Sunday, October 5, 2008

Monetary Policy, Pushing on a String - Not!

Two Schools of Thought about Monetary Policy Theory

How does the Federal Reserve influence interest rates, economic activity and the inflation rate? There are two schools of thought in this regard, one I call the weak form and the other I call the strong form of monetary policy theory. Note that I'm not addressing just monetary policy here, but the theory behind the policy.

The Weak Form

What I consider the weak form of monetary policy theory is the version where the chain of events goes thus:

1. The Fed eases by lowering the federal funds rate in the interbank market.

2. The lower fed funds rate causes other short-term rates to fall as well.

3. As the front end of the yield curve moves lower, businesses and individuals begin to take on more credit.

4. The increase in borrowing (and the associated increase in purchasing) generates an increase in economic activity.

5. Eventually, if rates are held too low for too long, the increase in economic activity generates inflationary pressures and pressure grows for the Fed to reverse course and begin raising the federal funds rate.

This is the way the world is viewed by most investors and commentators. The editorial page of the Wall Street Journal, for instance, espouses this theory. The weak form also leads to the old "pushing on a string" analogy of monetary policy. The assumption is that things can be so bad that the action of lowering interest rates does not induce any additional business activity (step 3, above) and so the economy remains stagnant. This belief also leads some economists to advise politicians that the only way to get things moving again is to spend some government money, i.e., to introduce some fiscal stimulus. Well, we tried that this year once already and it failed. Unfortunately, under the weak form of the theory our only available option is to do more fiscal stimulus. As before, it just won't work.

The Strong Form

Here, in what I call the strong form of monetary policy theory, is what I'm nearly certain actually occurs during an easing of policy.

1. The Fed, possibly inadvertently, adds sufficient excess reserves to the banking system to get reserves circulating furiously, driving down the federal funds rate at the end of the reserve calculation period. During this process, the average federal funds rate does not have to even be falling and might, in fact, even be rising.

2. If the Fed repeats this process for more than two reserve calculation periods, the excess fed funds being circulated in the banking system are forced into the money supply via other business and individual banking transactions. Again, this process might be planned by the Fed, or inadvertent. If inadvertent, the average fed funds rate is probably stable or even rising.

3. The pressure of the excessive money creation, if sustained for more than two reserve calculation periods, finds its way into the securities markets, particularly the stock market, causing an almost immediate rally in equity prices.

4. Once the increase in money supply has been generated the Fed institutionalizes it, probably inadvertently, by supplying the necessary reserves in future reserve calculation periods to support the now-higher money supply.

5. Along with the increase in securities prices, particularly stocks, other economic activity also begins to accelerate, but the lags are such that the reported increase in such activity only begins to appear approximately six months later.

6. Virtually all increases in the level of the money supply, properly defined, eventually cause a corresponding increase in the general level of prices, i.e., the inflation rate.

Now, under the strong form of the theory, increases in excess reserves, even though provided only intermittently and possibly even during a period of perceived tightening, generate increased money flows in the economy, reflected in immediate stock market improvement, an improvement in the economy reported with a six-month lag and an increase in the general price level that occurs, and is reported, over a period of several years.

Under the strong form, the Fed drives economic activity short term and tax policy and other government policies regarding regulation, etc., drive economic activity over the long term. Also, under the strong form, the level of interest rates is nearly irrelevant to the process, and fiscal stimulus is almost certainly counter-productive given that it sucks resources from the far more productive private sectors of the economy.

Read the Monograph to Better Understand How This Can Happen

As I explained in A Strong Form of Monetary Policy on September 20th, you should read A Monograph on Monetary Policy to better understand the complete picture of what I'm saying and to understand why I can assert the following:

It is possible, under the Strong Form of Monetary Policy Theory that I describe here, for the Federal Reserve to actually be tightening, i.e., causing reduced economic activity and lowering the overall price level, even though they are lowering the federal funds rate in the interbank market.

This can happen simply because the Fed can make, and does make, an occasional mistake in providing the necessary reserves to the banking system in any given reserve calculation period. That is, to take the current time frame, even though they have lowered the average funds rate over a period of months, they might have underestimated how many reserves were needed several times during those months.

Thus, even though the Fed intervenes in the market when the funds rate rises just a bit, thereby convincing the market participants that the Fed wants rates to be lower, they might inadvertently inject too few funds to satisfy reserve requirements for the entire reserve period. This mistake only shows up late in the reserve calculation period when individual banks realize they are short reserves and the calculation period is coming to a close. If this happens system wide, the scramble for the needed reserves results in a one-day escalation in the funds rate, sometimes a severe escalation. Yet, the next day begins a new calculation period and with the Fed again intervening at the expected low rate, everything settles back down.

The reason it takes several weeks for the pressures to escape into the other financial markets is that banks can carry forward a reserve deficit or surplus for one period, but not two periods. During the first period of tightness, the reserve desk managers hold off paying an excessive rate for fed funds because they can cover the shortage the following reserve period. However, they can't do this the second period and so the rate skyrockets as the system scrambles for fed funds that are not there in aggregate. All this while, the Fed, and most participants and observers, think the Fed is in an easing posture.

Has the Fed Really Been Easing in 2008?

I don't think so. In fact, I think 2008 could be characterized as a period of monetary tightening, under the strong form interpretation, a case that I will make in the next post.

Next Post: The 2008 Federal Reserve Tightening

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