The Fed’s risky and reckless tight money policy

I rarely use the term ‘risk’ in my macro posts.  It would barely show up in any word cloud.  I rarely use the term ‘power’ in my micro posts.  Those are my blind spots.  Today I’m going against conventional wisdom by arguing that the Fed’s ultra-tight monetary policy has dramatically increased risk in three areas: policy fragility, balance sheet risk, and financial system fragility.

Who says Fed policy is ultra-tight?  Actually, Ben Bernanke said so in 2003, when he argued that the money supply and interest rates were misleading, and that the “only” way to determine the stance of monetary policy is by looking at NGDP growth and inflation.  If you average those two variables, the past 46 months have been the tightest money since Herbert Hoover was President.  NGDP growth has averaged only 1.9%/year, inflation only 1.1%.

And what are the consequences of this policy?

1.  It’s obviously made the financial crisis much worse, as an unexpected slowdown in nominal income growth almost inevitably makes it harder to repay loans.  After all, income represents the resources that people, businesses and governments have to repay nominal debts.  Less nominal income leads to more defaults.  This is currently an even bigger problem is Europe.

2.  Less obvious is the fact that the ultra-tight monetary policy has lead to  a much bigger Fed balance sheet.  If you look  around the world you’ll see that countries with lower NGDP growth rates have lower nominal interest rates and much bigger monetary bases (as a share of GDP.)

Here is the data for the past 5 years, for three major economies:

Country         NGDP growth         5 year Gov bond yield          Base/GDP in 2011

Australia             41.3%                            3.69%                                 4.0%

America              12.8%                            0.90%                                 17.9%

Japan                  -8.3%                            0.31%                                 23.8%

(I took this from an old blog post, so the data’s slightly out of date.)

I actually worry less about this risk than the other two, as the Fed holds mostly T-securities and any losses it suffers are gains to the Treasury.  And the EMH says the expected gains or losses are roughly zero.  And it’s currently making vastly larger than normal profits.  But others who worry about this issue should favor much faster NGDP growth so we could shrink down closer to the RBA’s balance sheet (actually 6% of GDP is the “normal” level for the US.)

3.  The third big problem is policy risk.  When rates are above normal the Fed is able to use its preferred policy instrument (the fed funds target) combined with the Taylor Rule to deliver stable NGDP growth.  But ever since we’ve moved to the ultra-low tight money policy, interest rates have fallen to the zero rate bound.  There are other tools that would work, but the Fed isn’t comfortable using them.  This makes it less likely that they will hit their macro policy objectives.  This isn’t to say they’d stopped doing policy, they still try things like QE and interest rate guidance, rather it means they’ve introduced more macroeconomic risk.  That’s why volatility in the equity markets increased in the period after 2007, just as stock market volatility more than doubled in the 1930s.

The Fed has adopted an extremely reckless and risky policy.  But here’s the great irony; 99% of economists think that solving the problem, going back to faster NGDP growth, would be a risky decision for the Fed.   “Oh dear  . . . they might have to buy so much stuff.”   It’s all about fear of the unknown.  I’m here to tell you that 5% NGDP growth is the known.  What we have today is the unknown.  This applies doubly to Europe.  Remember those who said the euro would bring ‘stability,” that it would eliminate the instability of exchange rate fluctuations?  The Economist has a wonderful metaphor in their new issue:

Speaking recently in Brussels, the IMF’s Nemat Shafik compared such a process of internal devaluation to painting a house. “If you have an exchange rate you can move your brush back and forth. If you don’t have an exchange rate you have to move the whole house.”

The Europeans have picked up the whole country of Greece and are shaking it back and forth.  The result is an economic/social/political earthquake.  The real risk is not doing too much with monetary policy, it’s doing too little.

BTW.  Nick Rowe has a great new post–probably my favorite blog post of the year.  I’m sure that some of my future posts will be triggered by thinking about the implications of Nick’s metaphors.

PS.  I’ll be running behind this week on comment responses.

Update:  I forgot to mention that Yichaun Wang has an excellent post that discusses the risks associated with Switzerland’s tight money policy.  Because Switzerland prefers a low inflation/NGDP growth rate, it’s hard for the Swiss National Bank to cut interest rates enough to deter speculators.  Other options like currency pegs also carry risk.


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60 Responses to “The Fed’s risky and reckless tight money policy”

  1. Gravatar of Major_Freedom Major_Freedom
    19. June 2012 at 08:05

    ssumner:

    Who says Fed policy is ultra-tight? Actually, Ben Bernanke said so in 2003, when he argued that the money supply and interest rates were misleading, and that the “only” way to determine the stance of monetary policy is by looking at NGDP growth and inflation.

    NGDP growth “and” inflation? Actually, Ben Bernanke has stated many more times than his statement in 2003 that price stability is the primary goal. Remember when he and Ron Paul were debating, and Bernanke said, with much emphasis “I know you like the gold standard, but the Fed’s task is PRICE STABILITY”.

    If you go back further than 46 months, and you look at long term price inflation, then the Fed has been averaging around 2.5% since 2000. The last 46 months of low price inflation is offset by pre-2008 high price inflation (peaking at around 5% in 2007).

    Yes, NGDP collapsed, but the Fed’s mandate is targeting price inflation, not NGDP, and not NGDP and price inflation.

    No, you can’t claim that the Fed is “supposed” to run higher price inflation during recessions and lower price inflation during booms, because that would imply the Fed is “supposed” to stabilize NGDP, which is not their current policy.

    If you average those two variables, the past 46 months have been the tightest money since Herbert Hoover was President.

    If you average pre- and post-2008 price inflation, money has been neutral.

    It’s obviously made the financial crisis much worse, as an unexpected slowdown in nominal income growth almost inevitably makes it harder to repay loans.

    Inflation from the Fed that depends on credit expansion introduces new loans that increase overall risk. It helps put a lid on the Ponzi-like scheme of debt expansion used to pay back old debt expansion.

    After all, income represents the resources that people, businesses and governments have to repay nominal debts.

    Debt can be defaulted on, renegotiated, paid back early. In a 100% reserve standard, debt defaults do not subtract one cent from the money supply. In our economy, it does, because bank credit is to a large degree backed by no prior saving.

    No, you can’t say that bank credit is backed by collateral, because the collateral itself is dependent on credit expansion to form prices. Collateral backed by dollars that were created ex nihilo when new credit is made, means the collateral is not backed by anything tangible either.

    Less nominal income leads to more defaults. This is currently an even bigger problem is Europe.

    Yes, Ponzi schemes do that. The only reason everyone is so worried about debt is because debt has come to be a gigantic portion of the economy, due precisely to the fact that central banks encourage bank credit expansion, and encourage more borrowing by governments.

    Less obvious is the fact that the ultra-tight monetary policy has lead to a much bigger Fed balance sheet. If you look around the world you’ll see that countries with lower NGDP growth rates have lower nominal interest rates and much bigger monetary bases (as a share of GDP.)

    What about the absolute size of a central bank’s balance sheet over time? Countries with higher inflation have central banks with faster growing balance sheets than countries with lower inflation.

    I actually worry less about this risk than the other two, as the Fed holds mostly T-securities and any losses it suffers are gains to the Treasury.

    What about the over $1 trillion of bad mortgage debt the Fed purchased from mortgage lenders and banks? You’re OK with the Fed owning real estate?

    And the EMH says the expected gains or losses are roughly zero. And it’s currently making vastly larger than normal profits. But others who worry about this issue should favor much faster NGDP growth so we could shrink down closer to the RBA’s balance sheet (actually 6% of GDP is the “normal” level for the US.)

    That would require the absolute size of the Fed’s balance sheet to be even greater than it has already become. What about those who worry that the Fed’s balance sheet is becoming too large relative to the past?

    The third big problem is policy risk. When rates are above normal the Fed is able to use its preferred policy instrument (the fed funds target) combined with the Taylor Rule to deliver stable NGDP growth. But ever since we’ve moved to the ultra-low tight money policy, interest rates have fallen to the zero rate bound.

    As Yichuan pointed out to you last week, you can’t claim that today’s low interest rates is caused by low NGDP, because it is also possible that low interest rates are due to ultra loose monetary policy, whereby the reverse hot potato effect is taking place for a temporary period of time.

    If you are right that the ultra-low rates are caused by ultra low NGDP growth, then it would have to the case that that if the Fed stopped buying Treasuries from the banks tomorrow, then the fed funds rate would become even lower than it is now. But is that what we should expect? Shouldn’t we expect the banks to scramble for funds to meet their obligations, which would see banks seeking to borrow more in the overnight market, and abstain from lending their existing cash into the overnight market, thus making the fed funds rate increase, and fast?

    There are other tools that would work, but the Fed isn’t comfortable using them. This makes it less likely that they will hit their macro policy objectives.

    They have hit their long term price inflation policy objective. They’re already at, or close to, their maximum limit (e.g. 2.5% price inflation since 2000) If employment continues to remains low, despite the long run price stability, then the Fed would almost certainly, and so far they have, call upon Congress to fix the rest.

    Yes, the Fed is failing to keep unemployment low, but according to Bernanke, the Fed has worked very hard the last 30 years acquiring an international reputation of price stability, and they would rather not sacrifice that. The Fed is more concerned with its international dominance and prestige than it is with US employment. After all, the world is currently still using the US dollar as reserve. They do not want to go back to the 1970s of high price inflation.

    This isn’t to say they’d stopped doing policy, they still try things like QE and interest rate guidance, rather it means they’ve introduced more macroeconomic risk. That’s why volatility in the equity markets increased in the period after 2007, just as stock market volatility more than doubled in the 1930s.

    The reason the stock market became “more volatile” in 2007 is because that was very soon after the Fed raised the fed funds rate by reducing the extent to which it injected reserves into the banking system. All the investments that depended on low interest rates and inflation, became exposed as less profitable, or unprofitable. And some sectors were hit harder than other sectors. Construction and durable goods manufacturing were falling faster during 2006-2007 than the service and retail sectors. This is because the former are more sensitive to interest rates.

    The Fed has adopted an extremely reckless and risky policy.

    You’re right. Far too much monetary inflation the last 46 months. Record amounts.

    But here’s the great irony; 99% of economists think that solving the problem, going back to faster NGDP growth, would be a risky decision for the Fed. “Oh dear . . . they might have to buy so much stuff.” It’s all about fear of the unknown. I’m here to tell you that 5% NGDP growth is the known. What we have today is the unknown. This applies doubly to Europe.

    NGDP targeting, as the experience of Australia 1990-2008 has shown (and as Brazil and Argentina from the 1960s to the 1990s has shown), leads to UNSUSTAINABLE, ACCELERATING aggregate money supply growth. Look at the Australia M3 data that is easily available. While NGDP growth was long term stable 1990-2008, aggregate money supply was not. It was accelerating. You can’t have accelerating money supply growth in the long run. The inevitable result is currency breakdown.

    Remember those who said the euro would bring ‘stability,” that it would eliminate the instability of exchange rate fluctuations?

    Yeah, the same thinker types said the same thing about central banks in general. Remember when economists said long term price inflation targeting would eliminate instability?

    The same thing is the case for NGDP targeting.

    Sumner, you’re going to have to just accept the fact that the free market cannot handle communist institutions like fiat standard central banks over the long run. NGDP targeting is not the end game. It is merely another flavor of the month, another quick fix solution, another ad hoc totally groundless doctrine that presupposes fallacious economic beliefs.

    Speaking recently in Brussels, the IMF’s Nemat Shafik compared such a process of internal devaluation to painting a house. “If you have an exchange rate you can move your brush back and forth. If you don’t have an exchange rate you have to move the whole house.”

    Keynes had an even better analogy:

    Printing money is akin to turning stones into bread.

    The Europeans have picked up the whole country of Greece and are shaking it back and forth. The result is an economic/social/political earthquake.

    If Greece should have monetary independence, then the same logic can be used to make the case for monetary independence at the individual human level. If you say no, individuals should be coerced into using a monopoly currency if they happen to live and do business in a geographical territory controlled by a state, then by that same logic, the same argument can be made for the Greeks.

    The real risk is not doing too much with monetary policy, it’s doing too little.

    No, it’s doing too much. An economy will never experience a currency breakdown with too little money printing.

  2. Gravatar of Nick Rowe Nick Rowe
    19. June 2012 at 08:14

    MF: “No, it’s doing too much. An economy will never experience a currency breakdown with too little money printing.”

    It’s already happening in Greece, where they are resorting to “barter” (actually, local exchange systems) because people want to exchange stuff but don’t have enough Euros to buy and sell stuff with. E.g. http://www.bbc.co.uk/news/world-europe-17680904

    Thanks Scott!

  3. Gravatar of John John
    19. June 2012 at 08:25

    Scott,

    I had a couple of questions about the EMH related to financial markets. Let’s say a company like Microsoft releases a new product and the stock of Microsoft rises that day and the next day in proportion a general rise in the market. Would that be an indication that the markets are predicting the new product would be a success or failure?

    Another question, say that the markets rally in anticipation of an announcement of further easing by the Fed. The Fed makes an announcement and markets rise about 5% over the next week. Say that in the week before they rose 5% and the week after the announcement they rose 5%, would that be an indication of market approval for said policy?

    I’m interested in the idea that the success or failure of a policy is instantly transmitted through market movements, but am finding that it is not as clear as you seem to describe it when you look at the real world. It seems that even if you accept the premise of the EMH, it is still a tough tool to correctly apply to analyzing markets.

  4. Gravatar of John John
    19. June 2012 at 08:54

    MF,

    That’s a good point that if the Fed stopped buying treasuries, the discount rate would probably rise, but only until it matched the Fed funds rate because then banks would just go to the Fed to borrow.

    I suspect Sumner is going to say something like they could also increase inflation expectations with large-scale asset purchases.

    Never the less, I think you’ve hit on a key point about why it is a little fishy to solely identify low interest rates with tight money. In my opinion, if it weren’t for central banks trying to drive rates down in times of crisis, we would never have these permanent low interest rate environments. In the three cases of low-rate environments- present U.S., Japan, and Great Depression U.S.- low interest rates came after central bank attempts to ease. Absent these conscious attempts to create a zero-rate environment, I seriously doubt that there would be a “liquidity trap.” Most likely, rates would spike during a financial panic then fall back in line with the general supply/demand of loanable funds.

  5. Gravatar of Tom Tom
    19. June 2012 at 09:16

    The Greek gov’t has promised to spend too many euros — in amounts they are unwilling to forcefully collect.

    The Greek gov’t should print up 1 year, 0% bearer bonds, and use these bonds to pay gov’t bills — as wages, entitlements, and other payments. Thus, they force the recipients of excess gov’t spending to loan the Greek gov’t the money needed to pay.

    The gov’t would accept the bonds at 100% value for tax and other payments, but would not make the bonds legal tender, requiring peaceful, private companies to accept them. Tho this would be allowed, at any agreeable discount.

    Scott, bearer bonds could save the euro by making adjustments politically possible — and similarly save CA and NY and other over-spending gov’t.

    As a near-money, printing bonds is also a fiscal way of increasing “money” in circulation.

  6. Gravatar of Major_Freedom Major_Freedom
    19. June 2012 at 09:52

    Nick Rowe:

    “No, it’s doing too much. An economy will never experience a currency breakdown with too little money printing.”

    It’s already happening in Greece, where they are resorting to “barter” (actually, local exchange systems) because people want to exchange stuff but don’t have enough Euros to buy and sell stuff with. E.g. http://www.bbc.co.uk/news/world-europe-17680904

    That’s because they aren’t producing enough.

    One city? Come on. The same thing exists in Ithica with their “Ithica Hours” local currency system.

    A lack of money does not mean a lack of money printing. It can, and in Greece’s case it most certainly does, mean a lack of productivity.

    There is no Euro breakdown in Greece. It’s still universally accepted. Taxes, wages, investment, are all still paid in Euros.

    When the the Euro ceases to be universally accepted in Greece, then you can claim there was a Euro breakdown in Greece. One group of 800 members in one city in Greece does not mean the Euro collapsed in Greece.

    It’s like someone got laid off for lying on their loan application, and they resort to panhandling on the street. Is the problem here a lack of money printing for this person’s benefit? No, the problem is his own behavior.

    The Greek people in Volos are essentially suffering for the transgressions of their government. It’s not because the ECB didn’t print enough Euros to buy Greek debt.

  7. Gravatar of Major_Freedom Major_Freedom
    19. June 2012 at 10:00

    John:

    That’s a good point that if the Fed stopped buying treasuries, the discount rate would probably rise, but only until it matched the Fed funds rate because then banks would just go to the Fed to borrow.

    I was actually referring to the fed funds rate rising. If the Fed stopped buying treasuries, it is likely that the banks would set a higher overnight rate for the money they borrow and lend to each other.

    The discount rate is set by the Fed, so if anything, the fed funds rate would probably rise to match the 0.75% discount rate currently in place, and then we might see more borrowing at the discount window.

    I suspect Sumner is going to say something like they could also increase inflation expectations with large-scale asset purchases.

    Yes, but that requires the fed to purchase treasuries. I am suggesting a scenario where the Fed STOPPED buying treasuries. They can’t promise higher inflation if they’re not buying treasuries.

    In my opinion, if it weren’t for central banks trying to drive rates down in times of crisis, we would never have these permanent low interest rate environments.

    In the three cases of low-rate environments- present U.S., Japan, and Great Depression U.S.- low interest rates came after central bank attempts to ease.

    Absent these conscious attempts to create a zero-rate environment, I seriously doubt that there would be a “liquidity trap.” Most likely, rates would spike during a financial panic then fall back in line with the general supply/demand of loanable funds.

    Bingo.

  8. Gravatar of ChargerCarl ChargerCarl
    19. June 2012 at 10:07

    japan has had negative NGDP growth?

    thats kind of shocking.

  9. Gravatar of ssumner ssumner
    19. June 2012 at 10:22

    Nick, Very interesting post. It made me realize that there are three forms of monetary stimulus. New definition of the dollar, with no change in the money supply (US 1933), increase in the money supply with no change in the definition of the dollar (US after 1973), and both (a currency reform.)

    John, I don’t think I’ve described it as easy, it is often hard to figure when the market gets information, and what they are responding to. But there are occasions where it’s fairly clear, as when the market responds strongly and immediately to a major Fed annoucement or policy speech.

    In the Microsoft example I’d say there is very little evidence of market impact.

    I suspect that recent rumors of Fed action have helped the market a bit, but I have no proof.

    You said;

    “That’s a good point that if the Fed stopped buying Treasuries, the discount rate would probably rise, but only until it matched the Fed funds rate because then banks would just go to the Fed to borrow.”

    You must be new here. Nothing MF says is “a good point.” He’s wrong about everything. Always.

    Tom, That might work, but only if the bonds replaced the euro as the medium of account.

  10. Gravatar of ssumner ssumner
    19. June 2012 at 10:24

    ChargerCarl, Their NGDP is considerably lower than in 1993, and their population is larger. That’s way tighter than US monetary policy during the most deflationary period of the gold standard (1870s-1890s).

  11. Gravatar of Major_Freedom Major_Freedom
    19. June 2012 at 10:28

    ChargerCarl:

    japan has had negative NGDP growth?

    thats kind of shocking.

    You might be interested to know that Japanese GDP per capita (PPP) has been increasing since 1999:

    http://i.imgur.com/Gj4lx.png

  12. Gravatar of Major_Freedom Major_Freedom
    19. June 2012 at 10:30

    ssumner:

    You must be new here. Nothing MF says is “a good point.” He’s wrong about everything. Always.

    Notice how these accusations are never accompanied by actual refutations. Never.

    Sumner is always wrong about money. Always. And I have shown it time and time again.

  13. Gravatar of Major_Freedom Major_Freedom
    19. June 2012 at 10:37

    At some point Sumner, you’re going to have to learn the incredibly uncomfortable, and inconvenient truth that I, someone who is an actual market monetarist and disagree with you about virtually every claim you make concerning money, know more about monetary economics than you do.

    That probably makes you made, laugh, cry, and all sorts of other emotions that compel you to calling me an idiot, and not even dumb. It just re-emphasizes to me that I am right.

    The more you try to brainwash your readers with empty attacks on me, the more I know I am right.

    The more you correct yourself after my criticisms, by you sheepishly using other poster’s similar comments as a springboard from which you go off on a tangent, the more I know I am right.

    The more you plead to your readers not to listen to me, the more I know I am right.

    The more you continue to insist that the foundation of economic science are aggregates, collectives, groups, and other universal abstract concepts, the more I know I am right.

    Face it. Learn it. Love it.

  14. Gravatar of Saturos Saturos
    19. June 2012 at 10:45

    Scott, do you think maybe larger than normal Fed profits could be used as an indicator of bad monetary policy?

    Everyone, Evan Soltas has an absolutely fantastic new post up, on the Fed’s level targeting mandate. Yes, you heard that right – the Fed has a level targeting mandate. (I swear to God he’s gotten even smarter over the past six months – if that’s even possible.)

  15. Gravatar of John Thacker John Thacker
    19. June 2012 at 10:51

    No, it’s doing too much. An economy will never experience a currency breakdown with too little money printing.

    Nonsense. Look at what happened to money market mutual funds breaking the buck because the nominal GDP dropped, and thus there wasn’t enough money in circulation to sustain yields of zero of above. That lack of money supply can be terribly damaging, because there really is a zero lower bound to the rate people will accept as a return on their currency. (Well, unless, say, the risk of theft starts skyrocketing so people won’t be willing to just hold paper currency, in which case you’ve got other problems.)

    The risk of MMM funds breaking the buck is another huge risk.

    M_F:

    The more you continue to insist that the foundation of economic science are aggregates, collectives, groups, and other universal abstract concepts, the more I know I am right.

    versus M_F:

    NGDP targeting, as the experience of Australia 1990-2008 has shown (and as Brazil and Argentina from the 1960s to the 1990s has shown), leads to UNSUSTAINABLE, ACCELERATING aggregate money supply growth. Look at the Australia M3 data that is easily available.

    Who’s the person insisting that aggregates and other abstract concepts are the foundation of economic science? Looks like it’s M_F.

    You have to be pretty focused on your abstract concepts like M3 to insist that Australia’s economy is the example to avoid from 1990 until now. Those of us who prefer to look at real things rather than made up concepts like M3 can easily witness that.

  16. Gravatar of Major_Freedom Major_Freedom
    19. June 2012 at 10:55

    From “A Discussion With FRIEDRICH A. VON HAYEK”

    Held at the American Enterprise Institute on April 9, 1975, pages 8-9. At the time, there was an inflationary recession.

    “For forty years I have preached that the time to prevent a depression is during the preceding boom; and that, once a depression has started, there is little one can do about it. My advice was completely disregarded as long as the boom lasted. Now suddenly, when my prediction has come true and we have reached the stage where, in my opinion, little can be done about the inevitable reaction which has set in, people suddenly turn to me and ask for my opinion. I am very much tempted to answer, “Well, if you had listened to me before, you wouldn’t be in that mess/7 Of course, I do not mean you—I mean the public in general.
    What I want to discuss is policy in the long run—by which I mean not only the very long run in the Marshallian sense, but policy over the next few years. What we should absolutely avoid is any attempt to recreate employment, or diminish unemployment by a further does of inflation.

    “I will confess that I do not know whether, at this moment, even a strong additional dose of inflation would still be effective. I expect that it will be attempted, and I rather hope that it will not succeed and that we shall be forced to turn to the fundamental problem of the readjustment of the structure of production.
    But the main point is: what can we do to avoid the same sort of mistakes in the future?

    “The public, having so long been taught false doctrines, is still convinced that the government has it in its power substantially to reduce or perhaps, in the short run, completely to abolish unemployment by such tricks as deficit spending, increasing the quantity of money, and so on. Is there any possibility of preventing the government, even if it should wish to act more sensibly, from being forced by public opinion into repeating its mistakes and being driven to more and more-inflation?

    “This leads me to a point where I am afraid I have persistently disagreed with many of my closest friends and associates. I believe that if we want to prevent the government from giving in to public pressure for quick and rapidly effective measures, we must put fetters on what the government can do and restore several institutions which were designed to prevent the government from abusing its powers, and particularly its powers to inflate.”

    ——

    How many market monetarists are calling for more inflation because they are unhappy with the current state of employment? All of them. How many are claiming its not because of employment? All of them. How many would Hayek agree with? None of them.

    What did Hayek mean when he said he wanted to RESTORE “several institutions” which were designed to prevent the government from abusing its powers? A gold standard. How many market monetarists want that? None of them.

  17. Gravatar of Major_Freedom Major_Freedom
    19. June 2012 at 11:23

    John Thacker:

    Nonsense. Look at what happened to money market mutual funds breaking the buck because the nominal GDP dropped, and thus there wasn’t enough money in circulation to sustain yields of zero of above.

    That isn’t currency breakdown. Those are investment denominated in currency that incurred a loss.

    That lack of money supply can be terribly damaging, because there really is a zero lower bound to the rate people will accept as a return on their currency.

    “Damaged” investments is not currency breakdown either.

    And people don’t accept returns on their cash. They accept returns on their loans. There is a difference.

    The risk of MMM funds breaking the buck is another huge risk.

    MMM incurring losses is not currency breakdown! Good lord people.

    “The more you continue to insist that the foundation of economic science are aggregates, collectives, groups, and other universal abstract concepts, the more I know I am right.”

    versus M_F:

    “NGDP targeting, as the experience of Australia 1990-2008 has shown (and as Brazil and Argentina from the 1960s to the 1990s has shown), leads to UNSUSTAINABLE, ACCELERATING aggregate money supply growth. Look at the Australia M3 data that is easily available.”

    And?

    Who’s the person insisting that aggregates and other abstract concepts are the foundation of economic science? Looks like it’s M_F.

    Hahaha, no, that’s me making an argument about money supply, by using microeconomic fundamentals.

    I am not saying one is prevented from making arguments concerning aggregates. I am saying one ought not base their theory on them.

    You have to be pretty focused on your abstract concepts like M3 to insist that Australia’s economy is the example to avoid from 1990 until now.

    Nobody said one should not address aggregates. It’s the foundation of one’s arguments concerning the aggregates that I am talking about.

    I am just showing that Australia’s history is consistent with my theory that NGDP targeting requires an accelerating aggregate money supply growth.

    Those of us who prefer to look at real things rather than made up concepts like M3 can easily witness that.

    Made up? That’s funny, considering how NGDP targeting theory DEPENDS on the validity of aggregate money supply having a meaning. Aggregate spending is borne out of aggregate money supply.

    Made up concepts. That’s hilarious. You’ll realize just how real cash balances are when you find that they have to continually accelerate in size in order to prop up the increasingly distorted real economy. Then you’ll ask “Why didn’t we look at total cash balances?”

  18. Gravatar of Major_Freedom Major_Freedom
    19. June 2012 at 11:26

    Then you’ll hate yourselves for falling prey to yet another Keynesian “spending” fallacy.

    Market monetarism and Keynesianism are based on the same perception of the economy. They only differ in terms of who should have the power to bring it all about, the Treasury or the Fed.

  19. Gravatar of John Becker John Becker
    19. June 2012 at 11:45

    MF,

    I got the discount rate and the fed funds rate confused. What I meant to say was that the fed funds rate (rate of interbank lending) could only rise to the discount rate (rate at which banks borrow from the fed) because once they were at parity, the banks could just borrow from the Fed and not have the credit risk of borrowing from another regular bank.

    About my other point though, it would be very interesting to see what happened if the fed just stopped all their purchases and adjusted the discount rate so that it stayed above the fed funds rate. I suspect that you’re right that rates would rise.

    Eventually interest rates have to match supply and demand. Right now I see the increase in money parked at the federal reserve as a type of non-price rationing. When the price mechanism doesn’t work, you get shortages or surpluses. Right now banks have a surplus of cash parked in reserve because the price of loanable funds (interest rates) is below the market clearing level.

  20. Gravatar of John John
    19. June 2012 at 11:49

    Scott,

    You often point to lower than normal inflation as a sign of tight money and say that we have lower than normal inflation now. I also know that you like to look at future expectations as a measure. Given that, the Five Year Forward Breakeven Inflation rate is 2.49%. Down from a year high of 3.23% on 8/1/11.

    http://www.bloomberg.com/quote/FED5YEAR:IND

    This seems broadly consistent with a central bank that is using inflation targeting in the forwards market to meet a dual mandate of full employment while giving priority to a 2% inflation target. Combine that with an expectation of around 2% growth in 2012 and 1.9% annualized growth in the first quarter, and you have expected inflation and real GDP growth in the 4-5% region. According to your metrics, it seems like the Fed is on their game this year.

  21. Gravatar of Major_Freedom Major_Freedom
    19. June 2012 at 12:06

    John Becker:

    I got the discount rate and the fed funds rate confused.

    Yeah no worries.

    What I meant to say was that the fed funds rate (rate of interbank lending) could only rise to the discount rate (rate at which banks borrow from the fed) because once they were at parity, the banks could just borrow from the Fed and not have the credit risk of borrowing from another regular bank.

    True, but the Fed can pick and choose how much they are willing to lend through the discount window. Like if a bank went to the Fed discount window and asked for $10 trillion, and they could afford to pay the interest, then the Fed won’t just accommodate it. They’ll have to grant permission first, for the Fed is responsible for the rate of inflation.

    About my other point though, it would be very interesting to see what happened if the fed just stopped all their purchases and adjusted the discount rate so that it stayed above the fed funds rate. I suspect that you’re right that rates would rise.

    Indeed they would, which was exactly what happened in 2005-2006, when the Fed reduced the rate at which they purchased treasuries, and the fed funds rate rose from 2% to 5%.

    Eventually interest rates have to match supply and demand.

    They never come to match supply and demand, because the Fed is constantly in control over the key interest rates being discussed here. In a free market, the rates would never come to match supply and demand either, but it will be CLOSER to prevailing supply and demand.

    Right now I see the increase in money parked at the federal reserve as a type of non-price rationing. When the price mechanism doesn’t work, you get shortages or surpluses. Right now banks have a surplus of cash parked in reserve because the price of loanable funds (interest rates) is below the market clearing level.

    That’s one reason. But just like we’re considering the fed stopping its treasury purchases, imagine instead that the Fed stopped paying interest on reserves. What will the banks do with all that cash that is no longer able to be loaned to the fed at interest? The banks would probably lend it, and we’d see rising price inflation.

    But I think the Fed is scared to death of what would happen if all those trillions were lent. I think they started paying interest on reserves as a way to bail out the banks with inflation, but without the consequent runaway price inflation. They just bailed themselves out, and let the economy suffer from all the past years of inflation. It is at this point that people like Sumner say the problems started when the Fed refused to bail out everyone and not just the banks, but they don’t realize that the problems were already brewing DURING the boom, which required accelerating monetary inflation to prevent exposure to losses, which the Fed didn’t, indeed couldn’t, do for reasons of saving the currency and retaining world reserve status.

    So they had to reduce the rate of money printing, and that finally allowed the market to correct, but no sooner later, the fed again started to inflate, but they bailed out the banks, and so we’re basically copying what Japan did wrong. Years of stimulus, then only stimulus for the banks, and then hope the zombie banks fix their problems asap, so that the fractional reserve process can continue. It doesn’t work.

  22. Gravatar of 123 123
    19. June 2012 at 12:25

    Scott, all three points are 100% on target. But they have only two common sources:
    1. Buffet has called derrivatives ” the financial weapons of mass destruction “. Well, cash is an option near the zero rate bound.
    2. Minsky cycle

  23. Gravatar of ChargerCarl ChargerCarl
    19. June 2012 at 12:55

    Major Freedom:

    [i]You might be interested to know that Japanese GDP per capita (PPP) has been increasing since 1999[/i]

    That is good to know. However the stories I hear from japanese are mostly negative and consist of difficulty finding decent work and diminishing oppurtunities for young people. Despite the growth in real GDP everyone still feels like the economy sucks. Maybe NGDP growth could help?

  24. Gravatar of ChargerCarl ChargerCarl
    19. June 2012 at 12:56

    also, can someone tell me how to write in italics?

  25. Gravatar of 123 123
    19. June 2012 at 13:25

    Scott, in the spirit of euro soccer cup 2012, I posted this in the Facebook NGDP targeting group: ” Euro antideflation cup 2012 match Switzerland-England 1:5 (Hildebrand 10′, Bean 49′, Tucker 53′, King 62′, 90′, Osborne 66′. Red cards Hildebrand 15′, Posen 44′)
    Swiss 1.20 euro peg no match for the forthcoming BoE “funding for lending” scheme. “,

    with a later update ” 1:6 after extra time (Cable 119′)”.

    Even if GBP appreciates against CHF, I’m sure UK will generate more NGDP than Switzerland.

  26. Gravatar of Alex Godofsky Alex Godofsky
    19. June 2012 at 13:39

    ChargerCarl: to write in italics do the following:

    [left angle bracket]em[right angle bracket]text to be in italics[left angle bracket]/em[right angle bracket]

    except replace the [] with the respective characters.

  27. Gravatar of John John
    19. June 2012 at 14:52

    MF,

    Yeah with bailouts, paying interest on reserves, and pumping more money in the system than they want to ever get out, they’ve almost put themselves in a position to where the best possible thing that could happen from the Fed’s perspective is stagnation. It avoids any of the really bad things from happening like very high inflation or a horrible depression. The problem is that the things they’ve done make an actual recovery almost impossible. It is one of history’s most bitter jokes that we walked into the exact thing the Japanese did after we “learned their lessons.”

    I’m not saying I endorse his keynesian aggregate approach, but sometimes Scott has some interesting posts when he doesn’t talk about money. One of them was recently about Japan. Whether or not you think Japan has done ok comes down to which inflation statistic you believe.

  28. Gravatar of ChargerCarl ChargerCarl
    19. June 2012 at 14:57

    [em]thanks alex![/em]

  29. Gravatar of ChargerCarl ChargerCarl
    19. June 2012 at 14:58

    aw nuts

  30. Gravatar of Cedric Cedric
    19. June 2012 at 15:02

    /hahayouloser

  31. Gravatar of Major_Freedom Major_Freedom
    19. June 2012 at 16:02

    ChargerCarl:

    However the stories I hear from japanese are mostly negative and consist of difficulty finding decent work and diminishing oppurtunities for young people.

    You hear that in every modern country.

    John:

    Yeah with bailouts, paying interest on reserves, and pumping more money in the system than they want to ever get out, they’ve almost put themselves in a position to where the best possible thing that could happen from the Fed’s perspective is stagnation. It avoids any of the really bad things from happening like very high inflation or a horrible depression. The problem is that the things they’ve done make an actual recovery almost impossible. It is one of history’s most bitter jokes that we walked into the exact thing the Japanese did after we “learned their lessons.”

    I’m not saying I endorse his keynesian aggregate approach, but sometimes Scott has some interesting posts when he doesn’t talk about money. One of them was recently about Japan. Whether or not you think Japan has done ok comes down to which inflation statistic you believe.

    This is a good point. For me I like to look at GDP per capita (PPP), and even better, which I don’t have easy access to, is GDP less government spending per capita (PPP). This tells me just how much wealth is being produced in the market, per person, (mostly) corrected for nominal changes. It’s not perfect, but it’s a heck of a lot better than GDP.

  32. Gravatar of Bill Ellis Bill Ellis
    19. June 2012 at 16:02

    S Sumner… Excellent post. Thank you for the new perspective.

    Besides that though, this bit surprised me…. “99% of economists think that solving the problem, going back to faster NGDP growth, would be a risky decision for the Fed.”

    I thought only the FED , a lot neo classical economists and economist to the right of neo classical economist thought that. Is it more wide spread than that ? Or is that 99% of economists ?

    Man, I must be in a lot smaller info bubble than I thought.

  33. Gravatar of Major_Freedom Major_Freedom
    19. June 2012 at 16:03

    ChargerCarl, if you want to know how to format text, use this site:

    http://www.w3schools.com/html/default.asp

    You can test stuff here:

    http://www.w3schools.com/html/tryit.asp?filename=tryhtml_intro

  34. Gravatar of Major_Freedom Major_Freedom
    19. June 2012 at 16:06

    ChargerCarl:

    To do italics,

    Type:

    less than key, small i, greater than key, TEXT YOU WANT TO ITALICIZE, less than key, forward slash (the same key as question mark), small i, greater than key.

    #TEXT YOU WANT TO ITALICIZE

  35. Gravatar of Cedric Cedric
    19. June 2012 at 16:07

    I wish I could embed animated gifs into my comments. I find that gifs of Office Space and Jersey Shore make my points for me better than I do.

  36. Gravatar of ssumner ssumner
    19. June 2012 at 16:43

    Saturos, Yes, another excellent Soltas post.

    John, The Fed should pay no attention to market forecasts of things it can’t control, like inflation 5 to 10 years out, and instead focus on what they can control, which is inflation zero to 5 years out. And that inflation forecast is below 2%.

    But even if you were right, it wouldn’t suggest monetary policy was appropriate, as the Fed still needs to catch up for the recent undershoot of its 2% target.

    And then there’s the high unemployment . . .

    123, I’m afraid I don’t follow—what’s wrong with derivatives?

    Bill, Krugman has said it would be risky to do monetary stimulus, although he favors it nonetheless. I think it’s risky not to do it.

  37. Gravatar of John John
    19. June 2012 at 16:56

    Scott,

    What measurement are you using to find inflation expectations for under a 5 year time frame? Last I checked they don’t have TIPS spreads for anything under 5 years.

    I couldn’t find data on anything less than 5 years. The Cleveland Fed projects 10 year inflation expectations at 1.18%; down from 1.38% a few months ago but 2.47% inflation in 5 years.

    http://www.clevelandfed.org/research/data/inflation_expectations/index.cfm

    Core CPI came in at 2.3% (off the top of my head) and headline was slightly lower at 1.7% due to falling energy and food prices in May of 2012.

    Shouldn’t the Fed target the forecast over a 5-10 year period? If inflation expectations are falling over 10 years, that seems like a sign that the Fed should do something as most “long term” decisions like hiring and capital investment have that type of time frame in mind.

  38. Gravatar of Bill Ellis Bill Ellis
    19. June 2012 at 18:25

    cool/ cool /

  39. Gravatar of Last chance? | Historinhas Last chance? | Historinhas
    19. June 2012 at 18:31

    [...] Scott Sumner sums it well: The Fed has adopted an extremely reckless and risky policy.  But here’s the great irony; 99% of economists think that solving the problem, going back to faster NGDP growth, would be a risky decision for the Fed.   “Oh dear  . . . they might have to buy so much stuff.”   It’s all about fear of the unknown.  I’m here to tell you that 5% NGDP growth is the known.  What we have today is the unknown.  This applies doubly to Europe.  Remember those who said the euro would bring ‘stability,” that it would eliminate the instability of exchange rate fluctuations? Rate this:Share this:EmailTwitterLike this:LikeBe the first to like this. This entry was posted in Uncategorized. Bookmark the permalink. ← Maybe it´s not that farfetched [...]

  40. Gravatar of Bonnie Bonnie
    19. June 2012 at 18:35

    I agree. Inflation targeting as implemented isn’t delivering the goods as promised:

    From a 2005 Businessweek article:

    “Why does Bernanke favor inflation targeting?
    He thinks that a more “transparent” Federal Reserve policy would promote stable, noninflationary economic growth by giving businesses and consumers more certainty about the future course of interest rates and inflation.”

    We have everything but stability and certainty, and we’re lucky to get any growth at all given the circumstances. Even by Bernanke’s own standards this policy is a failure.

  41. Gravatar of Benjamin Cole Benjamin Cole
    19. June 2012 at 19:47

    I’ll say it again. Another excellent post by Scott Sumner.

  42. Gravatar of Philip George Philip George
    19. June 2012 at 21:13

    What you say has some similarities with what Milton Friedman and Anna Schwartz said about the period preceding the 1929 crash. “The antecedents of the contraction have no parallel in the more than fifty years covered by our monthly data,” they wrote. “… no other contraction before or since has been preceded by such a long period over which the money stock failed to rise.”

    In fact, this should have been a clear indication to Friedman and Schwartz that the way they measured money was incorrect and therefore that their whole analysis of money was wrong. Money was expanding at a wild rate. But it was being used to inflate the prices of financial assets, not real goods and services.

    Be sure that a Depression is on the way.

  43. Gravatar of ChargerCarl ChargerCarl
    19. June 2012 at 21:58

    MF:

    “You hear that in every modern country.”

    Do you? I speak to a lot of australians at my job so I’m going to start asking their opinions on their own economy. Should be interesting.

  44. Gravatar of Saturos Saturos
    19. June 2012 at 22:12

    Philip, have you heard of a little something called the demand for money? Have you looked into the empirics of that?

  45. Gravatar of Saturos Saturos
    19. June 2012 at 22:17

    ChargerCarl, our economy’s doing fine thanks, except it’s about to go down the toilet in a few weeks thanks to Gillard’s new carbon tax.

    http://news.smh.com.au/breaking-news-business/australian-shares-down-on-carbon-plan-20110711-1h9ed.html

  46. Gravatar of Saturos Saturos
    20. June 2012 at 00:15

    Scott, you simply must take a look at this old ECB Working Paper on the Great Depression (when you have the time): http://www.ecb.int/pub/pdf/scpwps/ecbwp326.pdf

    HT Lars Christensen

  47. Gravatar of Saturos Saturos
    20. June 2012 at 00:18

    Lars says this is your model right here.

  48. Gravatar of J.V. Dubois J.V. Dubois
    20. June 2012 at 04:03

    This is a little bit off topic, but I have to say this. I was originally reserved when I first read praise about monetary analysis from highs school kid Evan Soltas, but man it was not justified. I have read through some of his recent blogs and I have to say that it was great experience. He can write about broad spectrum of topics in a very interesting, thought provoking way. He is already on my lists of blogs to visit regularly.

    I urge anybody who was lazy to give it a try – go to his blog and read it. He kind of reminds me of Yglesias but with less US politics and more very interesting economic stuff.

  49. Gravatar of Saturos Saturos
    20. June 2012 at 04:27

    Scott – Miles Kimball just totally ripped off your idea:
    http://blog.supplysideliberal.com/post/25354569525/going-negative-the-virtual-fed-funds-rate-target

    Well, he makes it sound like he’s got the ear of the FOMC, so if that gets us somewhere…

  50. Gravatar of Wednesday Morning Links | Iacono Research Wednesday Morning Links | Iacono Research
    20. June 2012 at 04:29

    [...] – O.C. Register No Need for Easing, Fed’s Work Is Done: Former Fed Governor – CNBC The Fed’s risky and reckless tight money policy – Money Illusion QE and sudden starts – Macro Matters No comments [...]

  51. Gravatar of WWBBD — What will Beb Bernanke Do? #Wonkbook WWBBD — What will Beb Bernanke Do? #Wonkbook
    20. June 2012 at 04:34

    [...] SUMNER: The Fed’s tight monetary policy is reckless. “Today I’m going against conventional wisdom by arguing that the Fed’s ultra-tight monetary policy has dramatically increased risk in three areas: policy fragility, balance sheet risk, and financial system fragility…The Fed has adopted an extremely reckless and risky policy. But here’s the great irony; 99% of economists think that solving the problem, going back to faster NGDP growth, would be a risky decision for the Fed. ‘Oh dear . . . they might have to buy so much stuff.’ It’s all about fear of the unknown. I’m here to tell you that 5% NGDP growth is the known. What we have today is the unknown. This applies doubly to Europe. Remember those who said the euro would bring ‘stability,’ that it would eliminate the instability of exchange rate fluctuations?…The Europeans have picked up the whole country of Greece and are shaking it back and forth. The result is an economic/social/political earthquake. The real risk is not doing too much with monetary policy, it’s doing too little.” Scott Sumner in The Money Illusion. [...]

  52. Gravatar of Saturos Saturos
    20. June 2012 at 04:38

    I just forgave him slightly – he later did an excellent post on economic growth: http://blog.supplysideliberal.com/post/25423469963/leveling-up-making-the-transition-from-poor-country-to

  53. Gravatar of ssumner ssumner
    20. June 2012 at 07:49

    John, Go to the St Louis Fred and compare yields on 2 year TIPS and two year notes.

    It would be a horrible idea to target inflation over the 5 to 10 year window, because if policy wasn’t highly credible it could cause huge swings in short term inflation. It would be highly destabilizing. Inflation is expected to be 1% over the next couple years, yet the 5 to 10 says tighten further–and lower inflaiton even below 1% short term. That’s destabilizing.

    Bonnie, Agreed.

    Thanks Ben.

    Philip, The only money supply controlled by the Fed is the base, and that didn’t increase during the 1920s, it fell in per capita terms. I’ve done many posts on the Austrian myth of an inflationary 1920s.

    JV, The Yglesias comparison is a good one—Matt has even linked to him.

    Saturos, Thanks, I have a new post on that.

  54. Gravatar of ssumner ssumner
    20. June 2012 at 07:51

    Saturos, My computer locks up everytime I try to open that ECB paper. Can you summarize what’s similar to my model?

  55. Gravatar of Saturos Saturos
    20. June 2012 at 09:39

    Actually I haven’t read the whole thing myself yet, so I’ll just refer you to Lars’ post on it: http://marketmonetarist.com/2012/06/18/the-ecb-has-the-model-to-understand-the-great-recession-now-use-it/

    The abstract sounds a bit similar to you, though of course they’re looking at domestic money and not gold.

  56. Gravatar of 123 123
    20. June 2012 at 10:38

    Scott: ” I’m afraid I don’t follow—what’s wrong with derivatives? ”
    Derivatives magnify losses and gains and so they are dangerous in huge quantities. The only way I can explain this post by Delong is to assume he fears the insolvency of the central bank:
    http://delong.typepad.com/sdj/2012/06/the-spread-between-the-30-year-treasury-bond-rate-and-the-30-year-tips-rate-is-now-222year.html

  57. Gravatar of Counterparties: What the Fed didn’t do | Felix Salmon Counterparties: What the Fed didn’t do | Felix Salmon
    20. June 2012 at 13:40

    [...] date to December, the same time America is set to fall off its “fiscal cliff“. Scott Sumner argues that Bernanke has actually overseen an excessively tight monetary policy, at least in terms [...]

  58. Gravatar of ssumner ssumner
    22. June 2012 at 15:54

    Saturos, If they are looking at money and not gold it’s hard to see how it would be similar to my model, which is all about gold.

    123, I don’t agree that derivatives increase risk.

  59. Gravatar of 123 123
    23. June 2012 at 06:49

    Scott, they do increase risk, usually to the side of the transaction that is getting the leverage.

  60. Gravatar of TheMoneyIllusion » The Fed's risky and reckless tight money policy | Political Blogs Watch TheMoneyIllusion » The Fed's risky and reckless tight money policy | Political Blogs Watch
    25. June 2012 at 04:52

    [...] TheMoneyIllusion » The Fed's risky and reckless tight money policy Go to this article [...]

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