The game will be well into the first half before the Fed gets on its uniform!

Who Controls Interest rates? The Fed or the Market?

Since we are spending so much time oohhing and ahhhing about the Fed, it isn’t a bad idea to get into some arcane but straight forward realities about interest rates.

The markets were so happy to hear on Tuesday that the Fed is NOT going to raise interest rates yet. A collective global sigh was heard as we learned that the economy is still too soft to withstand tighter money and higher interest rates. The price of gyros firmed in Athens!

But does the Fed really control interest rates? It depends on which rates you mean. Does it control mortgage rates? Rates on business loans? Rates on commercial paper? Car loan rates? No, No, No, No. Hmm – so what does the Fed control?

To make a long story short, the Fed directly controls the discount rate – the Fed can “dial-up” a higher discount rate easily. The discount rate is what the Fed charges when it lends money to commercial banks. Second, it controls the target rate for something called the federal funds rate (ffr). I say it controls the target because the ffr is really a market rate driven by the supply and demand for short-term funds that commercial banks lend to each other. If the Fed decides on a higher ffr target than exists today in the fed funds market, it will sell part of its bond holdings, essentially draining liquidity out of the banking system. As funds become scarcer, the usual buying and selling of federal funds will generate a higher ffr. If the Fed hits its target rate– and it usually does – it really sets the ffr (and not just the target). To summarize – if the Fed wants to lift the ffr to 1.0% , it would sell some bonds and watch the market ffr rise. When the market rate rises to 1% then the Fed will know it sold enough bonds. Viola!

So the discount rate and the ffr are about the only rates the Fed really controls. That is worth knowing – especially in this environment of wondering when the Fed is going to begin its drive to increase interest rates. The main point is that when it comes to car loans and mortgage loans, and various other financial transactions, the interest rates are set by the interplay of supply and demand. While the Fed’s actions are part of the supply and demand and the Fed’s decisions influence these markets, they are by no means the only factor to impact these and other interest rates.

For example, we know the Treasury needs a bunch of money. So they are selling a wagonload of bonds each month and will be doing this for quite some time. As the economy recovers in the coming year we expect demand for houses, cars, business equipment, Jack Daniels, and many other items to increase. This means that more and more households and firms will be borrowing – taking out banks loans and selling bonds. Even without any change in the Fed’s monetary policy there will be a cyclical reason, therefore, for interest rates to rise as more and more borrowers compete with each other for a given amount of funds.

So rates can rise even if the Fed’s policy is unchanged. Now here is the fun part. Let’s suppose the Fed does NOT want the rates to rise – what can it do? Keep in mind that one of the market rates that might begin rising is the ffr. If the Fed has a goal to keep the ffr no higher than 0.25%, then it will have to PEG THE MARKET RATE AT THE TARGET RATE – which means supplying more liquidity to the market. Notice that when the Fed tries to peg the ffr rate in the face of rising loan demand – this means injecting even more liquidity into the banking and economic system. THIS MEANS INJECTING EVEN MORE MONEY AT A TIME WHEN THERE IS ALREADY MUCH TOO MUCH MONEY IN THE SYSTEM. THIS MEANS THAT THE JOB OF REMOVING THE LIQUIDITY AT THE MAGIC MOMENT BECOMES EVEN HARDER AND THE RISK OF HIGH INFLATION GETS BIGGER.

Okay so the money supply grows but what about the interest rates? It is hard to say. The Fed might try to prevent the ffr from rising but if the market knows that fundamental factors are driving interest rates upward, then the pegged ffr might not reduce the pressure on the other rates. And if the risk of future inflation is truly perceived to be higher – this too will add to interest rates today.

Hmm – so is the Fed or the market driving the interest rates? My guess is that in the coming year, Fed policy will be a lagging indicator of interest rate change. Once the Fed does announce a policy to tighten money and withdraw liquidity, the rates will have already risen and the ffr and discount rate will come in line with the rates that have already risen….Upshot – keep your eye on the markets. The game will be well into the first half before the Fed gets on its uniform!

The Fed Can't get No Satisfaction

There is a blurb this morning on Bloomberg.com titled “Fed ‘Squeezed’ by Recovery Momentum May Affirm Low-Rate Pledge.” The experts are predicting that the Fed will not change its language about policy and will continue to guarantee virtually zero interest rates for an extended period of time. They note that while there has been much positive economic news and financial markets are awaiting some sign the Fed will begin to worry about inflation, the Fed is compelled to continue to focus on high unemployment, especially since inflation continues to be tame.

That’s the story. And it underscores a worry that there may not be a clear signal for when the Fed really does begin to suck out all that liquidity that threatens economic stability. Let’s face it, the economy grew at a strong pace in the latter half of 2009 and appears to be growing at 3+% in 2010:Q1. Is a zero interest rate compatible with US economic growth averaging 4% or more for three-quarters of a year? If you answer yes, then what happens if the economy grows at a mere 3% in 2010:Q2? Then we will have had a full year with real GDP averaging almost 4%. Is that enough to change policy? What if the unemployment rate is still high in July? Will these same experts be ready to prod the Fed away from zero interest rates? I think you are starting to see the policy risk here.

Simmer down Larry. So what if the Fed is a bit late in coming to the inflation party? Why should we care so much about inflation when so many people are unemployed? The ANSWER is that we care about future inflation MOSTLY because it will lead to a cycle in which unemployment gets WORSE. We care about inflation BECAUSE we care about unemployment. When do you start your diet – only after you have nothing left to wear but a potato sack? I hope not! It might be better to start just before your current jeans are so tight that you have to unbutton them to breathe now and then. Anyway, let me keep this short and summarize the issue:

First, there will be no AHA time when everyone agrees it is time to start tightening. There are always expects who see softness or the next recession around the corner. Please Mom, my pants are supposed to look like that.

Second, tightening money growth will mean higher interest rates and will cause consternation among many groups. It will take a very tough Fed to deal with the ugliness that arises when a phase of tightening begins – even though this phase largely will be meant to remove a ton of excess liquidity. Notice that raising the Fed Funds rate to 1% would be considered a big jump from the current 0.25% -- but also notice that a 1% Fed Funds Rate is VERY low in historical terms. Please Mom, let me have one more piece of cake!

Third, the policy change will probably come later rather than sooner and will lead to higher unemployment than necessary because it will have to deal with rising inflationary expectations and higher prices for commodities. Geez Mom, this diet is making me dizzy.

In the US we have an independent Fed with a newly reappointed Chair. The Fed has a choice. It can play to popular opinion a while longer and risk much higher inflation AND unemployment. Or it can move quickly (and gradually) to reassure domestic and international publics that the best way to keep a strong stable economy with low unemployment is through price stability. So which ways is it going to be? I guess we will learn more tomorrow.

Monetization challenges in India -- leading indicator for the rest of us?

Monetization is playing itself out in India this week. One of my previous posts (In The Black Trunks…, Monday, April 12) I discussed monetization in the context of the USA. Monetization is a very specific term meant to describe how (even independent) central banks act as if they are “printing money” to help governments finance their deficits. Since US deficits are VERY large, the worry is the monetization could lead to a very large wave of money growth and future inflation. But since inflation in the USA is low and stable right now, this future tsunami is not taken very seriously….

But India is in the eye of the storm right now. A report out this week portrays the Reserve Bank of India as in quite a pickle. India’s robust recovery from the recession is already generating double-digit inflation and the RBI has already begun draining reserves from the system and raising key policy interest rates. But whoa Silver (the Lone Ranger’s horse was named Silver) – it turns out that the RBI is concerned that the government of India has a lot of bonds to sell to cover large government deficits. As the government sells these bonds this adds even more pressure for interest rates to rise. So what – isn’t that what they want? Yes, the RBI wants to cool off the economy with higher interest rates, but India is just like Little Red Riding Hood who wanted her porridge warm but not too hot. The RBI wants a cooler economy but considering that the economy is not quite out of the recession woods yet, if interest rates rise too much and too soon, the RBI could find itself with a double dip.

The astute reader at this point might recognize that the RBI might solve this dilemma easily -- just suspend its open market bond sales and let the government suck the money out of the system with its bond financing activities. But that would not work. The government of India is raising funds so they can spend them! The result is that any money they collect through bond sales gets injected back into the economy as more spending. So if the RBI stands back and does nothing – the money or liquidity problem remains and they have put off or stalled a policy designed to reduce future inflation.

So there is the pickle or the rock and hard place thing. What’s a good central bank to do? The RBI wants to stop the inflation rate from rising through higher interest rates. The government is sending rates even higher than desirable so the RBI responds by buying government bonds to try to bring the rates back down. If they tighten too much they risk a recession. If they monetize too much they threaten inflation. It just doesn’t seem fair! But, of course, India is just a little ahead of the inflation curve and most nations could be in the same situation later this year.

Geez, how did we all get in this jam? The answer is that the recession scared the wee wee out of us and we asked our policymakers to inject historical amounts of stimulus. There we are – lots of juice running through our veins and it needs to come out. The most intuitive approach is to begin removing the stimulus before it creates devastating inflation. It would help if at the same time we come up with appropriate reforms that effectively address the causes of the recession. Finally, I will say the S-word and note that an aggressive supply-side policy which focuses on raising national productivity relative to business costs is known to have the desirable impact of reducing inflation and unemployment at the same time. Now where is that cake that I want to have and eat it too?

Should wages be determined by the market?

I saw an editorial recently that concluded that it might be better to not let the market determine wages. This article made me see how bad economists are at communicating their most important concepts, in this case market determination. As you will see below (if you are still awake) it makes good sense for the market to determine wages. In future posts we might apply similar points to market determined interest rates, stock prices, profits, and rents.

What market determined wages (MDW) DOES NOT mean. First, MDW are not set by the government. Second, they are not determined by some guy (or gal) named Market. Third, wages are not determined in a big workers’ tent similar to the goods tent where people buy and sell used goods like cuckoo clocks, Depression glass, and Barbie dolls.

MDW means that wages change according to the laws of supply and demand. AHA – says the skeptic – that’s a bunch of bunk. My wage is determined by that creep they call my boss who sits in the big office by the window. It is true. Depending on where you work there is always someone or some committee who tells you your wage. Or maybe you tell them what wage you will accept. “Listen here Fred, unless you guys give me a 10% raise this year, I am going to retire and play third base for the Yankees. “ Maybe your wages are set as a result of a big negotiation between your union and the management.

Let’s call this person/committee/negotiation the One who sends you the Wage News (or THE ONE, for short. Okay? So the relevant question becomes, how does THE ONE decide that you are worth an extra 10% this year? This is where THE MARKET comes in. This is where SUPPLY AND DEMAND comes in.

Let’s suppose you are a website designer and it turns out that a new report forecasts that many companies are going to need new websites next year. You look in the newspaper and there are hundreds of ads for web designers. Wow! Clearly the demand for your services is up and this is the kind of year when you might be able to get a good wage. Your skills haven’t changed a bit but the demand for your services is much higher. That’s an example of the impact that demand has on the labor market and your wage.

What about supply? This is the example that bothers people – especially people who compete with low-to-medium-skilled workers globally. Globalization has increased the number of people globally who compete with you when it comes to producing various kinds of manufactured goods. You continue to be a good citizen and hard worker, but the truth is that labor supply has increased substantially. When there are other workers who really want to work and who are willing to work for a lower wage, this is an example of labor supply increasing. If labor demand does not automatically increase as much as the supply, then the market wages declines.

Summary of the theory of the labor market:

o If labor supply increases and/or labor demand decreases – the market wage rises less than expected or it declines.

o If labor supply decreases or/or labor demand increases – the market wage rises more than expected or increases.

The One Who Sends You the Wage News will usually use this theory of the labor market to determine your wage. If he/she does not, then the organization’s costs are not being managed efficiently – that he/she is wasting the organization’s resources. If THE ONE consistently pays you more than the market values you, then the organization might have been using the surplus payments more wisely. If THE ONE pays you less than the market wage, then the organization has saved money but it will result in less productive employees and probably higher turnover costs. Of course, YOU might be worth more or less than the average wage or you might be married to the boss so The ONE will naturally bring all that into the equation as well. Normally not everyone will receive the exact same wage increase.

Is any of this FAIR? It depends on what you mean by FAIR. A market system’s main goal is to use a nation’s resources as efficiently as possible. That means the system tries to minimize waste. That seems like quite an undertaking. In doing so, it cannot also make sure that every human resource is paid equally. That’s why we have a mixed economic system in which the government attempts to offset the worst income inequalities through taxes and spending. If the government can reduce the worst wage inequities while not creating perverse long-term disincentives, then a mixed system might be able to achieve two goals – near-optimal efficiency and near-optimal income distribution.

We are in this together -- let’s throw out the bums!

An asteroid is going to hit the earth in 24 hours destroying us all. Okay – so you prefer tsunamis or earthquakes or a visit from your mother-in-law. Whatever. Let’s assume we all have very little time left. What are you going to do? Will you argue with your neighbor about the leaves from his tree that blew into your yard? Will you complain to the Mayor about excessive traffic calming devices? Will you argue with your Dad about the unfair burden left to you by spendthrift baby boomers?

Most of you probably won’t do any of those things. If you really only have 24 hours left, there is a lot to do. So what are you going to do? Of course, you will do things that are most important to you. Some of you will spend time with your families. Some of you will pray. Some of you will make apologies to people you might have harmed. Some of you will go to Vegas one more time. Get the point? There are things that are really important to each of us and there are things that are less so.

Why am I saying this? Just to remind you that we all have a lot in common. It is pretty naïve to think that we are all alike in this regard – but it seems to me that most of us share a lot of values. In the economic sphere we want to do the best we can to provide security, food, and general well-being for our families. Most of us would like to see more effective ways to reduce crime, improve education, reduce discrimination, and so on. Most of us would like to find effective ways to take care of the earth’s resources and not waste them. Most of us want to be healthy. I don’t know many religions, community groups, or political organizations that stand against any of these things. We have common bonds and we share in the need to attain our goals in the best ways. We are deprived when we can’t attain our goals.

Today we are involved with very large short-term and long-term challenges. If there was ever a time to see our shared interdependence it is now – when the stakes are the highest. We don’t have a lot of time to mess around. Solving these challenges unites us and brings us all benefits.

Yet we fiddle while Rome burns. We point fingers and call people names. I talk to so many people who are sick and tired of the process. It really is outrageous yet the solution is simple. We are in it together. Okay – so we come from a lot of different backgrounds and we don’t agree on a lot of things. But we do agree on the key things. My liberal friend tells me that conservatives are rich, hateful jerks who don’t want to help people get out of poverty. Do you REALLY believe most conservatives are such cold-hearted brutes? Is it possible that they have different beliefs about the best ways to approach the poverty issue? My conservative friend says that liberals are all heart and no brain and won’t rest until they have spent all our money. Are most liberals really like that or do they have a different way of viewing the problem?

The sad truth is that NOTHING will get done to relieve poverty or our other challenges because we won’t even talk to each other. Rather than spend a little time actually listening and talking to each other, we spew invectives and platitudes and all manner of ugliness. Where did we learn this behavior? Why do we prefer to do nothing about our most pressing problems? Is there no stomach left for real discussion and negotiation? Could we not go into discussions with good faith -- with the understanding that all parties want a good shared outcome? Could we not honestly negotiate knowing that we might win a few – lose a few.

You probably think I am off my rocker. And maybe I am. But I really think change is going to come because the average person is starting to realize that we now have the worst group of politicians in memory on both sides of the aisle. The change will not be a red/blue Party thing so I am betting that the middles of both parties are going to get rid of the trouble-makers. Major political change can happen but only if we demand it. What can you do to get the message to these troublemakers? It is a very simple message – all of us need to require than political candidates pass the intuition test. First they have to stop all the self-defeating name-calling. Second, they have to show to us they are acting logically and in good faith with respect to our many challenges. At minimum we need to know that they are willing to: identify the problems, discuss and debate their solutions, and give us results that make us better as a people and a nation.

In the Black Trunks weighing in at 3% is inflation

As a result of Mike's comment on my last post, I want to dig further into the issue of inflation. Some economists are very worried that the government will monetize its historically large deficits. Monetizing a deficit in the USA today means that the government does not borrow by issuing new bonds. Well -- it's a little more complicated than that. They actually do borrow but when the ensuing competition in the credit markets drives up interest rates, there is much pressure aimed at the Fed to bring them back down. How does the Fed do this? They buy government bonds in the market. Summary -- (1) government sells bonds to the public, (2) the Fed buys bonds (not necessarily the exact same bonds but it doesn't really matter), (3) bonds in the credit markets are replaced by money. While the government did not literally PRINT money to finance its debt, the result was the same.

Economists believe that money is the root of all evil -- just kidding -- money is the root of spending. Since money has no real interest associated with it -- its main purpose is for spending. Unless prices are falling it does not make a good saving device. In the long-run this money will eventually raise spending. A large injection of money will eventually increase spending at a much faster pace than supply can respond and the difference is inflation. Now this is getting to be as much fun as a colonoscopy. Right?

So it is appropriate to worry that today's government deficits could lead to higher long-term inflation. But many just shrug their shoulders. Why should we care so much about high and rising inflation? There are a lot of answers to this question but the one I want to focus on today is the bout between inflation (Black Trunks) and unemployment (White Trunks). Let's face it -- very few leaders are going to say openly and repeatedly that they want to focus on inflation stability when so many people are unemployed in the USA. Most of these leaders base this PREFERENCE on a so-called TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT. Any policy that would reduce inflation today, according to this trade-off, will reduce the growth of spending, reduce the rate of inflation and raise the number of people unemployed. So -- if you are worried about inflation and you activate a policy to reduce it, then you must "pay for it" with fewer jobs and employment. This is not the stuff of reelection.

Did this piece of trade-off economics come down from on high? Not really. In fact, while the trade-off might exist at times, there are also plenty of times in recent USA history when policy was able to reduce both the inflation and the unemployment rate. There have also been some times when both inflation and unemployment rose. Hmmmm -- so much for a reliable and predictable tradeoff.

What causes the inflation/unemployment tradeoff to vanish at times? Answer -- an active supply-side. The trade-off is totally spending or demand based. But surely the expectations and behaviors of firms matter as they decide how much to produce and at what price to sell. Of course expected demand for computers is important to Dell -- but also of importance to Dell and its competitors is the expected wage, the price of commodity inputs, the level of productivity, tax on healthcare, and many other supply-side factors. Notice that any factor -- policy induced or otherwise -- that will have the impact of increasing business productivity and confidence relative to their business costs will have the interesting effect of reducing the cost per unit produced -- allowing them to produce more without raising prices markedly. Viola. Supply can make the trade-off disappear.

Did you ever believe that an economist would say "you can have your cake and eat it too?" But that is the magic of supply-side economics and supply-side policy. Right now we are faced with policy choices with huge implications. Monetizing the government deficits will have a predictable trade-off that could lead to high and rising inflation. But we have other choices. We know that firms are the ones who create the jobs. It seems very sensible to me that part of our policy arsenal should be devoted to finding ways for them to be permanently more competitive, especially if this frees us from undesirable trade-offs and lets us have our cake and eat it too.

One more point about supply. Letting inflation rise in the next couple of years as we use demand remedies to increase demand and employment is a very risky policy. If the increases in ACTUAL inflation causes a rise in EXPECTED future inflation, then the result will be an adverse supply shift as business costs rise faster than productivity. That will lead to higher unemployment and inflation. The trade-off is a very tricky theory to use. There is a lot more to say on this topic but I think I will leave it right here for the time and see if you post any comments.

Macro Bits and Pieces

As I peruse my usual sources of information I am overwhelmed by the lack of excitement this week. Butler lost to Duke. The healthcare reform vote is over for the time being. Spring is slowly arriving and our neighborhood deer are feasting on new green shoots. We postponed our China finger-wagging. The US and the world economy seems to be generating some momentum and the stock market is making us feel rich enough to maybe purchase an Ipad (whose market entry finally happened).

This is the usual environment surrounding Macro when we aren't in a recession -- ho hum. It isn't easy to get people excited about bits and pieces. But lurking below all this information is a scenario that has both good and not-so-good implications. Two stages usually follow the worst part of the recession -- one (the recovery) in which the declines get smaller and then one in which true expansion takes place. We now appear to be in the expansion phase and we are already seeing tell-tale signs -- including rising commodity prices and increases in interest rates. This is normal. This is expected. This shows that resource slack is declining and we are starting the movement toward normal capacity production. If this continues for a while it will eventually impact labor and employment. Once this occurs the signs of the expansion will be broader and should engender a more optimistic stance from consumers.

So far so good. But now think about your latest battle with the flu -- the bug left your body and you felt stronger so you decided to cook dinner, wash your car, and mow the yard. Hmmm -- you did a bit too much and now you are back in bed. The economy is no different. While the patient is feeling stronger right now -- this won't lead to a lasting recovery until three things happen. First, the disease has to be gone before a full recovery is possible. Note that we still have not done much to resolve the housing or the credit problems that preceded the recession. If excessive use of leverage by private companies and government precipitated the recession, this too needs to be addressed. Second, even with the original disease gone, we have to make sure that we don't overdo the recovery...we don't want to do too much too soon. If the world economy jumps into fifth gear too quickly and oil prices rise to $90+ per barrel or if long-term interest rates, including mortgage rates, jump another 100 basis points -- surely this will negatively impact the pace of economic growth. Third, we have to pay close attention to side-effects of whatever drugs we took. That is, in the past year or two the government spent a lot of money. The Fed emitted a great deal of liquidity into the economy. We now have future prospects of inflation and much larger deficits and debt that must be financed. This means we will have to make collective decisions about the future course of expenditures and taxes.

The point of this post is to emphasize that while the news seems a little boring right now -- there is much to think about and much to do. We should not get lulled to sleep by a nice cup of calming tea. Avoiding a double-dip recession or an extended period of slow growth is possible but it means sticking to the medicine and the right treatments.

New Comment Procedure

With the growth of the blog and the number of comments I was having a very hard time keeping up with and finding your new comments. It seems that the best way for me to keep up and respond in a timely way is to use the permissions option. Now when you post a comment I will receive an email notifying me. I then approve the post. Please understand that this is NOT a means for me to edit or filter your comments. I have no intent to do that -- I welcome all respectfully written comments whether they agree or disagree with me. Note that even without this option, as the author of the blog I have always had the ability to edit/delete your comments and I have never used that option. I hope you had a great weekend. I was away from my computer since Friday morning so I was very inactive this weekend. I hope to get back in the saddle soon.