The Federal Open Market Committee Minutes, Employment Data And Inflation Data Reveal Weakness Of Monetary Policy Transmission

Pity the Fed monetary policy wizards. Pity them their tools. Pity them their true distance from the levers of the economy. Pity them their view through the keyhole into the enormous room of the US economy and through it the vistas of the world economy that stretch into blue distance. Pity them their puniness in the face of the awesome power of the virus to smash any plan to smithereens. Pity them in the dual mandate that seems to pull them in opposite directions.

The independent behavior of many disparate actors, which coalesces into a national economy cannot be controlled easily. Especially if there is freedom to act, either clandestinely or in a manner that can be said to be in the self-interest. Even these self-interested actors are functioning in an information challenged universe, trying to maximize their returns, which are a future phenomenon, even when the returns are guaranteed. What if inflation wipes out those returns, eroding them? The economy of any nation is an enormous non-linear decentralized dynamic system, including the way credit money is generated. The national economy in turn interacts with multiple such systems to create local as well as world economies. No centralized actor can hope to control such a system directly. It is not for want of trying.

The Federal Reserve Act

The Federal Reserve Act that originally established the Fed, defines the purpose of the Fed. The masthead of the Fed says “The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system.” Revisiting the Federal Reserve Act “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”. The use of the term “long run” should be noted. As for dealing with monetary and credit aggregates, the Fed does this only indirectly. As with any system that uses past data to control the future, the enterprise is fraught from the get-go. It is important not to forget that all this is to provide the nation, a synecdoche, meaning the people that make up the United States, with a safe, flexible and stable monetary system. The Fed only controls the monetary policy, and not fiscal policy which is the prerogative of the executive branch. The Fed has to act in concert with the fiscal authority, the treasury department, guided and directed by the legislative branch, mainly by buying treasuries. Fiscal policy deals with government spending.

Dual Mandate

The dual mandate of the Fed is to promote employment and prevent excessive inflation through monetary policy. At this point, excessive means a long-run rate of 2% or below. The implementation of the monetary policy is through three tools, the discount rate, reserve requirements and open market operations. The reserve requirements are already at zero, implemented when the pandemic started, in spite of this, the reserves of institutions are at an all time high. That means the only two tools left to stimulate the economy are the discount rate and open market operations.

A view of the economy as a dynamic system, controlled through an expanding and contracting money supply driven by interest rates is the operating principle for enforcing the dual mandate. The fed controls the risk free interest rate, through a variety of means. They include the fed funds rate, the prime credit rate, overnight repo rates, treasury prices, mortgage backed security prices, corporate bond prices and repos on MBS. The fed funds rate is the interest paid on unsecured lending of bank reserves by depositary institutions, or institutions that have a reserve account. Open market operations result in price based action on treasuries, MBS and corporate bonds which control the yield, as the yield (or the effective interest) falls as prices go up. When the Fed appears as a buyer in these markets, they prop up the prices causing yield to fall or remain steady. Almost all of these actions affect the short term interest rates. Most of these actions buoy primary and relatively safe asset prices and depresses their returns. This base set of interest rates transmit through to short-term interest rates, foreign exchange rates, long-term interest rates, creation of credit and hence money, and, thence, unemployment rates, GDP, and prices. In this theoretical chain of causation the good and the bad are evident. The good being increased employment, the bad, increased prices.

Pushing On A String

The meeting minutes of the FOMC and the Board this week need to be read carefully to see where the gaps in knowledge and execution exist. The overall policy statement reveals their helplessness. The Fed says that inflation has gone up but they attribute most of it to transitory factors, that is the ruction in supply chains due to the pandemic; which they are unable to control. They have done a reasonable job of shoring up the largest institutions and top earners in the economy, preventing a sudden collapse of the economic system. They will continue their accommodative policies to support the flow of credit to US households and businesses. Businesses and high income households seem to be doing well, but the majority of the householders who rely on credit for car loans and short term borrowing using credit cards, as well as student debt do not see accommodative rates. Unemployment remains stubbornly high. In fact some of these rates have risen. The largesse of the Fed and the reach of its tools seem to have stopped at Wall Street, the transmission mechanism does not reach deep into Main Street where most people live.

Two factors seem to be inhibiting the Fed, the frequency of the FOMC meetings; meant to be about eight times a year. Another is the breakdown of the chain of interest rates where the institutions closest to the Fed benefit greatly without passing on the savings to its consumers. The Fed’s mandate is to stabilize the entire economy by promoting employment and productivity. If it is failing a large portion of its clientele, it might be because of the tools in its arsenal and frequency of redeploying them.

Continuous And Automated Monetary Policy

The frequency of FOMC meetings and the tools they employ are anachronisms. It is time time to rethink both. Clearly we need better tools and better data. A large portion of the time, the Eccles boardroom, as in the image above, is empty. The FOMC meets only 8 times a year. When most of our transactions are digital, a boardroom such as this where important people come together to set monetary policy seems anachronistic. It smacks of the 19th century more than it does the 20th century. The first element would be some form of telemetry to gather trusted data. Today’s data collection is submitted using forms such these, FR 2420 is required from institutions that have assets worth $18 billion or more or transact in $200 million or more when they have assets more than $5 billion. A thorough analysis needs to be done of such processes to automate them if possible. Of course the kind of data on FR 2420 is not generated by ordinary businesses or people. To see whether the chain of interest rates is working, it would be necessary to get data from different points in the chain. Once this is accomplished, maybe there can be adjustments in some elements of the monetary policy at a greater frequency than eight times a year. First it would be necessary to identify tools slightly different than short term interest rates that affect certain assets; then have some deliberate and automatic steps within some limits to affect these rates. DeFi has to coalesce with this form of CeFi to reflect back to ordinary households. This is not to say that we should leave everything to machines; human oversight, short circuiting mechanisms etc. could control some of these actions. The coming of CBDCs will allow more programmable money mechanisms targeting small holders. Let us hope we can ease the anxiety and the burden on central bankers with these tools.

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