The Fed Fails to Understand Supply and Demand

Several Fed leaders keep expressing concern about letting go of QE2 and monetary stimulus too soon. One worried that the economy was too fragile to stand an end to QE2. Another said specifically that rising interest rates would put us in a double-dip recession.

Let’s understand a few things. First, banks are sitting on tons of money and not lending it out. Mostly they are buying government bonds. Reversing QE2 means taking that money out of the system that is doing nothing but sitting there. It is like taking away half of your kid’s score of candy on Halloween night. The kid is not going to eat three large grocery sacks of candy. Taking it away does nothing. Second, would an increase in the Fed funds rate from basically zero to 1 or 2 percent really cause tsunami-like ripples in the financial system? Please. You guys gotta be kidding me.  Third, what is this talk about a fragile economy? Check it out. We are growing at 3+% and the recession was over almost two years ago. If the recovery was a golden retriever, the new born puppy would weigh 80 pounds in 2 years. Sure, the economy is not growing fast enough. Sure the economy has some soft spots. But please – 0% interest rates for another year!  Admit it, you are hooked on stimulus and you just can’t get off.

But a bigger point is that these leaders simply are confused and have not learned their lessons of supply and demand. I apologize if I have to use highly technical terms like supply and demand, but I will try to make this as painless as possible. (Go drink two ounces of your favorite alcoholic beverage to prepare for this.)  Now you are ready. 


Here is the key point. It is true that if the Fed made a clear signal that they were going to raise interest rates in the future, some long-term rates might begin to rise by 100 basis points or more. It is also true that higher interest rates might increase the cost of borrowing and might induce some households and business to NOT borrow. If businesses and households do not borrow then they don’t spend and this threatens spending and output and employment. Okay – I get all that. But the truth is that borrowing and spending is not very high anyway. Why? Because both borrowers and lenders are worried about the future. As I said above, banks are sitting on tons of cash and they are NOT LENDING IT because they are worried they won’t be repaid. They are worried it won’t be repaid because these goofy Fed (and Treasury) people keep telling them how weak the economy is.

The problem is what we sometimes called a supply-constrained disequilibrium in the credit market. We don’t have a demand (for loans) problem – we have a supply problem since bankers don’t want to lend out the money. Imagine that Fed and Treasury folks started emphasizing the glass half-full -- i.e.focusing on all the good or positive parts of the economy and the bankers and borrowers became more optimistic about the future. With stronger confidence a credit supply response might be faster and more elastic than a demand increase. In terms of basic supply and demand what you have is a situation in which a renewed confidence causes supply to increase more than the demand – and a fall in the price of credit. If demand increases but supply increases even more – then prices fall! Here is the interpretation in a nutshell in terms of banking and loans:

o   The Fed stops QE because the economy has shown strength

o   Bankers decide to make more loans

o   Spenders borrow more money

o   Interest rates on business and consumer loans fall though in time will begin to rise back to normal historical averages

o   Higher spending leads to more output and employment

But the Fed is afraid to do this right now. They focus on the negative and they spread hand-wringing concern about weakness in the economy. It is no wonder a tightening of money would scare people and lead to a bad result. Your little kid is afraid to learn to swim. Why? Every time he gets near the pool his parents hover and make sure he knows how dangerous it is. The kid won't get near the water..  Some Fed officials need a good dunking in the pool. Only then will the pool party begin.