Wednesday, July 14, 2010

Fed Monetary Confusion Hits Front Page of WSJ

The lead story in today's WSJ discusses the supposed Fed easing policy and whether the Fed should do more, given that the Fed has driven interest rates to "near zero"

In fact, rates are not at zero. The effective Fed Funds rate is at 0.17%. At the same time, the Fed continues to pay interest of 0.25% on excess reserves. There are over a trillion dollars in excess reserves.These are reserves not in the system. The Fed Funds rate is the rate banks are bidding for reserves to loan out.

As long as the Fed pays more for excess reserves than the going Fed Funds rate, it will be extremely difficult for the Fed to expand the money supply. WSJ appears to ignore this fact, as do some Fed members.

The Fed doesn't need to add reserves, it simply needs to drop the rate paid on excess reserves below the Fed Funds rate and those reserves will come flying into the system.

That said, it would be a mad policy and highly inflationary to do so. But the fact that WSJ and Fed members don't seem to understand the relationship between the funds rate and the rate paid on excess reserve is a stunning example of the basic ignorance of how the Fed operates and ignorance of what the Fed's impact on the economy is.

The history of this era, if written by these people, will talk of how the Fed's "aggressive" policy failed to turn the economy around, and only caused deflation. There evidence will be the "near zero interest rates." They will not once realize that as far as monetary policy goes, the relation between various rates is as important, if not more so, than the absolute rates themselves.

A stable money policy (which the Fed appears to be conducting by accident) is the ideal money policy. However, in  a world where the government wants to manipulate the country out of a downturn and thus prevent the adjustments that a stable monetary policy would bring, we have the current government created stagnation. A stagnation created by propping up the failed and weak sectors of the economy--sectors that can only survive in an inflationary environment.

It's the equivalent of now embalming the body of George Steinbrenner propping the body up in a chair at Yankees Stadium and allowing him to run the team for one more year.

Time has moved beyond Steinbrenner and beyond the last bout of monetary inflation, and they both should be allowed to rest in peace, and the economy should be allowed to adjust to their absence.

1 comment:

  1. All this "sterilization" nonsense is about having your cake and eating it, too (i.e., creating more money to avoid a deflationary collapse, but not actually letting it get into the system, because, you know - that might cause inflation).

    How I long for private money.