Cochrane on monetary policy

John Cochrane has an excellent (and fairly long) post on monetary policy. He starts by discussing the pessimistic view of current Fed policy. Taylor Rule models suggest that we need much higher interest rates to get on top of the inflation problem—to get high enough real interest rates to drive inflation down. Then he discusses a more optimistic view of the Fed:

But what if expectations are rational? Here’s a little modification of the model with the arrows pointing to the changes. What if, the real interest rate and the Phillips curve are centered at expected future inflation rather than lagged inflation? Same simulation: Put in the federal funds rate path, anchor inflation at last year’s inflation. Turn off all shocks. What happens? I obtain almost exactly what the Federal Reserve is projecting. 

Intuitively, the rational expectations Phillips curve looks at inflation relative to future inflation. Unemployment is low, as it is today, when inflation is high relative to future inflation. Inflation high relative to future inflation means that inflation is declining. And that’s exactly what this projection says. Rational expectations means you solve models from future to present. If people thought inflation was really going to be high in the future, inflation would already be high today. The fact that it was only five percent tells us that it’s going to decline and go away. 

To be clear I don’t think the Fed thinks this way procedurally. They have a gut instinct about inflation dynamics, informed by lots of VAR forecasts and model simulations. But this theory gives a pretty good as-if description, a slightly more micro founded model that makes sense of those intuitive beliefs. 

So the Federal Reserve’s projections are not nuts! Inflation might just go away on its own! There is a model that describes the projections. And this is a perfectly standard model: it’s the new-Keynesian model that has been in the equations if not the prose of every academic and central bank research paper for 30 years. So, it is not completely nuts. Our job is to think about these two models and think about which one is right about the world. 

Cochrane points out that financial markets also believe that inflation will subside:

The markets, by the way, seem to agree with the Fed. Until the Fed started saying it’s going to move, markets also seemed to think inflation would go away all on its own. 

I am a big fan of the rational expectations/efficient markets approach to macro, so I find that argument to be quite appealing. Of course there is no guarantee that the markets will be correct. Market inflation forecasts a year ago turned out to be incorrect as the Fed unexpectedly abandoned average inflation targeting. But Cochrane is right that controlling inflation doesn’t necessarily require high interest rates. A credible anti-inflation policy pushes inflation expectations much lower than current inflation, making the necessary adjustment in rates much less painful.

This is the central paradox of monetary policy. The most effective policies often (not always) look to average people like the least effective policies.

I slightly part company with Cochrane when he veers close to NeoFisherism:

Another, more uncomfortable way of putting the question, 

  • Is the economy stable or unstable with an interest rate that reacts less than one for one to past inflation? 

The Fed’s projections say, stable. If we just leave interest rates alone, eventually, inflation will settle down. There may be a lot of short-run dynamics on the way, which these models don’t capture. But it settles down in the end. This answers Larry’s [Summers] last question. It’s not necessarily a mistake. This is a model of the world in which nominal things do control nominal things, and the nominal interest rate eventually drags inflation along with it. A k percent interest rate rule is possible. Not necessarily optimal, but possible. 

I was with Cochrane until he used the NeoFisherian term “drags”, instead of “follows”. The “nominal things” the Fed does to drag inflation down is controlling the nominal supply of base money and the real demand for base money. Turkey tried to drag inflation down with low interest rates. It didn’t work. Never reason from a price change.

Again, policies that lead to low interest rates are often contractionary (as Cochrane suggests). But lowering interest rates is not in itself contractionary.

Cochrane then applies the fiscal theory of the price level to the US, but it’s not a good fit. There’s no doubt that fiscal deficits drive inflation in places like Venezuela. But the Fed did not create the Great Inflation of 1966-81 because it was trying to finance fiscal deficits (which were quite small at the time.) It printed money in a misguided attempt to create jobs. The Fed is the dog and fiscal policymakers are the tail.



38 Responses to “Cochrane on monetary policy”

  1. Gravatar of Capt. J Parker Capt. J Parker
    1. June 2022 at 08:28

    Ok, so, what should we make of the Fed’s policy going forward given where we are now with inflation? Is money actually tight enough now as Cochrane’s rational expectations model suggests?

    On the who wags who issue, in 2020/2021 it seems that monetary policy worked in coordination with fiscal policy – no monetary offset and hence the inflation we have. So the Fed seemed happy to let the fiscal tail do the wagging this time.

  2. Gravatar of Carl Carl
    1. June 2022 at 09:42

    I, of course, can’t speak for Cochrane, but I think Cochrane is arguing that we’re in a different situation today than we were in the Great Inflation because of our high debt to GDP ratio and the dwindling faith in the seriousness of our government to address fiscal imbalances.
    I don’t see how anyone could have faith in the fiscal rectitude of our government, so I have to assume you simply believe we have a long way to go before we experience fiscal dominance. I’m curious where that threshold lies.

  3. Gravatar of Kester Pembroke Kester Pembroke
    1. June 2022 at 09:52

    Scott, please read this with an open mind:

    They were already saving the money and are just swapping it for a higher yielding asset. In an inflation people are short of money. They are not in a saving mood. They are spending more on things that are more expensive.

    And since if as you say the ‘interest income is insignificant’ then why would they buy the bonds anyway. It has to be significant or they won’t do it. You can’t have it both ways.

    As a new Fed paper points out, monetary policy doesn’t conquer inflation. Other changes to the labour market do.

  4. Gravatar of David S David S
    1. June 2022 at 10:50

    Scott, Thank you for these comments on Cochrane’s post. I had been hoping you would address some of his concerns—particularly the fiscal theory of the price level. I like the dog and tail metaphor.

    I suppose another one word answer to claims that large deficits will fuel high inflation rates is “Japan.” We’re certainly not on a Japan path at the moment but it’s conceivable that Fed policy could return to something like the 2009-2018 model.

  5. Gravatar of Capt. J Parker Capt. J Parker
    1. June 2022 at 11:24

    @David S,

    I thought this was an interesting take on Japan’s outlier status:

    But, I’m not sure I buy the whole argument that is being made. Subsidies might affect relative prices but the entire basket of consumer goods? Still an interesting point about falling wages.

  6. Gravatar of Daniel Daniel
    1. June 2022 at 13:49

    Cochrane says “How forward looking are expectations in the bond market, in the economy, and in the Phillips curve? Do people think about expected inflation, about what’s going to happen next year? Or do they mechanically take whatever inflation happened last year?
    In my view, the right answer is probably halfway in between.”

    It seems like it might be a good idea to write out a model with a weight (w) on Pi_t-1 and (1-w) on E_tPi_t+1 and figure out what value of w maximizes fit with empirical reality to see whether it truly is halfway in between (w=.5) or somewhere else along that continuum.

    Cochrane also says “In the long run, people catch on,” so it would be great to make w a function of whatever variables people look at to “catch on” with (rate of change in inflation rate, level of inflation rate, etc.) or with some additional parameters (e.g., bounded rationality). I’m not saying getting good estimates will be extremely easy (endogeneity!), but “write down a model.” Cochrane does a great service comparing two models, but he endorses neither…so what does a model he would endorse look like? How well would it fit reality? And what are its novel implications for economic theory?

  7. Gravatar of Effem Effem
    1. June 2022 at 14:17

    What I find most interesting is all the talk of “will inflation come back down” as opposed to “should the Fed make up for past overshoots?” The Fed massively misses its target, which effectively results in upward wealth redistribution (e.g., the 35% who don’t own a home have almost certainly fallen far behind) – and we are super quick to simply let them off the hook as though they have zero responsibility for the political volatility this will likely create. “Just get it back to 2% some day far off in the future and all is forgiven” is the basic attitude.

  8. Gravatar of ssumner ssumner
    1. June 2022 at 15:12

    Captain, Money is still not tight enough. NGDP growth is still too high.

    That Japan article is sort of weird.

    Carl, Yes, we are a long way from fiscal dominance, a very long way.

    Effem, Good point.

  9. Gravatar of yersinia pestis yersinia pestis
    1. June 2022 at 16:38

    bottom line is all of you economists are guessing. is it expectations? is it current? then you’ll reason from a result later that may be confirming the past or the future. all i know is, the current inflation is destroying lives, and some retribution is overdue.

  10. Gravatar of Michael Sandifer Michael Sandifer
    1. June 2022 at 18:14


    Yes, money is not tight enough if you want the mean expected NGDP growth path at or below 4%. It currently stands at about 4.39%.

    But, what do you make of the fact that the nominal broad US Dollar index has been rising since June of last year?

    Partly a result of high expected fiscal deficits, despite some recent consolidation?

    Increasing relative long-run real GDP growth expectations?

    A combination of the above, more than offsetting higher inflation rates?

  11. Gravatar of Nick S Nick S
    1. June 2022 at 19:46

    Who is this clown Cochrane and why is he still talking about the Taylor rule and the Phillips Curve? Jeezus. I remember my first Econ class… It’s like we’re not even trying anymore. The lack of innovative thought is painful.

    We don’t have any “inflation” in the monetary sense, as Friedman would define it. It’s painfully obvious, that supply shocks caused prices to explode (and also a bit, well maybe more than a bit of spending by the US Treasury). Soooo why would the Fed attempt to fight supply chain related price increases with tight monetary policy?

    It’s almost like, if there was a plague that caused the world economy to shut down, that caused prices of food to go up because less food was being produced, and saying hey, these high food prices are a problem, so let’s bring em down by destroying demand (I don’t think the Fed has the ability to create or destroy demand, however, that is the mainstream narrative of the “all powerful Fed” who, btw can’t even control short term interest rates… seen the basis between bills and RRP lately?).

    Scott – your statements below pretty much are in agreement with my view that the Fed is merely a cheerleader.

    “But Cochrane is right that controlling inflation doesn’t necessarily require high interest rates. A credible anti-inflation policy pushes inflation expectations much lower than current inflation, making the necessary adjustment in rates much less painful.“

    Sooo if the Fed doesn’t do anything with rates they can still control inflation, as long as they have a “credible inflation policy?” So what does this consist of? Repeatedly having Dudley spout off on financial media, talking tough hawkish policy? You honestly think that merely talking about having a “credible” policy can solve an economic problem? If we’re at that point, then we are wayyy past the point of credibility. Remember how QE was a temporary measure? “14 days to slow the spread?” (Sorry couldn’t help myself)..

  12. Gravatar of Sarah Sarah
    1. June 2022 at 20:19

    14% increase in nominal wages, yet only a 4.4% savings rate.
    Lowest since 2008. If you cannot save, then you cannot invest. No investment means no production, no innovation, and no growth.

    Households and small businesses are broke. The rise in consumer spending is simply the result of financing their needs with short term debt, and this debt is given to them by banks who are overleveraged. Furthermore, the dollars reserve status will weaken over the next couple of years as CDBC’s are rolled out, and then crash abruptly once global businessmen move their dollars into foreign currencies that have better fiscal and social conditions, and that pay higher yields.

    A weakening dollar, lower savings, and higher borrowing rates will precipitate more printing to cover the rising debt, which will increase inflation more: the marxist democrats will tell the public that the businessmen is to blame, that he is profiteering, and they will use that crisis to call for total control over the means of production; sadly, the people will almost certainly side with the marxists because it’s easier to feel envious of others, and to believe you are the victim of some great conspiracy than it is to look in the mirror and realize the problem is you.

    This will create a one party state, infighting, money fleeing, limits on bank withdrawals, and a larger underground economy which means more printing to cover the deficit and more inflation as a result of the excess printing. That vicious cycle will continue until the economy is destroyed.

    We’ve seen this all before.

  13. Gravatar of Trying to Learn Trying to Learn
    1. June 2022 at 21:04

    Unrelated, but have you read “How Asia Works” @Scott? It talks up industrial policy and managed trade as a way to foster economic growth for developing countries. Curious if you agree with the general prescription? It’s a long way from libertarianism.

  14. Gravatar of ssumner ssumner
    2. June 2022 at 05:04

    Michael, Don’t know about the dollar. Might be the factors you cite, and also some weakness in Europe, Japan and the EMs for various reasons.

    Nick, You said:

    “Who is this clown Cochrane and why is he still talking about the Taylor rule and the Phillips Curve? Jeezus.”

    Um, he’s criticizing those models. Who is this clown Nick?

    BTW, the rest of your comment is nonsense; you don’t have a clue as to what I am saying in the post. Did you even read this:

    “The “nominal things” the Fed does to drag inflation down is controlling the nominal supply of base money and the real demand for base money”

    Trying to Learn, I haven’t read that specific book, but I’ve read some long articles on industrial policy in Asia. I’ve done a number of posts critical of the view that IP explains Asia’s success.

  15. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    2. June 2022 at 07:58

    Re: “Inflation might just go away on its own!” That’s what N-gDp targeting is all about. Cap unwarranted AD and you’ll minimize inflation.

    Markets aren’t rational or efficient. U * and R * are fictional. The Wilshire Index hit 49,089.39 on Nov. 5, 2021 (what was it forecasting?). The 10-year constant maturity rate hit 1.19% on Aug. 4 2021 (what was it forecasting?)

    Markets are only forward looking to the extent of the pertinent data they are following. How do you differentiate in advance the inflation from supply-chain shortages, and demand side pressures?

    There’s one overriding error in economics, the Keynesian macro-economic persuasion that maintains a commercial bank is a financial intermediary. Economists haven’t been able to fashion the commercial banks in a system-wide context. From a system’s framework, banks don’t lend deposits. Saved deposits, deposits which are always transferred from demand deposits, are frozen, lost to both consumption and investment. That’s what brings about secular stagnation.

    Powell: “We trust financial intermediaries (banks) to hold and transfer funds in a safe and secure manner to meet the needs of commerce. The payments system provides financial institutions and their customers a variety of ways to transfer funds, but the goal is essentially the same in all cases: to move money from one individual or business to another in a reliable, secure, low-cost, and convenient manner.”

  16. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    2. June 2022 at 09:59

    Where does Powell think money comes from anyway? We know he doesn’t know how inflation works.

    Take the “Marshmallow Test”: (1) banks create new money (macro-economics), and incongruously (2) banks loan out the savings that are placed with them (micro-economics).

    F. Scott Fitzgerald: “The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.”

    You have to retain the cognitive dissonance capacity, like Walter Isaacson described Albert Einstein’s ability: to hold two thoughts in your mind simultaneously – “to be puzzled when they conflicted, and to marvel when he could smell an underlying unity”.

  17. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    2. June 2022 at 14:57

    The DIDMCA of March 31st 1980 turned the nonbanks, the MSBs, CUs, and S&Ls, into banks. It gave them the right to do a demand deposit business, the right to hold deposits transferable on demand, without notice, and without income penalty.

    But the S&Ls, and CUs, had their interbank demand deposits classified as money, overstating M1 (but not MSBs, as they were previously, always wrongly classified).

    Powell further clouded the issue: “Other liquid deposits consist of negotiable order of withdrawal and automatic transfer service balances at depository institutions, share draft accounts at credit unions, demand deposits at thrift institutions, and savings deposits, including money market deposit accounts.”

    That’s mud pie. The turnover ratio for those deposits varies widely.

    Powell also eliminated the 6 withdrawal restrictions on savings accounts, which isolated money intended for spending, from the money held as savings.

    Powell is incompetent. The FED should be audited.

  18. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    2. June 2022 at 15:13

    Bernanke’s is wrong: “a flawed and over-simplified monetarist doctrine that posits a direct relationship between the money supply and prices”.

    The 24-month rate-of-change in Demand Deposits (WDDNS) does a pretty good job. Core PCE peaked, the Fed’s preferred inflation gauge, at the same time:

    03/1/2020 ,,,,, 0.214
    04/1/2020 ,,,,, 0.397
    05/1/2020 ,,,,, 0.455
    06/1/2020 ,,,,, 0.497
    07/1/2020 ,,,,, 0.532
    08/1/2020 ,,,,, 0.562
    09/1/2020 ,,,,, 0.611
    10/1/2020 ,,,,, 0.683
    11/1/2020 ,,,,, 0.79
    12/1/2020 ,,,,, 1.261
    01/1/2021 ,,,,, 1.313
    02/1/2021 ,,,,, 1.409
    03/1/2021 ,,,,, 1.51
    04/1/2021 ,,,,, 1.596
    05/1/2021 ,,,,, 1.639
    06/1/2021 ,,,,, 1.759
    07/1/2021 ,,,,, 1.875
    08/1/2021 ,,,,, 1.894
    09/1/2021 ,,,,, 1.832
    10/1/2021 ,,,,, 1.909
    11/1/2021 ,,,,, 1.795
    12/1/2021 ,,,,, 2.007
    01/1/2022 ,,,,, 2.055 peak
    02/1/2022 ,,,,, 1.562

    Since DDs underweight Vt, the momentum in the growth of the money stock should have produced an acceleration in the transactions’ velocity of funds. And how do you account for supply side issues?

  19. Gravatar of yersinia pestis yersinia pestis
    2. June 2022 at 16:29

    not my blog, but spenser bradley hall of mirrors needs an editor, to combine his prolix replies, a bottle of jack, and someone to love.

  20. Gravatar of William Peden William Peden
    3. June 2022 at 02:19

    An old monetarist (using good money supply measures) would agree that we are in/entering into the peak of inflation, and that the Fed doesn’t have to do a lot to bring down inflation in the medium term:

    All the Divisia money supply measures are now contracting in real terms year-on-year. Divisia M4 is contracting the most, but that also has the largest overhang from 2020-2021, so the overall picture is the same on any of the measures.

    2020-2022 seems a lot like 1971-1973. And, like that period, it seems like the Fed may overreact, resulting in a sharp recession. The additional danger then, as in 1974-1976, is that the Fed reacts by starting another inflationary spiral, especially due to supply shocks.

    This is why NGDP targeting is so necessary. Inflation targeting doesn’t seem to work well in the presence of supply shocks, either in 2008 or in 2020-2022, though admittedly IT would do a lot better with much more focus on market expectations.

  21. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    3. June 2022 at 04:46

    I agree that Treasuries are used as money. But essentially everything clears thru DDs.

    Barnett didn’t get the early 80’s right. And he uses a y-o-y figure. His #s are not forward looking. If you use a 25-month roc, then inflation peaked in Feb. After that you get more supply side issues rather than demand side pressures.

  22. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    3. June 2022 at 05:21

    “CFS Divisia M4, including Treasuries (DM4) – the broadest and most important measure of money calculated by the Center for Financial Stability – grew by 3.4% in April 2022, on a year-over-year basis. In contrast, CFS Divisia M4 increased by 12.4% in April 2021 over the preceding year.”

    How does that % change compare to prices?

    Money flows on the other hand show a significant deceleration in the 4th qtr. this year.

  23. Gravatar of Michael Rulle Michael Rulle
    3. June 2022 at 09:28

    BEA shows month over month change in PCE, ex-food and energy, in section called NATIONAL DATA-national income and product accounts-interactive tools.(

    Anyway, inflation this year (Jan-April) as of May 27 is annualizing at approximately 3.97%. Even more strange–April 2021-April 2022—declined from .6% to .3%—negative 3.6% inflation annualized.

    I do not know what to make of the BEA numbers—but I found it interesting and perplexing.

  24. Gravatar of Michael Rulle Michael Rulle
    3. June 2022 at 09:45


    with F and E included, this year inflation (month over month) is annualizing at 6.48%. Also, if you can persuade yourself that April is the start of a trend, things look good. But one month is not a trend. And the numbers look scary by and large when looking at all the categories

  25. Gravatar of Ricardo Ricardo
    3. June 2022 at 10:34

    “A credible anti-inflation policy pushes inflation expectations much lower than current inflation, making the necessary adjustment in rates much less painful”

    — The problem is that there is no credible anti-inflation policy. The best policy is to let the invisible hand replace dumb money with smart money, not to subsidize dumb money with smart money, which is what the Fed has been doing.

    All you had to do was let the dumb money lose in 2008, and the economy would have been roaring again within two years. Instead, you dragged out the recession with uncessary stimulus and bailouts.

    This is what the American public has had to deal with since 1913.

    Btw, this weekend a group of globalist and mercantilist thugs will meet in a secret Washington D.C. location to discuss their “agenda”.

    I’m sure these unelected officials all have our best interest in mind =/

  26. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    3. June 2022 at 14:38

    @yersinia pestis: You aren’t concerned that Powell destroyed the deposit classifications? The Phillips curve adherents are doomed to error again (like last year). U * is fictional.

    ps. Sumner asks not to respond to me. I’ll get the ax eventually. In the mean time I’ll drink my honey whiskey.

  27. Gravatar of Nick S Nick S
    4. June 2022 at 18:56

    Scott – Yes, I read…

    “The “nominal things” the Fed does to drag inflation down is controlling the nominal supply of base money and the real demand for base money”

    And then I puked in my mouth, considering how moronic of a statement it was.

    For the 1000th time, the Fed doesn’t create money, banks create money. The Fed creates bank reserves, which is not a useful form of money (when has anyone bought anything with a bank reserve held at the Fed?).

    And please explain to me how the Fed controls real base money demand? Because it sure seems that they don’t have much control of anything.

  28. Gravatar of William Peden William Peden
    5. June 2022 at 04:33


    Real Divisia M4 rose rapidly in the year to April 2021, but is now falling. There is presumably a significant overhang from the 2020-2021 rise in money demand, but in general monetary conditions are contractionary according to that measure. They seem less contractionary if one uses M4- or M3, but these aggregates have less of an overhang, since they didn’t increase as rapidly in 2020-2021.

    Nick S,

    I think you need to read more widely before coming to such strong opinions. Reading about reserve requirements and interest on excess reserves would help, as would the role of reserves within the money multiplier story. You’re entitled to disagree with the latter, but not before you read about it from those who advocate it. A bad idea would be to just read Post-Keynesians, money circuit types etc. giving their spin – like basing your understanding of Keynes’s General Theory based on descriptions by Henry Hazlitt and Murray Rothbard.

  29. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    5. June 2022 at 06:22

    @William Peden – re: “monetary conditions are contractionary” That’s one way to look at it. But inflation is still high. The “response variable”, long-term money flows, won’t show much deceleration until the 4th qtr. And that is exclusive of supply-side issues.

    Powell has been a disaster. But the worst is still to come.

  30. Gravatar of Jon Jon
    5. June 2022 at 21:21

    Scott, Carl:

    What I read in John’s debt doubt was the question: if the Fed raises the short-rate considerably, is that deflationary or inflationary? The combined Fed-Treasury balance sheet is more short-dated now than in the past. 1) Because the Fed has been purchasing long-dated securities and creating the largest ever reserve balances and 2) Because the Treasury has had a policy of decreasing the term structure of the Federal debt to reduce interest expense.

    Then he argued that there are circumstances it is inflationary if it causes significant interest expense, which the Treasury debt finances.

    I am reminded of this passage from a NYFED staff report 833, January 2018:

    The literature defines central bank solvency in terms of its intertemporal budget constraint: a central bank is solvent if the sum of its “tangible wealth” (the difference between the current market value of assets minus interest-bearing liabilities) plus “intangible wealth” (the expected present discounted value (EPDV) of future seigniorage) is positive.16 The sum of the two—tangible and intangible wealth—equals the EPDV of remittances. If the central bank posts losses, but intangible wealth is positive and larger, the institution should not require recapitalization from the fiscal authority in order to pursue its mandate, as it can compensate current losses by borrowing against future remittances. However, if the EPDV of remittances were negative, the central bank would be insolvent. Of course, a central bank in a fiat money regime can always address insolvency by creating more liabilities and/or printing money (that is, generating more seigniorage), but at the cost of potentially compromising its inflation objective.

  31. Gravatar of ssumner ssumner
    6. June 2022 at 08:03

    Yersinia, Yup.

    Nick, LOL, It appears you do not know what the monetary base is. (I was clearly discussing the base, not M1 or M2.)

    Jon, It depends whether the Fed raises rates with an easy money policy or a tight money policy.

  32. Gravatar of Nick S Nick S
    6. June 2022 at 18:41

    William – I’m well aware of the “roles” of excess reserves and IOR. You’re making my point. The Fed cannot control inflation, because inflation requires a sustained increase in the price level driven by increased money supply. During QE balance sheet expansion, the assets on Fed’s balance sheet increased, but we’re offset primarily by an increase in bank reserves (I.e. banks chose to park the proceeds from their bonds sales to the Fed, right back at the Fed. They didn’t create new loans, and hence, the multiplier effect you mentioned did not take place. The Fed has admitted in recent papers that QE does not create inflation, as it is simply an asset swap (banks swap bonds for reserves), and not money creation. Additionally, because the unwillingness for banks to make new loans (due to a combo of post GFC capital requirements, HQLA, Sup Lev ratio, SIFI designations, etc.), the Fed had to resort to providing a reverse repo facility (RRP), for banks and money market funds to park their excess cash, else, rates would be negative (current facility usage is over $2.1 trillion). Also, Take a look at 1m T-Bills, which trade well below the RRP rate of 80bp, signaling that there is an extreme demand for safe, high quality treasury collateral, as opposed to willingness to lend capital that would lead to true money creation. This has been the story ever since QE1, which explains why the Fed was unable to create inflation back then. Why would it all of a sudden be able to create it now? So maybe next time, before you come at me with your Econ 101 bullshit from the 1970s (whoa the FRED money supply graph is up and to the right, must mean inflation!), you should try using some critical thinking skills yourself.

  33. Gravatar of ssumner ssumner
    7. June 2022 at 08:31

    Nick, “This has been the story ever since QE1, which explains why the Fed was unable to create inflation back then.”

    LOL, the Fed RAISED interest rates in 2015.

    If the Fed doesn’t know how to create inflation, I’ll gladly show them!

  34. Gravatar of Nick S Nick S
    7. June 2022 at 09:14

    They barely got rates off the ground in 2015 before they had to reverse course again. Additionally, the balance sheet reduction during that time was even more pathetic.

    Because the Fed cannot lend directly to non members, they cannot create inflation. They have tried to get around this problem by coordinating with the US Treasury to finance fiscal spending via debt monetization. This has created short lived rises in the price level, but is not sustainable without continued coordination with the Treasury.

    So please explain how you would “show them how.” As mentioned previously, banks determine money supply via credit creation, so how do you force them to lend? And at that point, you are getting closer and closer to a centrally planned economy.

  35. Gravatar of Don Geddis Don Geddis
    7. June 2022 at 12:04

    @Nick S: Creating inflation is trivial. Drop Interest on Excess Reserves (IOER) back to zero — as it was for the first century of the Fed’s existence. During that period, the quantity of excess reserves was also (approximately) zero. Banks only held required reserves, not excess reserves.

    Then engage in Open Market Operations to increase the quantity of (unwanted) reserves.

    Finally, increasing commercial bank lending is not the goal. The primary monetary policy transmission mechanism instead is the Hot Potato Effect, based on forcing the public to hold more wealth in the form of money than the current demand for money. The attempt to “get rid of” the excess cash increases velocity, and thus aggregate demand, and thus the price level. This mechanism would function even in an economy with no banks and no bank lending at all.

  36. Gravatar of Don Geddis Don Geddis
    7. June 2022 at 12:09

    @Nick S: And it also seems that you might want to read up on just what people are talking about here: E.g. Monetary Base, Open Market Operations, Federal Funds Rate, etc. You seem to be reacting as though you’re using some private intuitive definition for what are instead precise economic terminology.

  37. Gravatar of ssumner ssumner
    8. June 2022 at 08:04

    Nick, You are hopelessly confused. Monetary policy is not about banking and lending. The Fed controls the price level by controlling the supply and demand for base money.

    The fact that they only increased rates nine times between 2015-18 is beside the point. The point is that the Fed raised rates not because they were trying to increase inflation, rather they were trying to reduce it. That’s why they raised rates. Talk about the Fed being powerless to raise inflation is just silly.

  38. Gravatar of Nick S Nick S
    10. June 2022 at 05:49

    Scott – The only part of that monetary base that the Fed can control are the amount of reserves that banks hold with them. If the Fed buys bonds via crediting banks with fresh reserves, the monetary base increases, however, this is not inflationary. What is inflationary, is when banks transform those reserves into deposits via lending. As seen in the graph in the link below, money getting “into the system” post pandemic, was not a function of deposit creation from bank lending, but rather from government spending (PPP stimulus, etc). As seen in the graph, “currency in circulation” and “consumer bank loans” have pretty much been on top of each other ever since they have been measured. However, you see a large divergence post pandemic , where “consumer bank loans” decrease and “currency in circulation” increases. The difference can be attributed almost entirely to the fiscal PPP program (also seen in the graph). Therefore, the fiscal authorities created this inflation, not the Fed.

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