The Perils of Powell: Inflation, Illiquid Banks, Lonnng Lags

01 Saturday Apr 2023

Posted by Nuetzel in Inflation, Monetary Policy

Tags

Austrian Business Cycle Theory, Boom and bust, CPI, David Beckworth, Federal Funds Rate, Federal Open Market Committee, FOMC, Hard Landing, Hedging, Inflation, Interest Rate Risk, Jason Furman, Jerome Powell, Lender of Last Resort, Liquidity, Money Supply, NBER, Owner’s Equivalent Rent, PCE Deflator, Price Stability, Quantitative Tightening, Rate Targeting, Shelter Costs, Soft Landing

To the great chagrin of some market watchers, the Federal Reserve Open Market Committee (FOMC) increased its target for the federal funds rate in March by 0.25 points, to range of 4.75 – 5%. This was pretty much in line with plans the FOMC made plain in the fall. The “surprise” was that this increase took place against a backdrop of liquidity shortfalls in the banking system, which also had taken many by surprise. Perhaps a further surprise was that after a few days of reflection, the market didn’t seem to mind the rate hike all that much.

Switchman Sleeping

There’s plenty of blame to go around for bank liquidity problems. Certain banks and their regulators (including the Fed) somehow failed to anticipate that carrying large, unhedged positions in low-rate, long-term bonds might at some point alarm large depositors as interest rates rose. Those banks found themselves way short of funds needed to satisfy justifiably skittish account holders. A couple of banks were closed, but the FDIC agreed to insure all of their depositors. As the lender of last resort, the Fed provided banks with “credit facilities” to ease the liquidity crunch. In a matter of days, the fresh credit expanded the Fed’s balance sheet, offsetting months of “quantitative tightening” that had taken place since last June.

Of course, the Fed is no stranger to dozing at the switch. Historically, the central bank has failed to anticipate changes wrought by its own policy actions. Today’s inflation is a prime example. That kind of difficulty is to be expected given the “long and variable lags” in the effects of monetary policy on the economy. It makes activist policy all the more hazardous, leading to the kinds of “boom and bust” cycles described in Austrian business cycle theory.

Persistent Inflation

When the Fed went forward with the 25 basis point hike in the funds rate target in March, it was greeted with dismay by those still hopeful for a “soft landing”. In the Fed’s defense, one could say the continued effort to tighten policy is an attempt to make up for past sins, namely the Fed’s monetary profligacy during the pandemic.

The Fed’s rationale for this latest rate hike was that inflation remains persistent. Here are four CPI measures from the Cleveland Fed, which show some recent tapering of price pressures. Perhaps “flattening” would be a better description, at least for the median CPI:

Those are 12-month changes, and just in case you’ve heard that month-to-month changes have tapered more sharply, that really wasn’t the case in January and February:

Jason Furman noted in a series of tweets that the prices of services are driving recent inflation, while goods prices have been flat:

A compelling argument is that the shelter component of the CPI is overstating services inflation, and it’s weighted at more than one-third of the overall index. CPI shelter costs are known as “owner’s equivalent rent” (OER), which is based on a survey question of homeowners as to the rents they think they could command, and it is subject to a fairly long lag. Actual rent inflation has slowed sharply since last summer, so the shelter component is likely to relieve pressure on CPI inflation (and the Fed) in coming months. Nevertheless, Furman points out that CPI inflation over the past 3 -4 months was up even when housing is excluded. Substituting a private “new rent” measure of housing costs for OER would bring measured inflation in services closer the Fed’s comfort zone, however.

The Fed’s preferred measure of inflation, the deflator for personal consumption expenditures (PCE), uses a much lower weight on housing costs, though it might also overstate inflation within that component. Here’s another chart from the Cleveland Fed:

Inflation in the Core PCE deflator, which excludes food and energy prices, looks as if it’s “flattened” as well. This persistence is worrisome because inflation is difficult to stop once it becomes embedded in expectations. That’s exactly what the Fed says it’s trying to prevent.

Rate Targets and Money Growth

Targeting the federal funds rate (FFR) is the Fed’s primary operational method of conducting monetary policy. The FFR is the rate at which banks borrow from one another overnight to meet short-term needs for reserves. In order to achieve price stability, the Fed would do better to focus directly on controlling the money supply. Nevertheless, it has successfully engineered a decline in the money supply beginning last April, and recently the money supply posted year-over-year negative growth.

That doesn’t mean money growth has been “optimized” in any sense, but a slowdown in money growth was way overdue after the pandemic money creation binge. You might not like the way the Fed executed the reversal or its operating policy in general, and neither do I, but it did restrain money growth. In that sense, I applaud the Fed for exercising its independence, standing up to the Treasury rather than continuing to monetize yawning federal deficits. That’s encouraging, but at some point the Fed will reverse course and ease policy. We’ll probably hope in vain that the Fed can avoid sending us once again along the path of boom and bust cycles.

In effect, the FFR target is a price control with a dynamic element: the master fiddles with the target whenever economic conditions are deemed to suggest a change. This “controlled” rate has a strong influence on other short-term interest rates. The farther out one goes on the maturity spectrum, however, the weaker is the association between changes in the funds rate and other interest rates. The Fed doesn’t truly “control” those rates of most importance to consumers, corporate borrowers, government borrowers, and investors. It definitely influences those rates, but credit risk, business opportunities, and long-term expectations are often dominant.

The FOMC’s latest rate increase suggests its members don’t expect an immediate downturn in economic activity or a definitive near-term drop in inflation. The Committee may, however, be willing to pause for a period of several meeting cycles (every six weeks) to see whether the “long and variable lags” in the transmission of tighter monetary policy might begin to kick-in. As always, the FOMC’s next step will be “data dependent”, as Chairman Powell likes to say. In the meantime, the economic response to earlier tightening moves is likely to strengthen. Lenders are responding to the earlier rate hikes and reduced lending margins by curtailing credit and attempting to rebuild their own liquidity.

Is It Supply Or Demand?

There’s an ongoing debate about whether monetary policy is appropriate for fighting this episode of inflation. It’s true that monetary policy is ill-suited to addressing supply disruptions, though it can help to stem expectations that might cause supply-side price pressures to feed upon themselves (and prevent them from becoming demand-side pressures). However, profligate fiscal and monetary policy did much to create the current inflation, which is pressure on the demand-side. On that point, David Beckworth leaves little doubt as to where he stands:

“The real world is nominal. And nominal PCE was about $1.6 trillion above trend thru February. Unless one believes in immaculate above-trend spending, this huge surge could 𝙣𝙤𝙩 have happened without support from fiscal and monetary policy.”

In reality, this inflationary episode was borne of a mix of demand and supply-side pressures, and policy either caused or accommodated all of it. Nevertheless, it’s interesting to consider efforts to decompose these forces. This NBER paper attributed about 2/3 of inflation from December 2019 – June 2022 to the demand-side. Given the ongoing tenor of fiscal policy and the typical policy lags, it’s likely that the effects of fiscal and monetary stimulus have persisted well beyond that point. Here is a page from the San Francisco Fed’s site that gives an edge to supply-side factors, as reflected in this breakdown of the Fed’s favorite inflation gauge:

Of course, all of these decompositions are based on assumptions and are, at best, model-based. Nevertheless, to the extent that we still face supply constraints, they would impose limits to the Fed’s ability to manage inflation downward without a “hard landing”.

There’s also no doubt that supply side policies would reduce the kinds of price pressures we’re now experiencing. Regulation and restrictive energy policies under the Biden Administration have eroded productive capacity. These policies could be reversed if political leaders were serious about improving the nation’s economic health.

The Dark Runway Ahead

Will we have a recession? And when? There are no definite signs of an approaching downturn in the real economy just yet. Inventories of goods did account for more than half of the fourth quarter gain in GDP, which may now be discouraging production. There are layoffs in some critical industries such as tech, but we’ll have to see whether there is new evidence of overall weakness in next Friday’s employment report. Real wages have been a little down to flat over the past year, while consumer debt is climbing and real retail sales have trended slightly downward since last spring. Many firms will experience higher debt servicing costs going forward. So it’s not clear that the onset of recession is close at hand, but the odds are good that we’ll see a downturn as the year wears on, especially with credit increasingly scarce in the wake of the liquidity pinch at banks. But no one knows for sure, including the Fed.

Oh To Squeeze Fiscal Discipline From a Debt Limit Turnip

01 Wednesday Feb 2023

Posted by Nuetzel in Fiscal policy, Monetary Policy

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Brinksmanship, British Consols, Congressional Budget Office, consumption tax, David Andolfatto, Debt Limit, Debt to GDP, Entitlement Trust Funds, Extraordinary Measures, Fed Independence, Federal Debt, Federal Default, Federal Reserve, Fiscal Restraint, Income Tax, Inflation tax, IRS, Janet Yellen, Joe Biden, John Cochrane, Josh Barro, Kevin McCarthy, Matt Levine, Modern Monetary Theory, Monetarist Arithmetic, Neil Wallace, Pandemic Benefits, Payment Prioritization, Perpetuities, Platinum Coin, Premium Bonds, Privatization, Rashida Tlaib, Rohan Grey, Saving Incentives, Thomas Sargent, Treasury Debt, Trillion Dollar Coin, Value Added Tax

It’s as if people view the debt limit controversy as a political nuisance rather than the stopgap enforcement mechanism for fiscal sanity that it’s intended to be. That’s a lesson in how far we’ve gone toward an unhealthy acceptance of permanent federal deficits. Oh, most people seem to realize the the government’s spending is prodigious and beyond our capacity to collect taxes, but many don’t grasp the recklessness of the ongoing blowout. Federal deficits are expected to average $1.6 trillion per year over the next decade, versus less than $0.9 trillion and $1.25 trillion over the two previous decades, respectively. That $1.25 trillion includes the massive (and excessive) transfers that took place during the pandemic, which is why we’ve bumped up against the debt limit earlier than had been expected. The trend isn’t abating, despite the fact that the pandemic is behind us. And keep in mind that the Congressional Budget Office has been too optimistic for the past 20 years or so. Take a look at federal debt relative to GDP:

Unpleasant Arithmetic

With federal debt growing faster than GDP, the burden of servicing the debt mounts. This creates a strain in the coordination of fiscal and monetary policy, as described by David Andolfatto, who last year reviewed the implications of “Some Unpleasant Monetarist Arithmetic” for current policy. His title was taken from a seminal paper written by Thomas Sargent and Neil Wallace in 1981. Andolfatto says that:

“… attempting to monetize a smaller fraction of outstanding Treasury securities has the effect of increasing the rate of inflation. A tighter monetary policy ends up increasing the interest expense of debt issuance. And if the fiscal authority is unwilling to curtail the rate of debt issuance, the added interest expense must be monetized—at least if outright default is to be avoided.

Andolfatto wrote that last spring, before the Federal Reserve began its ongoing campaign to tighten monetary policy by raising short-term interest rates. But he went on to say:

“Deficit and debt levels are elevated relative to their historical norms, and the current administration seems poised to embark on an ambitious public spending program. … In the event that inflation rises and then remains intolerably above target, the Federal Reserve is expected to raise its policy rate. … if the fiscal authority is determined to pursue its deficit policy into the indefinite future, raising the policy rate may only keep a lid on inflation temporarily and possibly only at the expense of a recession. In the longer run, an aggressive interest rate policy may contribute to inflationary pressure—at least until the fiscal regime changes.”

So it is with a spendthrift government: escalating debt and interest expense must ultimately be dealt with via higher taxes or inflation, despite the best intentions of a monetary authority.

Fiscal Wrasslin’

Some people think the debt limit debate is all a big fake. Maybe … there are spendthrifts on both sides of the aisle. Still, the current debt limit impasse could serve a useful purpose if fiscal conservatives succeed in efforts to restrain spending. There is, however, an exaggerated uproar over the possibility of default, meaning a failure to make scheduled payments on Treasury securities. The capital markets aren’t especially worried because an outright default is very unlikely. Establishment Republicans may well resort to their usual cowardice and accept compromise without holding out for better controls on spending. Already, in a politically defensive gesture, House Speaker Kevin McCarthy has said the GOP wishes to strengthen certain entitlement programs. Let’s hope he really means restoring solvency to the Social Security and Medicare Trust Funds via fundamental reforms. And if the GOP rules out cuts to any program, let’s hope they don’t rule out cuts in the growth of these programs, or privatization. For their part, of course, Democrats would like to eliminate the debt ceiling entirely.

One of the demands made by Republicans is a transformation of the federal tax system. They would like to eliminate the income tax and substitute a tax on consumption. Economists have long favored the latter because it would eliminate incentives that penalize saving, which undermine economic growth. Unfortunately, this is almost dead in the water as a political matter, but the GOP further sabotaged their own proposal in their zeal to abolish the IRS. Their consumption tax would be implemented as a national sales tax applied at the point of sale, complete with a new Treasury agency to administer the tax. They’d have done better to propose a value added tax (VAT) or a tax on a simple base of income less saving (and other allowances).

Gimmicks and Measures

We’ve seen proposals for various accounting tricks to allow the government to avoid a technical default and buy time for an agreement to be reached on the debt limit. Treasury Secretary Janet Yellen already has implemented “extraordinary measures” to stay under the debt limit until June, she estimates. The Treasury is drawing down cash, skipping additional investments in government retirement accounts (which can be made up later without any postponement of benefits), plus a few other creative accounting maneuvers.

Payment prioritization, whereby the Treasury makes payments on debt and critical programs such as Social Security and Medicare, but defers a variety of other payments, has also been considered. Those deferrals could include amounts owed to contractors or even government salaries. However, a deferral of payments owed to anyone represents a de facto default. Thus, payment prioritization is not a popular idea, but if push comes to shove, it might be viewed as the lesser of two evils. Missing payments on government bonds could precipitate a financial crisis, but no one believes it will come to that.

Two other ideas for avoiding a breach of the debt ceiling are rather audacious. One involves raising new cash via the sale of premium bonds by the Treasury, as described here by Josh Barro (and here by Matt Levine). The other idea is to mint a large denomination ($1 trillion) platinum, “commemorative” coin, which the Treasury would deposit at the Federal Reserve, enabling it to conduct business as usual until the debt limit impasse is resolved. I’ll briefly describe each of these ideas in more detail below.

Premium Bonds

Premium bonds would offer a solution to the debt limit controversy because the debt ceiling is defined in terms of the par value of Treasury debt outstanding, as opposed to the amount actually raised from selling bonds at auction. For example, a note that promises to pay $100 in one year has a par value of $100. If it also promises to pay $100 in interest, it will sell at a steep premium. Thus, the Treasury collects, say, $185 at auction, and it could use the proceeds to pay off $100 of maturing debt and fund $85 of federal spending. That would almost certainly require a “market test” by the Treasury on a limited scale, and the very idea might reveal any distaste the market might have for obviating the debt limit in this fashion. But distaste is probably too mild a word.

An extreme example of this idea is for the Treasury to sell perpetuities, which have a zero par value but pay interest forever, or at least until redeemed beyond some minimum (but lengthy) term. John Cochrane has made this suggestion, though mainly just “for fun”. The British government sold perpetuities called consols for many years. Such bonds would completely circumvent the debt limit, at least without legislation to redefine the limit, which really is long overdue.

The $1 Trillion Coin

Minting a trillion dollar coin is another thing entirely. Barro has a separate discussion of this option, as does Cochrane. The idea was originally proposed and rejected during an earlier debt-limit controversy in 2011. Keep in mind, in what follows, that the Fed does not follow Generally Accepted Accounting Principles (GAAP).

Skeptics might be tempted to conclude that the “coin trick” is a ploy to engineer a huge increase the money supply to fund government expansion, but that’s not really the gist of this proposal. Instead, the Treasury would deposit the coin in its account at the Fed. The Fed would hold the coin and give the Treasury access to a like amount of cash. To raise that cash, the Fed would sell to the public $1 trillion out of its massive holdings of government securities. The Treasury would use that cash to meet its obligations without exceeding the debt ceiling. As Barro says, the Fed would essentially substitute sales of government bonds from its portfolio for bonds the Treasury is prohibited from selling under the debt limit. The effect on the supply of money is basically zero, and it is non-inflationary unless the approach has an unsettling impact on markets and inflation expectations (which of course is a distinct possibility).

When the debt ceiling is finally increased by Congress, the process is reversed. The Treasury can borrow again and redeem its coin from the Fed for $1 trillion, then “melt it down”, as Barro says. The Fed would repurchase from the public the government securities it had sold, adding them back to its portfolio (if that is consistent with its objectives at that time). Everything is a wash with respect to the “coin trick”, as long as the Treasury ultimately gets a higher debt limit.

Lust For the Coin

In fairness to skeptics, it’s easy to understand why the “coin trick” described above might be confused with another coin minting idea that arose from the collectivist vanguard during the pandemic. Representative Rashida Tlaib (D-MI) proposed minting coins to fund monthly relief payments of $1,000 – $2,000 for every American via electronic benefit cards. She was assisted in crafting this proposal by Rohan Grey, a prominent advocate of Modern Monetary Theory (MMT), the misguided idea that government can simply print money to pay for the resources it demands without inflationary consequences.

Tlaib’s plan would have required the Federal Reserve to accept the minted coins as deposits into the Treasury’s checking account. But then, rather than neutralizing the impact on the money supply by selling government bonds, the coin itself would be treated as base money. Cash balances would simply be made available in the Treasury’s checking account with the Fed. That’s money printing, pure and simple, but it’s not at all the mechanism under discussion with respect to short-term circumvention of the debt limit.

Fed Independence

The “coin trick” as a debt limit work-around is probably an impossibility, as Barro and others point out. First, the Fed would have to accept the coin as a deposit, and it is under no legal obligation to do so. Second, it obligates the Fed to closely coordinate monetary policy with the Treasury, effectively undermining its independence and its ability to pursue its legal mandates of high employment and low inflation. Depending on how badly markets react, it might even present the Fed with conflicting objectives.

Believe me, you might not like the Fed, but we certainly don’t want a Fed that is subservient to the Treasury… maintaining financial and economic stability in the presence of an irresponsible fiscal authority is bad enough without seating that authority at the table. As Barro says of the “coin trick”:

“These actions would politicize the Fed and undermine its independence. In order to stabilize expectations about inflation, the Fed would have to communicate very clearly about its intentions to coordinate its fiscal actions with Treasury — that is, it would have to tell the world that it’s going to act as Treasury’s surrogate in selling bonds when Treasury can’t. …

These actions would interfere with the Fed’s normal monetary operations. … the Fed is currently already reducing its holdings of bonds as part of its strategy to fight inflation. If economic conditions change (fairly likely, in the event of a near-default situation) that might change the Fed’s desired balance sheet strategy.”

On With The Show

Discussions about the debt limit continue between the White House and both parties in Congress. Kevin McCarthy met with President Biden today (2/1), but apparently nothing significant came it. Fiscal conservatives wonder whether McCarthy and other members of the GOP lack seriousness when it comes to fiscal restraint. But spending growth must slow to achieve deficit reduction, non-inflationary growth, and financial stability.

Meanwhile, even conservative media pundits seem to focus only on the negative politics of deficit reduction, ceding the advantage to Democrats and other fiscal expansionists. For those pundits, the economic reality pales in significance. That is a mistake. Market participants are increasingly skeptical that the federal government will ever pay down its debts out of future surpluses. This will undermine the real value of government debt, other nominal assets, incomes and buying power. That’s the inflation tax in action.

Unbridled growth of the government’s claims on resources at the expense of the private sector destroys the economy’s productive potential, to say nothing of growth. The same goes for government’s insatiable urge to regulate private activities and to direct patterns of private resource use. Unfortunately, so many policy areas are in need of reform that imposition of top-down controls on spending seems attractive as a stopgap. Concessions on the debt limit should only be granted in exchange for meaningful change: limits on spending growth, regulatory reforms, and tax simplification (perhaps replacing the income tax with a consumption tax) should all be priorities.

In the meantime, let’s avoid trillion dollar coins. As a debt limit work-around, premium bonds are more practical without requiring any compromise to the Fed’s independence. Other accounting gimmicks will be used to avoid missing payments, of course, but the fact that premium bonds and platinum coins are under discussion highlights the need to redefine the debt limit. When the eventual time of default draws near, fiscal conservatives must be prepared to stand up to their opponents’ convenient accusations of “brinksmanship”. The allegation is insincere and merely a cover for government expansionism.

Price Stability: Are We There Yet?

22 Thursday Dec 2022

Posted by Nuetzel in Inflation, Liberty, Monetary Policy

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Adam Shapiro, Bloomberg, Cleveland Fed, Demand-Driven Inflation, Federal Reserve, Great Recession, Inflation Targets, Joe Wiesenthal, Median CPI, Modern Monetary Theory, Money Printing, Noah Smith, Omnibus Spending Bill, Optimal Rate of Inflation, Pay-As-You-Go Law, PCE Deflator, Price Stability, Quantitative Easing, Rate Targets, Strategic Petroleum Reserve, Supply-Driven Inflation, Team Transitory, Trading Economics, Trimmed CPI

The answer to that question, kids, is a resounding no! The Federal Reserve created far too much liquidity during and after the pandemic and waited too long to reverse that policy. That’s a common view among the “monetarazzi”, but far too many analysts, in the next breath, assert that the Fed is going too far in tightening policy. Sorry, but you can’t have it both ways! Thus far, the reductions we’ve seen in the monetary aggregates (M1, M2, M3) represent barely a trickle out of the ocean of liquidity released during the previous two years. The recent slight moderation in the rate of inflation is unlikely to gain momentum without persistence by the Fed.

This Could Be Easier

I humbly concede, however, that a different approach by the Fed might have been less disruptive. A better alternative would have involved more aggressive reductions in the gigantic portfolio of securities it acquired via “quantitative easing” (QE) during the pandemic while avoiding direct intervention to raise short-term interest rates. In fact, allowing interest rates to be determined by the market, rather than via central bank intervention, is more sensible in terms of pricing debt of any duration. It also suggests a more direct and sensible approach to managing the growth of the money supply. Of course, had the Fed unwound QE more aggressively, short-term rates would surely have risen anyway, but to levels appropriate to rationing liquidity more efficiently. Furthermore, those rates could have served as a useful indicator of the market’s ability to digest a particular volume of sales from the Fed’s portfolio.

Getting Tight

The chart below shows the level of the monetary base (bank reserves plus currency) over the past five years from the Trading Economics site. The monetary base is the narrow monetary aggregate supporting growth of the money stock and is under fairly direct control of the Fed.

The base has declined substantially during 2022 largely as a consequence of the Fed’s restrictive policies. However, it has retraced only about a third of the massive expansion engineered by the Fed over the two prior years. Here is the corresponding plot of the M1 money stock (currency plus checking deposits):

So the reductions in the base have yet to translate into much of a reduction in the money stock, though growth in all of the aggregates has certainly declined. No one thinks this will be a walk in the park. Withdrawing liquid capital from markets accustomed to swilling in excesses will have consequences, particularly for investors who’ve grown undisciplined in their approach to evaluating prospective assets. Investors and society at large inevitably pay the price for the malinvestment encouraged by unbridled money growth (not to mention misdirected industrial policies … that’s a different can of worms).

But the squeamish resist! I got a kick out of this tweet by Noah Smith in which he pokes fun at those who insist that the surge in inflation was a mere transitory phenomenon:

“Team Transitory: OMG inflation is just going to go away, you don’t need to raise interest rates.

Fed: *raises interest rates*

Inflation: *goes down a bit*

Team Transitory: SEE, I told you inflation was going away and that you didn’t need to raise interest rates!!”

Well, in fairness, “Team Transitory” has been fixated on supply disruptions that very well should resolve with private efforts over time. Some have resolved already. And again, we’ve yet to feel much impact from the Fed’s tighter policy, but I’m amused by the tweet nevertheless.

In fact, the surge in inflation has been driven by both supply and demand factors, and it’s true the Fed can do very little about the former. But stalling the effort to purge excess liquidity and demand-side inflation risks allowing expectations of inflation to edge higher, creating an environment in which price pressures are more resistant to policy actions.

Inflation And Its Proximate Sources

It is indeed good news that inflation has tapered slightly over the past few months, or at least the “headline” inflation numbers have tapered. Weaker energy prices helped a great deal, though releases from the Strategic Petroleum Reserve aren’t sustainable. Measures of “core” inflation that exclude food and energy prices, and more central measures of inflation within the spectrum of goods and services, have moved sideways or perhaps shown signs of a slight moderation.

Here’s a plot of several measures of CPI inflation taken from the Cleveland Fed’s web site. Note that the median component of the CPI has finally hit a plateau, and a “trimmed” measure that excludes CPI components with extreme changes has dipped slightly. The Core CPI has fluctuated in a range just above 6% for most of the year.

The deflator for personal consumption expenditures (PCE) gets more emphasis from the Fed in its policy deliberations. The latest release at the start of December showed patterns similar to the CPI:

With respect to the PCE deflator, the slight dampening of price pressure we’ve seen recently came primarily from the supply side, with some progress on the demand side as well. Energy was one factor on the supply side, but even the core PCE deflator shows less supply pressure. Adam Shapiro has a decomposition of the PCE deflator into supply-driven and demand-driven components (but the chart only goes through October):

First, without endorsing Shapiro’s construction of this dichotomy, I note that the impact of monetary policy is primarily through the demand side of the economy. Of course, monetary instability isn’t good for producers, and excessive money growth and inflation create uncertainty that inhibits supply. But what we’ve seen recently has more to do with the curing of supply chain bottlenecks that cropped up during the pandemic (or in its wake), and Shapiro attempts to capture that kind of phenomenon here.

Still, many would argue that the November CPI showed sufficient progress for the Fed to pause its tightening campaign. The reductions in the monthly price increases were fairly widespread, as shown by this table from the CPI report:

The next chart from Joe Wiesenthal (via Bloomberg) displays trends in broad CPI categories, but it shows vividly that the reductions were concentrated in energy components and goods prices, while services and food inflation did not really abate. (The legend is so hard to read that I took the liberty of blowing it up a bit below the chart itself):

Playing Catch-Up

While the Fed’s effort to restrain inflation began in earnest in the spring of this year, it lifted the federal funds rate target rapidly. Here’s another chart from Adam Shapiro, via the Wall Street Journal: the Fed’s current tightening cycle is the fastest in 40 years in terms of those rate hikes:

Fast, yes, but they got a late start in the face of a rapid acceleration of inflation, and for what it’s worth, the Fed’s rate target remains below the rate of inflation. Yes, I’m forced to acknowledge here that the Fed’s preference for rate intervention and targeting is just what they do, for now. In any case, top-line inflation and strictly demand-side inflation are still above the Fed’s 2% target.

Fabian Fiscal Expansionists

One “fix” recommended in some circles suggests that the Fed’s inflation target is too low, as if price stability had nothing to do with its mandate! The idea that low-grade inflation is a healthy thing has never been convincingly demonstrated. In fact, the monetary literature leans strongly in the direction of price stability and an optimal rate of inflation of zero! That the Fed should aim for higher inflation seems like a cop-out intended to appease those who still subscribe to the discredited notion that there exists a reliable long-run tradeoff between inflation and unemployment.

In fact, proposals to increase the central bank’s inflation target would enable more deficit spending financed with the “printing press”, which is at the root of the demand-side inflation problem we now face. A major justifications for ballooning levels of federal spending has been so-called Modern Monetary Theory (MMM), which has gained adherents among statists in the years since the Great Recession. MMM holds that “important” initiatives can simply be paid for with new money creation, rather than interest bearing debt, or God forbid, taxes! “Partisan” is probably a better description than “theorist” for any fan of MMM, and they have convinced themselves that money financed deficits are without inflationary consequences. Of course, this represents a complete suspension of the law of resource scarcity, not to mention years of monetary history. Raising the Fed’s inflation target plays well with the same free-lunch advocates who rally behind MMM.

The Fed’s Unfaithful Fiscal Partner

Federal budget control is likely to take another hit this week with passage of the $1.7 omnibus spending bill. It includes spending increases with no immediate offsets as required under the pay-as-you-go budget law. It delays those offsets to 2025 and increases deficits in the interim by hundreds of billions of dollars. It also sets a new, higher baseline for discretionary appropriations in future years. The federal deficit has already risen dramatically compared to a year ago under the fiscal profligacy of Congress and the Administration. Another contributing factor, however, is that the interest cost of servicing the national debt has spiked as interest rates have risen. Needless to say, none this makes the Fed’s job any easier, especially as it seeks to reverse QE.

Say Uncle!?

When will the Fed begin to take its foot off the brake? It “only” raised the Fed funds target by 50 basis points at its meeting last week (after four 75 bps moves in a row. It is expected to raise the target another 50 bps in early February and perhaps another 25 in March. Strong signals of imminent recession would be needed for the Fed to call it off any sooner, and we’re definitely seeing more hints of a weakening economy in the data (and see here, here, here, and here). More definitive declines in inflation would obviously help settle things. Otherwise, the Fed may pause after March in order to gauge progress toward its goal of 2% inflation.

“Hard Landing” Is Often Cost of Fixing Inflationary Policy Mistakes

05 Wednesday Oct 2022

Posted by Nuetzel in Inflation, Monetary Policy

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Ample Reserves, Budget Deficit, Core CPI, Demand-Side Inflation, Energy Policy, Expected Inflation, Hard Landing, Inflation, Inflation Targeting, Inverted Yield Curve, Jeremy Siegel, John Cochrane, M2, Median CPI, Median PCE, Monetary Base, Monetary policy, PCE Deflator, Price Signals, Recession, Scott Sumner, Soft Landing, Supply-Side Inflation, Trimmed CPI

The debate over the Federal Reserve’s policy stance has undergone an interesting but understandable shift, though I disagree with the “new” sentiment. For the better part of this year, the consensus was that the Fed waited too long and was too dovish about tightening monetary policy, and I agree. Inflation ran at rates far in excess of the Fed’s target, but the necessary correction was delayed and weak at the start. This violated the necessary symmetry of a legitimate inflation-targeting regime under which the Fed claims to operate, and it fostered demand-side pressure on prices while risking embedded expectations of higher prices. The Fed was said to be “behind the curve”.

Punch Bowl Resentment

The past few weeks have seen equity markets tank amid rising interest rates and growing fears of recession. This brought forth a chorus of panicked analysts. Bloomberg has a pretty good take on the shift. Hopes from some economists for a “soft landing” notwithstanding, no one should have imagined that tighter monetary policy would be without risk of an economic downturn. At least the Fed has committed to a more aggressive policy with respect to price stability, which is one of its key mandates. To be clear, however, it would be better if we could always avoid “hard landings”, but the best way to do that is to minimize over-stimulation by following stable policy rules.

Price Trends

Some of the new criticism of the Fed’s tightening is related to a perceived change in inflation signals, and there is obvious logic to that point of view. But have prices really peaked or started to reverse? Economist Jeremy Siegel thinks signs point to lower inflation and believes the Fed is being too aggressive. He cites a series of recent inflation indicators that have been lower in the past month. Certainly a number of commodity prices are generally lower than in the spring, but commodity indices remain well above their year-ago levels and there are new worries about the direction of oil prices, given OPEC’s decision this week to cut production.

Central trends in consumer prices show that there is a threat of inflation that may be fairly resistant to economic weakness and Fed actions, as the following chart demonstrates:

Overall CPI growth stopped accelerating after June, and it wasn’t just moderation in oil prices that held it back (and that moderation might soon reverse). Growth of the Core CPI, which excludes food and energy prices, stopped accelerating a bit earlier, but growth in the CPI and the Core CPI are still running above 8% and 6%, respectively. More worrisome is the continued upward trend in more central measures of CPI growth. Growth in the median component of the CPI continues to accelerate, as has the so-called “Trimmed CPI”, which excludes the most extreme sets of high and low growth components. The response of those central measures lagged behind the overall CPI, but it means there is still inflationary momentum in the economy. There is a substantial risk that expectations of a more permanent inflation are becoming embedded in expectations, and therefore in price and wage setting, including long-term contracts.

The Fed pays more attention to a measure of prices called the Personal Consumption Expenditures (PCE) deflator. Unlike the CPI, the PCE deflator accounts for changes in the composition of a typical “basket” of goods and services. In particular, the Fed focuses most closely on the Core PCE deflator, which excludes food and energy prices. Inflation in the PCE deflator is lower than the CPI, in large part because consumers actively substitute away from products with larger price increases. However, the recent story is similar for these two indices:

Both overall PCE inflation and Core PCE inflation stopped accelerating a few months ago, but growth in the median PCE component has continued to increase. This central measure of inflation still has upward momentum. Again, this raises the prospect that inflationary forces remain strong, and that higher and more widespread expected inflation might make the trend more difficult for the Fed to rein in.

That leaves the Fed little choice if it hopes to bring inflation back down to its target level. It’s really a only a choice of whether to do it faster or slower. One big qualification is that the Fed can’t do much about supply shortfalls, which have been a source of price pressure since the start of the rebound from the pandemic. However, demand pressures have been present since the acceleration in price growth began in earnest in early 2021. At this point, it appears that they are driving the larger part of inflation.

The following chart shows share decompositions for growth in both the “headline” PCE deflator and the Core PCE deflator. Actual inflation rates are NOT shown in these charts. Focus only on the bolder colored bars. (The lighter bars represent estimates having less precision.) Red represents “supply-side” factors contributing to changes in the PCE deflator, while blue summarizes “demand-side” factors. This division is based on a number of assumptions (methodological source at the link), but there is no question that demand has contributed strongly to price pressures. At least that gives a sense about how much of the inflation can be addressed by actions the Fed might take.

I mentioned the role of expectations in laying the groundwork for more permanent inflation. Expected inflation not only becomes embedded in pricing decisions: it also leads to accelerated buying. So expectations of inflation become a self-fulfilling prophesy that manifests on both the supply side and the demand-side. Firms are planning to raise prices in 2023 because input prices are expected to continue rising. In terms of the charts above, however, I suspect this phenomenon is likely to appear in the “ambiguous” category, as it’s not clear that the counting method can discern the impacts of expectations.

What’s a Central Bank To Do?

Has the Fed become too hawkish as inflation accelerated this year while proving to be more persistent than expected? One way to look at that question is to ask whether real interest rates are still conducive to excessive rate-sensitive demand. With PCE inflation running at 6 – 7% and Treasury yields below 4%, real returns are still negative. That’s hardly seems like a prescription for taming inflation, or “hawkish”. Rate increases, however, are not the most reliable guide to the tenor of monetary policy. As both John Cochrane and Scott Sumner point out, interest rate increases are NOT always accompanied by slower money growth or slowing inflation!

However, Cochrane has demonstrated elsewhere that it’s possible the Fed was on the right track with its earlier dovish response, and that price pressures might abate without aggressive action. I’m skeptical to say the least, and continuing fiscal profligacy won’t help in that regard.

The Policy Instrument That Matters

Ultimately, the best indicator that policy has tightened is the dramatic slowdown (and declines) in the growth of the monetary aggregates. The three charts below show five years of year-over-year growth in two monetary measures: the monetary base (bank reserves plus currency in circulation), and M2 (checking, saving, money market accounts plus currency).

Growth of these aggregates slowed sharply in 2021 after the Fed’s aggressive moves to ease liquidity during the first year of the pandemic. The monetary base and M2 growth have slowed much more in 2022 as the realization took hold that inflation was not transitory, as had been hoped. Changes in the growth of the money stock takes time to influence economic activity and inflation, but perhaps the effects have already begun, or probably will in earnest during the first half of 2023.

The Protuberant Balance Sheet

Since June, the Fed has also taken steps to reduce the size of its bloated balance sheet. In other words, it is allowing its large holdings of U.S. Treasuries and Agency Mortgage-Backed Securities to shrink. These securities were acquired during rounds of so-called quantitative easing (QE), which were a major contributor to the money growth in 2020 that left us where we are today. The securities holdings were about $8.5 trillion in May and now stand at roughly $8.2 trillion. Allowing the portfolio to run-off reduces bank reserves and liquidity. The process was accelerated in September, but there is increasing tension among analysts that this quantitative tightening will cause disruptions in financial markets and ultimately the real economy, There is no question that reducing the size of the balance sheet is contractionary, but that is another necessary step toward reducing the rate of inflation.

The Federal Spigot

The federal government is not making the Fed’s job any easier. The energy shortages now afflicting markets are largely the fault of misguided federal policy restricting supplies, with an assist from Russian aggression. Importantly, however, heavy borrowing by the U.S. Treasury continues with no end in sight. This puts even more pressure on financial markets, especially when such ongoing profligacy leaves little question that the debt won’t ever be repaid out of future budget surpluses. The only way the government’s long-term budget constraint can be preserved is if the real value of that debt is bid downward. That’s where the so-called inflation tax comes in, and however implicit, it is indeed a tax on the public.

Don’t Dismiss the Real Costs of Inflation

Inflation is a costly process, especially when it erodes real wages. It takes its greatest toll on the poor. It penalizes holders of nominal assets, like cash, savings accounts, and non-indexed debt. It creates a high degree of uncertainty in interpreting price signals, which ordinarily carry information to which resource flows respond. That means it confounds the efficient allocation of resources, costing all of us in our roles as consumers and producers. The longer it continues, the more it erodes our economy’s ability to enhance well being, not to mention the instability it creates in the political environment.

Imminent Recession?

So far there are only limited signs of a recession. Granted, real GDP declined in both the first and second quarters of this year, but many reject that standard as overly broad for calling a recession. Moreover, consumer spending held up fairly well. Employment statistics have remained solid, though we’ll get an update on those this Friday. Nevertheless, payroll gains have held up and the unemployment rate edged up to a still-low 3.7% in August.

Those are backward-looking signs, however. The financial markets have been signaling recession via the inverted yield curve, which is a pretty reliable guide. The weak stock market has taken a bite out of wealth, which is likely to mean weaker demand for goods. In addition to energy-supply shocks, the strong dollar makes many internationally-traded commodities very costly overseas, which places the global economy at risk. Moreover, consumers have run-down their savings to some extent, corporate earnings estimates have been trimmed, and the housing market has weakened considerably with higher mortgage rates. Another recent sign of weakness was a soft report on manufacturing growth in September.

Deliver the Medicine

The Fed must remain on course. At least it has pretensions of regaining credibility for its inflation targeting regime, and ultimately it must act in a symmetric way when inflation overshoots its target, and it has. It’s not clear how far the Fed will have to go to squeeze demand-side inflation down to a modest level. It should also be noted that as long as supply-side pressures remain, it might be impossible for the Fed to engineer a reduction of inflation to as low as its 2% target. Therefore, it must always bear supply factors in mind to avoid over-contraction.

As to raising the short-term interest rates the Fed controls, we can hope we’re well beyond the halfway point. Reductions in the Fed’s balance sheet will continue in an effort to tighten liquidity and to provide more long-term flexibility in conducting operations, and until bank reserves threaten to fall below the Fed’s so-called “ample reserves” criterion, which is intended to give banks the wherewithal to absorb small shocks. Signs that inflationary pressures are abating is a minimum requirement for laying off the brakes. Clear signs of recession would also lead to more gradual moves or possibly a reversal. But again, demand-side inflation is not likely to ease very much without at least a mild recession.

The Fed’s Balance Sheet: What’s the Big Deal?

08 Sunday May 2022

Posted by Nuetzel in Government Failure, Inflation, Monetary Policy

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Allocation of Capital, Bank Reserves, crowding out, Debt Monetization, Fed Balance Sheet, Federal Funds, Federal Reserve, Fiscal Inflation, Inflation tax, Interest Rate Targeting, MBS, Monetary policy, Mortgage Backed Securities, QE, Quantitative Easing, Scarcity, Tapering

The Federal Reserve just announced tighter monetary policy in an attempt to reduce inflationary pressures. First, it raised its target range for the federal funds rate (on overnight loans between banks) by 0.5%. The new range is 0.75% – 1%. Second, on June 1, the Fed will begin taking steps to reduce the size of its $9 trillion portfolio of securities. These holdings were acquired during periods of so-called quantitative easing (QE) beginning in 2008, including dramatic expansions in 2020-21. A shorthand reference for this portfolio is simply the Fed’s “balance sheet”. It includes government debt the Fed has purchased as well as privately-issued mortgage-backed securities (MBS).

What Is This Balance Sheet You Speak Of?

Talk of the Fed’s balance sheet seems to mystify lots of people. During the 2008 financial crisis, the Fed began to inject liquidity into the economy by purchasing large amounts of assets to be held on its balance sheet. This was QE. It’s scope was unprecedented and a departure from the Fed’s pre-crisis reliance on interest rate targeting. QE had the effect of increasing bank reserves, which raised the possibility of excessive money supply growth. That’s when the Fed began to pay interest to banks on reserves, so they might be content to simply hold some of the reserves over and above what they are required to hold, rather than using all of that excess to support new loans and deposits (and thus money growth). However, that interest won’t stop banks from lending excess reserves if better opportunities present themselves.

The Fed has talked about reducing, “normalizing”, or “tapering” its balance sheet for some time, but it only recently stopped adding to it. With inflation raging and monetary policy widely viewed as too “dovish”, analysts expected the Fed to stop reinvesting proceeds from maturing securities, which amounts to about $95 billion per month. That would shrink or “taper” the balance sheet at a rate of about $1.1 trillion per year. Last week the Fed decided to cap the “runoff” at $47.5 billion per month for the first three months, deferring the $95 billion pace until September. Monetary policy “hawks” were disappointed by this announcement.

Monetizing Government

So, one might ask, what’s the big deal? Why must the Fed taper its securities holdings? Well, first, the rate of inflation is far above the Fed’s target range, and it’s far above the “average Joe’s” comfort range. Inflation imposes significant costs on the economy and acts as a regressive form of taxation, harming the poor disproportionately. To the extent that the Fed’s huge balance sheet (and the corresponding bank reserves) are supporting incremental money growth and fueling inflation, the balance sheet must be reduced.

In that connection, the Fed’s investment in government debt represents monetized federal debt. That means the Fed is essentially printing money to meet the Treasury’s financing needs. Together with profligate spending by the federal government, nothing could do more to convince investors that government debt will never be repaid via future budget surpluses. This dereliction of the government’s “full faith and credit”, and the open-armed acceptance of the inflation tax as a financing mechanism (à la Modern Monetary Theory), is the key driver of fiscal inflation. Reducing the balance sheet would represent de-monetization, which might help to restore faith in the Fed’s ability to push back against fiscal recklessness.

Buyer of First Resort

Perhaps just as critically, the Fed’s heavy investment in government debt and MBS represents an ongoing distortion to the pricing of financial assets and the allocation of capital. Some call this interference in the “price discovery process”. That’s because the Fed has represented a market-altering presence, a willing and inelastic buyer of government debt and MBS. Given that presence, it’s difficult for buyers and sellers to discern the true values of alternative uses of capital, or to care.

QE was, among other things, a welcome institutional development for the U.S. Treasury and for those who fancy that fresh money printing is an ever-valid form of government payment for scarce resources. The Fed’s involvement also means that other potential buyers of Treasury debt need not worry about interest rate risk, making public debt relatively more attractive than private debt. This is a dimension of the “crowding out” phenomenon, whereby the allocation of capital and flows of real resources between public and private uses are distorted.

The Fed’s presence as a buyer of MBS depresses mortgage rates and makes mortgage lending less risky for lenders and investors. As a result, it encourages an over-investment in housing and escalating home prices. This too distorts the allocation of capital and real resources, at the margin, toward housing and away from uses with greater underlying value.

Conclusion

The magnitude of the Fed’s balance sheet is an ongoing testament to an increasingly dominant role of central authorities in the economy. In this case, the Fed has served as a conduit for the inflation tax. In addition, it has unwittingly facilitated crowding out of private capital investment. The Fed’s purchases of MBS have distorted the incentives (and demand) for residential investment. These are subtle effects that the average citizen might not notice, just as one might not notice the early symptoms of a debilitating disease. The long-term consequences of the Fed’s QE activities, including the inflation tax and distorted allocations of capital, are all too typical of failures of government intervention and attempts at central planning. But don’t expect anyone at the Fed to admit it.

Inflation Doomsayers and Downplayers

25 Friday Jun 2021

Posted by Nuetzel in Inflation, Monetary Policy

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Consumer Price Index, Core CPI, Cryptocurrencies, Deficits, Energy Policy, Federal Reserve, Financial Velocity, Fisher Effect, Helicopter Money, Housing Costs, Import Prices, Inflation, Inflation Premium, Irving Fisher, M1, Median CPI, Monetary policy, Monetization, Shrinkflation, Trading Volume, Trimmed CPI, Velocity of Money

There’s a big disconnect between recent news about escalating inflation and market expectations of inflation. In fact, there’s a big disconnect between market expectations and what we’re hearing from some conservative economists. The latter are predicting more inflation based on the recent spurt in prices and the expansionary policy of the Federal Reserve. Can these disparate views be reconciled?

Market Predictions

Market interest rates are considered pretty good predictors of inflation, at least relative to surveys and macroeconomic models. That’s because a fixed interest return is eroded by inflation, and fixed income investors will bid up interest rates to incorporate a premium to compensate for perceptions of increased inflation risk. This is known as the Fisher Effect, after the economist Irving Fisher. In fact, investors should bid rates up more than one-for-one with expected inflation, because the inflation premium will be taxed. A higher return must compensate for both higher expected inflation and taxes on the increased inflation premium.

After rising by about 1.2% from last summer through mid-March, interest rates on Treasury notes have declined slightly. The earlier run-up anticipated a strengthening economy, but if the increase was due to higher expected inflation, we could say it represented an added premium of about 1%, and that’s roughly in-line with changes in some other market-based gauges of expected inflation (ignoring pandemic lows).

Recent Inflation News

Meanwhile, measured inflation certainly has increased in 2021. I say “measured” because 1) “true” price changes are measured imperfectly, and 2) there is a difference between real inflation, which is a continuing process, and month-to-month changes in prices. Here, we’re really talking about the latter and hoping it doesn’t turn into a bad case of the former!

The green line in the chart below is the percent change in the consumer price index (CPI) from a year earlier. After declining during the pandemic, it rebounded sharply this year to almost 5% in May. The purple line is the increase in the CPI excluding food and energy prices, otherwise known as the “core” CPI. The jumps shown in the chart are well in excess of the market’s assessment of inflation trends.

Both versions of the CPI have jumped in the past few months, but it turns out that durable goods like washing machines, TVs, and (probably) Pelotons have jumped the most sharply. Most of the weakness in prices during the pandemic was in non-durable goods, which stands to reason because so many activities away from home were curtailed. Also noteworthy about these price movements: when measured over a span of two years, prices excluding food and energy have risen at an annualized rate of only 2.6%.

There are two other lines in the chart above that demonstrate much less alarming changes in prices: the orange line is so-called “median” inflation, which is the price change in the median component of the CPI. That is, half of all price components included in the CPI rose faster and half rose slower than the median. It has barely accelerated this year and stood at only about 2.1% higher in May than a year earlier. The blue line is the so-called “trimmed” CPI, or the average price change of the middle 84% of all CPI components. While it has accelerated in 2021, the year-over-year increase was only 2.6% in May.

Thus, the breadth of the jump in prices was limited. The Federal Reserve and a lot of market participants insist that the uptick is narrow and temporary — a transitional phenomenon related to the sluggish recovery of supplies in the post-pandemic environment.

But again, the accuracy of price measures is always in question. For example, the housing cost component of the CPI was up only 2.2% in May from a year ago, but it is calibrated to actual survey data only twice a year, the survey is a weak data source, and we know home prices and rents have risen aggressively. Quality and quantity adjustments are always in question as well. An old approach for businesses dealing with rising costs is to reduce package size, which has been called “shrinkflation”. It seems to be back in vogue.

Inflation Drivers

It’s not yet clear how much wage pressure is occurring now. The economy-wide average hourly earnings data has been distorted over the past 15 months by the changing mix of employment, first shifting toward greater concentration in high-wage (work-at-home) occupations and now shifting back toward lower-wage jobs as the economy reopens. But we know many employers are facing a labor shortage, due in large part to extended unemployment benefits and other pandemic-related aid, so this puts upward pressure on wages. In 2021, minimum wage rates are undergoing substantial increases in 17 states, and a number of large employers such as Amazon have increased their minimum pay rates. That creates competitive pressure for smaller employers to boost pay as well.

The fundamental cause of an “honest-to-goodness” inflation is “too much money chasing too few goods”. The Federal Reserve has certainly given us enough to worry about in that regard. The basic money stock (M1) increased by four-fold in the late winter and early spring of 2020, just as the pandemic was spreading. Today, it is almost five times greater than in early 2020, so growth in the money stock remains quite fast even as the recovery proceeds. No wonder: the U.S. Treasury is issuing about $1 trillion of new debt every four-to-six weeks, and the Fed is essentially monetizing these deficits by purchasing a huge chunk of that debt.

That’s a lot of “helicopter” money… new money! But are there too few goods for it to chase? Or is it really chasing anything? Is it just sitting idle? First, GDP is likely to exceed its pre-pandemic level in the second quarter, despite the fact that private payrolls are still down by about 7 million employees. Of course, that doesn’t eliminate the ostensible imbalance between money and goods, and one might expect a veritable explosion in price inflation under these circumstances.

So far that seems unlikely. The so-called velocity of money (its rate of turnover) has plunged since the start of the pandemic, with no discernible rebound through the first quarter of 2021. That means a lot of the cash is not being used in transactions for real goods, but financial transaction volume has been quite strong in 2020-21. Daily stock trading volume was up by more than 50% in 2020 from 2019, and in the first quarter of 2021 it stood another 34% higher than the 2020 average (though volume tapered in April). This is to say nothing of the increased frenzy in cryptocurrency trading. So, while some money is turning over, the expansion of the money stock remains daunting and pressure might well spill-over into goods prices.

Caution Is a Virtue

So long as the Fed keeps printing money, and assuring investors that it will keep printing money, the equity markets are likely to remain strong. There are mixed signals coming from Fed officials, but the over-riding message is that the recent uptick in prices is largely temporary and limited in scope. That is, they assert that certain prices are being squeezed temporarily by rebounding demand for goods while suppliers play catch-up.

Market expectations of inflation seem to agree with that view, but I have strong trepidations. There are cash reserves held in the private sector to support more aggressive spending. Large companies, consumers, and banks are still holding significant amounts of cash. The Biden Administration is doing its best to spend hand-over-fist. This administration’s energy policy is causing fuel bills to escalate. Home prices and rents are strong. The dollar is down somewhat from pre-pandemic levels, which increases import prices. Finally, the Fed is reluctant to reverse the huge increase in the money supply it engineered during the pandemic. If the recent surge in prices continues, and if higher inflation embeds itself into expectations, it will be all the more difficult for the Fed to correct.

The market and the Fed might be correct in predicting that the spike in measured inflation is temporary. The recent data show that these worrisome price trends have not been broad. Just the same, I don’t want to hold fixed income investments right now: if higher expectations of inflation cause market interest rates to rise, the value of those assets will fall. Stock values should generally keep pace with inflation barring stronger signals of tightening by the Fed. Unfortunately, however, many would suffer in an inflationary environment as wages, fixed assets, and benefits are devalued by rising prices.

The Federal Reserve and Coronatative Easing

09 Monday Mar 2020

Posted by Nuetzel in Monetary Policy, Pandemic

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Caronavirus, Covid-19, Donald Trump, Externality, Federal Reserve, Fiscal Actions, Flight to Safety, Glenn Reynolds, Influenza, Liquidity, Michael Fumento, Monetary policy, Network Effects, Nonpharmaceutical Intervention, Paid Leave, Pandemic, Payroll Tax, Quarantines, Scott Sumner, Solvency, Wage Assistance

Laughs erupted all around when the Federal Reserve reduced its overnight lending rate by 50 basis points last week: LIKE THAT’LL CURE THE CORANAVIRUS! HAHAHA! It’s easy to see why it seemed funny to people, even those who think the threat posed by Covid-19 is overblown. But it should seem less silly with each passing day. That’s not to say I think we’re headed for disaster. My own views are aligned with this piece by Michael Fumento: it will run its course before too long, and “viruses hate warm weather“. Nevertheless, the virus is already having a variety of economic effects that made the Fed’s action prudent.

Of course, the Fed did not cut its rate to cure the virus. The rate move was intended to deal with some of the economic effects of a pandemic. The spread of the virus has been concentrated in a few countries thus far: China, Iran, Italy, and South Korea. Fairly rapid growth is expected in the number of cases in the U.S. and the rest of the world over the next few weeks, especially now with the long-awaited distribution of test kits. But already in the U.S., we see shortages of supplies hitting certain industries, as shipments from overseas have petered. And now efforts to control the spread of the virus will involve more telecommuting, cancellation of public events, less travel, less dining out, fewer shopping trips, missed work, hospitalizations, and possibly widespread quarantines.

The upshot is at least a temporary slowdown in economic activity and concomitant difficulties for many private businesses. We’ve been in the midst of a “flight to safety”, as investors incorporate these expectations into stock prices and interest rates. Firms in certain industries will need cash to pay bills during a period of moribund demand, and consumers will need cash during possible layoffs. All of this suggests a need for liquidity, but even worse, it raises the specter of a solvency crisis.

The Fed’s power can attempt to fill the shortfall in liquidity, but insolvency is a different story. That, unfortunately, might mean either business failures or bailouts. Large firms and some small ones might have solid business continuation plans to help get them through a crisis, at least one of short to moderate duration, but many businesses are at risk. President Trump is proposing certain fiscal and regulatory actions, such as a reduction in the payroll tax, wage payment assistance, and some form of mandatory paid leave for certain workers. Measures might be crafted so as to target particular industries hit hard by the virus.

I do not object to these pre-emptive measures, even as an ardent proponent of small government, because the virus is an externality abetted by multiplicative network effects, something that government has a legitimate role in addressing. There are probably other economic policy actions worth considering. Some have suggested a review of laws restricting access to retirement funds to supplement inadequate amounts of precautionary savings.

Last week’s Fed’s rate move can be viewed as pre-emptive in the sense that it was intended to assure adequate liquidity to the financial sector and payment system to facilitate adjustment to drastic changes in risk appetites. It might also provide some relief to goods suppliers who find themselves short of cash, but their ability to benefit depends on their relationships to lenders, and lenders will be extremely cautious about extending additional credit as long as conditions appear to be deteriorating.

In an even stronger sense, the Fed’s action last week was purely reactive. Scott Sumner first raised an important point about ten days before the rate cut: if the Fed fails to reduce its overnight lending target, it represents a de facto tightening of U.S. monetary policy, which would be a colossal mistake in a high-risk economic and social environment:

“When there’s a disruption to manufacturing supply chains, that tends to reduce business investment, puts downward pressure on demand for credit. That will tend to reduce equilibrium interest rates. In addition, with the coronavirus, there’s also a lot of uncertainty in the global economy. And when there’s uncertainty, there’s sort of a rush for safe assets, people buy treasury bonds, that puts downward pressure on interest rates. So you have this downward pressure on global interest rates. Now while this is occurring, if the Fed holds constant its policy rate, it targets the, say fed funds rate at a little over 1.5 percent. While the equilibrium rates are falling, then essentially the Fed will be making monetary policy tighter.

… what I’m saying is, if the Fed actually wants to maintain a stable monetary policy, they may have to move their policy interest rate up and down with market conditions to keep the effective stance of monetary policy stable. So again, it’s not trying to solve the supply side problem, it’s trying to prevent it from spilling over and also impacting aggregate demand.”

The Fed must react appropriately to market rates to maintain the tenor of its policy, as it does not have the ability to control market rates. Its powers are limited, but it does have a responsibility to provide liquidity and to avoid instability in conducting monetary policy. Fiscal actions, on the other hand, might prove crucial to restoring economic confidence, but ultimately controlling the spread of the virus must be addressed at local levels and within individual institutions. While I am strongly averse to intrusions on individual liberty and I desperately hope it won’t be necessary, extraordinary measures like whole-city quarantines might ultimately be required. In that context, this post on the effectiveness of “non-pharmaceutical interventions” such as school closures, bans on public gatherings, and quarantines during the flu pandemic of 1918-19 is fascinating.

Fiat Money, Government and Culture

24 Wednesday Aug 2016

Posted by Nuetzel in Monetary Policy

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Asset Price Inflation, Commercial Culture, Crony Culturalism, Debt Monetization, Distribution of Wealth, Federal Reserve Act, Fiat Money, Full Faith and Credit, Gresham's Law, Inflation, Jörg Guido Hülsmann, Mises Wire, Redeemability, Tyler Cowan

The money we use every day has roughly zero intrinsic value. That includes paper, coins made from base metals, and electronic bookkeeping entries that can be drawn on via plastic cards and communication devices. We take it for granted that all of these forms of payment will be accepted in transactions. The dollars we use in the U.S. are backed only by the “full faith and credit” of the U.S. government, which is quite a bit of nothing when it comes right down to it. This form of money is called “fiat money” because it derives value essentially by decree, including the government’s willingness to accept your dollars in payment of taxes. It’s a fine thing that such a level of trust exists in society, and most important is trust that the next seller will accept your dollars in trade.

An old maxim in economics known as Gresham’s Law holds that “bad money drives out good”, particularly when the “good money” and the “bad money” are assigned the same legal value in exchange. The good money, having greater intrinsic value than the bad money, will quickly disappear from use as a medium of exchange. Like any asset, the good money will be held as a store of value, but not used in routine transactions.

In the past, our “good money” consisted mainly of claims on precious metals. However, the U.S. government stopped redeeming dollars in gold in the 1930s, silver in the 1960s, and silver coins stopped circulating at about the same time.

What’s so “bad” about fiat money, given that we trust its usefulness in the next transaction? The lack of intrinsic value places its issuing authority, the Federal Reserve in our case, in a position of tremendous power and responsibility as the keeper of the “full faith” of the U.S. government. However, the Fed is privately owned (by banks), and no one at the Fed is elected. The members of its Board of Governors are appointed by the President to 14-year terms. The lengthy terms are hoped to keep the Fed independent and immune to political manipulation. Ostensibly, the Fed conducts policy in the objective pursuit of price stability and full employment. (Never mind that the two goals may be incompatible.)

The Fed, as the authority responsible for the nation’s fiat money, has traditionally allowed the money supply to grow by issuing “new money” in exchange for federal debt obligations, like Treasury bonds. The Fed buys the bonds, and the payment becomes a seed for new money growth. For the Treasury, which raises funds to finance government activities by collecting taxes and borrowing, this mechanism is quite convenient. The Fed can act to “accommodate” the government’s needs, essentially printing money to fund deficits.

Does it happen? Absolutely, although in the past few years, the Fed has demonstrated a more subtle variation on this theme, and one that is cheaper for the government. That will be the subject of a future post. The key point here is that with the cooperation of the monetary authority, the government avails itself of the so-called printing press. Thus, it is not answerable to taxpayers for any expansion in its spending. The government can commandeer resources as it sees fit, with no restraint from the governed.

That’s the key point made by Jörg Guido Hülsmann in a post on the Mises Wire blog, “How Fiat Money Destroys Culture“. On that note, I’d say first that enabling the displacement of private commerce for government-directed activity is a sure-fire prescription for degrading the culture. Government is not and never will be a font of creativity. Capitalism and markets, on the other hand, deliver an astonishing degree of cultural wealth to every segment of society. The freedom to create and share art, cuisine, customs and technology, without interference by government, is the very essence of culture. Some might object that government often serves as a conduit for bringing cultural works to the public, and that government can and does direct resources to the arts. There is an extent to which that’s true, of course, but it may be a deal with the devil: public sector support for new art is often subject to strings, politicization, and favoritism. That’s crony culturalism, to coin a phrase.

Hülsmann discusses other cultural repercussions of fiat money. By enabling the government to compete for resources with the private sector, and by swelling the quantity of money relative to goods and assets, fiat money puts upward pressure on prices. This might manifest in the prices of goods, the prices of assets, or both, and it might be very uneven. This changes the distribution of rewards in society in fundamental ways.

Price inflation penalizes those who hold currency. Hülsmann says:

“In a free economy with a natural monetary system, there is a strong incentive to save money in the form of cash held under one’s immediate control. Investments in savings accounts or other relatively safe investments also play a certain role, but cash hoarding is paramount, especially among low-income families. … By contrast, when there is constant price inflation, as in a fiat-money system, cash hoarding becomes suicidal.“

Price inflation also rewards those in debt. Strictly speaking, this is true only when inflation accelerates unexpectedly, since lenders tend to demand sufficient interest to offset expected inflation. Hülsmann blames the widespread growth of debt financing in modern society on fiat currency. There is an element of truth to this assertion, but it strikes me as an exaggeration, given the advances in financial markets and technologies over the past century or so. We are much better at allocating resources inter-temporally than in 1900, for example, so the growth of consumer and business debt over the years should be viewed in the context of future earning power and enabling technology. Still, there are those for whom these markets and technologies are out of reach, and the destructive effect of inflation on their ability to save should not be minimized. This contributes to greater dependency at the lowest levels of the socioeconomic spectrum, a very regrettable kind of cultural change.

Growth of the money stock tends to reward many at the top of the socioeconomic spectrum, partly because it is associated with stock market appreciation. Again, when the Fed buys government bonds, or mortgage bonds, or any other asset, it always finds willing sellers, usually brokers/dealers and banks. Successful bidding by the Fed for assets is the first step in lifting asset prices (and reducing yields). But market participants tend to know all this in advance. Therefore, private traders will bid up asset prices in advance, assuming that the Fed has indicated its intentions. Other assets, being substitute vehicles for wealth accumulation, will also be bid upward, as a given amount of income produced by an asset is valued more highly when competing yields are low. After the Fed completes a round of asset purchases, the process can repeat itself.

Goods inflation and higher asset prices generated by continuing debt monetization and distorted interest rates tend to skew the distribution of wealth toward the top and away from the bottom. Moreover, if cost and pricing pressure build up in goods markets, those with the greatest market power always fare best. Thus, debt monetization has the potential to be a very inegalitarian process, and one not based on fundamental economic criteria such a productivity. This too represents a damaging form of cultural change.

A more accurate form of Gresham’s law might be the following: government ambition drives out “good money”. The existence of fiat money creates an avenue through which the expansion of government can be funded without approval by current or future taxpayers. This ultimately leads to a stagnant economic environment and a stagnant culture: government displaces private activity, the economy’s growth potential and vibrancy deteriorates, and society’s ability to support all forms of culture declines. To add insult to injury, the process of monetizing government debt punishes small savers and rewards the privileged. The distribution of cultural rewards will follow suit.

Negative Rates and the Thrift Imperative

18 Thursday Aug 2016

Posted by Nuetzel in Monetary Policy

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Central Banking, Federal Reserve, Income effect, negative interest rates, Nominal Interest Rates, Rate Normalization, Reach For Yield, Real Interest Rates, Retained Earnings, Saving and Negative Interest Rates, saving behavior, Steven R. Beckman, Substitution effect, Supriya Guru, Thrift, Time Preference, Undistributed Corporate Profits, W. James Smith, Wall Street Journal, Working Capital

An article of faith among central bankers is that negative interest rates will stimulate spending by consumers and businesses, ending the stagnant growth that has plagued many of the world’s biggest economies. Short-term rates are zero or negative in much of Europe and Japan, and even the Federal Reserve holds out the possibility of bringing rates below zero in the event of a downturn. This policy is almost assuredly counter-productive. It very likely stimulates saving, especially in the context of an aging population, and it distorts the allocation of resources over time and across the risk classes to which saving is applied.

Real vs. Nominal Rates

A preliminary consideration is the distinction between the so-called nominal or stated interest rates, those quoted by banks and bond sellers, and real interest rates, which are net of expected inflation. If the short-term nominal interest rate is zero, but expected inflation is -2%, then the real interest rate is +2%. If expected inflation is +2%, then the real interest rate is -2%. When negative rates are discussed in the media, they generally refer to nominal rates, and central bank interest rate targets are discussed in nominal terms. Again, some central banks are targeting very low or slightly negative nominal rates today. In most of these cases, inflation is low but positive, indicating that real interest rates are negative. With that said, it’s important to note that the discussion below relates to real interest rates, not nominal rates, despite the fact that central banks explicitly target the latter.

Saving Behavior

Most macroeconomists casually assume that lower interest rates discourage saving and thus stimulate spending. However, this is being called into question by observers of recent central bank actions around the world. Those actions have been relatively futile in stimulating spending thus far. In fact, data suggest that the negative-rate policies might be increasing saving rates. These points are discussed in “Are Negative Rates Backfiring? Here’s Some Early Evidence” in the Wall Street Journal (or this Google search if the first link fails).

An examination of the microeconomic foundations of the standard treatment of saving behavior shows that it requires some limiting assumptions. We all face constraints in meeting our future income goals: our current income imposes a limit on what we can save, and the rate of return we can earn on our funds limits what we can accumulate over time from a given level of saving. Those constraints must be balanced against an individual’s preferences for present pleasure relative to future gain.

Time Preference

The rate at which agents are willing to sacrifice future for present consumption is often called the rate of time preference. This differs from one individual to another. A high rate of time preference means that the individual requires a large future reward to induce them to set aside resources today, foregoing present consumption. A low rate of time preference means that little inducement is necessary for saving, so the individual is “thrifty”. It’s generally impossible to directly observe differing rates of time preference across individuals, but they reveal their preferences for present and future consumption via their saving (or borrowing) behavior. If an individual saves more than another with an equal income, it implies that the first has a lower rate of time preference at a given level of present consumption.

Substitution and Income Effects

A lower interest rate always creates a tendency to substitute present for future consumption. That’s because the change is akin to an increase in the price of future consumption. However, that substitution might be offset, or more than offset, by the fact that total achievable lifetime income is diminished: the lower rate at which the individual’s use of resources can be transferred from the present to the future means that some sacrifice is necessary. In other words, the negative “income effect” might cause consumers to reduce consumption in the future and in the present! Thus, saving may increase in response to a lower interest rate. Perhaps that tendency will be exaggerated if rates turn negative, but it all depends on the shape of preferences for present versus future consumption.

Which of these two effects will dominate? The substitution effect, which increases present consumption and reduces saving? Or the income effect, which does the opposite? Again, consumers are diverse in their rates of time preference. There are borrowers who prefer to have more now and less later, and savers who might wish to equalize consumption over time or accumulate assets in pursuit of other goals, such as bequests. A shift from a positive to a negative interest rate would reward borrowers who wish to consume more now and less later. Both their substitution and income effects on present consumption would be positive! In fact, spending by that segment might be the only unambiguously stimulative effect from negative rates. But individuals with low rates of time preference are more likely to spend less in the present, and save more, after the change. Two individuals with identical substitution effects in response to the shift to negative rates may well differ in their income effects: the largest saver of the two will suffer the largest negative income effect.

Ugly Intervention

These uneven impacts on saving are a testament to the pernicious effects of central bank intervention leading to negative rates. Savers are punished, while those who care little about self-reliance and planning for the future are rewarded. Of course, at an aggregate level, saving out of income is positive, so on balance, agents demonstrate that they have sufficiently low rates of time preference to qualify for some degree of punishment via negative rates. After all, savers will unambiguously suffer a decline in lifetime income given the shift to negative rates.

The Necessity of Thrift

The fact that a standard macroeconomic treatment of saving ignores negative income effects at very low rates of interest is surprising given the very nature of thrift. Savers obviously view future consumption as something of a necessity, especially as they approach retirement. Present and future consumption are locally substitutable, but large substitutions come only with great pain, either now or later. Another way of saying this is that present and future consumption behave more like complements than substitutes. (A more technical treatment of this distinction is given in “Complementarity, Necessity and Preferences“, by Steven R. Beckman and W. James Smith.) This provides a basic rationale for a conflicting assumption often made in macroeconomic literature: that economic agents attempt to “smooth” their consumption over time. If present and future consumption are treated as strict complements, there is no question that the income effect of a shift to negative rates will increase saving by those who already save.

This is not to imply that savers always respond to lower rates by saving more. In “Choice between Present Consumption and Future Consumption“, Supriya Guru asserts that empirical evidence for the U.S. suggests that the substitution effect dominates. However, extremely low or negative interest rates are a recent phenomenon, and empirical evidence is predominantly from periods of history with much higher rates. Moreover, the advent of very low rates is coincident with demographic shifts favoring more intense efforts to save. The aging populations in the U.S., Europe and Japan might reinforce the tendency to respond to negative rates by saving more out of current income.

Risk As a Relief Valve

Another complexity regarding the shape of preferences is that consumers might never be willing to substitute present consumption for less in the future. That is, their rate of time preference may be bounded at zero, even if the interest rate imposed by the central bank is negative. An earlier post on Sacred Cow Chips dealt with this issue. In that case, saving will increase with a shift to negative rates under two conditions: 1) there is a minimal level of future consumption deemed a necessity by consumers; and 2) that level exceeds the consumption that is possible without saving (endowed or received via transfers). That outcome represents a “corner solution”, however. Chances are that consumers, having been forced to accept an unacceptable tradeoff at negative “risk-free” rates, will lean more heavily on other margins along which they can optimize, such as risk and return.

That eventuality suggests another reason to suspect that very low or negative rates are not stimulative: savers face a range of vehicles in which to place their funds, not simply deposits and short-term money market funds earning low or negative yields. Some of these alternatives earn much higher returns, but only at significant risk. Nevertheless, the poor returns on safe alternatives will lead some savers to “reach for yield” by accepting high risks. That is a rational response to the conditions imposed by central banks, but it leads consumers to accept risk that is otherwise not desired, with a certain number of consumers suffering dire ex post outcomes. It also leads to an allocation of the economy’s capital that is riskier than would otherwise occur.

Furthermore, as mentioned in the WSJ article linked above, consumers might regard negative rates as a foreboding signal about the economic future. The negative rates are bad enough, but even reduced levels of future consumption might be under threat. Thus, risk aversion might lead to greater saving in the context of a shift to negative rates.

Corporate Saving and Capital Investment

A great deal of saving in the economy is done by corporate entities in the form of “undistributed corporate profits”, or retained earnings. It must be said that these flows are not especially dependent on short-term yields, even if those yields have a slight influence on corporate management’s view of the opportunity cost of equity capital. Rather, those flows are more dependent on the firm’s current profitability. To the extent that very low or negative interest rates discourage consumption, their effect on current profitability and the perceived profitability of new business capital projects cannot be positive. To the extent that very low or negative rates portend risk, their effect on capital investment decisions will be negative. Savings out of personal income and from retained earnings is likely to exceed the amount required to fund desired capital investment. The funds accumulated in this way will remain idle (excess working capital) or be put toward unproductive uses, as befits an environment in which real returns are negative.

We Gotta Get Out of This Place

Central banks will be disappointed that the primary rationale for their reliance on negative interest rates lacks validity, and that the policy is counterproductive. Statements from Federal Reserve officials indicate that the next expected move in their interest rate target will be upward. However, they have not ruled out negative rates in the event that economic growth turns down. Perhaps the debate over negative rates is still raging inside the Fed. With any luck, and as evidence piles up from overseas on the futility of negative rates, those arguing for a “normalization” of rates at higher levels will carry the day.

Central Banks Stumble Into Negative Rates, Damn the Savers

01 Tuesday Mar 2016

Posted by Nuetzel in Central Planning, Monetary Policy

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Bank of Japan, central planning, Federal Reserve, Helicopter Drop, Income Effect vs. Substitution Effect, Interest Rate Manipulation, Intertemporal Tradeoffs, Malinvestment, Mises Institute, Monetary policy, negative interest rates, NIRP, Printing Money, Privacy Rights, QE, Quantitative Easing, Reach For Yield, regulation, War on Cash, Zero Interest Rate Policy, ZIRP

Dollar Cartoon

Should government actively manipulate asset prices in an effort to “manage ” economic growth? The world’s central bankers, otherwise at their wit’s end, are attempting just that. Hopes have been pinned on so-called quantitative easing (QE), which simply means that central banks like the U.S. Federal Reserve (the Fed) buy assets (government and private bonds) from the public to inject newly “printed” money into the economy. The Fed purchased $4.5 trillion of assets between the last financial crisis and late 2014, when it ended its QE. Other central banks are actively engaged in QE, however, and there are still calls from some quarters for the Fed to resume QE, despite modest but positive economic growth. The goals of QE are to drive asset prices up and interest rates down, ultimately stimulating demand for goods and economic growth. Short-term rates have been near zero in many countries (and in the U.S. until December), and negative short-term interest rates are a reality in the European Union, Japan and Sweden.

Does anyone really have to pay money to lend money, as indicated by a negative interest rate? Yes, if a bank “lends” to the Bank of Japan, for example, by holding reserves there. The BOJ is currently charging banks for the privilege. But does anyone really “earn” negative returns on short-term government or private debt? Not unless you buy a short-term bill and hold it till maturity. Central banks are buying those bills at a premium, usually from member banks, in order to execute QE, and that offsets a negative rate. But the notion is that when these “captive” member banks are penalized for holding reserves, they will be more eager to lend to private borrowers. That may be, but only if there are willing, credit-worthy borrowers; unfortunately, those are scarce.

Thus far, QE and zero or negative rates do not seem to be working effectively, and there are several reasons. First, QE has taken place against a backdrop of increasingly binding regulatory constraints. A private economy simply cannot flourish under such strictures, with or without QE. Moreover, government makes a habit of manipulating investment decisions, partly through regulatory mandates, but also by subsidizing politically-favored activities such as ethanol, wind energy, post-secondary education, and owner-occupied housing. This necessarily comes at the sacrifice of opportunities for physical investment that are superior on economic merits.

The most self-defeating consequence of QE and rate manipulation, be that zero interest rate policy (ZIRP) or negative interest rate policy (NIRP), is the distortion of inter-temporal tradeoffs that guide decisions to save and invest in productive assets. How, and how much, should individuals save when returns on relatively safe assets are very low? Most analysts would conclude that very low rates prompt a strong substitution effect toward consuming more today and less in the future. However, the situation may well engender a strong “income effect”, meaning that more must be saved (and less consumed in the present) in order to provide sufficient resources in the future. The paradox shouldn’t be lost on central bankers, and it may undermine the stimulative effects of ZIRP or NIRP. It might also lead to confusion in the allocation of productive capital, as low rates could create a mirage of viability for unworthy projects. Central bank intervention of this sort is disruptive to the healthy transformation of resources across time.

Savers might hoard cash to avoid a negative return, which would further undermine the efficacy of QE in creating monetary stimulus. This is at the root of central bank efforts to discourage the holding of currency outside of the banking system: the “war on cash“. (Also see here.) This policy is extremely offensive to anyone with a concern for protecting the privacy of individuals from government prying.

Another possible response for savers is to “reach for yield”, allocating more of their funds to high-risk assets than they would ordinarily prefer (e.g., growth funds, junk bonds, various “alternative” investments). So the supply of saving available for adding to the productive base in various sectors is twisted by central bank manipulation of interest rates. The availability of capital may be constrained for relatively safe sectors but available at a relative discount to risky sectors. This leads to classic malinvestment and ultimately business failures, displaced workers, and harsh adjustment costs.

With any luck, the Fed will continue to move away from this misguided path. Zero or negative interest rates imposed by central banks penalize savers by making the saving decision excessively complex and fraught with risk. Business investment is distorted by confusing signals as to risk preference and inflated asset prices. Central economic planning via industrial policy, regulation, and price controls, such as the manipulation of interest rates, always ends badly. Unfortunately, most governments are well-practiced at bungling in all of those areas.