control of the Fed which would
- pull market-determined interest rates toward the Federal Funds rate
- to induce desired changes in the demand or supply of loanable funds (bank borrowing and bond market activity)
- so that market-determined financial instrument prices would change to cause
- yield rates on financial instruments to move toward the announced reserve deposits interest rate
- with expectation (or hope) that just enough force had been applied to cause spending in the economy to change in the direction intended by the reserves deposit rate announcement
- without precipitating (further) recession or inflation.
Obstruction of monetary policy intent may occur if market participants key their decisions on their perceptions of the capital scarcity rate of interest that is different from the announced policy rate. In an open-economy world, policy process obstruction may be brought about by unexpected trade and capital flows that affect the relevant money supply, financial instrument prices, and yield rates. Monetary policy interruption may be caused by unexpected spending changes as occurred in 2019-2022 due to the Covid pandemic and supply chain congestion, in 2022-2024 by unexpected military hostilities, by natural disasters, and by ensuing climate change.
Summary
A region's rate of real economic growth and its rate of price inflation depend critically on the relationship between market-determined interest rates and the region's capital scarcity interest rate. The region's central bank may specify an inflation rate goal, but if the interest rate target intended to reach the price inflation goal is below the region's capital scarcity interest rate, inflation at a rate faster than the goal may persist. The region's central bank may be able to manipulate market interest rates, but whether an induced change of market interest rates will be in the right direction or magnitude to alleviate price inflation (or deflation) depends on how the resulting market rates stand relative to the region's capital scarcity interest rate.
42. Monetary Policy by Committee
During 2025 and early 2026, the rate of inflation in the U.S. had been trending downward toward the Fed's 2 percent goal, but the initiation of war in Iran in April 2026 was accompanied by an increase in the rate of inflation to 4.2 percent on June 10. By early May 2026, bond market traders, wary of the increasing size of the U.S. public debt and the uncertainties of the Iranian war and Mr. Trump's tariff policies, had begun to offer lower prices to purchase newly-issued government bonds, causing their yields to increase.
In early 2026 President Trump pushed the Federal Reserve's Open Market Committee to lower interest rates. The nominal intent was to help budget-stressed citizens faced with accelerating inflation due to the Iran war. The more likely purpose may have been to lessen the Treasury's burden of financing interest paid on outstanding public debt.
It is indeed true that lower interest rates would facilitate the sale, not only of bonds by the U.S. Treasury to finance new debt, but also bonds issued by private corporations to finance investment and research. However, assisting the Treasury and private corporations to issue and finance debt is not within the dual mandate of the Federal Reserve, i.e., to maintain price stability (averting both excessive inflation and deflation) and to maintain full employment and facilitate economic growth.
Mr. Trump has complained that the Fed under Chairman Jerome Powell often has delayed needed interest rate adjustments. Upon Chairman Powell's retirement on May 22, 2026, Mr. Trump appointed Kevin Warsh to chair the Fed in anticipation that he would be more amenable to lowering interest rates. Mr. Trump seems oblivious to the fact the at the Chair of the Fed is only one of the 12-member FOMC who alone cannot change interest rates. Other members of the FOMC may follow the lead of the Chair or dissent.
Jeff Cox, writing on the CNBC website, May 20, 2026, says that
(https://www.cnbc.com/2026/05/20/fed-officials-see-rate-hike-ahead-if-inflation-stays-elevated-minutes-show.html?msockid=24a0c80650066ccc1210df2151386d48).
This episode begs the question of whether majority committee voting is an effective way to conduct monetary policy. This approach virtually eliminates the possibility of acting proactively and with expediency when the need for a policy change is perceived. It portends a "follow-the-market" approach to setting monetary policy. This procedure may serve as the basis for Mr. Trump's complaint that Fed Chair Powell often has acted belatedly to address interest rate changes that Mr. Trump wants.
43. Leading or Following the Market?
Jason Douglas and Jon Sindreu, writing in The Wall Street Journal, December 11, 2016, say
. . . .
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)
Sean Williams, a columnist for The Motley Fool, writing on the MSN website on May 25, 2026, says that
The Fed minutes primarily paint a picture of patience, with policymakers preaching a wait-and-see approach. Given the persistent price stickiness of President Trump's tariffs on the goods sector and the energy price shock associated with the Iran war, the 12-person body responsible for setting the nation's monetary policy doesn't want to jump the gun.
(https://www.msn.com/en-us/money/markets/uh-oh-the-fed-meeting-minutes-point-to-a-big-shift-in-monetary-policy-that-may-upend-a-historically-pricey-stock-market/ar-AA23ZLJb?ocid=msedgdhp&pc=DCTS&cvid=6a14490cdac94d708b0f9327bda1234d&ei=11)
44. Shorter- and Longer-term Bond Yield Rates
The media foster the notion that the Federal Reserve sets and changes interest rates in the U.S. economy. It's a bit more complicated than that, and it's not certain that market interest rates change at the behest of the Fed. President Trump has demanded that the Fed lower interest rates to lessen the Treasury's burden of paying interest on the pubic debt, but thus-far the Fed has resisted the President's demand in the interest of addressing inflationary pressures.
In a column dated June 6, 2026, Washington Post economic columnist Andrew Ackerman notes that President Trump does not understand that interest rates may serve as a macroeconomic tool.
To facilitate the rate cut, the New York Federal Reserve branch, acting on behalf of the Federal Open Market Committee (FOMC), also may enter the bond market to buy bonds, likely by engaging in overnight repurchase and reverse repurchase transactions (see Essay 32). Assuming that bond supply does not increase, the increasing bond demand would cause their market prices to rise and their yield rates to fall toward the lower Federal Funds rate target. Retail lenders (banks, credit unions, other mortgage lenders) would reset their lending rates with respect to the 10-year Treasury Bill rate as it follows the Federal Funds rate decrease. Good so far, but this is only the first stage of adjustment to the decreased Federal Funds rate target.
In a second stage of adjustment, bond supply also may increase. Mortgage, autoloan, and other retail lenders who set their lending rates with respect to the Federal Funds rate or the 10-year Treasury Bill rate would enjoy increasing loan demand at the lower market rates. Financial institutions could 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, undermining the Fed's intent to lower market interest rates. Whether the upward pressure of this second-stage is strong enough to outweigh the first-stage interest rate decrease depends on the relative magnitudes of bond demand and supply changes.
Ackerman suggests that anticipation of faster inflation (attributable to the Iran war?) has put the bond market "in a sour mood." Yields on outstanding bonds may no longer cover the loss of purchasing power due to the faster rate of inflation. Bond market investors may shift to buying only bonds offered at lower prices (higher yields), or they may increase purchases of longer-term bonds promising higher yields to cover the purchasing power loss due to inflation. The increasing demand for lower-priced or longer-term bonds relative to supplies would increase their prices and lower their yield rates, thus supporting the Fed's intent to lower interest rates. But the decreasing demand for higher-priced and shorter-term bonds relative to supplies would lower their prices and increase their yield rates, thereby opposing the Fed's intent to lower interest rates. Again, whether the short-term bond yield rate increase is great enough to outweigh the long-term bond yield rate decrease depends on the relative magnitudes of bond demand and supply changes.
As bond market investors shift their bond purchases from shorter-term to longer-term bonds, the falling longer-term bond yield rates and increasing shorter-term bond yield rates may tend to converge. Longer-term bond yield rates normally are higher than shorter-term bond yield rates to cover greater price risk during the longer terms. But if longer-term bond yield rates fall below the increasing shorter-term bond yield rates, historical experience suggests that such a rate inversion may portend the possibility of a coming recession (see essay #41, section on "Normal and Inverted Yield Curves"). A recession in 2027 could result if the FOMC were to precipitate a rate inversion by cutting the Federal Funds target rate in late-2026.
In the FOMC meeting on June 16, 2026, members voted to hold the Federal Funds rate target range constant between 3.5 and 3.75 percent. FOMC members did not vote to lower interest rates to accommodate President Trump's demand. It remains to be seen whether faster inflation during the latter half of 2026 will persuade the FOMC to favor increasing the Federal Funds rate target.
The analysis for a Federal Funds target rate decrease may be recast for a Federal Funds target rate increase by reversing the bond market demand and supply direction shifts. The Fed's first step in an effort to increase market interest rates would be to issue an announcement of a Federal Funds target rate increase. This increase would be accompanied by a commensurate increase in the reserves balance interest rate that the Fed pays to banks on their deposits at the Fed. Federal Funds lending rates would be expected to follow the reserves balance interest rate.
To facilitate the rate increase, the New York Federal Reserve branch, acting on behalf of the FOMC, may enter the bond market to sell bonds, possibly by engaging in overnight repurchase and reverse repurchase transactions (see Essay 32). Assuming that bond demand does not increase, the increasing bond supply would cause their market prices to fall and their yield rates to rise toward the higher Federal Funds rate target.
But, as bond supply increases, bond demand also may increase. Mortgage, autoloan, and other retail lenders who set their lending rates with respect to the Federal Funds rate or the 10-year Treasury Bill rate would suffer decreasing loan demand at the higher market rates, thereby freeing-up reserves. They may deposit their excess reserves at the Fed to capture reserves deposit interest, or they may buy Treasury Bills and other shorter-term bonds. Increasing demand for bonds relative bond supply would increase bond prices and decrease their yield rates. An increase of the Federal Funds rate target thus could cause downward pressure on market interest rates, undermining the Fed's intent to increase market interest rates.
If bond market investors shift to buying shorter-term bonds, the decreasing demand for longer-term bonds relative to supply would decrease their prices and raise their yield rates, thus supporting the Fed's intent to increase market interest rates. But the increasing demand for shorter-term bonds relative to supply would raise their prices and lower their yield rates, thereby opposing the Fed's intent to increase market interest rates. Whether the short-term bond yield rate decrease is great enough to outweigh the long-term bond yield rate increase depends on the relative magnitudes of bond demand and supply changes. A rate inversion is unlikely to occur as longer-term bond yield rates increase and shorter-term bond yield rates decrease to preserve the "normal" relationship between short- and long-term bond yields.
Accellerating inflation during the second half of 2026 would militate in favor of Federal Funds target rate increases by the FOMC, but whether market interest rates increase or decrease depends entirely on the relative magnitudes of bond demand and supply changes.
The bottom line is that market interest rates respond to bond demand and supply changes that may or may not accord with the Fed's intent to cause market interest rates to change by respecifying the Federal Funds target rate or the reserves deposit rate. The Fed cannot simply dictate market interest rates or rate changes. Retail lenders should pay more attention to what is happening in their respective markets than to the Fed's manipulation of its administered prices.
__________
Chris MacDonald, writing on the MSN website, July 10, 2026, says that
Further, I think a flattening [yield] curve compounds investors' concern. A [yield] spread [between long-end bonds and 10-year Treasury bills] that has moved from 0.74% to 0.35% in five months, with a June low of 0.27%, sits at the 4th percentile of its 12-month range. Historically, sustained flattening toward inversion has preceded slower growth, and it is happening while federal debt has grown by $3.17 trillion year over year to $39.39 trillion as of July 1, 2026.
(https://www.msn.com/en-us/money/savingandinvesting/the-fed-s-8-trillion-balance-sheet-is-sending-a-clear-signal/ar-AA27EQqO?ocid=msedgntp&pc=DCTS&cvid=6a514d39521240e38fa224f4eae92762&ei=37)
46. The U.S. Economy at Mid-2026
Turmoil in the U.S. macroeconomy at mid-2026 is revealed in selected web pages:
47. A Final Word The commentaries included in this essay collection have surveyed the difficulties of implementing monetary policy. The final word is a reprise of a statement made in the Introduction. Today we live in an open-economy world characterized by imperfect human knowledge, complex transmission mechanisms, inadequate predictive models, imprecise policy calibration techniques, and political institutions that are compelled to deficit finance their expenditures. Intelligent human operatives can perceive, rationalize, and act to thwart the intentions of government officials.
If the world were populated exclusively by intelligent and knowledgeable rational expectations decision makers, then no action by any politician or public policy decision maker would have any permanent effect. Monetary policy would be ineffective and pointless. But monetary policy actions by central bank officials occasionally appear to work. Why? There are enough people in any population who are of lesser intelligence, who pay little attention to what is happening around them, who do not systematically extrapolate past experience to future expectations, and who do not think rationally that politicians and public policy makers can implement surprise policy actions that fool or manipulate them.
Jason Ma, "The Treasury is walking a tightrope on US debt by relying so much on short-term rates that are at the mercy of a suddenly very hawkish Fed," Fortune on the MSN website, July 20, 2026:
https://www.msn.com/en-us/money/markets/the-treasury-is-walking-a-tightrope-on-us-debt-by-relying-so-much-on-short-term-rates-that-are-at-the-mercy-of-a-suddenly-very-hawkish-fed/ar-AA28jd84?ocid=msedgdhp&pc=DCTS&cvid=6a5f5e642045481dba7e52f4e24f547d&ei=80
John Towfighi, "The world’s most important market is flashing red about the Iran war," CNN on the MSN website, July 23, 2026:
https://www.msn.com/en-us/money/general/the-world-s-most-important-market-is-flashing-red-about-the-iran-war/ar-AA28xixP?ocid=msedgntp&pc=DCTS&cvid=6a635fa36d0b42258cb98c43e7063f81&ei=101
Martin Baccardax, "The bond market has a clear warning for investors as Iran war rages on," Barrons on the MSN website, July 23, 2026:
https://www.msn.com/en-us/money/general/the-bond-market-has-a-clear-warning-for-investors-as-iran-war-rages-on/ar-AA28x0CG?ocid=msedgntp&pc=DCTS&cvid=e6b3cb407fdf46398e2c86831e431daf&ei=21
Karen Brettell, "Fed Chairman Warsh faces cruel summer as bond yields spike," Reuters on the MSN website, July 24, 2026:
https://www.msn.com/en-us/money/economy/fed-chairman-warsh-faces-cruel-summer-as-bond-yields-spike/ar-AA28BiAb?ocid=msedgntp&pc=DCTS&cvid=6a635fa36d0b42258cb98c43e7063f81&ei=121
Seeking Alpha on the MSN website, "Market to Fed: Act on inflation or we will. US30Y surges to 19-year high," July 29, 2026:
https://www.msn.com/en-us/money/general/market-to-fed-act-on-inflation-or-we-will-us30y-surges-to-19-year-high/ar-AA290ljX?ocid=msedgntp&pc=DCTS&cvid=6a6a88c9c40146c985d9412c41e18d29&cvpid=ba1be9b640c14ff0b3f37ea3eafb6698&ei=5
Noel John and Anjana Anil, "Gold rises 2% as Fed holds rates steady, markets parse Warsh's comments," Reuters on the MSN website, July 29, 2026:
https://www.msn.com/en-us/money/economy/gold-rises-2-as-fed-holds-rates-steady-markets-parse-warsh-s-comments/ar-AA290kOR?ocid=msedgntp&pc=DCTS&cvid=6a6a88c9c40146c985d9412c41e18d29&cvpid=ba1be9b640c14ff0b3f37ea3eafb6698&ei=11
Misty Severi, "Dow Jones plummets 1,100 points for greatest single day loss since April 2025," Just the News on the MSN website, July 29, 2026:
https://www.msn.com/en-us/money/economy/dow-jones-plummets-1-100-points-for-greatest-single-day-loss-since-april-2025/ar-AA290MMG?ocid=msedgntp&pc=DCTS&cvid=6a6a88c9c40146c985d9412c41e18d29&cvpid=ba1be9b640c14ff0b3f37ea3eafb6698&ei=24
Sam Goldfarb, "Kevin Warsh’s honeymoon with the bond market is already over," Markets Today on the MSN website, July 30, 2026:
https://www.msn.com/en-us/money/general/kevin-warsh-s-honeymoon-with-the-bond-market-is-already-over/ar-AA295SIq?ocid=msedgdhp&pc=DCTS&cvid=6a6deb935be847bd81451c48e33de725&ei=44
Steven Porrello, "The stock market is sending a chilling warning, and history isn't reassuring," The Motley Fool on the MSN website, August 9, 2026:
With this accumulated information, it may seem that the U.S. economy is approaching the edge of a fiscal and financial precipice. How many more steps can it take before it tumbles into the abyss? And then what? Can a tumble be averted?
Most of the mid-2026 macroeconomic turmoil can be analyzed as conventional demand-supply relationships.
Anxious and nervous investors and bond market traders are concerned about the possibility of escalating inflation due to the Iran War, the Pentagon's request for an additional $67 billion to defray Iran war expenses, the passage by Congress of the National Defense Authorization Act that will add $1.15 trillion to the debt, increasing energy costs, corporate bond issuance to finance the on-going AI build-out, the government's growing annual deficit, half of which is to pay interest on the outstanding debt, the continuing ability of the U.S. government to fund increasing debt and refund maturing debt, and the issuance of more debt by foreign governments in the U.S. and other global bond markets.
These factors cause government and corporate issuers of bonds to try to meet their financing requirements by increasing their supplies of bonds relative to demands, but with different effects on shorter- and longer-term bond prices and yields.
Nervous bond market investors are selling longer-term bonds and decreasing their demands for new issues of longer-term bonds relative to increasing government and corporate supplies. Both the increasing supply of longer-term bonds to the bond market and the decreasing demand for them causes longer-term bond prices to fall and their yield rates to rise.
At the same time, nervous bond market traders are increasing their demands for shorter-term bonds relative to government and corporate supplies, causing shorter-term bond prices to rise and their yield rates to fall. This along with the sell-off of longer-term bonds causes the basis-point spread between longer- and shorter-term bond yields to increase and the yield curve to steepen.
The spread is aggravated by nervous investors selling volatile-price stocks and shifting the proceeds to buy precious metals and shorter-term bonds with less price risk. The increasing supplies of stocks coming onto stock markets relative to demands cause stock prices to fall. Precipitous falls occur when investors are disappointed that their Fed rate hike expectations are not met.
The increasing demand for gold and other metals relative to their supplies causes their dollar prices to rise and the dollar to fall on foreign exchange markets. As foreigners' demands for dollars to buy gold and U.S.-issued bonds increase relative to the U.S. money supply, foreign currency prices of the dollar rise, i.e., the dollar depreciates.
A longer-term issue is the credibility of the U.S. government to fund continuing and increasing annual deficits, pay interest due on oustanding debt, and refund maturing debt. The post-World War II solution to the war debt problem was for the economy to inflate and grow in real terms while issuing no new debt so that the outstanding debt became an ever-smaller proportion of increasing GDP.
Accelerating inflation, on-going AI build-out, and expansion of wind, solar, and nuclear energy sources may provide possibilities for dealing with the debt, but not if the cumulative debt continues to increase faster than the rates of inflation and real growth.
Emerging Artificial General Intelligence (AGI) technology has been touted eventually to become smarter than humans and have the ability to greatly improve the welfare of humanity. Investment in AI technology is expected to be a driver of growth that could diminish the accumulating debt problem. Hannah Rubinton and Bontu Ankit Patro, writing on the website of the Federal Reserve Bank of St. Louis on January 12, 2026, say that
But an AI danger lurks in the possibility that AGI agents might "go rogue" and escape human control (https://www.washingtonpost.com/technology/interactive/2026/07/30/timeline-cyberattack-by-openais-ai-agent-shows-its-sophistication/). It is hypothesized that AGI agents could decide to extinguish humankind (https://www.scientificamerican.com/article/could-ai-really-kill-off-humans/). And there is a possiblity that the AI build-out investment process will crash in a financial bubble that will burst. Jonathan Mahler, Jim Rutenberg, and Kirsten Grind, writing in a New York Times Magazine column dated July 31, 2026, say that
The growing consensus is that these kinds of numbers add up to a bubble. The more salient question may be how big a bubble, and also what will happen if it bursts. One macroeconomic research firm, MacroStrategy Partnership, has estimated that the A.I. bubble is 17 times as large as the dot-com bubble and four times as large as the 2008 housing bubble. ....
The financial structure of the data center build-out makes it especially vulnerable to a crash. The deals themselves are built on enormously complicated debt and equity schemes that involve circular financing. The hyperscalers are investing heavily in the same companies they are counting on to buy their computing power. It’s what economists call an interlocking liability structure. If their customers struggle to monetize their products, they will be hit extra hard — and so will their investors, which include a lot of everyday Americans. And these are just the U.S. companies. The A.I. boom has been a global phenomenon; an A.I. collapse would be as well.
https://www.nytimes.com/2026/07/31/magazine/larry-ellison-ai-oracle.html
The Editorial Board of The Washington Post describes the federal budget debacle that will be reached in the 2030s:
The Bureau of Labor Statistics' July employment report indicated that 23,000 jobs were lost in July compared to an expected gain of 80,000. The June employment gain was adjusted downward from 57,000 to 20,000. The July unemployment rate decreased from 4.2 percent to 4.1 percent because the labor force participation rate (LFPR) fell from 61.5 percent to 61.4 percent, its lowest in more than five years, as 264,000 people no longer had jobs or were seeking jobs. This decline in the LFPR is due in part to demographic change that adds seniors to the non-working segment of the population as it reduces the LFPR. The Washington Post Editorial Board describes the emerging demographic change:
The CBO's estimates are based on optimistic assumptions: no wars, no recessions, low and stable inflation, and no new government programs or tax changes. But as of summer 2026, the Iran war appears never-ending, COPE ratios in the stock market are approaching an historic peak, the AI build-out process may be on a financial bubble that could break, and the steepening yield curve in bond markets suggest that the U.S. economy may be in store for a recession.
The Fed has been focused on the inflation side of its dual mandate. If it were to shift its attention to the employment side by decreasing its benchmark interest rate to avert recession and stimulate growth and employment, that might please the President and the Treasury Secretary, but it could also accelerate the rate of inflation.
So, how can a step over the financial and fiscal precipice be averted?
Even if all of these actions are taken, there is no guarantee that a precipice tumble can be averted.
<>
It is a delusion to think that central bankers can successfully implement monetary policy to achieve price stability, satisfactory economic growth, or low-enough rates of unemployment. Such conditions, if they occur, are more likely to come about by the normal functioning of the economy, and perhaps in spite of central bank interventions to manipulate the economy.
So, I profess agnosticism about monetary policy. Despite my formal economic training, I no longer have faith in the ability of central bank officials to implement monetary policy with good effect. Sometimes it works; more often it doesn't. The world may be better off letting nature take its course without policy interventions to alter its direction or force. Que sera, sera!
Appendix. Lessons from American Banking History
An Historical Outline of American Commercial and Central Banking:
Banking during colonial times, banking is primitive at best; a few English-owned banking companies serve depository functions in the colonies; the only money in use is English or Spanish.
1776, American Revolution, after which a few gold or silver smiths begin to operate as depositories on their own authority (i.e., not chartered by any official agency).
1776-1781, Congress could not finance the Revolutionary war with large tax increases, as the memory of unjust taxation from the British stood fresh in the minds of the American public; the Continental Congress borrowed money from other nations, Benjamin Franklin securing loans of over $2 million from the French Government and President John Adams securing a loan from Dutch bankers and from domestic creditors; 1781, Congress establishes the U.S. Department of Finance.
1783, Revolutionary War ends; total debt reaches $43 million; Congress raises taxes.
1791, The ("First") Bank of United States is chartered by act of Congress to assist with finance of Revolutionary War debts; the 20 year charter expires in 1811, just before War of 1812.
1800, perhaps 300 or so private banks have been chartered by new state governments.
1812-1815, War of 1812 more than doubles nation’s debt from $45.2 million to $119.2 million; Treasury Department issues bonds to pay a portion of the debt.
1816, The ("Second") Bank of United States is chartered by Congress to assist government with financing of 1812 War debts, the 20 year charter to expire in 1836.
1820s and '30s, states charter new banks at rapid pace with no controls; eventually over 3000 banks chartered in the 13 states formed from the original colonies, each bank issuing as many as half dozen denominations of currency; "wildcat banking"; counterfeiting; no other federally chartered banks.
1829, Andrew Jackson elected President on promise of not renewing charter of Second Bank; Jackson feared and hated banking interests because a bank had foreclosed the mortgage on his father's farm.
1829-1836, Jackson regards the debt a “national curse;” blocks infrastructure projects and raises revenue by selling federally owned western lands; pays off the national debt after six years in office and divides a government surplus among indebted states.
1836, banking chaos ensues with termination of operations of second Bank of the United States; money, which has to be shifted from vaults of second bank to state banks, goes into transit along waterways, wagon-ways, and railroads, and is thus not available to facilitate commerce.
1837 to Civil War, "Free Banking" era, about half of the states allow anyone with a minimum amount of their own funds to open a bank; banking and economic instability ensues, but paper money issued by reputable state banks is generally convertible to gold at face value (par); paper money issued by distant or "unknown" ("wildcat") banks circulates at discount from par (economist Barry Eichengreen describes the ensuing chaos in a New York Times column, June 17, 2025, "This Bill Will Return Us to an Era of Economic Chaos," https://www.nytimes.com/2025/06/17/opinion/genius-act-stablecoin-crypto.html?campaign_id=39&emc=edit_ty_20250617&instance_id=156686&nl=opinion-today®i_id=74240569&segment_id=200089&user_id=86b0d837dd357b2a6e0e749321f6ed7f).
1860-1865, Civil War finance requires issue of paper money by governments on both sides; paper money is over-issued by state chartered banks and by both governments; excessive issue of Union (North) treasury notes, known as "greenbacks," eventually results in circulation at discounts from par; same occurs for Confederate (South) money, but even worse; at war's end Confederate issues of money become worthless, Federal greenbacks continue to circulate at discounts.
1869-1875, first American "Great Depression" follows from deliberate withdrawal of paper money by Congressional act to eliminate discount from par, with the objective to reestablish convertibility of currency to gold at par.
1873, collapse of Jay Cooke & Co., a major bank invested in railroading, causes the Panic of 1873; nearly a quarter of the country’s railroads go bankrupt, more than 18,000 businesses close, unemployment hits 14 percent; New York Stock Exchange suffers collapse; a period of deflation ensues and slow growth continues for 65 months; government collects less tax revenues and the national debt continues to grow.
1865-1913, in the absence of a central bank to exercise control over the banking system, the Treasury Department begins to learn and exercise some central banking functions; by the turn of the century there is widespread recognition of the inflationary potential of allowing the same governmental office responsible for financing government's expenditures to also be responsible for providing and controlling its money supply; demands for monetary reform become more outspoken.
1875-1890, era of Bimetalism; silver mining interests demand governmental support; Congress passes legislation to define sixteen ounces of silver as equal in value to an ounce of gold, and par values are determined between the dollar and both metals in the ratio of 16:1; but relative market values of gold and silver change; for a while gold is overvalued at the mint, and so is drained from circulation (mostly to Europe) and replaced by silver; later silver becomes overvalued and is drained from the economy to Europe (gold flows in from Europe); consequent economic instability ensues as gold flows into and out of the country, thereby affecting the domestic money supply; eventually bimetallism is ended and the U.S. government defines the value of the dollar exclusively in terms of gold, thereby committing to the international Gold Standard.
1880, beginning of charter of "National Banks" by federal government; state banks are prohibited from further issuance of bank notes; only National Banks chartered by the federal government are authorized to issue bank notes, but most banks choose to remain state banks in order to avoid control by the Treasury; money supply begins transition from mostly paper money to mostly demand deposits.
1880s until 1913, banking instability continues; money supply is inflexible in sense that much of the money is in bank vaults in the cities when it is needed in rural areas to facilitate planting, harvest; during off-seasons most money remains in rural areas when it is needed in the cities; banking panics precipitate numerous episodes of economic instability which worsen.
1912-1913, Congress debates the need for a central bank and the shape it is to take; the need for independence from the Treasury is a critical issue; Federal Reserve Act is passed by Congress in 1913.
1914-1932, Federal Reserve System (FRS) begins to operate, has to learn central banking functions; national banks lose authority to issue currency; this authority becomes the exclusive function of FRS in order to provide a uniform currency and a flexible money supply; number of state as well as national banks increase, state banks by much larger numbers because of FRS regulation of national banks; bulk of money supply is now demand deposits rather than currency.
1929-1932, after boom decade of 1920s, U.S. seconomy goes into depression with collapse of business confidence; output and employment contract by nearly 25 percent.
1930, Congress passes Smoot-Hawley Tariff Act, intended to protect American agriculture and business by raising import duties by approximately 20% on wide range of agricultural and industrial goods; Act contributes to worsening depression (a second "Great Depression") by stifling international trade and sparking retaliatory tariffs by other nations.
1932-1936, banking system collapses; FRS Board fails to comprehend its mission of being "lender of last resort" to the commercial banks, or that it is fundamentally different from commercial banks in that it cannot fail; FRS lets the money supply drop drastically as it mistakenly attempts to decrease its outstanding deposit liabilities in order to keep itself from failing; as FRS decreases its deposit liabilities (deposits of commercial banks), commercial banks cannot meet reserve requirements, call loans many of which are bad, become insolvent, fail; banking population drops from over 30,000 to less than half; the U.S. nationalizes all gold in the country and suspends gold payments to foreigners, thus goes off Gold Standard.
1936, with monetary stringency, interest rates rise in the U.S. relative to Europe, capital inflow increases, supplies American banks with excess reserves which FRS officials view with alarm as having great inflation potential; FRS does not realize that bankers wish to hold idle excess reserves for liquidity; FRS raises reserve requirements to "mop up" excess reserves, precipitates another banking crisis, monetary contraction, second downturn and depression trough.
late 1930s, gradual recovery as FRS officials begin to comprehend effects of their actions; FRS ceases decreasing reserves and the money supply.
early 1940s, beginning of WWII, FRS takes subsidiary role to Treasury, assists with war finance by keeping interest rates low, lets money supply increase, causing inflationary pressures; inflation is contained by price controls and rationing.
late 1940s, rationing and price controls are lifted at war end; pent-up inflationary pressures are released, causing a significant inflation; the U.S. participates in forming the Bretton Woods international monetary system by committing to fix the value of the U.S. dollar to gold so that other countries can fix the values of their currencies to the dollar (a pseudo Gold Standard).
post-WWII era, the U.S. runs chronic balance of payments deficits due to Marshall Plan, American tourism, American overseas investment, growing imports of foreign merchandise; the U.S. for a while maintains the value of the dollar to gold as its monetary gold stock depleats; confronted with continuing decline of the U.S. monetary gold stock, in 1971 President Nixon suspends domestic redemption of currency into gold; by 1973 Nixon suspends international gold payments by the U.S., thus ending the Bretton Woods international monetary system and initiating a flexible exchange rate system.
1951, William McChesney Martin, Jr., is appointed by President Eisenhower to chair the Federal Reserve Board of Governors; Martin negotiates an "accord" with the Treasury to regain its autonomy and independence; the Fed acts to raise interest rates and restrict the money supply to control inflation.
1952-1960, prices remain stable through rest of '50s; recession emerges in 1958 in second Eisenhower administration, the first on record with both rising unemployment and rising prices; "stagflation" is born.
early 1960s, Kennedy administration implements first "supply side" tax cut that stimulates growth; FRS pursues interest rate as monetary target due to Keynesian theoretical influence, lets money supply expand to keep interest rates under control; inflationary pressures worsen.
late 1960s, initiation of Viet Nam war requires increased military expenditures, adding to President Johnson's "Great Society" social welfare spending programs; increasing inflationary pressures; FRS targeting of interest rate control allows monetary aggregates to expand to keep interest rates low, fuels accelerating inflation.
1970, Nixon appoints personal friend Arthur F. Burns to succeed Martin as chair of Federal Reserve Board, leans on Burns to keep interest rates low; Burns acquiesces, but runaway price increases result in uncontrolled inflation.
early 1970s, Nixon administration tries wage-and-price guidelines, but is unsuccessful in containing inflation; Nixon resigns in 1974 Watergate scandal; Nixon is succeeded for two years by President Ford; President Carter is elected in 1976.
late 1970s, inflation psychology emerges with growing budget deficits, rising nominal interest rates; with crowding-out effect threatened, Fed acts to expand money supply to prevent further interest rate increases, but this only aggravates inflationary pressures.
1979, Paul Volker is appointed by President Carter to chair Federal Reserve Board, but Volker turns out to have monetarist rather than Keynesian leaning; Volker redirects FRS policy away from interest rate targeting and toward control of monetary aggregates so as to reduce the rate of growth of the money supply.
1981-1982, Volker's monetary stringency precipitates deep though brief recession; inflation psychology is broken and monetary and economic stability follow.
1983-1990, Reagan administration cuts taxes, pursues "supply side" policies which, coupled with careful control of monetary aggregates, initiates longest period of sustained U.S. expansion on record; FRS now indoctrinated in the need to pay more attention to monetary aggregates than to interest rates as target of monetary policy.
1980s and 1990s, failure of nearly a quarter of the more than 3200 savings and loan associations, requiring bailouts totaling nearly $90 billion; new home construction slows, contributing to early '90s recession.
late 1980s, President George H. W. Bush says "no new taxes" as a campaign promise, but confronted with rising Federal budget deficits, raises taxes after election; this brings about the end of the long expansion in 1990 and Bush's defeat in 1992.
1987, President Reagan appoints Alan Greenspan to succeed Volker as Fed chair; Greenspan is reappointed at successive four-year intervals until retiring early 2006; Greenspan's "easy-money" policy is likely cause of the "dot-com bubble" and the subprime mortgage crisis; Greenspan argued that the housing bubble was not a result of low-interest short-term rates but rather a global phenomenon caused by the progressive decline in long-term interest rates.
1989, enactment of FDIC Improvement Act requires all banking institutions receiving deposits to insure with the FDIC and all such institutions to come under the regulation of the Federal Reserve.
early 1990s, after Volker's retirement, the Greenspan FRS continues to give lip service to monetary aggregates and to targeting a range of growth for M2, but begins to give occasional attention to interest rates as Federal government runs ever larger budget deficits.
1992, Bill Clinton elected President, raises taxes in effort to control budget deficit, precipitates recession; interest rates at post-WWII lows as outside world purchases U.S. government bonds, thereby assisting the U.S. in financing its budget deficit without interest rate increases.
1993-1994, recovery occurs gradually with FRS leaning against monetary expansion; FRS raises discount rate five times during 1994, the latest being a 3/4 percent increase in mid-November 1994; long-term interest rates continue to rise, indicating that capital markets think that not enough yet has been done by the FRS to impose monetary stringency and avert inflation.
1999, Glass-Steagall Act repealed, removing separation between investment banks and depository institutions; this repeal is thought by many banking analysts to have contributed to financial crisis in 2007-2010.
late 1990s, early 2000s, wave of banking mergers among larger banks and acquisitions of smaller banks; many larger depository banks begin investment banking operations as enabled by repeal of Glass-Stegall Act.
2006, President George W. Bush appoints Ben Bernanke to succeed Greenspan as Fed Chair; Bernanke oversees the Fed's response to the 2008 "Great Recession" for which he is named the 2009 Time Person of the Year; Bernanke is awarded (jointly) the 2022 Nobel Memorial Prize in Economic Sciences for his analysis of the Great Depression; President Obama reappoints Bernanke as Fed chair in 2010; in a 2015 book Bernanke asserts that it was only the novel efforts of the Fed that prevented economic catastrophe greater than the Great Depression.
late 2000s, worst financial crisis and recession since the Great Depression of the 1930s; liquidity shortage in the banking system contributes to collapse of financial institutions and elicits bank bailouts by the government; stock market market suffers major decline; housing foreclosures contribute to construction decline and business failures in related fields; investor confidence collapses; government responds with massive fiscal stimulus which fails to have intended effect; unemployment increases toward 10 percent of the labor force; economic growth near zero.
2008, the Fed responds to the ensuing recession by lowering interest rates to near zero and initiates the process of "quantitative easing" in the effort to stem the so-called "Great Recession"; quantitative easing entails purchases of large quantities of bonds from commercial banks, paid for by crediting the reserves of commercial banks; most banks have large amounts of reserves in excess of legal requirements; the Federal Funds rate decreases toward zero, rendering it useless as a monetary policy tool.
2008, to put a floor under the Federal Funds rate and provide the Fed with some modicum of control, the Fed starts paying interest on commercial banks' reserve balances on deposit at the Fed; reserve balances interest rate changes expected to induce same-direction changes of the Federal Funds interest rate.
2008-2016, U.S. economy continues to be sluggish with real growth rate below 2 percent per annum; U.S. CPI inflation rate remains below the Fed's announced goal of 2 percent per annum; to induce the inflation rate to approach its announced goal, the Fed attempts to enable increased commercial bank lending by increasing bank reserves with four episodes of quantitative easing between 2008 and 2021; in an environment of fear, anxiety, and pessimism, the Fed is unable to force bankers to lend or prospective borrowers to borrow; most of the increased liquidity ends up in commercial bank excess reserves and business cash hoards rather than in circulation to stimulate spending.
2010, Congress temporarily increases deposit insurance limit to $250,000, passes Dodd-Frank Wall Street Reform and Consumer Protection Act to improve regulatory oversight of the banking system.
2010, emergence of privately-issued cyptocurrencies such as "bit coin."
2010-2011, financial crisis begins to ease, unemployment begins slow decline; economic growth increases toward 2 percent per annum; government budget deficit and accumulating public debt become central presidential campaign issues; Fed intends to keep interest rates low indefinitely.
2014, President Obama appoints Janet Yellen to succeed Bernanke as Fed chair; she is reappointed by President Trump in 2016; Yellen is succeeded by Jerome Powell in 2018 after Trump declines to renominate her for a second term; President Biden appoints Yelllen to serve a Secretary of Treasury, 2021-2025.
2015, long-time low rates are thought to cause financial instability and pose threat to the economy; Fed increases reserve balances interest rate for first time since 2006; reserve balances interest rate remains in low range of 1.25 percent to 1.5 percent, well below historical standards.
2017, Fed indicates that it intends to continue to implement systemwide "ample reserves," a policy that renders both the discount rate and the Federal Funds rate irrelevant as policy tools even if reserve balances interest rate changes elicit changes of the Federal Funds rate.
late 2017, President Trump declines to reappoint Democrat Janet Yellen, instead appoints Republican Jerome Powell to chair Fed Board; Powell reappointed by President Biden in 2021; Powell reduces quantitative easing (QE) and mortgage-backed security (MBS) purchases due to 2021–2023 inflation surge, with the consumer price index (CPI) in November 2021 reaching 6.8%.
2019-2023, Fed attempts to gain control of the inflation rate that exceeds its target of 2 percent per annum; supply-chain congestion and Covid pandemic cause market interest rates to fall; declining investment and other interest-sensitive spending precipitate a brief recession in 2020; U.S. inflation rate rises to 5 percent per annum by mid-2023 before beginning to decrease in late-2023.
2024-2025, Donald J. Trump elected to second presidential term, launches programs to trim size of government, eliminate DEI influences in government and American society, imposes off-and-on tariff increases above the historical 2% average rate on imports; elevated uncertainty in financial and business sectors begins to slow economic activity, accelerate inflation rate.
2024, Trump family issues "World Liberty" cybercoin, earns $57.35 million from sales of it in 2024.
April 2025, Trump presses Federal Reserve Board chairman Jerome Powell to fight impending recession by lowering interest rates; Powell, concerned about inflation potential, declines to comply; Trump indicates desire to terminate Powell's chairmanship; turmoil erupts in U.S. financial sector, sets in motion backlash; Trump backs away from intent to fire Powell.
June 2025, "Genius Bill" introduced in Congress; if passed into law it would authorize companies to issue a type of cryptocurrency called a stablecoin, the value of which would be tethered to a stable asset like the dollar; passage of the bill would authorize stablecoins to be issued by federally insured banks or by companies such as Walmart and Amazon; see the New York Times column by economist Barry Eichengreen, June 17, 2025, "This Bill Will Return Us to an Era of Economic Chaos," https://www.nytimes.com/2025/06/17/opinion/genius-act-stablecoin-crypto.html?campaign_id=39&emc=edit_ty_20250617&instance_id=156686&nl=opinion-today®i_id=74240569&segment_id=200089&user_id=86b0d837dd357b2a6e0e749321f6ed7f.
June 2026, Powell retires; former Federal Reserve Board member Kevin Warsh is appointed by President Trump to chair the Federal Reserve Board of Governors; Warsh declines to promote a Federal Funds rate cut at his first Board meeting, announces the end of "forward guidance" by the Fed in the interest of letting banks make decisions based on market information rather than predictions of Fed actions.
Lessons from U.S. Monetary and Banking History:
1. One society can use another society's money.
2. Banking innovation often occurs in response to the needs of war finance.
3. Free (or uncontrolled) commercial banking typically results in banking and currency chaos.
4. Gresham's Law: Bad money drives out good; cheap money drives out dear; debt money replaces commodity money; paper money replaces metallic money; digital money replaces paper and metallic money.
5. Disruptions to the banking system often are caused by misguided government policy.
6. No more than one monetary standard can be in effect at any one time.
7. If part of a nation's money supply becomes unavailable for circulation, its volume of commerce likely will contract.
8. Over-issue of the money medium results in the depreciation of its purchasing power.
9. The fiscal and monetary functions of government should be separate because of an inherent potential for inflation.
10. Central banking is fundamentally different from commercial banking; one is profit-oriented, the other is control-oriented.
11. Unlike a commercial bank, a central bank cannot fail.
12. A nation's money supply needs to be flexible and responsive to the needs of commerce and growth.
13. Commodity monies are strictly limited in quantity; debt monies can be expanded without limit (but with consequences).
14. Bankers may desire to hold reserves greater than they are required by law or authority to hold.
15. International capital flows can change a nation's commercial bank reserves and its money supply.
16. The central bank's commitment to a fixed exchange rate may deplete the nation's stocks of gold and foreign exchange.
17. A monetary policy of targeting interest rates is likely to cause monetary expansion and contribute to inflation.
18. A monetary policy of targeting the growth of a monetary aggregate (such as M2) can alleviate inflation, but with some undesirable side effects.
19. Price controls and rationing can only suppress inflationary pressures, not eliminate them.
20. If the monetary authority is subjugated to the fiscal authority, inflation is a likely consequence.
21. Efforts by the monetary authority to prevent crowding out of private investment usually results in monetary expansion and may contribute to inflation.
22. Supply-side fiscal policies may be able to stimulate an economy without causing inflation.
23. If the demand for bonds is increasing, it may be possible for government to finance its deficits without causing interest rates to rise.
24. A central bank can dictate only its own interest rate, but not market-determined interest rates.
25. Simply raising the central bank's interest rate may not achieve monetary restraint; the banking system's reserves must be decreased.
26. Simply lowering the central bank's interest rate may not achieve monetary stimulus; simply increasing the banking system's reserves may not achieve monetary stimulus.
27. Monetary expansion may produce price "bubbles" in areas other than measured by common price indexes, e.g., in financial, housing, and commodities markets.
28. Virtually any regulation imposed in the financial sector eventually will be circumvented by financial innovation.
29. Mixing depository and investment banking may have detrimental effects on the financial system.
30. Open market operations to provide banks with additional reserves (a.k.a. "quantitative easing") may not elicit additional bank lending if bankers see few viable lending opportunities.
31. In a democratic political system, electing an economically illiterate president with an anti-democratic (i.e., authoritarian) ideology has potential to co-opt the banking system for the executive's purposes; "stagflation" (simultaneous recession and inflation) is a possible consequence.
32. Implementing tariffs by legislative act or by executive order has potential to elicit tariff reciprocity by other nations with deleterious effects for banking systems and global economic stability.
Diminishing Marginal Utility of Money
The link between money supply increases and consumer spending is what economists refer to as the "diminishing marginal utility" of money balances. The sense of this is that when the money supply increases, the additional dollars held by a rational and normally risk-averse person (i.e., neither a gambler nor a miser) mean ever less to him. When the utility (a.k.a. "satisfaction") of the last dollar added to a person's money holding drops below the utility of a dollar's worth of something that he could buy, it becomes rational to part with the dollar and buy the item. The vernacular of this is that "money burns a hole in the pocket." If the additional spending adds to the demand for items relative to their supplies, prices may be bid up. When this happens across the spectrum of the goods that are consumed, inflation occurs.
The phenomenon of the diminishing marginal utility of money balances may not always work as predicted. Distributions of pandemic relief funds during 2021 seem to have resulted in hoarding as some of the funds were held rather than being spent by consumers. A possible explanation is that pandemic distribution recipients suffered sufficient uncertainty about the future that they held back on spending the funds. When the pandemic appeared to be alleviated, the release of pandemic hoardings caused aggregate demand to increase faster than could be accommodated by supply increases, resulting in rising inflation in late 2021 and early 2022.
The marginal utility of money balances may also work in reverse. If the money supply decreases such that individual money balance holdings decrease, the marginal utility of the remaining money balances held will increase for normal, risk-averse money balance holders (neither misers nor gamblers), inducing them to decrease their spending. When the marginal utility of a dollar held rises to exceed the marginal utility of something that the dollar could buy, a rational consumer will suspend further spending. Hoarding behavior may be explained for people who experience increasing marginal utility as their money balances increase (e.g., misers).
It is important to remember that money held as assets of banking institutions is not in circulation. As the Fed begins to "unwind" its bond portfolio in 2022 by selling bonds, it will siphon money from the bank accounts of bond purchasers, thereby reducing the quantity of money in circulation. The expectation is that the majority of people are normal, rational, and risk-averse (neither misers nor gamblers) so that the marginal utilities of their held money balances will increase, thereby reducing consumer spending and curbing inflation.
Arbitrage
Changes in the prices of bonds (and thus their yield rates) become transmitted to the prices (and yields) of other types of financial instruments via the process of arbitrage, i.e., the simultaneous purchase and sale of different types of financial instruments. Arbitrageurs are successful if they are able to operate by the criterion of “buy low, sell high.” Buying will tend to increase price in the lower-price market; selling will tend to lower price in the higher-price market. If they are successful, they will both capture profits and precipitate convergence of prices (and yields) across the markets. Unsuccessful arbitrageurs will suffer losses and tend to destabilize markets, and they may cause interest rates on different types of financial instruments to diverge.
Diminishing Returns
Diminishing returns is the physical phenomenon underlying the capital scarcity rate of interest. Most real world production processes exhibit the phenomenon of diminishing returns, i.e., beyond some point, output begins to increase at a decreasing rate. A graphic model of a diminishing returns production process is illustrated in Chart 9. The back walls of a 3-dimension (3rd order) production surface are illustrated in quadrant I as outlined by the path 0ABC0 in which product output (Q) is on the vertical axis, and amounts of labor (L) and capital (K) are on the right and left floor axes, respectively. The total product function label Q = f ( L , K | . . . ) may be read, "output is a function of the amounts of labor and capital, given fixed amount of all other inputs."
Marginal Products of Labor and Capital
The figure in quadrant V of Chart 10 depicts for the K2 amount of capital the average product curve, APL = (Q / L), and the marginal product curve, MPL = (?Q / ?L) for the smallest possible ?Q. Marginal product measures the rate of change of total product, i.e., the slope of the Q function along the K2 slice from E to F, G, H, and J. APL at first is greater than MPL but turns down and passes through the peak of MPL at the L2 amount of labor. Beyond the L2 amount of labor, MPL decreases (slopes downward) until it reaches zero on the labor axis at L5, corresponding to the maximum amount of product that can be produced, given the K2 installed plant. The downward sloping range of the MPL cuve illustrates the phenomenon of diminishing returns to labor, given the K2 amount of capital.
Capital often is thought of as a fixed input to which labor is the variable input that is added. But in some production processes the amount of labor is fixed (e.g., members of the family on a family farm) while the amount of capital can be varied by acquiring more or disposing of some equipment. Quadrant VI of Chart 10 illustrates diminishing returns to capital, given a fixed amount of labor, L2. The previous paragraph could be repeated with L and K swapped to reveal the phenomenon of diminishing returns to capital illustrated by the downward concavity of the Q = f ( K | L2 , . . . ) function beyond the K1 amount of capital and the downward slope of the MPK curve beyond the K2 amount of capital. It is this phenomenon that underlies the capital scarcity rate of interest.
The figures in quadrants VII and VIII of Chart 10 show that every point along a Q slice of the production function for a fixed amount of one factor is also on a Q slice for a fixed amount of the other factor. In the quadrant VII diagram, as the amount of labor is increased in a fixed plant K2, the slope of the Q function path decreases but the slopes of the cross-cutting K slices increase. Another way to describe this is that with an increasing amount of L, given the K2 plant, the marginal product of L decreases while the marginal product of K increases. And this also would be true in quadrant VIII as the amount of capital is increased for use by a fixed amount of labor L2. Increasing the amount of capital, given a fixed amount of labor, will increase the marginal product of labor even as the marginal product of capital decreases.
Technological advance that improves the efficiency of both of the factors of production would shift the 3-D surface 0ABC0 upward and outward along both of their axes to forestall the effects of diminishing returns to both factors. The marginal product curves of both factors also would shift upward and outward to forestall the effects of diminishing returns. Technological advance that improves the efficiency of only one of the productive factors will skew the surface upward and outward only along the axis of that factor. Such technological advance would forestall diminishing returns to that factor and increase the productivity of the other factor.
Yield Rates Vary Inversely with Market Prices
A simple example illustrates that yield rates vary inversely with market prices. A zero-coupon bond (one that promises no interest payment) would sell in the bond market only at a price lower than face (or par) value. The formula for computing the nominal yield rate on a zero-coupon bond is (face value - market price) / face value. For example, if a 1-year term bond with face value of $1000 can be purchased for $950, its nominal yield rate would be [ (1000 - 950) / 1000 ] = .05 or 5 percent. If a purchaser is willing to pay a higher price of $960 for this bond, the nominal yield rate would be lower: [ (1000 - 960) / 1000 ] = .04 or 4 percent.
Bond Demand and Supply
The yield rates or rates of return on bonds vary inversely with the prices of those bonds. The bond yield rates are implicitly the interest rates on the bonds.
In the bond market, demand and supply
are presumed to be normally sloped relative to the prices of the bonds
as illustrated in Figures 1 and 2. Since financial instruments exhibit
a wide range of denominations, the "quantity of bonds" on the
horizontal axis should be understood not in terms of a number of such
financial instruments, but rather as an amount of financing demanded or
supplied by such instruments. For purpose of exposition, a standard
bond of fixed denomination, e.g., $1 million, might be assumed so that
the horizontal axis units can be understood as the number of such
bonds. An increase in the demand for bonds from D1 to D2
in Figure 1, other things unchanged relative to the supply of
bonds, results in an increase in the price of bonds from P1
to P2, and a corresponding fall in their yield rate. If the
demand for bonds should decrease from D1 to D3,
the price of bonds would fall to P3 and the yield rate
would rise.
Bonds are supplied to the market by corporations seeking funds to finance investments and by governments needing to finance budgetary deficits. In Figure 2 an increase in the supply of bonds from S1 to S2, other things unchanged for bond demand, results in a decrease in the price of bonds from P1 to P2, with corresponding rise in the yield rate. A decrease in the supply of bonds to S3 would elicit an increase in the price of bonds to P3 and a fall in their yield rate.
When private parties have more money than they want to hold in their bank accounts (or under their mattresses), they can purchase goods and services, or they can purchase financial instruments in the bond market. When they do the latter, the demand for bonds increases as in Figure 1, pushing bond prices higher and yield rates lower. When private parties want to hold more money than they have, they can cut back on their purchases of goods and services relative to their continuing income flows, or they can sell some of their financial instruments in the bond markets. To the extent that they do the latter, the supply of bonds increases as in Figure 2, pushing bond prices lower and yield rates higher.
The supply of bonds may be affected by the intents of businesses to finance capital investments, the needs of governments to finance deficits or dispose of surpluses, and the intent of the central bank to execute monetary policy. Changing interest rate differentials between domestic and foreign locales may also induce bond demand or supply shifts. It is the market forces of demand and supply in the bond market that cause bond prices to change and their yield rates to change in the opposite direction.
Changes in the prices of bonds (and thus their yield rates) become transmitted to the prices (and yields) of other types of financial instruments via the process of arbitrage, i.e., the simultaneous purchase and sale of different types of financial instruments or financial instruments in different local markets. Arbitrageurs are successful if they are able to operate by the criterion of “buy low, sell high.” If they are successful, they will both capture profits and precipitate convergence of prices (and yields) across the markets. Unsuccessful arbitrageurs will suffer losses and tend to destabilize markets, and they may cause interest rates on different types of financial instruments to diverge.
Monetary Policy Transmission Mechanism
A monetary policy transition mechanism consists of the steps in the linkage between an action taken by a monetary authority and the ultimate goal that is expected (or hoped) to be impacted. On analogy, it is a bit like the transmission in an automobile that conducts power from the engine to the drive wheels. This analogy is imperfect because, unless the auto transmission is worn or damaged, the power conducted to the drive wheels is certain (although with some loss of power, the longer and the more steps in the linkage).
A better analogy might be the transmission mechanism entailed in the effort by a classic 8-ball billiards game player to cause one of his balls to drop into a pocket. Upon "breaking" the racked set of balls,
- the player lines up his cue stick on the cue ball and
- pokes it with sufficient force and proper direction
- to roll toward one of his balls (striped or solid) and
- hit it at just the right angle and with enough force
to cause it to roll toward a pocket and drop into it.
And like the 8-ball billiards game, the monetary policy transmission mechanism is complex and has many linkages, each of which may fail the monetary authority's intent. The steps in the Fed's pre-2008 policy linkage was
- first to announce a change in the Federal Funds target rate,
- then engage in open market operations
- to alter the excess reserves positions of commercial banks which would
- induce desired changes in the demand or supply of loanable funds (bank lending and bond market activity)
- so that financial instrument (bond) prices would change to cause
- the market-determined Federal Funds rate to move toward the announced Federal Funds target rate and
- yield rates on financial instruments to move toward the announced Federal Funds target rate
- with expectation (or hope) that just enough force had been applied to cause spending in the economy to change in the direction intended by the Federal Funds target rate announcement
- without precipitating (further) recession or inflation.
- first to announce a change in the Federal Funds target rate,
- then change the interest rate paid to commercial banks on their reserve balances on deposit at the Fed
- so as to impose a floor below the nominal market-determined Federal Funds rate,
- rendering it a de facto administered rate under the indirect control of the Fed which would
- pull market-determined interest rates toward the Federal Funds rate
- to induce desired changes in the demand or supply of loanable funds (bank borrowing and bond market activity)
- so that market-determined financial instrument prices would change to cause
- yield rates on financial instruments to move toward the announced reserve deposits interest rate
- with expectation (or hope) that just enough force had been applied to cause spending in the economy to change in the direction intended by the reserve deposits rate announcement
- without precipitating (further) recession or inflation.
Possible monetary policy process obstruction may occur if market participants key their decisions on their perceptions of the scarcity rate of interest that is different from the announced policy rate. In an open-economy world, policy process obstruction may be brought about by unexpected trade and capital flows that affect the relevant money supply, financial instrument prices, and yield rates. Monetary policy interruption may be caused by unexpected spending changes as occurred in 2019-2022 due to the Covid pandemic and supply chain congestion, in 2022-2024 by unexpected military hostilities, by natural disasters, and by ensuing climate change.
<Return to Monetary Policy in an Open-Economy World>
<Return to The Reserves Balance Interest Rate>
Repurchase and Reverse Repurchase Operations
Open market operations may be implemented by the Fed in the process of "unwinding" its huge portfolio acquired in three episodes of "quantitative easing" between 2008 and 2014. The Federal Reserve Bank of New York (FRBNY) website currently identifies the only other open market operations as repurchase and reverse repurchase operations. In a repo auction, security dealers bid on borrowing money from the Fed, offering U.S. Treasury securities as collateral. They implicitly "sell" the securities to the Fed on the day of agreement, and then repurchase them the next day. In a reverse repo auction, dealers offer interest rates at which they would lend money to the Fed. They implicitly "buy" securities from the Fed on the day of agreement, and the Fed repurchases them the next day. Repurchase agreements are made at the initiative of the trading desk at FRBNY which implements monetary policy at the behest of the Federal Open Market Committee (FOMC).
Economic Growth and Development
Due to the effect of diminishing returns, the scarcity rate of interest is higher in regions where capital is scarce and lower in regions where capital is more abundant. Regional differences in scarcity rates invite interregional capital flows. The high capital scarcity interest rate should entice investment spending both by locals and by foreigners contemplating off-shore investments. The capital scarcity interest rate would be expected to fall as capital becomes more abundant with on-going economic development.
Economists distinguish between economic growth and economic development. "Growth," taken to be an improvement in the material well-being of humans, is usually measured as the rate of increase of per capita real income or output of a society. "Real" means that adjustments have been made to eliminate the effects of inflation so that the real component of nominal income increase can be examined. "Per capita" means that some measure of the total output of a society, typically its Gross Domestic Product (GDP), has been divided by the population of the society to get a measure of income on a per-person basis.
"Development" is understood to mean change in the structure of society. The various dimensions of social structure include economic, social, political, moral, religious, and environmental. Development is both a requisite of growth and a consequence of growth--they are inseparable.
A serious problem is that development is typically disruptive of social structures, and thus entails costs. While by definition growth yields only benefits, development seems to involve mostly costs. A rational judgment of whether a process of development cum growth is desirable should be based on the relationship between the benefits of growth against the costs of development, i.e., Bg/Cd. If the value of the ratio of Bg/Cd is greater than 1, the growth-development process is desirable. It is undesirable if the value of the Bg/Cd ratio is less than 1.
Economists make the case that the most effective poverty alleviating vehicle over the past couple of centuries has been economic growth that has been enabled by economic development, and that market economies are more favorable to development than are authoritarian economies.
The suffering of the poor may be less amenable to relief by sharing the existing wealth than by a process of economic development that increases the society's stock of capital (which is part of its physical wealth) due to its high scarcity rate of return to capital. The poor are helped via the "spill-over effects" of employment and income generation, and in terms of a growing volume of lower-priced consumables that are more affordable to the poor.
Interregional Trade and Comparative Advantage
Trading relationships among nations exhibit variations in scarcity interest rates that correspond to their resource endowments. Since the pure theory of trade abstracts completely from references to nation states, it is necessary to shift from the language of "international trade" to that of "interregional trade." Different regions of the world have different endowments of natural, human, and capital resources. Different regions within nation states also may exhibit divergent scarcity interest rates.
Due to the principle of diminishing returns, regions that are richly endowed with capital resources can be expected to exhibit lower capital scarcity rates of interest than trading partner regions that are deficient of capital resources but well endowed with natural and human resources. Economists have enunciated the so-called principle of comparative advantage to explain regional specialization in the production of goods and services.
It is a fact of physical nature that resources are unequally distributed across the earth's geographic space. Some resources approach ubiquity (found everywhere); others are concentrated by regions. Resources that are found in only one or two places on earth may be referred to as geographic uniquities. Examples include rare elements or precious gems or metals, agricultural commodities that grow only under very special conditions, and natural tourist attractions. Populations of regions possessing such uniquities are fortunate in having access to such resources which they are able to exploit; populations elsewhere are correspondingly unfortunate. Populations of regions devoid of such uniquities may acquire them (or things produced using them) by engaging in interregional trade or military aggression to capture them.
There are few perfect ubiquities or uniquities among productive resources. Most resources are found in many places across the globe, although in greater or lesser geographic concentrations. Goods and services requiring those resources as inputs may be produced more cheaply in regions where they are found in abundance than in other regions where they are scarce.
Economists have developed the principle of comparative advantage to explain regional specialization in the production of goods and services. According to this principle, people in each region should specialize in producing those goods and services that can be produced most efficiently in their region compared to other regions. "Most efficiently" means at least opportunity cost (in terms of other goods and services foregone) compared to the other regions. Since the production of goods becomes geographically specialized, people in different regions must trade their specialties for the specialties of people in other regions.
Generalization in consumption is enabled everywhere through trade even though there is regional specialization in production. It can be shown with theoretical exercises as well as empirical information that those who specialize their production according to the principle of comparative advantage and trade with one another enjoy higher welfare than they would under conditions of autarky.
It is sometimes suggested that there are regions of the world that are essentially devoid of productive advantages, whereas other regions seem to possess all of the advantages (veritable "Gardens of Eden"). This problem can be resolved by further refining the definition of comparative advantage. A region's absolute advantages include all of those things that it can produce at lower opportunity costs than can be achieved in other regions. A region's absolute disadvantage is anything that can be produced elsewhere at lower costs in terms of other goods and services which must be foregone.
It may well be that opportunity costs of most things are lower in one region relative to all others, but this does not mean that the region should generalize in production. Its comparative advantages lie in producing those things for which it has greatest absolute advantage(s), while the comparative advantages of other regions lie in producing the things for which they have least absolute disadvantages. They should still specialize in production, but the one in its greatest absolute advantage and all the rest in their least absolute disadvantages. It follows logically from this definition of comparative advantage that it is not possible for a region to have no comparative advantage(s). Furthermore, it can be shown that all of the regions of the world, the sparsely-endowed as well as the abundantly endowed, will enjoy higher welfare with specialization according to the principle of comparative advantage and trade with one another unencumbered by politically imposed constraints.
Modern elaborations of the theory of comparative advantage recognize at least five bases for regional comparative advantages: capital and other resource endowments, cultural preferences, known technologies, scale economies, and company-specific knowledge. The first three are endogenous to locale; the last two technically are independent of geography but may become location specific at the discretion of production decision makers.
It would be highly unlikely in any of these cases that perfect specialization (i.e., only product X is produced in region A and only product Y is produced in region B) would result. Both goods would continue to be produced in both regions, but in each region more of the comparative advantaged good would be produced and less of the comparative disadvantaged good(s). Also, the real world is composed of many regions, some of which are similar to others in respect to resource endowments, preferences, or technologies, and different from the other regions in various respects. The basis for comparative advantage of each may lie in one of these areas or a combination of them. Empirical evidence indicates that a larger volume of the world's trade is conducted among regions that are similar in income levels and preferences than among regions that are widely divergent in any of these areas.
Unless offset by regional decrease of capital in non-comparative-advantaged industries (e.g., by non-replacement of worn equipment, natural disaster, or war), the process of investing in capital to increase regional specialization in comparative-advantaged industries should be expected to decrease the marginal productivity of the region's capital stock and cause its capital scarcity rate of interest to decrease.
Industrial Policy
As trading relationships become more open and free with on-going globalization, specialization of production toward each nation's real comparative advantages ensues. Regions with abundant natural and human resources but meager stocks of capital will experience increasing specialization in producing products that employ intensively their abundant resources. But the government of a region with a meager stock of physical capital may wish to promote industrial investment in production activities for which the region does not have comparative advantages.
As industrial investment increases specialization in the non-comparative advantaged production processes, the formerly comparative advantaged processes become despecialized. Jobs will be threatened and businesses in comparative advantage production will suffer declining sales and profits attributable to the ensuing process of comparative advantage despecialization. Those who feel threatened can be expected to appeal to their congressional or parliamentary representatives to provide protection for the domestic industry in the form of tariffs or non-tariff barriers to trade.
Industrial policy has been described as government picking winners and identifying losers among the resident industries within the nation, and then acting to encourage and support the chosen winners. The most likely reason for an industrial policy to fail is that bureaucratic choices of national-champion industries may not correspond to the nation's natural or acquired comparative advantages. If an administration chooses to support non-comparative-advantaged domestic industries, production costs will be higher than in potential trading-partner nations that do possess the respective comparative advantages. Consumers of the nation will pay higher product prices for domestically-produced goods and enjoy lower levels of welfare than they might have enjoyed if they had consumed comparable imports from regions possessing the respective comparative advantages.
Various U.S. states have practiced forms of industrial policy in their efforts to attract industry or particular firms to locate plants within their borders. The principle underlying state-level industrial policy is the contention that since capital is generally more mobile geographically than is labor, capital should move to sites where it can employ capable and well-trained labor. States vie with one another to demonstrate that their labor forces are capable and well-trained, and that they possess the physical and financial infrastructure to support the sought-after industry. State-level industrial policy may cause market interest rates to diverge from the region’s scarcity rate.
A variant of industrial policy, import-substitution industrialization (ISI), was adopted as development vehicle in several capital-scarce nations during the second half of the twentieth century. The idea was to try to "birth" and protect from global competition non-comparative-advantaged "infant" domestic industries until they could "grow up" and somehow attain comparative advantages on world markets. In the meanwhile, domestic consumers would pay the price of protection in the form of higher prices of domestically-produced goods compared to the lower prices of imports. But the ISI strategy has been discredited in favor of export-oriented development (EOD), i.e., identifying and pursuing development of nations' actual comparative advantages in producing both industrial goods and primary products that can be exported to pay for lower-priced imports.
Industrial policy may cause market-determined interest rates to diverge from the region’s scarcity rate. Industrial policy that only shifts investment from comparative-advantaged production to non-comparative-advantaged production may cause little change in the gross capital stock of the region and thus leaves the capital scarcity interest rate of the region unchanged. Industrial policy that increases the region's capital stock by stimulating investment in non-comparative-advantaged production as capital investment in comparative-advantaged production continues may cause the scarcity interest rate of the region to increase as the marginal productivity of capital in the region declines. This phenomenon may have occurred with South Carolina's industrial policy that stimulated investment in the automobile, tire, aircraft, and other "tech" industries as investment continued to sustain capital engaged in South Carolina's agriculture.
Protectionist Policy
Governments often resort to various forms of protectionist policy when domestic industries are threatened by foreign competition. The most common forms of protection of a domestic industry are tariffs imposed on imports, non-tariff barriers to restrict the inflow of imports, and subsidies that promote domestic industries which compete with imports. If the region has been capital abundant with a low capital scarcity interest rate, these protection measures will tend to increase the capital scarcity interest rate of the region. In a capital scarce region with a high capital scarcity interest rate, the imposition of protectionist measures will tend to lower the capital scarcity interest rate.
A tariff is a tax on an imported good that is paid, not by the exporter, but by the consumers in the nation whose government imposes the tariff. The effect of the imposition of a tariff by the government is to raise the price of the imported product to domestic consumers, which, if the domestic demand for the import is sufficiently elastic with respect to price, will reduce the volume of the import, thereby providing a modicum of protection to the domestic industry. With the tariff in place, domestic producers will be able to sell their product at the higher imported price, although a smaller quantity. The increased price of the import has the effect of worsening the nation's terms of trade; since the foreign-made product now costs more to domestic consumers, each unit of a domestically produced export can buy only a smaller quantity of the import. However, if the domestic demand for the import is sufficiently inelastic, the tariff may not greatly decrease the amount of the product imported.
Once a tariff is imposed, the domestic market price of the product rises. Domestic producers are all too happy to accept the higher price although it may still not be as high as the pre-trade domestic price. Domestic production increases. At the higher market price, domestic consumption falls and the quantity of the product imported decreases. These effects will be relatively small if the world supply is fairly inelastic with respect to price, but the effects will become larger if world supply increases and becomes more elastic.
Non-tariff barriers (NTBs) include quotas on imports, health and safety restrictions on imports, import packaging and labeling requirements, discriminatory performance standards for imports, etc., that are intended to curb imports or raise their delivered prices. Both tariffs and NTBs may cause market-determined interest rates to diverge from the region’s scarcity rate.
Protectionist measures that only shift investment from comparative-advantaged production to non-comparative-advantaged production may cause little change in the gross capital stock of the region and thus leave the capital scarcity interest rate of the region unchanged. Protectionist measures that increase the region's capital stock by stimulating investment in non-comparative-advantaged production as capital investment in comparative-advantaged production continues may cause the scarcity interest rate of the region to increase as the marginal productivity of capital in the region declines.
Lags in the Adjustment Process
Economists refer to the time between when a macroeconomic change occurs and when it is recognized by government officials as the recognition lag, and the time between recognition of such a change and the taking of some action to offset it as the response lag. Needless to say, the lags are both variable in duration and themselves unpredictable. The response lag for monetary policy may be a matter of days or weeks, while that for fiscal policy may be months or quarters. In democratic societies, fiscal policy actions must be proposed, debated, and legislated, processes that often are very time consuming.
There is yet another lag which may eclipse the first two in duration. It is the so-called reaction lag, the period between when an action is taken and the effects of the action fully work through the economy. The reaction lag usually involves a multiplier process of consecutive rounds of respending. Experience in the U.S. economy suggests that the multiplier effect of a fiscal policy action may be completed in as little as a year, but may not be fully worked out in more than two years. The duration of the reaction lag is therefore even less predictable than are the recognition and response lags. The three lags together may span a period of as little as a year, or as much as three or more years. These lags taken together put the government in the position of having to implement a compensating policy even before some event shocks the economy.
This brings us to the most serious problem of implementing any government policy in the interest of stabilizing the economy. It is that the natural adjustment mechanisms of the economy will likely have reversed the direction of change of the economy by the time that the policy designed to deal with the original problem finally has its effect. For example, in a contracting economy, expansionary fiscal and monetary policies are called for. But by the time the contraction can be confirmed, expansionary policy implemented, and the multiplier process completed, the economy of its own volition will likely have begun its recovery. So the expansionary monetary policy impacts an already-expanding economy. A similar, but reversed, scenario can be depicted for an economy entering a period of expansion. Because of variable and unpredictable time lags in the implementation of macropolicy, government's well-intentioned efforts to stabilize the economy often end up destabilizing it--"booming the boom," or "depressing the depression."
Macroeconomic Adjustment to International Disturbances
As the world economy becomes progressively more open and economically integrated, the vehicles for macroeconomic adjustment to internationally-sourced disturbances attain ever greater significance. Basically, there are only three macroeconomic adjustment vehicles: exchange rates, domestic prices (including interest rates), and domestic employment (and incomes). A progression of "if statements" identifies the relevant adjustment possibilities:
1. If exchange rates are allowed sufficient flexibility, they may serve as "shock absorbers" for the domestic economy against internationally-sourced disturbances.
2. If exchange rates are fixed by government authorities, domestic prices assume the burden of adjustment.
3. If domestic prices are insufficiently flexible, the adjustment process must descend upon domestic employment and incomes.
4. If government authorities employ macropolicy to stabilize domestic prices, employment, and incomes, exchange rate flexibility must serve as the adjustment vehicle.
5. If government authorities attempt both to stabilize domestic prices and employment and to fix exchange rates, there is no effective vehicle of macroeconomic adjustment to international disturbances. In the absence of an effective adjustment vehicle, payments imbalances will persist.
An important conclusion emerges from these considerations: the degree of domestic macroeconomic stability of a nation may depend upon the degree of flexibility that its government accords to rates of exchange between its currency and other currencies. As a general rule, we may expect domestic macroeconomic conditions in any economy to be more volatile in response to international disturbances the less flexible are its exchange rates. Fixing or stabilizing exchange rates forces the adjustment to international disturbances upon domestic macroeconomic conditions of prices and employment.
How does U.S. macropolicy mesh with these adjustment vehicles? The top and middle panels of Chart 11 have been brought forward to Chart 12 to be compared to the U.S. dollar-to-euro spot exchange rate in the bottom panel. The exchange rate path shown in this panel demonstrates that U.S. exchange rates are not fixed; their flexibility provides a modicum of shock absorption to both domestic- and internationally-sourced disturbances.
The Federal Reserve does practice macropolicy in its pursuit of price stability, but the interest rate targets that it sets may cause market-determined interest rates to diverge from regional capital scarcity interest rates. It cannot be said that any U.S. authority implements fiscal policy with consistency. The Congress typically legislates spending bills with respect to politically-perceived program needs and only occasionally with regard to employment and income deficiencies. The Treasury Department of the executive branch of the U.S. government is tasked with implementing Congressional legislation to finance federal government expenditures, including regular annual deficits. The sporadic nature of these hodge-podge fiscal actions are not oriented primarily toward achieving macroeconomic stability of employment and incomes. The incoherence of U.S. macropolicy may be a source of the price, employment, and income instability that has been experienced.
Exchange Rates During the Great Recession
The 2008 “Great Recession” was an internal disturbance to the U.S. economy that had international repercussions. The bottom panel of Chart 12 shows that the dollar appreciated as the dollar price of the euro fell from $1.58 in June 2008 to $1.27 in November 2008 (i.e., the euro price of the dollar increased from 0.63 euro to 0.79 euro).
In the effort to alleviate emerging recessions since 2008, the Fed engaged in four rounds of quantitative easing by increasing the reserves of depository institutions: QE1, November 2008; QE2, November 2010; QE3, September 2012; QE4, March 2020. Following QE1, the dollar depreciated as the price of the euro rose from $1.27 in February 2009 to $1.49 in November 2009 (i.e., the euro price of the dollar decreased from 0.79 euro to 0.68 euro).
Quantitative easing in the U.S. is implemented by the Federal Reserve when it purchases bonds from depository institutions, paying for the bonds by increasing their reserves. The increased reserves enable lending that increases the quantity of money in circulation to stimulate business investment and consumer spending in the economy. The increasing quantity of money in circulation may cause market-determined interest rates to diverge from the capital scarcity interest rate and set in motion adjustment processes. The increasing quantity of money in circulation won’t change the capital scarcity interest rate unless it induces investment that causes a change in the capital stock of the region.
As the Fed buys bonds during a quantitative easing action, bond supplies decrease on U.S. financial markets relative to bond demands, bidding up bond prices and decreasing bond yield rates. The proceeds from selling bonds at higher bond prices motivate businesses and governments to issue new bonds to finance investment and spending plans. Some of the new bond issuers are foreign businesses and governments who receive payment in dollars that must be converted to their own currencies for repatriation. The repatriation of these funds shows up in the middle panel of Chart 12 in a capital account deficit. The U.S. capital account, roughly in balance in 2008, had a deficit of nearly $5.88 billion in 2009. A deficit in the capital account implies that money is flowing out of the country and suggests that the nation is increasing its possession of foreign assets (e.g., bonds).
The increasing supply of dollars on foreign exchange (FX) markets during 2009 depressed the euro price of the dollar from 0.79 euro to 0.68 euro. Deficits in the capital account (middle panel of Chart 12) weakened the dollar (bottom panel of Chart 12) when dollar proceeds of bond sales by foreigners were converted to foreign currencies on FX markets for repatriation. Subsequently, the weakened dollar stimulated exports of U.S. products and services, increasing the demand for dollars on FX markets to purchase U.S. goods and services (top panel of Chart 12) and reversing the dollar appreciation attributed to the quantitative easing. In 2010 the dollar price of the euro fell from $1.49 in November 2009 to $1.22 in June 2010 (i.e., the euro price of a dollar rose from 0.67 euro to 0.82 euro). Even with this dollar depreciation, the U.S. trade balance deficit increased from $379.7 million in 2009 to $432.0 million in 2010 as American imports continued to exceed its exports.
Similar patterns may be discerned in each of the subsequent episodes of quantitative easing. Following the brief 2020 recession, the pattern for QE4 differed from the earlier quantitative easing episodes in that the disturbance was externally sourced by the Covid19 pandemic and the clogging of west-coast supply chains. The Editorial Board of The Washington Post, July 4, 2025, provides an explanation of the circumstances that led the Federal Reserve Board to implement QE4 in 2020:
Regressions on monthly data, July 1954 through October 2024, for Federal Funds and 10-Year Treasury Bills, with dependent variable lags and leads.
SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 2 10YrTB PERIODS LAGGED: 0 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 1 FF COEF OF MULTIPLE CORRELATION (R): 0.9051 CORRECTED R: 0.9051 COEF OF MULTIPLE DETERMINATION (R^2) 0.8192 CORRECTED R^2: 0.8192 STANDARD ERROR OF THE ESTIMATE: 1.2317 MEAN SQUARED ERROR: 1.5172 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 7067.2774 843 REMOVED BY REGRESSION: 5789.7906 1 F-VALUE: 3816.0894 RESIDUAL: 1277.4868 842 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FF 0.9051 0.7337 0.0119 61.7745 0.0000 CONSTANT (A) 2.2223 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 2 10YrTB PERIODS LAGGED: 1 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 1 FF COEF OF MULTIPLE CORRELATION (R): 0.9049 CORRECTED R: 0.9049 COEF OF MULTIPLE DETERMINATION (R^2) 0.8188 CORRECTED R^2: 0.8188 STANDARD ERROR OF THE ESTIMATE: 1.2332 MEAN SQUARED ERROR: 1.5207 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 7056.3455 842 REMOVED BY REGRESSION: 5777.4456 1 F-VALUE: 3799.2273 RESIDUAL: 1278.9000 841 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FF 0.9049 0.7329 0.0119 61.6379 0.0000 CONSTANT (A) 2.2300 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 2 10YrTB PERIODS LAGGED: 2 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 1 FF COEF OF MULTIPLE CORRELATION (R): 0.9037 CORRECTED R: 0.9037 COEF OF MULTIPLE DETERMINATION (R^2) 0.8166 CORRECTED R^2: 0.8166 STANDARD ERROR OF THE ESTIMATE: 1.2402 MEAN SQUARED ERROR: 1.5381 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 7045.7816 841 REMOVED BY REGRESSION: 5753.7859 1 F-VALUE: 3740.8640 RESIDUAL: 1291.9957 840 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FF 0.9037 0.7314 0.0120 61.1626 0.0000 CONSTANT (A) 2.2412 SIMPLE LINEAR REGRESSION: Y = A + B(1)*X ________________________________________ DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 2 10YrTB PERIODS LAGGED: 3 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 1 FF COEF OF MULTIPLE CORRELATION (R): 0.9023 CORRECTED R: 0.9023 COEF OF MULTIPLE DETERMINATION (R^2) 0.8142 CORRECTED R^2: 0.8142 STANDARD ERROR OF THE ESTIMATE: 1.2481 MEAN SQUARED ERROR: 1.5578 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 7035.3224 840 REMOVED BY REGRESSION: 5728.3293 1 F-VALUE: 3677.1947 RESIDUAL: 1306.9931 839 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FF 0.9023 0.7298 0.0120 60.6399 0.0000 CONSTANT (A) 2.2531 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 2 10YrTB PERIODS LAGGED: 5 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 1 FF COEF OF MULTIPLE CORRELATION (R): 0.8989 CORRECTED R: 0.8989 COEF OF MULTIPLE DETERMINATION (R^2) 0.8081 CORRECTED R^2: 0.8081 STANDARD ERROR OF THE ESTIMATE: 1.2684 MEAN SQUARED ERROR: 1.6088 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 7015.2898 838 REMOVED BY REGRESSION: 5668.7352 1 F-VALUE: 3523.6086 RESIDUAL: 1346.5546 837 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FF 0.8989 0.7261 0.0122 59.3600 0.0000 CONSTANT (A) 2.2792 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 2 10YrTB PERIODS LAGGED: 10 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 1 FF COEF OF MULTIPLE CORRELATION (R): 0.8922 CORRECTED R: 0.8922 COEF OF MULTIPLE DETERMINATION (R^2) 0.7960 CORRECTED R^2: 0.7960 STANDARD ERROR OF THE ESTIMATE: 1.3073 MEAN SQUARED ERROR: 1.7090 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 6970.4841 833 REMOVED BY REGRESSION: 5548.5860 1 F-VALUE: 3246.6627 RESIDUAL: 1421.8981 832 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FF 0.8922 0.7184 0.0126 56.9795 0.0000 CONSTANT (A) 2.3355 ________________________________________Conclusion: 10YrTB data are highly correlated to simultaneous FF data beginning at row 1 (July 1954), but there is no significant lag of 10YrTB after FF.?
SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 1 FF PERIODS LAGGED: 0 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 2 10YrTB COEF OF MULTIPLE CORRELATION (R): 0.9051 CORRECTED R: 0.9051 COEF OF MULTIPLE DETERMINATION (R^2) 0.8192 CORRECTED R^2: 0.8192 STANDARD ERROR OF THE ESTIMATE: 1.5195 MEAN SQUARED ERROR: 2.3089 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 10754.8987 843 REMOVED BY REGRESSION: 8810.8345 1 F-VALUE: 3816.0894 RESIDUAL: 1944.0642 842 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTB 0.9051 1.1166 0.0181 61.7745 0.0000 CONSTANT (A) -1.6482 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 1 FF PERIODS LAGGED: 1 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 2 10YrTB COEF OF MULTIPLE CORRELATION (R): 0.9013 CORRECTED R: 0.9013 COEF OF MULTIPLE DETERMINATION (R^2) 0.8124 CORRECTED R^2: 0.8124 STANDARD ERROR OF THE ESTIMATE: 1.5478 MEAN SQUARED ERROR: 2.3958 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 10740.3694 842 REMOVED BY REGRESSION: 8725.5372 1 F-VALUE: 3642.0784 RESIDUAL: 2014.8322 841 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTB 0.9013 1.1113 0.0184 60.3496 0.0000 CONSTANT (A) -1.6163 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 1 FF PERIODS LAGGED: 2 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 2 10YrTB COEF OF MULTIPLE CORRELATION (R): 0.8930 CORRECTED R: 0.8930 COEF OF MULTIPLE DETERMINATION (R^2) 0.7975 CORRECTED R^2: 0.7975 STANDARD ERROR OF THE ESTIMATE: 1.6081 MEAN SQUARED ERROR: 2.5861 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 10728.8366 841 REMOVED BY REGRESSION: 8556.4992 1 F-VALUE: 3308.6294 RESIDUAL: 2172.3374 840 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTB 0.8930 1.1008 0.0191 57.5207 0.0000 CONSTANT (A) -1.5556 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 1 FF PERIODS LAGGED: 3 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 2 10YrTB COEF OF MULTIPLE CORRELATION (R): 0.8829 CORRECTED R: 0.8829 COEF OF MULTIPLE DETERMINATION (R^2) 0.7795 CORRECTED R^2: 0.7795 STANDARD ERROR OF THE ESTIMATE: 1.6782 MEAN SQUARED ERROR: 2.8164 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 10716.2332 840 REMOVED BY REGRESSION: 8353.3155 1 F-VALUE: 2966.0076 RESIDUAL: 2362.9177 839 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTB 0.8829 1.0879 0.0200 54.4611 0.0000 CONSTANT (A) -1.4812 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 1 FF PERIODS LAGGED: 5 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 2 10YrTB COEF OF MULTIPLE CORRELATION (R): 0.8628 CORRECTED R: 0.8628 COEF OF MULTIPLE DETERMINATION (R^2) 0.7444 CORRECTED R^2: 0.7444 STANDARD ERROR OF THE ESTIMATE: 1.8067 MEAN SQUARED ERROR: 3.2640 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 10687.5542 838 REMOVED BY REGRESSION: 7955.5572 1 F-VALUE: 2437.3384 RESIDUAL: 2731.9970 837 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTB 0.8628 1.0619 0.0215 49.3694 0.0000 CONSTANT (A) -1.3300 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 1 FF PERIODS LAGGED: 10 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 2 10YrTB COEF OF MULTIPLE CORRELATION (R): 0.8183 CORRECTED R: 0.8183 COEF OF MULTIPLE DETERMINATION (R^2) 0.6697 CORRECTED R^2: 0.6697 STANDARD ERROR OF THE ESTIMATE: 2.0547 MEAN SQUARED ERROR: 4.2219 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 10633.3159 833 REMOVED BY REGRESSION: 7120.7142 1 F-VALUE: 1686.6228 RESIDUAL: 3512.6017 832 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTB 0.8183 1.0053 0.0245 41.0685 0.0000 CONSTANT (A) -1.0003 ________________________________________Conclusion: FF data are highly correlated to simultaneous 10YrTB data beginning at row 1 (July 1954), but there is no significant lag of FF after 10YrTB (i.e., lead of 10YrTB ahead of FF).
Regressions on monthly difference data, July 1954 through October 2024, for Federal Funds and 10-Year Treasury Bills, with dependent variable lags and leads.
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 4 10YrTBDIF PERIODS LAGGED: 0 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 3 FFDIF COEF OF MULTIPLE CORRELATION (R): 0.3288 CORRECTED R: 0.3288 COEF OF MULTIPLE DETERMINATION (R^2) 0.1081 CORRECTED R^2: 0.1081 STANDARD ERROR OF THE ESTIMATE: 0.2515 MEAN SQUARED ERROR: 0.0633 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 59.5722 841 REMOVED BY REGRESSION: 6.4413 1 F-VALUE: 101.8376 RESIDUAL: 53.1309 840 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FFDIF 0.3288 0.1805 0.0179 10.0915 0.0000 CONSTANT (A) 0.0013 ________________________________________ DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 4 10YrTBDIF PERIODS LAGGED: 1 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 3 FFDIF COEF OF MULTIPLE CORRELATION (R): 0.0782 CORRECTED R: 0.0782 COEF OF MULTIPLE DETERMINATION (R^2) 0.0061 CORRECTED R^2: 0.0061 STANDARD ERROR OF THE ESTIMATE: 0.2656 MEAN SQUARED ERROR: 0.0706 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 59.5719 840 REMOVED BY REGRESSION: 0.3646 1 F-VALUE: 5.1664 RESIDUAL: 59.2073 839 SIG: 0.0219 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FFDIF 0.0782 0.0429 0.0189 2.2730 0.0219 CONSTANT (A) 0.0018 ________________________________________ DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 4 10YrTBDIF PERIODS LAGGED: 2 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 3 FFDIF COEF OF MULTIPLE CORRELATION (R): 0.0158 CORRECTED R: 0.0158 COEF OF MULTIPLE DETERMINATION (R^2) 0.0002 CORRECTED R^2: 0.0002 STANDARD ERROR OF THE ESTIMATE: 0.2666 MEAN SQUARED ERROR: 0.0711 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 59.5696 839 REMOVED BY REGRESSION: 0.0148 1 F-VALUE: 0.2080 RESIDUAL: 59.5548 838 SIG: 0.6534 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FFDIF 0.0158 0.0086 0.0190 0.4561 0.6534 CONSTANT (A) 0.0019 ________________________________________ ? DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 4 10YrTBDIF PERIODS LAGGED: 3 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 3 FFDIF COEF OF MULTIPLE CORRELATION (R): 0.0052 CORRECTED R: 0.0052 COEF OF MULTIPLE DETERMINATION (R^2) 0.0000 CORRECTED R^2: 0.0000 STANDARD ERROR OF THE ESTIMATE: 0.2668 MEAN SQUARED ERROR: 0.0712 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 59.5673 838 REMOVED BY REGRESSION: 0.0016 1 F-VALUE: 0.0224 RESIDUAL: 59.5657 837 SIG: 0.8759 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FFDIF -0.0052 -0.0028 0.0190 -0.1496 0.8759 CONSTANT (A) 0.0019 ________________________________________Conclusion: 10YrTBDIF monthly difference data are moderately correlated to simultaneous FFDIF monthly difference data beginning at row 3 (September 1954), but there is no significant lag of 10YrTBDIF after FFDIF.
DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 3 FFDIF PERIODS LAGGED: 0 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 4 10YrTBDIF COEF OF MULTIPLE CORRELATION (R): 0.3288 CORRECTED R: 0.3288 COEF OF MULTIPLE DETERMINATION (R^2) 0.1081 CORRECTED R^2: 0.1081 STANDARD ERROR OF THE ESTIMATE: 0.4582 MEAN SQUARED ERROR: 0.2099 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 197.7342 841 REMOVED BY REGRESSION: 21.3803 1 F-VALUE: 101.8376 RESIDUAL: 176.3539 840 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTBDIF 0.3288 0.5991 0.0594 10.0915 0.0000 CONSTANT (A) 0.0030 ________________________________________ DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 3 FFDIF PERIODS LAGGED: 1 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 4 10YrTBDIF COEF OF MULTIPLE CORRELATION (R): 0.3717 CORRECTED R: 0.3717 COEF OF MULTIPLE DETERMINATION (R^2) 0.1382 CORRECTED R^2: 0.1382 STANDARD ERROR OF THE ESTIMATE: 0.4506 MEAN SQUARED ERROR: 0.2031 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 197.7104 840 REMOVED BY REGRESSION: 27.3223 1 F-VALUE: 134.5367 RESIDUAL: 170.3880 839 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTBDIF 0.3717 0.6780 0.0585 11.5990 0.0000 CONSTANT (A) 0.0034 ________________________________________ ? DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 3 FFDIF PERIODS LAGGED: 2 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 4 10YrTBDIF COEF OF MULTIPLE CORRELATION (R): 0.1437 CORRECTED R: 0.1437 COEF OF MULTIPLE DETERMINATION (R^2) 0.0206 CORRECTED R^2: 0.0206 STANDARD ERROR OF THE ESTIMATE: 0.4806 MEAN SQUARED ERROR: 0.2310 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 197.6599 839 REMOVED BY REGRESSION: 4.0802 1 F-VALUE: 17.6633 RESIDUAL: 193.5797 838 SIG: 0.0001 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTBDIF 0.1437 0.2621 0.0624 4.2028 0.0001 CONSTANT (A) 0.0043 ________________________________________ DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 3 FFDIF PERIODS LAGGED: 3 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 4 10YrTBDIF COEF OF MULTIPLE CORRELATION (R): 0.0142 CORRECTED R: 0.0142 COEF OF MULTIPLE DETERMINATION (R^2) 0.0002 CORRECTED R^2: 0.0002 STANDARD ERROR OF THE ESTIMATE: 0.4859 MEAN SQUARED ERROR: 0.2361 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 197.6593 838 REMOVED BY REGRESSION: 0.0400 1 F-VALUE: 0.1693 RESIDUAL: 197.6194 837 SIG: 0.6841 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTBDIF -0.0142 -0.0260 0.0631 -0.4115 0.6841 CONSTANT (A) 0.0048 ________________________________________Conclusion: FFDIF monthly difference data are moderately correlated to simultaneous 10YrTBDIF monthly difference data beginning at row 3 (September 1954), but there is no significant lag of FFDIF after 10YrTBDIF (i.e., lead of 10YrTBDIF ahead of FFDIF).
Regressions on monthly data, July 1954 through October 2024, for Federal Funds and 10-Year Treasury Bills, with dependent variable lags and leads, beginning row 326 (July 1981).
SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 2 10YrTB PERIODS LAGGED: 0 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 1 FF COEF OF MULTIPLE CORRELATION (R): 0.9251 CORRECTED R: 0.9251 COEF OF MULTIPLE DETERMINATION (R^2) 0.8558 CORRECTED R^2: 0.8558 STANDARD ERROR OF THE ESTIMATE: 1.1907 MEAN SQUARED ERROR: 1.4178 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 5081.9878 518 REMOVED BY REGRESSION: 4348.9776 1 F-VALUE: 3067.3808 RESIDUAL: 733.0102 517 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FF 0.9251 0.8468 0.0153 55.3839 0.0000 CONSTANT (A) 2.0025 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 2 10YrTB PERIODS LAGGED: 1 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 1 FF COEF OF MULTIPLE CORRELATION (R): 0.9226 CORRECTED R: 0.9226 COEF OF MULTIPLE DETERMINATION (R^2) 0.8512 CORRECTED R^2: 0.8512 STANDARD ERROR OF THE ESTIMATE: 1.1999 MEAN SQUARED ERROR: 1.4398 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 4991.2761 517 REMOVED BY REGRESSION: 4248.3519 1 F-VALUE: 2950.7042 RESIDUAL: 742.9242 516 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FF 0.9226 0.8370 0.0154 54.3204 0.0000 CONSTANT (A) 2.0251 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 2 10YrTB PERIODS LAGGED: 2 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 1 FF COEF OF MULTIPLE CORRELATION (R): 0.9191 CORRECTED R: 0.9191 COEF OF MULTIPLE DETERMINATION (R^2) 0.8447 CORRECTED R^2: 0.8447 STANDARD ERROR OF THE ESTIMATE: 1.2148 MEAN SQUARED ERROR: 1.4756 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 4892.8094 516 REMOVED BY REGRESSION: 4132.8635 1 F-VALUE: 2800.7580 RESIDUAL: 759.9459 515 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FF 0.9191 0.8256 0.0156 52.9222 0.0000 CONSTANT (A) 2.0536 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 2 10YrTB PERIODS LAGGED: 3 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 1 FF COEF OF MULTIPLE CORRELATION (R): 0.9145 CORRECTED R: 0.9145 COEF OF MULTIPLE DETERMINATION (R^2) 0.8364 CORRECTED R^2: 0.8364 STANDARD ERROR OF THE ESTIMATE: 1.2358 MEAN SQUARED ERROR: 1.5273 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 4797.3158 515 REMOVED BY REGRESSION: 4012.2816 1 F-VALUE: 2627.0355 RESIDUAL: 785.0342 514 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FF 0.9145 0.8136 0.0159 51.2546 0.0000 CONSTANT (A) 2.0853 ________________________________________Conclusion: 10YrTB data are highly correlated to simultaneous FF data beginning at row 326 (July 1981), but there is no significant lag of 10YrTB after FF (i.e., lead of FF ahead of 10YrTB).
? SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 1 FF PERIODS LAGGED: 0 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 2 10YrTB COEF OF MULTIPLE CORRELATION (R): 0.9251 CORRECTED R: 0.9251 COEF OF MULTIPLE DETERMINATION (R^2) 0.8558 CORRECTED R^2: 0.8558 STANDARD ERROR OF THE ESTIMATE: 1.3008 MEAN SQUARED ERROR: 1.6922 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 6065.3423 518 REMOVED BY REGRESSION: 5190.4961 1 F-VALUE: 3067.3808 RESIDUAL: 874.8462 517 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTB 0.9251 1.0106 0.0182 55.3839 0.0000 CONSTANT (A) -1.4408 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 1 FF PERIODS LAGGED: 1 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 2 10YrTB COEF OF MULTIPLE CORRELATION (R): 0.9247 CORRECTED R: 0.9247 COEF OF MULTIPLE DETERMINATION (R^2) 0.8551 CORRECTED R^2: 0.8551 STANDARD ERROR OF THE ESTIMATE: 1.2844 MEAN SQUARED ERROR: 1.6497 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 5875.1341 517 REMOVED BY REGRESSION: 5023.8841 1 F-VALUE: 3045.3145 RESIDUAL: 851.2501 516 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTB 0.9247 0.9944 0.0180 55.1844 0.0000 CONSTANT (A) -1.3822 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 1 FF PERIODS LAGGED: 2 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 2 10YrTB COEF OF MULTIPLE CORRELATION (R): 0.9217 CORRECTED R: 0.9217 COEF OF MULTIPLE DETERMINATION (R^2) 0.8495 CORRECTED R^2: 0.8495 STANDARD ERROR OF THE ESTIMATE: 1.2946 MEAN SQUARED ERROR: 1.6760 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 5734.3236 516 REMOVED BY REGRESSION: 4871.2047 1 F-VALUE: 2906.5180 RESIDUAL: 863.1189 515 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTB 0.9217 0.9795 0.0182 53.9121 0.0000 CONSTANT (A) -1.3272 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 1 FF PERIODS LAGGED: 3 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 2 10YrTB COEF OF MULTIPLE CORRELATION (R): 0.9175 CORRECTED R: 0.9175 COEF OF MULTIPLE DETERMINATION (R^2) 0.8418 CORRECTED R^2: 0.8418 STANDARD ERROR OF THE ESTIMATE: 1.3143 MEAN SQUARED ERROR: 1.7274 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 5611.1453 515 REMOVED BY REGRESSION: 4723.2866 1 F-VALUE: 2734.4096 RESIDUAL: 887.8587 514 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTB 0.9175 0.9647 0.0184 52.2916 0.0000 CONSTANT (A) -1.2715 ________________________________________Conclusion: FF data are highly correlated to simultaneous 10YrTB data beginning at row 326 (July 1981), but there is no significant lag of FF after 10YrTB (i.e., lead of 10YrTB ahead of FF).
Regressions on monthly difference data, July 1954 through October 2024, for Federal Funds and 10-Year Treasury Bills, with dependent variable lags and leads.
SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 4 10YrTBDIF PERIODS LAGGED: 0 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 3 FFDIF COEF OF MULTIPLE CORRELATION (R): 0.3019 CORRECTED R: 0.3019 COEF OF MULTIPLE DETERMINATION (R^2) 0.0911 CORRECTED R^2: 0.0911 STANDARD ERROR OF THE ESTIMATE: 0.2628 MEAN SQUARED ERROR: 0.0691 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 39.2869 518 REMOVED BY REGRESSION: 3.5807 1 F-VALUE: 51.8458 RESIDUAL: 35.7062 517 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FFDIF 0.3019 0.2780 0.0386 7.2004 0.0000 CONSTANT (A) -0.0120 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 4 10YrTBDIF PERIODS LAGGED: 1 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 3 FFDIF COEF OF MULTIPLE CORRELATION (R): 0.1014 CORRECTED R: 0.1014 COEF OF MULTIPLE DETERMINATION (R^2) 0.0103 CORRECTED R^2: 0.0103 STANDARD ERROR OF THE ESTIMATE: 0.2729 MEAN SQUARED ERROR: 0.0745 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 38.8242 517 REMOVED BY REGRESSION: 0.3995 1 F-VALUE: 5.3642 RESIDUAL: 38.4247 516 SIG: 0.0197 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FFDIF 0.1014 0.0929 0.0401 2.3161 0.0197 CONSTANT (A) -0.0184 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 4 10YrTBDIF PERIODS LAGGED: 2 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 3 FFDIF COEF OF MULTIPLE CORRELATION (R): 0.1597 CORRECTED R: 0.1597 COEF OF MULTIPLE DETERMINATION (R^2) 0.0255 CORRECTED R^2: 0.0255 STANDARD ERROR OF THE ESTIMATE: 0.2705 MEAN SQUARED ERROR: 0.0732 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 38.6631 516 REMOVED BY REGRESSION: 0.9865 1 F-VALUE: 13.4851 RESIDUAL: 37.6766 515 SIG: 0.0005 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FFDIF 0.1597 0.1461 0.0398 3.6722 0.0005 CONSTANT (A) -0.0178 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 4 10YrTBDIF PERIODS LAGGED: 3 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 3 FFDIF COEF OF MULTIPLE CORRELATION (R): 0.0670 CORRECTED R: 0.0670 COEF OF MULTIPLE DETERMINATION (R^2) 0.0045 CORRECTED R^2: 0.0045 STANDARD ERROR OF THE ESTIMATE: 0.2736 MEAN SQUARED ERROR: 0.0748 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 38.6411 515 REMOVED BY REGRESSION: 0.1734 1 F-VALUE: 2.3176 RESIDUAL: 38.4676 514 SIG: 0.1244 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 FFDIF 0.0670 0.0612 0.0402 1.5224 0.1244 CONSTANT (A) -0.0198 ________________________________________Conclusion: 10YrTBDIF monthly difference data are moderately correlated to simultaneous FFDIF monthly difference data beginning at row 326 (July 1981), but there is no significant lag of 10YrTBDIF after FFDIF.
? SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 3 FFDIF PERIODS LAGGED: 0 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 4 10YrTBDIF COEF OF MULTIPLE CORRELATION (R): 0.3019 CORRECTED R: 0.3019 COEF OF MULTIPLE DETERMINATION (R^2) 0.0911 CORRECTED R^2: 0.0911 STANDARD ERROR OF THE ESTIMATE: 0.2854 MEAN SQUARED ERROR: 0.0815 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 46.3480 518 REMOVED BY REGRESSION: 4.2243 1 F-VALUE: 51.8458 RESIDUAL: 42.1238 517 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTBDIF 0.3019 0.3279 0.0455 7.2004 0.0000 CONSTANT (A) -0.0209 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 3 FFDIF PERIODS LAGGED: 1 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 4 10YrTBDIF COEF OF MULTIPLE CORRELATION (R): 0.2908 CORRECTED R: 0.2908 COEF OF MULTIPLE DETERMINATION (R^2) 0.0846 CORRECTED R^2: 0.0846 STANDARD ERROR OF THE ESTIMATE: 0.2823 MEAN SQUARED ERROR: 0.0797 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 44.9229 517 REMOVED BY REGRESSION: 3.8000 1 F-VALUE: 47.6818 RESIDUAL: 41.1229 516 SIG: 0.0000 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTBDIF 0.2908 0.3116 0.0451 6.9052 0.0000 CONSTANT (A) -0.0187 ________________________________________ SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 3 FFDIF PERIODS LAGGED: 2 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 4 10YrTBDIF COEF OF MULTIPLE CORRELATION (R): 0.1294 CORRECTED R: 0.1294 COEF OF MULTIPLE DETERMINATION (R^2) 0.0167 CORRECTED R^2: 0.0167 STANDARD ERROR OF THE ESTIMATE: 0.2805 MEAN SQUARED ERROR: 0.0787 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 41.2105 516 REMOVED BY REGRESSION: 0.6896 1 F-VALUE: 8.7642 RESIDUAL: 40.5209 515 SIG: 0.0036 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTBDIF 0.1294 0.1328 0.0449 2.9604 0.0036 CONSTANT (A) -0.0187 ________________________________________ ? SIMPLE LINEAR REGRESSION: Y = A + B(1)*X DEPENDENT VARIABLE (Y) IS MATRIX COLUMN: 3 FFDIF PERIODS LAGGED: 3 INDEPENDENT VARIABLE (X) IS MATRIX COLUMN: 4 10YrTBDIF COEF OF MULTIPLE CORRELATION (R): 0.0929 CORRECTED R: 0.0929 COEF OF MULTIPLE DETERMINATION (R^2) 0.0086 CORRECTED R^2: 0.0086 STANDARD ERROR OF THE ESTIMATE: 0.2799 MEAN SQUARED ERROR: 0.0783 ANALYSIS OF VARIANCE: SUMS OF SQUARES DEGREES OF FREEDOM TOTAL: 40.6185 515 REMOVED BY REGRESSION: 0.3506 1 F-VALUE: 4.4751 RESIDUAL: 40.2679 514 SIG: 0.0327 INDEP VAR SIMPLE R COEF (B) S.E. COEF T-VALUE SIGNIFICANCE 1 10YrTBDIF 0.0929 0.0948 0.0448 2.1154 0.0327 CONSTANT (A) -0.0180 ________________________________________Conclusion: FFDIF monthly difference data are moderately correlated to simultaneous 10YrTBDIF monthly difference data beginning at row 326 (July 1981), but there is no significant lag of FFDIF after 10YrTBDIF (i.e., lead of 10YrTBDIF ahead of FFDIF).
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