Friday, August 27, 2010

Five Second ... Sumner on what the Fed does

It's so nice to have him back from vacation.
2. The first misconception is that the Fed “controls” interest rates.  In fact, the Fed controls the monetary base, and targets interest rates.  Rates are always allowed to find their free market values, given the setting of the monetary base.   So if the Fed wants to reduce rates, it might increase the monetary base until the equilibrium free market rate falls to the desired level.
3.  But doesn’t the Fed distort the bond market when they swap cash for T-bills?  Maybe a tiny bit, but that’s not really why rates fall when the Fed increases the monetary base.  The same liquidity effect used to occur in the old days when the Fed bought gold.  The effect occurs because there is more non-interest bearing money in the public’s hands.  Until consumer prices have had a chance to rise, the only way to get people to hold this extra money is for free market rates on alternatives assets to fall.  These rates are the opportunity cost of holding cash.  So monetary policy is fundamentally about the supply and demand for money.  Interest rates are just one of many variables that change as a result of changes in the money supply.  ... Imagine someone criticizing a reduction in the inflation target from 3% to 2% on the grounds that it would be a subsidy to consumers!
4.  ... But isn’t there some sort of “natural rate” and isn’t the Fed messing things up by setting rates below that natural rate?  ... Obviously credit markets (financial asset prices) can adjust to any inflation rate, but the real economy has trouble when inflation (or NGDP) rises or falls unexpectedly.  So if there is a “natural rate of interest” it would be the rate where inflation or better yet NGDP is optimal, where the macro economy is in some sort of equilibrium.  Where you don’t have mass unemployment, or overemployment, because nominal wages are temporarily stuck at the wrong level.  Even if you don’t believe in sticky wages or prices, and simply support steady 2% inflation, there is still a natural rate; it is the rate that generates that target inflation rate.  But one shouldn’t even focus on the natural interest rate, as we don’t have any way of directly estimating it ...  Instead, the focus should be on NGDP and inflation expectations.  Get those variables right, and then interest rates will also be at the proper level.
5.  Thus the question is never whether low rates unfairly subsidize borrowers, or whether high rates unfairly tax borrowers, because the Fed is not directly fixing interest rates, or driving any sort of tax or subsidy wedge between lenders and borrowers.  Rates are set in the market.  The question is whether the money supply is set at a level that produces the sort of interest rates, exchange rates, prices, NGDP, etc, that are consistent with optimal macroeconomic performance.
 And on our current situation?
the latest TIPS spreads:
5 year conventional T-bonds 1.33%,  Indexed bonds 0.08%,  TIPS spread 1.25%
10 year conventional T-bonds 2.50%, Indexed bonds 1.03%, TIPS spread 1.47%
Both have been falling like a stone.  This suggests that a sharp slowdown in NGDP growth is very likely.  Until now I’ve tried to remain an optimist, disappointed in the pace of recovery, but assuming that we were at least muddling forward.  But it is now clear that we are no longer recovering. ...

Excluding WWII, no one has ever overshot toward high inflation coming out of a zero rate trap.  That’s why Krugman and I can have such serene confidence that the inflation scare-mongers will be proved wrong.  I’ve seen this movie already.  Several times.

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