Saturday, December 5, 2015

Have I Gone Keynesian?

The commenter sonepatchworth, who (hee, hee) doesn't think the Fed will raise rates at their December monetary policy meeting, left the following comment at my post, "211,000 New U.S. Jobs All But Guarantees a Fed Hike":
If RW thinks higher rates will not traumatize an economy with a labor structure, capital structure, and cash flows adjusted to and dependent on the embedded subsidy and distorted signals of artificially low rates, and RW thinks higher rates will not start to rupture artificially levered-up asset price bubbles, then RW implicitly endorses the effectiveness of artificially lowered interest rates at creating real and lasting improvements in jobs, productivity, and asset prices.
In other words, if RW's prediction is correct that the Fed can allow rates to rise and the economy will not turn for the worse, then Keynesianism is correct!

Generally, I would consider such a troll attack infra dignitatem to respond to. However, commenter Hollow Daze followed up with this comment:
Very well said. I would like to hear RW's response to that...
So based on the possibility that there are some EPJ readers genuinely confused, I will slice the sonepatchworth's comment to bits.

First, sonepatchworth creates something of a straw man when he writes, " RW thinks higher rates will not start to rupture artificially levered-up asset price bubbles,"

I do not hold the view that all Fed rate hikes will not start a crash of the Fed manipulated economy, merely, as I have pointed out here at EPJ and emphasised in the EPJ Daily Alert. a 25 basis point hike in the target rate is minuscule. In my book, it is not much different than a Fed rate hike of 0.000000001%, That is, this will result in no slowdown in Fed money supply growth because it is a very small matter, especially if we start to see an acceleration in price inflation of the type  that I am expecting.

More significant, however, is that sonepatchworth and most of the financial community have their eye on the wrong interest rate. The most important interest rate (and, again, this is something I have pointed out in the  EPJ Daily Alert) is the effective funds rate. This rate, as can be seen in the chart below, has been climbing for some time:

Despite this climb in the effective Fed Funds rate, money supply growth has generally been growing,

This can occur if the natural rate, by which I mean the rate that would exist if the Fed didn't interfere in the rate market, is climbing faster than the effective rate. It is this growth in the money supply, caused by the natural rate-effective funds rate differential that is fueling the current Fed manipulated boom. There is a level at which the Fed could raise rates and it would stop the manipulated boom, but we are just far from that point.

I hasten to add that I do expect  some climb in the effective Fed funds rate, once the Fed raises the "target rate," and I will have a more detailed discussion in the  ALERT about this, so I won't go into it here. It's suffice to understand here that a minuscule hike in the target rate is unlikely to mean a slowdown in money growth, Thus, far from being a Keynesian who " implicitly endorses the effectiveness of artificially lowered interest rates at creating real and lasting improvements in jobs, productivity, and asset prices," I just have a sharper, deeper and more sophisticated understanding of interest rates, money supply growth and Austrian Scool Business Cycle Theory than does sonepatchworth.

Rates below market levels create the distorted boom, which we are experiencing now. There is nothing "lasting" about this manipulation, since it requires greater and greater amounts of new money to be added to the system to keep the manipulated boom going on. It is a boom that will eventually end, if for no other reason than because it will ultimately lead to serious accelerating price inflation that will cause the Fed to seriously raise rates significantly enough to stop money supply growth (Alternatively, a price inflation crack up boom is theoretically possible that could destroy the currency.).

Thus, I see nothing "effective" about such Fed manipulations.



  1. Thanks for taking the time to respond. Kinda tough to follow, though. You replied to the statement "RW thinks that higher rates will not start to rupture artificially levered-up asset price bubbles" by saying "all Fed rate hikes (particularly 25 bps) will not start a crash of the Fed manipulated economy." Levered up asset price bubbles and the economy are not the same thing (Wall St. vs. Main St.) I would expect different outcomes for each.

    Next, you're talking about the target rate, then the fed funds rate, then the "natural rate", the differential between fed funds rate/natural rate, then money supply growth, then accelerating price inflation. I don't claim to be an Austro-Hungarian Econometrician so I'll admit I don't know what the hell you're talking about here.

    My take away, I think, is that you are saying that a 25 bps hike will not slow down money supply growth and therefore will not "traumatize an economy with a labor structure, capital structure, and cash flows adjusted to and dependent on the embedded subsidy and distorted signals of artificially low rates" but a certain (unstated) level of higher rates could "stop the manipulated boom." Therefore, under your analysis, it is possible for the Fed to blow bubbles in asset markets and cause distortions in the economy via ZIRP policies but avoid calamity by raising rates only slightly, even though there is the risk of accelerating price inflation (which the Fed claims to want, btw). This may not be an endorsement of Fed "effectiveness" but it doesn't exactly discredit its effectiveness, either.

    The thing is, your analysis would've applied just as well in September but nothing happened. I'm sticking with no rate hike and, if there is a hike, large downsides in asset price markets over the short term and negative consequences, although to a lesser extent, for the general economy and especially government finances over the medium term. Such downsides would quickly generate a political call for the Fed to reverse course (Ms. Chairman, get to work!). Then on to cashless society and negative rates...

    1. The analysis did apply the last couple of rounds, but their fears and kick the can won out. That's what I felt would happen and it did. They kicked the can but the can is up against a wall now. They are stuck. To remain credible they have to increase by something however small and irrelevant.

  2. RW refers to 3 different interest rates here: the Fed target rate (FTR), the Fed effective rate (FER), and the normal or market rate. The FTR is actually a range, currently between 0.00 and 0.25. The FER is the actual interest rate, and the Fed manipulates it using open market operations (money printing), but they keep it within the target range. The normal rate is what the rate would be if the Fed were not manipulating the market. Unfortunately it is impossible to tell for sure what this value is, but it can be deduced that it would be higher than the inflation rate because in a free market negative real rates would not exist.

    If the FER is less that the normal rate, the Fed must print money to keep it supressed. But that doesn't mean they are printing enough money to maintain the current capital structure. This is why it is important to look at money supply growth as RW does in order to predict future economic conditions.

    1. Short to medium term economic predictions are a fools game. None of these rates is knowable with precision. Even the money supply growth rate is a government statistic based on faulty assumptions. You waste your time with this as there is no need to predict. Set your targets, manage your risk and execute when you hit your targets.

  3. Thanks for the thoughtful reply. Responding to opposing views with content reflects highly upon you and is appreciated over radio silence. I'll go digest and study what you wrote. You are more experienced and formally qualified than I to dissect Fed machinations. If you prove me wrong in this case, it will be my educational gain, and I will owe you my thanks for setting me straight.

    But I don't base my positions on the credentials or opinions of others. Just on such facts and reasoning as make sense to me. Which is how I came to be a libertarian despite every earthly practical reason not to.

    If "troll" (or "pseudo-Austrian") be the label applied to me and presumably any other libertarians who counterpose your economic stance, then I suppose troll I must be. Maybe I should start wearing a viking horn hat, carrying an ax, and saying churlish things. I'm new to this, is there a how-to guide somewhere?

    1. "Economics in One Lesson" by Hazlit and "what has the government done to our money" by Rothbard are entry level

  4. An excellent post, sone. Just ignore the name calling. A point of logic, that the fact that Wenzel believes that the Fed will raise rates, correctly this time I think, doesn't mean he doesn't think it would cause harm, and thus doesn't make him a Keynesian. He could hold the belief that they will raise rates and it will cause massive harm like some others, e.g. Rickards. Although in this case, Wenzel doesn't think it will cause a catastrophe because it won't slow down money creation enough. But we do enter a gray area here. How big a rate would hurt? How fast must the money supply grow to maintain the capital structure? Austrian theory teaches us that money supply must be accelerating to maintain a "bubble" economy. But at what rate? These are things that can not be known for certain. Methodology matters too: Wenzel prefers an annualized three month MS approach, I prefer a year to year comparison. The best introduction to business cycle is Rothbard's book: America's Great Depression. Hayek wrote some interesting things about the business cycle, of course. But my personal favorite is Richard Strigl's book: Capital and Production. These works are available at Mises org

  5. I’ve studied your argument. I think we share more views than not and am more clear now on where we diverge. Here’s what I see:

    Weakness #1) Observing that the Fed Funds Effective rate can slightly differ from Fed Funds Target rate is a triviality. It makes no meaningful difference because Fed operations ensure the gap between them almost never gets beyond 10-20 basis points:

    Weakness #2) Observing only that a single 25 basis point rise in the Fed Funds Target rate is by itself not enough to directly, significantly impact the cost of money without also observing the ramifications is to don blinders. No one believes a 25bp hike will be the beginning and end of Fed raising of rates. All market participants presume this first raise will constitute “liftoff,” i.e. the beginning of a series of raises ostensibly culminating in “normalization” hundreds of basis points later after progressive hiking throughout 2016 and 2017 consistent with a fundamental change in Fed policy to stop suppressing interest rates. The Fed does not change its interest rate policy every few months. That would create enormous market uncertainty and shatter the Fed’s narrative that they know what the hell they are doing.

    So if we do like everyone else and price-in a series of hikes after a December hike, we see a substantial narrowing ahead for the gap between the natural rate and the effective rate, i.e. a progressive reduction in the rate of the money supply expansion keeping the current bubbles inflated.

    Strong Point) Price inflation changes the calculation. The natural interest rate includes the price inflation rate along with the time value of money rate.

    As we agree, huge actual+potential money supply inflation has already happened with the ton of base money printed, yet realized price inflation has been forestalled by numerous factors. As you correctly observe, the Fed keeping interest rates steady, or even raising them more slowly than the rate at which price inflation is increasing, is still tantamount to printing money at a faster rate to keep the bubble inflating. The gap between the effective and the natural rate would still be increasing. In other words, Fed rate increases that lag or just keep pace with increases in the rate of price inflation, are not TVM rate increases. That is a great point, easily overlooked.

    My Counterpoints) It is all but impossible to quantitatively assess and pick exact timing of and size of price inflation. The breadth and scope of factors masking and compensating for money supply inflation are numerous and broad. In the next year, foreign central bank or investor flight-to-safety demand for dollars may skyrocket, domestic demand for discretionary goods may collapse, or default-rates/risk-premia on loans may rise. Despite the massively expanded money supply compared to 2007, in the near term, we may very well observe price deflation rather than price inflation. Given this, how can we predict whether a series of 0.25% hikes in 2016 will be outpaced by price inflation in 2016? We can’t. So we shouldn’t.

    Moreover, at minimum, a Fed rate hike series kickoff signals a material slowing of the rate of increase of money printing. Since markets price all expectations of forward conditions, including the trajectory of money printing, this downward revision must have a negative impact on an economy and asset prices buoyed up only by increases in money printing rather than real productivity.