The discussion started off with an email to Fil Zucchi so let’s start there.
Mish to Professor Zucchi
Fil, I would like to discuss a comment you made about the “Fed pumping money”. I am not trying to nitpick but “pumping money” doesn’t seem to be the best description of what is really happening. Here is how I look at things:
This Fed has chosen to defend an interest rate target. The Fed must supply all demand for credit at that target. If the Fed failed to do so the interest rate target would not be hit and interest rates would either rise or drop accordingly.
Now I am a big fan of abolishing the Fed and letting the market set rates, but as long as the Fed has an interest rate target (as opposed to a money supply target) the Fed is not pumping money per se, the Fed is defending an arbitrary target that it has established, no more no less. Thus it is not the Fed initiating anything, the Fed is merely meeting demand for money at the arbitrary target they set.
Now if the Fed instead set money supply targets instead of interest rate targets then interest rates would float day to day and money supply policy would be known. Yet every day I hear the same comments every day “The Fed is pumping to save housing” or “The Fed is pumping to save the stock market” or “The Fed is pumping the PPT”. All of this kind of talk seems ass backwards to me. The Fed is meeting money supply demands at its target. Period. Typically the Fed has been meeting demand for money with repos. Repos are short term loans, not part of permanent money supply.
But people take these ideas about “pumping” as well as conspiracy theories about M3 and draw still more inaccurate conclusions as to what is going on. I can and will make a case that looking at M3 in isolation is missing the big picture (at least from an Austrian perspective) as to what is really going on with money supply. But that is another issue for Friday or early next week in my blog.
Right now, it’s time to clear up this “pumping money” issue. Claims that the “Fed is pumping money” is putting the cart before the horse because by defending an interest rate target instead of a money supply target the Fed does NOT have a choice as to what the demand for money will be at its designated (and arbitrary) target currently set at 5.25%.
In essence I feel that “pumping money” statements only serve to reinforce various conspiracy theories that are now running rampant. If I am mistaken then perhaps you or John Succo or Scott Reamer can clear up my misconceptions and I welcome the opportunity to learn.
Response from Professor Zucchi
HI Mish – great points and I understand what your saying, but I am not sure I agree entirely with it. A response will require me to wear my thinking cap for a while, but I’ll certainly post one. Meanwhile I’m gonna send this on to Succo, Reamer and Sedacca as I imagine they may wanna give a crack at it as well. Hear u soon, Fil
Response from Professor Succo
Both are right…we are picking over semantics.
The Fed has set an artificially low interest rate. The market wants higher rates because it sees the problems these low rates are causing: that money is getting into speculation and very low grade credit. The Fed must supply enough new credit (repo) in order to keep rates from rising. The recent steepening of the yield curve is telling us that this is hard to do: they are doing too many repos trying to keep rates low.
If the Fed wants to stop pumping money they would admit that rates are too low and would raise them.
In fact the recent steepening is very alarming. It is due to defaults/foreclosures/ where lenders are saying they cannot continue to pass on to speculators/low quality borrowers all that new credit the fed is trying to force into the market.
An inverted yield curve normally predicts a recession. That recession comes home to roost when the yield curve suddenly steepens our of that inversion: the market is tightening out of necessity just as the fed is trying to make it not to.
Response from Professor Reamer
There is another operational element here that very few folks appreciate and it is this: In setting the fed funds target rate and defending it, the Fed’s open market operations take the form of either pumping liquidity into or out of the banking system (via Fed Funds) in an effort to keep the target rate at (for now) 5.25%.
Let’s say that economic activity is heating up; there is more manufacturing activity, more employment, more lending by banks and as a result of all of those, more demand for short term monies by commercial banks. Bank lending activity goes up and their demand for short term money (the cost of which is set by the Fed) increases commensurate with their need to keep capital/coverage ratios at whatever bare minimum regulations demand they be. So, net/net greater economic activity implies more money demand by commercial banks. If money demand by commercial banks increased, in the absence of the Fed, we would see the ‘cost’ of the money (the interest rate) do what?
Like all goods, when the demand for something goes up, the price increases in the short run. So in the case of short term (Fed) funds, increased economic activity generates greater demand for short term funds by commercial banks and that increases the cost of those monies – increases the interest rate of these monies. But the rate – cost – of Fed Funds is 5.25% and the good boys at the NY Fed have pledged that it will defend the FOMC’s Fed Funds target – neither letting it rise nor fall. But if increased economic activity is driving up the Fed Funds rate, then the Fed must increase the supply of credit in an attempt to keep the rate at 5.25%. This is of course a basic law of economics: in the face of increased demand, prices rise. The only thing that can keep prices the SAME would be an immediate increase in supply. And that is what the NY Fed does when economic activity increases – they increase the supply of monies in the system (via repos and other means) in order to defend that Fed Funds target.
More interesting than that is what happens when economic decreases. The opposite situation arrives: when economic activity decreases the demand from commercial banks for short term funds decreases and thus the price (rate) falls. In order to maintain and defend that fed funds target in a scenario where economic activity is decreasing and lending activity is slowing, the Fed has to decrease the supply of monies available to the system. Thus, the Fed will be taking money from the system once economic activity decreases unless and until they change the Fed Funds rate target.
That period of time between a slowdown in economic activity and an eventual decrease in the Fed Funds rate can take months or quarters. If the size and severity of the misallocation of investments in the economy are significant, that period where the NY Fed open market desk is defending the FOMC’s rate by decreasing monies in the system, need not be lengthy at all to create the kind of tightening of monies that is so anathema to a credit-driven, asset-based economy. A few months of taking money out of the system in order to defend a Fed funds target is all that is theoretically needed to create the type of tail event that we believe it highly probable in the credit and stock markets, not to mention the real economy.
The conditions of decreasing economic activity are present; the malinvestments are both huge and pervasive; the Fed could easily start to take money out of the system to keep the Fed Funds rate at 5.25%; and commercial bank lending declined last week more than it has at any time since February 1960. Those are the conditions – sufficient but perhaps necessary – for a credit-based contagion event. And few times in history have markets been implying the odds of this are so low.
I took the liberty of passing on Professor Succo’s comments to my Austrian minded friend who goes by the name of Trotsky.
Trotsky Chimes In
- You are right – Since the Fed has abandoned ‘money supply targeting’ it merely supplies WHATEVER the market demands at the prevailing set target. Note however, that lately, the Fed has supplied funds quite often well BELOW target, so the idea that it is busy ‘pumping’ right here and now is not totally off the wall. Nonetheless I agree with the general thrust of your argument.
- Succo is also right – When the curve begins to steepen out of an inversion, the recession alarm bells go off. This is due to the nature of the whole thing – Why is the curve inverted? It is not because the Fed has deliberately inverted it – After all, in setting the FF rate, the Fed actually tends to follow rather than lead the short term market interest rate. In other words there is a feedback loop – when the market expects them to tighten, it will raise t-bill yields before they actually tighten, and vice-versa. So what creates inversions? It is mostly enormous demand for short term speculative credit.
- The previous episode of money pumping (examine money supply growth charts for 2001-2002 when they dropped rates to 1%, and you will see they went off the charts) begins to percolate through the markets setting off asset bubbles (stocks, housing, commodities – what have you), that produce returns that far exceed the rate charged by the Fed. Consequently, demand for credit based speculation heats up, as the bulk of traders, hedge funds, etc. are simply trend followers. This eventually inverts the curve. Thus, when the curve begins to steepen out of an inversion, it signals a growing loss of liquidity, as speculative demand for credit wanes (for whatever reason – it could well be that lenders become reluctant to supply more credit, such as is the case in housing now).
- The ‘market is tightening out of necessity’ just as Succo has put it. Since the boom was entirely artificial and credit driven, the sudden loss of credit intermediation support shows up as a steepening curve and morphs into a recession/bear market.
- The Fed IS or HAS BEEN pumping in the sense that the rate it has set is still lower than the one the market would have set if rates were completely free in the face of such overwhelming demand for credit. In short, the housing bubble would have been stopped in its tracks much sooner in a truly free market, as the demand for mortgage credit would have pressured rates higher much earlier. Of course, in a truly free market, the entire rate term structure would look different – there would be scant difference between short and long rates most of the time, and rates overall would be far lower in an honest money system.
- As Professor Reamer points out the big risk is for a “credit-based contagion event” especially if the Fed artificially tries to hold the Fed Funds Rate higher than where the market thinks rates should on the way back down. Such actions would require various monetary draining operations by the Fed that perhaps the market is not prepared for.
- If the Fed has indeed been supplying money at rates below the Fed Funds Rate as Trotsky pointed out, then the word “pumping” in and of itself seems appropriate.
- If the Fed was targeting money supply instead of defending an arbitrary interest rate target it would be easier to defend claims one way or another whether or not the Fed was “pumping money”.
- In a free market economy where the market set interest rates instead of the Fed, the housing bubble never would have gotten as big as it did because interest rates would have been driven higher faster and may not have gotten as low as they did in the first place.
Outside of the Fed supplying money below their targeted rate, this may be a debate over semantics as Professor Succo suggests. Nonetheless I am sticking with my cart/horse scenario simply because defending an interest rate target while claiming to be fighting inflation (as the Fed is doing now) is putting the cart before the horse.
When it comes to inflation fighting discussions, talk about the CPI, PPI, capacity utilization, as well as the price of oil, copper and cotton is in reality nothing but a sideshow. Inflation starts with an expansion of money and credit. It is striking (as well as absurd) that we have a monetary policy where the Fed discusses everything but money.
By arbitrarily defending interest rates targets that the market never would have set, the Fed put itself in a box and started chasing its own tail inside that box. The Fed is now wondering what to do next when there simply is no right solution at this point other than to abolish the Fed and let the market fix the problem over time. Since that is not about to happen any time soon, the best we can do is watch for conditions that might signal the beginning of a “credit-based contagion event“.
Mike Shedlock / Mish/