Friday, July 18, 2014

New Bill Calls for Built in Money Printing by The Fed...

...via a mathematical formula that determines Federal Reserve fed funds target interest rate.

Alan Blinder explains:
 The bill under consideration is called the Federal Reserve Accountability and Transparency Act. (That's right: FRAT.)...the meat-and-potatoes of the House bill has little to do with either transparency or accountability...

As the title of Section 2 puts it, FRAT would impose "Requirements for Policy Rules of the Federal Open Market Committee." A "rule" in this context means a precise set of instructions—often a mathematical formula—that tells the Fed how to set monetary policy. Strictly speaking, with such a rule in place, you don't need a committee to make decisions—or even a human being. A handheld calculator will do...

About two decades ago, Stanford economist John Taylor began plumping for a...rule, one which forces monetary policy to respond to changes in the economy—but mechanically, in ways that can be programmed into a computer. While hundreds of "Taylor rules" have been considered over the years, FRAT would inscribe Mr. Taylor's original 1993 version into law as the "Reference Policy Rule." The law would require the Fed to pick a rule, and if their choice differed substantially from the Reference Policy Rule, it would have to explain why...

In a town like Washington, the message to the Fed would be clear: Depart from the original Taylor rule at your peril...

So what is this rule that FRAT would turn into holy writ? It's a simple equation, which starts by establishing a baseline federal-funds rate that is two percentage points higher than inflation; that's about 3.5% now. It then adds to that baseline one-half of the amount by which inflation exceeds its 2% target (that "excess" is now roughly minus 0.5%). Next, it adds one-half the percentage amount by which gross domestic product exceeds an estimate of potential GDP (that gap is controversial but is perhaps minus 4% today). Thus Taylor's mechanical rule wants the current fed-funds rate to be about 3.5 – 0.25 – 2.0 = 1.25%—which is vastly higher than the actual near-zero rate.
Of course, the problem with this formula is that it completely ignores free market interest rate determination and would result in erratic changes in money supply growth. SEE: Murray Rothbard in Austrian School Business Cycle Theory for the best discussion of how interest rates and money supply manipulations cause the business cycle.

There is no need for a formula to determine interest rates. In fact,  it is a special form of price control that can lead to shortages or oversupplies, since it will generally result in a rate that would be different from market rates. In the case of controls on interest rates via the Fed, it is credit that will find itself at greater or lesser levels than would occur in a free market.

It is economic technocrats like Taylor, who simply hate free market and who are mesmerized by mathematical formulas, that attempt to plan out and distort natural market conditions. There is no need for such mathematical formulas, they are dangerously distorting, as are all manipulations of interest rates by the Federal Reserve.


1 comment:

  1. Monetary discord

    Last Monday’s Daily Telegraph carried an interview with Jaime Caruana, the General Manager of the Bank for International Settlements (the BIS). As General Manger, Caruana is CEO of the central banks’ central bank. In international monetary affairs the heads of all central banks, with the possible exception of Janet Yellen at the Fed, defer to him. And if any one central bank feels the need to obtain the support of all the others, Caruana is the link-man.

    His opinion matters and it differs sharply from the line being pushed by the Fed, ECB, BoJ and BoE. But then he is not in the firing line, with an expectant public wanting to live beyond its means and a government addicted to monetary inflation. However, he points out that debt has continued to increase in the developed nations since the Lehman crisis as well as in most emerging economies. Meanwhile the growing sensitivity of all this debt to rises in interest rates is ignored by financial markets, where risk premiums should be rising, but are falling instead.

    From someone in his position this is a stark warning. That he would prefer a return to sound money is revealed in his remark about the IMF’s hint that a few years of inflation would reduce the debt burden: “It must be clearly resisted.”
    There is no Plan B offered, only recognition that Plan A has failed and that it should be scrapped.