“There’s every risk of an overshoot”

Because of the bloated monetary base there has been much concern recently about the supposed risk of future inflation.  There are at least four important misconceptions associated with this issue, and I’ll try to address all four in this post.  The first misconception is that it will be difficult to pull the excess reserves back out of circulation after the economy recovers and interest rates rise to a more normal level.  As Hall recently pointed out, if we continue to pay interest on reserves it would not be necessary to pull those reserves out of circulation in the future, just pay enough interest for banks to want to continue holding them.  But for the moment let’s assume that’s not feasible.  In the following quotation from the WSJ, Kenneth Rogoff expresses a widely held fear:

“It’s very difficult to pump this money in and pull it out later,” says Kenneth Rogoff, a professor of economics at Harvard University. “There’s every risk of an overshoot.”

Let me first say that Rogoff has been very good on the need for an explicit inflation target for the Fed; in fact I seem to recall him suggesting a target of 6%, so he is not someone oblivious to the need for monetary stimulus.  In addition, it’s easy to make generalizations when talking to the press, so I really don’t know whether he is actually all that worried about this issue.  But some people clearly are.  And this reflects a misunderstanding of monetary theory.

During the 1960s, 1970s and early 1980s there was a lot of concern about inflation gaining momentum, and then being hard to stop.  Once inflation expectations start to rise, wage increases accelerate, and the core inflation rate also rises.  At this point it is hard to put the genie back in the bottle.  Reducing inflation once expectations have risen; runs into the well-known Phillips Curve problem.  But that problem should never occur unless the central bank is grossly negligent.  After 1982 central banks around the world figured out how to keep inflation under control.  The key is to tighten monetary policy aggressively at any sign of an upswing in inflation expectations.  As long as the Fed doesn’t let nominal/indexed bond spreads exceed 3%, there will be no severe problem of inflation overshooting.  (That’s not to say they will be perfect, there certainly may be the occasional problem of slightly above target inflation.)

The second misconception is that monetary stimulus requires a massive increase in the monetary base.  I have said from the beginning that if my policy were pursued the monetary base would probably be much lower than it is today.  Now that the world’s leading expert on interest payments on reserves has endorsed my signature proposal, let’s look more closely at how the plan would actually work.

Before the crisis there was about $800 billion in cash, $80 billion in required reserves, and less than $8 billion in excess reserves.  (I don’t recall the exact figures, but it doesn’t matter.)  After the Fed started paying interest on reserves in early October, excess reserves ballooned up to about $800 billion, 100 times the normal level.  With a penalty rate on excess reserves that number would go back down to less than $8 billion.  In that case to prevent hyperinflation the Fed would need to pull almost all the extra $800 billion out of circulation.  It’s hard to know how big a QE would be needed with a penalty rate on excess reserves; it depends on how credible the policy is.  But in my view less than $100 billion would be required to hit any reasonable inflation or NGDP target.

Why so little?  Because with a penalty rate on excess reserves all the extra $100 billion would go into cash in circulation.  I did my dissertation on cash, and I can tell you that cash demand is nothing like what we learn in our textbooks.  Because of the fear of theft, transactions balances are amazing small, even at near zero interest rates.  Many people only carry a few hundred dollars, or even less.  Where is the other more than $2000 per capita?  Hoarded by tax evaders, criminals, and foreigners.  And it is very costly for those groups to quickly adjust the size of their cash balances.  They prefer the anonymity of cash, and thus often don’t have large amounts of financial assets to exchange for cash when rates fall.

I have no idea what would happen if the Fed tried to force even another $100 billion into circulation.  It is possible that it would be put into safety deposit boxes, if T-bill yields went negative.  But I think a much more likely outcome is that even before they got anywhere near $100 billion extra cash in circulation, there would be such a reaction in inflation sensitive markets (commodities, stocks, bond yields) that the Fed would fear overshooting their nominal target.  It would be easy to generate 2% expected inflation, or 5% NGDP growth.  To summarize, although I often do thought experiments about the Fed doubling the money supply, keep in mind that in the real world a bloated base is a sign of failure, of deflationary policies (i.e. the U.S. 1933, Japan 2002, the U.S. 2008.)  I don’t expect my proposal to fail, and hence I believe the base would be much lower.

[BTW, should I start calling my proposal the “Sumner/Hall/Woodward plan?”]

The third misconception relates to the cost of maintaining interest payments on reserves after we return to normal.  Hall clearly favors maintaining the program indefinitely, as he has advocated interest on reserves since 1983.  In a recent post David Beckworth addressed some of the same issues as Hall and Rogoff:

Once the economy begins to recover I see four potential paths the Fed could take with regards to the large buildup of excess reserves:

  1. The Fed could do nothing and allow the inflationary pressures to emerge.
  2. The Fed could reverse the buildup of excess reserves and in the process stall the economic recovery.
  3. The Fed could pay even higher rates on the excess reserves and potentially incur large fiscal costs.
  4. The Fed could pray for super-robust economic growth that would allow the economy to quickly grow (i.e. increase real money demand) into the money supply. This would be the cure all solution–no need to reign in the buildup of excess reserves and no need to worry about inflation.

Number (4) is pipe dream. I suspect some combination of numbers (1) and (2) will be the likely outcome. Note that if the Fed pulls a Paul Volker and focuses solely on number (2) it would not only stall the economic recovery but may also incur some fiscal costs. This is because the Fed could have a negative equity position on its balance sheet by that time–interest rates will eventually go up and, in turn, push down the prices on securities currently held by the Fed–that would require it to either borrow securities from the Treasury or issue its own debt in order to reign in the expanded monetary base. The bottom line is there are no easy options ahead for the Fed once the recovery begins.

I agree that we can’t rely on 4, and shouldn’t do 1.  As I’ve already indicated I don’t think we need fear option 2 as much as most others do.  I don’t expect inflation to build up the head of steam we saw in the late 1970s.  But I’d also like to address point 3.  I haven’t yet made up my mind about the desirability of interest-bearing reserves in normal times.  But I don’t think it need be as costly as many might assume.

Go back to my earlier numbers and remember that no interest would be paid on cash.  So the Fed could still earn about as much seignorage as ever on the gradual increase in cash demand over time (say about $40 billion a year assuming 5% growth.)  They would lose the seignorage on reserves, but reserves are normally very small.  What about the huge cost of paying interest on the now bloated reserves—including an extra $800 billion in excess reserves under Hall’s plan?  That should be a wash.  Hall envisions them paying interest at about the same rate as earned on government securities.  So if interest rates were 5% then the Fed would pay banks $40 billion a year on the $800 billion in excess reserves.  But on the other hand that reserve demand would not exist in the long run without the interest incentive, so the Fed would also hold $800 billion more Treasury debt than otherwise, and thus reduce the net debt held by the public by that amount.

The extra cost would then be merely the interest on the much smaller required reserves.  And although I believe Hall favors interest on required reserves to avoid the distortion of a tax on money, there is no reason why the interest on reserves program couldn’t be limited to excess reserves.  Banks must hold required reserves whether they want to or not.  [BTW, as with Rogoff, I often agree with David Beckworth.  His blog is worth checking out if you haven’t seen it.]

The fourth misconception involves the politics of inflation.  A worldly, sophisticated reader will say “yes, your reassurances about inflation are fine in theory, but history shows that governments that run up massive debts will eventually resort to inflation—it’s the easiest way to get out from under a heavy debt burden.”  I have two responses to this.  First, I’m not sure countries with large debts inevitably resort to inflation.  I seem to recall that Italy and Japan both have large debt/GDP ratios, and both still have low inflation.  But perhaps it is too soon to judge.  After all, there is a risk premium in Italian government bonds right now.

My second and much more important response is that even if this argument is true, it is not an argument against monetary stimulus involving massive QE, rather it is a strong argument for just such a policy.  Consider the Italian example I just mentioned.  Why did Italian bonds suddenly become so risky in 2008?  After all, they have had a high debt/GDP ratio for quite some time.  Clearly the reason is the dramatic slowdown in NGDP growth, which worsens the budget situation in real terms.  Thus the tight money policies of the ECB have increased the risk of the Italian government defaulting on its debt.  And one way of avoiding explicit default, is to return to the lira and then depreciate the currency.  Or if enough European governments get into trouble perhaps they can pressure the ECB to inflate at some future date.

Deflationary monetary policies almost inevitably raise the debt/GDP ratio.  If debt leads to inflation, the best way to avoid inflation is to avoid debt.  And the best way to avoid debt is to use monetary stimulus, not fiscal stimulus.  David Beckworth does raise one argument that slightly cuts the other way.  If the Fed buys a lot of government bonds, and later sells them back at a lower price (once interest rates have risen) then they may suffer some capital losses.  But recall that if markets are efficient then the expected gain or loss on Fed purchases is roughly zero, and even in the worst case, the sort of extreme estimates of capital losses tossed around by people like Krugman tend to be around $200 billion, far smaller than the cost of fiscal stimulus.

There are actually only very small risks of inflation overshooting.  But as with America in the 1930s, and Argentina in 2001, there are huge risks to our free market economy from continuing these deflationary monetary policies.



33 Responses to ““There’s every risk of an overshoot””

  1. Gravatar of JKH JKH
    14. April 2009 at 19:57

    “Because with a penalty rate on excess reserves all the extra $100 billion would go into cash in circulation … I have no idea what would happen if the Fed tried to force even another $100 billion into circulation.”

    Sorry. I don’t understand this at all. To me, this is getting at the crux of the whole issue. Just how do you “force” the public to hold an additional $ 100 billion in currency as a matter of monetary policy?

    The only example I have seen of this as a remotely implementable idea is the completely wacky “helicopter drop” strategy. And even if this was done, just how do you prevent the public from cashing in their currency at the banks for deposits, and the banks in turn cashing it in to the Fed, resulting in a self-defeating reversal of the initially forced monetary base expansion?

    The public’s holding of currency is determined by the public’s demand for currency, not by the Fed’s whim.

  2. Gravatar of dWj dWj
    14. April 2009 at 20:31

    My recollection is that you’ve generally been talking about a small penalty rate. If banks were holding $8 billion in excess reserves when those earned 525 basis points less than the cost of funds, presumably, as a first guess, you would need a 500 basis point penalty to get to $8 billion now — in which case it starts to become worth building a bigger vault, or something equivalent, to turn it into cash, if the penalty rate only applies to reserves. Does this seem wrong to you? At what point does it become worth the trouble of hoarding more cash? How big a penalty do you propose?

  3. Gravatar of Nick Rowe Nick Rowe
    15. April 2009 at 02:02

    JKH: That is indeed the crux of the issue, and reveals the two ways of thinking about monetary policy (the Fed setting the quantity of money vs. the Fed setting a rate of interest and the public setting the quantity of money).

    Suppose someone (e.g. the Fed) gives me a good offer for my car, my house, my stocks, my bonds. I sell my car, house, stocks, bonds, and accept money in return. Not because I want to hold the money, but because money is the medium of exchange. I plan to exchange the money for something else. Each individual can get rid of the money, but in aggregate we can’t. It becomes a hot potato.

  4. Gravatar of JKH JKH
    15. April 2009 at 03:05


    The hot potato is a problem for more than currency. It’s a problem for the public’s deposit balances with the banks, and it’s a problem for the banks’ deposit balances with the Fed.

    But there’s a big difference in the causality of the hot potato problems, as between the Fed and the rest of the system.

    The Fed determines the level of bank deposit balances with it. This is the primary operational channel for monetary policy, which the Fed itself defines as setting the policy rate, notwithstanding that many aficionados of this blog may have a different view. (All of this QE business only supplements the policy rate at the zero bound.)

    The Fed does not allow volatility in currency transactions to interfere operationally with the level of deposit balances it wants the system to have, and the effect of those balances on the fed funds rate. Because the commercial banks are agents for currency distribution, and have their own inventory positions in currency, Fed currency transactions with the banks (issuance and redemption) have a potential impact on bank deposit balances at the Fed. But the Fed normally offsets volatile effects through OMO, etc., other things equal, in order to control the level of the funds rate. Over time obviously, the trend (not volatility) in net outstanding currency is higher, and currency serves as the core source of funding for expansion of the Fed’s balance sheet. And obviously, with today’s extraordinarily expanding balance sheet, the Fed has a lot more other considerations in determining the level of excess bank deposits, along with currency flows.

    The Fed does not determine the public’s demand for currency. The public determines it. The Fed responds to it.

    The Fed does determine the level of bank deposit balances. It takes the potential effect of currency flows on balances into account in doing this.

    The point being that the two Fed liability components of the monetary base – bank deposit balances and currency – have an entirely different functional mode in terms of their contribution to monetary policy and the management of the fed funds rate. There’s too much abstraction and not nearly enough attention devoted to this differentiating aspect by monetary analysts and economists.

  5. Gravatar of Bill Woolsey Bill Woolsey
    15. April 2009 at 04:13

    This is what the Fed does may be interesting to Fed watchers. However, Sumner is arguing that the Fed should do something different.

    Nominal interest rate is foolish.

    The Fed chooses to accomodate changes in the demand for currency so that it can hit a target for interbank lending. Well, under current conditions they should stop doing that.

    By the way, I don’t understand why Scott said that only currency is a use of base money other than excess reserves. And expansion of transactions deposits and required reserves will have the same impact.

    Anyway, nominal interest rate targetting breaks down in the face of deflation. Also, low credit demand because of a depressed economy have much the same problem.

    Fed policy based upon ancient real bills doctrines or else IS-LM reasoning with stable expectations for nominal income fail when we are out of that box.

    And so, you have to move to thinking about the money multiplier, the quantity of money, and velocity.

    Telling us about the failed policies of the Fed does little to help.

  6. Gravatar of JKH JKH
    15. April 2009 at 04:35

    “Telling us about the failed policies of the Fed does little to help.”

    There are a couple of judgments in that statement that aren’t yours alone to make, but …

    You want change? Fine. Then for starters, tell me how you “force” the public to hold an additional $ 100 billion in currency as a matter of monetary policy.

  7. Gravatar of septizoniom2 septizoniom2
    15. April 2009 at 05:34

    very interesting post and commentary. any insight as to why the fed does not see the issue as you do? why the disagreement?

  8. Gravatar of Dilip Dilip
    15. April 2009 at 05:42

    “Telling us about the failed policies of the Fed does little to help.”

    I haven’t seen this tone adopted in any of Scott’s posts/comments section till date and I believe that is what has allowed some real healthy debates to take place here. Bill Woolsey shouldn’t be putting that in jeopardy.

  9. Gravatar of David Pearson David Pearson
    15. April 2009 at 05:45


    I believe your arguments on stimulus reversal are not well developed.

    “The key is to tighten monetary policy aggressively at any sign of an upswing in inflation expectations.”

    I agree. However, the upswing will occur ahead of the actual increase in NGDP. This is the nature of forward-looking markets, and it drives self-reinforcing hedging behavior (i.e. an increase in velocity which begets higher inflation expectations). You might argue that if NGDP expectations have turned up, that the Fed can then remove stimulus without much ill effect. This represents a massive assumption that an upturn in NGDP expectations necessarily leads to self-sustaining growth. I would argue that it ignores the variance of policy and its effect on expectations: i.e., that NGDP expectations will turn down as soon as the Fed is seen removing stimulus.

    So what do you propose to do about the lag between expectations and reality? How long is the lag? At what level of unemployment will the Fed feel that it can act “aggressively”? Will unemployment still be increasing when that decision HAS to be made? What level of interest on reserves will be sufficient to stem velocity growth? How do we know that level? How should the Fed react if there is a lag between raising the interest on reserves and the impact on velocity? Will it wait out the lag or jack up the rate faster?

    I don’t have a problem with you disagreeing with my answers to these questions. I have a problem with you not posing them. I believe this is indicative of one thing: implicitly, you assume a V-shaped recovery as stipulated in “point 4)” of Beckworth’s piece. That is the assumption that makes most of my questions irrelevant. The Fed will want to stem inflation, and this will have little impact on NGDP expectations — all because self-sustaining growth will be well on its way.

  10. Gravatar of JKH JKH
    15. April 2009 at 06:29


    “BTW, should I start calling my proposal the “Sumner/ Hall/ Woodward plan?”

    You’ve opined in the previous thread comments, understandably, that you and I disagree on monetary policy, so take this advice for what it’s worth, which may not be much:


    My impression is that you would like to change the world. That means you want a new model that would map to a new operational reality.

    Suppose we think about monetary policy in 3 stages: pre-crisis, intra-crisis, and post-crisis.

    I think you have to be clear about 6 different models and 6 different mappings to operational reality.

    Three of those models are the Fed’s.

    Three of them are yours.

    The three Fed models are the two actual pre-crisis and intra-crisis models, and the third is their intended post crisis model. Your three models are your pre-crisis and intra-crisis counterfactuals, and your intended post crisis model.

    Then you have to be clear about how your 3 models map to your very specific counterfactual or proposed changes for the Fed “operating system” in each stage.

    I’ll give you just one example. I think you have to be clear on an intra-crisis basis regarding your related ideas that the Fed was too easy last fall and that the Fed should start charging for reserves. You need to map that to specific operational changes.

    One of my points was that your idea for interest charges on excess reserves must imply something about a related issue in terms of the role of the fed funds rate in your desired model. My point was that in the context of the Fed’s existing operating system, your first idea implies that the Fed should have dropped the target funds rate to zero much more quickly. That would be a first order of business in my view. Next would be the consistent treatment of reserves in that context. Your second idea about the treatment of reserves per se now implies something about the rule for the fed funds rate, but I can’t figure out what your position is based on what you have written. Your concern about reserve interest seems disembodied from the current Fed relationship between the funds rate range and the lower bound of the funds rate range as a reserve rate. So I don’t know what you’re thinking about the operating rule for the funds rate, as it may affect your model for any of the three stages of the analysis as suggested.

    One of your commenters has made the point repeatedly that my only contribution here is describing how the Fed works now. I do that when I see proposals that don’t seem to me to hang together because they either contradict the current operating framework for the Fed, or they don’t propose what I think are the facilitating changes required to fit your model to an operating framework. I know where you stand on reserve interest, but I don’t know where you stand on the funds rate operating system as it exists now and as you think it should have existed in the past or should exist in the future. And until I understand that, I will continue to observe that your reserve interest proposal isn’t necessarily consistent with the current operating framework for the funds rate. But that’s just one example.

    The model at all stages needs to map to specific operational changes.

    That’s why if I were you I’d continue to develop my own model further, and not hang my hat together with any similar simultaneous but partial discovery of a potentially good elsewhere.

    P.S. I wouldn’t necessarily conclude myself that we disagree on monetary policy, at least until I can see your vision for a Fed operating framework. The jury currently may be leaning one way, but is still out.

  11. Gravatar of Alex Alex
    15. April 2009 at 09:16


    People seem to be confused about some things. There are very important differences between a change in the level of the money supply and a change in the money supply growth rate. The first one will generate inflation in the short run but not in the long run while the second one will increase inflation permanently. The type of monetary policy we are talking about now is the first one. Yes there is the risk of doing too much but it is also very easy to undo it (which as I explain later it is actually a problem). You put MB in buy buying treasuries and you can take it out by selling the same treasuries. Are we worried that a change in the treasuries price will make the Fed face a loss? That is nothing to the trillions we are talking about this days and in the end it is not really a loss, it is only a transfer from the Fed to the bond holders. Now are we worried about getting any inflation at all? Some people are, but if you want to stimulate the AD curve then you have to have the inflation. That is the short run Phillips curve. No such thing as a free lunch, or however you want to call it. So you either live with the high inflation in the short run and a lower unemployment or have low inflation and high unemployment. You choose. Now of course there is a way in which we can try to cheat. The Fed can increase the Money supply and say it is a permanent change once the economy recovers and the price level starts to catch up to the new higher money supply then the Fed can pull out the additional cash from the economy then the issue becomes what credibility will the Fed have to generate inflation the next time it is called to save the world from a deflation (see the time inconsistency post form a couple of days ago). Also it could be the case that people anticipate now that the Fed will remove the additional money once things improve and hence the current increase in the money supply is not taken as permanent and has no effect. So we need to do two things:

    * Increase the Money Supply in a way that is credible to be permanent.

    * Do not attempt to remove the money supply in the future under any circumstance. If the Fed overshoots then suck it up, live with your mistakes and learn for the next time.

    “Alex, I appreciate the goal you have, but we can do this without a lot of added debt, which is the last thing we need.”

    As I posted many times in this blog I think that the best way to achieve a credible inflation promise is by sending tax rebates out financed by new debt and having that debt monetized by the Fed. This is in the closest thing to a helicopter drop (i.e. a permanent increase in the money supply). Scott notice that since debt in hands of the public does not increase and the price level goes up, the real burden of the debt has actually gone down. Another important feature of this policy is that is the most fair policy I can think of. Everybody gets the additional cash, it is not directed to borrowers, nor lenders, nor banks, nor AIG, nor any group in particular. The cost? Well as I mentioned before the real value of the debt goes down so bond holders loose, In general anybody holding dollar denominated assets loses (inflation tax) which to me it means: let China pick up the tab.

    “Where is the other more than $2000 per capita? Hoarded by tax evaders, criminals, and foreigners.”

    Are you talking to me?

    One last thing, I don’t see the similarities between Argentina in 2001 and the US in 2008. First it is hard to find a measure of monetary tightness when you have a curency board. I guess the Real Exchange rate would be the measure we would want to look at. Dollar interest rates in Argentina (equivalent to real rates in the US) are not a good measure of tightness becuase they are contaminanted by the country risk. It is true that Argentina was having a deflation, but the deflation had started in 1999. It is also true that the real exchange rate was appreciated. Notice that since we were pegged against the dollar and we were having a deflation then we were depreciating in real terms against the dollar but the US was not our major trade partner so the relevant peso was overvalued relative to the real and the euro, which hurt Argentina’s exports. Larry Sjaastad recommended that Argentina should have changed the currency board from a peg on the dollar to a peg on a basket of currencies. Looking back he was probably right. But in the end that would have been just a way to buy some additional time. Monetary policy was not the culprit in Argentina’s fall. The problem is that permanent fiscal deficits are not consistent with fixed exchange rate regimes. Yes, you can devalue the currency once (lose monetary policy) and promise never to do it again … but who was going to believe that? Argentina’s crisis was not caused by an increase in the money demand which was not met by the Central Bank. When things go bad in Argentina we do like anybody else and we jump to liquid safe assets, and the peso is not one of those. So money (pesos) demand falls and money (dollar) rises. In the end the problem is not tight monetary policy but an anticipated lose monetary policy in the near future due to high fiscal deficits.


  12. Gravatar of nacken nacken
    15. April 2009 at 11:51


    I agree with you on the fact that a deflationary spiral is more dangerous than inflation overshooting.

    But there may be a problem with regard to inflation targeting or NGDP targeting if the world economy returns to robust growth. Then it is very likely that some commodity prices and especially energy will also recover due to simple demand/supply forces and scarcity of ressources. If I recall right the discussion preceeding on inflation in Europe preceeding the crisis were primarily about this kind of “imported” inflation.

    This may create a problem for simple rule-based NGDP and inflation targeting, as this kind of price increase is not related to the dangers of a inflationay price-wage spiral but could plant the seeds if there is an overshooting. What should a central bank do in such a situation?

    Maybe there was already an answer to this question earlier in this blog. Sorry if this was the case.

    P.S. Great blog.

  13. Gravatar of ssumner ssumner
    15. April 2009 at 16:22

    JKH, To be precise, it is the monetary base, not cash. But basically the monetary base is completely determined by the Fed. Banks cannot return base money they don’t want to the Fed. All they can do is loan it to others. I referred to cash because I assumed my plan would hold down reserve demand, and thus in practice most of the new base money would be cash. And see Nick’s comment below.

    DWj, Even at a 2% fed funds rate (such as last June) there was very little demand for excess reserves. I think a 2% penalty would do the job. Vault cash would also be counted as part of reserves (or else capped) so that’s not an escape hatch for banks.

    Nick, Thanks. How was your vacation?

    JKH, The fundamental theorem in monetary theory is that the central bank controls the nominal supply of money and the public controls the real demand. Between them they control the price level. That’s not just “on my blog” that’s as basic as you can get: Money 101.

    Bill, You are right that I should have included required reserves. As a practical matter it would be almost all cash, but if RRs went up too, that’s fine.

    Septizoniom2, I don’t know what goes on inside the Fed, but I recently heard someone say there was a dispute over the interest on reserves idea. Those that had pushed for it for a long time insisted on going forward. I do know that nobody inside the Fed understands this issue better than Robert Hall, or even as well.

    Dilip, Thanks, I’m sure no disrespect was intended.

    David, Let me start by saying that I definitely don’t agree with point 4, so if you think I am in any way basing my argument on that point, I am being misunderstood. I’m not sure what you mean when you ask how long is the lag between NDP expectations and reality. I’m inclined to say the lag between one year forward expected NGDP and reality is one year, and the lag between two-year forward NGDP and reality is two years, and so on. But I probably misunderstood you. Maybe you could rephrase the question.

    You ask at what level of unemployment should the Fed act aggressively. I think the Fed should pay no attention to unemployment. I favor having the Fed target NGDP growth at 5%. Ideally they would use futures contracts. In that case the expected rate of growth in NGDP would always be 5%. To me that would be ideal. Obviously we can never perfectly stabilize actual NGDP, so stabilizing expected NGDP is the next best thing. By the way, this is not some wild theory, Bernanke has also publicly endorsed targeting the forecast, but out over 3 to 5 year ranges, not the one year range I prefer. Also, he favors inflation targets (which even in my view makes a lot of sense if you go out 5 years) I favor NGDP, which makes more sense over a shorter time horizon. If we cannot do futures targeting, then I favor having the Fed set policy is such a way such that their internal forecast unit expects that they will at least come close to hitting their target. I don’t expect perfection. Obviously it’s much harder without the benefit of futures contracts, but they are clearly far off course now, and could certainly do better even under discretion.
    I don’t worry too much about brief fluctuations in actual NGDP growth, what hurts the economy badly is when policy loses credibility, and the expected NGDP growth going out several years falls far below the Fed’s implicit target. That’s what happened last October. There’s a reason the stock market crashed when it did.

    JKH#3, I have only one model, target NGDP growth at 5%. If the Fed insists on using the silly fed funds instrument, I will give them the best advice I can–such as lower it to zero in October. If they fail, and stumble into a liquidity trap because they haven’t maintained expectations of strong NGDP growth, then obviously they can’t cut the fed funds rate anymore. If they still refuse my futures targeting idea, then obviously I have to advise unconventional procedures–as even the Fed realized on March 18. So I will first advise the interest penalty, so that they don’t need such massive QE. It seems like three models, but only because the Fed keeps painting itself into a corner, and forcing us outsiders to develop new strategies.

    Alex, We’ll have to agree to disagree. I just don’t favor the high inflation your plan would produce. But even it might be less bad than current policy. Argentina’s problems were monetary. The peso got overvalued (at first in the late 1990s as you say) and deflation resulted. Deflation is a purely monetary problem. I cannot emphasize enough that fiscal problems are a SYMPTOM of deflation, not a cause, just as round two of the financial crisis last fall was a SYMPTOM of tight money and worsening recession, not a cause. BTW, Larry Sjaasted was my teacher long ago.

    Nacken, I don’t view imported inflation as being a big deal. As we saw last year, it doesn’t effect NGDP much, nor does it affect nominal wages. In an earlier post I talked about how those variables are more important for macro stability than the headline CPI. When the import price bubble passes away it won’t hurt the economy if you keep NGDP growing about 5%/year. James Hamilton thinks the oil shock tipped us into recession. But oil shocks don’t reduce NGDP–check out the 1970s!

  14. Gravatar of Bill Woolsey Bill Woolsey
    15. April 2009 at 16:49

    Sorry to be rude.

    Arguments of the form, “the Fed does it this way,” are irrelevant to proposals that the Fed do it a different way.

    The Fed has targeted the Federal Funds rate. That approach failed. It needs to do something different–at least now.

    In particular, a policy of passively supplying currency to meet withdrawals by banks is not essential to monetary policy. And that the Fed has had that policy has nothing to do with the ability of the Fed to control base money.

    If the Fed chooses not to control base money, then, of course, it doesn’t control base money.

    Anyway, how does the Fed “force” the public to hold currency? It doesn’t.

    The proposal to charge penalty rates on excess reserves will cause the banks to expand their balance sheets. This process will continue until either people hold sufficient transactions balances so that all the reserves are required or else people are willing to hold increased currency. Either the banks will demand the existing quantity of reserves or else reserves will be drained from the banking system to meet currency demand.

    And the key result is that the demand for the monetary base will rise to meet the quantity. The split between currency and reserves isn’t important.

    I don’t know, but I presume Sumner was going with the simple “currency-deposit” ratio approach. And so, the demand for currency is a fraction of the deposits. As the banks expand deposits, the demand for currency rises.

    In the end, however, the reason currency demand rises will be higher nominal income.

    A dollar of currency defines he dollar. A dollar of deposit is worth a dollar because it is redeemable in terms of the currency that defines the dollar. Other financial instruments have market prices that vary in terms of dollars. And the goods and services that make up the flow of income and output, as well as the resources used to produce that output all have variable prices in terms of dollars.

    A unit of currency that defines a dollar has no variable market price in terms of dollars.

    These are essential considerations of monetary policy. That a central bank chooses to passively adjust the quantity of currency in ways consistent with keeping some interest rate at a varying target is just one possible way of manipulating the quantity of currency.

  15. Gravatar of JKH JKH
    15. April 2009 at 17:23


    “Banks cannot return base money they don’t want to the Fed. All they can do is loan it to others.”

    Where do you get this idea?

    Banks can obviously redeem currency in exchange for deposits with the Fed. That will boost excess clearing balances at the Fed. The Fed will OMO the same amount out of the system to control the fed funds level. The base contracts as a result. This happens all the time, particularly when currency demand is volatile; e.g. peak seasonal demand around Christmas holidays when the Fed increases currency followed by a drop afterwards when it reduces it.

  16. Gravatar of JKH JKH
    15. April 2009 at 17:25

    “Anyway, how does the Fed “force” the public to hold currency? It doesn’t.”

    That was Scott’s oontention, to which I was indirectly responding by asking you how you would deal with it.

  17. Gravatar of Alex Alex
    15. April 2009 at 17:30


    I don’t favor it either. I just point that if inflation is what you want there is a very simple way to get it. The problem is that some people want the inflation but don’t want to live with the concenquences. But that is cheating, sometimes you can do it but in the end it is not beneficial.

    Going back to the case of Argentina. I agree with the view that inflation is always and everywhere a monetary phenomenom as you do. The thing is that I don’t view monetary policy independently of fiscal policy. High inlfation countries don’t have hyperinflations just because their central bankers are stupid and print money just because. They have to print the money because they have to resort to the inflation tax. In your models the Fed and the Treasury each have a budget constraint while in mine there’s only one. Argentina’s real exchange rate problems didn’t force the government to run fiscal deficits. I actually think the causality ran from the fiscal deficit to the current account deficit. There was nothing the central bank of Argentina could have done to prevent the crisis specially since inflating away the debt was not an option given that Argentina’s debt was dollar denominated. I don’t have so much faith in the independence of the Central Bank and in the end it is a slave to the treasury (i.e. the Central Banks lost the chicken game).

    I know Larry was your teacher. Even though many people didn’t like him I think he was a great teacher and his retirement was a loss for many students who are interested in real policy issues specially in developing economies.

  18. Gravatar of JKH JKH
    15. April 2009 at 17:34

    “The proposal to charge penalty rates on excess reserves will cause the banks to expand their balance sheets.”

    Only if they have the capital to support new assets according to their risk weighting. If they take on assets that are zero risk weighted, such as t-bills, they’ll do so until t-bill yields are driven negative as well. But either way, you’ll never get an asset and deposit expansion sufficiently large to mathematically convert the existing outsized level of excess reserves to required reserves. The Fed understands this, which is why they won’t charge interest on reserves.

  19. Gravatar of Bill Woosley Bill Woosley
    16. April 2009 at 03:32


    You again reply to Scott with statements about the Fed’s current operating procedure. So what?

    Banks cannot get rid of base money by depositing it into their reserve accounts at the Fed. All that does is change the form of base money.

    Then, you go on to say that the Fed will destroy base money to keep the Federal Funds rate from falling. Yes. There you go. The banks didn’t destroy base money. The Fed did in order to keep the Federal Funds rate at some target. That is the point. The banks didn’t destroy base money. The Fed did because it is targetting the Federal Funds rate–a failed policy that needs to change.

    There is 5 trillion in outstanding national debt. All of this has a zero risk weighting. Instead of transactions balances being $800 billion or so, they could be $5.8 trillion without any further increase in bank capital.

    Banks could also substitute transactions accouts for CDs.
    That could increase transations another $2 trillion.

    I think the policy irrelvant response that would first happen is that banks would report many savings accounts as transactions accounts. (The sweep accounts would stop operating.) No one keeps records on this, but that would double transactions accounts immediately according to some (old) estimates.

    And, of course, this could all lead to a currency drain. The argument that the Fed would increase currency (and base money) so that this has no impact on reserves is not a useful point.

    Now, if the purpose of all of this is to get banks to make more commercial loans, and there is no capital to support commerical loans, then, it cannot work. But that isn’t the point of the policy. If the Fed’s only interest is to expand some kind of lending and so, it will never do what Scott wants, then that just means that the Fed needs new leadership.

    Anyway, Scott isn’t arguing that the Fed can keep its target for the Federal Funds rate at some particular level and do what needs to be done. That needs to change.

    Negative yields on T-bills and other government bonds are a feature, not a bug.

    Negative yields on transactions deposits, savings accounts, and CDs at banks (FDIC insured financial instruments) are a feature, not a bug.

    If the Federal Funds rate turns negative, THE FED SHOULD _NOT_ implement open market sales to keep it on target.

    The point of the policy is to create a quantity of base money that would be equal to the amount that would be demanded in nominal income is on target. All interest rates should adjust however needed. Penalty rates on excess reserves decreases the quantity of base money demanded. Quantitative easing inceases the quantity of base money.

    I am not trying to argue that Federal Reserve policy is aimed at getting nominal income back to target. I don’t doubt that many things they are trying to do (say direct lending into what they consider to be troubled credit market) are irrelevant to getting nominal income back to target. So what?

    Arguments that all suggest, “you don’t understanda what the Fed is trying to do,” are beside the point. I don’t care what the Fed is trying to do now. I want the Fed to do something different. Get nominal income back to its previous growth path.

  20. Gravatar of JKH JKH
    16. April 2009 at 03:50

    “Banks cannot get rid of base money by depositing it into their reserve accounts at the Fed. All that does is change the form of base money.”

    You’re right. That’s true for individual banks.

    My point is that it’s not true for the banking system as a whole, when you take into account the Fed’s normal response to the redemption of currency.

    An individual bank will redeem currency in exchange for a credit to its deposit account with the Fed. That’s true and that’s your point.

    But the increase in clearing balances for the individual bank increases the level of excess clearing balances for the system. This is a function of the fact that banks typically carry more vault cash than what they have pledged as reserves. Additional customer redemptions of cash that are passed through to the Fed then have the potential effect of immediately increasing the excess reserve setting. Therefore, the Fed will normally drain that excess to avoid a decline in the Fed funds rate. That’s true and that’s my point.

    I’m also right.

  21. Gravatar of JKH JKH
    16. April 2009 at 03:56

    “You again reply to Scott with statements about the Fed’s current operating procedure. So what?”

    As far as I know, I’m not breaking the law by pointing out what I believe to be some flaws in the diagnosis of a condition on which a proposed remedy is based.

  22. Gravatar of JKH JKH
    16. April 2009 at 04:07

    “There is 5 trillion in outstanding national debt. All of this has a zero risk weighting. Instead of transactions balances being $800 billion or so, they could be $5.8 trillion without any further increase in bank capital.”

    Good point – very specific and operational. And it’s consistent with capital constraints. So it’s workable, provided the banks want to do it. Is it the right thing to do? I don’t know.

  23. Gravatar of JKH JKH
    16. April 2009 at 04:17

    “Anyway, Scott isn’t arguing that the Fed can keep its target for the Federal Funds rate at some particular level and do what needs to be done. That needs to change.”

    I know. I’ve been trying to find out what his specific proposed mechanism is that would replace the current operating framework for a target fed funds rate, and the Fed’s management of the effective fed funds’ rate against that target. So far – no luck. I suppose that’s partly why I keep raising issues about the current operating framework – I have nothing to compare it to by way of a specific proposal, other than charging interest on reserves, which is disembodied from a required but absent integrated proposal. And that’s why I suggested mapping his model to a new operating system for the Fed.

    With all due respect, saying “That needs to change” is about as specifically illuminating as “Yes we can”.

  24. Gravatar of JKH JKH
    16. April 2009 at 04:33

    Scott said he has one model.

    So does the model include abandonment of fed funds rate targeting now and forever?

  25. Gravatar of David Pearson David Pearson
    16. April 2009 at 06:07


    My point is that NGDP expectations turn up ahead of NGDP. You would count this as a “victory”, but my view is you put too much stake in the stability of expectations.

    Scenario: with unemployment still near 10% (down from 12%), NGDP expectations begin to turn up rather steeply. The Fed has to decide how much to raise the interest rate on reserves. It has two choices: 1) Greenspan/Bernanke’s “measured pace” approach, which essentially communicates that there is no risk of an inflationary overshoot so the Fed can “go slow”; or 2) an “aggressive” raise, which presumably you would prefer.

    If the Fed chooses the second scenario, the market will adjust GGDP expectations downward. You assume that this will be a slight drift down to the target level. Perhaps. Just as likely, if not more, is that the market will overshoot. It will be concerned that a stimulus-driven recovery will collapse once the second derivative of stimulus changes meaningfully. In other words, in the absence of a self-sustaining growth dynamic, the market may well conclude that, “the party’s over”. What would be the consequence? Higher credit spreads, lower credit availability, lower consumer confidence, a higher dollar, higher Treasury yields (given the prospective absence of Fed support for a still-massive budget deficit).

    So basically, we go quickly back into a negative NGDP-expectation spiral. The Fed, according to your game plan, must then adjust by announcing an increase in stimulus.

    This is known as stop-go monetary policy. It is the chief criticism of the kind of monetary free-lunch that you seem to believe in. Why not address it head on? It is simply not sufficient to say that the Fed can rely on the stability of NGDP expectations. Again, that assumes a “point 4)” V-shaped, self sustaining recovery.

  26. Gravatar of JKH JKH
    16. April 2009 at 06:35

    My impression is that Scott’s model advocates targeting nominal GDP and supplying enough base money to achieve this goal on an ongoing basis.

    I’m going to assume that the answer to my previous question is yes – that the Fed should no longer target the fed funds rate as part of its operating framework. It should only concentrate on supplying the right amount of base money.

    Scott also advocates that the Fed should charge interest on excess reserves at this time.

    Since there is only one model, I’m going to assume that the model allows the Fed to determine the rate applicable to excess reserves at all times.

    But this is a contradiction. If the Fed determines the rate for excess reserves, that is the rate that serves as the natural lower bound for the rate at which banks are willing to trade reserves with each other. But that is the Fed funds market by definition. So if the Fed determines the rate for reserves, it is effectively setting the rate for a fed funds market.

    I suppose this might not be the case if the model says that the determination of a negative interest rate on reserves is a one-off requirement for this crisis. This would translate to an operating framework that allows the Fed to set interest rates on reserves only if the interest rate is less than or equal to zero. But I’m not assuming the model has such a rule.

    Therefore, I’m assuming the Sumner model targets interest rates as part of its operating framework.

    As I understand it, the new model would be different therefore, not in the substance of its operational interest rate targeting, but in the domain of its economic targeting. It would specifically target nominal GDP.

    I would actually compare the Sumner model to the Volcker framework.

    I think it’s understood that Volcker’s “strategic” monetary target was broad money supply. Remember everybody going over to the ticker tape at 4 p.m. on Thursdays and waiting breathlessly for the M report and then watching the bond market react? Volcker targeted broad money. When he thought broad money was increasing too fast, he raised rates aggressively.

    Beyond that, my interpretation of what Volcker did is probably different from the conventional view, but perhaps somewhat consistent with the way in which I approach the Sumner framework. The mechanism by which Volcker raised rates was substantially no different than what Greenspan or Bernanke did. He squeezed the level of excess reserves in the system in order to get an immediate interest rate response from the banks in terms of the fed funds rate. There was one operational difference in that he didn’t announce it in quite the way that the Fed does today. So there was somewhat more of an element of surprise in the timing, and probably marginally more pressure required on system excess reserve settings due to both this surprise element and the aggressiveness of the rate hikes, compared to what might be required under the announcement regime of today. But these are relatively minor differences in operational features. The bottom line is that when Volcker didn’t like the money supply growth, he raised the fed funds rate.

    So the monetary policy response mechanism hasn’t really changed at all. What has changed is the domain of economic or “strategic” targeting. Greenspan and Bernanke became a lot more eclectic in their focus than money supply, to the point where eventually they almost ignored money supply.

    So my reading of the Sumner Reserve System is that it is nearer to the Volcker system, in the sense that it targets a fairly focused economic rule – nominal GDP – comparable in this sense to Volcker’s money supply.

    The question remains, does the Sumner Reserve System target short term interest rates, essentially in the same way that Volcker, Greenspan, and Bernanke did in support of targeting their chosen strategic variables, in order to implement this system of targeting nominal GDP?

    As noted, unless I’m educated otherwise, it would seem to do that.

  27. Gravatar of JKH JKH
    16. April 2009 at 15:23

    Above, I questioned the following statement:

    “Banks cannot return base money they don’t want to the Fed. All they can do is loan it to others.”

    Having claimed this is not true for the banking system as a whole, I’ve dug up several examples from the Fed’s own data base to demonstrate this.

    In review, when individual banks redeem currency at the Fed, the Fed will credit their clearing accounts. This will increase excess reserve levels. As I noted above, this is a function of the fact that banks typically carry more vault cash than what they have pledged as reserves. Additional customer redemptions of cash increase bank’s level of vault cash even more. Therefore, redemptions of vault cash at the Fed in return for clearing balances that count toward reserves results in an increase in the level of excess reserves via those increased clearing balances.

    The Fed will then normally withdraw such excess reserves from the system via OMO, which results in a return of system excess reserves back to normal levels. The Fed must do this because the effective fed funds rate is normally hypersensitive to the level of excess reserves (pre September 2008; pre payment of interest on reserves).

    This dynamic as described often happens around year end, when the public typically has a greater demand for currency. This is followed by currency redemptions early in the following year.

    Thus, when the public and the banks redeem currency on a net basis at the Fed, the full dynamic effectively forces a contraction of the monetary base. This contraction is attributable ultimately to the constraint of finely tuned excess reserve levels in the normal operation of the Fed (i.e. pre September 2008). The idea that the banks cannot return base money to the Fed is a variation on the fallacy of composition, considering this usual constraint on excess reserve levels.

    The examples follow. Each data item is from a distinct data series found here:


    December 2007/February 2008 ($ billions):

    Total Reserves 42.7 / 42.7
    Required Reserves 40.9 / 41.0
    Excess Reserves 1.8 / 1.7
    Clearing Balances 8.2 / 8.2
    Total Vault Cash 52.1 / 53.6
    Reserve Vault Cash 34.5 / 34.6
    Monetary Base 836 / 829

    The monetary base declined by $ 7 billion; clearing balances were unchanged. This means currency redeemed by the banks was $ 7 billion. Total vault cash increased by $ 1.5 billion. This means currency redeemed by the non-bank public was about $ 8.5 billion. The monetary base was forced to contract by the Fed’s maintenance of the excess reserve setting at a relatively constant level.

    December 2006/February 2007 ($ billions):

    Total Reserves 43.3 / 42.6
    Required Reserves 41.4 / 41.1
    Excess Reserves 1.8 / 1.5
    Clearing Balances 8.5 / 7.6
    Total Vault Cash 50.9 / 53.7
    Reserve Vault Cash 34.8 / 34.9
    Monetary Base 825 / 820

    The monetary base declined by $ 5 billion; clearing balances declined by $ .9 billion. This means currency redeemed by the banks was about $ 4.1 billion. Total vault cash increased by $ 1.5 billion. This means currency redeemed by the non-bank public was about $ 5.6 billion. The monetary base was forced to contract by the Fed’s maintenance of the excess reserve setting at a relatively steady level.

  28. Gravatar of ssumner ssumner
    16. April 2009 at 16:54

    JKH, Many of your points are based on a fundamental mistake. You assume that commercial banks control the monetary base, and not the Fed. It makes no difference if 1000 times in a row when banks return $47,000,000 dollars in cash to the Fed, the Fed reduces the monetary base by exactly $47,000,000. The point is that it is entirely the Fed’s choice. They control the base.

    If they don’t control the base when rates hit zero, then there is no stopping the base from spiraling downward, and deflation could last indefinitely, even with trillions in fiscal stimulus. They know that, and that’s why they are taking things into their own hands with QE, and forcing money out there.

    Bill, I entire agree. BTW, when I said it will all go into currency, I should have mentioned that a bit will go into required reserves. Your reply to JKH is more complete than mine.

    Alex, I don’t know for certain that the fiscal deficit was caused by deflation. But look what’s happened to our fiscal deficit with a tiny amount of deflation and a small depression. Argentina had a lot of deflation and a bigger depression. So it’s hard for me to believe that the monetary policy wasn’t a big factor in the fiscal deficit. But perhaps irresponsible spending was also part of the story. It is Argentina, after all.

    JKH, No one is suggesting adding $800 billion to required reserves, that would produce 1000% inflation. Even adding it to cash would produce 100% inflation.

    David, As bad as stop-go policies are, and they are certainly not my first choice, they are far better than what we have. I also don’t understand your concern with lags and uncertainty. We have that under any discretionary Fed policy. The current Fed policy has produced the most amount of uncertainty of any I have seen in a long while. I don’t see how my proposal would produce more uncertainty, but I do see how it would move the median forecast for NGDP growth closer to the target.

    My first choice is NGDP futures targeting, where the circularity problem you mention goes away. For readers who don’t know, the circularity problem occurs when you try to target market expectations, but don’t let the market actually set the monetary instrument. In that case, it’s hard to know which movement in the instrument would be necessary to hit the target. What I find so ironic about all this is that for 23 years I have presented papers in many settings (including several Fed banks like the NYC Fed) where I argued for futures targeting, which would eliminate the problems you raise. I was constantly reassured that the Fed knew what it was doing, that it could forecast the economy better than the markets. Now we get into a crisis and I’m being constantly told the Fed can’t target the forecast. I’d love to be able to go back to all those seminars and show them a newspaper from the future, showing that I was right about the danger of relying on internal Fed forecasts. But let me also say that even with all the circularity problem, which does prevent them from precisely targeting the forecast, they could do far, far better than the current policy–which is way off course.

    JKH, The previous paragraph addresses my optimal policy. If they insist on sticking with a discretionary regime then they obviously cannot rely on the fed funds rate right now. so new tactics are needed, like an interest penalty. By constant policy I meant not tactics, but overall strategy, which should always be 5% expected NGDP growth in my view.

  29. Gravatar of JKH JKH
    17. April 2009 at 01:42


    I’ve not said or implied that commercial banks control the monetary base. At an operational level, the central bank controls the level of excess reserves, and public and commercial bank demand for currency controls the currency component of the monetary base. You and I do seem to disagree on it; it’s an observable fact as far as I’m concerned. But I haven’t said or implied that commercial banks control the monetary base.

    What I did say was that it was possible for the actions of the public and the commercial banks with regard to their own currency demand to cause a fairly predictable change in the size of the total monetary base, given the normal response of the central bank in controlling the level of excess reserves. You said it wasn’t possible in the quoted statement. I provided the reasoning and examples to the contrary. The examples tell the story. The precipitating action comes from the public. The reaction comes from the central bank. The central bank is normally constrained in controlling the level of excess reserves because it wants to control the fed funds rate. That’s why their reaction is predictable, and why the examples bear that predictability out. And the fact that the central bank does control excess reserve levels explains exactly why and how they withdraw reserves so predictably in response to the redemption of currency. Moreover, the stability of the excess reserve time series proves beyond a doubt that this sort of central bank response to volatility in outstanding currency must happen regularly under normal operating conditions.

  30. Gravatar of Bill Woolsey Bill Woolsey
    17. April 2009 at 02:33


    Just because what the Federal Reserve has done is fairly predictable doesn’t mean that it isn’t the Federal Reserve changing base money. When your argument gets to the point, the Fed understakes open market sales to absorb the reserve balances, you have granted the only point that is being made. The Fed has to take action to change base money.

    Paying interest on reserves (or charging banks to store excess resreves) doesn’t imply a target for the Federal Funds rate. While it does create a lower bound for the Federal Funds rate to some degree, (clearly not entirely since the effective rate has remained below the interest rate paid on reserve balances for some months now,) that allows for plenty of room above that lower bound for the Federal funds rate to fluctuate based upon market forces.
    Also, the Fed could pay 50 basis points less than the effective Federal Funds rate. Or 100 basis points below the interest rate on the 4 week T-bill in the secondary market. With such a policy, the rate paid on reserve balances would not create a lower bound on interest rates.

    I believe that Scott favors using the quantity of base money as the policy intrument and the growth path of nominal income as the policy goal. The level of base money at any point in time, however, depends on the response of a variety of financial market indicators. It isn’t clear to me how that translates into periodic instructions to the open market trading desk.

    My understanding of the nominal income index futures trading is a bit different from Scott’s, I think, but the way I see it, the open market trading desk would be instructed to use open market operations in bonds to keep the Fed’s position in the futures contract at zero. So, if there are currently more bears than bulls in that market, so that the Fed is buying contracts (offsetting the position of some of the bears,) then the open market trading desk must purchase bonds in whatever amount needed until some bears close their position or new bulls appear, either of which effectively closes the Fed’s open position as a buyer of the contracts. The private sector bulls and bears match up.

    If on the other hand, there are more bulls than bears on the market, the Fed must sell bonds to whatever degree needed so that some bulls close their position or bears appear on the market, effectively allowing the Fed to close its open position as a seller of the futures.

    The Fed pegs the price of the future by buing and selling the contracts at the target price. That always leaves the Fed holding the opposite position as the rest of the market. Then the open market trading desk buys and sells government bonds (and so determiens the quantity of base money) so that the Fed’s position on the contract is at zero.

    In equilibrium, market sentiment is balanced between bulls and bears. The Fed has no open position. When nominal income is realized, funds are transfered between the bulls and the bears based on who was correct.

    The Fed will only have a position on the contract if the open market trading desk failed to move market sentiment enough to close the Fed’s position on the contract. And then, the Fed will either make or lose money on the contract depending on the realization of nominal income.

    If the rest of the monetary system is more or less the same, base money, and open market purchases would be increasing all the time, and so the “purchases” and “sales” described above would be more rapid purchases or slower purchases. But, of course, slower purchases shades over into net sales as well.

  31. Gravatar of JKH JKH
    17. April 2009 at 11:28

    Bill Woolsey,

    Thanks for your comment. We are debating a pretty fine point here, but one that I find important. We’re reasonably close but still quite different in the way we characterize what’s going on. In fact, the first paragraph of my previous comment doesn’t contradict the first paragraph of your response. So I’ll give it a rest for now. Perhaps I’ll be able to express my points better sometime in the future.

  32. Gravatar of Random Links XXXXII « Random Musings of a Deranged Mind Random Links XXXXII « Random Musings of a Deranged Mind
    15. May 2009 at 16:56

    […] is often asserted (also here; critiques here & here) that recent massive increases in the Fed’s balance sheet carries a significant risk of […]

  33. Gravatar of Vince Vince
    11. September 2013 at 00:53

    Scott has to use Italy as an example of a country not resorting to inflation to get rid of its debt. But Italy is on the Euro and can not resort to inflation. Japan is the only real counterexample and if I am right people soon will not want to hold it up as an example. Be interesting to see the next BOJ report tonight at 9 PM.

    If Italy tried to return to the Lira before fixing their deficit they would get hyperinflation right away.

    The Fed may suffer some capital losses. He thinks if the market is efficient they won’t? Can you follow any logic there? Central banks can artificially depress the price on long term bonds by being huge buyers and then have losses when they later try to sell them. He thinks that a gigantic government distortion of the market can’t happen by efficient market theory? He is wrong.

    When an economist says that if things don’t work out the way he predicts it could only be because people at the central bank or government are grossly negligent, he has left himself a copout. This economist will throw out all experimental results that contradict his theory by saying, “well in that case those humans were bad”. It is not real science.

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