If the Fed had a meeting, how would that affect inflation?
Does that question seem incomplete? Then try this one (from a commenter):
If the Fed raised interest rates how would that affect inflation?
Still maddeningly incomplete? Then how about this one:
If the Fed adopted a more expansionary monetary policy, how would that affect inflation?
Finally we have a real question! People often seem to forget that changes in interest rates are an effect of “the thing the Fed does” whereas monetary policy is “the thing itself.”
The first question should have been:
If the Fed adopts an expansionary monetary policy how will that affect interest rates?
Because of the liquidity and Fisher effect, there is no unambiguous relationship between interest rates and inflation. But there is an unambiguous relationship between monetary policy and inflation. Easy money leads to higher inflation (ceteris paribus) and vice versa. But exactly what is easy money? And why can’t we talk about changes in the fed funds rate as being “the thing itself?”
First of all, the fed funds rate is not always equal to the fed funds rate target, so obviously there are forces beyond Fed policy that influence that rate. It is affected by Fed policy, but it isn’t the thing itself. Here’s what I mean by easier money:
A policy that increases the supply of base money or reduces the demand for base money is expansionary. Here are ways to increase the supply of base money:
1. Open market purchases
2. Discount rate cuts
Here are ways to reduce the demand for base money:
1. Lower reserve requirements.
2. Lower interest on reserves.
None of these policy changes will have much effect if temporary.
And here is a very reliable way to signal an intention to adopt an easier monetary policy (usually an intention to boost the base through open market purchases):
1. Lower the fed funds target, relative to expectations.
That signaling device has been so reliable over the years that central banks have been able to see a clear connection between their policy signaling and asset prices linked to inflation expectations (such as stock and commodity prices, or TIPS spreads.)
It is that reliable response of asset prices to unexpected fed funds changes, i.e. unexpected changes in the expected future path of the base, that causes central banks to be absolutely confident the neo-Fisherites are wrong. They see evidence of their policies “working.” But here are two facts that lead to confusion:
1. The vast majority of the time interest rates and inflation are positively correlated—the Fisher effect dominates the liquidity effect.
2. Central banks and their supporters in the academic community often talk as if interest rates are “the thing itself.” That’s incorrect, and it leads them to often confuse easy and tight money, because of point 1.
Combine those two facts, and it’s easy to understand how intelligent, freethinking economists might reject the conventional wisdom, and end up as neo-Fisherites.
The solution is not to throw out mainstream Keynesian monetary theory and embrace neo-Fisherism, the solution is to throw out mainstream Keynesian monetary theory and embrace market monetarism.
Like Coke, it’s the real thing the thing itself.
PS. Off topic, but I only hate Noah on days where he insults me or my friends on Twitter, otherwise I like his blog a lot. Love the sinner, hate the sin.
And a person Miles and Izabella like can’t be all bad. 🙂
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27. April 2014 at 06:34
“But there is an unambiguous relationship between monetary policy and inflation. Easy money leads to higher inflation (ceteris paribus) and vice versa.”
So if there is an oil price shock ceteris paribus which causes a spike in inflation you would say that is easy money even if monetary policy was not responsible?
Maybe I read that wrong.
27. April 2014 at 07:02
So if there is an oil price shock ceteris paribus which causes a spike in inflation you would say that is easy money even if monetary policy was not responsible?
I actually facepalmed when I read that.
An “oil shock” IS NOT CETERIS PARIBUS.
27. April 2014 at 07:05
Daniel
Ah thats were I went wrong. Its getting late my concentration is poor.
27. April 2014 at 08:37
“A policy that increases the supply of base money or reduces the demand for base money is expansionary.”
Here’s something I’m genuinely puzzled about — I had an exchange with Nick Rowe about this:
Over time, higher interest on reserves means more base money in circulation (ceteris paribus). Does that mean that raising the interest rate on reserves would be “expansionary” (ceteris paribus)?
27. April 2014 at 09:37
“A policy that increases the supply of base money or reduces the demand for base money is expansionary.”
This is half correct. The first part is right, but not the second.
Since base money is a medium of exchange, there can be no reduction in the demand for base money economy wide, unless of course that which is base money is refused by everyone. Short of that point, any reduction in the demand for base money would necessarily be limited to certain individuals wanting, and succeeding, in holding less base money. But there would have to be another group of individuals who accept that base money being traded away. So it is necessary for there to be an exactly off-setting increase in the demand for base money.
The net effect of course is no economy-wide increase (this also holds true for any decrease) in the demand for base money.
Demand for money is always (short of total rejection of the money) offsetting.
Supply is a different story. An increase in the supply of base money need not be limited to certain people increasing their supply with a corresponding decrease in the supply held by others.
And this is why inflation is so deceptive. A small group of bankers and politicians can experience an increase in the supply of their base money without a corresponding noticeable decrease (let alone increase) in the supply held by the public, because they are legally banned from increasing the supply of dollars, and yet dollars are the only thing the government demands in payment. So the public is forced into this. This shifts purchasing power towards those who recieve the new money first, and away from everyone else. It is why the primary dealers don’t give up their privileged position of recieving payments from the Fed. It is why non primary dealers would love to get on that list.
The claim that it doesn’t matter who gets the new money first is false. It does matter. Economists 200 years ago understood it matters.
Back to the demand for base money. What is likely being described as a “fall in demand” is a rise in the number of times a given unit of base money is “turned over” during a period of time, like a year. Ok, that in itself can of course take place, but that is not a fall in the demand for base money. It is a fall in the amount of time that a given unit of base money is held, on average. The demand is still always offsetting even when base money is turned over more quickly. If “velocity” rises from 4 to 5 per year, which is likely what Sumner means by a “fall in the demand for base money”, then there is an actual offsetting rise in the demand for money from a factor of 4 to a factor of 5 in terms of “velocity.”
A quickening in the pace of base money traded away, is a quickening in the pace of base money accepted and then held.
27. April 2014 at 10:52
Scott, w/o even reading this, I’ll guess you’re not a fan, but I’ll ask anyway: What is your take on the paper that Noah links to?
http://www.columbia.edu/~mu2166/Making_Contraction/paper.pdf
27. April 2014 at 11:35
Tom Brown:
There should be a rule that any time any author references a “shock”, they have to explain the causes.
27. April 2014 at 11:56
MF, I still haven’t even read the thing yet, but I did notice there were a lot of “shock” references after you mentioned it. Instead I read this one about the paper:
http://mainlymacro.blogspot.co.uk/2014/03/more-thoughts-on-expectations-driven.html
A short but noteworthy packed comments sections there: Simon Wren-Lewis, Nick Rowe, David Aldofatto, and Stephen Williamson.
27. April 2014 at 13:29
M Ricks, No it’s contractionary–it increases the demand for bank reserves.
Tom, It’s not a good sign when a paper starts off with “facts” about the economy that are not true.
27. April 2014 at 13:31
“Tom, It’s not a good sign when a paper starts off with “facts” about the economy that are not true.”
Saves a lot of fruitless reading then I guess.
27. April 2014 at 17:10
“Because of the liquidity and Fisher effect, there is no unambiguous relationship between interest rates and inflation. But there is an unambiguous relationship between monetary policy and inflation.”
Sophistry as always.
Fed tools? Interest rate plus some stuff that doesn’t matter because the broader economy can hardly sense it changed (like the monetary base). So the monetary policy IS the interest rate. And you are right: it hardly matters.
27. April 2014 at 23:41
Sumner wrote:
“M Ricks, No it’s contractionary-it increases the demand for bank reserves.”
If there is an actual, transactionary increase in the demand for bank reserves, then that implies there is an equal and offsetting rise in actual, transactional spending of bank reserves.
See my previous comment above for a more detailed explanation.
M Ricks, a change in interest rates on bank reserves is neither expansionary nor contractionary.
28. April 2014 at 17:32
Major wrote:
“Since base money is a medium of exchange, there can be no reduction in the demand for base money economy wide, unless of course that which is base money is refused by everyone. Short of that point, any reduction in the demand for base money would necessarily be limited to certain individuals wanting, and succeeding, in holding less base money. But there would have to be another group of individuals who accept that base money being traded away. So it is necessary for there to be an exactly off-setting increase in the demand for base money.”
The problem with this reasoning is that it doesn’t take prices into account. Yes, if I buy something from you using cash, the amount of cash that exists before and after the transaction is the same. But so what? The value we both place on my cash will affect the transaction. The more that I want to keep my cash, and the more you want to get it from me, the more product you will have to offer me to get a deal done. In other words, the cash price of what you are selling will fall (or I won’t buy).
Prices rise when 1) producers believe they can charge more for their product and 2) consumers are, in fact, willing to pay those higher prices. For the most part, producers aren’t going mark their prices up to the point where they are driven out of business by low sales. And if they do go under, those prices won’t figure into CPI anymore.
Now some producers might think, “Holy Bernanke! The monetary base has exploded — I need to raise my prices by an order of magnitiude just to break even.” But even if producers think this, their actual ability to do it and still sell their products depends on consumers’ willingness to pay.
The part of the monetary base that is sitting in reserves at the Fed or is stuffed in people’s mattresses is not having any direct impact on prices, because that money isn’t being used to buy stuff.
One could imagine a scenario where, over time, banks become more willing to reduce their excess reserves and consumers
29. April 2014 at 04:23
Peter, So countries experiencing hyperinflation have “tight money,” because they have high interest rates. Okay . . . .
29. April 2014 at 09:18
The expansion coefficient is equal to required reserves (which is the de facto monetary base). RR’s are based on transaction type accounts 30 days prior. RR’s are largely driven by bank payments (commercial bank debits). Hence, transaction accounts divided by RRs = the money multiplier (c. 9%). The non-bank public simply determines the mix of its holdings: currency outside the banks relative to their bank deposits.
See: ” MEMBER BANK RESERVE REQUIREMENTS — ANALYSIS OF COMMITTEE PROPOSAL”
http://fraser.stlouisfed.org/docs/meltzer/bogsub020538.pdf
See also: http://bit.ly/yUdRIZ
Quantitative Easing and Money Growth:
Potential for Higher Inflation?
Daniel L. Thornton
Money flows MVt = our means-of-payment money times its transactions rate-of-turnover (money is the measure of liquidity). Given those parameters, an easy money policy is one where the rate-of-change in monetary flows (the 10 month roc in the proxy for real-output), is 2-3 percent greater than the 24 month roc in the proxy for the inflation indices.
Interest rates are determined by the supply and demand for loan-funds (not Keynes’ Liquidity Preference Curve or not the supply and demand for money).
The Fed’s new policy tool – the remuneration rate emasculates the Fed’s “Open Market Power”. Whereas prior to Oct 2008, the CBs would buy, e.g., t-bills (which now yield far less than the IOeR rate), they instead, let their clearing balances earn the remuneration rate on excess reserve balances. Whereas purchases & sales of securities (OMOs), between the CBs & the non-bank public formally created new money & reserves; after the payment of interest on IBDDs, purchases & sales of securities just between the Reserve Bank & the commercial banks now just expand excess reserves.
See:
“Should Commercial Banks Accept Savings Deposits?” by Leland J. Pritchard, Edward E. Edwards, and Lester V. Chandler at the 1961 Conference on Savings and Residential Financing in Chicago, Illinois
29. April 2014 at 09:50
Lester Chandler’s diagram is a treasure & fully explains the Great-Depression & the failure to rebound from subpar growth.
“Should Commercial Banks Accept Savings Deposits?” by Leland J. Pritchard, Edward E. Edwards, and Lester V. Chandler at the 1961 Conference on Savings and Residential Financing in Chicago, Illinois
2. May 2014 at 06:38
Dear Scott,
I’ve seen you state that you would expect the dollar to strengthen over the long-term due to the moderate pace of recovery in the US and demand for its exports. But, as the economy improves, isn’t it possible that firms and banks are more likely to reduce their cash balances, spend on capital expenditures, and borrow, in turn moderately depressing the value of the dollar over the medium-term?
Thanks for the great work.
2. May 2014 at 17:35
Sam, I honestly don’t recall that claim–but I’m sure I made it. My general view is that the value of the dollar is affected by the relative growth rates in the US and overseas. If we grow fast the dollar often strengthens, but you also must look at other countries. So I’d be reluctant to make any unconditional predictions.