Conservative Keynesianism leads the Fed astray
From the Financial Times:
The Fed chair said she expected inflation to return to a 2 per cent annual rate over the next few years as temporary influences wane.
Why? What will cause inflation to return to 2%?
Ms Yellen added that there were financial stability risks to holding rates at ultra-low levels for too long.
“Continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability.”
Why would low rates encourage excessive risk taking? And if they do, how does the Fed remedy that situation? Do they raise rates for a couple years, at the cost of lower rates for a couple decades, or do they lower rates for a couple years, at the cost of higher rates for a couple decades? Where is the model? How do they get from here to there?
“Reducing slack along these other dimensions may involve a temporary decline in the unemployment rate somewhat below the level that is estimated to be consistent, in the longer run, with inflation stabilising at 2 per cent,” Ms Yellen said.
Allowing the unemployment rate to fall below its long-run level for a period could also have the benefit of “speeding the return to 2 per cent inflation”, Ms Yellen argued. It could have the extra positive of reversing some of the supply-side damage suffered by the US economy in recent years.
Since when has the Phillips Curve been a reliable model for predicting inflation?
Keynesianism is usually considered a “liberal” model. That’s a bit misleading, as most conservative economists also use a Keynesian framework for analyzing the economy. They talk about the various sectors of the economy; consumption, government, net exports, etc. They worry that monetary policy is ineffective at the zero bound. They think inflation is caused by low unemployment. They think low interest rates can lead to excessive risk taking.
In fact, except in the very short run, interest rates reflect the conditions of economy, not the stance of monetary policy. Inflation is not caused by low unemployment, but rather by excessive NGDP growth.
The latest TIPS spreads have fallen to shockingly low levels:
5 Year TIPS spread = 1.19%
10 year TIPS spread = 1.50%
30 year TIPS spread = 1.69%
Recall that the Fed’s CPI inflation target is around 2.3% (give or take a few tenths.) These TIPS spreads call for monetary easing, or else the Fed may soon lose credibility.
Fortunately there is a ray of hope:
“Inflation may rise more slowly or rapidly than the committee currently anticipates; should such a development occur, we would need to adjust the stance of policy in response,” Ms Yellen said at the Philip Gamble Memorial Lecture University of Massachusetts, Amherst.
If this happens (and pretty I’m confident it will) then the Fed needs to do more than “adjust the stance of policy.” The Fed needs to rethink its entire approach to policy. The Fed needs to define what they mean by “the stance of policy.” The Fed needs to revisit past decisions, and figure out what they did wrong. I hope they will look at what their critics have been saying. Then the Fed needs to start setting the stance of policy at a position where the markets expect the Fed to succeed.
PS. I understand the Fed has a dual mandate, and I don’t think it’s a big deal if they undershoot their inflation target for a couple straight years. I do think it’s a big deal if they undershoot for a couple straight decades, as the Japanese have done, and the Europeans are doing. I expect more from the Fed, especially as they’ve had the benefit of seeing what happened with other central banks, when they tried to raise rates above the Wicksellian equilibrium rate.
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24. September 2015 at 16:59
Excellent blogging. Japan has very low unemployment rates and yet the Bank of Japan can barely hit the bottom side of its inflation target.
Print more money.
By the way, when interest rates go to low you see winos and crackheads walking in from the park to the local bank and getting $100,000 loans at teaser rates. it’s terrible!
24. September 2015 at 17:06
We are doomed.
Separately, when will you start posting the hypermind prediction of 2016 NGDP?
Thx.
24. September 2015 at 17:07
Yellen, “The fact that these survey measures appear to have remained anchored at about the same levels that prevailed prior to the recession suggests that, once the economy has returned to full employment (and absent any other shocks), core inflation should return to its pre-recession average level of about 2 percent.” http://ftalphaville.ft.com/2015/09/24/2140809/yellen-surveys-of-inflation-expectations-either-useful-or-not/ Her speech is at http://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm
24. September 2015 at 17:14
Another Fed research attempt to downplay TIPS spreads: “Market-based measures of inflation expectations are calculated from the prices of financial securities. Their advantage is that they are readily available at high frequency and therefore are widely monitored. However, they reflect not only the public’s inflation expectations but also other idiosyncratic factors that affect market prices, which are difficult to quantify. For example, they include a risk premium to compensate investors for inflation uncertainty and are affected by changes in liquidity, unusual demand flows, and, more broadly, “animal spirits” that change prices but are unrelated to expectations (see Bauer and Rudebusch 2015). Hence it is unclear how much useful information they provide, and how much one should pay attention to these rates when forecasting inflation.”
http://www.frbsf.org/economic-research/publications/economic-letter/2015/september/market-based-inflation-forecasting-and-alternative-methods/
24. September 2015 at 18:15
1. Tongue in cheek:
https://thefaintofheart.wordpress.com/2015/09/24/anyway-shes-trying-hard/
2. Serious:
https://thefaintofheart.wordpress.com/2015/09/20/for-more-than-one-year-monetary-policy-has-been-tightening-but-the-fed-thinks-its-highly-accommodative/
24. September 2015 at 18:31
More contradictory statements:
“If it waits too long, Ms. Yellen said, the Fed might end up having to raise rates abruptly to stop the economy from overheating. ”
“”The decline in inflation compensation [in bond markets] over the past year may indicate that financial market participants now see an increased risk of very low inflation persisting,” she said. “Although the evidence, on balance, suggests that inflation expectations are well anchored, policy makers would be unwise to take this situation for granted.””
http://www.wsj.com/articles/janet-yellen-says-fed-interest-rate-increase-still-likely-this-year-1443128438
24. September 2015 at 18:38
@ benjamin cole – you’re trolling right? Nobody seriously writes like you do, unless they are in a cult.
@ sumner – c’mon, you’re a professional economist and you don’t know what Yellen is trying to say? It’s pretty clear: she thinks the Fed has the power to control interest rates, and also inflation. Both premises are wrong. In the short and even in the long term, the Fed cannot do much to effect interest rates nor inflation, nor any real variables in the economy. The Fed follows the market, as Marcus Nunes points out graphically in the first link. Even when Volcker was in charge, monetary policy was countercyclical to the real economy: sometimes when he cut rates, inflation rose, and when he loosened rates, inflation fell. Regarding prices, in the longer term, prices adjust to the money supply, but that’s of nothing more than historical curiosity (e.g., the daily wage at some point in the 19th century was $1/day). Nominal interest rates however are hardly affected by Fed policy: today’s fiat money low rates are lower than back in the 19th century with hard money.
Repeat after me: money is neutral, the Fed follows the market, and (sorry MF) there’s no such thing as Austrian nonsense “malinvestment” caused by low rates.
24. September 2015 at 19:09
Ray you’re ignorant and wrong.
Money is not neutral, as Bernanke’s study showed, and yes artificially low interest rates do cause malinvestment.
24. September 2015 at 19:16
FYI:
on September 24, 2015 at 6:57 PM, updated September 24, 2015 at 8:01 PM
Yellen’s remarks before she ended her speech are reported here.
AMHERST – Federal Reserve Board Chair Janet Yellen Thursday talked about interest and inflation rates in a University of Massachusetts address that ended abruptly with her seeking medical attention.
A spokesman for the university said the 69-year-old was fine after being checked out by EMTs and was to continue her schedule which included a faculty dinner at the home of the Chancellor Kumble Subbaswamy.
Yellen was delivering the annual Philip Gamble Memorial Lecture at the University of Massachusetts at Amherst in the Fine Arts Center Concert Hall.
Yellen appeared to lose her place in her speech and said, “I think I’ll stop here.” As faculty thanked her EMTs rushed up to her and walked with her into a waiting room where she was checked out.
A statement from the Federal Reserve Board spokesman said: “Chair Yellen felt dehydrated at the end of a long speech under bright lights. As a precaution, she was seen by EMT staff on-site at U-Mass Amherst. She felt fine afterward and has continued with her schedule Thursday evening.”
24. September 2015 at 19:26
Ray says I am a “troll.”
But then, Donald Trump is running for President—and winning.
Bill Gross says because insurance companies are losing money, the Fed should raise interest rates. (Of course, raising rates will eventually lower bond yields…oh never mind).
GOP myrmidons once forced a U.S. President onto national TV, where they asked him, “Have you ever inserted a cigar holder into the vagina of Monica Lewinsky?”
But then. President Clinton said, “I did not have sex with that woman.”
Why do people write fiction? (BTW, I wrote a couple good detective novels).
All you got to do is read the papers, as my grandfather said.
24. September 2015 at 19:36
There is nothing the Fed can do.
Central banks are institutional front-runners. They jawbone finance and take credit for increases or decreases in funding rates. Janet Yellen has been jawboning like crazy since she took office and the market hasn’t budged … because it can’t. It is bound to the zero-bound.
The economy drives money worth, not the other way around. The price of money — dollars particularly — is set at gas pumps by millions of motorists around the world every single day, in exchange for a valuable physical good. Money price is not set by a handful of Goldman-Sachs alumni meeting in dark paneled offices in central banks. Priced in fuel, dollars have worth … that worth is increasing more now than just a short year ago.
Dollar is becoming a hard currency like the gold dollar of 1932, the effect on the greater economy of hard oil-backed dollars is going to be the same as in was during that time period.
In 1933 FDR took gold out of circulation and depreciated the dollar 40% … against gold. The bosses have been trying mightily to depreciate their various currencies against each other with no success. Why? Because central bankers have been barking up the wrong tree.
The bosses have to depreciate the dollar vs. petroleum, the new gold, the ultimate store of value. … To do so the establishment must take fuel out of circulation like FDR took specie out of circulation in 1933!
The public has responded to scarcity of the world’s most important form of capital and are voting with their wallets. There is nothing the economists, central bankers, academics or dictators can do.
24. September 2015 at 21:51
Benjamin
It’s tough when you have placed the world on your shoulders and are getting things wrong. She looked and sounded poorly at the post-FOMC press conference last week. The US press are terribly polite and kind not to raise the issue. In the UK we’re much nastier, for good or ill.
24. September 2015 at 22:36
Footnotes look interesting. Eg Fn. 28, from the concrete steppes:
“I am somewhat skeptical about the actual effectiveness of any monetary policy that relies primarily on the central bank’s theoretical ability to influence the public’s inflation expectations directly by simply announcing that it will pursue a different inflation goal in the future. Although such announcements might potentially persuade some financial market participants and professional forecasters to shift their expectations, other members of the public are probably much less likely to do so. Hence, actual inflation would probably be affected only after the central bank has had sufficient time to concretely demonstrate its sustained commitment and ability to generate a new norm for the average level of inflation and the behavior of monetary policy–a process that might take years, based on U.S. experience. “
24. September 2015 at 23:05
FYI from Bloomberg:
Bonds Show Inflation Outlook Falling to Lowest Level Since 2009
Daniel Kruger
September 24, 2015 “” 11:05 PM WIB
Gauges near levels not `seen outside of times of crisis’
Traders await speech by Fed Chair Yellen on Thursday
The bond market’s inflation outlook for the next 10 years touched the lowest since May 2009, raising questions about the Federal Reserve’s ability to increase interest rates this year.
The 10-year break-even rate, a bond-market measure derived from the yield difference between Treasuries and inflation-linked bonds, showed consumer prices rising at an average pace of 1.48 percent during the next 10 years, well below the Fed’s target of 2 percent. The inflation measure preferred by Fed officials last reached that level in April 2012.
“You’re getting close to levels you haven’t seen outside of times of crisis,” said Aaron Kohli, a fixed-income strategist at Bank of Montreal, one of 22 primary dealers that trade with the central bank. “The market is becoming a lot more pessimistic about the direction of inflation.”
The economy and the bond market have resisted policy makers’ efforts to stoke expectations for higher prices. Instead a slowdown in global growth has fueled a slump in commodities and led the Fed to mention risks posed to U.S. output by reduced growth rates overseas, particularly in China, in its most recent policy statement.
Side note to James Alexander: My thoughts also. Yellen looks perfectly awful, and was an underpowered sort to begin with. I only hope for good health to her, but is she the right person for the job now? We need a real gut-fighter, someone who can show steel and fight for growth.
25. September 2015 at 01:12
Hi Scott, do you have an explanation for the market rallying on the back of Yellen’s comments that a 2015 hike is on track? Surely that’s a data point that counts against either
(i) your faith in EMH OR
(ii) your belief money is too tight?
25. September 2015 at 02:24
Fed’s ability to raise inflation expectations: not if they announce a 2% target then champ at the bit to raise rates when inflation is well below target, not rising and the market doesn’t expect it to hit target for decades.
Yellen’s health: reportedly she was dehydrated and, after brief treatment, fine.
WSJ.com lead headline: “Global Markets Rebound on Yellen’s Comments on Rates
Global stock markets are sharply higher after Federal Reserve Chairwoman Janet Yellen eased investors’ concerns that last week’s decision to keep rates near zero had put off a rate rise for the foreseeable future.”
25. September 2015 at 04:56
“Why would low rates encourage excessive risk taking?”
Reach for yield.
https://www.richmondfed.org/-/media/richmondfedorg/publications/research/econ_focus/2013/q3/pdf/federal_reserve.pdf
25. September 2015 at 05:04
Oh, and it is amazing how many really bad projects start to look better and better when the discount rate used in the cash flow calculations gets lower and lower.
25. September 2015 at 05:25
“Inflation may rise more slowly or rapidly than the committee currently anticipates; should such a development occur, we would need to adjust the stance of policy in response”
Should this not come without saying? If reality is different then what is anticipated, why wouldn’t they adjust?
25. September 2015 at 06:00
Bill, First I’d have to find the money.
Foosion, Given the Fed’s track record since 2008, I don’t find those comments reassuring.
James, What is the context of that inflation expectations quote? Is she discussing the proposal to raise the inflation target to 4%? If so, the fact that it would require concrete steps is not really an argument against it.
GD, I certainly wouldn’t revise my views on the EMH based on one data point. As far as stocks, can you send me a link to yesterday’s stock futures, so I can see how the market responded to the speech? I ask that because I notice that todays futures soared in the early morning hours, which presumably had nothing to do with the speech. But I can’t find yesterday’s futures prices.
But let’s suppose stocks did rise yesterday after the speech, then yes, I would revise my view that a rate increase would reduce RGDP growth. I would have somewhat less confidence in that view. But only somewhat less, because we’ve recently also seen stocks fall on worries about a rate increase. And I would not revise the views expressed in this post. Here I argued not that a rate increase was bad for the economy, but rather that a rate increase would move the Fed further away from its 2% inflation target. And that’s based on TIPS spreads, not stock prices. So the question of whether a rate increase is good for the economy is different from the question of whether the Fed is on track to hit its targets.
Steven, Let’s say that’s right, how does the Fed fix the problem? Would a rate increase in December reduce the problem? If so, why?
25. September 2015 at 06:32
Scott, other than those from Kocherlakota, I don’t find any recent Fed comments reassuring. Alas, he’s in the minority and will soon lose his vote.
Steven & Scott, I thought one idea of low rates is to encourage projects that would not have made sense at higher rates. More projects means more economic activity, which seems a good thing.
Marginal projects which become attractive; it’s not a binary situation where projects are either great or awful.
25. September 2015 at 06:35
http://www.investing.com/indices/us-spx-500-futures has historic futures. Click on “15” (or whatever time period you like) and move your cursor back and forth in the chart area.
25. September 2015 at 06:50
Thanks Foosion.
GD. It looks to me like the big rise in futures took place early this morning, not yesterday evening. Might futures have risen in sympathy with European markets?
25. September 2015 at 06:52
In response to TIPS spreads being unreliable:
>> For example, they include a risk premium to compensate investors for inflation uncertainty and are affected by changes in liquidity, unusual demand flows, and, more broadly, “animal spirits” that change prices but are unrelated to expectations
Is my intuitive math wrong, or is there no way that an inflation insecurity premium would lead to an underestimation of expected inflation?
If investors thought that they would face convex losses from higher-than-expected inflation, then they would seek to hold more TIPS securities than they would with a strictly linear loss function. That would increase the equilibrium price of TIPS and reduce their real yield compared to the linear world.
In turn, that would mean that TIPS spreads overestimate, rather than underestimate, inflation. Seeing TIPS spreads well below the target 2% is a more worrying signal in an “uncertainty” world.
25. September 2015 at 07:03
Scott, you wrote: “Inflation is not caused by low unemployment, but rather by excessive NGDP growth.”
But Nominal GDP growth is just Real GDP growth plus the inflation rate, by definition. So whatever actually does cause the inflation rate also directly impacts NGDP, by definition.
You seem to be saying that NGDP grows first, and thereby causes inflation, but whatever it is that raises NGDP relative to RGDP is raising inflation by definition.
Rising NGDP (relative to RGDP) can’t cause inflation because all NGDP represents is the inflation rate relative to RGDP. Whatever is causing one is by definition causing the other. That seems obvious.
25. September 2015 at 07:03
Low interest rates clearly do lead to excessive risk taking. We’ve had numerous lending bubbles pop over the past few decades S&L crisis, various international markets, the housing market a few years ago.
In every case, borrowed money went into nonproductive uses and various borrowers and lenders had to be bailed out.
That’s been the primary reason behind slowing growth in the past 20 years.
…
I understand the magical appeal of zero rates. Free money for everybody! We can have free health care and free this and free that. We never have to pay down our debts. The central bank will replace banks and insurance companies.
But it’s dishonest not to admit that what you are proposing is an entirely new financial system that will have its own risks and dangers.
25. September 2015 at 07:03
Wonkblog post on some of the more interesting footnotes in Yellen’s speech, including factors keeping inflation low for the moment and not raising inflation target to 4%. http://www.washingtonpost.com/news/wonkblog/wp/2015/09/25/the-hidden-messages-in-janet-yellens-big-speech/
Max: the Fed’s view that the TIPS spread is unreliable is not very popular here. However, think of TIPS as providing inflation insurance. This raises their price (insurance is not free), lowering their yield (moves in opposite direction as price) and therefore widens the spread.
OTOH, slightly lower liquidity probably counteracts this.
It seems the Fed doesn’t like the TIPS spread because it wants to raise rates and the TIPS spread suggests that would be nuts.
25. September 2015 at 07:10
Let’s see what a Nobel prize gets you;
http://finance.yahoo.com/news/shiller–the-market-is-overvalued—and-what-to-do-about-it-120337758.html#
Things might go better or worse. Don’t put too much into the stock market…nor too little…keep it just right.
Housing? Well, you need a place to live…and he has two, but housing isn’t a good investment. He’s troubled. And he’s rich!
25. September 2015 at 07:19
All: I would like to see a serious discussion here of the possibility that the Fed’s abandonment of its traditional monetary tools has rendered it essentially irrelevant when it comes to affecting the inflation rate.
Here’s my complete post of the matter:
Has the Federal Reserve Made Itself Irrelevant?
And here’s the paragraph that might cause one to stop reading it because clearly, today, the level of excess reserves is not affecting the money supply:
The previous posts on monetary policy described a “strong form” of monetary policy by which the Fed has direct control over the level of the money supply. Following an injection of excess reserves, money grows. Then the economy responds and eventually the price level (inflation) responds. Similarly, withdrawing reserves shrinks money, causes the economy to contract, and puts downward pressure on the inflation rate. This is a model that can be shown to have worked in the past. Furthermore, it’s the most obvious operating procedure to deploy in a system of fractional reserves, but one the Fed has apparently never consciously adopted.
To understand why the current level of excess reserves no longer generates a dependable rate of money growth, and therefore why the Fed is not longer relevant to the inflation rate is where I’m trying to get to in this discussion.
25. September 2015 at 07:27
Rod: Excess reserves don’t matter because they don’t circulate in the economy. *Banks don’t lend reserves.*
The Fed is trying to stimulate lending, but it can’t do this by changing the levels of reserves. And to the extent it has stimulating lending with low rates to banks, that lending has largely gone into financial assets. The Fed believes that driving up asset prices will generate economic activity, but this wealth effect is small.
25. September 2015 at 07:46
Charlie: My entire point is that the level of excess reserves mattered in the past, pre-Quantitative Easing, but that the Fed has abandoned their management in favor of the QE process.
I understand that banks don’t lend reserves, but in the past banks definitely circulated reserves when they were in excess, and did so aggressively because there was an opportunity cost to holding them. That process of circulation, I believe, led to money growth and, if sustained, to inflation.
I am, without doubt, going to be challenging most of the assumptions people have about the Fed in this discussion, but I’m also confident that I will not be making unverifiable assertions, such as “NGDP causes inflation” or “Excess reserves don’t matter because they don’t circulate in the economy.” They don’t “circulate in the economy” but they still matter very much. The problem is that the Fed can’t do much about how they matter, now that they’ve rendered traditional reserve management obsolete (or at least unbearably difficult) with the QE’s.
25. September 2015 at 07:54
Charlie: One additional point. You wrote: “The Fed is trying to stimulate lending, but it can’t do this by changing the levels of reserves.”
You’re right today, but prior to driving the funds rate to zero, paying interest on reserves and bloating the excess position with the QE’s, the Fed could indeed stimulate lending by changing the levels of reserves. That’s how a fractional reserve system works, although I also argue that the Fed never fully appreciated how directly it worked.
We are on a long downward path paved by the Japanese. To get off of that path we first have to understand where we went wrong. That’s the discussion I’m trying to generate here, and as I said above, that process will challenge a lot of assumptions that people have been making, assumptions that are arguably incorrect.
25. September 2015 at 07:56
Rod: I applaud you bringing up this discussion.
If banks circulate reserves, I don’t see how that reduces the aggregate number of reserves in the system.
I doubt the Fed ever really managed the economy. I believe the banks and the markets and sometimes the politicians dictate to the Fed.
25. September 2015 at 08:02
“Inflation is not caused by low unemployment, but rather by excessive NGDP growth.”
Isn’t that a backwards way of saying the same thing? In this case, NGDP growth would be too high because the labor market can’t support enough RGDP growth and thus the NGDP – RGDP (inflation) gap grows. I just don’t see the point of this sentence.
25. September 2015 at 08:12
Majromax— I think you are right, TIPS spreads would tend to be a lowball estimate of inflation. I would not lend money for 10 years without quite a bit of padding in there for potential inflation.
25. September 2015 at 08:19
Scott,
What specifically should the Fed do?
I would love to hear your ideas in 1,2,3 format.
Keep interest rates low, charge for reserve deposits, buy more bonds (QE).
Ideally lay it out in a format that an intelligent layman can understand
25. September 2015 at 09:23
John Bailey, Scott has been doing what you are asking, for seven years. Just start with the links on the right side of this blog under, ‘Quick intro to my views’.
25. September 2015 at 09:26
Majro,
Good point. It does seem like traditional bonds would include an additional inflation risk premium and thus, the TIPS spread could be larger than actual inflation expectations.
25. September 2015 at 09:32
Why? What will cause inflation to return to 2%?
No one ever asks this. So tired of the assumption this is some natural law.
25. September 2015 at 09:55
‘Why? What will cause inflation to return to 2%?’
Because the supply of money is growing faster than the supply of economic goods and services.
I don’t think we’ve seen inflation because money creation primarily is going to the 1 pct, who are putting it into financial assets and not into circulation.
Traditionally when money is created it winds up in wages that are spent on goods and services, but it’s not doing that this time.
25. September 2015 at 10:34
majromax, It could go either way.
Rod, You said:
“Rising NGDP (relative to RGDP) can’t cause inflation because all NGDP represents is the inflation rate relative to RGDP. Whatever is causing one is by definition causing the other. That seems obvious.”
Would it also be correct to say?
“Rising money supply (relative to money demand) can’t cause inflation because all money growth represents is the inflation rate relative to money demand. Whatever is causing one is by definition causing the other. That seems obvious.”
I will say that your mistake is not as embarrassing as those commenters who complain that my claim that “falling NGDP causes recessions” is a tautology.
Charlie, You said:
“Banks don’t lend reserves.”
And customers can never walk out of a store. That’s because if they left a store, they’d no longer be customers! Just as if banks lent out reserves, they’d no longer be reserves!
And you say money goes “into” financial assets. Do you believe that financial assets have a sort of pocket, like a kangaroo, where the money goes inside? If I peak inside a financial asset will I see a big wad of cash?
And if banks don’t lend out reserves, where do the “1%” get all this Fed created money that they put into financial assets?
John, The Fed needs to set an explicit NGDP target, and then do level targeting. The market should determine the money supply and interest rates, I have no opinion on where they should be.
25. September 2015 at 10:43
Charlie Jamieson,
*Banks don’t lend reserves”
banks lend base money, and ‘reserves’ are base money, so yeah, banks do lend reserves.
25. September 2015 at 11:01
” Inflation is not caused by low unemployment, but rather by excessive NGDP growth.”
Lets add Freidman.
“Inflation is always and everywhere a monetary phenomenon.”
Don’t you realize that these are all the same thing?
Money Growth is AD growth. AD growth (when supply is near capacity) is Keynesian cost-push inflation. We have 3 schools using three models that in the big picture say the same thing. The question then is in the details which gives a more timely indication / better policy guidance.
The second half of your piece is right on. Inflation expectations are low. Inflation will be below the Fed’s announced target, Money is a currently a little bit tighter than ideal.
Does the fed control interest rates? My usual response to this, is which rates? There are a multitude of rates that reflect the conditions by which money is flowing from lender to borrower. The Fed targets just one of those.
but then I saw this the other day.
http://www.chicagobooth.edu/capideas/magazine/fall-2015/whos-really-in-charge
25. September 2015 at 11:36
Scott, Yellen’s full footnote 28 was from Thursday’s speech. She doesn’t think central, banks can influence inflation expectations by announcing a different goal, except over the very long term and that monetary policy is highly accommodative right now. Two errors in one paragraph.
http://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm
This was the bit of the speech:
Although the evidence, on balance, suggests that inflation expectations are well anchored at present, policymakers would be unwise to take this situation for granted. Anchored inflation expectations were not won easily or quickly: Experience suggests that it takes many years of carefully conducted monetary policy to alter what households and firms perceive to be inflation’s “normal” behavior, and, furthermore, that a persistent failure to keep inflation under control–by letting it drift either too high or too low for too long–could cause expectations to once again become unmoored.28 Given that inflation has been running below the FOMC’s objective for several years now, such concerns reinforce the appropriateness of the Federal Reserve’s current monetary policy, which remains highly accommodative by historical standards and is directed toward helping return inflation to 2 percent over the medium term.29
This the full footnote:
28. My interpretation of the historical evidence is that long-run inflation expectations become anchored at a particular level only after a central bank succeeds in keeping actual inflation near some target level for many years. For that reason, I am somewhat skeptical about the actual effectiveness of any monetary policy that relies primarily on the central bank’s theoretical ability to influence the public’s inflation expectations directly by simply announcing that it will pursue a different inflation goal in the future. Although such announcements might potentially persuade some financial market participants and professional forecasters to shift their expectations, other members of the public are probably much less likely to do so. Hence, actual inflation would probably be affected only after the central bank has had sufficient time to concretely demonstrate its sustained commitment and ability to generate a new norm for the average level of inflation and the behavior of monetary policy–a process that might take years, based on U.S. experience. Consistent with my assessment that announcements alone are not enough, Bernanke and others (1999) found no evidence across a number of countries that the initial disinflation which follows the adoption of inflation targeting is any less costly than disinflations carried out under alternative mo
25. September 2015 at 11:39
… alternative monetary regimes.”
(End of footnote)
25. September 2015 at 11:41
The market is cruel and heartless. I think it rallied in Europe and Asia because Yellen appeared unwell. And the dollar rose again. No small matter.
25. September 2015 at 12:05
Actually I feel bad for Yellen; she really didn’t look well during her speech.
I suspect she is suffering from cognitive dissonance and stress. Look at the contradictory arguments in her speech and the last Fed decision!
I suspect Fed-Borg is staging a rearguard action to assimilate Yellen, and it is causing an cognitive immune response. It is not just the rogue Fed Governors, it is likely also career staffers. Yellen is smart and conscientious so hopefully she can fight off the Fed-Borg infection!
https://www.youtube.com/watch?v=1YAEHJvNscs
25. September 2015 at 12:22
Charlie: You wrote: “If banks circulate reserves, I don’t see how that reduces the aggregate number of reserves in the system.”
It doesn’t reduce the aggregate reserves in the system. Only the Fed can do that. However, in the past a high excess reserve position would indeed circulate in the sense that the funds desk managers would sell their excess at almost any rate as the reserve calculation deadline approached because to sit on them would yield no benefit. Thus, they’d hit the bid, driving it down at the end of the reserve week.
I believe, on the basis of some evidence by the way, that the process of funds desk managers liquidating their excess reserve positions directly caused money growth over that same period of time. The resulting increase in deposits then raised the required reserve level in the banking system, while reducing the excess reserve position in the same amount.
Today, the Fed no longer has that degree of control and money transfers back and forth between required reserves and excess reserves depending upon the behavior of deposits, particularly demand deposits. The total of excess plus required reserves remains static, however, unless the Fed adds or drains.
25. September 2015 at 12:38
Scott: You wrote: “Would it also be correct to say?
“Rising money supply (relative to money demand) can’t cause inflation because all money growth represents is the inflation rate relative to money demand. Whatever is causing one is by definition causing the other. That seems obvious.“
You wrote that in response to my observation that your assertion that NGDP causes inflation is simple nonsense. NGDP is defined as RGDP plus inflation, so you’re citing a tautology (A=A) and ascribing cause to one side and effect to the other. That’s patent nonsense.
Now, if you want to discuss what causes NGDP to vary from RGDP, that’s a different story, because whatever causes that also causes inflation. I would maintain that it’s usually excessive money growth.
As for your cute substitution, money growth and inflation are not in synch by definition, as you incorrectly imply. Historically the inflation rate has lagged money growth by several years. However, NGDP and inflation are in synch, by definition. Thus, my statement was accurate, whereas yours assumes one to one correspondence between money growth and the observed inflation rate, which is usually not the case.
If, indeed, it were the case that money growth and inflation were one and the same, then I would still be asking “So, what caused the money growth?” which is the key question, obviously. Did inflation itself cause the money growth, or did something else generate the money growth and later the inflation?
25. September 2015 at 12:57
John Bailey: You wrote (asking of Scott):
What specifically should the Fed do?
I would love to hear your ideas in 1,2,3 format.
Keep interest rates low, charge for reserve deposits, buy more bonds (QE).
Ideally lay it out in a format that an intelligent layman can understand.
I’d like to answer you as well.
1. Reduce the excess reserve position to the marginal amount that it used to run, on the order of hundreds of millions of dollars. This will likely cost the Federal Reserve (and the taxpayers) hundreds of billions of dollars, but that has to be done to restore the Fed’s control of a fractional reserve system. Until it is done, the Fed is essentially irrelevant to money growth. They have no control over it whatsoever.
2. Stop paying Interest on Reserves, or at least on Excess Reserves, so that banks hit any bid greater than zero in the fed funds market with their excess position.
3. Once the excess reserve position is minimal again, do reverse repos until fed funds trade at a minimum of, say, 2%. That will ensure that banks attempt to liquidate their excess reserve positions when they have them, and it would be a trivial exercise to convince the funds market that 2% is the floor because if the rate fell below it the reverse repo drain it would generate from the Fed would leave banks clamoring for needed reserves. You could easily drive the rate to 10% at the end of the reserve calculation period, even in today’s economic environment (provided #1 and #2 were implemented first, of course.)
4. Once the 2% floor is established, the Fed should routinely do whatever adding or draining is required to keep the deposit base relatively stable, probably on a seasonally adjusted basis. They should not set a ceiling, or a floor above 2%. Let the funds market trade during the week wherever it wants, provided the 2% floor is maintained.
More here: Monetary Policy: Part 6 – Getting from Here to There
If you read the post, you’ll see that I also think that demand deposits should alway pay zero interest, and that savings deposits that earn interest should only be available upon a delay of a few days, as used to be the case. There are valid reasons to separate transaction balances from savings balances in a fractional reserve system if it’s to be operated efficiently.
On the unlikely event that you go on to read posts 1-5 that precede post 6, you’ll see why that’s the case.
25. September 2015 at 13:10
Philippe: You wrote: “banks lend base money, and ‘reserves’ are base money, so yeah, banks do lend reserves.”
Technically, the banking system as a whole doesn’t lend reserves. Instead, banks make loans out of the air and balance the books by adding the same amount of deposits on the other side of the ledger.
Thus, a bank lends $1,000,000 and adds the loan to the asset side of the ledger and simultaneously deposits $1,000,000 in the borrower’s account, adding that to the liability side of the ledger.
The impact on reserves is after the fact, when the banking system is required to hold required reserves against the $1,000,000 increase in deposits. And with the excess reserve position of today, there is no constraint on banks whatsoever in that regard. I would add that there’s also nothing to stop the banks for drawing down both loans and the associated deposits.
The Fed’s QE’s have rendered it impotent when it comes to affecting the level of loans and deposits in the system.
25. September 2015 at 15:04
Scott, I do agree with you that TIPS spreads point to the need for additional easing but I’m wondering why the spreads are dropping? M2 growth has been in the high 5 to low 6 percent range, which seems high enough for rGDP growth in the high 2 percent range. Yet we’re getting PCE growth near 0.25%. Falling commodity prices are certainly part of it, but even core-PCE growth is only growing at 1.25%. Any idea why we’re not seeing higher inflation figures?
25. September 2015 at 15:48
If “low” interest rates cause “bubbles”, I wonder how we had any bubbles prior to the winter of 2008?
🙂
25. September 2015 at 15:56
A question to anybody: is there a stat that tracks how much banks have in their reserves that are *above* the minimum required? I once saw this for a historical survey, but is there a real time version for today’s banks? That is, if the Fed requires banks to hold 7% reserves, how close are the banks, right now, to that limit? Are the ‘riskier’ banks at 7.001% (almost right at the limit) while the more conservative banks at say 11% (way off the limit)? As I recall from the historical survey, the banks all tended, at least in boom times, to ‘cluster’ right at the limit, but the more conservative banks had slight more reserves than the minimum. Maybe for today’s subdued times the banks are nowhere near the limit?
Maybe we can learn something from this site in the comments. Certainly we’re not going to learn anything…ok no negativity for one post. Just one post, I promise.
25. September 2015 at 16:12
Ray,
Here is a graph
25. September 2015 at 19:05
Scott,
Perhaps if the Fed would (1) raise the target Fed Funds rate; and (2) RAISE the inflation target and/or institute a sufficiently high level of NGDP targeting via resumption of asset purchases on the intermediate/ long-end, we might have the following: (1) Neo-Fisherians would be happy since raising the FF target would be deemed inflationary; (2) Market Monetarists wouldn’t care because they would believe that the expectations effect of NGDP targeting at the longer end would likely make the FF target moot and also possible overtake the liquidity effect at the long end; (3) Austrians might watch for an acceleration into the Crack-Up Boom due to the asset purchases; (4) New Keynsians would remained confused; and (5) Paul Krugman , after observing the results would claim he predicted the actual outcome.
25. September 2015 at 21:24
@Rod
-Loans, yes, deposits, absolutely not. QE is a direct contribution to deposits.
26. September 2015 at 04:00
Rod,
Technically, the banking system as a whole does lend reserves, and it borrows reserves from depositors. A bank deposit is a loan of base money from the depositor to the bank.
“banks make loans out of the air”
Are banks lending people air? No, they are lending people base money.
“and balance the books by adding the same amount of deposits on the other side of the ledger”
A deposit is a loan of base money from the depositor to the bank.
26. September 2015 at 05:00
Philippe:
You clearly have little understanding of how fractional reserve banking works.
The easiest way to understand that yes banks do indeed create money “out of thin air” (that is an expression by the way, so your response of that rhetorical question shows not only do you not understand banking, but you purposefully do not even try to understand it, which is even more despicable), is to look at reports that contain estimates of the total quantity of base money and the total quantity of money as such (M2, M3, etc).
What you find is the case on every day of the year is that the total quantity of money vastly exceeds the quantity of base money.
The reason this is the case is because banks are creating new media of exchange (out of thin air is the expression, but it is ultimately dependent on the trust of the public) when they issue new loans.
What you don’t yet grasp is that banks are extending loans far in excess of the reserves they have on hand. But how can that be you might ask? How can a bank issue a loan of money it does not have? The answer is that these promises the banks are making, and yes they are promises not boatloads of dollar bills in almost all cases, end up circulating as that which is exchanged for real goods and services. People trade these “promises to pay” as if they are money. And, the law allows banks to account for these promises as legal tender.
But how can this all “work”? How can banks owe money that exceeds the money they actually have on hand? This is the part which bankers figured out hundreds of years ago. Bankers have found, and governments throughout those hundreds of years have encouraged it because the government can also benefit from it, that depositors rarely if ever ask for physical money all at the same time. Most of the time they just exchange the promises to lay with each other. Well, banks have found that they can issue more promises to pay than the money they actually have on hand, and earn even more interest.
This is fractional reserve banking. Maybe you’ve heard of it.
An example may help. Suppose I am a banker who has $1000 of cash on hand, given to me by depositors, who either don’t know what I do with the money, or they do but they don’t care as long as I pay them when they ask.
Suppose I then phone up Bill and tell him I am willing to extend him a loan for $1000, due in a year.
So far this is the extent of your understanding of banking.
But it gets more complex. Suppose after I lend that $1000 to Bill, he wants to go out and buy a computer. He needs to pay for it right? Well, our agreement was not that I would give him $1000 in dollar bills, but rather to add $1000 to his bank account, digitally. When he goes to the store, to buy the PC, the store owner is provided with information that Bill has $1000 in his bank account. So Bill and the store owner make an agreement that the $1000 is now the property of the store owner. The bank makes an accounting entry.
But nowhere did any physical cash be exchanged.
And here is where the bank gets smart.
The bank notices that the $1000 loan they originally gave to Bill, circulates throughout the economy, from Bill to the PC store owner, from the PC store owner to the workers say, and from the workers to the grocery store say, and so on.
All the while the bank is asked occasionally for $100 here and there from any of the people who are holding the property titles to the $1000.
The bank learns that the loan of $1000 is translating into an actual physical money liability of only $100 total cash held in the wallets of the depositors. The rest the depositors keep in the bank and rarely if ever withdraw it. They rather just do the majority of their buying and selling with the bank’s promise to pay, and only about 10% with physical cash.
So the bank gets the idea “Hey, if I have $1000 cash on hand, and I can earn interest on lending $1000, but only ever have to have $100 of physical money on hand to facilitate cash transactions, what would happen if I start telling people I am willing to add more money to their bank balances, as digitial loans, to earn more interest? By my calculations, for every $1000 I lend, I only need to have about $100 of physical money on hand to give to the depositors when they ask for cash. The rest they keep with me and they conduct their exchanges by just exchanging the promise to pay. I know! I could lend $10,000 total, earn interest on $10,000 instead of $1000, and all this would require me to have about $1000 of physical on hand! Which I have!”
The accounting then leads to there being $10,000 in total money supply, but only $1000 in base money, in this hypothetical economy.
The above is a simplified description of how banks really do extend loans “out of thin air”, and thus create new money in the form of “circulating credit”.
This credit expansion process adds to the total quantity of money and volume of spending in the economy. It is the largest component of the money supply. By a significant margin.
The Fed’s purpose is to not to target NGDP. Hahahaha. The Fed’s true purpose is to allow banks to engage in this credit expansion process together all at more or less the same rate, so as to earn more interest income. See, prior to the Fed, banks found that the fractional reserve game is a risky venture that can come back to haunt them. When the public starts to distrust the banks, and ask for their deposits at the same time, that makes it impossible for banks to make good on all the loans they extended. Bankruptcies were likely to occur.
This happened in the Panic of 1907. It was then that the bankers jumped on the already growing ” progressivism” sweeping throughout the nation over from European Socialism, where central banks were already in existence. The Houses of Morgan and Rockefeller back in the US wanted a “lender of last resort” governmental entity as well, so that banks could continue to lend more than what they had on hand, earn more interest, and be protected from insolvency with an essentially counterfeiting machine.
The banker’s stool pigeons in US Congress waited until Christmas when most politicians were out of office, and they passed the Federal Reserve Act.
26. September 2015 at 05:54
I didn’t say that banks don’t create ‘money’ out of thin air. I asked whether banks lend people air. The answer is that no, they do not lend people air. Banks lend people base money. And bank deposits are loans of base money from depositors to banks. In other words, bank deposits are promises to pay base money, or bank debts.
However these deposits, or bank debts, are themselves a form of ‘money’ (but not base money), in the sense that they also serve as a media of exchange. So instead of people paying each other directly with base money, they can pay each other with bank deposits.
26. September 2015 at 06:25
“How can banks owe money that exceeds the money they actually have on hand?”
All borrowers owe more money than they currently have on hand. If you have a mortgage, you owe more money than you currently have on hand.
“banks have found that they can issue more promises to pay than the money they actually have on hand”
So banks have discovered the deep hidden secret, which everybody knows and which is just obvious common sense, that you can owe more money than you currently have on hand. Wow.
26. September 2015 at 06:37
Philippe: You wrote: “A deposit is a loan of base money from the depositor to the bank.”
This is true in only one instance, that being when someone takes currency out of their personal stash and deposits it in a bank. Currency in circulation is, by definition, a component of the monetary base, i.e., it’s base money.
All other “base money” (assuming we’re talking about the same thing here, which might be a shaky assumption) consists of banking systemwide reserves held on deposit at the Federal Reserve.
And as long as the banking system, as a whole, has excess reserves on its books it can, indeed, create money “out of thin air.” (But you apparently don’t understand that colloquialism, so I’ll rephrase.) As long as excess reserves are available, the banking system can expand the deposit base at will simply by making additional loans.
Those deposits are the offsetting entries to the new loans. The bank expands it’s assets by extending the loan, and it expand its liabilities by crediting the borrower with a deposit equal to the amount of the loan. Nowhere does that deposit require a holder of “base money” to participate directly, although in the next reserve reporting cycle the banking system will have to allocate a small portion of its excess reserves toward required reserves.
Frankly, I was hoping to generate a reasonable discussion here. I’m disappointed in the result thus far.
26. September 2015 at 06:46
Major Freedom: I think we differ on our definition of “fractional banking” and I want to clarify what I mean by the term.
In your example it appeared to me that you use the term “pre-Federal Reserve”, i.e., in a totally unregulated banking system.
I use it in the context of the Fed’s reserve requirements. In that context, a 20% reserve requirement allows an injection of $1,000 in new excess reserves to support an increase in the deposit base of $5,000.
So when I refer to a system of fractional reserves I’m referring specifically to the sort of system the Fed oversees, not an unregulated banking system of the sort you described. Just to be clear, not arguing.
I find it interesting that when when Jimmy Stewart in “It’s a Wonderful Life” came out almost 70 years ago, most adults in the theater probably understood the why behind what was going on in the bank run part of the story, while today I suspect very few adults would have a clue as to the underlying fundamentals of a bank run. Another result of overly-protective regulation, perhaps? The Fed protects us. Why worry?
26. September 2015 at 07:02
E. Harding: You wrote: “-Loans, yes, deposits, absolutely not. QE is a direct contribution to deposits.”
I’m assuming your reply addresses this comment of mine: “The Fed’s QE’s have rendered it impotent when it comes to affecting the level of loans and deposits in the system.”
Yes, I agree that the QE directly increases deposits. Securities are replaced, one for one, with deposits in the customer accounts. This is why asset markets tend to appreciate in response, of course. All those new deposits are not going to be left on account at nearly zero interest.
However, my point was to the Fed’s control of the money supply in a traditional sense. The QE’s ballooned the excess reserve position and that is what rendered the Fed impotent in its traditional role of managing the size of the deposit base. For example, the seller of the securities could have decided to take the resulting deposit and pay down a loan. Deposits would drop accordingly.
If you take the time to take my writing at my blog seriously, you’ll possibly come to understand what I refer to as “The Strong Form of Monetary Policy” in which I explain that the Fed once had nearly ironclad control over the size of the deposit base, i.e., over the size of the M1 money supply. They no longer do; they are completely impotent in that regard, and by their own doing. And in the doing, they’ve made it exceptionally difficult to regain their previous control.
Here’s the first of six posts:
Monetary Policy Theory: Part 1: Fractional Reserves
26. September 2015 at 07:05
James, Even if it takes “years”, that’s no reason not to do it.
Steve, I sympathize with her. In my last years of teaching I often felt like I was going to faint. And I was just in my late 50s, she’s even older.
Rod, You said:
“You wrote that in response to my observation that your assertion that NGDP causes inflation is simple nonsense. NGDP is defined as RGDP plus inflation, so you’re citing a tautology (A=A) and ascribing cause to one side and effect to the other. That’s patent nonsense.”
No, I didn’t cite a tautology, because I never said A = A. I never said inflation equals NGDP growth. If it were a tautology, then the claim that monetary growth causes inflation would also be a tautology, since inflation is nothing more than growth in money supply minus growth in real money demand, by definition.
Jeff, M2 is not helpful. Money is still relatively tight if you look at better indicators like NGDP growth and wages. But I do expect headline inflation to rise. My bigger concern now is tail risk–especially of a global recession in 2016. That’s not likely to occur, but the risk is higher than I’d like to see.
Bill, I agree. And rates were not low during the 1929, 1987, and 2000 stock price surges.
gofx. 🙂
26. September 2015 at 07:25
“This is true in only one instance, that being when someone takes currency out of their personal stash and deposits it in a bank”
No. A deposit is a bank liability. i.e. it’s a bank debt. If you own a bank deposit this means the bank owes you base money. So the bank is borrowing base money from you and you are lending base money to the bank.
Yes, banks can create deposits “out of thin air” without a depositor directly handing them cash. But that deposit means that the bank owes the depositor base money, so the bank is borrowing base money from the depositor even if the depositor didn’t physically hand them cash.
“All other “base money” consists of banking systemwide reserves held on deposit at the Federal Reserve.”
Right. And if I own a bank deposit, I can instruct the bank to pay base money to someone else on my behalf (because the bank owes me base money). So let’s say I want to make a payment to someone who has an account at another bank. I instruct my bank to make a payment to that person on my behalf. The amount is then transferred from my bank’s CB reserve account to the reserve account of that person’s bank. (in practice the payments between banks mainly cancel out however, so net transfers between bank reserve accounts are less than the overall flow of payments between customer accounts).
26. September 2015 at 07:37
Felipe- thanks but I think your graph is merely showing excess reserves for the entire system as a whole, rather than individual banks. Perhaps the data for individual banks is proprietary? Also it’s not clear why excess reserves prior to 2008 are zero. Some sort of Fed artifact at play? Ah, I see now, it’s not zero but the Y-value is so close to zero, since the scale is distorted by post-2008 excess reserves, that it appears zero. The Fed’s giving of ‘corporate welfare’ to member banks, via giving 0.25% interest on reserves, since 2008, is obvious from this graph.
26. September 2015 at 08:46
mf,
“The banker’s stool pigeons in US Congress waited until Christmas when most politicians were out of office, and they passed the Federal Reserve Act.”
That’s nothing but a dumb myth. The act was originally passed by a vote of 298 to 60 in the House of Representatives and 43 to 25 in the Senate, and the Fed was then re-chartered by another vote in 1927. The original act has also been amended a few times since then.
26. September 2015 at 09:16
mf,
an ‘austrian’ goldbug economist explains fractional reserve banking to clueless Rothbardians:
https://www.independent.org/pdf/tir/tir_07_3_white.pdf
26. September 2015 at 09:19
>Why? What will *cause* inflation to return to 2%?
The obvious interpretation is that Yellen believes the natural rate of interest will soon rise sufficiently that a Federal Funds rate of -1% will generate inflationary pressure. At this point, she thinks the Fed will be able to hit its inflation target using conventional monetary tools.
Presumably, she thinks the natural rate will rise because she doesn’t buy pessimistic secular-stagnation style arguments, and thinks that improving household and firm balance sheets, and the steady downward march of the unemployment rate, will lead to continued increases in demand.
Personally, I’m a bit more pessimistic, mainly due to international factors.
26. September 2015 at 11:24
Jonathan, That’s a reasonable answer. I’m also a bit pessimistic, partly due the the international factors you cite, and partly due to the TIPS spreads, which I take more seriously than the Fed does.
26. September 2015 at 11:53
“I don’t think it’s a big deal if they undershoot their inflation target for a couple straight years.”
You should because it calls into question whether the Fed has a 2% inflation target or not or rather, it demonstrates that they do NOT have a 2% inflation target. The point of an inflation target is to allow better formation of expectations about relative prices in the future. And the point of the target not being zero is that some prices are sticky downward. How many and how sticky governs the choice of the average price level trend target.
26. September 2015 at 12:17
ThomasH: And I would argue that undershooting their 2% target calls into question whether they any longer have the tools to hit the target, no matter how desperately they wish to hit it.
As I keep saying, the Fed relinquished its traditional monetary tools when it did the QE’s. They’ve just been whistling in the dark about the Fed’s effect on the economy since.
Incidentally, the reason Yellen passed on the September rate hike is probably due to concerns of an impending recession. After all, to finally tighten after 7 years and doing so on the cusp of a new recession would make them look like they don’t have a clue.
26. September 2015 at 12:20
Philippe: You wrote: “No. A deposit is a bank liability. i.e. it’s a bank debt. If you own a bank deposit this means the bank owes you base money. So the bank is borrowing base money from you and you are lending base money to the bank.”
You seem to have your own unique definition of “base money.” Show me an authoritative reference that claims that a bank owes a depositor “base money” and I’ll continue this. Otherwise, it’s just a waste of time.
26. September 2015 at 12:31
Scott: You wrote: “No, I didn’t cite a tautology, because I never said A = A. I never said inflation equals NGDP growth.
I didn’t say that you claimed “inflation equals NGDP growth.” Your claim was that excessive NGDP growth causes inflation. That’s utter nonsense since the definition of NGDP growth incorporates the inflation rate. (NGDP-RGDP)=inflation rate. The change in NGDP=the change in the inflation rate, a tautology.
Whether you see it or not, you might not think you’re citing a tautology, but you are. You could just as easily argue it the other way, i.e., that inflation causes excessive NGDP growth, i.e., growth in NGDP well above RGDP. The change in the inflation rate causes the change in NGDP.
26. September 2015 at 12:37
Scott, my question was why is money tight. I get the point that the Fed isn’t hitting g it’s target so it should do something “more.” But if I was a central banker I would feel more comfortable doing more, like increasing the money supply if I knew how that action is going to effect the target. And right now it looks like a bit of a mystery why the current actions are not hitting the target. Why do you think that’s the case?
26. September 2015 at 12:38
Rod,
You seem to have your own unique definition of “base money.”
No, I don’t. Base money is cash (central bank notes and coin) and reserve deposits held at the central bank.
“Show me an authoritative reference that claims that a bank owes a depositor “base money”
what exactly do you think a bank owes to the depositor? A deposit is a bank debt. The bank owes money to the depositor.
26. September 2015 at 12:53
Scott,
Good point about TIPS, but I consider international factors the main reason inflation expectations have fallen. For instance, the fall in the 10-year breakeven rate has tracked the rise in the dollar very closely:
https://research.stlouisfed.org/fred2/graph/fredgraph.png?g=1X4A
Incidentally, this relates to Matt’s comments on your Abenomics post, pointing out that there is often a significant lag in the AD effects of changes in the real exchange rate. Over the last year, we’ve seen a 16% rise in the dollar. Right now, exports are around 13% of GDP, and imports around 16%. Following Matt in assuming an elasticity of 1 for both imports and exports, this implies a reduction in AD of >4% of GDP.
Now some of this adjustment may have already happened, but probably not much: net export share has been essentially flat over the last year. But if this calculation is approximately accurate, it implies quite a significant drag on demand. Probably more than enough to explain a 50bp fall in 10-year inflation expectations.
26. September 2015 at 13:07
Philippe: You wrote: “what exactly do you think a bank owes to the depositor? A deposit is a bank debt. The bank owes money to the depositor.”
No argument there. Of course the bank owes “money” to the depositor. But why do you keep calling it “base money”?
Again, cite me an authoritative source that claims money owed to a depositor is referred to as “base money” (and why), because you are the only person I’ve heard make that claim thus far.
26. September 2015 at 13:38
Rod,
“why do you keep calling it “base money”?”
because that’s what is owed. What other kind of money would a bank owe to a depositor other than base money? Please tell me what kind of money you think a bank owes to its depositors, i.e. to its creditors.
26. September 2015 at 18:18
Again, Philippe, please cite just one authoritative source that agrees with your calling money owed a depositor “base money.” Just one, other than yourself.
And if you can’t do so, you might consider the possibility that you’re misusing the terminology.
26. September 2015 at 23:08
Scott
Yellen is happy. She’s got a 2% target and believes inflation WILL get there in 2018 and “nearly there” in 2017, ie years and years.
The market is puzzled though. And as she was asked in the September press conference, why change interest rates now?
27. September 2015 at 07:09
Thomas, The real problem is that they’ve already undershot their inflation target since 2008, with one brief exception. So a further undershoot gets added on to the previous undershooting—which is a way of agreeing with your point.
Rod, You need to rethink this whole issue, as you are making a fundamental error. This is just as much a tautology:
Growth in money supply minus growth in real money demand equals inflation.
So it’s also a tautology to claim that excessive money growth causes inflation? Obviously not.
And this statement is just absurd:
“The change in NGDP=the change in the inflation rate, a tautology.”
Wrong. It would imply that RGDP never changed.
Jeff, There’s no mystery at all, as many of their current actions are contractionary:
1. IOR is contractionary
2. Promising to raise rates soon is contractionary.
3. Predicting sub-2% inflation in 2017 is contractionary.
The Fed doesn’t need to print more money, they’ve done plenty of that already, they need a smarter policy.
Jonathan, Here you need to stay away from reasoning from a price change. The strength of the dollar partly reflects the strength of the US economy—it’s not all about monetary policy.
27. September 2015 at 09:48
Philippe:
“I didn’t say that banks don’t create ‘money’ out of thin air. I asked whether banks lend people air.”
What a dumb comment. Nobody here is actually positing banks lend “air”. Out of thin air is an expression.
“Banks lend people base money. And bank deposits are loans of base money from depositors to banks. In other words, bank deposits are promises to pay base money, or bank debts.”
Banks do not only lend base money. The majority of their loans are not backed by any base money. This is how that total money supply becomes vastky larger than the base money supply.
Banks are extending credit in excess of base money.
“However these deposits, or bank debts, are themselves a form of ‘money’ (but not base money), in the sense that they also serve as a media of exchange.”
The bank debts exceed the supply of base money.
“So instead of people paying each other directly with base money, they can pay each other with bank deposits.”
They could not pay each other ONLY with base money even if they tried, because the dollar amounts of the loans exceeds the dollar supply of base money.
It is not that people are just exchanging claims to existing base money deposits. They are in fact exchanging a sum of claims to base money that does not actually exist. This is how the total supply of money can exceed the base money supply.
“How can banks owe money that exceeds the money they actually have on hand?”
“All borrowers owe more money than they currently have on hand.”
That is because banks do not ONLY lend base money. The banks have liabilities that exceed the money they have on hand precisely because the bank loans are not only base money loans. Indeed, base money makes up only a small fraction of the “money” that is lent.
“If you have a mortgage, you owe more money than you currently have on hand.”
But the bank that extended the loan to you with the house as collateral, that loan is not backed 100% by base money. The bank extended the home seller a promise to pay that is the full price of the house, and the home seller also does not typically withdraw the full amount in cash. They too take out only a small portion in cash. The bank in your example is just doing what I described above. Adding another party to the process does not affect that process.
“banks have found that they can issue more promises to pay than the money they actually have on hand”
“So banks have discovered the deep hidden secret, which everybody knows and which is just obvious common sense, that you can owe more money than you currently have on hand.”
Glad that you finally seem to get it that banks do not actually loan only base money. That the loans they extend are not backed by anything tangible 100%. That your initial claim that banks loan base money, as if base money was all they loaned, is false.
27. September 2015 at 09:56
Philippe:
“A deposit is a bank liability. i.e. it’s a bank debt. If you own a bank deposit this means the bank owes you base money. So the bank is borrowing base money from you and you are lending base money to the bank.”
No, that is false. If I acquire a bank loan, and like you said the bank owes me base money if I ask for it, it does not follow from them not giving me base money that I somehow lent them base money.
The deposit that is created is not fully backed by base money.
In other words, the deposit that is created by the bank extending me a loan that is not in cash which I then redeposit, does not add to the base money supply. Fractional reserve banks do not create base money.
You are confusing base money and M1. Deposits created by way of bank loans not fully backed by base money, add to M1, but they do not add to base money.
Base money is controlled by the Fed and Treasury.
27. September 2015 at 09:59
Philippe:
“Base money is cash (central bank notes and coin) and reserve deposits held at the central bank.”
This contradicts your earlier contention that bank loans that are not 100% backed by base money, but are redeposited bank into a bank as a deposit, is base money being deposited.
You are so clueless.
27. September 2015 at 10:08
Philippe:
“What exactly do you think a bank owes to the depositor? A deposit is a bank debt. The bank owes money to the depositor.”
You are reversing cause and effect. Yes, a bank owes money to a depositor, but you have to consider where that deposit you’re talking about originated. If you go into a bank, you can either deposit cash, which is base money, or, and this is where you get confused, you can deposit a sum of “money” that was itself created by bank credit expansion not 100% backed by base money.
A bank that extends more loans than they have in base money, is a bank that is creating new money deposits that are greater than the supply of base money.
They say they are able and willing to pay base money on demand to make good for the depositors, and in most cases a bank can do this because depositors rarely ask for their entire deposits in cash, and even more rare do all the depositors do so at the sa e time.
However, if all the depositors asked for all of the base money owed them at the same time, the bank would be unable to pay all the depositors in base money. If you can grasp this, then you should be able to grasp the fact that banks are granting loans and creating deposits in something other than base money. If it was only base money, then the base money supply would always equal the total money supply.
28. September 2015 at 14:35
Scott: You wrote: “And this statement is just absurd:
“The change in NGDP=the change in the inflation rate, a tautology.”
Wrong. It would imply that RGDP never changed.”
I agree, that was an error on my part. It doesn’t change the fact that your statement that NGDP growth causes inflation is equally absurd, however.