For six months, half a year, the US CPI inflation rate has remained in the 3% range, averaging 3.4% in that time. That is low inflation. The inflation rate almost never exactly equals the 2% Fed target. Rather the inflation rate has bounced around 2%, and a 3% number for 6 months leaves little doubt that the Fed successfully has met its target range.
Of course, the 2% target is totally arbitrary: it was established by the Fed illegally in 2012 Fed minutes in contravention of the 0% target set by US law in the 1978 Fed Act, which is absolutely-watertight binding for any unemployment rate of 4% or below, for 16 years and older, as we have been experiencing since January 2018 except for Covid. That’s quite a few years when the official real Fed target is 0%.
John Cochrane wrote that I argue for price stability in his Homer Jones lecture footnote last year. That is not the case exactly. I simply state the statutory law guiding the Fed is a 0% inflation rate. This is not price stability; this is having the same average as one has when the only money printed by the Fed is the amount sufficient to meet money demand. This gives the Fed the “natural seigniorage” of supplying a fully stable money.
As mentioned in a previous blog, the Fed did not need to raise the interest rate the last increment in July of 2023 from 5.15% to 5.40% where it has been since. Why? Because in July the inflation rate was already down in the 3% range. Let’s use Irving Fisher’s rule for determining the real interest rate that exists after you take into account inflation. If R is the market rate, and π the inflation rate, then the real rate is R-π. Now the real rate is 5.40% – 3.10% = 2.3%. This is a very high real interest rate compared to more than twenty years of negative real rates that only ended when Trump became President but then became undone by the impending election and then Covid, when we went back to unending negative real rates. In March 2023 the inflation rate and Interest rate on Reserve Balances or IORB, as the Fed calls it, became equal at 4.9% (give or take some decimal points). This means that back in March the Fed already got to a zero real interest rate. Since May, the real rate has been positive and rising.
Historically a 2-3% real interest rate, during the 1960s, 1980s, and 1990s, occurred only as the economy boomed. This is the upper limit. When inflation rate targeting of the 1978 Act was carried out initially by Volcker, with the aim of 3% by the law by 1983 and 0% from 1988 onwards, yes the real rate was higher because markets did not expect Volcker to carry out the drop in the inflation rate required by law. But he did, and the real rate was above 4%.
In the Great Depression, market rates were near zero: the real rate was 10%. This is why we had a Great Depression, or at least it is a crucial part of it.
Too high real interest rates cause recessions and depressions. Just right real interest rate occur during economic booms when the Fed is not intervening in capital markets. Too low real interest rates occur when the Fed is massively sterilizing the money supply increase by the Fed by paying the seigniorage out to private banks instead of returning it to the US Treasury so that private bank keep the money in reserve at the Fed and less loans and investment become endemic.
Think of the 3 bears and what was just right. Here “normal” real interest rates are just right when the Fed does not intervene in capital markets except to supply a steady stream of money that targets a 0% or even a 2% inflation rate. All the Fed needs to do is let the money supply growth equal the real GDP growth and there will be no intervention in capital markets. Or if they insist on 2% for no real reason ever established in Economics, then they let the money supply growth rate equal the rate of real GDP growth plus 2%. That would give a stable inflation rate that would be built into capital markets which would allow the Fed to raise more money for fiscal finance through the inflation tax. This is fine albeit illegal by US 1978 law. It would mean the real rate would rise and fall with the business cycle from 2-3% in expansions down to 0% in recessions, for the short term say 3-month Treasury bill real interest rate.
The Fed could do such a policy starting tomorrow. They need to end payment of seigniorage that is supposed to be remitted to the US Treasury but goes instead to private banks holding reserves. How? Simply end the payment of interest on reserves. Nothing else is necessary.
If so simple, why doesn’t the Fed do it? Because the Fed worries about how much inflation would rise once the excess reserves are lent out and the money supply no longer has a source of ongoing persistent never-ending sterilization through reserves held at the Fed.
The leaf-covering that the Fed projects for this highly distortionary policy that is full of “moral hazard” that decreases investment and growth is that high reserves help make the bank system safe.
Right. But the Fed owns none of the excess reserves, cannot lend it out to banks such as SVB, and ultimately just relies on the FDIC saving banks since it has no power, no authority, and no solid tools for doing such bank insurance. It does it ad hoc, any way it can such as Maiden I, II, and III corporations, very hidden means for example that do not bode well in the light of day. They are not Bagehot’s Bank of England pooling reserves and lending them out for good collateral at high real interest rates. Rather the Fed is paying banks to give the Fed reserves that it does not own and cannot pool and cannot use for any saving of banks during a panic.
What is the Fed really doing with all of these shenanigan policies invented during the non-FDIC insured investment bank run of 2008? They are financing massive Treasury spending by printing money that does not enter circulation. Two birds with one stone in this case means the Treasury does not raise the real interest rate due to massive borrowing. Instead, the first bird is that the Fed raises the eventual inflation tax to finance the spending. The second bird is that inflation does not go up right away since the new money is held as excess reserves by private banks getting paid to hold the reserves. This is the opposite of Bagehot’s Bank of England that was given the reserves by the private banks so that less reserves were held overall in the English financial system and more investment occurred.
The Fed’s policy causes more reserves to be held in a willing-nilly fashion, if I may, with no knowledge about how many reserves will be held and no control over that amount, except for the control exerted by Fed officials telling the select “systematically important banks” how many reserves to hold or otherwise Congress will increase capital reserve requirements as in Dodd-Frank 2010. So the Fed heads who communicate with these banks certainly have something going on in terms of collusion given that from 2008 to 2014 ALL increases in the money supply, in terms of Fed-held Treasury debt, were held as excess reserves in a one-to-one fashion. This means all of the new money printed by the Fed was sterilized by the systematically important banks up until 2014.
So the Fed knows what it is doing, but no one else does. The Fed talks a good game about “forward guidance” but no one has any idea when the excess reserves will enter circulation and cause inflation to go up.
Now the Fed continues to keep their non-market but rather dictated interest rate on reserve balances above the inflation rate by more than 2%. Why? They are worried the excess reserves will enter circulation and raise the inflation rate. Their policy is in total tatters. They are paying out interest to banks instead of the US Treasury, which is the inflation tax revenue. They have no idea what excess reserves will be now or in the future. They have no idea what the inflation rate therefore will be now or in the future.
Ending the policy of giving the inflation tax revenue to the “systematically important banks” instead of the US Treasury can happen in a single day. The Fed stops paying interest on reserves. Period.
The excess reserves will gradually enter circulation. Capital markets will stop being distorted. Inflation will be a bit higher than everyone would like. The real interest rate could go back to being a market determined rate rather than a Fed-distorting real rate resulting from Fed dictates on what they set as the market interest rate (the IORB).
And yes, all excess reserves are actually just “reserves” since part of the Fed shenanigans was eliminating all reserve requirements in 2020.
Fed: Get out of the business of ex-post distortionary bank insurance policy for the non-bank banks and work with the US elected government to find a way to create an efficient ex-ante bank insurance system based around voluntary expansion of FDIC risk-based premiums to any financial intermediary that wants the insurance.
Fed: Stop creating moral hazard worldwide through setting market interest rates, inducing 20 years of negative real rated that drive increasing risk-taking in equity portfolios to balance out the negative US Treasury real yield. Fed: Admit your mistakes and get on with contributing to a stable global financial system in which democracy with well defined property rights including in money and banking social insurance polices can flourish, unlike now and declining democracy, global negative real interest rates, greater nationalistic policy globally and the Fed-globally induced increase in volatility.
Max Gillman 