The Fed’s Abilities

Chum, This is a topic that has potential, but my economics courses were taken over 45 years ago. I studied both macro and micro economics, and have some ideas about the money supply and how the US federal reserve has played with interest rates in order to control inflation.

As you have already stated, it's impossible for anybody to forecast future economic activity which is the engine that moves money.

The how, when, and why's of money and the world economy would be an interesting discussion.

bm

Hi cicerone imposter,

In essence the inflation hawks in the Fed are micro-managing the short end to a net deleterious effect, in the misguided belief that they are stabilizing economic conditions.

As discussed, without a predictive tool, they are driving with the rear view mirrors.

In fact, I suggest that this blind micro-managing of the short end exacerbates, not moderates interest rate volatility.

It does all tie in with global economic interdependence, but again, it's a lot of work for me and I need critical mass of posters to make it interesting, otherwise I'm just pissing in the wind, even if it is well thought out pee.

Thanks for the bm, let's hope for more mass!

Do you have evidence for that? Is interest rate volatility greater now than it was under the gold standard? Enough so to offset the reduced volatility in inflation?

Thomas, From MPV, I see the fractional percentage point changes in the interest rate to be immaterial to the overall money supply.

If in a closed micro-economy, let's say the money supply is 10 billion dollars, but the total economy only produces 1 billion dollars. People do not realize it, but we already have inflation; there's too much money in circulation compared to the productive capacity of the economy.

Trying to control inflation by toying with the interest rate on money is not the solution in MHO.

Paying five percent interest to the holders of currency results in more inflation. Unless the productive capacity keeps up with interest rate increaes, we only end up with more money in circulation. I call that inflation.

But in reality, the ratio is more nearly the other way round: the economy produces 10 trillion dollars worth of goods and services each year, while 1 billion dollars circulate in cash. The exact ratio depends on which assets you define as "money". But whatever your definition of `money', the value of the money in circulation is always a fraction of the value of goods the economy produces every year.Here is the latest Fed report on the quantity of money. And here is the latest GDP report from the Bureau of Economic Analysis. As you can see, the amount of currency increased from $700 B to $735 B (or about 5%) over the last year, while the economy grew by 3.5%. Based on this, you would predict that inflation was 1.5%. The actual value was 3.6% -- mostly because of rising energy prices, which the Fed cannot directly target. I see nothing out of line in this picture.


Well, the Bureau of Labor Statistics isn't realizing it either. In its latest report, the inflation rate it measures has been 2.6% over the quarter (anualized) and 3.6% over the year. None of this is out of line.


But that isn't what's happening. The holders of currency (also known as cash) are not being paid any interest at all; the five percent you mention are paid to those who hold bonds instead of currency. This discourages the holding of currency, thus reduces the money supply, which in turn decreases the rate of inflation. The Federal Reserve Bank's website has a primer on monetary policy. It's a bit too animation-happy for my taste, and it evidently targets people much younger than us. But it explains the basics fairly well.

Thomas wrote:
But in reality, the ratio is more nearly the other way round: the economy produces 10 trillion dollars worth of goods and services each year, while 1 billion dollars circulate in cash.

A: It doesn't matter that there's only 10 percent of the dollars are in circulation. It matters that most households and our federal governmen are in debt up to their eyeballs that continues to cost for those borrowed monies. That's money already spent withou any source to back it up. That's all part of the formula for inflation.

Thomas wrote:
Well, the Bureau of Labor Statistics isn't realizing it either. In its latest report, the inflation rate it measures has been 2.6% over the quarter (anualized) and 3.6% over the year. None of this is out of line.

A: See my answer above. It does matter, and it is "out of line" when compared to the public and private debt.

Thomas wrote:
The holders of currency (also known as cash) are not being paid any interest at all; the five percent you mention are paid to those who hold bonds instead of currency.

A: Same answer as above. I agree the holders of currency doesn't earn any interest, but the real issue is the debt, not the cash being held.

No it's not. Debt by itself has nothing to do with inflation. For example, debt in Italy is much higher than in Germany, but inflation is not. There is no connection there.

Thomas wrote:
Debt by itself has nothing to do with inflation.

A:
Money, Debt, Hyper-Inflation & Deflation

John Lee

I wrote about money and debt quite a few times before. Amid Japan's coming out deflation and US large debt problem, let me elaborate further on the subject here.

In a normal society, money is an asset. A transaction is complete and extinguished when money and goods changed hand. Buying a loaf of bread with gold is one such transaction since gold itself is an asset.

Today, money is created through borrowing - pure and simple. When you receive that new creditline/mortgage/loan, money is created out of thin air. This is how money is created and how prices managed to rise amid technology improvements. Just look at how much money is created since 1970 (M3 from less than 800 million in 1970 to now nearly 10 trillion, or about 13 fold increase in 35 years).




Under this debt-as-money scenario, the paper you get for giving up a loaf of bread isn't worth a thing until you exchange that paper for some real goods.

Now I want to talk one thing about debt that other analysts rarely understand. Debts are a feature created by man. It's abstract, a promise that can be broken.


Now let's talk about Japan, Japan had nearly 20 years of stagnant economic growth and real estate prices under the pretence of debt-caused deflation. Does this mean Japan created no wealth and advances in the last 20 years? Check out the cars in your driveway and local electronic store - you know they accumulated lots of know-how and Japan is world's largest saver.

All that debts did to the Japanese is creating a 2-decade-long pent-up demand. It takes a flip of a switch in mental attitude to go from deflation-wealth-preserving mode to inflation-spending mode, and I believe Japan in 2005 has undergone such shift in attitude (see market update). The Japanese economy I see for the next decade is a robust one that revives through Chinese and Japanese domestic consumption.

On the other side of the coin, as long as the US government promotes easy credit and US public resist from shifting to the savings mode. We will continue towards hyperinflation.

Paper money eventually resorts to hyperinflation without fail. The trick is the timing. Frequently people ask me what happens after hyperinflation. Deflation? Yes, in a way. After hyperinflation, we start with a new currency. The unit of measure changes completely therefore it will be tough to compare prices before and after the currency transition. The ratio of leveraged assets to unleveraged assets should decline by orders of magnitude. So when the new currency is instituted after the last one blows up, the exchange ratio between an apple and orange should still be the same, but it will most likely take a lot fewer apples to buy an apartment or a share of Google stock.

In hyperinflation, most public aren't affected seriously since most of them are broke. Your job as a saver is to identify things to keep that will preserve your savings. Things to stay away are paper currency and leveraged assets. Things to get into are unleveraged tangibles of necessity - soybean, copper, gold, oil, land. Those are basic commodities that survive through the ravage of hyperinflation.



John Lee

who is John Lee, and what makes him an authority? (He sounds like somebody who's trying to sell you gold.)

It doesn't matter who John Lee is; what matters is his thesis about hyperinflation based on debt.

Many consumers have credit card debt with interest rates exceeding 10 percent (some as high as 20). In a 3 percent inflation world, they're paying a high premium for every purchase they make on their credit cards. That's pure inflation whether anybody sees it or not.

Defining Inflation and Deflation
Webster's says, "Inflation is an increase in the volume of money and credit relative to available goods," and "Deflation is a contraction in the volume of money and credit relative to available goods." To understand inflation and deflation, we have to understand the terms money and credit.

Defining Money and Credit
Money is a socially accepted medium of exchange, value storage and final payment. A specified amount of that medium also serves as a unit of account.

According to its two financial definitions, credit may be summarized as a right to access money. Credit can be held by the owner of the money, in the form of a warehouse receipt for a money deposit, which today is a checking account at a bank. Credit can also be transferred by the owner or by the owner's custodial institution to a borrower in exchange for a fee or fees - called interest - as specified in a repayment contract called a bond, note, bill or just plain IOU, which is debt. In today's economy, most credit is lent, so people often use the terms "credit" and "debt" interchangeably, as money lent by one entity is simultaneously money borrowed by another.


Price Effects of Inflation and Deflation
When the volume of money and credit rises relative to the volume of goods available, the relative value of each unit of money falls, making prices for goods generally rise. When the volume of money and credit falls relative to the volume of goods available, the relative value of each unit of money rises, making prices of goods generally fall. Though many people find it difficult to do, the proper way to conceive of these changes is that the value of units of money are rising and falling, not the values of goods.

The most common misunderstanding about inflation and deflation - echoed even by some renowned economists - is the idea that inflation is rising prices and deflation is falling prices. General price changes, though, are simply effects.

The price effects of inflation can occur in goods, which most people recognize as relating to inflation, or in investment assets, which people do not generally recognize as relating to inflation. The inflation of the 1970s induced dramatic price rises in gold, silver and commodities. The inflation of the 1980s and 1990s induced dramatic price rises in stock certificates and real estate. This difference in effect is due to differences in the social psychology that accompanies inflation and disinflation, respectively.

The price effects of deflation are simpler. They tend to occur across the board, in goods and investment assets simultaneously.

Well, on the empirical evidence, his thesis is wrong, so I have no reason to take John Lee seriously. The United States' debt has been experiencing huge swings since its founding. (For example, immediately after the Civil War, it was higher than it is now, compared to GDP.) Its inflation has swung between single digit deflation and double-digit inflation -- but it has never experienced a hyperinflation like Germany in the 1920s or Brazil in the 1970s.


An interest rate is a cost of living for those who pay it and an income for those who receive it. But it's not inflation. If you use economic terminology, please use it correctly, or communication becomes extremely difficult.

CI -- I have no major problem with the definitions in your last post. Let's apply them and look how the quantity of currency and credit has changed over the last year, and how that compares to the growth of goods and services produced.

To keep track of these various measures, the Fed defines several monetary aggregates, which vary in the amount of credit they contain. The narrowest of these measures is base money or currency, the cash in circulation. Over the last year, this has increased from $700B to $735B, or 5%.

The next-broader measure, called M1, contains currency plus traveller checks, demand deposits, and checking accounts. This aggregate has increased from $1369B to $1375B, or 0.4%.

Finally, M2, the broadest monetary aggregate, contains M1 plus savings deposits, small-denomination time deposits, and retail money market funds. This measure has grown from $6455B to $4758B, or 4.7%.

What about credit cards and consumer credit in general? The Fed considers it irrelevant for setting monetary policy, but your source seems to find it important, so we may as well look at it. According to the Fed's latest statistical release, consumer credit grew from $2114B to $2162B, or by 2.2%.

Contrast this to a real GDP growth of 3.6%, and you see neither currency nor credit expanding at an alarming rate. Whatever measure of currency or credit you prefer, it is more or less in line with the amount of goods and services the American economy produces.

Hi Thomas,
please understand I am not making a comparison between the present day preemptive inflationary manipulations by the Fed and an earlier time when the currency was backed by gold. The presence or lack of a commodity based underpinning of the currency is not relevant to my assertions.

I do not have specific evidence of this preemptive inflationary manaifiapation exacerbating volitititly per se but I can successfully argue how it would need to rely on a predictive mechanism of which there is no such animal and how without such a predictive mechanism such manipulations has a reasonable chance for being counter productive and hence exacerbating volatility.

Before I go further, it will be necessary to understand the efficient market hypothesis and the random walk as they apply to markets, and grok the difference between the short and the long end of the debt market. Are we OK on this?

I have read and understood "A random walk down Wall Street". I know what the efficient market hypothesis is, I know that it doesn't always hold in practice, and I know that it is nevertheless often a useful assumption. With that, I await your argument.

To keep track of these various measures, the Fed defines several monetary aggregates, which vary in the amount of credit they contain. The narrowest of these measures is base money or currency, the cash in circulation. Over the last year, this has increased from $700B to $735B, or 5%.

As mentioned earlier, the cash in circulation is only one part of a larger problem called debt. The debt base is many multiples of actual cash in circulation. How one is to measure "cash plus all debt" vs economic output should be the issue. The repayment of all debt by creditors is highly questionable. In the face of asset valuations, especially the housing market where prices have been increasing at double-digit increments, it's highly questionable as to its real value - especially the mortgages funding these assets.

The next-broader measure, called M1, contains currency plus traveller checks, demand deposits, and checking accounts. This aggregate has increased from $1369B to $1375B, or 0.4%.

This is essentally the currency in circulation; no disagreements here.

Finally, M2, the broadest monetary aggregate, contains M1 plus savings deposits, small-denomination time deposits, and retail money market funds. This measure has grown from $6455B to $4758B, or 4.7%.

I would contend that most of these savings deposits and money market funds are owned by a very small portion of the total population.

What about credit cards and consumer credit in general? The Fed considers it irrelevant for setting monetary policy, but your source seems to find it important, so we may as well look at it. According to the Fed's latest statistical release, consumer credit grew from $2114B to $2162B, or by 2.2%.

The trend seems to always be on the increase, and no decrease. That doesn't look promising for the future of consumer debt when the latest statistics shows the average to be over $85,000 per capita while income is well below that level.

Contrast this to a real GDP growth of 3.6%, and you see neither currency nor credit expanding at an alarming rate. Whatever measure of currency or credit you prefer, it is more or less in line with the amount of goods and services the American economy produces.

The unemployment rate in the US is now 5.1 percent, a rate some economists claim is "full employment." Just how is the US going to continue expanding our economic growth at full employment without impacting inflation? With scarce labor market, the only trend for wages is upward.

Yes, the trend is always on the increase, but that is true for economic output too. Can I please see the statistics that show the average amount of consumer debt to be over $85000? it is grossly at odds with every number I see in the Statistical Abstract of the United States.


The US is going to continue expanding your economic growth at full employment by increasing labor productivity. And over the last 8 years or so, it has been doing a very impressive job at this. (Source: Bureau of Labor Statistics)

Thomas, I probably confused the per capita amount of the federal debt. The CBO article that follows answers most of my opinion on why the continual increase in debt is not sustainable.

How Rising Deficits Would Affect the Economy

Such rapidly rising debt would have serious consequences for the economy. Federal debt would displace private capital in housing and in business plant and equipment. It would also increase U.S. borrowing from foreigners. Thus, the economy would produce less output, and a larger fraction of that output would have to be paid to foreigners to service the borrowing from abroad. The rising debt would eventually put an end to the long-term growth of real gross national product (GNP) per capita.(2)

Although CBO's projections show the economy responding smoothly to the rapidly rising debt, those adjustments would probably be much more disorderly. Foreign investors cannot be expected to lend to the United States forever in the face of explosive debt, as CBO assumed in its projections. At some point, foreign lenders would lose confidence in the United States and withdraw their capital. If that happened abruptly, the exchange rate would plummet, interest rates would shoot up, and the economy would drop into severe recession. No one knows when that would occur, but when it did, the United States would have to service its foreign debt at unfavorable terms.

Of course, the above scenario is not a forecast of what will actually happen to the debt and the economy. Instead, it is a conditional projection of what could happen if the United States blindly followed current policies into the 21st century. Surely, policymakers would take the necessary steps to limit the growth of debt before it reached unthinkable levels. But because debt can quickly snowball out of control at levels above 100 percent of GDP, policymakers would need to act well before the debt reached that critical level.

Great I'll get on it, for starters:

1) Would you accept the argument that the Fed cannot know what the structural economic fundamentals both domestically and globally will be say 15 years from now?

2) Would you accept the argument that if the Fed cannot know what the structural economic fundamentals both domestically and globally will be say 15 years from now, the present day manipulations of short term rates dues to incorrect future assumptions may exacerbate/induce/magnify/extend what may be a period of stag-flation (or other unforeseen but problematic and structural economic negative)

3) We need to agree on what inflation & deflation mean, here is what I intend to use
Inflation: Too many dollars chasing too few goods
Deflation: Too few dollars chasing too many goods

4) Have you given some consideration as to how Burton Malkiel's assertions can affect the Fed?

Notes:

a) By structural I mean features that have some permanence.

b) By short term rates I mean the overnight rate (more or less) but in essence I am imputing some control of how "easy" money is to be had. It is important to note I am not imputing the Fed has control over the long end of the debt market and that an inverse yield curve might well be an expectation if the market does not agree with the Fed.

c) When I refer to stag-flation above it is intended as a hypothetical to illustrate a point not as my future speculation in 15 years.

Thomas, are we golden on all of the above so far? And where the hell is CI and has he done his homework yet?

I have to do a bunch of work around the house so digest away and I'll be back this evening or tomorrow to move ahead.

It's great to have some thoughtful well read people to talk to chat about my views on the Fed as my dog agrees with everything I say if I give her a cookie or two!

Cheers,

Chum