The Fed Is Flying Blind

The Washington Times ^ | November 28, 2004 | Jude Wanniski; Wayne Jett

[n-tres-ted]

It has been eight months since the Federal Reserve Board surprised the financial markets by announcing it might soon end its accommodative monetary policy to head off an inflation it suspected lurked in the wings.

Then, Fed Chairman Alan Greenspan told Congress it might only take a quarter-point rise in the interest rate charged to banks for overnight reserves (the "federal funds rate") to strike a balance between inflation and economic growth.

The rate was then 1 percent, the lowest since 1958. And after four quarter-point increases beginning June 30, it is now 2 percent. Yet serious market commentators say the rate may have to go to 3 or 4 or even 5 percent to halt the slide in the dollar against other currencies and gold.

Not only have we argued all along that the Fed's premise of a higher funds rate strengthening the dollar is invalid, but also that the increases would more likely turn a small inflationary problem that could cure itself if left alone into a larger problem that would cause economic distress.

Indeed, the dollar is now at its weakest levels of the year against the euro and the Japanese yen. And an ounce of gold, which cost $380 in the midst of the Fed's inflation concerns last spring, traded last week at $452. Instead of reviewing the policy that was supposed to work in the opposite direction -- a policy with no known support in modern economic theory, its advocates say the Fed has been too timid. The Fed though, has been flying blind, on a hunch that the higher rates would reduce inflation expectations.

No direct correlation exists between the funds rate and inflation... Inflation is an entirely monetary phenomenon caused by many variables affected by Fed practices...

[n-tres-ted]

This was linked on RealClearPolitics.com yesterday. They are saying the interest rate hikes by the Fed are actually causing more inflation and cannot stabilize the dollar or prices. Any thoughts?

[n-tres-ted]

I know tax policy reform is important to you. How about monetary policy reform?!!

[Protagoras]

Any thoughts?

Government set prices are incompatible with free markets and thus freedom. Soviet style governments set wage and prices.

The US government sets many prices, in this case, the price on money (credit). It also has a minimum wage floor. (which becomes a ceiling many instances)

In these ways, our government is like a communist government. A non elected, non responsible agency, sets the prices, we have no say, nor does the free market.

Hallo comrade, welkom to Amerika.

[FredZarguna]

Wanniski is always good. You left out the most important part of the article from your excerpt:

The most reliable target would be gold, which was the key to the Bretton Woods system President Nixon abandoned in 1971 in an attempt to inflate the economy into prosperity. Alan Greenspan still discusses this operating mechanism with nostalgia in congressional testimony, but says it is up to Congress to make the change.

This is a remarkable insight from the truly clueless Greenspan, whose bizarre monetary theories and exercises have left us with too much liquidity (late 1999) and too little (late 2000) to name just a couple. Greenspan's never seemed to learn to keep his mouth shut either. His comments are great for the portfolio, wherever you may be heavy. Let's also not forget that Greenspan is the guy who claimed that rising productivity fuels inflation. Huh? Howzat again? The Fed doesn't have any idea what the relationship between the fund rate and money supply should be, given all the variables. I'm not a gold bug, but it seems clear that the best thing to do would be to take monetary policy effectively out of their hands, by returning to gold.

[n-tres-ted]

Thanks for your post. Yes, the limitations for an excerpt on FR are 300 words, so I had to leave out the best parts of the article. Click on the Washington Times link above to read the entire article.

[n-tres-ted]

You are right that attempting to set interest rates at the Fed is central planning at its worst. It has no chance of working and actually does harm to the stated objective of achieving price stability. I would love for Freepers to take monetary policy on as a cause for reform. The "floating" dollar value makes no sense to any working person. I can't believe the intellectuals have actually come to the point of professing the belief that making the dollar change values every day is really the "smart" thing to do!

[Mudcat]

The Fed though, has been flying blind, on a hunch that the higher rates would reduce inflation expectations That's not flying blind - that's proper implementation of sound Monetarist economic theory. 30+ years after Keynesian economics have been disproven, and people STILL think inflation is related to something other than money supply.

[SteelTrap]

Gold bug bump! It's the Way the World Works.

[n-tres-ted]

Here's more of the article:

If the Fed had a mathematical formula defining how the dollar's unit value is determined, the funds rate might be one variable in the formula. At best, fixing or adjusting the funds rate leaves all other variables, including the dollar's value, free to change. In fact, doing so makes change in the dollar's value almost inevitable.

The nature of this change is unpredictable, though, because so many variables other than the funds rate are present. Thus, the funds rate is not really a "tool" for managing the dollar's value. It is no more than one variable among many. Targeting the funds rate as the Fed does actually hurts more than it helps dollar stability. The monetarist experiment of 1979-82 had the same problem when it targeted the money supply and assumed the demand for money (its velocity) would remain constant. When it didn't, the gold price went through the roof and so did the inflation rate and bond yields.

The only way the Fed can achieve dollar stability is by directly targeting a specific value. In theory, the Fed could target the value of the euro and avoid inflations and deflations as long as the European Central Bank targets commodity prices as it adds or subtracts money to meet the market's demand for liquidity. At one point during the disastrous monetarist experiment at the Fed, the Carter administration even gave thought to targeting the Japanese yen.

The most reliable target would be gold, which was the key to the Bretton Woods system President Nixon abandoned in 1971 in an attempt to inflate the economy into prosperity. Alan Greenspan still discusses this operating mechanism with nostalgia in congressional testimony, but says it is up to Congress to make the change.

At an exchange rate closer to $400 per ounce, the Fed would simply add or subtract money supply to keep the price constant. The market would almost instantly adjust all other variables, including interest rates.

In 1987, former Treasury Secretary James Baker III proposed an international monetary reform to stabilize exchange rates, with a "basket of commodities including gold" as a reference point. But adding more variables to a gold target merely increases instability because, as Mr. Greenspan has noted, the world's large stock of gold relative to demand makes it the least vulnerable to temporary supply-and-demand considerations.

Raising the funds rate does nothing to curb inflation and may actively contribute to inflation expectations through the rise in the price of gold, the most monetary of all commodities.

The financial markets, after all, are told the higher rates are needed to slow the economy and reduce demand for goods and services that drive up prices. But a slower economy will reduce the need for dollar liquidity, and the Fed's current operating mechanism has no way to drain surplus money from the exchange economy. So prices of goods are bid up, not down.

Since raising the funds rate to fight inflation has no realistic chance of success without recession, the prospect of a virtuous cycle as described above should be tried. Were the Fed to abandon its inapt use of the funds rate target, of course, this exercise would be unnecessary. Sound money would relieve the economy of such distractions.

[ancient_geezer]

. They are saying the interest rate hikes by the Fed are actually causing more inflation and cannot stabilize the dollar or prices. Any thoughts?

No, what the fed is doing with the funds rate is irrelavent,

"Not only have we argued all along that the Fed's premise of a higher funds rate strengthening the dollar is invalid," ... "No direct correlation exists between the funds rate and inflation"

and

that the increases would more likely turn a small inflationary problem that could cure itself if left alone into a larger problem that would cause economic distress.

Which means, more inflation until they do something that make a substantive difference in the money money supply like increase the reserve rate, buy dollars up with foreign currencies, ... take real actions that actually remove dollars out of the money supply.

Fiddling with Fedrates is just short term Fed psyops, and not much substance.

[dix]

I'm not an expert,and yes I am self interested, but why don't we want to keeo interest rates down?

[Southack]

"The US government sets many prices, in this case, the price on money (credit)."

That's incorrect. The Fed merely sets a rate at which it will loan money to banks. It's not the only source.

If you can get your money from a cheaper source, then the federal rate is meaningless. For instance, companies frequently obtain interest-free, lifetime loans by going public with an IPO or subsequent stock offering.

That's not something that Soviet corporations or individuals could do, so your characterization of the U.S. as having a Communist economy is ill-thought and entirely uneducated.

[Southack]

"I'm not a gold bug, but it seems clear that the best thing to do would be to take monetary policy effectively out of their hands, by returning to gold."

That's archaic and ill-advised. You'd shift control of "money" from the Fed over to the largest gold producers in Russia and South Africa. You'd shift from using money as a means of "exchange" to using money to "store wealth," a very, very bad idea as that slows down the velocity of money and drags economies down to medieval crawls.

[Southack]

"The only way the Fed can achieve dollar stability is by directly targeting a specific value."

We don't want Dollar stability. We especially don't want Dollar stability set up at levels so high that foreign imports are essentially free while U.S. exports are priced out of global competition.

Dollar stability is *only* good for storing wealth, and it's a bad idea to try to store wealth inside currencies in the first place (slows down the speed of money).

[Toddsterpatriot]

Inflation is an entirely monetary phenomenon caused by many variables affected by Fed practices...

Hey, Southack, where have I heard this before?

See that word monetary?

of or relating to money or to the mechanisms by which it is supplied to and circulates in the economy

Monetary

See, what that means is inflation is caused by the Fed printing too much money. That wasn't hard now, was it?

[ETERNAL WARMING]

"I'm not a gold bug, but it seems clear that the best thing to do would be to take monetary policy effectively out of their hands, by returning to gold."

There's a significant theory that JFK was asassinated for just that. He was in Texas visiting Connelly because in Texas, money was still backed by silver. Both he and Bobby Kennedy were shot for that sovereign position.

[Toddsterpatriot]

There's a significant theory that JFK was asassinated for just that. He was in Texas visiting Connelly because in Texas, money was still backed by silver. Both he and Bobby Kennedy were shot for that sovereign position.

Money in Texas was no different than money anywhere else in the country. It was backed by the Treasury, not the states.

[RebelTex]

Inflation is caused by too much money chasing too few goods and services.  (Supply & Demand)  

One side of the coin:

1. Increases in goods and services relative to the money supply causes prices to fall.   (Too many goods and services competing for the same dollars.)
2. Decreases in goods and services relative to the money supply causes prices to rise (inflation).   (Too many dollars competing for the same goods and services.)

The other side of the coin:

1. Increases in the money supply relative to goods and services causes prices to rise (inflation).   (Too many dollars competing for the same goods and services.)
2. Decreases in the money supply relative to goods and services causes prices to fall.   (Too many goods and services competing for the same dollars.)

Let's examine the money side of the coin.  What are the sources of money in the economy?

1. Government - prints/coins new money, burns/retires old money.
2. Credit - Government lending (bonds, T-bills, etc) & banks multiply actual dollars through book entry debits by discount rates with the Fed.  (If this is unclear to you, pick up a book on the Federal Reserve and how it regulates banks.)
3. Buying, investing - circulating the supply in the economy as opposed to hoarding it.
4. Trade surplus/deficits - caused by buying/selling goods and services with other countries.
5. The Currency Exchange - exchanging one country's currency for another country's currency or hoarding it.

Pay strict attention to numbers 2, 4 & 5 as important indicators of inflation/deflation.   (These factors have more influence if the currency is allowed to float than if it was tied to a standard like gold or silver.)

Potential triggering events to watch:

1. Other countries dumping our Government's bonds, etc. (Calling in the debt.)
2. Other countries redeeming credits from trade surplus/deficit.
3. Other countries &/or investors dumping our currency on the Currency Exchange & Futures market.

[Moonman62]

I'm not a gold bug, but it seems clear that the best thing to do would be to take monetary policy effectively out of their hands, by returning to gold.

The truth is Greenspan has always followed dollar policy, except for brief periods of time when he needed to add liquidity, or when he wanted to settle his personal score with the stock market (2000). There is nothing mysterious about it. Greenspan's problem is he can't admit publicly that he does what the president wants him to do. By law he's supposed to be independent. Thus, his real job is to keep people confused as to his true intent and methods.

The president has three weapons he can use against the Federal Reserve Chairman: The Treasury, appointments, and the bully pulpit. That's why the Chairman usually does what the president wants.

[FredZarguna]

a very, very bad idea as that slows down the velocity of money and drags economies down to medieval crawls.

A bare assertion isn't the same thing as the naked truth. Prove it.