Monday, August 10, 2015

Monetary Policy: Part 5 - The Perfect Monetary Policy

The previous post describes an alternative theory of money growth. I prefer to call it The Strong Form of Money Growth, contrasting it to the Fed's long-term adherence to what is clearly A Weak Form of Money Growth.

The Strong Form Versus the Weak Form

As already described in previous posts, the Fed has always operated as though money growth is a result of demand rather than supply. That is, they first adjust interest rates in the hope that a rate increase or decrease will cause the desired change in economic activity, after which the demand for money will adjust accordingly. Then, as money demand adjusts, hopefully in their preferred direction at the time, the Fed supplies the new amount demanded. This is a weak form of money growth because it requires such a significant lag time for the level of money supplied to adjust.

In the strong form described in the previous post, the money supply adjusts almost immediately in response to the infusion of a larger-than-needed supply of excess reserves. Markets, other interest rates, and the economy then adjust accordingly. Thus, in the strong form, the Fed has absolute control over the supply (not demand, but supply) of money in the economy.

One might ask why the money supply always tended to grow then, and rarely dropped, even in recessionary periods, during the 60's and 70's. This was probably due to the Fed treating daily reserve provision as a routine process, one in which they wanted to ensure that the reserves to cover the banking system's daily needs were almost always present. Then, when they did make a mistake, it tended to be because they added a modest amount of reserves that weren't needed at the time, then locked in the resultant increase in the money supply by following their normal routine of supplying the needed reserves. They were operating assuming the weak form of money growth, so any growth was viewed as a reaction to rates rather than to the reserves supplied earlier.

Monetary Policy Implications of the Strong Form Theory

If the strong form of monetary theory is correct, then the Fed has absolute control over the amount of money circulating in the economy at any given time. Suppose this to be the case. Several issues immediately arise

First, if it's conceded that inflation is caused by increasing the money supply beyond what is needed, then the primary goal should be to stabilize the money supply. Under the strong form, this is trivial, and could indeed be done by one person at the Fed with access to good data and a computer program. Just assign that person the task of keeping the seasonally adjusted level of total reserves in the system constant.

Second, it immediately becomes obvious under the strong form that the Fed is capable of causing recessions any time they desire. This assigns the Fed Chairman and Board so much power that their mandate should be changed so that the direction of economic activity is of no concern of theirs. That is, maintain stable money and let the real world work out why economic activity is going up or down. For if the strong form is reality, it's quite clear the the Fed would be capable of deciding presidential elections simply by ensuring that the current administration goes into the election either burdened with an ongoing recession or being carried along on a monetary boost. Recessions, in particular, often decide presidential elections. In fact, it's quite likely that the Fed has, in the past, decided a few without intending it.

Third, again assuming the strong form is correct, adjustments could, and should, be made to the rules under which the banking system operates so that the Fed isn't frustrated in its effort to maintain a stable money supply (and price level.)

Adjustments Suggested if the Strong Form is to be Implemented

Demand deposits should no longer earn interest. Why? Because that ensures that people will minimize them in their personal and business accounts. It's the minimization that makes the strong form work. Without it, the Fed won't know if funds in the system are being held for transactions (demand balances) or instead constitute savings balances, and it's demand balances that generate inflation in the strong form, not savings.

To ensure minimization of demand accounts, the interest rate on savings should be a rational positive number, not zero or near-zero as is the case today. At an effective rate of zero on short-term savings balances people just let the funds sit in their checking accounts earning no interest, as is the case today. This can easily be accomplished under the strong form. Just have the Fed intervene in the funds market whenever rates fall below, say, 2%. Market participants would soon learn that 2% is the least they should expect to earn on savings balances.

To clearly differentiate demand balances from savings balances, not only should demand balances earn no interest, but they should be the only accounts available for same-day, and probably even next-day transactions. In other words, all debit cards would be issued only on zero-interest demand accounts, and would not be tied to savings accounts. Similarly, a delay of one or even two days would be required to replenish a checking account from savings.

In addition to demand balances not earning interest, neither should the total reserve balances held at the Fed earn interest. This is essential if fed funds traders are to seek to minimize their excess reserves each week. Paying them to hold them would obviously frustrate that process, a fact in evidence today with over $2.5 trillion of excess reserves sitting on the sidelines earning interest from the Fed.

The Zero Boundary Issue

The zero boundary issue, or problem as it is seen by the Fed today, is the thinking that the economy can be so stagnant that interest rates fall to zero, and that once there the Fed loses the ability to cut interest rates further in an effort to stimulate the economy. Implicit in this theory is that money reacts to the economy, of course, and with a lag at that. But the zero boundary issue is really a non-issue under the strong form, particularly if the Fed operates it as described above. The money supply can always be maintained at the desired (stable) level under the strong form. Just set total reserves accordingly.

Then combine a Fed rule that limits it to managing a stable money supply with the operating procedure to maintain the fed funds rate above 2%, and the zero boundary issue disappears. It's still possible that a recession caused by external factors could drop long rates below 2%, but then people would just decide whether to move money shorter or not. They would always be able to earn savings account interest at some part of the yield curve.

Note that nothing is said about the Fed managing the fed funds rate in the strong form argument (with the exception of keeping it above 2%, that is.) The Fed would maintain a stable total reserve balance and short term rates would go where the economy drove them on a day to day basis. This would include the rate on fed funds which would fluctuate on its own unimpeded by the threat of Fed intervention. That is, the Fed should just supply or drain reserves as needed without regard to the fed funds rate at the time. In fact, they should probably intervene at exactly the same time each day, so it would be clear that the interest rate at the time was completely irrelevant.

Getting There from Here

The next post will address the issues the Fed would face in implementing the suggestions presented here. Unfortunately, even if all agreed to do so, the Fed actions of the past six years have placed some significant roadblocks in the way of getting there. The roadblocks aren't impassable although they could be extremely expensive to negotiate.

For some additional insight as to the expense involved, refer to an earlier post: The Fed's Massive Conflict of Interest.

Interestingly, the politics of the matter seem to be lining up in such a way that it might actually be possible to realign Fed policy in the manner described here. Of course, that would mean that first people would have to decide that the strong form of monetary policy is an accurate depiction of reality. That will obviously be the real, and possibly insurmountable, problem.

Continue to Monetary Policy: Part 6 - Getting from Here to There

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